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09/21/2010

Micro-origins of the Financial Crisis


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The current global financial crisis and the US government’s response to it—bailouts of too-big-to-fail banks, tax-financed props for an ailing auto industry, mortgage-rescue plans for overextended households—have upset the public’s sense of fair play. Citizens have also had to struggle with their attempts to link the fragile, ethereal, economic construct revealed by recent events to the concrete realities of food on their tables and roofs over their heads. And they don’t want to have to study the intricacies of monetary policy, public debt management, and international capital flows to maintain their faith in capitalism.

Unfortunately, everywhere they look, they find cause for concern. During the first quarter of 2009, investors had more money in money market fund accounts than in equity market fund accounts, the leading US investment banks and several international banks had vanished, and $50 trillion worldwide—a year’s global economic output—was devalued to $0. People can’t help but ask how this happened. And some of the answers are fairly simple—who’s to blame (O’Hara 2009; Schmudde 2009; Star 2009), solutions we might try (Persand 2008; Sachs 2009; Schmudde 2009; Star 2009), or what caused the crisis at a macro level (Nanto 2009).

A thorough investigation of the actual dynamics of the securities industry is not one of those simple answers, but it’s an essential component of any meaningful response. Nevertheless, partly out of exhaustion and partly out of fear, little has been written, at a detailed micro level, about the way legislation such as the Glass–Steagall Act forged, more than 70 years ago, fundamental aspects of our markets; about the basic credit products and the markets that have supported their growth; about the evolution of financial products over the past 30 years; about the combined devolution of regulation over the past eight presidential terms; or about the lead-ups to the individual corporate failures at the cusp of the “Great Recession.”

The broad historical attributes of the securities industry—the industry’s formational event, differences in transaction types, or participant responsibilities, for example—are cornerstones of the crisis. So is the evolution of the CMO (collateralized mortgage obligation) and of the CDS (credit default swap). And so is the massive expansion of leverage and the implosion that followed.

THE STO

“STO” (security trading organization) can be used in place of “investment bank” or the more common term “brokerage firm” to identify corporations licensed for and focused on making a profit with investment products (Simmons 2002). An STO has two roles for transacting trades in markets: it trades for clients with their money as an “agent,” and it trades for itself with its own money as a “principal.” Keeping the capital sources segregated has been a hallmark of the industry; keeping the risk separate has not.

Agent trades earn modest fees and are riskless to the STO, with the exception of operational risk. Principal trades put the firm’s capital at risk, incur fees, and may realize either a profit or a loss when converted back into capital. Traditional commercial banks prefer and historically have been restricted to the predictability of the agency business. Agency fees are the same as any other bank transaction fees: small profits and small risks. They can be explained and correlated to conventional metrics, such as volume of transactions or transactions per customer, in the annual earnings report, with a simple graph.

That’s not the case with business transacted as principal, which represents investments made with the firm’s capital and which is actively hidden from competitors. STOs prefer principal business, for which the potential profit is dramatically higher. However, the outcomes of principal transactions are difficult to predict, uncorrelated to metrics, and entail a large risk of losing the firm’s capital. All transaction types are either agent or principal, and all STOs are classified by degrees of intensity and the extent of the blend of agent and principal business activity.

STOs trade two categories of products: regulated (for which government rule-making bodies permit market participants specific practices) and unregulated. STOs will insist those product categories should really be money, debt, and equity, as on all retail account statements. But the division of money, debt, and equity is not as useful as the dichotomy of regulated and unregulated products when it comes to breaking down marketplace dynamics. Indeed, it is rare for STOs to identify which of their products are subjected to regulation except in the fine print of the opening contract of a new client’s account. Across STOs, product names are distinguished by subtle differences that only add confusion to an already complex discussion.

One misconception, for example, is that a money market fund contains cash. Actually, a money market fund’s valuation of $1,000 is the STO’s estimation of the real cash the owner may receive when the owner requests liquidation of the shares in the money market fund. When an account owner of a bank checking account sees a statement with $1,000, the owner knows there is really $1,000 of cash in the account that can be used in exchange for goods and services. The checking bank account reports the amount of legal tender held for the depositor while the money market fund account reports the estimated liquidation value if converted to legal tender.

REGULATED AND UNREGULATED PRODUCTS

Those two different types of accounts—checking and money market fund—are offered by two different types of licensed banks. Those two types of banks were created, 76 years ago, by a grouping of regulations commonly referred to as Glass–Steagall. Glass–Steagall was born when the Great Depression allowed then-President Franklin Roosevelt to segregate savings banks, which transacted loans and took deposits, from STOs, which bought and sold securities, in order to separate the risk of loss of “savings” capital from the risk of loss of “investment” capital. In 1933, the FDIC (Federal Deposit Insurance Corporation) emerged as a vehicle allowing the government to insure savings depositors without insuring the greater risk associated with investment depositors. This, in turn, boosted people’s confidence that a savings bank’s investment activity could not result in the loss of the savings capital deposited with the bank.

Congressional records and SEC (Securities and Exchange Commission) committee reports spanning the past eight presidential terms, or 32 years, show Glass–Steagall being effectively revoked in order to enhance market efficiencies through increased competition and to mitigate government regulatory burdens on the free market system. It was never updated for today’s world. It was simply eliminated, and an alternative was not sought by any administration or offered by any Congress.

What kind of update would have been required? What new demands were these regulations facing? To answer this, it’s important to understand first that, on a basic level, regulated investment products represent an ownership interest (equity shares, for example) in a corporation. Their valuation is related to the corporation’s solvency as defined by laws, accounting standards, and governmental rules. The valuation of the regulated product is defined by the underlying components of the corporation issuing the shares.

Unregulated investment products, on the other hand, represent speculation on events expected to occur. They are written legal “contracts” and may be unsecured, or secured by assets representing a debt interest (that is, by bonds and loans). All unregulated investment products trade in the OTC (over the counter) markets, which means that they trade informally: over the phone or through systems of convenience. The valuation of an unregulated product is defined by the historical experience of similar products and the probability of realizing an expected return.

Although conventional GAAP (Generally Accepted Accounting Principles) accounting equates savings and investing, they’re unequal in this context. Savings are fixed-interest payments over a defined period with only counterparty risk and little or no risk of loss of principal. Investments are speculative agreements contractually linking payments with the acceptance of counterparty risks and principal risks for a defined period. Cash in a tin can, in comparison, is a neutral reference point, neither a savings product nor an investment product, exposed only to a serious operational loss like theft or fire.

Clear, detailed regulations pertain to what lies to the left of the tin can. For example, some basic regulations are specific to the securities industry and apply generally to all activity. One such basic regulatory grouping includes the KYC (know your customer) regulations. Originally created to address STOs’ responsibilities in accepting drug money from terrorists and sanitizing its entry into the monetary system, KYC regulations were expanded by best practices guidelines to include the concept of professional behavior. They make the seller liable for client losses resulting from selling high-risk products to very clearly risk-averse and trusting clients, such as retirees and orphans. As part of the licensing process, the seller’s expertise is made responsible for discerning and maintaining an internal level of best practices for appropriately matching the product-risk and client-risk profiles. Sellers are not allowed to invoke “buyer beware” if the buyer is obviously incapable of recognizing the exposure to capital loss.

But these low-risk savings products were not the catalyst of the current financial crisis. For that, look to the tin can’s extreme right: the CDS zone, where almost no regulation intrudes. Even financial professionals have difficulty understanding CDS products. How are these derivatives created? What are their markets?

THE CMO AND CDO

The financial debt vehicle called the CMO was first created in June 1983 by Salomon Brothers (as well as, independently, by First Boston for use by the Federal Home Loan Mortgage Corporation, aka Freddie Mac). In the early 1980s, disintermediation and collateralization were innovations. Disintermediation was used to gain access to new capital and collateralization was used to move assets into products. The result was capital exchanged for new high-yield collateralized products. Freddie Mac owned a huge inventory of home loans and needed additional capital to issue more loans to pursue its Congressionally mandated mission of providing liquidity, stability, and affordability to the housing market. The concept was to move assets off Freddie Mac’s balance sheet and move working capital onto it. The CMO allowed for the creation of securitized high-yield products by repackaging mortgage pools.

A CMO is a contract between a special-purpose entity (created and incorporated as the owner of the mortgage payments) and the CMO buyer to share a defined portion of the mortgage payment stream. An STO sells investors a CMO contract, sometimes whole, sometimes in parts, as a high-yield investment product. In reality, though, the contract is an investment in the special-purpose entity. The CMO is like shares in a company established to process mortgages and distribute the mortgage payments to the shareholders. The original cash the investors provide for these shares is given to the STO, creating the special-purpose entity as payment for the mortgages and services, always at a mark-up (spread) from the cost of acquiring the assets, or mortgages.

In the early days of the CMO market, the spreads for the CMO creator were outstanding. It was such a profitable process that it was applied to other types of assets that fit the pattern, including credit cards, student loans, and car loans. The industry products grew and became asset-backed securities. All together, they became collectively known as CDOs (collateralized debt obligations) and constituted a huge unregulated market of structured credit products, some associated with hard assets and some not. Once such a structured credit product was created, it was traded OTC between STOs: in agency transactions, on behalf of the STOs’ clients, using the clients’ capital; or in principal transactions, using the STOs’ own capital.

THE CDS

Some STOs retained parts of the original assets or underlying products during the CDO creation process, first as a way to earn greater profits by holding onto higher-quality segments, and later as a way to contain quality problems that would prevent sales. In the latter instance, a retained segment was kept on the STO’s books as a principal transaction. Eventually, as its quality continued to decrease, it became known as “toxic waste.” One approach to improving and possibly selling these lower-quality CDOs was to contract for a CDS: that is, for a guarantee in the event the CDO failed. These insurance-like contracts—credit derivative contracts between two counterparties—were written to protect capital invested from risk of loss and were often developed by other participants (AIG being a noteworthy example).

The ability to improve the risk rating of low-quality CDO contracts with the addition of insurance-like CDS products meant that the contracts could be sold to even those investors affected by federal regulations constraining their capital’s exposure to risk—an investor such as a pension fund. The ability to sell the toxic waste with an attached insurance policy allowed for increased sources of capital to enter the market. In exchange for the capital, STOs were able to remove sizable quantities of the toxic waste from their books. This had an incentivizing effect on everyone. As new working capital poured in, more products with effectively greater leverage were created on an increasingly grand scale, for an ever-swelling crowd.

Productized risk is a product, just like a lottery ticket, and for 30 years the CDS market and CDO industry have been complicated, opaque, unregulated, broad markets. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. CDS contracts have been compared to insurance because the buyer pays a premium and in return receives a sum of money if a specified event occurs. For example, Goldman Sachs may sell Citibank a CDS for $100,000 per year that pays $10 million if Lehman defaults on its obligations. Citibank would find this CDS very useful if Citibank also owned $10 million of the Lehman CDO and the existence of the CDS allowed for a lower risk rating on the Citibank position.

The ISDA (International Swaps and Derivatives Association), an industry trade group, announced on October 31, 2008, that $25 trillion in notional value had been eliminated from the CDS market since the beginning of 2008, reducing the total to $47 trillion. It wasn’t until November 2008 that the DTCC (Depository Trust and Clearing Corporation), the private electronic vault of record, first began reporting metrics on CDS transactions (DTCC 2008). In the first weekly report there were a total of $33.6 trillion in CDSs outstanding on corporate, government, and asset-backed securities. The concept of a trillion of anything is difficult to comprehend. For comparison, in June 2009 the US national debt was estimated at $11.3 trillion, the US housing market at about $18 trillion, and the market value of all US listed equities at $18 trillion.

This derivatives market segment is huge and was, until November 2008, completely hidden. And there’s another interesting wrinkle—the fact that CDSs no longer entail any requirement that either party have any exposure to the counterparty at risk. That’s why, for example, Goldman Sachs could have bought a CDS from AIG that would have paid out if Lehman were to have failed, without Goldman owning any Lehman product exposure. The CDS would have been a leveraged bet between Goldman Sachs and AIG on the likelihood that Lehman would remain creditworthy and solvent.

MARKET DYNAMICS

In 2000, the Commodity Futures Modernization Act largely exempted OTC from regulation by the Commodity Futures Trading Commission and seriously limited SEC authority. The bulk of these CDS contracts are directly transacted between two companies OTC, with no structured defined exchange or regulated marketplace. The aggregate market for all these products is the equivalent of a mind exercise. It exists in the same sense that there is a global used car market. There is, however, now the bare beginning of a central view of the size and only a hint at the ownership of the marketplace, with the DTCC providing a limited two-week view to the public, although the only information available is what each participant is willing to share. Still, on June 17, 2009, the US Department of the Treasury issued an encouraging report, “Financial Regulatory Reform”: “Investors and credit rating agencies should have access to the information necessary to assess the credit quality of the assets underlying a securitization transaction at inception and over the life of the transaction, as well as the information necessary to assess the credit, market, liquidity, and other risks of [asset-backed securities].”

Operational support for the CDS market has snarled, turning into the same kind of traffic jam that necessitated restructuring the listed equities markets. Regulators therefore continue to push for a central clearinghouse that would, for a small uniform fee, stand between counterparties, provide guarantees in the event of a counterparty’s default on a contract, and establish standard contracts.

While a CDS does not send a corporate stock price up or down, the movement in the stock price, and certainly any change in the corporate debt rating, will directly affect a CDS’s valuation. Lehman is, of course, the defining example. At the time of its bankruptcy filing, it was involved heavily and globally in every possible CDS combination. The DTCC took weeks to unwind all Lehman’s positions, even in the face of the bankruptcy court’s directive to liquidate with haste. This one insolvency prompted a mass stampede to safety and a dramatic reduction in liquidity, precipitating a downward spiral in valuations as products were reduced for sale again and again, spreading insolvency through contamination.

The issues are now twofold: how to unwind the transactions, and where to begin. The ISDA insists that the total notional amount of the CDS market, about $45 trillion, is not the amount that is in fact at risk (2008), and most people agree. Many contracts between the same counterparties can be “netted” to a smaller net amount. But because of the lack of standard documentation, the lack of a central depository or clearinghouse, and the lack of any regulatory reporting requirements (as the Treasury Department points out in the white paper quoted above) it might take a very long time for the ISDA to actually back up that claim.

Meanwhile, the insolvency has spread globally. This complicates our response to the crisis because it makes it necessary for us to identify the beneficiary of any relief effort. If a loan from the Troubled Asset Relief Program is aimed at a CDS asset, it’s not necessarily any more likely to benefit the US economy than to aid participants elsewhere on the globe. At the time the US Treasury was asked to help Lehman Brothers, Lehman derived less profit from the US than from its activity in the European and Asian–Pacific zones. A rescue of Lehman, then, would have been a rescue of many international counterparties as well. The political optics of the use of US taxpayer funds to pay non-US counterparties would undoubtedly have been negative. Recently, AIG disclosed foreign banks as the largest receivers of the AIG bailout monies.

CAN’T DRIVE 55?

Individual STOs are still not motivated to consider the market’s collapse in any terms other than the immediate loss of their own principal. They continue to view their clients’ principal risks as riskless agency trades. Unique marketing terms still make differentiation between regulated and unregulated products needlessly inconsistent and opaque. Disclosure regarding the relationships between regulations and products are still minimal. And, as of September 2008, we now have financial superstores active in all aspects of transactions, as agent or principal, in an echo of the days before Glass–Steagall.

For decades, various administrations and Congresses have actively dismantled industry regulations. The regulations that remain are national, while the OTC market for derivative products is multinational and disdains the standardized reporting a central clearinghouse provides. Each one of these structural deficiencies works to the advantage of the STO and the disadvantage of the individual investor.

An increased individual savings rate must be coupled with increased transparency of the differences between savings and investing. Glass–Steagall is gone, and the separation of banking from investment is gone with it. That separation was not perfect, and it was at odds with the rest of the developed banking world. But new regulation is required to provide greater transparency for an aggregate market view. Adam Smith believed government involvement in the market economy was justified. In his Inquiry into the Nature and Causes of the Wealth of Nations (1776), he encouraged a pragmatic, conservative bifurcation of capitalism and government, like travelers in opposite directions who share a roadway. The point is not to usurp the steering wheels of other drivers, but to enforce speed limits and build guardrails.

REFERENCES

DTCC. October 31, 2008. “DTCC to Provide CDS Data from Trade Information Warehouse.”

ISDA. October 31, 2008. “ISDA Applauds $25 Trn Reductions in CDS Notionals, Industry Efforts to Improve CDS Operations.”

Nanto, Dick. April 3, 2009. “The Global Financial Crisis: Analysis and Policy Implications.” Congressional Research Service. 1–105.

O’Hara, Neil A. Spring 2009. “Don’t Shoot the Messenger: The Unfair Attack on Fair Value Accounting.” Investment Professional, vol. 2, no. 2. 47–53.

Persand, Avinash. 2009. “Ratings War?” Public Policy Research, vol. 15, no. 4. 187–191.

Sachs, Jeffrey. 2009. “The Geithner–Summers Plan Is Even Worse Than We Thought.” Huffington Post.

Schmudde, David. 2009. “Responding to the Subprime Mess: The New Regulatory Landscape.” Fordham Journal of Corporate and Finance Law, vol. 14, no. 4. 708–770.

Simmons, Michael. 2002. Securities Operations: A Guide to Trade and Position Management. New York, NY. John Wiley & Sons. 9–31.

Star, Marlene Givant. Spring 2009. “Hive Mind: Organizational Psychology and the Origins of the Financial Crisis.” Investment Professional, vol. 2, no. 2. 58–65.

US Department of the Treasury. June 17, 2009. “Financial Regulatory Reform: A New Foundation, Rebuilding Financial Supervision and Regulation.” 45. [PDF available via http://www.bespacific.com/mt/archives/021616.html.]

Elven Riley, who has over 30 years of Wall Street experience, is the director of the Center for Securities Trading and Analysis at Seton Hall University. He wishes to thank Paula Alexander, Kurt Rotthoff, Eleanor Xu, Glenna Riley, Michael Majewski, Reverend Deacon Diane Riley, and Tony Loviscek.

The current global financial crisis and the US government’s response to it—bailouts of too-big-to-fail banks, tax-financed props for an ailing auto industry, mortgage-rescue plans for overextended households—have upset the public’s sense of fair play. Citizens have also had to struggle with their attempts to link the fragile, ethereal, economic construct revealed by recent events to the concrete realities of food on their tables and roofs over their heads. And they don’t want to have to study the intricacies of monetary policy, public debt management, and international capital flows to maintain their faith in capitalism.

Unfortunately, everywhere they look, they find cause for concern. During the first quarter of 2009, investors had more money in money market fund accounts than in equity market fund accounts, the leading US investment banks and several international banks had vanished, and $50 trillion worldwide—a year’s global economic output—was devalued to $0. People can’t help but ask how this happened. And some of the answers are fairly simple—who’s to blame (O’Hara 2009; Schmudde 2009; Star 2009), solutions we might try (Persand 2008; Sachs 2009; Schmudde 2009; Star 2009), or what caused the crisis at a macro level (Nanto 2009).

A thorough investigation of the actual dynamics of the securities industry is not one of those simple answers, but it’s an essential component of any meaningful response. Nevertheless, partly out of exhaustion and partly out of fear, little has been written, at a detailed micro level, about the way legislation such as the Glass–Steagall Act forged, more than 70 years ago, fundamental aspects of our markets; about the basic credit products and the markets that have supported their growth; about the evolution of financial products over the past 30 years; about the combined devolution of regulation over the past eight presidential terms; or about the lead-ups to the individual corporate failures at the cusp of the “Great Recession.”

The broad historical attributes of the securities industry—the industry’s formational event, differences in transaction types, or participant responsibilities, for example—are cornerstones of the crisis. So is the evolution of the CMO (collateralized mortgage obligation) and of the CDS (credit default swap). And so is the massive expansion of leverage and the implosion that followed.

THE STO

“STO” (security trading organization) can be used in place of “investment bank” or the more common term “brokerage firm” to identify corporations licensed for and focused on making a profit with investment products (Simmons 2002). An STO has two roles for transacting trades in markets: it trades for clients with their money as an “agent,” and it trades for itself with its own money as a “principal.” Keeping the capital sources segregated has been a hallmark of the industry; keeping the risk separate has not.

Agent trades earn modest fees and are riskless to the STO, with the exception of operational risk. Principal trades put the firm’s capital at risk, incur fees, and may realize either a profit or a loss when converted back into capital. Traditional commercial banks prefer and historically have been restricted to the predictability of the agency business. Agency fees are the same as any other bank transaction fees: small profits and small risks. They can be explained and correlated to conventional metrics, such as volume of transactions or transactions per customer, in the annual earnings report, with a simple graph.

That’s not the case with business transacted as principal, which represents investments made with the firm’s capital and which is actively hidden from competitors. STOs prefer principal business, for which the potential profit is dramatically higher. However, the outcomes of principal transactions are difficult to predict, uncorrelated to metrics, and entail a large risk of losing the firm’s capital. All transaction types are either agent or principal, and all STOs are classified by degrees of intensity and the extent of the blend of agent and principal business activity.

STOs trade two categories of products: regulated (for which government rule-making bodies permit market participants specific practices) and unregulated. STOs will insist those product categories should really be money, debt, and equity, as on all retail account statements. But the division of money, debt, and equity is not as useful as the dichotomy of regulated and unregulated products when it comes to breaking down marketplace dynamics. Indeed, it is rare for STOs to identify which of their products are subjected to regulation except in the fine print of the opening contract of a new client’s account. Across STOs, product names are distinguished by subtle differences that only add confusion to an already complex discussion.

Congressional records and SEC committee reports spanning the past eight presidential terms, or 32 years, show Glass–Steagall being effectively revoked in order to enhance market efficiencies through increased competition and to mitigate government regulatory burdens on the free market system. It was never updated for today’s world. It was simply eliminated, and an alternative was not sought by any administration or offered by any Congress.

One misconception, for example, is that a money market fund contains cash. Actually, a money market fund’s valuation of $1,000 is the STO’s estimation of the real cash the owner may receive when the owner requests liquidation of the shares in the money market fund. When an account owner of a bank checking account sees a statement with $1,000, the owner knows there is really $1,000 of cash in the account that can be used in exchange for goods and services. The checking bank account reports the amount of legal tender held for the depositor while the money market fund account reports the estimated liquidation value if converted to legal tender.

REGULATED AND UNREGULATED PRODUCTS

Those two different types of accounts—checking and money market fund—are offered by two different types of licensed banks. Those two types of banks were created, 76 years ago, by a grouping of regulations commonly referred to as Glass–Steagall. Glass–Steagall was born when the Great Depression allowed then-President Franklin Roosevelt to segregate savings banks, which transacted loans and took deposits, from STOs, which bought and sold securities, in order to separate the risk of loss of “savings” capital from the risk of loss of “investment” capital. In 1933, the FDIC (Federal Deposit Insurance Corporation) emerged as a vehicle allowing the government to insure savings depositors without insuring the greater risk associated with investment depositors. This, in turn, boosted people’s confidence that a savings bank’s investment activity could not result in the loss of the savings capital deposited with the bank.

Congressional records and SEC (Securities and Exchange Commission) committee reports spanning the past eight presidential terms, or 32 years, show Glass–Steagall being effectively revoked in order to enhance market efficiencies through increased competition and to mitigate government regulatory burdens on the free market system. It was never updated for today’s world. It was simply eliminated, and an alternative was not sought by any administration or offered by any Congress.

What kind of update would have been required? What new demands were these regulations facing? To answer this, it’s important to understand first that, on a basic level, regulated investment products represent an ownership interest (equity shares, for example) in a corporation. Their valuation is related to the corporation’s solvency as defined by laws, accounting standards, and governmental rules. The valuation of the regulated product is defined by the underlying components of the corporation issuing the shares.

Unregulated investment products, on the other hand, represent speculation on events expected to occur. They are written legal “contracts” and may be unsecured, or secured by assets representing a debt interest (that is, by bonds and loans). All unregulated investment products trade in the OTC (over the counter) markets, which means that they trade informally: over the phone or through systems of convenience. The valuation of an unregulated product is defined by the historical experience of similar products and the probability of realizing an expected return.

Although conventional GAAP (Generally Accepted Accounting Principles) accounting equates savings and investing, they’re unequal in this context. Savings are fixed-interest payments over a defined period with only counterparty risk and little or no risk of loss of principal. Investments are speculative agreements contractually linking payments with the acceptance of counterparty risks and principal risks for a defined period. Cash in a tin can, in comparison, is a neutral reference point, neither a savings product nor an investment product, exposed only to a serious operational loss like theft or fire.

Clear, detailed regulations pertain to what lies to the left of the tin can. For example, some basic regulations are specific to the securities industry and apply generally to all activity. One such basic regulatory grouping includes the KYC (know your customer) regulations. Originally created to address STOs’ responsibilities in accepting drug money from terrorists and sanitizing its entry into the monetary system, KYC regulations were expanded by best practices guidelines to include the concept of professional behavior. They make the seller liable for client losses resulting from selling high-risk products to very clearly risk-averse and trusting clients, such as retirees and orphans. As part of the licensing process, the seller’s expertise is made responsible for discerning and maintaining an internal level of best practices for appropriately matching the product-risk and client-risk profiles. Sellers are not allowed to invoke “buyer beware” if the buyer is obviously incapable of recognizing the exposure to capital loss.

But these low-risk savings products were not the catalyst of the current financial crisis. For that, look to the tin can’s extreme right: the CDS zone, where almost no regulation intrudes. Even financial professionals have difficulty understanding CDS products. How are these derivatives created? What are their markets?

THE CMO AND CDO

The financial debt vehicle called the CMO was first created in June 1983 by Salomon Brothers (as well as, independently, by First Boston for use by the Federal Home Loan Mortgage Corporation, aka Freddie Mac). In the early 1980s, disintermediation and collateralization were innovations. Disintermediation was used to gain access to new capital and collateralization was used to move assets into products. The result was capital exchanged for new high-yield collateralized products. Freddie Mac owned a huge inventory of home loans and needed additional capital to issue more loans to pursue its Congressionally mandated mission of providing liquidity, stability, and affordability to the housing market. The concept was to move assets off Freddie Mac’s balance sheet and move working capital onto it. The CMO allowed for the creation of securitized high-yield products by repackaging mortgage pools.

A CMO is a contract between a special-purpose entity (created and incorporated as the owner of the mortgage payments) and the CMO buyer to share a defined portion of the mortgage payment stream. An STO sells investors a CMO contract, sometimes whole, sometimes in parts, as a high-yield investment product. In reality, though, the contract is an investment in the special-purpose entity. The CMO is like shares in a company established to process mortgages and distribute the mortgage payments to the shareholders. The original cash the investors provide for these shares is given to the STO, creating the special-purpose entity as payment for the mortgages and services, always at a mark-up (spread) from the cost of acquiring the assets, or mortgages.

Unique marketing terms still make differentiation between regulated and unregulated products needlessly inconsistent and opaque. Disclosure regarding the relationships between regulations and products are still minimal. And, as of September 2008, we now have financial superstores active in all aspects of transactions, as agent or principal, in an echo of the days before Glass–Steagall.

In the early days of the CMO market, the spreads for the CMO creator were outstanding. It was such a profitable process that it was applied to other types of assets that fit the pattern, including credit cards, student loans, and car loans. The industry products grew and became asset-backed securities. All together, they became collectively known as CDOs (collateralized debt obligations) and constituted a huge unregulated market of structured credit products, some associated with hard assets and some not. Once such a structured credit product was created, it was traded OTC between STOs: in agency transactions, on behalf of the STOs’ clients, using the clients’ capital; or in principal transactions, using the STOs’ own capital.

THE CDS

Some STOs retained parts of the original assets or underlying products during the CDO creation process, first as a way to earn greater profits by holding onto higher-quality segments, and later as a way to contain quality problems that would prevent sales. In the latter instance, a retained segment was kept on the STO’s books as a principal transaction. Eventually, as its quality continued to decrease, it became known as “toxic waste.” One approach to improving and possibly selling these lower-quality CDOs was to contract for a CDS: that is, for a guarantee in the event the CDO failed. These insurance-like contracts—credit derivative contracts between two counterparties—were written to protect capital invested from risk of loss and were often developed by other participants (AIG being a noteworthy example).

The ability to improve the risk rating of low-quality CDO contracts with the addition of insurance-like CDS products meant that the contracts could be sold to even those investors affected by federal regulations constraining their capital’s exposure to risk—an investor such as a pension fund. The ability to sell the toxic waste with an attached insurance policy allowed for increased sources of capital to enter the market. In exchange for the capital, STOs were able to remove sizable quantities of the toxic waste from their books. This had an incentivizing effect on everyone. As new working capital poured in, more products with effectively greater leverage were created on an increasingly grand scale, for an ever-swelling crowd.

Productized risk is a product, just like a lottery ticket, and for 30 years the CDS market and CDO industry have been complicated, opaque, unregulated, broad markets. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. CDS contracts have been compared to insurance because the buyer pays a premium and in return receives a sum of money if a specified event occurs. For example, Goldman Sachs may sell Citibank a CDS for $100,000 per year that pays $10 million if Lehman defaults on its obligations. Citibank would find this CDS very useful if Citibank also owned $10 million of the Lehman CDO and the existence of the CDS allowed for a lower risk rating on the Citibank position.

The ISDA (International Swaps and Derivatives Association), an industry trade group, announced on October 31, 2008, that $25 trillion in notional value had been eliminated from the CDS market since the beginning of 2008, reducing the total to $47 trillion. It wasn’t until November 2008 that the DTCC (Depository Trust and Clearing Corporation), the private electronic vault of record, first began reporting metrics on CDS transactions (DTCC 2008). In the first weekly report there were a total of $33.6 trillion in CDSs outstanding on corporate, government, and asset-backed securities. The concept of a trillion of anything is difficult to comprehend. For comparison, in June 2009 the US national debt was estimated at $11.3 trillion, the US housing market at about $18 trillion, and the market value of all US listed equities at $18 trillion.

This derivatives market segment is huge and was, until November 2008, completely hidden. And there’s another interesting wrinkle—the fact that CDSs no longer entail any requirement that either party have any exposure to the counterparty at risk. That’s why, for example, Goldman Sachs could have bought a CDS from AIG that would have paid out if Lehman were to have failed, without Goldman owning any Lehman product exposure. The CDS would have been a leveraged bet between Goldman Sachs and AIG on the likelihood that Lehman would remain creditworthy and solvent.

MARKET DYNAMICS

In 2000, the Commodity Futures Modernization Act largely exempted OTC from regulation by the Commodity Futures Trading Commission and seriously limited SEC authority. The bulk of these CDS contracts are directly transacted between two companies OTC, with no structured defined exchange or regulated marketplace. The aggregate market for all these products is the equivalent of a mind exercise. It exists in the same sense that there is a global used car market. There is, however, now the bare beginning of a central view of the size and only a hint at the ownership of the marketplace, with the DTCC providing a limited two-week view to the public, although the only information available is what each participant is willing to share. Still, on June 17, 2009, the US Department of the Treasury issued an encouraging report, “Financial Regulatory Reform”: “Investors and credit rating agencies should have access to the information necessary to assess the credit quality of the assets underlying a securitization transaction at inception and over the life of the transaction, as well as the information necessary to assess the credit, market, liquidity, and other risks of [asset-backed securities].”

Operational support for the CDS market has snarled, turning into the same kind of traffic jam that necessitated restructuring the listed equities markets. Regulators therefore continue to push for a central clearinghouse that would, for a small uniform fee, stand between counterparties, provide guarantees in the event of a counterparty’s default on a contract, and establish standard contracts.

While a CDS does not send a corporate stock price up or down, the movement in the stock price, and certainly any change in the corporate debt rating, will directly affect a CDS’s valuation. Lehman is, of course, the defining example. At the time of its bankruptcy filing, it was involved heavily and globally in every possible CDS combination. The DTCC took weeks to unwind all Lehman’s positions, even in the face of the bankruptcy court’s directive to liquidate with haste. This one insolvency prompted a mass stampede to safety and a dramatic reduction in liquidity, precipitating a downward spiral in valuations as products were reduced for sale again and again, spreading insolvency through contamination.

The issues are now twofold: how to unwind the transactions, and where to begin. The ISDA insists that the total notional amount of the CDS market, about $45 trillion, is not the amount that is in fact at risk (2008), and most people agree. Many contracts between the same counterparties can be “netted” to a smaller net amount. But because of the lack of standard documentation, the lack of a central depository or clearinghouse, and the lack of any regulatory reporting requirements (as the Treasury Department points out in the white paper quoted above) it might take a very long time for the ISDA to actually back up that claim.

Meanwhile, the insolvency has spread globally. This complicates our response to the crisis because it makes it necessary for us to identify the beneficiary of any relief effort. If a loan from the Troubled Asset Relief Program is aimed at a CDS asset, it’s not necessarily any more likely to benefit the US economy than to aid participants elsewhere on the globe. At the time the US Treasury was asked to help Lehman Brothers, Lehman derived less profit from the US than from its activity in the European and Asian–Pacific zones. A rescue of Lehman, then, would have been a rescue of many international counterparties as well. The political optics of the use of US taxpayer funds to pay non-US counterparties would undoubtedly have been negative. Recently, AIG disclosed foreign banks as the largest receivers of the AIG bailout monies.

CAN’T DRIVE 55?

Individual STOs are still not motivated to consider the market’s collapse in any terms other than the immediate loss of their own principal. They continue to view their clients’ principal risks as riskless agency trades. Unique marketing terms still make differentiation between regulated and unregulated products needlessly inconsistent and opaque. Disclosure regarding the relationships between regulations and products are still minimal. And, as of September 2008, we now have financial superstores active in all aspects of transactions, as agent or principal, in an echo of the days before Glass–Steagall.

For decades, various administrations and Congresses have actively dismantled industry regulations. The regulations that remain are national, while the OTC market for derivative products is multinational and disdains the standardized reporting a central clearinghouse provides. Each one of these structural deficiencies works to the advantage of the STO and the disadvantage of the individual investor.

An increased individual savings rate must be coupled with increased transparency of the differences between savings and investing. Glass–Steagall is gone, and the separation of banking from investment is gone with it. That separation was not perfect, and it was at odds with the rest of the developed banking world. But new regulation is required to provide greater transparency for an aggregate market view. Adam Smith believed government involvement in the market economy was justified. In his Inquiry into the Nature and Causes of the Wealth of Nations (1776), he encouraged a pragmatic, conservative bifurcation of capitalism and government, like travelers in opposite directions who share a roadway. The point is not to usurp the steering wheels of other drivers, but to enforce speed limits and build guardrails.

REFERENCES

DTCC. October 31, 2008. “DTCC to Provide CDS Data from Trade Information Warehouse.”

ISDA. October 31, 2008. “ISDA Applauds $25 Trn Reductions in CDS Notionals, Industry Efforts to Improve CDS Operations.”

Nanto, Dick. April 3, 2009. “The Global Financial Crisis: Analysis and Policy Implications.” Congressional Research Service. 1–105.

O’Hara, Neil A. Spring 2009. “Don’t Shoot the Messenger: The Unfair Attack on Fair Value Accounting.” Investment Professional, vol. 2, no. 2. 47–53.

Persand, Avinash. 2009. “Ratings War?” Public Policy Research, vol. 15, no. 4. 187–191.

Sachs, Jeffrey. 2009. “The Geithner–Summers Plan Is Even Worse Than We Thought.” Huffington Post.

Schmudde, David. 2009. “Responding to the Subprime Mess: The New Regulatory Landscape.” Fordham Journal of Corporate and Finance Law, vol. 14, no. 4. 708–770.

Simmons, Michael. 2002. Securities Operations: A Guide to Trade and Position Management. New York, NY. John Wiley & Sons. 9–31.

Star, Marlene Givant. Spring 2009. “Hive Mind: Organizational Psychology and the Origins of the Financial Crisis.” Investment Professional, vol. 2, no. 2. 58–65.

US Department of the Treasury. June 17, 2009. “Financial Regulatory Reform: A New Foundation, Rebuilding Financial Supervision and Regulation.” 45. [PDF available via http://www.bespacific.com/mt/archives/021616.html.]

 

–Elven Riley, who has over 30 years of Wall Street experience, is the director of the Center for Securities Trading and Analysis at Seton Hall University. He wishes to thank Paula Alexander, Kurt Rotthoff, Eleanor Xu, Glenna Riley, Michael Majewski, Reverend Deacon Diane Riley, and Tony Loviscek.

 

This article was originally published in the Summer 2009 issue of the Investment Professional.

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Comments

The fact though is that the financial and bank crisis is easy to explain. The problem is that the explanation is too embarrassing for the regulators, who therefore have a vested interest in it not being known and in creating the myth that no one saw it coming.

All financial and bank crisis originate from excessive investments in what ex-ante is considered as being low risk; never ever has a financial or bank crisis originated from what is perceived as risky.

When therefore bank regulators created special incentives for banks to lend or invest in what ex-ante is perceived as not risky, and deterred them, more than they usually are, to lend or invest in what ex-ante is considered risky… they doomed the system to a mega-disaster.

In the video there is a brief and simple lesson on how bank regulators have become so fixated on seeing the gorilla in the room that they completely lost track of the ball. http://bit.ly/c66DLp

Per Kurowski
A former Executive Director at the World Bank (2002-2004)
http://subprimeregulations.blogspot.com/

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