According to David Warsh, a former Boston Globe columnist and now blogger, in August 2008 Bengt Holmström, a Nobel prize winning MIT Economics professor, created a false narrative that has plagued the Economics profession to this day.  His narrative:

opacity, not transparency, was a market’s friend.

That is quite the narrative isn’t it.

Where in the Information Matrix does Professor Holmström’s narrative say transactions should take place for the best possible outcome?

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

If opacity is the market’s friend, then the best quadrant for transactions to take place in must be the Blind Betting quadrant.

Hmmmm……  You and I might disagree.  We would begin by realizing it is hard enough to make a good investment decision when you have the facts. Without the facts, you and I know we would be relying on pure luck to make a good investment. So if you or I were building a financial system, what quadrant would we want most of the transactions to take place in?  The Perfect Information quadrant.

This just happens to be the same quadrant chosen by the FDR Administration when it redesigned the financial system during the Great Depression (a redesign subsequently adopted in many other countries).  It created the SEC to ensure every publicly traded security disclosed the information necessary so an investor could know what they owned.

This also just happens to be the quadrant where the standard Economic models involving the Invisible Hand and the best allocation of resources work.  After all, there is no reason to think that blind betting yields the same positive results as informed decision making.

However, if you are a Nobel prize winning economist, you get to build your own narrative around the Blind Betting quadrant. Naturally, you are helped in this endeavor by many other economists.  Mr. Warsh summarized the narrative as:

But some markets, Holmström said, actually depended on the opposite of transparency, opacity, or at least the assumption that information was symmetric, that in them nobody knew more than everybody else….

Perhaps trading in money markets was based on low information because no one had time to make detailed evaluations.

I like to refer to “no one had time to make detailed evaluations” as the investors are too lazy assumption.  The assumption is the Achilles’ Heel of the entire narrative.  There is zero proof the assumption is true.  There is overwhelming evidence showing it isn’t true.

But I am getting ahead of myself in my story.  How did Professor Holmström find himself in a position to propose this narrative?  According to Mr. Warsh:

in August 2008, a historian of banking Gary Gorton, of Yale University’s School of Management, gave a detailed account to the annual gathering of central bankers in Jackson Hole, Wyoming, of an apparently short-lived panic in certain obscure markets for mortgage debt that had occurred in August the year before. Bengt Holmström, of the Massachusetts Institute of Technology, a theorist, discussed Gorton’s 90-page paper. Gorton warned that panic was on-going; it hadn’t ended yet.

“We have known for a long time that the banking system is metamorphosing into an off-balance-sheet and derivatives world,” he told the audience.  The 2007 run had started on off-balance-sheet vehicles and led to a scramble for cash.  As with earlier panics, “the problem at the root was a lack of information”; the remedy must be more transparency. In his discussion, Holmström zeroed in on the opposite possibility.  Perhaps the information in the market was too much.  Sometimes, Holmström observed, opacity, not transparency, was a market’s friend.

Wall Street’s Opacity Protection Team doesn’t need any help, but there was Professor Holmström lending a strong supporting hand.

Regular readers know I have debunked Professor Gorton’s work at length because of the contortions he has to engage in over the assumption investors are too lazy to evaluate the risk of their investments.  This is the first time anyone has suggested he actually had the same narrative for the financial crisis as the Information Matrix and that he abandoned it.  Why did he abandon the idea the remedy for a lack of information must be more transparency?  Because Professor Holmström suggested there was already too much information!

Let’s quickly debunk the myth of too much information.  Consider an example where you and I might think there is too much information:  Bank of America disclosing all of its current exposure details.  You and I could not assess this data by ourselves.  However, there is no law preventing us or any other investor from turning to an expert for help.  In fact, the entire asset management industry exists to provide this help.  In our search for experts, we expect experts like JP Morgan or Citi would be capable of assessing all this data.  If not, the problem isn’t with transparency, the problem lies in the size of Bank of America.  It needs to be reduced in size until experts can assess all of its current exposure details.

There is nothing to suggest the asset-backed securities Professor Gorton was talking about disclosed so much data the experts were overwhelmed.  In fact, his research show they didn’t provide enough.

Gorton and Holmström quickly agreed upon the salience of Holmström’s surmise: it was entirely counterintuitive, but perhaps opacity, not transparency, was intended by the sellers of debt, banks and structured investment vehicles, and welcomed by the institutional investors who were the purchasers, in each case for legitimate reasons.

Clearly, the sellers wanted the debt to be opaque.  They know if investors cannot assess the risk of the debt, investors cannot properly price it.  But why would investors who were putting their money at risk welcome opacity and the risk of buying a security that wasn’t worth nearly as much as Wall Street’s valuation story suggested its value to be?

Perhaps the new-fangled asset-backed securities that served as collateral in the wholesale banking system, which soon would be discovered to be at the center of the crisis, had been deliberately designed to be hard to parse, not in order to deceive, but for the opposite reason:  to make it more difficult for knowledgeable insiders to take advantage of the less well-informed.

Wow!  I don’t want to spend too much time debunking this incredibly flawed reasoning.  I would simply point out there is no reason to expect this to work in practice.  As demonstrated by Goldman Sach’s Abacus deal, it didn’t work in practice.  As a knowledgeable insider about subprime mortgages, Goldman created an asset-backed security specifically to take advantage of the less well-informed investors.

With the passage of more time, Professor Holmström refined his narrative.

Stock markets existed to elicit information for the purpose of efficiently allocating risk. Money markets thrived on suppressing information in order to preserve the usefulness of bank money used in transactions and as a store of value.  Price discovery was the universal rule in one realm; an attitude of “no questions asked” in the other…. Serious mistakes would arise from applying the logic of one system to the other. He wrote,

This new view of the role of opacity in banking and debt is truly something new under the sun. One of the oldest forms of derision in finance involves dismissing as clueless those who don’t know the difference between a stock and a bond.   Stocks are equity, a share of ownership.  Their value fluctuates and may drop to zero, while bonds or bank deposits are a form of debt, an IOU, a promise to repay a fixed amount.

That economists themselves had, until now, missed the more fundamental difference – stocks are designed to be transparent, bonds seek to be opaque — is humbling, or at least it should be.  But the awareness of that difference is also downright exciting to those who do economics for a living, especially the young.

As I said, Wall Street doesn’t need help in its desire to sell high margin opaque securities. Lead by these two professors, it was getting plenty of help from the Economics profession.  And no place is this more true than the idea stocks are designed to be transparent, bonds seek to be opaque.

Let me start to debunk this notion by pointing out the existence of two types of investment analysts:  equity (aka stocks) and fixed income (aka bonds and money market securities like commercial paper).  Then let me point out a company like IBM issues both equity and fixed income securities.  Finally, let me point out there is nothing that stops a fixed income analyst from accessing the disclosure “transparency” equity analysts have.   Hmmm…. IBM’s fixed income securities don’t look that opaque after all and it is very clear price discovery operates for these securities.

Ok, the two professors weren’t looking at the IBMs of the world, they were instead focused on asset-backed securities.  Who would have wanted these securities to be opaque?  Wall Street and only Wall Street.

Given the easy access to experts, there is no reason an investor would want these securities to be opaque.

The professors go on to try to build their argument not on bonds, but on money market securities.  By definition, these are securities that mature in 90 days or less.  Investors in these instruments are looking primarily for capital preservation with a return slightly above treasury bills.

I want to focus on the investors’ primary interest in capital preservation.

If you were a corporate treasure seeking to preserve capital, would you put your job at risk by blindly betting on an opaque financial security created by Wall Street?

Didn’t think so, but then, you aren’t the two economic professors and their followers in the Economics profession.

If the professors and their followers cared to look, they could find plenty of fixed income analysts assessing money market securities at firms like Fidelity Investments or Vanguard.  Heck, they might even think the analysts at rating firms did this because these firms claimed to have the information necessary to assess the risk of these securities.  But looking for the experts doing the analysis investors relied on would undermine their narrative.

Finally, a reason this narrative gained traction is the Economics profession doesn’t have an explanation for the Great Financial Crisis.  The Queen of England famously asked why the Economics profession hadn’t seen it coming.  In the absence of the Information Matrix crisis narrative (the problem was a lack of transparency; the solution was more information), the Economics profession has been casting about for a story to tell.  The Economic professors supplied a fundamentally flawed narrative that satisfied the Economic profession’s lazy uncritical demand.

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In support of his narrative opacity is a market’s friend, Professor Holmström