FROM THE OFFICE OF PUBLIC AFFAIRS

                Our credit markets are adjusting to the prospect of price stability.  We can now better observe real rates across time and among different borrowers.  As a consequence, we can also better observe the shortcomings of current investor disclosures in providing the information needed to portray accurately risk-reward prospects in a world of derivatives and of structured credit products.

                Some attention has recently been given to the risks of deflation.  While a sustained decline in the general price level is a possibility, it is still one to which a rather low probability should be attached.  A higher probability should be attached to the “risk” that we will see a period of sustained price stability.  Recognizing the modest upward bias and the inevitable noise in our measures of inflation, we now appear to be at effective price stability. 

                The question for monetary policy, which I will not address, is how to sustain effective price stability.  The question for our credit markets, which I intend to address, is how to adjust to a world of price stability in which attention is more clearly focused on credit quality.

An environment of price stability, if sustained, will be characterized by low variance in the general price level and by expectations for more symmetric deviations from the current price level than we have experienced over the last thirty years.  If such an environment takes hold, credit market participants will come to expect that prices are as likely to rise modestly as to fall modestly, within a narrow range.  One consequence is that we will more readily observe both movements in aggregate real rates and the variance in real borrowing costs experienced by different borrowers.

While we have all understood that real rates change over time, during the recent decades of rising and falling inflation we have tended to focus on the movements in nominal rates as explained by changes in inflation and inflation expectations. We have also fallen into the bad habit of assuming that changes in inflation are the principle source of volatility in real asset values.

We should have known all along that real rates can also move around.  But now that we seem to have entered a period of price stability the observed variance in real rates is slapping us in the face.  While an imperfect measure of real rates, the Treasury’s inflation-protected ten-year note provides some evidence of recent changes in aggregate real rates.  The real yield on the 10-year TIPS peaked at 4.4 percent in early 2000 and now, just three years later, has fallen in recent weeks to between 1.4 and 1.6 percent, while implied inflation expectations moved in a narrower range.

Those of us inclined to make the simplifying assumption of a constant 2 or 3 percent long-run, real cost of capital, as suggested by economic historians, will need to think about the meaning of a greater than 50 percent decline in observed real rates in the space of a few years.  Those of you with risk management responsibilities will need to think carefully about your efforts to achieve 4 or 5 percent risk-adjusted, real returns in a world that may only be offering a riskless, real rate of less than 2 percent.

Removing aggregate inflation from the list of uncertainties allows investors to identify more clearly good managerial decisions from poor ones, sustainable cash flows from unsustainable ones.  Managers who are able to identify and expand markets where their firms have pricing power will enjoy persistently lower real costs of borrowing; whereas firms that face stiff competition will tend to face higher real borrowing costs.

With greater attention focused on credit quality, securitized assets should be able to perform well, given the relative simplicity and clarity of their cash flows and risk characteristics compared to the complexities and uncertainties associated with major corporate balance sheets.  However, if our traded credit markets are going to prosper in a world of increased attention to credit quality, all issuers of credit instruments will need to provide investors with disclosures that accurately portray the risk-reward characteristics of the non-linear and probabilistic claims on cash flows that are now routinely embedded in the structured products that investors hold both directly and indirectly. 

Our existing disclosure paradigm is not adequate for this task.

The mindset that dominates current disclosure and accounting practices continues to focus on identifying facts (about the past) that are precisely comparable between different firms and credits.  The risk management mindset – which inspired the development of our exchange-traded and over-the-counter derivative markets and still dominates financial management today – focuses on comprehending the probabilities of likely and unlikely future deviations from particular desired or expected outcomes.  As a consequence, our disclosure regime is inadequate for the task of informing investors about the financial underpinnings of the products in which they invest.

There are “just” two topics that need to be addressed to come up with a new disclosure paradigm: first, the non-linear nature of contingent financial claims; and, second, the subjective nature of risk.

Before even turning to the complexity of derivatives, we should acknowledge that there is no single perspective from which to consider accounting and disclosure.  Shareholders and creditors have different interests.  Generally accepted accounting principles are different from regulatory accounting principles and regulatory capital is different from shareholder equity.  There is also the additional perspective of tax accounting.  So we must be careful to avoid the assumption of a single “right” answer.

The non-linear nature of optionality drives much of the complexity of derivative instruments and poses a significant but manageable challenge for disclosure practices.  For example, investors need to understand different facts about an option at different stages in an option’s life cycle.  To prevent too many eyes from glazing over at the mention of non-linearity, let me try an analogy.

Turning to biology, imagine a short list of attributes needed to describe a caterpillar: length, width, color and number of legs.  Perfectly adequate to the task of portraying caterpillars, these four attributes will not portray very well the features of butterflies.  Precise comparisons of caterpillars and butterflies using just these few attributes may well mislead and confuse.  To describe the non-linear process of metamorphosis we need something more than a precise comparison of key facts about caterpillars or even key facts about butterflies.

More importantly, we are not just interested in observing facts.  To carry the analogy to investors forward, we are going to be keenly interested in whether these particular caterpillars are likely to turn into butterflies or whether they are likely to become moths.  We are not principally interested in comparing caterpillars to caterpillars.  We are interested in those attributes of caterpillars which help us comprehend the probability of the hoped for transformation into butterflies.

This brings up the subjective nature of risk.  Risk is deviation from a particular goal or objective.  You cannot understand risk without first articulating an objective.  The “intended”, the “desired” or the “expected” path must be identified before you can think clearly about likely and unlikely deviations.

In the world of derivative accounting and disclosure, this issue is frequently boiled down to the question: Is it the asset or is it the hedge?  Without a clear statement of objective it is difficult to answer that question.  But if you have a clear understanding of the objective (or, at least, of the expected outcome) then you can articulate the risks being managed and, therefore, identify which is the asset and which is the hedge.

The particular challenge for accounting and disclosure of derivatives is that this hinges on something as subjective as intention and expectation.  This poses a host of problems about “changing our minds”.  But for the present purpose, I want to draw attention to the problem of framing disclosures to investors that will help them better understand the probability of deviations from particular desired outcomes. 

Compared with this, coming up with formats for disclosing the non-linearity of options and related exposures is just a technical challenge of identifying those features that best foreshadow the probabilities of different outcomes and those that best summarize the course of the transformation.

The subjective nature of risk poses two significant challenges for disclosure practices.  First, it suggests that there is no single, correct way to account for or disclose a particular set of sliced and spliced contingent cash flows; we must look to the objective to understand the significance of particular assets and liabilities.  Second, accurate disclosure will require borrowers to be specific about their objectives and to be transparent about deviations from their objectives – that is, to be transparent about their failures or, perhaps we should more kindly say, their “un-successes”. 

The comparisons that we need to see are not principally between the simple facts about Borrower A and Borrower B.  Rather, we want to understand the relative success of Borrower A at managing deviation from his objective compared with the success of Borrower B at managing deviation from his objective.  Their objectives may be quite different but we ought to be able to compare their “risk management acumen”.

This is a major hurdle for improving disclosure practices.  I used to think that improvements in investor disclosures were principally held back by a “first mover” problem.  Upon reflection, I now think that it is the double hurdle of the first mover problem and the reluctance to be clear about “un-successes” that make it so difficult to achieve improvements in disclosure practices.

This is where you come in.  You have the opportunity to overcome this hurdle. 

You can compete with one another on the basis of the quality of the information you provide investors without it reflecting on the capabilities of any individuals.  Securitized assets don’t have “intent”.  Structured pools of mortgages, credit card receivables and auto loans don’t have their own “objectives” and they can’t be embarrassed when they experience unlikely outcomes.  They have only expected outcomes and likely and unlikely deviation from those expected outcomes.  So it is much easier for issuers of securitized assets to provide more detailed information about expected outcomes and the probabilities of deviations from those expectations.

In addition, you have already gotten over the first mover problem.  To compete with one another, and with other credit products, issuers in your industry already do compete on the basis of the information you provide about the pools of assets you securitize.  You need only reinvigorate your efforts to improve disclosures to present more accurately the non-linear and probabilistic attributes of the claims on cash flows embedded in your products. 

In closing let me note that the pressure on all issuers of credit instruments to disclose more and more information of marginal utility to investors is a function of investor discomfort with an inadequate disclosure paradigm.  Until the paradigm is shifted to one that better reflects the characteristics of the risks that investors face, our credit markets will continue to hear demands for more disclosure when what is needed is better disclosure. 

You can continue to let the costs mount – the burdens of both additional, unhelpful disclosures and of unhappy investors – or you can try to give investors the information they need to understand your products on the same terms that you do.  I do not mean to suggest that this will be easy, but I do think it’s important.