In 2007, Federal Reserve Chairman Ben Bernanke famously reassured Congress that the deepening crisis in subprime mortgages affected only a small part of the financial system and would be "contained."
We all know how that worked out. By September 2008, the panic had engulfed not only big banks and Wall Street, but also global financial markets. Even blue-chip industrial companies such as IBM and Caterpillar, which had nothing to do with housing or home loans, couldn't borrow money for more than 24 hours at a time. It was as close to financial Armageddon as the world has been.
Financial panics and contagions have many causes. They always begin with real problems, usually ones that have been building for a long time. Bad news on one front begets fear on other fronts. Previously obscure linkages become frighteningly apparent, such as those between Lehman Bros. and money market funds. Hyper-fast trading systems relay new signals in microseconds.
But recent research by Ilan Guttman, assistant professor of accounting at Stanford Graduate School of Business, shines a new light on overlooked contributors: information disclosure and "strategic transparency."
In a draft paper written with Ilan Kremer, professor of finance at Stanford, and Sivan Frenkel, post-doctoral research fellow at Hebrew University, Guttman argues that panicky investor behavior stems, in part, from the heightened reluctance of managers to disclose bad news in times of crisis.
Market analysts have observed for years that volatility and correlation are higher in bear markets than in bull markets. In a down market, for example, investors are more likely to take a piece of news from one company and infer that it applies to others in similar markets.
Why are reactions stronger in bad times than in good? One explanation is that negative shocks make investors more risk-averse in general. A second explanation is the "fire-sale'' effect: investors who take losses in one area may be forced by cash needs to sell other assets at fire-sale prices. Those additional sales may have nothing to do with the investor's actual concerns, but other investors read them as a signal of fear, and follow suit.
Both dynamics were on display during the financial crisis, and they are again now in the European debt crisis.
On June 9, for example, Spain reached agreement with European leaders on a $125 billion [100 billion euro] bailout of Spanish banks. The move should have brought relief to bond investors both about Spain and about the ability of Euro-zone leaders to act decisively. But when markets opened on Monday, the panic simply shifted to Italy. Italy's main stock index plunged, and yields on Italian sovereign debt jumped to the highest level in six months. "There is a permanent risk of contagion," warned Italian Prime Minister Mario Monti.
Guttman thinks there is more to the story than risk aversion and fire sales. After all, investors have to recalibrate risk in bull markets as well as bear markets. Likewise, bull markets create pressures on portfolio managers to bid up asset prices even when the fundamentals haven't changed. What is different about down markets?
Guttman and his colleagues argue that a key missing link is "strategic transparency." By that, they mean the discretion that corporate managers have in deciding what to disclose to the public. Publicly held companies face reams of mandatory disclosure requirements, but they also have discretion about when, whether, and how to release vast amounts of internal information.
In trying to better understand the particular dynamics during times of crisis, the researchers note that managers are inevitably less likely to disclose bad news than good news. As a result, companies generally become less transparent during times of crisis, when bad news is more common.
Investors instinctively know this, of course, and respond accordingly. They presume that a company in troubled times becomes more opaque, and they become more uncertain about its true condition. They also hunt harder and rely more heavily on external sources of information. Those external sources include information disclosed by similar companies, opinions by financial analysts, and fragments of market information. Last, but not least, investors become more sensitive to rumor and speculation.
The upshot is that markets become both more volatile and less discriminating. External information can be tremendously useful, but it is inherently spotty and open to a wide range of interpretation. The more markets rely on it, the more volatile they become. And because some of the most credible information often comes from other companies in the same sector, uncertain investors become increasingly likely to lump all companies in one basket.
Guttman doesn't make a judgment about how much information or how quickly a company should disclose. He cautions that his work is on theoretical models that help explain how decisions about transparency and disclosure interact with markets. In a separate paper with Ilan Kremer and another Stanford colleague, Theodore J. Kreps Professor of Economics Andrzej Skrzypacz, Guttman studied the interactions between the market and firms that privately learn multiple pieces of information over multiple periods. The firms strategically decide on whether, when, and what information to disclose. The researchers' model predicts that companies often get better market reaction when they delay disclosure of a particular piece of news.
The broader point, Guttman says, is that voluntary disclosure decisions can have big, and sometimes surprising, consequences. Until the financial crisis erupted in 2008, many investors thought they had enough diversity in their portfolios to protect them from the mortgage downturn. When the crisis hit in full force, the heavy reliance on external information probably increased the chances that very different companies were suddenly lumped into the same bucket. It's a lesson worth remembering.