“Guildenstern: We only know what we’re told, and that’s little
enough. And for all we know it isn’t even true.
Player: For all anyone knows, nothing is. Everything has to be taken on trust; truth is only that which is taken to be true. It’s the currency of living. There may be nothing behind it, but it doesn’t make any difference so long as it is honoured. One acts on assumptions. What do you assume?”
- Tom Stoppard’s Rozencrantz and Guildenstern are Dead
As we battle a crisis among crises, the informational asymmetry between sophisticated and unsophisticated investors becomes all the more striking.
The so-called sophistication level requirements have conveniently lingered despite the increasing complexities brought on by financial innovation: the dollar amount of income or net worth for natural persons to be considered “Accredited Investors,” for example, has not been adjusted for inflation in the almost 30 years since it was originally adopted; similarly investments in auction rate securities (ARS) were initially limited to institutional investors with minimums of $250,000. In recent years the minimum level has been brought down to $25,000 in an effort to lure as many market participants as possible, and more worryingly to make ARS available to the general public.
(“Accredited Investor” is defined to include natural persons having an annual income of $200,000 -- or $300k with spouse -- over specified periods or a net worth of $1mm or more. ARS typically refers to either municipal or corporate debt securities or preferred stocks which pay interest at rates set at periodic auctions. The market for ARS, prior to the collapse of the auction market, purportedly stood at around $350 billion.)
As such, Accredit Investors have over time become far less “accredited.” More importantly, the less “accredited” investors were being allowed to purchase increasingly complex securities. Investors, not wanting to look bad, chose to trust others rather than give voice to their lack of understanding. They place their trust in their lawyers, accountants, financial advisers and brokers. And the rating agencies.
They trust these parties differently: they trust their lawyers, financial advisers and brokers to act in their best interests and to be mindful of their risks. They trust them based on their credentials, the lengthy relationship they’ve had with them in the past and the fact that they have supervisory boards (e.g., FINRA, FASB and the SEC) tasked with ensuring they behave properly. They trust the rating agencies to provide an independent, objective opinion that has no party’s ulterior motives at heart and accuracy as its only goal.
Unable to perform their internal analysis, investors increasingly had to blindly trust the rating agencies’ ratings, from both a modeling perspective, and from an unbiased credit risk opinion perspective. Less sophisticated investors tended to rely more heavily on analyses performed by the rating agencies. More sophisticated investors, like Paulson, worked day and night to take advantage of their analytical advantage, by finding and betting against those bonds whose ratings least reflected their true credit quality.
The opaque, private securitization market provided a handy tool for poorly incentivized parties to take advantage of less sophisticated parties: the immature securitization market is noted for its lack of transparency and disclosure. More recently it has been marked by its misrepresentations. Battles continue to be fought over who owns the rights to the mortgages underlying the mortgage-backed securities vehicles; the bankruptcy process for off-shore vehicles remains underdeveloped relative to the United States; off-shore legal counsel seems nowhere to be found; and the complexity of some of the special purpose entities (and the number of different interests being represented) creates havoc for our litigious society.
In sum, the securitization market was particularly susceptible to being abused. And it was abused. The SEC vs. ICP case, seems only the tip of the iceberg as we begin to examine the repercussions that come from the several incentive misalignments that are apparent throughout the securitization vehicle. We are abounding with conflicts of interest while informational asymmetries, resulting in various forms of moral hazard, proliferate.
Economy-wide, we have realized that we need to encourage, if not force, the investor to perform necessary levels of due diligence both pre and post investing in complex securities. We need to impose adequate safe-guards on these vehicles to ensure that they are not mismanaged, and that managers are incentivized to manage across the capital structures, in the spirit of the deals. We also ought to encourage regulator responsibility, and permit them the authority necessary to step in sooner – to act before the problems become insurmountable. The recent, indefatigable, examiner activity seems too little too late. But it is crucial that the standard be set.