Nobel Prize Winner Wants You to Stop Treating Bonds Like Stocks
Ignorance is not just bliss. It's a necessary, structural feature of money markets.
That's the counterintuitive conclusion from Nobel Prize winner, Bengt Holmstrom, who was yesterday announced one of 2016's two economic laureates. It appears in a paper that the Massachusetts Institute of Technology professor delivered at the Bank for International Settlements's 2014 conference and published last year.
It's worth revisiting at a time when major central banks' easy monetary policies are helping bonds behave more and more like stocks — analysts at Deutsche Bank AG wrote last month of a "historic switching of roles" between the two asset classes, with investors now buying equities for income and debt securities for capital gain.
Holmstrom's paper serves as a reminder of the perilous consequences of actually treating them the same. Specifically, he cautions against imposing the transparency requirements on debt markets that are more commonly expected of equities.
"I will argue that 'no questions asked' is the hallmark of money market liquidity; that this is the way money markets are supposed to look when they are functioning well," he writes. Attempts to reform credit markets based on insights gleaned from equity markets "can be very misleading" the economist says — and worse, they can stoke the crises that they're trying to prevent.
A defense of obfuscation may sound unpalatable given the long shadows cast by the financial crisis, yet imposing transparency requirements on debt markets may make panics more likely, Holmstrom says. Information scarcity is not an attempt to hoodwink banks' clients — or, at least, it's not intended as such — but rather promotes liquidity in the bond market.
"People often assume that liquidity requires transparency, but this is a misunderstanding," he argues. "What is required for liquidity is symmetric information about the payoff of the security that is being traded so that adverse selection does not impair the market."
The economist makes an analogy between repurchase markets known as 'repo,' in which banks and other investors secure short-term financing against their assets, and pawn shops, which form a millennia-old forum for the collateralization of debt:
"The borrower brings to the pawn shop items against which a loan is extended. The pawn shop keeps the items in custody for a relatively short (negotiable) term, say one month, during which the borrower can get back the item in return for repayment of the loan. It sounds simple, but it is a beautiful solution to a complex problem. The beauty lies in the fact that collateralised lending obviates the need to discover the exact price of the collateral. A person that runs into a liquidity problem can sell an asset, a watch say, but selling the watch requires that an agreeable price be established. There may be a market for used watches, but it is unlikely to be very efficient at price discovery. If the watch is unique the price would have to be negotiated in bilateral bargaining. It may be costly to come to an agreement. And the highest value user of the watch could be the owner, so a sale will imply a potentially large liquidation loss or there may be no trade. The dilemma is solved by pawning the watch. In that case the parties do not have to agree on the value of the watch. The right to redeem the watch at the same price at a later date, hopefully when the borrower’s liquidity problem has passed, reduces bargaining costs. The information needed to reach an agreement on the price of the watch (the loan) is relatively small. The broker will offer a price that entails a big enough haircut so that she can recover her money by selling the watch if the owner does not come to redeem it. A safe lower bound is all that is needed. There is no price discovery in the sense that the price is close to what the watch would fetch in an arms-length bargaining process."
Just as information isn't a necessary component of debt markets, it may not be a desirable one, Holmstrom says. Still, he acknowledges there is an inherent danger to the logic of money markets: "If their liquidity relies on no or few questions being asked, how will one deal with the systemic risks that build up because of too little information?," he asks.
And while Halstrom warns against the post-crisis shift towards transparency, he also notes that the debt market has already been moving in that direction in one important way.
"The growing enthusiasm for covered bonds could be a harbinger of what lies ahead," he says, referring to the increasing popularity of centuries-old debt securities that involve banks selling debt that comes with an extra cushion of protection and whose cash flows and beefed-up collateral pools are typically well-shared with investors. While such debt became an important source of funding — particularly for European banks during the region's debt crisis — it also "eats into the fabric of traditional banking; the remaining collateral that backs up unsecured depositors is poorer."
In short, transparency in debt markets comes with a cost that may not yet be fully appreciated.
The paper is here and worth reading in full for its insights on the necessary vagueness of credit ratings, the huge disparity in the volume of equity research compared with bond-market analysis, and the reasons why European Central Bank President Mario Draghi's "whatever it takes" only works if it's as unspecific than that.