Transparency Is the New Black

What do Members Only jackets, jazzercise leg warmers, acid wash jeans, and collateralized debt obligations have in common? They've fallen out of style in a big way. Similarly, this year's financial fashionistas will be shunning opaque investments like they're Bedazzled denim jackets. When it comes to trendy new balance sheet items, transparency is the new black.

The global financial landscape is changing in unprecedented ways. When the dust settles, my guess is transparency will emerge as one of the more highly sought-after corporate attributes, both in the US and abroad.

For years, investment bank's financial statements were mysteries wrapped in enigmas shrouded in secrecy sprinkled with obscurity. You had a better chance of properly pronouncing Blagojevich than knowing what investment banks' books held. But the days of veiled books are likely over for the foreseeable future.

For one thing, mega investment banks don't exist anymore in the US—at least not as standalone firms. They've either gone bust (Lehman Brothers), been scooped up (Merrill Lynch and Bear Stearns), or converted to bank holding companies (Goldman Sachs and Morgan Stanley). In all cases, new regulatory scrutiny won't allow for the same shenanigans available to the companies as investment banks. Their leverage ratios will come down and their oversight will be ratcheted up. Now that firms have to open their proverbial kimonos, complex, illiquid financial instruments have lost their luster.

It's not just regulators who will be increasingly scrutinous. Considering the recent turbulence resulting from poorly understood investments, shareholders are likely to value transparency much more highly than in the past. So companies exhibiting greater balance sheet transparency should see greater demand for their shares and thus, higher stock prices than less forthcoming firms—a fact that won't go unnoticed by corporate executives.

Many types of investments will also be affected by a move toward greater transparency. But just as once outdated bell-bottom pants recently reappeared on runways and "leveraged buyouts" reemerged as much more palatable "private equity acquisitions," many of these instruments will likely be re-engineered with different names and somewhat different structures than disappear entirely. And that's not a bad thing. Many of today's most maligned investments are actually quite useful.

Consider structured debt instruments like mortgage backed securities (MBS) and asset-backed securities (ABS). For decades, these vehicles facilitated a robust secondary market for mortgages, credit card debt, auto loans, student loans, and other types of debt. This improved borrowing rates and spurred lending. More complex instruments, such as collateralized debt obligations (CDOs), have drawn more criticism than Britney Spears' parenting skills, but even these denigrated investments usefully packaged debt to meet investors' needs. Unfortunately, mark-to-market accounting rule changes caused investors to view these vehicles in the same light as a smallpox outbreak. But that doesn't mean the investments themselves are fundamentally flawed.

Unfortunately, some investment instruments might have permanently fallen out of favor. For instance, the problem with auction rate securities isn't so much transparency as liquidity. Auction rate securities are long-term debt instruments that are supposed to act like short-term debt thanks to regular auctioning of the securities. But when the auction rate market froze this year, it became clear investment banks, not investors, were supplying liquidity to this market by purchasing securities when there was a dearth of real buyers. When investment banks backed off, many auctions failed.

Investors and businesses using derivatives are likely to favor transparency as well. They'll likely utilize exchange traded futures contracts instead of non-tradable forward contracts. The former are standardized, tradable, easily priced, and cleared through established exchanges, whereas the latter are customized, non-tradable, can be difficult to price, and sometimes involve substantial counterparty risk. The credit default swap (CDS) market provides a prime example. Already, several big financial players are trying to move these derided vehicles onto exchanges. The Chicago Mercantile Exchange, Intercontinental Exchange, Eurex, and NYSE Euronext all submitted proposals to US regulators to establish clearinghouses for credit default swaps.

Many hedge funds will be affected too. They can thank Bernie Madoff for a push towards transparency. No matter how reputable the portfolio manager, there won't be many well-heeled investors looking to put money into funds not fully disclosing their investments.

Ultimately, the transparency push will benefit investors. They'll be able to better assess the risks their investments entail, bringing renewed confidence to both debt and equity markets. It's time to pack up the mock turtlenecks, sansabelt slacks, and opaque investments of yesteryear and ring in 2009 with some shiny new transparency!