In an excerpt from his book on how he saved the global financial system, Ben Bernanke observed in talking about the opaque securities Wall Street created:
Complexity reduced the ability of investors to independently judge the structured products’ quality. Some potential purchasers insisted on more information and greater transparency, but most took the easy way and relied instead on the credit ratings.
Those potential purchasers who insisted on more information and greater transparency didn’t buy Wall Street’s structured products. Complexity wasn’t there just to reduce the ability of investors to independently judge the structured products’ quality. Complexity was there to prevent investors from independently judging the structured products’ quality. These securities were deliberately designed to be opaque and providing transparency so investors could know what they owned would have defeated this intentional design.
Why were the structured products designed to be opaque? Financial incentives. Wall Street has known since the 1920s that its profit margins on the initial sale of opaque securities are dramatically higher than on transparent securities.
So if the investors who insisted on knowing what they owned didn’t buy Wall Street’s structured products, who did? Asset managers whose salary and bonus depended on buying these opaque products.
Bernanke observes in the absence of being able to do their own due diligence, these asset managers instead relied on credit ratings. This was not surprising. The rating firms’ core business model is based on their having access to material non-public information (companies routinely provide this information when meeting with the rating firms) and the idea this information is subsequently reflected in their ratings.
Wall Street understood this model didn’t apply when it came to its structured products. But the myth the model applied certainly made it easier to tell the story the valuation of these opaque securities could be based on their ratings. This in turn, made it easier for asset managers to raise money by telling investors they were experts in assessing the valuation and risk of these securities.
The asset managers who relied on the rating firms came in for a rude surprise when the rating firms told Congress in the fall of 2007 when it came to Wall Street’s structured products they did not have any more information than the asset managers did.
As Bernanke observed,
When AAA-rated securities that contained subprime mortgages began to go bad, those investors did not have their own analysis to fall back on. Contagion reared its ugly head. Just as depositors in 1907 ran on any bank with a whiff of a connection to the bankrupt stock speculators, investors a century later pulled back en masse from any structured credit product that might carry the subprime virus.
Regular readers will immediately recognize Bernanke’s observation as exactly what the Information Matrix says will happen when the valuation story for opaque securities is called into doubt. In the absence of the disclosure necessary to know what you own, there is no logical stopping point in the decline in the opaque securities’ value other than zero. Investors know this and naturally run as soon as the valuation story is called into doubt.
Wall Street’s structured products all belong in the Blind Betting quadrant of the Information Matrix.
|Does Seller Know What They Are Selling?|
|Does Buyer Know What They are Buying?||Yes||No|
|Yes||Perfect Information||Antique Dealer Problem|
|No||Lemon Problem||Blind Betting|
A reason for the Transparency Label Initiative is to highlight which securities are in the Blind Betting quadrant. This gives investors the ability to limit their exposure to opaque securities regardless of the securities’ rating.