A Plan for Regulatory Reform

On May 26, 2009, the Committee on Capital Markets Regulation (CCMR) released its report, “The Global Financial Crisis: A Plan for Regulatory Reform.” As stated in its press release, the plan presents its comprehensive approach “for reforming the U.S regulatory structure” as a result of the financial crises. The report presents 57 recommendations which address the flaws in the regulatory system which the crisis has exposed.

The Committee concludes that an effective regulatory system must achieve four objectives:
1. Reduced systemic risk
2. Increased disclosure to protect consumers and investors
3. A unified regulatory system with clear lines of accountability and improved transparency
4. International regulatory harmonization

(See “The Global Financial Crisis: A Plan for Regulatory Reform” link on the right)

On May 28th, the Wall Street Journal reported that Obama administration officials are close to recommending a single regulator to oversee the entire banking sector, a step which would effectively merge regulatory responsibilities of the Fed, the FDIC, the Office of the Comptroller and the Office of Thrift Supervision. The article also reported that the Fed would assume the role of a systemic regulator to oversee the entire financial sector, while the FDIC would assume powers to expand its ability to put any large financial company into receivership. Currently, no agency has explicit authority to monitor and manage systemic risks, and the FDIC only has authority to put banks into receivership. (See “Single-Regulator Plan for Banks Now Close” link.) These elements follow some of the recommendations contained in the CCMR report.

Following the Wall Street Journal story, Bloomberg News reported that House Financial Services Committee Chairman Barney Frank ruled out creating a single U.S. bank regulator. Congressman Frank stated that Congress would examine retaining the existing multi-regulator structure, while creating a new authority, which could be a combination of agencies, to deal with risks to the overall financial system. In contrast to the Administration’s thoughts, Congressman Frank’s statements appear to be precisely what the CCMR report recommended against. The consolidation of agencies and creation of a new authority would upset the existing oversight by various Congressional Committees, which would cause a reduction in power by some members of Congress who would lose oversight of existing government agencies. (“Frank Rules Out Creating Single U.S. Bank Regulator” link.)

CCMR Report: Shortcomings of the Current Market Environment and Regulatory Agencies

• While Credit Default Swaps are an important tool for measuring and diversifying credit risk, the current market significantly increased the potential for systemic risk with interconnected counter-party risk multiplying the effects of a chain reaction of defaults.
• The existing capital regime, which was established by the Basel Capital Accords, was inadequate to prevent financial distress of large financial institutions. The system also excluded other important financial institutions, which created moral hazard risk as the crisis developed.
• Regulatory agencies do not have sufficient tools to resolve the insolvency of all systemically important financial institutions. Its ability to manage insolvency is limited to banks and excludes its ability to address solvency issues of other financial institutions.
• The current securitization markets do not properly align the incentives of originators, investors and credit rating agencies involved in different aspects of the market.
• Disclosure requirements of existing SEC regulation AB do not require sufficient detail for securitized products to allow investors to independently value securities.
• Credit Rating Agencies failed to assess the risk of securitized issues accurately, had widespread conflicts of interest in the rating process, and did not provide sufficient transparency to the rating process. Investors placed excessive reliance on the ratings.
• Increased use of fair value accounting (FVA) may promote instability in financial markets, especially during periods of market distress. The approach required by FAS 157 combine three different valuation approaches into one number: market price, intrinsic value and replacement cost.
• U.S. financial market participants are regulated by a fragmented, sector-based model which does not reflect the complexity of the current market

CCMR Report: Selected Recommendations

• Mandate centralized clearing of Credit Default Swap (CDS) contracts to limit counterparty risk and improve liquidity.
• Adopt a CDS reporting system which requires volume and position data to be publicly available.
• Hold large financial institutions to higher solvency standards.
• Adopt counter-cyclical capital ratios.
• Establish a single insolvency regime applicable to all financial companies.
• Explore minimum risk retention by securitization product originators.
• Amend Regulation AB for securitized issues to increase loan-level disclosures.
• Increase disclosure of how credit ratings are determined for securitized products.
• Supplement FVA with a dual presentation of market values and intrinsic values.
• Replace the existing fragmented regulatory agencies with a new framework consisting of at most three agencies, while increasing the role of the Fed to become the systemic risk regulator. One agency should have total authority to regulate the financial industry, with that agency being either the Fed or a new U.S. Financial Services Authority.

About CCMR
(from its website at http://www.capmktsreg.org)

The Committee on Capital Markets Regulation is an independent and nonpartisan 501(c)(3) research organization that includes leaders in finance, business, academia, law, accounting, and the investor community from all across the political spectrum. The Committee provides policymakers with a nonpartisan, empirical foundation for public policy on capital markets regulation.

Bob Decker, CFA

The Role of Shareowners

“I know of no safe repository for the ultimate powers of society but the people themselves; and if we think them not enlightened enough to exercise their control with a wholesome discretion, the remedy is not to take it from them, but to increase their discretion by education.”
Thomas Jefferson

An interesting, worthwhile, and even crucial discussion has begun. It entails a fundamental basis of the free market, capitalist economy. As the incursion of government (with its police power) has risen throughout the financial crisis, many news articles and opinion pieces have skirted around the issue without taking it on in a direct manner. It is the elephant in the room: the role of shareowners.

On April 25th, the Wall Street Journal reported that Senator Charles Schumer planned to introduce a bill that would alter corporate governance. Among its features is a provision requiring that investors in companies with publicly traded stock be given an advisory vote on executive pay.

My immediate reaction was: Finally! Maybe the elephant in the room would begin to be discussed.

Until then, the debate seemed myopically focused on what role the Federal Government or regulators should have in setting not just executive compensation, but essentially, compensation deep into the management and employee ranks. The “discussion” of compensation surrounding certain employees at AIG became a loud shriek. When emotions cooled somewhat, the application of the concept began to turn to companies, primarily banks, who had, at the insistence of the Secretary of the Treasury, accepted funds from the TARP. When TARP recipients began to announce plans to repay the government, President Obama weighed in with the idea that compensation matters for all financial firms should become the purview of the Federal government. More recently, the President has been credited with thinking that shareholders should receive more of a say in executive compensation.

Citizens, who do not follow the stock market or its seemingly mundane legal requirements too closely, may seem somewhat unsure about the discussions. After all, ask any business owner, from the corner laundry and dry cleaning proprietor to the executive of a multi-million dollar family business, what his or her role in setting executive compensation is, and you would expect to find that the owners have a fairly significant say.

However, only recently has Congress required an advisory vote on executive compensation by shareholders for recipients of government funds. Other companies have voluntarily adopted advisory votes by shareholders. An advisory vote, though, carries no requirement that a Board of Directors do anything. The Securities Exchange Commission has never seen fit to endow shareholders with any direct power over executive compensation. The SEC has likewise stymied efforts to allow shareholders’ groups to appoint an alternative slate of candidates for the Board or to force other issues to a shareholder vote. In short, shareholders have historically been disenfranchised.

News stories which have appeared in the wake of Senator Schumer’s governance proposal express some of the rationale for this history. In a Wall Street Journal opinion piece, two lawyers and a business professor allege that his proposal “misses the mark” and will in fact have the effect completely opposite of its intention to prioritize the long-term health of a firm. Their argument proceeds along the following line: “excessive shareholder power” with its focus on short-term results created excessive risk taking by executives; these executives were incentivized to engage in risk taking to boost the share price in the short term; the risk taking was not balanced by “prudent regulation;” and the result is the current crisis. Since shareholders do not know what is good for them or for the firm, the authors’ solution is that shareholders should, in fact, have their power further diminished.

At this point, the words of Thomas Jefferson should be recalled. Even if one accepts the “excessive risk taking” premise (lack of wholesome discretion) as the cause of the financial crisis, it does not seem that the remedy should be to remove power from them. A broader understanding of the causes of the crisis would seem to be in order before a rush to disenfranchise shareholders further is embraced.

Bob Decker, CFA

Is the U.S. a Country Where the Rule of Law Rules?

President Obama seems to be taking lessons from Vladimir Putin: If you don’t like the result the law requires, ignore it; political connections should dictate results. The U.S. Bankruptcy Code delineates how creditors stack up in court. You don’t have to be a lawyer to understand the basics. The more senior the debt, the better off a creditor is when a company is forced to seek protection under Chapter 11 of the Bankruptcy Code. If a debtor’s assets are insufficient to cover all claims, the Code calls for strict prioritizing of the claims. Secured creditors are entitled to payment of their claims before junior claims can expect any payment. However, as lead negotiator in Chrysler’s attempt to settle its claims out of court, President Obama demanded all secured creditors forego their rights and submit to his demands. His settlement proposal (demand?) was to provide benefits to unsecured claims before the secured creditors’ claims were settled. Bloomberg reported that the U.S. government, as a secured creditor, would receive an equity stake of approximately 25% in a reorganized Chrysler.

As a former law professor, one might expect President Obama to understand and accept the law. However, three possible explanations for the President’s demands come to mind: he does not understand the Bankruptcy Code (and he should get competent legal counsel); he is just posturing as a negotiator on behalf of his secured position and on behalf of a group of unsecured creditors (an employee benefit trust); or he considers his position to be above the law.

Bloomberg News quoted President Obama as stating that a “small group of speculators” (i.e. “bad guys”) demanded that everyone else needed to “make sacrifices and they would have to make none.” President Obama must also know, then, the price at which the speculators bought their pieces of senior debt, specifically that they must have paid less than 32.6 cents per dollar of face amount, since that was the President’s last reported offer to them. Never mind that they probably paid more than that, and under the indenture contract, they were promised 100 cents on the dollar by Chrysler.

Meanwhile, under the President’s proposal, unsecured claims arising from employee benefit promises were offered equity in the reorganized Chrysler. Granted, in many Chapter 11 proceedings I have analyzed, strict priority of claims was often not applied; unsecured creditors usually received some equity in the reorganized company, but unsatisfied claims of secured creditors shared in a similar arrangement. Such arrangements, though, have been overseen and approved by a bankruptcy judge, not dictated by one creditor (in this case, the Federal Government), which President Obama has taken on the role to represent.

The holdout group is reportedly a minority group, as other secured creditors were willing to accept the President’s offer. One can readily understand the admittedly weaker negotiating position of a number of those secured creditors. They happen to include banks in which the Federal Government has invested TARP funds appropriated by Congress. The expectations are that much (if not most/all) of that preferred stock issued to the Government will be soon converted into voting common stock. One should not begrudge the President his leverage over those secured creditors to accept his offer.

However, the “speculators” also have a fiduciary duty to their investors to get the best deal they can. If they think that a bankruptcy judge offers them a better alternative, then it is their right (and duty) to avail themselves of it. As Mr. Bill Frezza points out on RealClearMarkets.com, their submission to a publicity campaign launched by the President could lead to a host of unintended, undesirable consequences. Unless, that is, we wish to abandon the rule of law.

Bob Decker, CFA

Bank Capital and Unintended Consequences

With some level of disclosure of the results of the special “Stress Test” by regulators looming, a number of related questions are likely to occupy the market: What banks need additional capital: who will provide that capital; what are the consequences of raising the capital?

University of Chicago Professor Raghuram Rajan suggests a regulatory framework for bank capital that would avoid the pro-cyclical behavior of the existing system. In a recent article in The Economist he explains how such a system would work. He argues that such a system needs to meet “the three Cs” test. It must be comprehensive, that is, apply to all leveraged financial firms; it must be contingent, come into force when a financial firm is “most likely to do itself harm;” and it must be cost-effective.

The current approach fails to meet any of these “C” tests. A Bloomberg News article, “Stress Tests May Force Banks to Convert TARP Stock,” points out that converting government held preferred stock issued under the TARP may be the only viable alternative for banks to raise additional capital. Thus, the government has come to be not only the “lender of the last resort” (through the Fed), but also an investor of the last resort (through the Treasury).

The ownership stake by the U.S. Government, where departments within the U.S. Treasury and the Fed regulate banks and other financial institutions, pose serious dilemmas for the market to decipher. Bank of America CEO, Kenneth Lewis, testified to New York Attorney General Cuomo that the Treasury and Fed told him not to terminate the Merrill Lynch acquisition in the face of steep losses and not to disclose those losses to his shareholders (and the public). Such pressure is especially destructive to the ability of finance companies to raise private capital. Mr. Lewis’ dilemma is likely to become a case study for business ethics classes: what is the “right” decision when the regulator essentially instructs you to violate securities laws? The regulators clearly subscribed to Col. Jessup’s view which he forcefully expressed to Lt. Kaffee in A Few Good Men, “You can’t handle the truth!” The results of the bank stress tests to be released during the week of May 4th will again demonstrate how much truth the regulators feel the financial markets can handle.

Even if strong banks who need no additional capital succeed in purchasing the preferred shares back from the Treasury, warrants issued with the preferred guarantee that a government ownership stake could still remain. Repurchase of those warrants will require further negotiations, as pointed out in another Bloomberg News article.

Former Labor Secretary Robert Reich, in an editorial piece in the Wall Street Journal, raised dilemmas, among them: If the Federal government owns a significant share of a bank (or any company), it “should be represented on that companies’ board of directors in direct proportion to the size of its stake,” and those public directors should be “appointed by the President.” Mr. Reich also posed a troubling question for shareholders: Given that the government owns a stake in a bank, is the CEO’s “main job still to make money for his shareholders, or does he now have a higher public responsibility to lend more money to Main Street?”

Thus, the dilemmas facing financial company CEOs, regulators, and the markets will not ease for the foreseeable future. Recapitalizing the banking system is getting messier. As Henry Kravis, a co-founder of Kohlberg Kravis Roberts & Co., recently pointed out, “We do not know about the terms” of government intervention, nor do we know whether investors are “going to be called into Congress because you are making money.”

Bob Decker, CFA

What caused the current financial crisis?

The search for the cause of the Financial Crisis will soon heat up.  On April 21, 2009, Bloomberg News reported that Speaker of the House Nancy Pelosi planned to push for a Congressional inquiry of Wall Street.  (Click the “Pelosi Probe Bloomberg News Article” link on the right.) However, any Congressional investigation into the causes of the Crisis is likely to become a partisan affair, and Congress is unlikely to look into the mirror.  The search for the culprits who started this mess should cast a wide net.  “Wall Street” just doesn’t seem wide enough, and limiting the search to Manhattan Island is more likely to find only scapegoats.

Perhaps the best explanation turns to that observer of human nature, Pogo:  “We have met the enemy and he is us.” A list of causes would need to include:

  • A patchwork of regulatory agencies with competing agendas, which allowed financial firms and financial products to engage in “regulatory arbitrage” or escape regulation completely.  One over-riding theme is not “deregulation” but a massive failure of overlapping, inconsistent, and conflicting regulations.  Basel II international standards on bank capital need to be included.  Those standards allow for banks to use their own “approved” risk models to calculate how much capital needs to be maintained for varying risks of different financial investments.  (Whoops!)
  • Legislative (and some Executive) acquiescence in maintaining the patchwork to protect turf and pet priorities (e.g. Fannie Mae and Freddie Mac; Community Reinvestment Act; Congressional stonewalling attempted regulatory reform by claiming “no need to fix what isn’t broken.”)
  • Mortgage originators who underwrote mortgages without standards (e.g. those the market began calling “liar loans”) for investment bankers who could likewise transfer the risk (until the music stopped) because they had protected agency purchasers. The culprits also need to include private buyers of mortgage and other consumer debt, who, through numerous “right sizing” reorganizations, had reduced in-house research, opting instead for…
  • Over-reliance on credit rating agencies with a protected oligopoly and a strong financial incentive to assign the highest rating the bond issuer demanded.
  • Shareholders (also known as equity investors) who pressured chief executives to produce growth in financial services companies to match that of tech companies, all the while having no say about base-pay and incentive compensation packages approved by Boards of Directors who were supposedly independent, but who, in reality, were members of the same tight little country club set as the chief executives.  (My mother, a retired high school English teacher, would be appalled at that elongated sentence.)
  • Undisciplined fiscal policy with massive tax cuts (usually good, except) with no spending cuts to match.  The Republicans forgot part of Ronald Reagan’s formula:  you cut Congress’ allowance in order to cut its spending; rather, as The Economist correctly pointed out, the Republican Congress “spent like drunken sailors.”  Now, the tax and spend Democrats are back!
  • Monetary policy, which created moral hazard by consistently slashing interest rates to bail out over-leveraged trading desks and consumers and, therefore, started to feed the next bubble.  Concern grew that the equity and bond markets came to expect that the “Greenspan Put” and a new “Bernanke Put” would bail them out.
  • Currency policies of emerging market governments in an effort to keep the local currency value relative to the dollar at a level which would maintain exports (which also benefited the over-leveraged U.S. consumer.)

Bob Decker, CFA

Welcome to Torpedo Boat 92K

Torpedo Boat 92K will provide an efficient and effective way for finance and investment professionals to communicate with their elected officials and with policy makers regarding proposed legislative and regulatory solutions to the Financial Crisis. These proposals will affect the ability of financial services and investment management professionals to meet the needs of their clients.

Guiding Principles
The current Financial Crisis has underlined the need for meaningful reform of the regulatory framework in which the financial services / investment management industry operates. In the rush to address the complex issues facing the nation, finance and investment professionals have individually expressed their growing concern about the increasingly expansive role that government initiatives are playing in day-to-day decisions. The Federal Reserve and the U.S. Treasury have provided crucial facilities to address liquidity and solvency challenges faced by financial market participants. However, members of Torpedo Boat 92K are concerned that government overreach has become a real threat with unintended consequences of deepening the crisis or delaying and hampering a recovery. A guiding principle of Torpedo Boat 92K is that market mechanisms, operating within a logical and well-thought-out regulatory framework, offer the most efficient solutions to correct market imbalances. Regulations and laws that attempt to eliminate or solve every real or perceived cause of the current crisis carry a real threat of strangling financial markets, resulting in a misallocation of scarce economic resources. Legislation that is retaliatory in nature to attack isolated or rare instances of private sector overreach is especially pernicious to smoothly operating markets. This conviction of the Group’s members is not based on ivory tower or ideological theories, but it results from their years of experience in meeting the investment needs of clients.

What’s in a Name?
Like a large, heavily loaded containership, regulatory changes have already set sail. Before this cumbersome ship reaches full speed on the stormy Financial Market Sea on its way to the port of Unintended Consequences, time is of essence to fire a few shots across its bow to slow it down. The size of Federal commitments to address the Financial Crisis amounts to more than $92,000 per individual tax return filed in the United States. ($12.8 trillion as calculated by Bloomberg News divided by 138.4 million personal tax returns in 2006, the last year of data available from the IRS.)

Bob Decker, CFA