Information Transformation

Justin Fox has a great post on Bengt Holmström's distinction between low-information and high-information assets:

There are low-information assets--cash, bank deposits, money-market securities--where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets--stocks are the best example--where the value is highly uncertain, and every investor assesses it differently.

Securitization is the process of transforming low-information assets, like corporate debt, into high-information assets, like opaque CDO-squareds. And I think this insight is the best way of answering Richard Wagner's exam question about securitization:

The burden of non-performing loans is thus dispersed throughout the economy rather than residing with the original lender. Does this development weaken the incentive offenders of lenders to monitor borrowers and thereby weaken overall economic performance?

Classically, the answer to this question -- the one which all of Wagner's students gave -- was no. Investors in CDO-squareds, under the kind of assumptions commonly made by economists, have perfect information about all the underlying loans.

In reality, of course, they don't. But more to the point, it's orders of magnitude harder to understand a CDO-squared than it is to understand a single loan -- and single loans are hard enough to understand themselves. You can start making correlation assumptions and the like in an attempt to simply matters, but that only pushes off the moment of reckoning: you still need to crunch a lot of data to come up with empirically-based correlation assumptions, and no one ever had either the ability or the inclination to do that.

Financial innovation nearly always involves a move towards higher-information assets from lower-information assets. This is not a good thing. It's easy to say things like "don't invest in something you don't understand", but how on earth is anybody meant to understand something as high-information as the stock market, let alone things like CPDOs?

A lot of the boom in debt markets during the Great Moderation, I think, was a result of buy-siders being seduced by instruments which they believed required little if any sleeves-rolled-up credit analysis. Maybe one surprising consequence of the credit crunch will be an increase in demand for people who can actually judge credits on their own, rather than relying on ratings agencies and buy-side quants to do it for them.