Monday, June 16, 2008

Institutional Risk Analyst Question of the Week: Is Risk Management Even Possible in an OTC Marketplace?

OTC derivatives had been legally permitted for the first time in 1993 by a regulatory exemption that Wendy Gramm had adopted as virtually her last act as CFTC chair. This allowed the growth of a business that is now estimated at over a hundred trillion dollars annually in terms of the notional value of contracts worldwide. Alan Greenspan had said that the growth of this market was the most significant development in the financial markets of the 1990s. The market was virtually unregulated and many, many times as big as the trading on the futures exchanges. The commission had kept some nominal authority over this market, but there were no mechanisms for enforcing the rules. For example, antifraud rules were retained, but no reporting was required. The market was completely opaque. Neither the commission nor any other federal regulator knew what was going on in that market! Also, there had been a number of major problems in the market, including the near collapse of Barings Bank until it was taken over by ING... During the time that I was at the commission, Long-Term Capital Management had to be bailed out by a number of the large OTC derivatives dealers because it had $1.25 trillion worth of derivative contracts at the same time it had less than $4 billion in capital to support them. I became enormously concerned about OTC derivatives and thought the market was a nightmare waiting to happen. About three months before we knew about Long-Term Capital Management, the commission came out with a concept release in the Federal Register asking for input from the industry and other interested people concerning the need for more oversight of the over-the-counter derivatives market. I was particularly concerned that there was no transparency. No federal regulator knew what kind of position firms like Long-Term Capital Management and Enron had in the derivatives markets. These instruments can be used to reduce economic risk, and they are certainly very valuable and useful economic instruments, but they can also create enormous risks, as they did at Enron and Long-Term Capital Management. (Brooksley Born, Washington Lawyer, October 2003)

The IRA was trolling the financial services channel in Washington last week, meeting with regulators and members of Congress to discuss the various topics arising from the widening subprime debacle. Probably the most significant discovery during our trip is news that the FDIC is making feverish operational preparations for an unprecedented wave of bank failures, large and small. This data point tracks with the rising number of calls we have been receiving at IRA HQ in Los Angeles from retail customers about the financial condition of specific banking institutions.

Just as abnormally low loan loss rates at US banks during the past five years suggested an eventual and equally abnormal upsurge in default rates, the fact of virtually no bank failures during that same period now means we shall see an above-normal number of failures in coming months and years. Our colleagues at the FDIC, at least among Washington regulators, seem to understand the systemic significance of this fact.

The largest failed bank resolutions by the FDIC to date involved institutions with tens or hundreds of thousands of depositors, but we hear in the channel that plans are being implemented to staff call centers to deal with inquiries from millions of depositors from multiple failed banks. The model for this effort, of note, is NetBank, the $2.5 billion asset Internet bank which failed last year at a cost of over $100 million to the deposit insurance fund. We described same in our comment (Death of a Business Model: NetBank, October 1, 2007).

We hear that the FDIC resolution of the virtual Netbank generated more than 3x the normal volume of inbound calls from depositors compared to a conventional, brick and mortal bank of similar asset size. We also hear that the FDIC is preparing a rule-making process to require banks to uniformly tag deposit accounts within their internal systems so that a resolution of a larger institution is possible.

FDIC Chairman Sheila Bair reportedly has made the completion of the deposit identification project the agency's top priority for 2008. At present, when FDIC personnel go into a failed institution, they often must manually reconstruct deposit ownership records using external software tools. The new rule is intended to address this potentially huge operational deficiency, but it may be too late - years too late -- to affect the outcome of the anticipated number and magnitude of bank failures.

Meanwhile on Capitol Hill, congressional staff asked The IRA what questions we would pose at the hearings on risk management by the Senate Banking Committee this week. Our response was simple: it is not possible to risk manage many of the OTC securities created by Wall Street -- at least not with the current generation of quant models. The death of Bear, Stearns & Co and the impending demise of Lehman Brothers (NYSE:LEH) provide grim witness to the truth of this observation.

We told the congressional staffers that no amount of new capital can save a broker dealer that populates its balance sheet with OTC paper and other inherently illiquid assets, assets which can neither be sold nor financed nor effectively "marked-to-market." After all, there is no market. In opaque OTC markets such as complex structured assets or even credit default swaps, risk management is basically impossible since liquidity is transitory at best and thus pricing for these assets is likewise uncertain. As George Soros wrote in his previous tome, the value of collateral is a function of liquidity.

We also advanced the view that the independent institutional broker dealer model may become extinct, again thanks to attributes of an OTC market structure. This means that once LEH has been disposed of in a sale to a large, probably foreign universal banking group, Goldman Sachs (NYSE:GS) will also probably be forced to sell as well thanks to the manifold blessings of financial market "innovation." It is a little ironic, don't you think, that the major dealers like Bear, LEH and GS are slowly being decimated by the very OTC markets that they helped to promote!

We had a number of interesting exchanges during our trip. One veteran federal regulator, who provided comments on our upcoming article for the Journal of Structured Finance, put to rest some of our fears that Washington is clueless about the nature of the OTC problem. Some excerpts follow:

The IRA: Where is the regulatory community in terms of coming to grips with the issues required to address the current financial crisis and particularly the structural problems of OTC markets?

Regulator: You suggest in your article that the issues raised by OTC markets have not been discussed within the regulatory community, but in fact it has and is being discussed intensively. Whether or not the OTC market needs to be officially "regulated" seems debatable, especially since regulators do not have the legal authority to enforce such a change.

The IRA: So the US and other nations must simply accept the fact that OTC markets are here to stay and that these inefficient markets will periodically destroy a large financial institution? That seems like a recipe for disaster, financially and politically.

Regulator: Part of the problem is cultural. Today we think that all markets are at a minimum weak form efficient. The Efficient Market Hypothesis is taught as gospel. The underlying assumptions of modern economic thought -- ready prices, informational symmetry, and rational expectations -- are all suspect and have been for a long time. We tend to view economics and modeling as a science governed by laws similar to the laws of nature. We believe that markets can be confined to probability spaces we understand and can reasonably estimate. This is not true.

The IRA: So you agree with our view that risk management of OTC markets is essentially impossible? Or does your statement apply to all financial markets?

Regulator: The reality is that economics is a social science and the attempts to make it "hard" are always going to run aground on the reality that human actions don't follow the "simple" laws of nature; they learn, adapt, herd, swarm, fall prey to trends, forget, remember, forget again - and in a semi-rational and sometimes irrational manner. The probability spaces are impacted by things traditional theory freely jettisons in order to make the model tractable. Therefore, risk models, upon which so much of the OTC market rests, are simply a way to communicate and express views of value -- usually rather naive and simplistic views -- and miss huge chunks of the real underlying "human action" risks.

The IRA: Ludwig von Mises, the author of Human Action, would be pleased to hear your comments. So, again, you agree with our view that most alleged "risk management" systems deployed on Wall Street are really just tools used to do deals and have no real capacity to measure let alone limit risk?

Regulator: The risk and pricing models are often created in order to convince traders and end-user investors that all these financial transactions -- behind which are human behaviors and cash flows -- are "manageable" and can be properly understood with the right analytics, data and "secret sauce." This witchcraft and sorcery can turn a toad into a prince, a rotten apple into a juicy melon. But it's all spurious precision. It's all vaporware. The models are used to create liquidity, which spurs volume, which garners big commissions and large EPS for dealers. The senior managers know that the models and assumptions upon which the higher spread product is based for things like OTC complex instruments are garbage, but you need a "basis" upon which to talk and compare so you can drive business. This charade works 90% of the time when things are calm, but as Hynman Minsky wrote in 1980 "stability is ultimately destabilizing." When risk regimes change, those who don't "know" these truisms find themselves naked.

The IRA: And they pretend to be surprised. So who should the Congress hold responsible for this mess, other than themselves? Do you agree with our view that Alan Greenspan, Robert Rubin and Larry Summers are among the leading culprits?

Regulator: I'll leave that judgment to the Congress. But your comments about former CFTC chairwoman Brooksley Born are on the mark. In fact, she was demonized over her supposedly naïve proposal to regulate the OTC markets.

The IRA: We've suggested to several members of Congress that Born's testimony is essential to help understand the current mess. We've also invited her to be interviewed for The Institutional Risk Analyst .

Regulator: People in the regulatory community remember this period well and how Born was treated. It is fair and nice to throw a feather in her cap. She had the courage to speak up, but it did cost Born a good deal of credibility. Ultimately, this question takes take us to a discussion about philosophy. Rubin, Greenspan and Summers all are taught and "want to" believe in general equilibrium theories. However, in times of turmoil they will act as the biggest socialist central planners in the world. Their hypocrisy seems to be lost on the media and the Congress.

The IRA: Maybe we should get a Soviet-era hammer and sickle for Ben Bernanke to put on his office wall! As our friend Jim Lucier at CapitalAlpha Partners likes to say, Washington is a city where every day is Halloween. Thanks.

We then spoke to Bob Feinberg, our favorite observer of financial services policy on Capitol Hill, about the state of the banking industry and congressional efforts to address the subprime financial meltdown.

The IRA: Bob, how do you see the solution to the subprime crisis shaping up on Capitol Hill?

Feinberg: Senator Reed (D-RI) recently said policymakers must act to restore the expectation that house prices will always go up. This is about the extent of congressional thinking on the issue so far.

The IRA: That doesn't sound very promising. The view we get from realtors in the New York area is that home prices could be moving down or at least sideways for the next couple of years.

Feinberg: At the last CMRE event that Elizabeth Currier allowed you and I to attend, which was in 2004, Larry Kudlow called for monetary reflation in order to make the economy look healthy so George W. Bush could be re-elected. It's happening again this year on behalf of all incumbents. The late Bob Weintraub called this the presidential cycle. It doesn't always work. In 1992, Greenspan didn't accommodate "41" (aka George H.W. Bush), and for a time there was doubt as to Greenspan's reappointment because 41 blamed Greenspan for his defeat. Fighting deflation becomes the Fed's excuse for pre-election monetary expansion, even if there is no deflation in sight. The way Greenspan put it in 2004 was that deflation was a low-probability, high-value event that must be staved off, just to be safe.

The IRA: But is it even possible to reflate the US economy when the financial industry is in such a terrible state?

Feinberg: I stand by my previous view about the model being broken, but I don't think people realize that this can't be fixed, that industries have life cycles, and the banking industry is about a half century past its best-if-used-by date. Greenspan once said to the Senate Banking Committee that some people would say that the only thing banks do is live off the yield curve. Whenever that model isn't available, they have to resort to extremely risky gambits to try to earn the returns Wall Street demands. It's a 19th century business model that got an extension thanks to the ability to arbitrage securities, but once they actually try to create new products, these instruments must be risky and opaque. So they've ended up as GSEs, CDOs and CDEs (Capital-Destroying Entities). Another acronym is the Disaster-Prone Organization (DPO), an expression coined by Prof. Anthony F.C. Sutton in his book, St. Clair, in which he laid out the reasons for the failure of the coal industry, which was just as powerful in its day as the banks are now.

The IRA: So you see the US banking industry going the way of king coal? Obviously the neither the Fed nor the Congress is willing to admit that a big constituency like the banking industry is moribund.

Feinberg: The bottom line is that the system is broken and can't be fixed. The reason the banks keep coming up with opaque products is that they're trying to de-commoditize a business that is mature and adds little or no value to the economy. In fact, over time and on net, the banking system destroys value. I wonder what song and dance the geniuses at Treasury are going to come up with next to justify buying worthless CDOs in the name of "reliquefying the market." I'm fascinated by the application of Gresham's Law to this situation; that bad collateral is manifestly driving out the good. I even read that banks are making bad loans in order to create some bad collateral, because the Fed will buy it.

The IRA: I take it that you do not expect the Congress to propose significant reforms of market structure?

Feinberg: After LTCM, the President's Working Group did a report and found that the financial system was just fine. After Amaranth, I think, some congressional committee(s), certainly Senate Banking, asked the PWG to go back and take a look at what they said in 1998, and PWG came back and said it had nothing to add. They asserted that the opaque market for derivatives could best be monitored by the banking regulators. I think this assertion needs to be rethought given what's happened with Bear and LEH.

The IRA: So even if we see more failures by banks and broker dealers, you do not expect the Congress to act in this election year?

Feinberg: The press in full of speculation about whether we're close to the end, but when you have antics like FHA making jumbo loans with 3% down, and the Dodd-Frank bill, which is intended to forestall the drop in house prices, these are signs that we're still in the bubble, because the political class is still trying to validate it and Restore Confidence. When Bernanke told the Senate Banking Committee that the Fed is encouraging banks to raise capital, he was careful to say that it's not because they need it, but because they need to be prepared to take advantage of the opportunites that will be presented when the economy starts growing again.

The IRA: Thanks Bob

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