Friday, March 23, 2012

Zero Hedge: Why breaking the tyranny of ignorance is the only solution

Periodically, I like to provide readers of this blog with another perspective on why ultra transparency needs to be adopted to cut through the fog and shed light on all the opaque corners of finance.

This perspective is provided by Zero Hedge which explains why breaking the tyranny of ignorance is the only solution.

In order to bring some clarity to the matter we present two of the seminal pieces on the topic: first, from the IMF: "The (sizable) Role of Rehypothecation in the Shadow Banking System" and then from one of the best scholars of shadow banking, Gary Gorton, "Haircuts."
Your humble blogger first introduced readers to Professor Gorton over a year ago.  Besides acting as a derivatives consultant to AIG prior to its massive bailout, Professor Gorton also wrote a number of academic papers based on the concept of informationally insensitive debt.

Your humble blogger debunked his idea that there is such a thing as informationally insensitive debt.  For example, he cited demand deposits as informationally insensitive.  Even a 6 year-old knows demand deposits are informationally sensitive.  They aren't handing their money over to a banker without knowing that the government is guaranteeing they will get it back.
We will let readers digest the wealth of information contained in these two pieces on their own, however, we will point out the two key messages: ...
And the other one comes from Gorton who explains why haircuts [on repurchase agreements] are the functional equivalent of information arbitrage: 
"Increases in repo haircuts are withdrawals from securitized banks—that is, a bank run. When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive; liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent." 
And the punchline: "Liquidity requires symmetric information, which is easiest to achieve when everyone is ignorant. This determines the design of many securities, including the design of debt and securitization." 
Reread the last statement as it explains perhaps better than anything, the true functioning of modern capital markets and why they are terminally broken: in order to preserve the system, the banking cartel need to make everything of virtually infinite complexity so that no one has a clear understanding of what is going on! 
Which is where sites like Zero Hedge step in - to expose "shadowy" places where things are best left unseen.

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