Is informationally-insensitive debt a good thing?
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.