Monday, March 22, 2010

Regulators and the Concentration of Risk

Gillian Tett has written an interesting book about CDS and CDOs – Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (Free Press: 2009). According to the book, in the early 1990s, J.P. Morgan was looking for ways to lower its capital requirements under the Basel I Accord of 1988. The risk weight on what it considered high quality loans was 100%, meaning that there was an 8% capital requirement on such loans. J.P. Morgan went to the OCC and the Fed to see if they could convince these regulators that, if the credit risk was off-loaded through credit derivatives, reduced capital requirements should apply. (See Fool’s Gold, pp. 45-49.)

On August 12, 1996, the Fed issued a “Supervisory Guidance for Credit Derivatives” which indicated that banks could lower their capital requirements through CDS to the risk category of the guarantor. In the case of another bank, the risk weight would be 20%.

When it came to synthetic CDS structures issued by an off-balance sheet entity, the bank retained what came to be called “super senior risk.” Initially the Fed said that to get capital relief on these transactions, banks would have to get rid of this risk (Fool’s Gold, p. 61). J.P. Morgan decided that the perfect counterparty for this was AIG Financial Products (Ibid., p. 62). Then, according to Tett, the OCC and the Fed decided that super senior risk need not be off loaded.

Apparently, though, the regulators in Europe did not see it that way. According to AIG’s March 2009 10-K filing

“A total of $234.4 billion (consisting of corporate loans and prime residential mortgages) in net notional exposure of AIGFP’s super senior credit default swap portfolio as of December 31, 2008 represented derivatives written for financial institutions, principally in Europe, for the purpose of providing regulatory capital relief rather than for arbitrage purposes. These transactions were entered into by Banque AIG, AIGFP’s French regulated bank subsidiary, and written on diversified pools of residential mortgages and corporate loans (made to both large corporations and small to medium sized enterprises). In exchange for a periodic fee, the counterparties receive credit protection with respect to diversified loan portfolios they own, thus reducing their minimum capital requirements.

“The regulatory benefit of these transactions for AIGFP’s financial institution counterparties is generally derived from the terms of the Capital Accord of the Basel Committee on Banking Supervision (Basel I) that existed through the end of 2007 and which is in the process of being replaced by the Revised Framework for the International Convergence of Capital Measurement and Capital Standards issued by the Basel Committee on Banking Supervision (Basel II). Prior to the adoption of Basel II, a financial institution was required to hold capital against its assets, based on the categorization of the issuer or guarantor of the assets. One of the means for a financial institution to reduce its required regulatory capital was to purchase credit protection on a group of its assets from a regulated financial institution, such as Banque AIG, in order to benefit from such regulated financial institution’s lower risk weighting (e.g., 20 percent vs. 100 percent) that is assigned to those assets under Basel I. A lower risk weighting reduces the amount of capital a financial institution is required to hold against such assets.”

(I was directed to this by a blog post of Arnold Kling.)

Interestingly, as Basel II is implemented, this capital benefit is reduced. The 10-K goes on to say:

“Unlike Basel I, Basel II gives credit to the relative risk of loss associated with the assets, meaning that less capital is required for such assets. After a financial institution has implemented a capital model that is compliant with Basel II and has obtained approval from its local regulator, the CDS transactions provide no additional regulatory benefit in most cases, except during a transition period. The Basel II implementation includes a transition period during which the financial institutions must calculate their capital requirements under both Basel I and Basel II (until December 31, 2009). During this period, the capital required is “floored” at a percentage of the Basel I capital calculation; therefore, until early 2010, these CDS transactions may still provide regulatory capital benefit for AIGFP’s counterparties, depending on each counterparty’s particular circumstances. In addition, in a limited number of instances, counterparties may decide to hold these CDSs for a longer period of time because they provide a regulatory capital benefit, while smaller, under Basel II.”

Regulators both here and abroad seem to have not realized the systemic risk their regulations were creating. Risk got concentrated at AIG and, with respect to super senior risk, some U.S. banks retained it and when the real estate bubble burst, it turned out that this super senior risk was more risky than assumed. CDS and CDOs served not to diversify risk, as regulators, most prominently Greenspan asserted, but concentrated it. (According to Fool’s Gold, J.P. Morgan did not retain much super senior risk. Her book relies heavily on J.P. Morgan sources, which does not mean it is wrong, but could mean that it is less critical of that bank than other writers, with other perspectives, might have been. For those interested in these issues, the book is well worth reading.)

Now that the House has passed the health care legislation, it is likely that there will be more Administration, Congressional, and press attention to financial regulatory reform. It is clear that there were regulatory failures that contributed to the financial crisis (which does not mean that private sector actors do not shoulder a considerable amount of responsibility.) While there should be some sort of regulatory reform, it should be kept in mind that there are limits to what regulation can do. Regulators can make mistakes. One can hope that whatever becomes law makes things safer but that does not create a false sense of security and complacency.

Tuesday, March 2, 2010

Housing Bubble or Derivatives Inferno -- Comments on Gensler's FT Article

Last week the Financial Times published an article by CFTC Chairman Gary Gensler – “How We Can Stop Another Derivatives Inferno.”   The article compares the 2008 financial crisis to the 1871 Great Chicago fire, which legend has it was started when Mrs. O’Leary’s cow kicked over a lantern, though the real cause remains a mystery.  With respect to current events, Gensler writes:  “In the autumn of 2008, certain financial institutions kicked over the lantern that set off the financial crisis – a fire that nearly burned down the global economy.”

As one might expect given his current position, Gensler’s article concentrates on derivatives.  Still, it is remarkable that an article about the financial crisis does not mention the housing bubble, subprime mortgages, or securitization.

One of the underlying questions about the financial crisis, on which there is not much, if any serious analysis, is what role the OTC derivatives market played.  The financial crisis is marked by a housing bubble which finally bursted.  Did OTC derivatives help create that housing bubble by enabling financial intermediaries to take on more leverage?  Once the housing bubble burst, did OTC derivatives make things worse?

The causes of the housing bubble will be debated for some time.  There will be discussions about the role of loose monetary policy, lax regulation, the madness of crowds, government policies designed to encourage home ownership, Fannie Mae and Freddie Mac, securitization, capital rules, rating agencies, etc.

The clear evidence that OTC derivatives made things worse was the AIG debacle.  Gensler focuses on that and also mentions the efforts to mask Greece’s true fiscal situation.  His remedies are to regulate OTC derivatives dealers directly and to require standardized OTC derivatives to trade on exchanges and to be submitted to clearinghouses.

While a good case can be made for these recommendations, many of the derivatives that AIG was engaged in would most likely not be viewed as “standardized,” since they were on particular CDOs, which have been identified by CUSIP number and counterparty in a document now publicly available.  Also, all the parties, including AIG were subject to regulation, either here or abroad.  While it is not surprising that the Office of Thrift Supervision was unable effectively to supervise AIG as its holding company regulator, other regulators had tools at their disposal to curtail the growing exposure of regulated entities to AIG if they had become concerned.  In any case, the exchange and clearing house recommendations seem to have little bearing on the AIG situation, nor apparently on what Greece and its financial institution counterparties may have arranged.

If AIG had been subject to regulation as an OTC derivatives dealer, this particular aspect of the financial crisis might have been prevented if its regulator had seen the problem.  But would that have prevented the housing bubble and its bursting?  While financial bubbles are probably inevitable, a better diagnosis of the causes of the financial crisis and an analysis of its effects is needed before anyone says they have definitively figured out how to prevent such large bubbles from forming and mitigating the damage of the bubbles that do form when they burst.

Finally, I am not sure what lantern it is that Gensler thinks financial institutions “kicked over” in 2008.  I would use a metaphor.  The subprime mortgage problems served as the catalyst setting off the crisis by acting to burst the housing bubble, which in turn created a host of other problems.  

Dodd-Corker: The CFPA, the Treasury, and the Fed

The news this morning that Senators Dodd and Corker may agree on making the proposed Consumer Financial Protection Agency a division of the Federal Reserve rather than the Treasury Department, as Dodd had offered, reminds me of the 1986 jurisdictional questions concerning government securities regulation.

In 1986, after some severe problems in the government securities repo market, especially the failure of ESM, an unregulated government securities dealer in Florida, and the consequent turmoil for the state-insured thrifts in Ohio, it was clear that heretofore unregulated government securities  brokers and dealers would be subject to regulation.  The Treasury had resisted this in the past, but it dropped that opposition in the face of continuing problems in the government securities market and the political inevitability that Congress would act.  The questions that remained were how much regulatory authority would be granted to a government agency in this area and the identity of that agency.

As to the second question, the identity of the agency, the SEC had quickly been written off as a  candidate to write rules in this area, partly because of Administration opposition.  The two remaining candidates were the Fed and the Treasury.  The Congress and some market participants were leaning to the Fed as the preferred regulator.  The arguments were similar to those probably being made today about were to house consumer financial protection if it is not entrusted to a new, “independent” agency.

It was pointed out that Treasury’s leadership was less stable than the Fed and that it is a more political agency.  The Treasury argued in response that it had responsibility for debt management and that it was, therefore, in the best position to assume this responsibility.  Moreover, the Treasury argued that there was no conflict in managing the public debt and regulating the dealers, because a market that was characterized by integrity would be best for minimizing interest costs on the government’s debt.  A market that was characterized by fraud, on the other hand, would shrink scare potential investors away and result in higher interest costs.

Fortunately, for the institutional interests of the Treasury, Secretary James Baker was an excellent politician and negotiator, and Treasury ended up with the rulemaking authority.  The Treasury has by all accounts done a good job of handling its responsibilities under the Government Securities Act of 1986.

Part of the reason that the Treasury did a good job in writing rules was due to the quality of the political leadership in Domestic Finance during the Reagan Administration.  While that Administration generally had a deregulatory bent, the attitude at Treasury was that, since the Government Securities Act had been enacted, was the law, and Treasury had argued for getting this new authority, the Treasury was going to do as good a job as possible in carrying it out.  In fact, the Congress had given very tight deadlines for putting out proposed, temporary, and final rules, and we met every deadline to the day.

Of course, there is no assurance that political staff at Treasury will always be good, just as there is no assurance that the Fed and its powerful staff will always make the correct judgments.  One of the tradeoffs, of course, is that while there is less institutional continuity at Treasury, there is also less danger that mistaken judgments will persists for years.

As to the current question, I find it hard to see why those who think the Fed failed in its consumer protection role would want to give the Fed even more authority, even if a mechanism can be devised to give the new division some independence from the Board.  As for the Treasury, a bureau might work, but if it had the independence of an OCC or OTS, there is little difference between that and an independent agency.  Given the amount of staff necessary to do this right and the lack of any connection to what the Departmental Offices do, putting this authority there would likely not work very well.

As a final point, if staffed with the right people, any structure would likely work; if staffed with the wrong people, the organizational structure will not matter.  If Congress creates something, the first years of a new consumer finance protection agency, bureau, or division will be extremely important.