April 27, 2009
Somewhere - Over the Counter
"I haven't got a brain... only straw. But some people without brains do an awful lot of talking... don't they?" Scarecrow in the Wizard of Oz.
The crazy congressmen from Capitol Hill are at it again!
By a bizarre anomaly of the US regulatory system, the body responsible for overseeing Credit Derivatives in the US is the Congress House Committee on Agriculture, I kid you not!
In various posts I have speculated that maybe a lifetime spent regulating pork belly or orange juice futures may not have fully equipped this particular committee to regulate global financial markets in complex derivatives (see Hillbillies and Animal Farm).
In February, the House Committee went a little further in proving that I might have a point, when passing the wonderfully named "HR 977: Derivatives Markets Transparency and Accountability Act of 2009".
Traditionally, the Committee operates through the Commodity Futures Exchange Commission (CFTC). The CFTC regulates commodities traded on US exchanges, such as the Chicago Board of Trade where futures and options commodities such as "mini-sized soybeans" and "rough rice" are traded. The CBOT also permits trading in certain financial contracts, such as 30-year bonds and the Dow Jones Index futures.
Note, these are all so-called Exchange Traded Contracts (ETC), which are traded on recognized exchanges and settled on recognized clearinghouses according to pretty restrictive rules, enforced rigorously by the CFTC. The markets regulated by the CFTC are large and sophisticated and as far as we know, sound, since no part of the Global Financial Crisis (GFC) can be attributed to anorexia pigs or wimpy wheat.
However when looking at Credit Derivatives, the Committee are, like Dorothy in the Wizard of OZ, "not in Kansas anymore".
Credit Derivative Swaps (CDS) are not traded on regulated exchanges but are commercial 'contracts' agreed between two parties, so-called Over The Counter or OTC transactions.
Like a frisky bull in springtime, the Committee, however, seems quite prepared to leap over this particular fence and start to regulate/dabble in areas of commercial law.
In Section 16 of the new Act, the committee has given the CFTC truly draconian powers to "summarily suspend trading in any credit default swap" and to "summarily suspend all trading on any contract market, derivatives transaction execution facility, or otherwise, in credit default swaps". Note that the un-elected CFTC may take such dramatic steps if in its own opinion "the public interest and the protection of investors so require".
Before considering some of the unintended consequences of the Committee's (bull in a china shop) foray into international finance, it is worth asking - what does the august body actually mean by a Credit Default Swap?
Never fearful of falling on their collective faces into a cow-pat, the committee actually go so far as to enshrine a definition of a CDS into US law: "the term 'credit default swap' means a contract which insures a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade".
Note the definition does not actually define a CDS but gives an example (such as default or downgrade). And a quick look at the definition would also show that it is extremely broad and probably covers lots of other OTC derivatives, such as Interest Rate Swaps, where any 'event' can occasion a loss!
Lawyers must already be licking their lips at the fees that will be earned debating this 'definition'?
Having defined CDS, the question then is whether the CFTC actually has the power to suspend any and all trading in contracts that just might include the words 'Credit', 'Default' or 'Swaps'.
What if, say, JP Morgan has signed a commercial contract with UBS Switzerland that walks and squawks like a CDS? According to HR 977, the CFTC may 'summarily suspend' this transaction if they think fit. Does that mean that they suspend the JP Morgan side or the UBS side, or, for example, the UK side, if the contract was signed by separately regulated UK subsidiaries of each bank? Does this mean that the CFTC has jurisdiction over UK commercial law? If so, has anyone told the House of Commons this yet?
What if, for example, JP Morgan was not involved, but the contract was between UBS and Credit Suisse under Swiss commercial law, and was based on an event for a US company, such as IBM? Can the CFTC intervene; say when IBM comes under short-selling pressure, which surely counts as public interest?
And even if the parties were in fact all US based, has the CFTC the power to interfere with perfectly legal contracts, entered into voluntary by knowledgeable parties?
Lawyers must already be window-shopping at Rolls Royce dealers in anticipation of the fees that will be earned fighting the resulting cases all the way up to the US Supreme Court.
As noted elsewhere, the House Committee on Agriculture appears not to understand that the market in OTC contracts (not just derivatives) is global, covered by laws in many different jurisdictions and overseen by bodies unfamiliar with the peculiarities of the US regulatory system.
HR977, if enacted, will be strenuously opposed by financial institutions because it creates exactly the type of 'regulatory arbitrage' that drives firms to move away from regulated markets to open up offices in more compliant jurisdictions. Which European or Asian bank is going to sign a contract with an American institution if the agreement can be summarily annulled by a third party whose expertise is in Soybeans? I think very few!
But this does not deter the Committee on Agriculture, who are much more than the biblical 'sons of the soil' or 'hewers of wood and drawers of water'. They are like the Wizard of Oz who boasted that "you are talking to a man who has laughed in the face of death, sneered at doom and chuckled at catastrophe."
They are not to be deflected by mere points of law or questions of feasibility, but will plough on regardless, humming the immortal words of L. Frank Baum, for the Scarecrow in the Wizard of Oz:
"I could while away the hours/conferrin' with the flowers/consultin' with the rain/And my head I'd be scratchin'/ While my thoughts were busy hatchin'/If I only had a brain."
Posted by pjmcconnell at 06:55 AM
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April 20, 2009
Digit in the Dyke
Ben Bernanke: "Recent experience has shown some ways in which financial innovation can misfire"
In a recent speech to a conference on Consumer Affairs, the Chairman of the Federal Reserve, Ben Bernanke, considered one of the most critical issues facing regulators - how to encourage financial innovation while protecting consumers from its unintended consequences?
Dr. Bernanke began by pointing out "as we have seen only too clearly during the past two years, innovation that is inappropriately implemented can be positively harmful." He went on to argue that it would be "unwise to try to stop financial innovation, but we must be more alert to its risks and the need to manage those risks properly".
While somewhat a statement of the (blindingly) obvious it is nonetheless obvious and worth stating.
The chairman articulated a laudable goal for regulators: "to strike the right balance: to strive for the highest standards of consumer protection without eliminating the beneficial effects of responsible innovation on consumer choice and access to credit."
Now that is a (really) tough challenge!
In reporting the efforts that the Fed has gone to in 'consumer testing' information disclosed about new financial products, the chairman concluded that "some aspects of increasingly complex products simply cannot be adequately understood or evaluated by most consumers, no matter how clear the disclosure." He did not point out, however, that some of these innovations were not adequately understood by regulators either, otherwise we wouldn't be in this mess.
Dr. Bernanke concluded that 'in those cases, direct regulation, including the prohibition of certain practices, may be the only way to provide appropriate protections." Wow, an admission that we may have to get the big stick out of the bullpen and retire the carrot!
So far, so good.
Then the Chairman's speech went down hill, rapidly.
In searching for an example of how regulation in the face of innovation may be applied, Dr. Bernanke spoke about the efforts of the Fed to attack the problems of 'over-charging' (or in Fed speak 'payment allocation') for cash advances on credit cards. It turns out that the nasty banks have been forcing customers to pay off outstanding 'low interest' balances (such as card purchases) before they allocate money against 'high interest' balances, such as cash advances. In this situation, of course, the term low and high are relative and must be likened to the difference between K2 and Everest; in fact 'low' means 'high' and 'high' means 'extortionate'.
[Maybe we could get Starbucks to design financial Product Disclosure Statements (PDS) and then we could charge Grande, or even Venti, interest rates?]
Having failed to come up with an adequate scheme for disclosing the complex rules for allocating payments, that ordinary folk could understand, the Fed admitted defeat and had put "rules in place that will limit the discretion of creditors to allocate consumers' payments made above the minimum amount required."
[Note, this is not as dramatic as - Stop! But more like: kindly take some time to consider should you slow down?]
The Chairman boasted that this, and other actions on mortgages, was "part of the most comprehensive change to credit card regulations ever adopted by the Board."
However, he forgot to point out that these rules are the first major changes to the famous/infamous 'Regulation Z' of the TLA (Truth in Lending Act) since 1981! Nor did he remind us that these changes have been in the pipeline for several years and that the legislation to enact the new rules is still wending its way through the US Congress.
The Fed appears to move at a pace that makes Tectonic plates seem like extras in 'Fast and Furious'.
Aside from the inability of the Fed to tackle the unpleasant side effects of financial innovation promptly, if at all, the more disturbing issue is the use of the credit card example.
Now while granted that the Chairman's speech was to a group of US consumer advocates, it is disconcerting that the only example of vigorous regulation that he could come up with was a relatively minor tweak to the rules for a product (credit card cash advances) that can hardly be termed state of the art.
What is the Fed going to do when it is faced with fiendishly complex products, such as CDO squared? It should be remembered that the market for complex CDOs only came into existence around 2004/2005 and flamed out in 2007/2008. And what is the Fed going to do about innovations that emanate from outside the US?
Unless regulators begin to think and, more importantly, move as fast as financial innovators, governments will be faced with more and more of the unpleasant side effects of innovation, such as trillion dollar deficits. Since banning innovation has never worked in the past, regulators must accept that innovation will happen and that it will have unintended consequences and they must focus on how best to protect consumers (and also the regulators' employers, the taxpayer).
Dr. Bernanke is like the little Dutch boy who put his digit in the dyke to prevent flooding, all the while, a few feet away, the levee has broken and (Katrina like) toxic waste is flooding into the financial system. Every little bit does help - but not a lot.
Finding a balance between financial innovation and consumer protection is extremely challenging for regulators, but when a senior regulator addresses the Global Financial Crisis using the example of revising relatively simple rules for allocating credit card payments, there is only one rational reaction - Panic!
Posted by pjmcconnell at 09:08 AM
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April 13, 2009
Basel 2.0
Has the Basel Committee been reading the Microsoft playbook?
Having failed miserably to build a Windows operating system that worked 100%, 100% of the time, Microsoft hit upon a brilliant strategy: build a system that definitely didn't work.
The strategy works this way.
First a Microsoft bigwig, usually Bill Gates, announces that the company will deliver a version of Windows that is the greatest advance since the printing press and will revolutionize the way that we all communicate, work and live together. Though the planned delivery date is often years away, Microsoft customers will reluctantly suspend disbelief to give the company one last chance.
Invariably, the project is delayed, first by months, then by years, but so what - still worth waiting for.
After some time, Microsoft announces that a 'beta' version will be released to selected customers. This is pure genius, the beta release definitely won't work but why spend money on your own staff, when you can get your customers to find problems for you. When the beta version is released to the geekocracy, the blogsphere is awash with plaudits and criticisms but, hey, any publicity is good publicity.
After some time, Microsoft finally announces a 'release date' and, like kids at Christmas, customers get excited about the arrival of the new software. About the same time, computer manufacturer announce that their hardware is 'ready' for the new system. In this situation, 'ready' is techno-speak for "this new operating system is such a dog that you will need a brand new computer that is at least twice as fast and big as your existing one to even get to the sign-on screen".
At last the great day arrives, and you queue for the new system, take it home, unwrap and load it up on your (new) computer. Then you find that your favourite software doesn't work; in this case 'backward compatible' does not mean compatible - just backward. After a fortnight or so, of (re) purchasing and loading software that used to work, the system is back (almost) to what it was before - though you tend to be disappointed by reality of the promised revolution in the way you work and communicate. Often the new system (like Windows Vista) is just plain annoying.
Then there is a 'ping' - you have email!
The email is from Microsoft and it warns you that the universe will implode and life as we know it will cease to exist, unless you immediately apply a mandatory 'security patch'. Of course, you do. But that is not the end, every day it seems that a new shock-mail arrives and, now frightened silly by newspaper articles on the end of civilization, you apply the latest patch. And so on for months.
Heaven forbid that you do not apply one of these patches because, for example, you have a life and a job to do. But beware, if you have to call Microsoft for what is laughingly called 'support'. After hanging on the phone for hours, a disembodied voice will first ask you "what patch level are you on?" But if you answer anything less that "version 2.43617/A/r142" the response will be "cannot help - get on the latest patch level". After some time, you give up trying to keep up and put up with the periodic 'dead green screen' and the galling loss of hours of work when your system crashes.
Just when you are getting ready to consider getting an Apple Mac, Microsoft announces that it is delivering a new PC operating system that will be the greatest leap forward since yada yada. Having wasted so much time and money on the current system, you again suspend disbelief and so the cycle continues. You rationalize that Microsoft must be doing something right, as Bill Gates is, once more, the richest man in the world.
Has the Basel Committee been taking lessons from Microsoft?
In November 2008, the Basel Committee announced what was, in effect, a new approach to issuing regulation. The announcement said that it was nothing less than a "comprehensive strategy to address the fundamental weaknesses revealed by the financial market crisis related to the regulation, supervision and risk management of internationally-active banks": - can't argue with that?
All sorts of promises were made. Among the many features to be found in this new super-duper Basel (so far un-numbered), were "strengthening the Basel II framework; enhancing the quality of Tier 1 capital; building additional shock absorbers [wow!] into the capital framework; strengthening supervisory frameworks to assess funding liquidity at cross-border banks; leveraging Basel II to strengthen risk management and governance practices at banks; promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles."
Suppressing the obvious question: "wasn't that exactly what Basel II set out to do?' in these trying circumstances, one can only wish the Committee well.
But the sting is in the tail. Instead of the tried and (very) tested Basel method of long consultation and detailed review the new approach would be snappy and up-to-the-minute. The Chairman of the Basel Committee, Nout Wellink, announced that the committee "expects to issue proposals on a number of these topics for public consultation in early 2009 [i.e. just a few weeks away]... and other topics will be addressed over the course of 2009." I.e. Basel will, from now on, be working at Internet speeds.
True to its promise, the Basel Committee did not let the Alpine pastures grow under its feet but issued the first in the new line of 'express proposals' in January 2009 - great turn-around, given that Christmas fell in between.
The timetable for this first set of jet-powered proposals is certainly aggressive. Comments on the proposals must be made by mid April and some parts are due to be implemented by 1 July 2009, less than 3 months away, with much of the remainder by year-end. Compared to the glacial pace of Basel II, this timetable is positively instantaneous.
And what about the regulatory changes proposed?
The new regulations range from the far-reaching to the relatively trivial.
For example, in Basel II, the issue of 'reputational risk' was barely touched (except to note that it was not covered under Operational Risk). The first set of the new express proposals requires banks to take reputational risk out of the 'too hard basket' and include this risk in its capital adequacy assessment, by end of 2009? Shouldn't be too difficult - eh?
At the other end of the spectrum, the new proposals mandate a slight change in the so-called Credit Conversion Factor (CCF) for "short-term eligible liquidity facilities within the securitisation framework would be changed from 20% to 50%". If only we had known that all we had to do was to change this simple factor instead of spending trillions on economic stimulus because securities had become illiquid. In future, maybe we should change this factor on a weekly or even daily basis, maybe we can get this factor from our local regulator over Reuters and cut out the risk manager altogether.
If it succeeds, what will this new 'always on', Generation Y approach to regulation look like?
First, new regulations will be promulgated by Twitter. And, instead of regulators being gray men in gray suits, the new breed will wear their baseball caps back-to-front and carry skateboards - respect to IRB, Dude.
And, in future, when a risk manager rings their regulator for clarification on some obscure point, they will be informed by their (slightly foreign sounding) call center 'regulation agent' that the firm's capital charge will have to be increased immediately because they have not downloaded the latest table of beta factors for their Standardized Approach to Operational Risk.
The new motto of regulators has become "Don't think - Do!" As Andy Warhol said: "As soon as you have to decide and choose, it's wrong. And the more you decide about, the more wrong it gets" [could have been an observation for Basel II also?].
However, when looking at Basel's new approach, the question that must be asked is: 'Given the cataclysm of the Global Financial Crisis, what is the purpose of tinkering at the edge of existing (discredited) regulation?'
This is not rearranging deckchairs on the Titanic; this is rearranging cushions on deckchairs on the Titanic while taking orders for dinner.
Optimistic but, honestly, a waste of (everyone's) time.
Posted by pjmcconnell at 07:49 AM
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