Wednesday, April 21, 2010

Is Full Disclosure the Solution?

Goldman Sachs is being sued by the SEC for details related to the sale of a collateralized debt obligation that might or might not have been truthfully or dishonestly disclosed to clients. This latest hoopla in the financial services industry brings to mind a belief that has plagued, and will always plague, the investment business: with enough disclosure and/or information regarding an investment, an individual can be fully protected from disaster.

While investment practitioners, statisticians, and economists have correctly understood that risk can be minimized while uncertainty can't (an idea first proposed by the economist Frank Knight), there is something very different about when the government (or one of its appendages like the SEC) markets itself as the protector of investors. The difference is that the government is implicitly claiming it can protect against something (through "uncovering" bad practices, or making things "fully disclosed," or creating "transparency," etc.) that it can't. Who could possibly be helped by a false sense of security?

The government is treating the issue of what Fabrice Tourre did and did not disclose to investors as though it makes a difference. It does not. When an investor makes a decision to buy or sell a security, he implicitly assumes that the person who is buying or selling the security from him, knows less than he does (if the investor thought the person buying or selling the security knew more, our investor would not make the investment!). Whether or not an individual or entity related to the investment really does know more or less than the investor, still does not change the fact that uncertainty might prove that investor wrong, regardless.

A perfect example is real estate which everyone "knew" goes up indefinitely. If the government had successfully made sure everyone involved in real estate transactions was being honest, would that have saved them when the real estate market crashed? No, it would just give them one less thing to complain about when it came to a bad decision they made. The issue of loss is what is driving investors (and the SEC, which is trying to cater to investors) to cry "fraud" when they never would have cried "fraud" if their investments went up rather than down. From a legal standpoint, either both of the two possible circumstances (gain or loss) is fraudulent or neither circumstance is fraudulent.

But what if knowledge, that the investor's counterparty is very smart, will make the investor change his mind (a question I anticipate will arise from the statement I made about how investors implicitly assume their counterparty knows less)? This is entirely beside the point when it comes to legality. Should law really be based on the perception that an investor might or might not have about the person he is doing business with? How do you prove perception? What if an investor knew that Paulson (to take the actual issue the SEC is dealing with right now) was on the other side of the trade but thought that Paulson is stupid? If our investor lost money in that instance would it no longer be fraud just because the investor knew about Paulson, thought he is stupid, and therefore made the trade anyway? Or what if our investor didn't know Paulson's identity, still made the investment, and made money? Would the SEC still complain? Should laws pertaining to financial markets then be based on whether an investor makes money? Or what if investor's don't know that their counterparty's grandmother's best friend's cousin is an astrologer who believes the investor is making a horrible mistake (and this astrologer has a great track record too!)? There is an infinite amount of detail that could be disclosed to an investor, none of which changes the fact that the investor needs to know there are lots of ways he might lose money. Disclosing information about a counterparty, what that counterparty thinks, or what that counterparty ate for breakfast, is entirely immaterial.

But there is still a bigger problem here alluded to in an earlier paragraph. The very existence of the SEC gives investors a false sense of security when it comes to investing. We have seen that the SEC does not do its job because Bernie Madoff and countless others have pulled off various schemes that lost investor money (I might add that even when the SEC was tipped off about these schemes it did nothing). When investors are given a false sense of security as a result of the existence of a government regulator, they are more likely to make an investment... and then potentially lose money that they might have been less willing to invest if they knew nobody was claiming to protect them. As radical as this idea might sound, would it be worse if no entity existed to supposedly protect investors (which obviously the SEC doesn't even do, but unfortunately people think it does) thereby making investors fully aware there is a very good chance of loss from any number of unanticipated events? I would argue that under this scenario, most of the individuals who would still be willing to make investments would be the ones with a bigger risk appetite (a characteristic all investors, but not all individuals, should have!). The goal should not be to get as many people investing as possible (which is what entities like the SEC seem to be trying to accomplish). Investing should only be for people who have a risk appetite. Why are we trying to give the impression that with just enough disclosure of information or with a specific type of information, uncertainty can be taken out of investing (a venture extremely prone to uncertainty), when uncertainty can never be taken out of anything? Or why are we trying to say that X amount of disclosure is sufficient for there to be no legal problem, but a Y amount of disclosure (assuming Y > X) isn't necessary? Where is the cutoff?

This is all yet another example of the unintended consequences of government policy. Whether or not Goldman Sachs (which could be vilified for lots of other reasons, but not this one) disclosed information to clients about the beliefs of another party in an investment makes absolutely no difference here, or at the very least no legal difference. Investing is an activity inherently full of uncertainty and the more people realize that the better. This whole fiasco could have been avoided if investors were made to feel less protected by the government in their investments, something that abolishing the SEC would go a long way towards accomplishing. In fact, imagine for a moment that the SEC ends up finding Goldman Sachs guilty of fraud. Everyone will perceive that to be an example of how effective the SEC is at protecting investors. Well guess how that might affect the willingness of people to invest? So, are you really confident enough in the SEC to give those people that impression?