Getting Just the Right Dose of Liquidity and TransparencyPublished: April 15, 2009 in Knowledge@Wharton
If the financial crisis has done anything good, it has focused experts' attention on two key factors influencing values of complex securities: transparency, the amount of information available about a security; and liquidity, the ability to easily find a buyer or seller for a given issue.
Nearly everyone agrees that pumping more information into the marketplace and making trading more active allows prices to better reflect supply and demand. But it's not entirely clear how much transparency and liquidity it takes to make markets work well, or just how these two factors affect one another. Nor is it clear whether it's possible to have too much of either, whether the credit-rating agencies are really improving transparency, or whether the two factors influence all markets the same way.
And in the current crisis, there are many examples of markets failing to work as expected, suggesting that an understanding of transparency, liquidity and securities pricing is incomplete.
Credit-default swaps (CDS), a kind of insurance against borrowers' failure to repay loans, should have served as a window into the risks building up in the market. As risks grew, CDS prices should have gone up, just as life insurance costs more for race car drivers. But the alarms failed. "We really didn't get an early warning signal from this market that anything was going on," said Loretta Mester, director of research at The Federal Reserve Bank of Philadelphia, speaking at a recent conference at Wharton's Weiss Center for International Financial Research. "The lack of transparency in this market, as well as a lot of over-the-counter markets, is a big issue," according to Mester, an adjunct finance professor at Wharton. The March 27 conference was titled, "Liquidity Risks -- Impact on International Financial Markets."
To improve transparency and liquidity and make the CDS market function better, regulators are thinking about shifting CDS trading from the current over-the-counter market -- where buyers and sellers deal with one another directly -- to a centralized clearinghouse or exchange, where intermediaries would reduce risks by providing certain guarantees, she said.
But the interplay of transparency, liquidity and pricing is subtle, and does not always work as expected. That makes it hard to predict how much improvement such changes would foster. A clearinghouse for credit default swaps would reduce uncertainties by providing an intermediary to guarantee that each party's obligations in a transaction were honored. And the clearinghouse would post market prices for all to see, while prices in the over-the-counter market are often hidden. An exchange would go even further, said Mester, by requiring that credit default swaps be standardized, dramatically improving transparency and liquidity.
Some experts worry, however, that centralized trading or standardization would make credit default swaps less useful because they could not be customized, as they have been in the past, to meet the buyers' and sellers' exact needs. The effort to provide more transparency and liquidity could thus backfire, with swaps becoming less efficient at shifting risks to investors best equipped to bear them.
The Main Culprit
In addition, some market participants may object to greater transparency and liquidity because they profit from the inefficiencies of the current system. With less transparency, for example, securities issuers can sell to investors who would be scared off if more information were available, said Marco Pagano, an economics professor at the University of Naples Federico II, summarizing his paper, "Securitization, Transparency and Liquidity." Since issuers and other participants can benefit from an opaque system, it may require new regulation to protect the broader market and economy from the hazards that accompany a lack of transparency, he said.
Pagano and his co-author, Paulo Volpin, a finance professor at the London Business School, cited complex mortgage-backed securities which they said are widely considered to be the main culprit in the financial crisis. "In particular, it is commonplace to lay a good part of the blame for the crisis on the poor transparency of the ratings that accompanied these massive securitizations," Pagano and Volpin write.
Mortgage-backed securities typically bundle thousands of mortgages together, allowing investors to share in homeowners' monthly payments. But the bundles can be sliced in many ways, making some securities riskier than others. Since it was nearly impossible for investors to assess these risks for themselves, they relied on ratings agencies like Standard & Poor's and Moody's. But the ratings firms failed to spot many of the hazards, giving securities better ratings than they deserved. As investors came to realize the dangers were greater than previously thought, they became reluctant to buy the securities, and prices dropped.
"After June 2007, the market for all structured debt securities shut down...," Pagano and Volpin write. "This illiquidity in turn created an enormous overhang of illiquid assets on banks' balance sheets, triggering or aggravating the credit crunch."
The antidote would appear to be simple: If the ratings process were more transparent, trust and liquidity would improve. But with a closer look, it doesn't seem so straightforward, the authors note.
Common wisdom says a lack of liquidity should undermine prices, since investors would worry about getting stuck with securities they no longer want. Firms that issue mortgage-backed securities would therefore be expected to exert pressure on ratings firms to get a transparent ratings process, bolstering liquidity and prices.
"But the pre-crisis behavior of issuers and investors alike suggests, instead, that they both saw considerable benefits in securitization based on relatively coarse [opaque] information," Pagano and Volpin write. This suggests that although transparency may be good for the markets overall, it is not always good for issuers and investors who want to make the most from individual securities.
Indeed, issuers want to appeal to as many investors as possible when they sell securities in the primary market, Pagano and Volpin write. That means appealing to unsophisticated investors as well as sophisticated ones. Releasing too much detail about the securities can make unsophisticated investors feel outgunned -- poorly equipped to compete with pros who are assumed to be better at figuring out the meaning of the details. In other words, hiding the details takes away the pros' advantage, thereby leveling the playing field for unsophisticated investors and keeping them in the market. With more buyers in the market, issuers can get better prices.
But Pagano and Volpin say this can cause problems in the secondary market, where securities are traded after their initial issue. If little detail about the securities has been disclosed, investors will assume that more detail will eventually come to light. Unsophisticated investors, worried they won't know what the new information means, will be reluctant to buy, undercutting prices. Pagano and Volpin believe, however, that these investors will worry less if they think there are no surprises to come -- if the complex details had already been disclosed and thoroughly evaluated by the pros when the security was first issued.
Issuers therefore have a choice: Releasing lots of information means lower prices in the primary market and higher ones in the secondary market. Releasing little information produces higher prices in the primary market and lower ones in the secondary market.
Issuers typically prefer the best prices they can get in the primary market, Pagano and Volpin said. That preference is so ingrained, they argued, that regulation is required to assure that enough information is disclosed to prevent surprises from causing problems in the secondary market.
Ratings and Emerging Markets
While that would require more disclosure about how the ratings agencies reach their conclusions, other conference speakers raised questions about how much credence market participants put in credit ratings.
Ked Hogan, managing director in the global strategies group at Barclay's Global Investors, argued that ratings in fact contribute very little to investors' understanding of risk. Sophisticated investors who dominate the markets do their own research, and are generally better at it than the ratings agencies, Hogan said. "Agency ratings -- they're irrelevant. They're absolutely irrelevant. They're behind the curve." Nonetheless, sophisticated investors need information to make their own risk assessments, he noted, concluding that: "Opacity is not a good thing."
A paper, titled "Liquidity and Credit Risk in Emerging Debt Markets," by Tulane University finance professors John Hund and David. A Lesmond, found that credit ratings may have more value in some markets than others. While a significant amount of research has shown that ratings do influence prices of corporate bonds in the United States, ratings seem to have less influence in emerging markets, because the ratings agencies are not as well equipped to assess risk in these countries, the researchers said. After studying bond markets in 16 countries over eight years, they concluded that, in those markets, liquidity has a far greater influence on prices than ratings.
"Compared to U.S. markets, liquidity is a much bigger component of yield spread -- four times larger," Hund told the conference. Yield spread is the difference between the interest rate paid to investors by one security versus another. Yields are higher for securities deemed riskier. A lack of liquidity increases risk -- since an investor can be stuck with a security he no longer wants -- and therefore widens yield spreads.
A body of research over the years has found that reduced transparency leads to higher transaction costs -- the research outlays, commissions, fees and other expenses in buying or selling a security. Along with greater transaction costs comes reduced liquidity, since fewer investors are willing to bear those costs. Because investors expect higher returns for taking on the risks of purchasing illiquid assets, it is more expensive for firms to raise money by selling illiquid assets. A firm might, for example, have to pay a higher interest rate to get investors to buy its bonds.
"Issues of transparency and liquidity have taken on particular relevance in light of recent disruptions in securities markets," write Mark Lang and Mark Maffett of the University of North Carolina at Chapel Hill and Karl V. Lins of the University of Utah.
Their paper, "Transparency, Liquidity and Valuation: International Evidence," reports on a study of the relationship between transparency, stock market liquidity and share prices for a broad sample of companies in 21 countries from 1994 through 2006. The study looked at factors that reduced transparency: executives' efforts to "manage" earnings by controlling the timing of expenses and revenues, coverage by fewer analysts, and use of weaker auditing firms and less rigorous accounting.
Companies ranked in the top 25% -- those enjoying the most transparency -- appeared far less risky to investors than companies in the bottom 25%. This was seen in the 40% smaller difference between "bid" and "ask" prices quoted for the stocks of the more transparent firms. Narrow bid-ask spreads mean investors are confident they can accurately determine a firm's value. Wide spreads signify worry about risk, with sellers demanding higher prices and buyers offering less because each group wants to be compensated more for taking more risk. The study also found that the more transparent firms were able to raise money more cheaply, and that they enjoyed higher stock prices, measured by Tobin's Q, the ratio of a firm's stock valuation to the value of its assets.
"Taken together," the authors conclude, "our results suggest that a focus on the transparency provided to those who invest in a firm's securities could be a fruitful component of an effort to more fully understand the recent increases in illiquidity and decreases in valuation for many assets worldwide."