Is informationally-insensitive debt a good thing?

By Felix Salmon
April 15, 2011
Ezra and I examined Gary Gorton's love of what he calls "informationally-insensitive financial assets" -- financial assets which (normally) don't change in price when new information about them emerges. Gorton thinks that such assets play an important role in the financial system, and he reprised that view in a short paper which makes the same claim for corporate debt. Matt Yglesias is buying it:

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A couple of years ago, Ezra and I examined Gary Gorton’s love of what he calls “informationally-insensitive financial assets” — financial assets which (normally) don’t change in price when new information about them emerges. Gorton thinks that such assets play an important role in the financial system, and he reprised that view in a short paper which makes the same claim for corporate debt. Matt Yglesias is buying it:

Going forward we need to do something—like maintain the existence of a large pool of federal debt—to make sure that the world has the quantity of information-insensitive debt it needs to continue routine operation.

No, actually, we don’t. Informationally-insensitive debt is the best repository the world has ever constructed for housing tail risk in an invisible and impossible-to-measure manner. Because it’s informationally-insensitive, the price doesn’t move when it gets riskier — so bankers and other financial innovators the world over have every incentive to structure products which turn risky assets into informationally-insensitive debt. In the run-up to the last crisis, that debt normally carried a triple-A rating, but the rating’s just a symptom of the underlying disease, which is financial instruments which are structurally designed to be mispriced.

The big picture here, then, is that informationally-insensitive debt causes crises. As I said to Ezra, we need to get individuals, companies, and institutional investors out of the mindset that they can do an elegant little two-step around the inescapable fact that anybody with money to invest perforce must take a certain amount of risk. If you have a world where people are all looking for risk-free assets, you end up shunting all that risk into the tails. And the way to reduce tail risk is to get everybody to accept a small amount of risk on an everyday basis. We don’t need more informationally-insensitive assets, we need less of them.

So let’s cheer, then, the advent of the single-name corporate CDS — an instrument which, because it can be conjured out of thin air, has the liquidity necessary to be able to provide price discovery for corporate debt. It has also helped to increase both demand for and supply of credit analysts and traders. That too is a good thing — much better that debt be examined critically than that it gets rated and bundled into a CDO and sold off to people with no idea what they’re eating.

If the world needs informationally-insensitive debt in order to operate routinely, that’s a problem with the world, and the way to deal with it is to reduce the amount of debt and increase the amount of equity. Informationally-insensitive debt is dangerous stuff, which is highly toxic and certain to blow up at some point. Let’s identify it, by all means. But once we’ve identified it, let’s try to make it as scarce as we possibly can. Because the alternative is more and bigger crises.

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Comments
10 comments so far

This is a very good post. I would add that treasury debt seems to fall in the category of informationally insensitive debt, which I find depressing since I agree with the points you just made. Our government seems to be able to do nothing but create more of this harmful substance you have identified.

All I know is, we are going to have to hold onto our towels.

Posted by DanHess | Report as abusive

Spot on. The way to a resilient economic system involves making all assets information-sensitive. Otherwise the costs of maintaining this information-insensitive pool flow straight from the taxpayer to banker bonuses.

Posted by macroresilience | Report as abusive

So… Matt Yglesias joins Alan Greenspan in worrying that the Federal Government will pay off the debt. That certainly adds a lot to Yglesias’ credibility, doesn’t it?

Posted by johnhhaskell | Report as abusive

“The big picture here, then, is that informationally-insensitive debt causes crises.”

No. Of course you can’t have a financial crisis without “informationally-insensitive” debt. That is because you can’t have finance without informationally-insensitive debt. Government bonds are informationally-insensitive debt. Bank deposits are informationally-insensitive debt. Money is informationally-insensitive debt. Gold, silver, sea-shells: all human inventions created to satisfy the demand for informationally-insensitive debt. This demand isn’t going to disappear just because you don’t like it. Why do you think goldbugs moan about “fiat currency”? They have notices that currency is not truly risk-free, and pine for an imaginary halcyon dream-time – founded on informationally-insensitive debt.

The “big picture” is that although the pretense that any asset can be truly risk-free is a polite fiction, it is a beneficial one. You spend every second of every day of your life shunting the risks of daily living into tails, and then ignoring them. You are alive today because your ancestors did the same. How do you propose to maintain your current life-style with no medium of exchange and no numeraire of account? How would you even buy your groceries if you and the checkout clerk had to do a bespoke credit analysis in order to execute the transaction?

The price of the completely safe financial system you dream of is to have no financial system. That would eliminate the possibility of downturns of, say, 10%, at the cost of a permanent reduction in economic activity of, say, 95%. Why would that be beneficial?

Posted by Greycap | Report as abusive

First of all, cash is informationally-insensitive debt.

Second, if there is a demand for it, companies will find a way to supply short-term AAA paper. If the companies are not AAA, the paper can be issued by AAA subs, secured by specific assets.

Third, market structure does not require a large government debt. If there were dislocation in the yield curve, the Fed could do open market operations repo-ing corporate securities, and investors could buy bank CDs, which have FDIC and implicit government backing.

Posted by TwasBrillig | Report as abusive

Greycap, isn’t there a big difference between scarcity and existing than being toxic and volatile. There is no perfectly safe financial system, but how about even relatively?

If it were just individuals who could afford the financial crack making and indulging in the risk, then there would be no crisis, but it is banks, TBTF and firms risking other people’s money with the burden of risk on the taxpayer that make ordinary folk so wary of this kind of talk of “what the world needs to continue routine operation.”

I rather doubt Greycap’s ancestors would have dreamed of CDs, let alone synthetic ones, the Quants would have been burned as witches and anyone who defrauded you would be shot or hung.

And if you are talking about your ancestors who were in the depression, they are frowning down on you right now for invoking them during this conversation.

I think most taxpayers would be just fine turning the financial system clock back to say, Glass-Steagall.

Posted by hsvkitty | Report as abusive

I meant CDS…

Posted by hsvkitty | Report as abusive

I completely agree with hsvkitty that most taxpayers would be just find with turning back the financial system clock to the era of Glass-Stegall. Unfortunately, “most taxpayers” don’t fund political campaigns in the U.S., the ones that have benefited most from the post-Gramm–Leach–Bliley Act universe we currently live in do.

Posted by Strych09 | Report as abusive

The more I think about this the more I feel that the entire concept of “informationally-insensitive financial assets” is misguided.

The problem is the term “information”. What it means for an asset to be informationally sensitive is that it responds actively to market changes in market conditions.

This may be a property you want or don’t want in an asset, but it doesn’t tell us anything about whether the price is “accurate” or not. Bubbles happen all the time in informationally high equity markets.

So I am not convinced what all this has to do our present crisis.

Posted by AASH | Report as abusive

“Is informationally-insensitive debt a good thing?”

If my bank issued public debt (which is doesn’t) I’m extreemly confidant that it would carry a A+ rating. (We have almost twice the capital we’re required to hold, and we pay no dividends.)

Half our balance sheet is made up of business, consumer, and CRE loans which would probably average BB (junk) on a dollar weighted basis.

That’s true of 99% of all small banks in the country.

“Extend and pretend” was a widely used term which held that banks were extending terms on existing shaky credits because they had little choice. Guess what, that’s ALWAYS true. Even in good times it’s unlikey you’ll get 80% of book value in a liquidation.

“Informationally-insensitive” debt is close to the very definition of banking.

Posted by y2kurtus | Report as abusive
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