Sunday, August 21, 2011

Everything You Always Wanted to Know About Information-Insensitive Debt But Were Afraid to Ask

Over the last few months, I’ve spent a lot of time studying the idea of "information-insensitive debt" (also known less gracefully as "informationally insensitive debt"). Gary Gorton, a professor at Yale’s graduate business school, appears to be the intellectual progenitor (or one of them) of this concept. In 1990, he wrote an academic paper with George Pennacchi titled "Financial Intermediaries and Liquidity Creation."



My fascination with information-insensitive debt arose from a sneaking suspicion that it was a bad thing (except for a couple of notable exceptions). My keen interest in writing about it, after all this research, arises from a conviction that it is a bad thing, and that the theory itself isn't much good either.



A rough-and-ready definition of information-insensitive debt -- we'll return later to Gorton's own more nuanced and precise definition -- is this, by way of Felix Salmon:

Financial assets which (normally) don’t change in price when new information about them emerges.
Now if you're a markets-oriented person, this very idea should make your skin crawl from the get go. What kind of zombie asset doesn't change in price when new information about it emerges? How weird is that?



MAKING BACON OFF MAGIC PIGS



To begin this series of posts about information-insensitive debt (there’s waaay too much to fit into a single piece, unfortunately), let me introduce you to my magic pigs.



Each magic pig is worth exactly $1 million. Its astonishing value resides in something I call a noumenon. When asked what this noumenon is, which is a thing unseen, I gladly provide a 9,000-word document, with much high-level math and abstruse concepts and economic formulas, to justify its value. I trade a lot in financial markets, and whenever my counterparty demands collateral, I offer bonds entitling him to a number of my magic pigs, should I fail to deliver on whatever I have promised.



So when $10 million of collateral is requested, I hand over certificates for 10 magic pigs. My counterparty doesn't object: the whole market has accepted that these pigs are magic and worth $1 million apiece (after all, I do have documentation and the pigs have been rated top grade by Standard & Poor’s -- ignore for the moment their pro-animal bias, as one of their officials once famously observed, “It could be structured by cows and we would rate it”).



Sometimes I sell a magic pig for $1 million, and the holder of that pig then uses it for collateral, or sells it. Or whatever. Because the value of the pig lies in this complex noumenon, no market participant has any advantage in trying to profit on my pigs (through trading), by first gaining private information. And if a leg falls off a pig, that doesn't matter because its noumenon isn't affected. Even if the pig dies, its noumenon stays intact. So it's still worth $1 million.



The certificates for my magic pigs are truly information insensitive debt -- at least, until I am revealed as a fraud, at which point they very rapidly become information sensitive and start rising and falling in accordance with the market on hog futures.



Next: What do “jumbo shrimp” and “information-insensitive debt” have in common?