Friday, October 30, 2009

RBC pioneers Canadian covered bond market

Posted in the Globe & Mail by Andrew Willis:

For centuries, German and Danish banks have raised money by selling what’s known as covered bonds. Now Royal Bank of Canada is bringing this form of financing to Canadian institutions.

Canada’s largest bank sold $750-million of covered bonds on Thursday, the first such issue in the local market by a domestic bank.

Covered bonds are belt-and-suspenders type borrowing. Investors get debt that is backed by both the institution that issues the paper, plus a claim on an underlying pool of assets, typically mortgages.

In return for all this security, covered bonds typically feature relatively low interest rates. That was the case on the Royal Bank (RY-T53.90-1.53-2.76%) issue: The five-year bonds paid 3.27 per cent interest, a premium of just 49.7 basis points over the comparable Government of Canada debt.

The prospect of even a little extra income with all kinds of covenants - the Royal Bank issue carried a triple-A rating - meant underwriters led by RBC Dominion Securities were able to bump up the size of the offering to $750-million from an initial minimum of $500-million.

Royal Bank was the first domestic borrower to tap the European covered bond market, with a €2-billion inaugural issue in October, 2007. Bank of Montreal also tapped this market in the fall of ’07.

When these issues rolled out, there were lofty predictions of $90-billion market developing in Canadian covered bonds. That estimate was based in part on the fact that federal regulators at OSFI ruled in 2006 that domestic financial institutions can finance up to 4 per cent of their total assets this way.

The credit crunch got in the way of further covered bond issues, but this week’s Royal Bank financing shows the market is back, and can be developed in Canadian dollar-denominated issues.

RBC Dominion used two separate syndicates to sell this offering, with one team of investment banks selling to Canadian institutional and retail investors, and a second group of dealers marketing to foreign clients.

The domestic dealers included CIBC World Markets , BMO Nesbitt Burns, National Bank Financial, Scotia Capital, TD Securities, Bank of America Merrill Lynch, HSBC Securities, JPMorgan Securities, Laurentian Bank Securities and Manulife Securities.

The global syndicate, which included heavy European content, was made up of Barclays Capital, BNP Paribas, Commerzbank and Morgan Stanley.

RBC Covered Bond Attracts Sell-Out Investor Crowd

Posted on the Housing Wire by Austin Kilgore:

The latest covered bond out of Canada was not short of investor interest. The Royal Bank of Canada (RBC) is issuing the third series of C$750m ($695.7m), five-year fixed-rate bonds of its self-titled covered bond program with expected success.

The deal is under the same terms of its €15bn ($22.2bn) global covered bond program, and market reports suggest that third-party interest in such structured products is growing in strength.

Moody’s Investor Services assigned a provisional long-term rating of triple-A to the deal. The covered bond program has a cover pool comprised of prime-quality, seasoned mortgages secured by Canadian residential properties with an average weighted loan to value (LTV) of 66.2%. It has a minimum overcollateralization of 3%, which RBC is contractually obligated to maintain at all times.

In assigning the rating, Moody’s said bond investors will benefit from RBC’s credit strength, and hedging arrangements with respect to interest rates between the assets in the cover pool and the covered bonds.

Moody’s added investors are exposed to a number sources of risk, including refinancing, market conditions, liquidity, set-off, credit and substitution, but noted all are partially offset by the transaction’s structural enhancements. These risk would only materialize in the event of RBC’s default, so “there is a degree of linkage between the rating of the issuer and the rating of the covered bonds,” Moody’s said.

According to the Wall Street Journal, bonds priced at 50 basis points above benchmark, with a 3.27% coupon. There is no word on subscription rates yet.

Covered bonds are rare in North America, compared to Europe. To date, Bank of America and Washington Mutual are the only two existing domestic issuers of covered bonds in the US – but Citi, JPMorgan and Wells Fargo all expressed interest last year in starting covered bond portfolios. However, the bonds are expensive, considering the dual recourse structure that leaves banks liable for losses. A typical bullet repayment also tends to appeal to a separate investor base than securitization.

Wednesday, October 28, 2009

Never Send a Boy to Do a Man's Job

Posted on the Epicurean Dealmaker:

Interesting article over at this morning. Did you see it?
Oct. 27 (Bloomberg) — In the months leading up to the September 2008 collapse of giant insurer American International Group Inc., Elias Habayeb and his colleagues worked nights and weekends negotiating with banks that had bought $62 billion of credit-default swaps from AIG, according to a person who has worked with Habayeb.

Habayeb, 37, was chief financial officer for the AIG division that oversaw AIG Financial Products, the unit that had sold the swaps to the banks. One of his goals was to persuade the banks to accept discounts of as much as 40 cents on the dollar, according to people familiar with the matter.

Among AIG’s bank counterparties were New York-based Goldman Sachs Group Inc. and Merrill Lynch & Co., Paris-based Societe Generale SA and Frankfurt-based Deutsche Bank AG.

By Sept. 16, 2008, AIG, once the world’s largest insurer, was running out of cash, and the U.S. government stepped in with a rescue plan. The Federal Reserve Bank of New York, the regional Fed office with special responsibility for Wall Street, opened an $85 billion credit line for New York-based AIG. That bought it 77.9 percent of AIG and effective control of the insurer.
Beginning late in the week of Nov. 3, the New York Fed, led by President Timothy Geithner, took over negotiations with the banks from AIG, together with the Treasury Department and Chairman Ben S. Bernanke’s Federal Reserve. Geithner’s team circulated a draft term sheet outlining how the New York Fed wanted to deal with the swaps—insurance-like contracts that backed soured collateralized-debt obligations.
Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.
Uh, okay.
* * *
I must admit, Dear and Long-suffering Readers, that my first reaction to this news was of a kind with several of the sources quoted in the article: white-hot, scalding rage.

I mean, what the f%#k?! Tim Geithner and pals left up to thirteen billion dollars of taxpayer money just sitting on the table? Why?
[B]ecause some counterparties insisted on being paid in full and the New York Fed did not want to negotiate separate deals, says a person close to the transaction.
Oh, that's a good reason. No, really, I mean it.

Dumb fucking c$%ks#@&ers.
* * *
Now, to be fair, I am not willing to swallow the Bloomberg article hook, line, and sinker. For one thing, none of the numbers I have been able to glean either from it or from other sources add up. I suspect the high-speed, real-time negotiations over cancelation of the credit default swaps, purchase of the "super-senior" CDOs underlying AIG's CDSs, and coincident payment by AIG of increasingly frequent, strident, and large collateral calls by its counterparties during the frantic days of mid-September a year ago make it damn difficult for anyone to reconstruct exactly what happened and who paid how much to whom and when, much less a bunch of underpaid, slightly innumerate financial reporters.

And you definitely need to read between the lines. Just because Elias Habayeb intended to persuade Goldman Sachs, SocGen, Merrill Lynch, Deutsche Bank, and several other representatives of The Great Deceiver Here on Earth to accept 40% haircuts doesn't mean he had a snowball's chance in hell of doing so. In fact, the GAO's September 2009 report on the AIG fiasco unequivocally states his efforts failed prior to the government takeover (p. 17):
AIG’s negotiations with counterparties and creditors to reduce the outstanding obligations through contract renegotiation had proven unsuccessful.
But this selfsame GAO report clearly outlines the issue with the Fed's subsequent precipitate actions (p. 18):
Critics of the government’s assistance have noted that by providing assistance to AIG for the purpose of providing or returning cash collateral to counterparties, the government was indirectly assisting the counterparties, and they questioned the efficiency of this approach. Some noted that banks that had bought CDS contracts from other failed insurers were paid 13 cents on the dollar in deals mediated by New York’s insurance regulator, whereas AIG’s counterparties were paid market value. They said that new capital to AIG in effect served as direct infusions to the counterparties, including foreign financial institutions. Conversely, Federal Reserve officials believed that if AIG had failed to pay the collateral amounts due, it would have been in default of its agreements, which could have resulted in AIG’s counterparties forcing it into bankruptcy. Moreover, they believed that the unfolding crisis warranted swift action to prevent total collapse of the financial system given its fragile state at that time.
It is clear that some banks were in deep doo-doo as AIG spiraled ever more quickly toward its predestinate sticky end (p. 22):
Finally, the Federal Reserve and Treasury stated in separate reports and testimonies in the fall of 2008 and early 2009 that the failure of AIGFP could have led to billions of dollars of losses at bank counterparties that bought CDS contracts from AIG.29 Because many banks used these contracts as credit protection, following losses to CDS contract holders, if any, AIG’s failure could have led to mounting losses through sudden, unhedged, uncollateralized exposure as market conditions worsened and underlying assets continued to decline in value. Banks and other counterparties could have faced declining capital bases because of these unrealized losses. Moreover, counterparties with unfulfilled derivative contracts could have faced difficulties in offsetting balance sheet exposures through replacement derivatives, and they would have had to confront the possibility of entering into new contracts at a time when market participants had become increasingly risk averse and unwilling to execute new transactions.
Of course, not all of AIG's counterparties would have faced wrack and ruin had it defaulted on its obligations. Most notably, Goldman Sachs crowed loud and long at the time that it was fully hedged against AIG's untimely demise, and that it couldn't give a rat's ass whether Bob Willumstad's company took the pipe or not. This has led more than one market observer to speculate that the $11 or $12 or $13 billion in cash which the Federal Reserve presented to Goldman on a silver platter represented a particularly fetching and unexpected gift from the pockets of the American taxpayer direct to the bank accounts of Goldman's employees. It certainly encourages me to believe that whatever difference between a realistic haircut Goldman could have expected to endure on AIG's CDSs and the no-haircut they did receive represents a particularly large and tasty helping of frosting on an already delicious and unexpectedly rich cake.

Taking, for argument's sake, the 40% figure bandied about, that would be about five billion dollars worth of buttercream for Lloyd and his buddies. Or, as a point of reference, a figure approximately equal to the entire compensation and benefit expense Goldman recorded in its most recent fiscal quarter. Sweet, huh?
* * *
So, what's my point?

Just this: Tim Geithner and the Federal Reserve got royally played. And you and I, my friends, paid dearly for the privilege.

Sure, the Fed was worried that AIG's uncontrolled collapse could lead to a complete and utter meltdown of the global financial system. Even now, with the worst of the crisis behind us and plenty of time to reflect, it is hard to criticize this worry as hysterical. It is also true that things were moving way too quickly to sit down and think them through logically, so we should not superimpose unreasonable expectations of measured, rational thought on the Fed's negotiators. It is also even remotely possible that some of AIG's counterparties were so inept and unprepared for the insurance company's troubles that they truly might have blown up themselves if it went down. (Although AIG's train wreck was so long coming and so well telegraphed that any bank so blind to the obvious and unprepared for the inevitable probably should have been shut down on pure principle.)

But Christ, people, think about it.

What moronic financial entity—fully hedged or not—would really risk global financial catastrophe by throwing AIG into bankruptcy, even if it had the contractual and legal right to do so? Because it insisted on receiving 100% of the proceeds due to it by contract? Even though parties to financial contracts renegotiate existing terms under normal market conditions all the time? What good, for example, would those extra five billion clams—not collected, by the way, until the bankruptcy judge wound the company down, if ever—have done Goldman Sachs if it, Morgan Stanley, and every other major investment and commercial bank were in liquidation too?

Furthermore, what foreign or domestic bank CEO in his right mind has the balls to threaten the government of the United States of America with financial meltdown if it doesn't cough up another couple billion dollars out of the public purse? Are you fucking kidding me?

AIG's counterparties had no leverage whatsoever. None.

Of course, Geithner and Bernanke were over a barrel, too, because they didn't want to do anything stupid to trigger Armageddon either. Among other things, I believe it is in their brief to prevent just such annoyances. I do not claim they should have been able to get all 40% of the target discount from the banks. But nothing? Not even from the guys who claimed not to care?

Give me a break.
* * *
Now, I am sure I will get flack from the usual suspects—ignorant twenty-somethings who have never renegotiated a contract in their lives and disingenuous ideologues who have and should know better—for suggesting it, but I think the Fed has a good case for clawing back some of AIG's payments. I think a couple of quiet words with the CEOs and Boards of Goldman Sachs, SocGen, BofA, and Deutsche Bank could go a long way toward encouraging a "voluntary" return of some of these monies to the public purse. Consider it, if you will, a generous donation from the assembled titans of finance for the benefit of the regulators who pulled their testicles out of the fire a mere thirteen months ago. A grateful gift, so to speak, from the money men to the people and officials who make their very existence possible.

Of course, history and common sense tell us that a mere bureaucrat will lack the credibility to deliver such a threat message to the Masters of the Universe. Even now, as Secretary of the Treasury, Mr. Geithner is more likely to inspire giggles of disbelief from Lloyd Blankfein et al. than deferential respect.

No, what you need is a professional psychopath, a highly trained and expert negotiator, who will tuck his Hermes tie into his shirt and slap the offending CEOs silly before emptying their firms' bank accounts. Someone who can run roughshod over the rights and expectations of self-interested plutocrats in the name of Life, Liberty, and the Pursuit of Happiness, or at least a balanced budget. Someone who can make assembled onlookers squeal in horror as he tramples precedent, custom, and noblesse oblige into the mud alongside all the other tired, self-righteous pablum capitalists and free marketeers have been reciting like Holy Writ for nigh on thirty years.

Someone who isn't afraid to negotiate hard. Someone who isn't afraid to scream, and yell, and threaten all sorts of horrible consequences, real and imagined, for anyone who doesn't accede to his demands.

And, since Steve Rattner is no longer in the picture, I guess it'll just have to be me.

Lloyd, you are so f%#ked.

Tuesday, October 27, 2009

OSC weighs in on derivatives

Posted in the Globe & Mail's Streetwise by Steve Ladurantaye:

The Ontario Securities Commission issued a report Tuesday outlining its position on contracts for differences, which are derivative-based products that have been made available in Ontario and Quebec this week for the first time.

“We would also like to take this opportunity to highlight some of the investor protection concerns we have with offerings of CFDs to investors in circumstances where such offerings are made without the protections of dealer involvement,” the OSC said in a note.

CMC Markets Canada received approval this month to offer the products, three years after first asking permission. When a client buys a CFD, they are betting on the price moving of an underlying product – be it currency, commodity, index or stock. They never actually own anything, and highly leveraged positions tend to open and close quickly.

The commission said that investors have had access to the products for some time through the Internet, and “appropriately registered dealers” may be able to provide some measure of investors protection.

The main sticking point during the three-year discussion was whether the CFDs are actually securities, and if so, whether they had to be sold along with a prospectus. The OSC note says yes, they are and yes, they must.

However, CMC Markets was granted an exemption to the prospectus rule because it agreed to work under a set of guidelines that control margin rates and client suitability, among other things. Any new dealer would also have to apply for an exemption before offering the CFDs to retail investors.

“We acknowledge that the prospectus requirement may not be well-suited to offerings of certain types of OTC derivative products, including CFDs and forex contracts ... OSC staff will consider exemption applications on a case-by-case basis.”

The full discussion can be found here.

New York Fed’s Secret Choice to Pay for Swaps Hits Taxpayers

Posted on Bloomberg by Richard Teitelbaum and Hugh Son:

In the months leading up to the September 2008 collapse of giant insurer American International Group Inc., Elias Habayeb and his colleagues worked nights and weekends negotiating with banks that had bought $62 billion of credit-default swaps from AIG, according to a person who has worked with Habayeb.

Habayeb, 37, was chief financial officer for the AIG division that oversaw AIG Financial Products, the unit that had sold the swaps to the banks. One of his goals was to persuade the banks to accept discounts of as much as 40 cents on the dollar, according to people familiar with the matter.

Among AIG’s bank counterparties were New York-based Goldman Sachs Group Inc. and Merrill Lynch & Co., Paris-based Societe Generale SA and Frankfurt-based Deutsche Bank AG.

By Sept. 16, 2008, AIG, once the world’s largest insurer, was running out of cash, and the U.S. government stepped in with a rescue plan. The Federal Reserve Bank of New York, the regional Fed office with special responsibility for Wall Street, opened an $85 billion credit line for New York-based AIG. That bought it 77.9 percent of AIG and effective control of the insurer.

The government’s commitment to AIG through credit facilities and investments would eventually add up to $182.3 billion.

Beginning late in the week of Nov. 3, the New York Fed, led by President Timothy Geithner, took over negotiations with the banks from AIG, together with the Treasury Department and Chairman Ben S. Bernanke’s Federal Reserve. Geithner’s team circulated a draft term sheet outlining how the New York Fed wanted to deal with the swaps -- insurance-like contracts that backed soured collateralized-debt obligations.

Subprime Mortgages

CDOs are bundles of debt including subprime mortgages and corporate loans sold to investors by banks.

Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.

The New York Fed’s decision to pay the banks in full cost AIG -- and thus American taxpayers -- at least $13 billion. That’s 40 percent of the $32.5 billion AIG paid to retire the swaps. Under the agreement, the government and its taxpayers became owners of the dubious CDOs, whose face value was $62 billion and for which AIG paid the market price of $29.6 billion. The CDOs were shunted into a Fed-run entity called Maiden Lane III.

Habayeb, who left AIG in May, did not return phone calls and an e-mail.

Goldman Sachs

The deal contributed to the more than $14 billion that over 18 months was handed to Goldman Sachs, whose former chairman, Stephen Friedman, was chairman of the board of directors of the New York Fed when the decision was made. Friedman, 71, resigned in May, days after it was disclosed by the Wall Street Journal that he had bought more than 50,000 shares of Goldman Sachs stock following the takeover of AIG. He declined to comment for this article.

In his resignation letter, Friedman said his continued role as chairman had been mischaracterized as improper. Goldman Sachs spokesman Michael DuVally declined to comment.

AIG paid Societe General $16.5 billion, Deutsche Bank $8.5 billion and Merrill Lynch $6.2 billion.

New York Fed

The New York Fed, one of the 12 regional Reserve Banks that are part of the Federal Reserve System, is unique in that it implements monetary policy through the buying and selling of Treasury securities in the secondary market. It also supervises financial institutions in the New York region.

The New York Fed board, which normally consists of nine directors, in November 2008 included Jamie Dimon, chief executive officer of JPMorgan Chase & Co., and Friedman. The directors have no direct role in bank supervision. They’re responsible for advising on regional economic conditions and electing the bank president.

Janet Tavakoli, founder of Chicago-based Tavakoli Structured Finance Inc., a financial consulting firm, says the government squandered billions in the AIG deal.

“There’s no way they should have paid at par,” she says. “AIG was basically bankrupt.”

Citigroup Inc. agreed last year to accept about 60 cents on the dollar from New York-based bond insurer Ambac Financial Group Inc. to retire protection on a $1.4 billion CDO.

Unwinding Derivatives

In March 2009, congressional hearings and public demonstrations targeted AIG after it was disclosed it had paid $165 million in bonuses that month to the employees of AIGFP, which is unwinding billions of dollars in derivatives under the supervision of Gerry Pasciucco, a former Morgan Stanley managing director who joined AIG after the CDS payments were mandated.

Far more money was wasted in paying the banks for their swaps, says Donn Vickrey of financial research firm Gradient Analytics Inc. “In cases like this, the outcome is always along the lines of 50, 60 or 70 cents on the dollar,” Vickrey says.

A spokeswoman for Geithner, now secretary of the Treasury Department, declined to comment. Jack Gutt, a spokesman for the New York Fed, also had no comment.

One reason par was paid was because some counterparties insisted on being paid in full and the New York Fed did not want to negotiate separate deals, says a person close to the transaction. “Some of those banks needed 100 cents on the dollar or they risked failure,” Vickrey says.

A Range of Options

People familiar with the transaction say the New York Fed considered a range of options, including guaranteeing the banks’ CDOs. They say that by buying the securities, AIG got the best deal it could.

According to a quarterly New York Fed report on its holdings, the $29.6 billion in securities held by Maiden Lane III had declined in value by about $7 billion as of June 30.

Edward Grebeck, CEO of Stamford, Connecticut-based debt consulting firm Tempus Advisors, says the most serious breach by the government was to keep the process of approving the bank payments secret.

“It’s inexcusable,” says Grebeck, who teaches a course on CDSs at New York University. “Everybody should be privy to the negotiations that went on. We can’t have bailouts like this happening behind closed doors.”

Secret Deliberations

The deliberations of the New York Fed are not made public. In this case, even the identities of the AIG counterparties weren’t disclosed until March 2009, when U.S. Senator Christopher Dodd, head of the Senate Finance Committee, demanded they be made public.

Bloomberg News has filed a Freedom of Information Act request seeking copies of the term sheets related to AIG’s counterparty payments, along with e-mails and the logs of phone calls and meetings among Geithner, Friedman and other New York Fed and AIG officials. The request is pending.

The Federal Reserve has been reluctant to publish information on its efforts to stabilize the financial system since the crisis began. The Fed has loaned more than $2 trillion, yet it refuses to name the recipients of the loans, or cite the amount they borrowed, saying that doing so may set off a run by depositors and unsettle shareholders.

Bloomberg LP, the parent of Bloomberg News, sued in November 2008 under the Freedom of Information Act for disclosure of details about 11 Fed lending programs. In August, Manhattan Chief U.S. District Judge Loretta Preska ruled in Bloomberg’s favor, saying the central bank had to provide details of the loans.

The Fed has appealed to the Second Circuit Court of Appeals, and the data remain secret while the appeal proceeds.

‘Cataclysmic Financial Crisis’

Information on the borrowers is “central to understanding and assessing the government’s response to the most cataclysmic financial crisis in America since the Great Depression,” attorneys for Bloomberg said in the Nov. 7 suit.

Questions about the New York Fed transactions may be answered by Neil Barofsky, inspector general for the Troubled Asset Relief Program, or TARP. He is working on a report, which may be released next month, on whether AIG overpaid the banks. TARP is the vehicle through which the Treasury invested more than $200 billion in some 600 U.S. financial institutions.

William Poole, a former president of the Federal Reserve Bank of St. Louis, defends the New York Fed’s action. The financial system had suffered through months of crisis at the time, he says. The investment bank Bear Stearns Cos. had been swallowed by JPMorgan; mortgage packagers Fannie Mae and Freddie Mac had been taken over by the government; and the day before AIG was rescued, Lehman Brothers Holdings Inc. had filed for bankruptcy.

‘Enough Trouble’

“I think the Federal Reserve was trying to stop the spread of fear in the market,” Poole says. “The market was having enough trouble dealing with Lehman. If you add, on top of that, AIG paying off some fraction of its liabilities, a system which is already substantially frozen would freeze rock-solid.”

Still, officials at AIG object to the secrecy that surrounded the transactions. One top AIG executive who asked not to be identified says he was pressured by New York Fed officials not to file documents with the U.S. Securities and Exchange Commission that would divulge details.

“They’d tell us that they don’t think that this or that should be disclosed,” the executive says. “They’d say, ‘Don’t you think your counterparties will be concerned?’ It was much more about protecting the Fed.”

‘An Outrage’

Friedman’s role remains controversial. In December 2008, weeks after the payments to the banks were authorized in November, Friedman bought 37,300 shares of Goldman stock at $80.78 a share, according to SEC filings. On Jan. 22, he bought 15,300 more at $66.61.

Both purchases took place before the payments to Goldman Sachs were publicly disclosed under pressure from Senator Dodd in March. On Oct. 26, Goldman Sachs stock closed at $179.37 a share, meaning Friedman had paper profits of $5.4 million.

Jerry Jordan, former president of the Federal Reserve Bank of Cleveland, says Friedman should have resigned from the New York Fed as soon as it became clear that Goldman stood to benefit from its actions.

“It’s an outrage,” Jordan says. “He needed to either resign from the Fed board or from Goldman and proceed to sell his stock.”

98,600 Goldman Shares

Friedman remains a member of Goldman’s board and held a total of 98,600 shares of the firm’s stock as of Jan. 22.

Vickrey says that one reason the New York Fed should have insisted on discounted payments for AIG’s CDSs is that the banks likely had hedges against their insured CDOs or had already written down their value. On March 20, Goldman Sachs CFO David Viniar said in a conference call with investors that Goldman was protected.

“We limited our overall credit exposure to AIG through a combination of collateral and market hedges,” Viniar said. “There would have been no credit losses if AIG had failed.”

In any event, former St. Louis Fed President Poole says the entire process should have been public and transparent. “There should be a high bar against not disclosing,” Poole says. “The taxpayer has every right to understand in detail what happened.”

Monday, October 26, 2009

Once Again, Nassim Taleb Slams His Critics For Not Understanding Him

Posted on the Falkenblog by Eric Falkenstein:

The ever amusing Nassim Taleb has penned yet another response to his critics. He simply oozes defensiveness, which combined with his arrogance, strong opinions, and popularity, makes him incredibly fun to write about (if you haven't been accused of WEB VANDALISM by NNT, you are missing out).

So, here's his new summary, which he notes parenthetically, "I have had to repeat continuously" (perhaps his emphatic reassertion is not compelling?). Anyway, he notes that "theories fail most in the tails; some domains are more vulnerable to tail events." I agree. Newton's theories don't work at the Plank length, cosmology has trouble explaining the first minute of the universe, and evolutionary biologists have trouble explaining the Cambrian explosion 500MM years ago. Explaining most of the data is easier, and generally more important.

Now, one may protest, it's not a new point. However, Taleb argues that "nobody has examined this problem in the history of thought", highlighting the common problem of autodidact philosophers, that they tend to be too dismissive of the scientific literature. He notes what he is not talking about includes most everything that is directly related to extreme events and uncertainty: falsification, power laws, Hume's problem of induction, Knightian Uncertainty, Austrian Uncertainty, integrating fat tails into models, etc. He's aware of these arguments, but claims his idea is different

His big twist: that rare events can't be estimated, because they are rare, especially, when they are rare and have large impacts. Well, I would argue this issue is addressed in the literature he notes is unrelated to this point, as long disquisitions on the difficulty in estimating an event like WWI, or standard errors on order statistics, seems like the same subject to me. He can say these earlier discussions are flawed, but they address his key point. The more he explains himself, the more he sounds like some passage from Knight, Keynes, Hume, Minsky, etc. once you translate his neologisms (historia, ludic fallacy). I would argue Taleb is much less clear than these writers, because he's trying so hard to make the old sound new. Saying it's really new doesn't make it so.

He ends with a strong plea to not be wedded to a theory, to look at the facts and avoid fitting them into a preconceived theory. I'm sure the vast 'preconceived, untestable theory' crowd has a lot of soul searching to do. Yet, I think he's the best example of their kind. He has a theory: that he's saying something really 1)new, 2)true, and 3)important. He says many things, often contradictory, but he never manages more than 2 of those attributes in any assertion.

Friday, October 23, 2009

Why Do Bankers Make So Much Money?

Posted on Rick Bookstaber's blog:

A tenet of economics is that in competitive markets there are no economic rents. That is, people get fairly paid for their efforts, their capital input, and for bearing risk. They are not paid any more than is necessary as an incentive for production. In trying to understand the reason for the huge pay scale within the finance industry, we can either try to justify the pay level as being a fair one in terms of the competitive market place, or ask in what ways the financial industry deviates from the competitive economic model in order to allow economic rents.

Do the banks operate in a competitive market?

No one expects competitive levels of compensation when there are deviations from a competitive market. In what ways might the banks – and here I mean the largest banks and those banks that morphed over the past year from being investment banks – fall away from the model of pure competition?

One way is through creating inefficiencies to keep competitive forces at bay. Banks can do this, for example, by constructing informational asymmetries between themselves and their clients. This gets into those pages of small print that you see in various investment and loan contracts. What we might call gotcha clauses and what the banks call revenue enhancers. And it also gets into the use of complex derivatives and other “innovative products” that are hard for the clients to understand, much less price.

Another way is to misprice risk and push it into other parts of the economy. The fair economic payoff increases with the amount of risk taken. If a bank takes on more risk it should get a higher expected payoff. If the bank can get paid as if it is taking on risk while actually pushing the risk onto someone else, then it will start to pull in economic rents. The use of innovative products comes up again in this context. They provide a vehicle for the banks to push risk to others at a less than fair price. Or, push the risk to the taxpayers by hiding the risk and then invoking the too-big-to-fail protections when it comes to be realized. The current “heads I win, tails you lose” debate centers precisely on this point.

A third, and most obvious reason banks might not be economically competitive entities is the organization of the industry. There are barriers to entry. No one can just decide to set up a major bank. And there are constraint in the amount of business any one bank can do. As we have seen with Citigroup, there finally are diseconomies of scale – after a point the communication and management issues make the bank less efficient and more prone to crisis. If there is fixed supply, then the banks can push up the price of their services. The crisis over this past year has made matters worse. If you are one of those still standing, you are a beneficiary of that crisis, which has choked off the supply even further.

Are the workers getting paid fairly for their efforts?

An alternative to the idea that the industry is not competitive is that the industry really is competitive and those who are getting these outsized paychecks are being fairly compensated for their efforts. This comes back to the term we hear bandied about in conversations on banker compensation: talent.

There is no denying there are many smart people in the banking industry. (Though I think from a social welfare standpoint, we might have done better if some of those physicist and mathematicians that populate the ranks of the banks had found greener pastures in, say, the biological sciences). But I don’t buy the notion that there are so many who have the level of talent that justifies tens and even hundreds of million in compensation. I think this level of compensation, and the notion of talent behind it, is the result of the inherent uncertainty in the financial enterprise, one that makes it very difficult to assess talent. Indeed, I think the invocations of talent for money producers in finance are akin to those that, in times past, were set aside for the mystical powers of saints and witches.

Far more than other fields of endeavor, it is difficult in finance to tell if someone is good or lucky. A top trader or hedge fund manager might have a Sharpe Ratio of 1.0 or 2.0. But that Sharpe Ratio is nothing less that a statement that if you get a hundred people trading, a few will do well just by luck. (And it doesn’t matter if that Sharpe Ratio occurred over the period of one year or twenty – it is still the same thing in terms of statistical inference, so a long track record does not get you away from this problem).

How does this tie in with saints and witches? People want certainty, and if they can’t get the certainty they want from the empirical, they fall back on superstition and witchcraft, or at least they used to way back when. In some medieval village, a priest prayed and a supplicant was healed. The odds that the supplicant would have healed spontaneously was whatever it was, but it provided more of a sense of certainty to feel that it was the manifestation of healing power.

There were false saints and true saints, which became manifest over time by how frequently the prayers were answered with affirmative results. Not that any saint had to bat a thousand. Sometimes there were understandable, exogenous circumstances that inhibited the saint’s healing talents from being operative, most commonly a lack of righteousness on the part of the supplicant, occasionally an inevitability, a higher power that overshadowed that of the saint. Maybe the will of God, maybe an unknown, evil curse.

I hope the analogy is apparent. And there is a related one, an analogy to Pascal's Wager. The bank should wager that the talent of its star employee exists, because it has much to gain over time if it does, while if it does not exist, the bank will lose little in expected terms. And in a competitive world, it is even worse if they incorrectly let the talent go for lack of proper compensation, because then some competitor will pick it up.

Thursday, October 22, 2009

Bank risk controls need much work, regulators say

Posted on Reuters by John Parry:

Banks across the world have much work to do in improving risk management and internal controls following the financial crisis, global regulators said in a report released on Wednesday.

The report, called "Risk Management Lessons from the Global Banking Crisis of 2008," was done by regulators from seven countries in the Senior Supervisors Group. Information for the report was gathered between March 2008 and last month, said a source familiar with the report.

The regulators concluded that despite firms' recent progress in improving risk management practices, substantial work is needed on underlying weaknesses in governance, incentive structures, information technology infrastructure and internal controls, said a release from the Federal Reserve Bank of New York.

In September, the Group of 20 nations endorsed a statement by its coordinating arm, the Financial Stability Board, recommending new rules for bankers' pay, one of which was that the size of the bonus pool should depend in part on the health of the balance sheet of a bank.

However, the global regulators' report released on Wednesday said, "supervisors are concerned about the durability of proposed changes," to compensation practices at financial firms.

Senior Supervisors Group Chairman William Rutledge, presenting the report, wrote in a letter dated Wednesday to Mario Draghi, Chairman of the Financial Stability Board at the Bank for International Settlements.

On practices at some financial institutions that contributed to the crisis, the letter cited "the failure of some boards of directors and senior managers to establish, measure, and adhere to a level of risk acceptable to the firm," and also "compensation programs that conflicted with the control objectives of the firm."

The report, a joint effort among nine supervisory agencies, "evaluates how weaknesses in risk management and internal controls contributed to industry distress during the financial crisis," the release said.

The banking crisis of 2008 -- the biggest financial shock since the Great Depression -- culminated in the fall of Lehman Brothers and the near collapse of the global financial system.

Lax risk management and heavy exposure to risky securities were among the catalysts that triggered the crisis, analysts say.

To keep the financial system working and counteract the severe shock to major economies, governments and central banks pumped trillions of dollars of support into financial institutions and securities markets.

The report identifies some progress in reducing global financial risks since then, including the financial industry's efforts to standardize practices and cut backlogs of unconfirmed over-the-counter (OTC) derivatives positions. These efforts "appear to have significantly mitigated a substantial systemic risk," the report said.

Regulators who undertook the report include; the Canadian Office of the Superintendent of Financial Institutions, the French Banking Commission, the German Federal Financial Supervisory Authority, the Japanese Financial Services Agency, the Swiss Financial Market Supervisory Authority, the U.K. Financial Services Authority, and, in the United States, the Federal Reserve, the Office of the Comptroller of the Currency and the Securities and Exchange Commission.

The report can be downloaded here.

Wednesday, October 21, 2009

OSFI to Address Insurer’s Double Leverage?

Posted on PrefBlog:

Mark White, who seems to have become OSFI’s chief public apologist, delivered a speech to the Osgoode Hall Financial Regulatory Reform Conference.

Assiduous Readers will remember my complaints about insurers’ double-leverage and lack of disclosure thereof. In the best news I’ve had all week, there seems to be recognition by OSFI that this is a problem:

Second, recent events, such as those at AIG, have shown that holding company strength is important to their regulated subsidiaries. This is particularly true where the holding company is the primary issuer of capital or is required to raise debt.

OSFI regulates both non-operating insurers acting as holding companies, and entities that are formed as holding companies under applicable financial institution legislation. Currently, this only affects the life insurance industry. OSFI is considering updating its current regulatory guidance for these entities.

For example, OSFI’s Minimum Continuing Capital and Surplus Requirements (MCCSR) tests could be used to evaluate a financial group’s consolidated riskbased capital – and an ACM like-test could be used to evaluate leverage.

It’s my guess that this is happening under Treasury’s resolve to look at consolidated capital - but the intellectual dishonesty of OSFI is such that no acknowledgement is made of any external source of ideas.

They are also considering changes in the MCCSR requirements as it applies to seg funds:

Currently, segregated fund guarantees are the only area where Canadian insurers use such models to determine capital requirements. The recent financial turmoil has shown flaws with internal capital models, and segregated fund models are no exception. Particularly as both traditional life insurance risks and non-diversifiable market risks are concerns when dealing with segregated fund guarantees.

OSFI is conducting a fundamental review of internally-modeled capital requirements for segregated fund guarantees. We hope to present the results to the MCCSR Advisory Committee early in 2010, and to use this as a cornerstone for our ongoing work.

It’s nice to know they’re actually going to spend some time thinking about it rather than just taking dictation from well-connected companies … but OSFI has blown its credibility as an enforcer; all credit analysis must be performed with the assumption that in times of trouble, the rules will be changed so it doesn’t look like trouble any more.

Sunday, October 18, 2009

RBC poised to spend C$1bn on buy-backs

Posted in the FT by Bernard Simon:

Royal Bank of Canada has signalled that it could spend more than C$1bn ($965m) of its bulging capital on share buy-backs, underlining the contrasting financial health of Canada’s banks and many of their US and European counterparts.

Canadian banks have built a sizeable capital cushion over the past 18 months through retained earnings and new equity and preferred-share issues designed to protect themselves from the credit market meltdown and recession-induced loan losses.

Peter Routledge, analyst at Moody’s, the ratings agency, calculates that the six biggest banks – RBC, Toronto-Dominion, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and Quebec-based National Bank – have C$30.7bn in surplus capital, assuming a comfortable minimum ratio of tier one capital-to-assets ratio of 8.5 per cent. The minimum ratio set by regulators is 7 per cent.

With financial markets now stabilising and the economy recovering, speculation is rife on how and when the banks will deploy the excess funds.

Brad Smith, analyst at Blackmont Capital in Toronto, said that “you will see share buy-backs well before you see dividend increases”.

Some of the banks are also widely expected to seek acquisitions beyond Canada’s borders. RBC, Toronto-Dominion and Bank of Montreal already have sizeable retail operations in the US, while Bank of Nova Scotia has extensive interests in Latin America and Asia.

Gordon Nixon, RBC’s chief executive, indicated in a recent interview with the Financial Times that the bank was especially interested in expanding its global capital markets and wealth management businesses.

RBC’s market value is now almost 50 per cent bigger than US-based Citigroup. It boasted a tier one capital ratio of 12.9 per cent at the end of July. The bank reported record net income of C$1.56bn for the three months to July 31, up 24 per cent from a year earlier.

RBC said late on Friday that it intended to buy back up to 20m common shares, equal to 1.4 per cent of the total outstanding. According to the announcement, made after markets closed, the proposed buy-backs would enable the bank “to balance the imperatives of maintaining strong capital ratios with the need to generate shareholder value”.

But Mr Smith cautioned that the bank may buy far fewer shares than the maximum, given the uncertain climate. “To start returning capital at this point in time would be premature,” he said.

RBC last bought back shares during the fiscal year ended October 31, 2008, spending a relatively modest $55m. It raised its dividend most recently two years ago.

Saturday, October 17, 2009

Pension crisis? What Crisis? (At least not in Canada!)

Posted in the Toronto Star by David Olive:

With its bankruptcy in January, putting in question the pension and disability benefits of thousands of its former employees, Nortel Networks Corp. has become an international poster child for pain inflicted on the most innocent victims of corporate bankruptcy.

Nortel retirees, employees on long-term disability and former employees staged a protest at Queen's Park last week that garnered wide attention. Elderly people in walkers and wheelchairs were in the front row. A Toronto Star photo elicited this response from a North Carolina blogger who covers the tech firms of Research Triangle Park, where Nortel for decades had a huge presence:

"Please, please, please, check out this Web link to one of the most compelling, heart-wrenching photographs I have seen in many moons," Rick Smith, editor of the Local Tech Wire, wrote of Vince Talotta's photo.

"Then read the story about former Nortel chief executive officer Mike Zafirovski filing a claim for more than $12 million (U.S.) in bankruptcy court. Doesn't that picture in the Toronto Star rip your heart? Do you feel any outrage?"

Yet, it's perhaps too easy to grieve over the fate of Nortel and make the leap that all or most Canadians are at risk of a lost retirement.

Canada actually has one of the best retirement systems in the world. This country is essentially tied with the Netherlands, Australia and Sweden for pensioner protection, as measured by adequacy of funding, long-term sustainability of payouts, and integrity in management in the Melbourne Mercer global pension index released Thursday. The survey of 11 industrialized nations was conducted by Mercer, one of the leading world corporate benefits consultants, and the Melbourne Centre for Financial Studies.

In the United States, the trust funds for Social Security will, by the most recent government calculation, be exhausted in 2037. Medicare, the U.S. health-assistance program for seniors, is expected to go broke even sooner, in 2017. According to AARP, the leading U.S. seniors' lobby, Americans older than 55 are the group most likely to declare bankruptcy. AARP finds that more than half of Americans 50 and older who carry debt spend most of their monthly income paying it down.

In contrast to the worrisome condition of Social Security, at the current Canadian Pension Plan contribution rate of 9.9 per cent, the CPP is sustainable for at least 75 years.

Indeed, combining CPP and employer pension plans, plus Canadians' prudence in building their personal retirement nest eggs, "Canadians live in a promised land," John MacNaughton, founding CEO of the Canada Pension Plan Investment Board wrote recently in the Literary Review of Canada.

McNaughton was reviewing author Bruce Little's new book on the remarkable process by which the CPP was reformed in the mid-1990s. Remarkable because Ottawa and the provinces worked together with unusual urgency and harmony to reform a system headed for insolvency.

Today, the Organization for Economic Cooperation and Development (OECD) and the World Bank identify Canada as one of only seven nations in which retirement assets – in government, employer and individual hands – exceed 100 per cent of GDP.

Following those mid-1990s reforms, Canada's chief actuary is now required to assess the efficacy of the CPP and report publicly every three years – more often if the feds increase benefits or make other changes. Which makes Canada the only country with a fail-safe mechanism to promptly identify long-distant shortfalls and make adjustments now to prevent them.

In Ontario alone there are more than 7,500 registered pension plans, covering more than two million plan members. It's true that across Canada, there are some eight million people in the workforce without an employer pension plan or a registered retirement plan. What we don't know is how many of those eight million people are in financial distress or at risk of it.

Beginning in the 1990s, many employers seeking to shed their pension obligations made it attractive, through lump-sum payments, for employees to set up their own retirement plans. That such people have fallen from the rolls of employer pension plans hardly means they all face destitution in old age. Indeed, many have managed their money better than the professional money managers to whom their employers had outsourced their pension-plan management.

There's no denying, given the recent recession and the stock-market swoon, that ordinary Canadians have had reason lately for concern about their retirement nest eggs. But housing values that slumped in the recession already are recovering. And the stock market bottomed out in March and has since made a rather astonishing 43-per-cent recovery from its nadir.

Share values will continue to rise, since the epic market collapse was a one-time event triggered by a not-unreasonable panic that the world's financial system was about to collapse. Once it became clear that world governments would not let that happen, corporate share values began returning to levels that reflect their true value.

To declaim on a pension "crisis" in Canada is an alarmist approach that needlessly scares the wits out of fixed-income retirees and gets in the way of sensible refinements to the system that are needed. And needed reforms are on the near horizon.

The federal Conservative government has vowed to introduce legislation this fall to guarantee workers at federally regulated employers – including telecommunications firms like Bell Canada, the railroads and the banks – 100 per cent of their pensions in the event of insolvency. In a competitive market for skilled labour, non-government-regulated employers, if history is any guide, will follow suit.

For Nortel pensioners and employees reliant on disability payments, Queen's Park need only top up the Ontario Pension Benefit Guarantee Fund (OPBGF). Unlike the CPP, the OPBGF does not collect funds through levies on employers and employees. It should start. And in the meantime, special legislation in Ontario, Quebec and Ottawa can be passed to cover the delinquency in Nortel's failure to meet its obligations.

And as I've noted in a previous column, the failed Nortel CEO, Zafirovski, can put in a bankruptcy-court claim for the moon and the stars. But he's just another ex-employee obliged to line up behind the banks, bondholders and trade creditors with very slim hopes of collecting a fraction of the amount stated in his pro forma claim.

A shame he wasn't at that Queen's Park rally. His standing might have improved at least a bit if he'd been photographed alongside fellow victims of a once-proud and sadly mismanaged enterprise.

Friday, October 16, 2009

Mark-to-Make-Believe Turns Junk Loans to Gold: Jonathan Weil

Posted on Bloomberg by Jonathan Weil:

Here’s the best tip I ever got on how to read a company’s financial statements: Read the footnotes first, because that’s usually where the bodies are buried.

The main caveat is that the notes might not tell the whole truth either. That’s especially the case with banks.

A big improvement to the accounting rules this year is that lenders now must disclose their loans’ fair-market values every quarter, rather than just once a year. When a bank says its loans are worth much less than their balance-sheet amount, that means a large portion of its capital cushion may be illusory.

Such gaps arise because loans don’t have to be carried on the balance sheet at fair value, giving lenders lots of wiggle room to play with.

One irksome problem: Sometimes the numbers in the fair- value footnotes look more like mark-to-make-believe than mark- to-market, particularly when weak banks say their loan values are rock-hard.

I’ll get to some of the big-name banks such as Citigroup Inc. shortly. First, consider an Illinois lender with $3.6 billion of assets on its books called Midwest Banc Holdings Inc.

Midwest said its loans had a fair value of $2.53 billion as of June 30, which was about $35 million more than their carrying amount on the bank’s balance sheet. There are reasons to be skeptical, though.

Fair value is supposed to represent the price at which an asset would change hands in an orderly, arm’s-length transaction. Judging by Midwest’s stock price, it’s hard to believe those loans are worth quite so much.

Lack of Trust

Midwest’s shares trade for 62 cents, giving the company a $17 million stock-market value. That’s less than 20 percent of its reported book value, or common shareholder equity, which tells you the market doesn’t trust the bank’s asset values. The stock hasn’t traded for more than a buck since June 22.

Meanwhile, Midwest missed its last two scheduled dividend payments under the Treasury Department’s Troubled Asset Relief Program. In August, it said it had not made a required $5 million principal payment to one of its lenders. If its assets are so valuable, management should buy the company for themselves.

Midwest is one of 33 banks that skipped paying TARP dividends to the U.S. bailout program in August, according to SNL Financial, a bank-research firm. It’s not the only one of them with funny-looking fair-value numbers.

Focusing on Auditors

Seacoast Banking Corp., based in Stuart, Florida, for example, said its loans were worth slightly more than the $1.5 billion on its balance sheet, as of June 30. First Bancorp, based in Puerto Rico, said the fair value of its loans exceeded their $12.7 billion carrying value. Both stocks trade at steep discounts to book value.

One reason to care about these lenders is that their outside auditors also are responsible for checking the numbers at the country’s largest, too-big-to-fail banks.

Midwest is audited by PricewaterhouseCoopers LLP, as is First Bancorp. Seacoast’s auditor is KPMG LLP. The accounting firms are required to conduct quarterly reviews of the companies’ financial statements, in addition to their full-blown yearly audits. Let’s hope they’re scrubbing the books carefully.

Citigroup, which is audited by KPMG, estimated its loans had a fair value of $601.3 billion as of June 30, just 0.2 percent less than their carrying amount. By comparison, the fair-value shortfall was 7.3 percent at Bank of America Corp., 4.3 percent at Wells Fargo & Co., and 2.5 percent at JPMorgan Chase & Co. PwC audits Bank of America and JPMorgan, while KPMG audits Wells.

Citigroup’s Loan

The banks all say their estimates were reasonable, of course. For a company that needed a government bailout, though, Citigroup’s loan values look amazingly solid, given the fair- value gaps at those other lenders.

Elsewhere, BB&T Corp., a PwC audit client based in Winston- Salem, North Carolina, said its loans were worth 1.5 percent more than their $94.3 billion carrying value as of June 30. Commerce Bancshares Inc., a KPMG client based in Kansas City, Missouri, said its loans’ fair value was 2.3 percent more than the $11.1 billion on its books.

BB&T and Commerce showed the highest such percentages among companies in the KBW Bank Index. Were those values legit? Beats me. All but seven of the 24 banks in the index said their loans’ fair values were less than what their balance sheets showed. My guess is some banks may be interpreting the Financial Accounting Standards Board’s rules differently than others.

Interpreting the Rules

One chief executive who has made this same point is Dowd Ritter of Birmingham, Alabama-based Regions Financial Corp. To be sure, he has reason to be defensive.

Regions, an audit client of Ernst & Young LLP, estimated the loans on its books as of June 30 were worth 25 percent less than their $90.9 billion carrying value. That was no surprise, though. Its shares trade for less than half the company’s book value. BB&T and Commerce, for instance, trade for more than book.

“We and our accountants interpreted that in the strictest manner,” Ritter said at a Sept. 15 investor conference, referring to the FASB fair-value rules. “I don’t think we’ll hear anything probably from the SEC. But I’d be surprised if some other banks don’t, or else we and our accountants missed something.”

Memo to Securities and Exchange Commission Chairman Mary Schapiro: Did you catch that?

Smart guys in history: The Trillin debate

Posted on FT Alphaville by Gwen Robinson:

Author Calvin Trillin has really set something off with “Wall Street Smarts”, a brief and whimsical take on the downfall of Wall Street, published earlier this week in the New York Times.

In brief, he argues that the smart guys caused the financial crisis, after flooding into Wall Street in the late 1980s/early 1990s. Up to then, the smart guys were drawn to “respectable” professions such as law, academia, or anywhere but finance.

And Wall Street was doing just fine, staffed and run by average guys who just wanted a “nice house in Greenwich and maybe a sailboat” — the kind of guys Trillin calls “the lower third-of the-class guys”. But the rewards being offered in finance became “just mind-blowing”, even as college tuition became so expensive that the smart guys — even those from reasonably prosperous families — were graduating with huge debts.

The rest, as we know, is history.

… Or perhaps we don’t know, judging by the overwhelming response from the blogosphere.

Even Paul Krugman — regarded (well, at least by some) as one of the smartest guys around — was moved to share with us his own “more specialised” memories from grad school. “Did the influx of smart people bring on disaster?”, he asks, concluding:

That’s a longer story. But the change in who went where is utterly real.

Krugman’s NYT colleague Floyd Norris goes further, praising Trillin (”he explains it a lot better than I do”) and noting:

I see a germ of hope in the analysis. Eventually, the smart guys will be promoted and we will have bosses who understand derivatives and all the other financial alchemy of this era. Maybe we will even have regulators who share that understanding.

Noam Scheiber writing on Stash at the The New Republic says that a disposition towards boundary-pushing is a good thing in almost every aspect of life, “it’s become clear that it can have enormous social costs in the financial sector”. He draws a two-fold moral from Trillin’s story:

1.) The government obviously needs to get better at this policing business.

2.) We need to realize that, while there were real advantages to having creative, entrepreneurial people descend on Wall Street, there’s a lot to be said for laziness and self-satisfaction in this particular sector (especially in overgrown banks).

Meanwhile, Baseline Scenario’s James Kwak — who says Trillin’s piece is “a cute story” but with “an element of truth to it” — resurrects a fascinating paper by Thomas Philippon and Ariell Reshef which measures the relative wage and relative educational levels of workers in the financial sector over the last century - and more or less bears out Trillin’s “lower third of the class” theory.

And John Gruber, on Daring Fireball, focuses on Trillin’s point that the world of big tech also faces the “smart guy” problem, noting:

That’s precisely what I meant about Trillin’s piece’s applicability to the difference between the old Microsoft under Gates (programmer), and the new Microsoft under Ballmer (sales guy). Ballmer is running a company whose products he doesn’t really understand.

All this hoo-hah over “smart guys” however leaves us somewhat bemused.

As history shows, some of the smartest guys ever, can go terribly wrong, as Zachary Shore points out in his book, Blunder: Why Smart People Make Bad Decisions.

Enablers of Exuberance: Legal Acts and Omissions that Facilitated the Global Financial Crisis

Postedon SSRN by Jennifer Taub:

Abstract: This paper explores certain legal acts and omissions that facilitated the over-leveraging and near collapse of the global financial system. These “Legal Enablers” fostered the boom that enriched a class of financial intermediaries who followed a storied tradition of gambling away “other people’s money.” These mechanisms also made the pain of the bust disproportionately felt by the middle class and poor while shielding the middlemen who created the problems. These Legal Enablers permitted the growth of a shadow banking system, without investment limits, transparency or government oversight. In the shadows grew a variety of highly leveraged private investment pools, undercapitalized conduits of securitized loans and speculation in complex credit derivatives. The rationale for allowing this unregulated, parallel system was that it helped to create innovation and provide liquidity. The conventional wisdom was that any risks associated with a hands-off approach could be managed by the “invisible hand” of the market. In other words, instead of public police, it relied upon private gatekeepers. A legal framework including legislation, rules and court decisions supported this system. This legal structure depended upon corporate managers, counterparties, “sophisticated investors” and the market generally to prevent irrational conduct.

The hands-off approach was premised upon a series of beliefs or expectations. The first was that corporate managers would not sacrifice long-term shareholder value for short-term gains. The second was that trading counterparties would monitor each other closely and discourage excessive risk. The third was that “sophisticated investors” had the ability to select and monitor “private” unregulated investment options and that such decisions affected the direct owners, not underlying investors and market integrity. And, the catch-all fourth belief was that even if there were blips and bubbles, the market would quickly “heal itself” before causing any major disruption or harm to society.

Only after the global financial crisis (“GFC”) struck and the government committed nearly $13 trillion and spent almost $4 trillion, to rescue the financial system and the economy, did many ministers of “private ordering” admit that these premises were faulty. They were shocked to find that, contrary to their expectations, corporate managers were willing to pursue unsustainable short-term strategies. When executives threatened shareholder value, they greatly enriched themselves personally. This was revealed not just in elevated pay that was decoupled from performance, but also in the behavior of executives in times of crisis, some literally off playing bridge while their firm went under. And sophisticated investors were out-matched by the complexity of new instruments. Unable to monitor, many were deceived and sometimes outright swindled. When President Bush declared “I’ve abandoned free-market principles to save the free-market system,” it was evident that the market could not heal itself.

These private gatekeepers failed for a few reasons. First, there was an explosion of increasingly varied and complex financial instruments. Even the most intelligent, experienced individuals using complex mathematical models could not accurately price them or understand their risk because there was not enough performance history, transparency as to the amounts outstanding and they were incredibly interdependent. Indeed some estimated that it would take many days for a powerful computer to calculate the price of some collateralized debt obligations. This was aggravated by the fact that whom the law deemed to be “sophisticated” enough to purchase these instruments and invest in unregulated pools were not defined by particular skills or knowledge, but wealth alone. Second, compensation structures at all levels encouraged short term gain over long-term value. Third, tremendous personal rewards came to those individuals who participated in these schemes and the players understood that it was a career stopper to be contrarian during this bubble.

It should not have taken the GFC to call the hands-off approach into question. There was plenty of historical evidence that demonstrated the dangers of excessive leverage and speculation. And, there was a largely effective legal framework available that had worked to rein in this behavior by mutual funds. This paper attempts to identify the causes of this collective amnesia. It also offers a challenge to those who resist regulation by building arguments upon these shaky premises.

Borrowing from the social sciences, this paper deems these acts and omissions “Enablers.” An enabler helps further another person’s self-destructive, addictive behavior, protects the abuser from suffering consequences and denies both the abuse and the harm caused to others. The enabler takes these actions due to his or her own dependency upon the abuser. By analogy, we created laws that further an unhealthy dependency on excessive borrowing or leverage and speculation. Legal Enablers protected those who engaged in these risky practices from suffering economic and legal consequences. In addition, Legal Enablers denied redress for the harm caused to the most vulnerable victims of this credit addiction. These Enablers depend upon the faulty premises identified above - the irrational belief in the police power of corporate managers, counterparties, sophisticated investors and the market to heal itself.

There were a considerable number of Legal Enablers of the recent global financial crisis (“GFC”), however this paper focuses upon those that contributed to the excessive leverage and speculation in the financial system and/or have the potential to ignite a future boom and bust cycle. First, investor protections were diminished and systemic risk elevated when the exceptions from the securities laws for hedge funds and other “private” investment pools were expanded. These unregulated pools were supposed to be limited to “sophisticated investors” in private offerings. However, with additional loopholes created in the 1996-7, these pools were able to flourish by attracting more investors through “retailization.” Unlike mutual funds, hedge funds were not restricted in areas such as use of excessive leverage. Individuals were exposed to risky investments from which they would have been protected as direct, retail investors. Yet, because their assets were gathered and then invested into these “private” pools by “sophisticated investors” such as U.S. mutual funds, corporate pension funds, public pension funds and union pension funds, they were exposed. The exceptions to government oversight through the securities laws were premised upon the ability of private gatekeepers to oversee increasingly complex instruments. However, our expectations of the ability of sophisticated investors to select and monitor investments proved unreasonably high. Second, the Commodity Futures Modernization Act of 2000 fostered the credit default swap (“CDS”) pandemic. These credit derivatives insured and ensured the origination and global distribution of risky securitized loans. Third, interpretations of and the wrong amendments to the U.S. Bankruptcy Code helped to support unwise financing trends and helped push overloaded borrowers into more debt. Fourth, court decisions in the area of corporate governance and securities fraud have created incentives for financial intermediaries to seek short-term, unsustainable, if not illusory profits and also shielded those same middlemen from liability. The convergence of undercapitalized mortgage pools, credit default swaps and leveraged hedge funds created the perfect storm.

After the bust, these Legal Enablers helped the middlemen to not just walk away unscathed, but wealthier than ever, and to leave the rest of society bereft. Uncertainty about the bankruptcy treatment of complex instruments and transnational structures made commercial bankruptcy through Chapter 11 less viable, thus the “middlemen” financial firms received massive taxpayer-funded bailouts. Meanwhile, Chapter 13 after the 1993 Court decision, prevented consumers from down-sizing underwater mortgages. Finally, the ability for ultimate investors to seek redress has been eroded through securities laws changes and legal doctrines shielding fiduciaries from liability.

This paper contends that if we wish to restore investor confidence and sustain a stable financial system, we must stop enabling the excessive leverage and speculation that create cycles of irrational exuberance followed by financial panics. Specifically, it recommends that we eliminate the loopholes that allow unregistered investment pools broad discretion to operate in the shadows, without transparency or supervision, to engage in self-dealing or related-party transactions, to inaccurately value and inadequately protect assets and to take on excessive leverage and illiquid portfolio holdings. This surpasses the Obama Administration’s proposal to bring hedge fund advisers under the Investment Advisers Act. In addition to the disclosure and enforcement that would affect hedge funds and advisers under that bill, this paper recommends revisiting the substantive protections of the Investment Company Act that apply to mutual funds. While the federal securities laws generally used mandated disclosure and enforcement as tools to regulate conduct, the country learned in 1929 and again in 2008 that regarding investment pools, disclosure is not enough. Substantive restrictions are more effective tools to protect pools of other people’s money. As part of this recommendation, the myth of the sophisticated investor and the private offering are confronted.

Second, this paper suggests that we avoid allowing devices, like credit default swaps, initially designed to minimize and distribute risk to be used for speculation or gambling. Third, it advises that we change our Bankruptcy Code to allow lien-stripping under Chapter 7 and 13, thus discouraging poor underwriting and inflated home valuations and protect the most vulnerable from the impact of the financial system abuses. Fourth, we should remove the obstacles that shield corporate officers, directors and others from liability for enabling destructive behavior.

This paper will also address the arguments that might be offered that would resist these reforms. These include, among others: (1) that we should not regulate hedge funds because they did not cause the GFC; (2) sophisticated investors can take care of themselves; (3) human nature (i.e. greed) cannot be successful constrained; (4) government regulation is ineffective and undermines business growth; (5) lien-stripping is too expensive and creates moral hazard; and (6) one should not second guess the behavior of corporate directors and managers trying to operate in the midst of a market-wide correction or collapse.

The paper can be downloaded here.