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Archive for the ‘regulation’ Category

The SEC action against Goldman again has me asking whether the industry might not actually be better off with some serious regulation of adverse selection. Goldman sold an asset hand-picked to fail as if it were just the average security. The retail investors has lots of protection, and so does the consumer. Imagine buying a car, and then being sold one off the lot that the mechanic who just tuned the engine is betting will break down. And not being told this. If car dealers could do this, cars would be hard to sell (this is the model and application for which George Akerlof won the Nobel prize in economics). Adverse selection makes assets illiquid. The more disclosure is required in simple, transparent ways, the more easily assets can be traded. If Goldman can hide the adverse selection behind tens of thousands of pages of “disclosure,” surely it makes it harder for any bank to securitize?

And this need not be regulation. Why doesn’t some bank start a private initiative of this sort?  In the car market, dealers provide guarantees.  Suppose that one of Goldman’s competitors made a pledge and provided a money back guarantee on losses directly caused by a listed set of shady practices. Wouldn’t that that bank almost never have to pay off and wouldn’t it gain a huge amount of business? Is the industry colluding to keep things opaque so they all decrease liquidity and increase profits?  I thought innovations that provided greater liquidity were the source of securitization and the financial boom, but maybe not . . .

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The Senate Agriculture Committee just passed a bill regulating the derivatives market. Summary here. The legislation imposes clearing and trading requirements and real-time reporting of derivatives trades. It provides exceptions for some businesses like electric cooperatives which have argued that hedging business risks are important. It also tackles the moral hazard problem that the possibility of bailouts creates. (That is, if banks feel that the government will bail them out when they lose money, they take more risks since the downside is smaller for them). If the bill becomes law, the Federal Reserve Board and the Federal Deposit Insurance Corp. will be prohibited from providing any federal funds to businesses who are involved in derivative deals. This seems to imply that banks engaging in naked swaps transactions would have to spin off their swap dealer desks or be out in the cold in a crisis when others might be receiving bailouts. Of course, in a  crisis, laws change, and if no one spins off their desks, we are unlikely to let all banks go under (see Fall 2008).

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Here is an interesting article about how the major brewers might have an important role in the future regulation of over-the-counter derivatives markets.

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The FDIC is modifying the measurement tools it uses to assess the risks that large banks pose. The FDIC currently places each bank in one of four categories of riskiness. This assignment is based on supervisory ratings and capital levels, and is used directly to price deposit insurance but more generally to regulate and evaluate banks’ solvency/riskiness/capital adequacy. Moving forward, the FDIC plans to

draw finer distinctions among large institutions based on the risk that they post.

But more importantly, it changes some of the inputs for the assessment so as

. . . to better capture risk at the time an institution assumes the risk, to better differentiate institutions during periods of good economic and banking conditions based on how they would fare during periods of stress or economic downturns, and to better take into account the losses that the FDIC may incur if an institution fails.

That is, the assessment will be more forward-looking and reign in risk taking more in booms than in recessions. And, if the FDIC cares not only about how much money its insurance fund might lose but what the state of the world is when this happens — meaning are lots of other banks failing at the same time – then this approach will also pay more attention to systemic risk than individual risk. Finally, the FDIC approach will differ for institutions that are simply very large and those that are “structurally and operationally complex or that pose unique challenges and risks in case or failure.” All very good steps forward. The full details are here.

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While we the people — through we the government – own the majority of GM and AIG, and a small share of most US banks, we completely own the GSE’s, that is the Government Sponsored Enterprises Fannie May and Freddie Mac. These institutions need a new charter, one that does not give executives and stockholders high pay and dividends when things go well and leave taxpayers footing the bill when they do not.

On Friday, the Republicans on the Committee on Financial Services have released a set of bullet points called “Goals and Principles for GSE Reform.” While the devil in legislation is in the details (not to say it isn’t also sometimes in the title too), the main points are right on track. The critical weak link in the release is: what is the mechanism that insures that we the taxpayers will not be bailing out these institutions again? Still, I am used to Barney Frank saying mostly the right things (post-crisis), and this document is on target and good to see. It makes one wonder what is taking the House so long to get a program in place?  Oh, that’s right, I forgot, the parties can’t even agree on what to order for lunch.

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FDIC Chair Sheila Bair speaking on March 8, 2010 gives a pretty standard description of the crisis and lays out quite a good framework for reform. The piece is FDIC centered, so emphasizes the problems of too-big-to-fail, failures in securitization, and regulatory arbitrage. But she dances a contorted political dance, like so many in DC forced to bow before sacred words, and ends with

“ . . . unless economic incentives are also appropriately aligned, regulation alone will fail.”

Uh, what appropriately aligns economic incentives if not the governmentally-enforced rules of the game, often called ‘regulation’? I guess everyone hates regulation, and everyone loves “laws that protect the American way.” And we wonder why we get the divided government we do. (Maybe I just need another cup of coffee.)

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Last July, the International Organization of Securities Commissions released a report on the regulation of hedge funds.  Now, with financial regulation proceeding in the U.S. and the E.U, securities regulators have settled on this report as a template for necessary fund disclosures to keep an eye on the systemic risks posed by hedge funds. I give the report a B+ because, while vague and missing a market-based approach to the regulation of systemic risk, it focuses more on limiting spillovers than restricting activities.

As most of you know, hedge funds are like mutual funds except that they require large minimum investments, face less regulation and typically restrict withdrawals. The assumption is that, since the minimum investments are large, their investors are more savvy (or at least more able to lose money without becoming destitute) and so these investors do not need (much) regulatory protection. Thus hedge funds engage in complicated and often highly risky investment strategies and charge high fees to do so.  And in the recent credit crisis, hedge funds lost lots of money. So far no problem.

But when financial institutions got into trouble, they cut back lending to hedge funds. This meant that all hedge funds had to unwind their positions together, which pushed down prices of what they were selling and holding, which made their investments look more risky and increased their measured leverage ratios, which lead to a further reduction in what large financial institutions were willing to lend them, which meant that all hedge funds had to unwind their positions together, which  . . . a vicious cycle. Add to this that some hedge funds were hidden inside (formerly) large financial institutions (like AIG, Bear Sterns, etc.) so that as hedge funds lose money, so do the large financial institutions, further restricting credit flows to hedge funds and increasing losses and . . . another vicious cycle. And you can see the potentially systemic implications.

So back to the report – posted here, it lists six overarching principals for hedge fund regulation.  Some are useful – like mandatory registration for managers and advisers, and the development of standards on operations, conflict of interest, and disclosure – but some are so vague as to be almost hopeless – like ongoing regulatory requirements relating to prudential regulation, and requiring the provision of relevant regulator information for systemic risk purposes. The report expands more than this, and in some sense the details must be left to country legislators or maybe even regulators.

But some of the reports suggestions are great. For example, I like the focus on cutting the spillovers from a hedge fund crisis into a more general financial crisis. The report for example recommends the regulation of prime brokers to ensure risk management in general and specifically with respect to their counterparty exposure to hedge funds. I love this.  Let hedge funds play with their money, but do not allow them to bring others down if they lose it.  In extreme, this cuts off lending to hedge funds, at least from the financial sector (there is no problem with hedge funds issuing bonds that private investors hold in their portfolios).  In a more moderate version, a regulator might only allow collateralized lending to hedge funds and set high haircuts for this lending. A good investment strategy should be able to raise equity and not rely on debt that is safe only when you really don’t need safety and loses money in the states of the world when you really need your financial institutions not to lose money.  Let the hedge funds seek alpha without society holding the downside beta.

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Securities and Exchange CommissionWhile the stock market collapse and recession are not the Great Crash and the Great Depression, the SEC is starting to act like it is.

The SEC amended to Rules 200(g) and 201 of Regulation SHO (on shorting) that will restrict short selling shares when a company’s shares drop more than 10% in a day (new release here). The regulation of shorting dates to 1934, when many restrictions were implemented in a significantly misguided attempt to prop up share prices. This regulation does not look good, although it is quite limited in scope. It means that short sellers have to wait for those with shares in hand to sell before selling. A good sign that the rule is bad is the defense given in the press release: “to preserve investor confidence. . . ”  If it actually had a large effect I would be worried – if I am buying a stock that has declined I would worry that a lot of people have really bad news and have sold out of the stock and that the price does not reflect fully their bad news because they are unable to short the stock until its price seems reasonable to them. Thus, I may pay a price to buy that many people might know is overinflated but are not able to make profits and make the price far. But what will the rule actually do? Well, I expect not much. People wanting to speculate on the decline of a stock can still take positions in the futures market and make their money and get their views out there. As long as enough people are paying attention and the market is liquid enough, the actions in the future market should lead to downward price pressure in the stock.

All that said, I understand the motivation for the rule. It is my view that today almost all firms are basically banks, funding long term projects with short term commercial paper (instead of deposits). This exposes them to the risk of a run.  And a decline in share price may lead to a run. Which might justify the decline in share price and make speculators very wealthy.  But the solution seems to me either 1) allow this to happen, equity holders will get burned and then run the firm with less maturity mismatch or buy some sort of run insurance or 2) provide a lender of last resort for corporations, the way the Fed does for banks.

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