Monday, June 1, 2015

Debt: The Virtues and Risks of Opacity

It's fairly straightforward to list the events leading up to the Great Recession of 2007-2009, and to argue which events had greater or lesser importance. Perhaps not surprisingly, such arguments tend to mirror the political beliefs already held before the recession: that is, those who favored more regulation in 2000 or 2005 tend to believe that lack of regulation set the stage for the Great Recession, while those who think government actions and guarantees often work out badly tend to believe that earlier government actions were the main cause. But a step behind this kind of partisan infighting, economists are struggling to enunciate the deeper economic lessons of what went  wrong.
Bengt Holmstrom offers a notable contribution along these lines in "Understanding the role of debt in the financial system," published as a Bank of International Settlements working paper (#479) in January 2015.

As a starting point, Holmstrom raises this question: "How could Wall Street trade in securities that they knew so little about? Why did no one ask questions?"

It's of course easy to point out that some folks in the financial industry have a profit motive to be obscure and opaque about risks involved. But that set of incentives has been true for a long time. A usual assumption is that other folks in the financial industry are drilling down into complicated financial deals. Thus, even though some folks are fooled some of the time, a combination of hard-headed investigation, legal and regulatory requirements for disclosure, and people who care about their reputation will tend to keep such behavior in check.

Notice that this explanation of how financial markets function relies on availability of information and on detailed arguments and analysis about that information. Holmstrom offers a much different answer. His argument is that healthy debt market function best, most of the time, with a high degree of opacity and a "no questions asked" mindset. In making this argument, Holmstrom draws a sharp contrast between the functioning of stock markets and "money markets"--which are markets for short-term borrowing and lending, where the loans are often backed by a high level of collateral. Holmstrom offers this table as a framework for discussion, contrasting the functions of stock markets and money markets, and arguing that intuition about stock market doesn't work well when applied to money markets.
For example, stock market most of the time are not a way for most firms to obtain funding. When one party buys or sells a share of stock, the firm doesn't get the money. Even when the original owners of a company sell stock in an initial public offering, a large part of the motivation is so that the owners can share the risk of financing the company in the future, rather than bear that risk themselves. Stock markets are famously sensitive to new information, with stock prices bouncing up and down based on news affecting the company and quarterly income reports. But debt markets are mostly not very sensitive to  specific information about a company, unless the company is actually likely to go broke. Most of the time, the reasonable working assumption is that short-term debt will be repaid. As long as the firm has posted collateral, there is little need to investigate further. Thus, stock markets are characterized by legions of analysts drawing up financial projections of future earnings and crunching the data under various scenarios. Debt markets have comparative modest investments. Stock market have many traders on exchanges; debt market operate with relatively few.

The last two characteristics in the table may be a bit counterintuitive, but they cut close to the heart of the issue. Even though stock markets tend to have more information and investigation, they are not usually very urgent. If you think a stock is a great buy today, most of the time the odds are it will still be a great buy in a few days or a week. But short-term borrowing is different, because it often involves rolling over past borrowing. If a bank or firm has been rolling over large amounts of short-term borrowing for months or years, and suddenly finds that it cannot do so, the shock to that organization is large--even conceivably fatal. The volumes traded in stock markets can bounce around, but the volumes trade in short-term debt markets are usually pretty stable, and a working definition of a financial crisis is when many actors in the economy suffer a sudden inability to borrow in the short-term markets.

With this dichotomy in mind, a set of fundamental economic tradeoffs that reach beyond the details of the 2007-2009 start to become clear. Most of the time, Holmstrom argues, short-term debt markets function so well precisely because they are somewhat opaque and insensitive to information. As he writes; "The quiet, liquid state is hugely valuable."

A financial crisis arises when those in the financial sector begin to raise questions and to demand information about  short-run debt, and to start trying to separate worthy and unworthy borrowers. Holmstrom writes ( citations omitted):
Panics always involve debt. Panics happen when information-insensitive debt (or banks) turns into information-sensitive debt ... A regime shift occurs from a state where no one feels the need to ask detailed questions, to a state where there is enough uncertainty that some of the investors begin to ask questions about the underlying collateral and others get concerned about the possibility. ... These events are cataclysmic precisely because the liquidity of debt rested on over-collateralisation and trust rather than a precise evaluation of values. Investors are suddenly in the position of equity holders looking for information, but without a market for price discovery. Private information becomes relevant, shattering the shared understanding and beliefs on which liquidity rested ...
Holmstrom points out that when a financial panic arises, the answer is often not more information, but instead persuading markets that they don't need additional information. For example, in the aftermath of the US recession, the policies that calmed the financial markets in 2009 didn't involve going to through all the collateralized debt obligation securities backed by subprime mortgages and trying to figure out how much each one was really worth, and which financial institutions had exposure to losses. Instead, it was to require that banks hold more capital and face "stress tests" to create confidence that they would be able to withstand future problems. As Holmstrom write, the idea was "getting us back to the liquid, no-questions-asked state."

Or in the financial problems over the last few years involving the euro and the EU debt markets, a major turning point happened in July 2012 when Mario Draghi, president of the European Central Bank, said in a prominent speech: "the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." As Holmstrom comments on this episode:
This is as opaque a statement as one can make. There were no specifics on how calm would be re-established, but the lack of specific information is, in the logic presented here, a key element in the effectiveness of the message. So was the  knowledge that Germany stood behind the message – an implicit guarantee that told the markets that there would be enough collateral, but not precisely how much. A detailed, transparent plan to get out of the crisis, including rescue funds, which were already there, might have invited differences in opinion instead of leading to a convergence in views. Explicit numbers can be put into spreadsheets and expertise and ingenuity can be applied to evaluate future scenarios. “Whatever it takes” cannot be put into a spread sheet and therefore promotes liquidity of the “symmetric ignorance” variety.
The policy implications of this view are still being thought through, but Holmstrom offers some preliminary thoughts. Higher capital requirements and more frequent regulatory "stress tests" are useful, because they offer a general reassurance that short-term debt markets are fundamentally sound. If and when a panic arises, the goal should be to recapitalize financial  institutions, again to offer reassurance that financial markets are fundamentally sound. There is a lot of room for discussion of the details of how these policies should be enacted. But it helps to enunciate the fundamental tradeoff of debt markets, as Holmstrom describes it: 
"I have explained why money markets function the way they do and that most of it makes perfect sense. ... But as the unpleasant trade-off emphasised, there is a danger in the logic of money markets: if their liquidity relies on no or few questions being asked, how will one deal with the systemic risks that build up because of too little information and the weak incentives to be concerned about panics. I think the answer will have to rest on over-collateralisation, stress tests and other forms of monitoring banks and bank-like institutions. But my first priority has been to exposit the current logic and hope that it will be useful for the big question about systemic risk as we move forward."