Sunday, 21 August 2011

Information-Insensitive Debt: An Unnatural Concept, For Starters

Now for Part 2 on Gary Gorton’s theory of "information-insensitive debt" in which we continue to study the question, "Is it a bad thing or is it a really bad thing?" :)



One big problem: the concept happens to be quite unnatural.



Fiat currency is probably the best example of information-insensitive debt, but it's essentially a trivial, artificial case. Retail banking deposits also qualify as a good example, but they're something different: a special case. Exactly how they're special is important to understand.



WHAT MAKES BANKING DEPOSITS REALLY, REALLY SAFE?



Gorton likes to illustrate the information insensitivity of retail banking deposits by using an example involving a check. Let's say I write a check for a $14 haircut. That piece of paper isn't worth $13.89 or $14.05 to my barber. It's worth exactly $14.



Likewise, if I go directly to my bank instead to withdraw that $14, I can be sure of getting the full amount, even if my bank is Lehman Brothers Savings Inc. and everyone's glumly packing their desk contents into boxes when I arrive. The FDIC insures my deposits up to $250,000. I can breathe easily.



So it doesn't behoove me, or anyone I trade with, to spend time investigating the financial soundness of my bank. No matter what terrible information surfaces about that bank, my deposits are covered.



See a problem already? The debt isn't naturally insensitive to information. It achieves this property by being insured. But the value of anything -- your collection of Pokemon cards or seashells -- can become information insensitive if insured. So, becoming information insensitive this way feels like cheating a bit.



That leaves the tantalizing question: which debt is naturally information insensitive?



None of it, really. On its face, the phrase is oxymoronic, like “jumbo shrimp.” (Note: Gorton parses the term in a special way, which we'll look at later.)



DEBT IN THE WILD IS NATURALLY SENSITIVE TO INFORMATION



Pretty much all debt in its natural state is information sensitive. Markets trade on this information. Some is public. Some is private (e.g., a stock price spikes right before a merger announcement, as the news leaks out). Much information arguably occupies a gray area between public and private. Is private analysis of public data showing that a bond is undervalued private or public information?



Even fear and wild speculation is information of a sort. Say there's a rumor that a neutron bomb will be detonated in Microsoft's main cafeteria tomorrow, based on absolutely nothing. If enough stupid investors believe it (ever hear the phrase "dumb money"?), they may sell their bond holdings in the software giant. Information about this crazy rumor will prompt a smart trader to jump in, scoop up Microsoft debt, and score a neat profit when the price rebounds.



A smart theory would posit that just about all debt is information sensitive. The theory might make an argument that there are varying degrees of sensitivity, and that a particular instance of debt lies on a continuum between very information sensitive and not-that-information sensitive. Okay, fine -- that would at least be nuanced and cautious. But instead, in Gorton's world, we get debt that is either "information insensitive" or "information sensitive" -- and of course debt that lurches from the former to the latter during a financial panic, as if undergoing a change of phase, like ice to water.



SO WHY SHOULD ANYONE CARE ABOUT ANY OF THIS IN THE FIRST PLACE?



Because there’s a shadow banking system in the U.S. that’s larger than the retail banking system. It’s where the financial crisis began in 2008.



Information-insensitive debt plays a key role in shadow banking’s repo market, according to Gorton (later, we’ll look at how repo works). Asset-backed securities, for example, are posted as collateral against repo borrowings. During the financial crisis, the securities suffered huge haircuts once they became "information sensitive" (or once investors discovered they more closely resembled magic pigs than Treasuries). At the same time, Gorton notes, other kinds of debt suffered very minor haircuts.



So here’s something to ponder: If we must have "information-insensitive" debt in our financial system, shouldn't we look to these other types for what it should look like, and not to securitizations that are opaque and become thinly traded with alarming suddenness?



Next: Gorton’s own definition of information-insensitive debt comes up short.