Why Full Disclosure in Securities Markets May Not Fix Finance
Yes, there is greed on Wall Street and most likely on your street too, but if we collectively attribute the current financial crisis to "devious intent," we may be condemned to relive it.
That's the opinion of Bengt Holmstrom, a 1978 PhD alumnus of the Stanford Graduate School of Business who is currently the Paul A. Samuelson Professor of Economics at MIT, the first Sheila and Mark Wolfson Fellow at Stanford's Institute for Economic Policy Research, and a member of the governing board of Nokia.
Some economists attribute the financial crisis to Wall Street bankers setting up a shadow banking system that intentionally provided investors with "false substitutes" for old-fashioned bank deposits. Holmstrom argues the bankers created securitized products from mortgages and other types of consumer loans that were valuable both to their investors and society as a whole.
Creating these asset-backed securities "was a perfectly sensible thing to do. No greed was necessary," he said on a recent day in his Stanford office as he prepared for a seminar. The crisis was caused not by unworthy underlying investments but by the fact that individual sellers and buyers don't watch out for the system as a whole.
"People say securitization is alchemy. That’s nonsense," Holmstrom said. "It's like if you have a thousand cows whose milk is very thin, you can still get plenty of cream by just making sure you take out the cream from the thousand. If you have mortgages that default 50 percent of the time, you put them in a bag with others that don't default and you will have some triple-A rated securities, because you will have money coming in unless the defaults on mortgages are perfectly correlated.
"The one thing you can criticize, in my view, is that [financial system regulators] should always be cautious when something is growing exceptionally fast, and the shadow banking system grew very fast."
Individual private banks, he said, may monitor their own risks by watching “how many drops they put into the systemic risk bucket,” but they don’t consider the social cost of the bucket running over its brim. For that reason, he said, “I am for reforms to provide some degree of transparency in asset-backed security markets.” But he added there are alternatives to complete public transparency, such as clearinghouses and behind-the-scenes stress tests on banks by regulators. Complete transparency only may push people to other nontransparent markets because there are good reasons why people want “information insensitive” or opaque markets.
Holmstrom says economists still don't fully understand the deeper causes of the crisis. They know that some investors lost their trust in the securitized assets, which eventually triggered a sudden run on the shadow banking system. Bank runs on commercial banks in the United States had ended after the Great Depression with the creation of federal deposit insurance. So why did the shadow banking system without this insurance grow so fast?
"The answer in part is that because of globalization, there were significant cash imbalances between countries," Holmstrom said. The Chinese and Eastern European governments, even corporations with billion-dollar surpluses, "looked for safe, relatively liquid places to put their money. Presumably they felt they might need the money soon, and you could get your money out of these investments fast and safely." The regular banking system was less useful because of the $250,000 cap on insurance.
Perhaps U.S. housing market securities became the cash "parking space" of choice, he said, because of American policies that in various ways encouraged people to buy homes. Also, the U.S. financial services industry had figured out how to transform such a long-term investment as a house into one so liquid that a lender could get his or her money out, like a demand deposit, at seemingly non-existent risk by using repurchase agreements.
In a repurchase agreement, party A buys a security from party B at a price below the market price. At the same time party B agrees to buy back the security on a future date, often overnight, for a pre-determined higher price. The two transactions look much like a securitized loan, Holmstrom said, but if a secured loan defaults, party A would have to wait for a bankruptcy court to award him something along with other claimants. In repo transactions, party A owns the security and can immediately sell if B cannot buy it back.
"The repo market seemed to be deposit insurance for people with hundreds of millions to invest. It gave strong protection," he said, and "it scaled, unlike regular banking that relies on small depositors." It therefore grew to "$12 trillion with some double counting over the course of two decades."
Withdrawal of large deposits, of course, is where the system begins to unravel. "If Goldman Sachs pulls out, everybody will know they took their cards and left the table. That's the danger of this high-stakes game," he said. "The ability to sell a security depends on not everyone wanting to do it at the same time."
While some economists advocate total revelation of information on the assets within a security, Holmstrom doubts full transparency will work because buyers and sellers seek investments where they don't need the time and money to fully analyze information. He points to research by George Akerlof on "lemons" for which Akerlof was awarded the Nobel Prize. In used car auctions, Akerlof showed that people are more willing to bid and will pay more if there is no time to examine the cars beforehand. They fear they will be stuck with a lemon because others with more knowledge will bid on the better cars.
"It sounds very trivial, but it has profound implications for markets," Holmstrom said. "It even happens in fruit markets. If you come late in the morning and you know the bags of fruit were inspected by other buyers, you ask, 'Why are these bags left?' That's why I think it's a knee-jerk reaction for people to say we should have full transparency.”
In a lecture to Stanford economists and Silicon Valley business leaders on Tax Day, Holmstrom was asked to compare his views on transparency to those of Nobel economist Joseph Stiglitz.
"Joe is right that we need to do something about it," Holmstrom said. "But we need to think about it in the right way in order to know what we should do about it. … I'm saying that private agents will not make it transparent, and there is a role for government, but they better understand that there's a good reason why private agents don't do it, or they will not find the right way" to fix the problem.