Tuesday, January 29, 2008

What has the Credit Crisis Taught Us?

(Information Arbitrage) I have read a lot of different views concerning the credit crisis, the market dislocations in its wake, and the lack of confidence in the Fed's ability to materially cushion the blow of the inevitable unwinding that will ensue. None has really brought it all together for me, however, in a way that looks at both the strengths and weaknesses of current market structure and regulatory regimes and charts a better way forward. I will share a few thoughts that hopefully sheds a little light on what I consider to be a key part of the dialog that remains under-addressed.

A story in yesterday's Financial Times asked a key question, and perhaps THE question, that remains to be answered:

A fundamental question therefore arises: is the financial system broken, corrupt and in need of reform; or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope? On that diagnosis rests the future of our highly liberalised financial markets.

As is usually the case with answers to very complex questions concerning very complex contexts, the answer is neither black nor white. Is the financial system somewhat broken and in need of reform? Absolutely. But is the increasingly liberalized system in place today an essential element of a healthy, integrated and global financial marketplace? I think the answer is also a resounding yes. So where have things broken down, and what can we do to fix them? Here are some ideas:

  1. Increase transparency among regulated institutions
  2. Homogenize global accounting standards
  3. Homogenize global regulatory frameworks
  4. Aggressively strip conflicts of interest out of the system
  5. Clarify the roles and responsibilities of fiduciaries
  6. Develop common sense compensation policies and practices

Greater transparency. Let's be honest, is anything more important than getting good, full and accurate information about assets, liabilities, cash flows, contingencies and accounting practices of institutions responsible for providing such information? I'd say not. And if there is one thing we've seen time and time again. banks, insurance companies and other regulated entities were not clear about their asset portfolios and the contingencies associated with off-balance sheet transactions. Further, they themselves did not have an accurate grip on how certain multi-billion dollar pools of exposures should be valued and reflected on their financial statements. Now as investors, regulators and counterparties to those institutions, isn't this information that you'd like to have in order to make an accurate assessment of their financial position and appeal as both an investment candidate or a commercial partner? I'd say so. Regulators across all the major financial markets need to get together and agree on standards for transparency and disclosure that provide market participants with all the data they need to make informed decisions. Because in a world lacking transparency one can imagine a perpetual boom-bust-boom-bust cycle with amplified volatility, because the markets will not be accurately pricing in all the relevant information - just all the information that they are getting, which is materially imperfect. Heightened and consistent transparency is an essential element of helping address one of the precursors of the latest market crisis.

Common accounting standards. Even with IAS, financial statement presentation is not yet consistent across markets and geographies. This issue is closely related to that of transparency. Accounting rule-makers across the globe should use the current crisis as an opportunity to effect change, by once and for all creating a level playing field for issuers and investors everywhere. Let companies compete on their own merits - the merits of their operating business - without regard to financial gamesmanship. The US and Europe have been groping towards common standards for probably 20 years, ever since I first became a financial markets denizen. Let's get to it and salvage some good from the bad we've witnessed over the past six months. The heightened level of investor confidence should be reason enough to build a global agreement in the accounting realm.

Common regulatory frameworks. Principles-based? Rules-based? The SEC model, the FSA model, the BaFIN model or something different? Hard question. Really, really hard question. But one thing is for sure, there is still immense friction operating regulated businesses across markets due to different rules and standards. It truly makes no sense and can contribute to the types of problems we've witnessed in the current crisis. Divergent valuation policies. Varying risk management standards. Alternative views of what constitutes a transaction of true economic substance versus financial statement window-dressing (as with SIVs that suddenly found themselves back on bank balance sheets)? As capital flows become increasingly fluid and institutions everywhere are attracting global investor bases, comparability in both financial statement presentation and regulatory oversight is critical to creating a global market based on fairness, common data and common sense.

Address systemic conflicts of interest. The crisis of confidence in rating agencies has sharp parallels with another crisis of confidence we saw in an institution fraught with conflict - sell-side research. Write a nice report, get an M&A assignment, an equity underwriting, a bond deal? The system was broken, those of us in it saw it was broken and eventually this unstable and utterly-conflicted system was laid bare for all to see. Fast forward to 2007 - is the situation with the rating agencies any different? Whenever the seller pays for someone's imprimatur, be they an II-ranked research analyst or a rating agency's seal of approval, the mere appearance of conflict should send alarm bells ringing. Did the rating agencies issue ratings on instruments they didn't fully understand, and whose behavior they couldn't have imagined upon issuing their rating? Apparently so. Should they have allowed the market to evolve, albeit with smaller deals and at much lower levels, by refusing to rate instruments that they've never seen behave across even a single market cycle? Probably. But they didn't. Because the market was there and they wanted the money. They're no dummies. Investors and regulators are, because they bought these ratings hook, line and sinker and allowed this flawed practice to continue unchecked. Why should anyone place value on a rating with such an apparent conflict? Beats me. This is simply one conflict that needs to be stripped out of the system, but such an essential one given the role of the rating agency in the institutional investment process.

Firm up the roles and responsibilities of fiduciaries. If you are the steward of someone's money, and it is your responsibility to make intelligent, informed decisions, is this a responsibility you can abrogate by passing on to another? And, if the responsibility is passed along and accepted by another, are they then held to the same fiduciary standard to which you are being held? For instance, if a pension fund hires a fund-of-funds manager because they themselves do not have the due diligence expertise in-house, is the fund-of-funds manager responsible for discharging their fiduciary responsibility? Or if they buy a CDO because S&P rates it AAA, do they then pass their fiduciary responsibility on to S&P? These are hard, hard questions. All I know is that the buck needs to stop somewhere, and right now it seems that the buck gets broken into change as fiduciaries retain consultants, asset managers and buy instruments with certain ratings that conform to their charter, and that when things go wrong the party harmed - the people whose money is being administered by the fiduciary - has nowhere to turn. This needs to change. Roles and responsibilities need to be clarified and everyone needs to know where the buck stops. Because it seems that abrogation of responsibility is rampant and it is the little guy who is getting screwed.

Develop common sense compensation policies. I come from Wall Street and I like money and pay-for-performance. But there is a problem between the asymmetric risk/reward so common on Wall Street where the incentive is to swing for the fences and to even game the system, because compensation is partly based on unrealized P&L. Heads I win, tails you lose. Frequently not a problem in up-markets, often catastrophic in down markets. This also gets to the issue of transparency. Like I've written before, compensation should largely follow the path of realized gains, with some measure of compensation paid on unrealized gains in liquid securities. In less-liquid or hard-to-value instruments, compensation should follow a private equity-type model - pay out cash when cash is realized. Otherwise, management is going to be wish they had a claw-back when such a model, we all know, is fanciful on Wall Street. The issue needs to be dealt with head-on, up front, not years down the road. Investors should pay more for the shares of a firm that pays its people well but pays them for value they've really created, not highly uncertain value that may or may not be realized down the road.


Free, flat and liquid markets hold the promise that has been discussed for years: optimal capital allocation, proper risk distribution, leveling of the playing field between large and small investors and cheap and efficient capital formation. The issue is that several factors need to hold in order for this promise to be realized. Markets really need to be free. They need to be flat. And they need to be liquid. And the current crisis shows us that none of these things are really true. But I do believe that my suggestions can go a long way towards helping us build a fair, integrated and global financial marketplace. Hopefully regulators and rule-makers everywhere will rise to the challenge.

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