Zero Hedge carried a very interesting post on the increasingly opaque debt markets.  Its conclusion:

Yet while passive investing dominates on the upside, or when stocks are rising, what happens when selling commences is a liquidity discontinuity that leads to unprecedented gaps lower as passive investors are unable to discover price once there is demand for actual underlying fundamentals.

Or as I like to say, in the absence of disclosure so investors can know what they own, when a security’s valuation story is called into doubt there is no logical stopping point in its price decline other than zero.

The Zero Hedge post is based on a recent note by TCW’s Chief Investment Officer of Fixed Income, Tad Rivelle.

His comments not only confirm what I have said about the role of transparency as the basis for liquidity in the financial markets, but also the role the lack of transparency (ie, opacity) plays in financial crises.  His note also make the case for the Transparency Label Initiative.

The Debt Markets Have Already Gone (Mostly) Dark

If democracy dies in darkness, so does liquidity in that embodiment of economic democracy, i.e., the capital markets. When information is scarce, investors must color in between the lines. That which is not known nor well quantified must be assumed or modeled. The door is therefore open to different investors reaching quite different conclusions about the underlying value of an asset leading, of course, to illiquidity.

Sounds exactly like what happened when investors were buying subprime mortgage-backed securities in the run-up to the 2007 Great Financial Crisis.  The opacity of these securities required investors to “color in between the lines” by making a ton of assumptions to plug into their models.

When the underlying assumptions were called into doubt, the market for these securities froze (the extreme of illiquidity).

Please note, just like the run-up to the financial crisis, there has to be a justification for blindly betting on these securities.  And just like pre-2007 the justification is the search for yield driven by central bank policy.

More so perhaps than any other in history, this cycle is the wellspring of the theories and actions of the central bankers who, in their infinite wisdom, determined that they could model interest rates better than markets could price them. Central banks have flooded the system with what they call “liquidity” but which are actually nothing more–nor less–than electronically conjured “loanable funds.” Under the banner of “doing whatever it takes,” trillions in loanable funds were created so that now $17 trillion in global debt is priced to yield less than nothing.

So what toxic side effect results from central banks “doing whatever it takes”?

The magic trick of inverting economic logic with negative rates results from the capacity of the central banks to create unlimited quantities of loanable funds at no cost. Trouble is, while loanable funds can be created without limit, the things that can be purchased with these funds is finite. But, “free money” not only makes loans cheap, it also erodes the capacity of lenders to ask for such reasonable terms as traditional loan covenants and basic financial disclosure.

Central bank policy undermines the ability of investors to make borrowers disclose the information investors need in order to know what they own.

This is an incredibly important point.

Borrowers know they should asked for financial disclosure.  They relearned this lesson the hard way by losing hundreds of billions of dollars on subprime mortgage related securities.

However, investors are not in a position to force it to happen as a result of two factors.

First, issuers do not need every investor to buy their securities. They only need investors who are willing to Trust the valuation story told about their securities without Verifying if the story is true or not.

Second, central bank policy for the last decade has effectively pushed investors into searching for yield.  The price investors have to pay for getting yield in the short term is giving up asking for disclosure.  Of course, like the subprime securities, over the longer term these opaque securities are likely to deliver capital losses well in excess of any yield investors get over the short term.

This central bank driven search for yield has driven a stake through the heart of our financial markets.  Trust, but Verify is a casualty of central bank policy as getting any yield requires blindly betting.

Mr. Rivelle goes on to describe just how bad the damage has been to the capital markets.

Traditionally, leveraged borrowers had this choice: borrow in the high yield bond market and live by the disclosure and reporting standards of the public debt markets. In the alternative, if management preferred to adhere to a lesser standard of disclosure, the company could issue in the (private) loan market and subject itself to a battery of covenants designed to limit the ability of management to engage in risky or lender unfriendly actions. Thanks to the central banks, borrowers this cycle no longer had to choose: they could obtain cheap loans without agreeing to restrictive covenants nor providing on-going financial disclosure.

Hence, not only have the debt markets ballooned in size, but the growth has come disproportionately from those segments of the debt market where financial disclosure is poor:

According to Mr. Rivelle, we now have over $3 trillion in opaque debt securities.

$3 Trillion!!!!

What could possibly go wrong when there are $3 trillion in opaque debt securities (and by the way, this doesn’t include securities issued by the opaque banks)?

While a paucity of financial disclosure is not problematic during a bull market for credit, it is a defining feature of a liquidity crisis during a bear market. Human beings are naturally inclined towards fear–even panic–when they are unable to obtain the information they deem critical to their (financial) survival.

Just what we saw in 2008 when the credit markets froze along the opacity fault line in the global financial system.  Then, investors panicked when they were “unable to obtain the information they [deemed] critical to their (financial) survival.”

It isn’t that the investors didn’t ask for the information in 2008.  Issuers and Wall Street refused to provide the information.

Finally, imagine a mechanism by which the providers of the money to buy debt securities could know when they would be blindly betting on opaque debt securities.  It would have a profound positive impact.

The existence of this mechanism would immediately shrink the pool of available investors for these opaque debt securities.  After all, there is no reason pension funds, sovereign wealth funds, insurance companies or endowments should buy an opaque debt security.  Once these institutional investors are removed from the market, do you think there would still be a market for $3 trillion in opaque debt securities?

This mechanism is the Transparency Label Initiative’s label.  The Initiative only awards labels to securities that provide the disclosure investors need to know what they own.  None of these opaque debt securities would get a label.  The absence of the label lets the providers of the money know buying these securities would be blindly betting.