Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis

Abstract

Conventional wisdom concerning the causes of the Financial Crisis posits that insufficient disclosure concerning firms’ exposure to complex credit derivatives played a key role in creating the uncertainty that plagued the financial sector in the fall of 2008. To help avert future financial crises, regulatory proposals aimed at containing systemic risk have accordingly focused on enhanced derivative disclosures as a critical reform measure. A central challenge facing these proposals, however, has been understanding whether enhanced derivative disclosures can have any meaningful effect given the complexity of credit derivative transactions.

This Article provides an empirical examination of the effect of enhanced derivative disclosures by examining the disclosure experience of the monoline insurance industry in 2008. Like AIG Financial Products, monoline insurance companies wrote billions of dollars of credit default swaps on multi-sector CDOs tied to residential home mortgages, but unlike AIG, their unique status as financial guarantee companies subjected them to considerable disclosure obligations concerning their individual credit derivative exposures. As a result, the experience of the monoline industry during the Financial Crisis provides an ideal setting with which to test the efficacy of reforms aimed at promoting more elaborate derivative disclosures.

Overall, the results of this study indicate that investors in monoline insurers showed little evidence of using a firm’s derivative disclosures to efficiently resolve uncertainty about a monoline’s exposure to credit risk. In particular, analysis of the abnormal returns to Ambac Financial (one of the largest monoline insurers) surrounding a series of significant, multi-notch rating downgrades of its insured CDOs reveals no significant stock price reactions until Ambac itself announced the effect of these downgrades in its quarterly earnings announcements. Similar analyses of Ambac’s short-selling data and changes in the cost of insuring Ambac debt securities against default also confirm the absence of a market reaction following these downgrade announcements.

Following a qualitative examination of how investors process derivative disclosures, the Article concludes that to the extent the complexity of CDOs impeded informational efficiency, it was most likely due to the generally low salience of individual CDOs as well as the logistic (although not necessarily analytic) challenge of processing a CDO’s disclosures. Reform efforts aimed at enhancing derivative disclosures should accordingly focus on mechanisms to promote the rapid collection and compilation of disclosed information as well as the psychological processes by which information obtains salience.

Keywords: Financial Crisis, Disclosure, CDOs, Monoline Insurers

JEL Classification: G14, G22, G28, G38, K22