Have asset managers told investors (the people and firms who actually put up the money) they have blindly bet the investors’ money on $3+ trillion in opaque debt securities?

Thanks to TCW’s Tad Rivelle, its Chief Investment Officer of Fixed Income, we know asset managers are aware of the size of the market for opaque debt securities.  He summarized the blind bets as follows:

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:

That is over $3 trillion in opaque debt securities that do not disclose the fundamental information needed for asset managers or investors to know what they own.

Which raises the interesting question of “did the investors’ knowingly approve of the asset managers blindly betting their money?”.

I would bet not!

Why?

It isn’t in any asset manager’s self-interest to admit to blind betting.  What asset managers have offer is their “expertise”.  This is true regardless of whether the asset manager works internally for the firm putting up the money to invest (think insurance company) or works for an asset management firm like TCW.  Saying you are blindly betting and relying on luck doesn’t sound much like expertise.  And while truthful, it would be extremely career limiting.

So asset managers sell investors on their expertise and past performance while neglecting to inform investors they are blindly betting the investors’ money.  As a result, investors don’t know how much of their money is being blindly bet.

I suspect the amount investors would be willing to blindly bet is decidedly less than $3+ trillion blindly bet on these opaque debt securities.

Why?

Getting a 5% return for a blind bet where you can lose 100% of your money doesn’t sound like an attractive risk/return proposition.  I would think for the risk of losing everything, investors would want a potential 20+% return.

I would also bet investors are unaware that every time an asset manager like TCW buys one of these opaque debt securities it is doing so based on a series of assumptions about what should be knowable facts.

When information is scarce, investors [or their asset managers like TCW] 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 …

Opacity means asset managers cannot Trust, but Verify the valuation story told about the opaque debt securities.  Rather, asset managers must Trust the story and then make a series of assumptions to confirm the story.  If the asset manager’s assumptions confirm the story, then they blindly bet the investors money by buying the opaque debt security.

Here is the problem with this approach.

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.

Shorter, investors (and not their asset managers) in these opaque securities lost $100s of billions during the Great Financial Crisis when it turned out the assumptions used to confirm the valuation story were wrong.

As Mr. Rivelle points out, with a bear market we are likely to get a repeat of the 2007 Financial Crisis and the 2008 Banking Crash as the market for opaque securities freezes.

---

I would like to thank Mr. Rivelle for a) confirming the existence of the Blind Betting quadrant of the Information Matrix and b) confirming securities in this quadrant make up a sizable portion of the financial markets.

Regular readers are familiar with the Information Matrix.

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

The $3+ Trillion dollars of opaque debt securities fall into the Blind Betting quadrant.  In the secondary market, neither the buyer or the seller has the fundamental information they need to value the security.  So the act of buying or selling is purely blind betting.

Up until now, PhD Economists have dismissed the existence of the Blind Betting quadrant by saying the amount of securities in the quadrant isn’t significant.  In the US alone, this quadrant is significant as it contains $3+ Trillion dollars of debt securities and this is before we add in the securities from opaque issuers like the Too Big to Fail Banks.

Finally, it is very rare for an asset manager to admit he and his firm purchase opaque securities.  In 2007/2008, the asset managers who purchased subprime mortgage-backed securities and their related derivatives insisted they had adequate disclosure.  They did so even after BNP Paribas suspended withdrawals from three funds saying it could not value this opaque securities.  They did so even after the market for these securities froze.