Are Debt Investors Different from Equity Investors?
Since the acute phase of the Great Financial Crisis began in 2008, Economists (broadly defined to include finance professors) and legal scholars have argued debt investors are different from equity investors. What is the difference? Debt investors buy securities, particularly money market securities, that are designed to be insensitive to information. Equity investors buy securities that are always sensitive to information (see the Efficient Market Hypothesis and the idea all publicly available information is reflected in the price).
If you are like me, you might observe in your personal portfolio you own both debt and equity. This is also true for pension funds, endowments, insurance companies and hedge funds. So immediately, a red flag should go up and you should be asking yourself “is this remotely reasonable that you or I approach the informational needs for our debt and equity investments differently”.
If you are like me, it is entirely likely you buy mutual funds and you own the debt and equity securities of the same company. Again, a red flag should go up. This time asking yourself “is it remotely reasonable to think there is no carryover between the ongoing analysis of the equity securities to the debt securities”.
If you are like me, you notice there are lots of job openings at these mutual funds (as well as pension funds, endowments, insurance companies and hedge funds) for both credit/debt analysts and for equity analysts. Again, a red flag should go up. This time asking yourself “if there really is a difference between debt and equity investors, who would want to be an equity analyst who has to work long hours and look at all the new information that comes out when they could be credit analysts and do nothing all day”.
If you are like me, you don’t have a Nobel prize in Economics. So when you say the same investors act in exactly the opposite way in the two markets, everyone looks at you like you are crazy. Unfortunately, when someone has a Nobel prize, a remarkable number of people nod their heads and go “that is brilliant”.
Of course it isn’t brilliant, it is pure BS without a shred of supporting evidence.
In 1933, the global financial system was redesigned. Specifically, transparency was introduced. It became the role of government to ensure the information investors needed to know what they owned was disclosed.
Investors immediately understood the quid pro quo in this redesign. In exchange for the necessary information, investors understood they and they alone were responsible for all gains/losses on their investments. This responsibility gave investors an incentive to Trust, but Verify the valuation stories Wall Street told about their investments.
Please note, the redesign did not distinguish between debt or equity investments. In all cases, it was the role of government to ensure disclosure. For every investment, it was up to investors whether or not to use this disclosure in making their investment decision. The redesign did not rule out investors blindly betting with their money. However, the redesign did give investors an incentive not to blindly bet as there is reason to believe informed decision making produces better investment results.
If we look at this redesign, there is a reason for both credit/debt and equity analysts. They are there to use the disclosed information to either verify or reject Wall Street’s valuation story.
Before going on, we need to focus on why transparency was introduced. It was realized people like a good story and Wall Street was loaded with individuals who were very good at telling stories that may or may not be true. So this was a way of allowing investors to like an investment story and then verify if it was true or not.
Do you think Wall Street supported having the information disclosed investors needed so they could know if Wall Street was telling the truth?
Of course not!
Wall Street opposed this as the bankers knew they made much more money selling high margin, opaque, possibly fraudulent securities than they did selling low margin, transparent securities. This was true in the 1930s, still true in the 1980s and still true in the 2020s.
Unfortunately, in redesigning the financial system, policymakers gave the responsibility for ensuring disclosure to the SEC. This single point of weakness ensured opaque securities would be reintroduced into the global financial system and we would have a financial crisis.
Why was the SEC a single point of weakness?
The investors were not organized to do it for themselves.
Wall Street understood this and focused its resources on weakening the SEC’s disclosure requirements. It big break came under the Reagan Administration which said Wall Street and not the investors was the SEC’s “client”. From that point forward, the SEC progressively abandoned requiring the necessary disclosure.
One area where this lack of disclosure existed was the money markets. Specifically, investors didn’t have the information they needed to know if Wall Street could repay its short term borrowings or not.
The Nobel prize winning Economist argued opacity in the money markets was beneficial. Why? Because it was expensive for those credit/debt analysts to do the work to verify the valuation story told about these securities.
Really?
Let’s take the case of a Wall Street firm who issues money market, intermediate term debt, long term debt and equity securities. At some point as we move from money market to equity, I suspect the Economist would agree with me it isn’t too expensive for both the credit and the equity analysts to be verifying the valuation story.
Where we disagree is I think a credit analyst who verifies the valuation story for intermediate term and long term debt can with no additional work verify the valuation story for the Wall Street firm’s money market securities too.
By the way, these credit analysts can have their own firms and tell their clients the results of their findings.
Hmmmm…….
But what about when the issuer only sells money market securities?
Again, is there any reason to think credit analysts won’t try to verify the valuation story? No.
On the other hand, there is a case where credit analysts cannot verify the valuation story. This occurs when they do not have access to the information they need. And this was at the heart of the 2008 acute phase of the Great Financial Crisis.
Rating firms and their ratings were substituted for the work of credit analysts. Why? The rating agencies maintained they had access to the information needed to verify the valuation story even though the credit analysts didn’t.
Of course, the rating firms testified before Congress they did not have access to the necessary information and it was a mistake by investors to think they did. But by that point, trillions of dollars of opaque securities were now outstanding. Oops …