French Prime Minister Francois Fillon learned a lesson yesterday about the importance of exactly how senior government officials word their comments about foreign exchange rates. The French press quoted him as saying (in French): “Depuis des années, avec le président de la république, nous nous plaignons du fait que cette parité entre l'euro et le dollar ne correspond pas à la réalité de nos économies et handicape nos exportations. Je n'ai pas d'inquiétude quant à l'actuelle parité entre l'euro et le dollar.”
In context, the last sentence can only mean that he is not worried about the current exchange rate between the euro and the dollar. But in English, the use of the word "parity" caused confusion, as this Daily Mail article explains. Dow Jones also had an article about this (subscription required).
Fillon's sentence right before the two quoted above also propelled the confusion: “J'ai déjà eu l'occasion de dire que je ne voyais que des bonnes nouvelles dans la parité entre l'euro et le dollar, je n'ai pas changé de discours.”
Peter Boone and Simon Johnson writing at The Baseline Scenario website translated this in part to say: “I see only good news in parity between euro and the dollar.” They characterize this statement as “a quote for the ages” and go on to say: “Be careful what you wish for – such statements will drive the Germans crazy as they see further evidence that inflation lovers are clearly winning influence and might just gain control at the European Central Bank (ECB).” Apparently realizing that the translation they used might have not accurately reflected what Fillon said, they later updated their post with one of the sentences quoted in French. They then further commented: “Saying this on a day when the euro is collapsing, [Fillon] is clearly condoning further collapse.”
Boone and Johnson may be right in their conclusion if not in their translation. This incident reminds me, though, how sensitive markets sometime are to any change in wording when it comes to exchange rates. For example, it seems to be a rule that Secretaries of the Treasury periodically say that they are in favor of “a strong dollar policy," whatever that might mean, especially when the U.S. periodically complains that China should let its currency appreciate.
Saturday, June 5, 2010
Joe Nocera's Column on Financial Regulatory Reform
Joe Nocera has an interesting column on financial regulatory reform in today's New York Times. I agree with him that, even though the House and Senate bills are long and complicated, they do less than advertised to reduce systemic risk.
Near the beginning of the column, Nocera writes that "there is nothing even remotely radical about anything in these bills. Nobody is suggesting setting up a new Securities and Exchange Commission, which reshaped Wall Street regulation when it was formed in 1934. Nobody is talking about breaking up banks the way they did in the 1930s with the passage of the Glass-Steagall Act. Nobody is even talking about a wholesale revamping of a regulatory system that so clearly failed in this crisis."
While responsibility for the financial crisis can be attributed widely, the failure of government regulators to do more to head off or lessen the severity of the impending crisis was not in the main due to a lack of authority but to a refusal to use it. The argument that hardly anyone saw it coming is not convincing. While the severity of the crisis probably surprised most people, it was obvious to that there could be a financial crisis of some sort. That there were problems in the subprime mortgage was clear, as was a rate of increase in real estate prices that was unsustainable and had resulted in a very high ratio of house prices to rents.
Unfortunately there has been very little attempt to address the causes for this regulatory failure. Rather, there has been highlighting of such provisions as forcing plain vanilla swaps onto trading platforms and into clearinghouses. This is not necessarily a bad idea, but it seems to be a smokescreen for the absence of more fundamental reform.
Near the beginning of the column, Nocera writes that "there is nothing even remotely radical about anything in these bills. Nobody is suggesting setting up a new Securities and Exchange Commission, which reshaped Wall Street regulation when it was formed in 1934. Nobody is talking about breaking up banks the way they did in the 1930s with the passage of the Glass-Steagall Act. Nobody is even talking about a wholesale revamping of a regulatory system that so clearly failed in this crisis."
While responsibility for the financial crisis can be attributed widely, the failure of government regulators to do more to head off or lessen the severity of the impending crisis was not in the main due to a lack of authority but to a refusal to use it. The argument that hardly anyone saw it coming is not convincing. While the severity of the crisis probably surprised most people, it was obvious to that there could be a financial crisis of some sort. That there were problems in the subprime mortgage was clear, as was a rate of increase in real estate prices that was unsustainable and had resulted in a very high ratio of house prices to rents.
Unfortunately there has been very little attempt to address the causes for this regulatory failure. Rather, there has been highlighting of such provisions as forcing plain vanilla swaps onto trading platforms and into clearinghouses. This is not necessarily a bad idea, but it seems to be a smokescreen for the absence of more fundamental reform.
Friday, June 4, 2010
Comments on Financial Regulatory Reform
The financial regulatory reform bill that will be going to conference is a bit of a muddle. Some aspects of it are necessary and others not so much; some provisions are oversold; and some needed reforms are not included.
Consumer Protection
On the plus side of the ledger, setting up a consumer financial protection agency, whether nominally housed in the Fed or fully “independent,” is an important provision. The financial crisis began with a housing bubble, which would not have happened to the extent it did without inappropriate mortgages being offered to prospective house buyers. The Federal Reserve failed in its consumer protection role, and other regulatory agencies did not get at this problem from the other side, safety and soundness. In the absence of consolidating the regulatory agencies, this new agency should both serve to protect consumers and help to reduce systemic risk by preventing the large scale offering of loans individuals cannot afford unless everything goes right. That is, it will do this if it is not overrun by the other regulatory agencies in the turf wars the new legislation is likely to encourage. Also, for political reasons, it seems consumers will be less protected when it comes to auto loans offered by dealers.
Derivatives
Some of the derivatives provisions seem to be unnecessary and how meritorious they are can be debated. They do broaden the turf of the CFTC and the SEC, which may be a good thing but could turn out badly if vicious turf wars develop.
Among the likely legislative outcomes is forcing standardized derivatives, such as interest rate swaps, to be traded on a central platform of some sort and to be submitted to a clearinghouse. More complicated, customized derivatives, such as credit default swaps on particular securities, will probably not be subject to these requirements, since their lack of liquidity and customization make it too difficult to impose such requirements without in effect making these types of contracts illegal (which is probably the agenda of some participants in the debate). The CFTC and the SEC will have new authority, though, to regulate customized derivatives, which will probably put these agencies in conflict with the bank regulators and perhaps with each other in cases where the jurisdictional lines between the two agencies is less than clear.
It is peculiar that the likely outcome is to impose more regulation on the plain vanilla derivatives, which have not been a source of major problems, than on more complicated, customized derivatives, which in the case of credit default swaps exacerbated the financial crisis. The trading platform requirement for standardized derivatives may serve to improve transparency, though price information is available to those with the appropriate terminals, such as provided by Bloomberg. One can argue both ways the merits of concentrating risk in a clearinghouse. As for a provision that the U.S. government will never, ever bailout a derivatives clearinghouse, this lacks credibility for large, systemically important ones. In a crisis, the government will find a way, if necessary by passing statutes, to do what it believes necessary. Our recent experience demonstrates that.
It is also strange that the Treasury is apparently acquiescing in having the CFTC have a role in the OTC market for foreign exchange, including apparently options, unless the Secretary of the Treasury formally exempts them in writing. It is not clear how regulation would work in an international market. Moreover, dating back to the 1973 legislation creating the CFTC, the Treasury has consistently opposed the CFTC applying the Commodity Exchange Act ("CEA") to the wholesale OTC foreign exchange market, including options, and was able to get a provision in the 1973 statute known as the “Treasury Amendment” to attempt to attempt to accomplish this. (In 1997, the Supreme Court decided in the Dunn case that the Treasury Amendment exclusion from the CEA included FX options.)
Resolution Authority
With respect to resolution authority for systemically important financial institutions, this is a useful authority for the government to have. As it stands, the Bankruptcy Code process in certain situations is not ideal. In the Long-Term Capital Management situation, the New York Fed successfully persuaded major Wall Street firms to fund a workout outside of bankruptcy in order to provide for an orderly wind down of the fund. The Lehman bankruptcy caused market panic. The provisions for close-out netting for certain types of financial contracts, including “swaps,” which provide an exemption from the Code’s automatic stay, were supposed to mitigate systemic risk. In certain situations, though, these provisions may exacerbate it. The problem is that, if a large institution fails, its counterparties may all rush to sell the underlying collateral for eligible contracts at the same time, thus causing a market problem.
It is, however, not clear how the resolution authority would work for large institutions which are failing and which have significant foreign operations subject to the laws and regulations of different countries. It is also not clear in a financial crisis with more than one failing institution how long it would take for the FDIC to staff up sufficiently to handle multiple “resolutions.” Improvisation, as we have witnessed, may be resorted to once again.
Whether improvisation is a “bail-out” depend on what one means by this inexact term. Stockholders would almost certainly be wiped out, as they, to a large extent, have been for some of the large financial institutions, such as Citigroup. Some uninsured creditors would likely fare better than others. What happens to existing management is also a question. It is not, though, credible to say that the government will never step in with funds or guarantees in a financial crisis.
What the legislation does not do is address the problem of regulatory capture and turf wars. This is a serious problem about which I will have more to say.
Consumer Protection
On the plus side of the ledger, setting up a consumer financial protection agency, whether nominally housed in the Fed or fully “independent,” is an important provision. The financial crisis began with a housing bubble, which would not have happened to the extent it did without inappropriate mortgages being offered to prospective house buyers. The Federal Reserve failed in its consumer protection role, and other regulatory agencies did not get at this problem from the other side, safety and soundness. In the absence of consolidating the regulatory agencies, this new agency should both serve to protect consumers and help to reduce systemic risk by preventing the large scale offering of loans individuals cannot afford unless everything goes right. That is, it will do this if it is not overrun by the other regulatory agencies in the turf wars the new legislation is likely to encourage. Also, for political reasons, it seems consumers will be less protected when it comes to auto loans offered by dealers.
Derivatives
Some of the derivatives provisions seem to be unnecessary and how meritorious they are can be debated. They do broaden the turf of the CFTC and the SEC, which may be a good thing but could turn out badly if vicious turf wars develop.
Among the likely legislative outcomes is forcing standardized derivatives, such as interest rate swaps, to be traded on a central platform of some sort and to be submitted to a clearinghouse. More complicated, customized derivatives, such as credit default swaps on particular securities, will probably not be subject to these requirements, since their lack of liquidity and customization make it too difficult to impose such requirements without in effect making these types of contracts illegal (which is probably the agenda of some participants in the debate). The CFTC and the SEC will have new authority, though, to regulate customized derivatives, which will probably put these agencies in conflict with the bank regulators and perhaps with each other in cases where the jurisdictional lines between the two agencies is less than clear.
It is peculiar that the likely outcome is to impose more regulation on the plain vanilla derivatives, which have not been a source of major problems, than on more complicated, customized derivatives, which in the case of credit default swaps exacerbated the financial crisis. The trading platform requirement for standardized derivatives may serve to improve transparency, though price information is available to those with the appropriate terminals, such as provided by Bloomberg. One can argue both ways the merits of concentrating risk in a clearinghouse. As for a provision that the U.S. government will never, ever bailout a derivatives clearinghouse, this lacks credibility for large, systemically important ones. In a crisis, the government will find a way, if necessary by passing statutes, to do what it believes necessary. Our recent experience demonstrates that.
It is also strange that the Treasury is apparently acquiescing in having the CFTC have a role in the OTC market for foreign exchange, including apparently options, unless the Secretary of the Treasury formally exempts them in writing. It is not clear how regulation would work in an international market. Moreover, dating back to the 1973 legislation creating the CFTC, the Treasury has consistently opposed the CFTC applying the Commodity Exchange Act ("CEA") to the wholesale OTC foreign exchange market, including options, and was able to get a provision in the 1973 statute known as the “Treasury Amendment” to attempt to attempt to accomplish this. (In 1997, the Supreme Court decided in the Dunn case that the Treasury Amendment exclusion from the CEA included FX options.)
Resolution Authority
With respect to resolution authority for systemically important financial institutions, this is a useful authority for the government to have. As it stands, the Bankruptcy Code process in certain situations is not ideal. In the Long-Term Capital Management situation, the New York Fed successfully persuaded major Wall Street firms to fund a workout outside of bankruptcy in order to provide for an orderly wind down of the fund. The Lehman bankruptcy caused market panic. The provisions for close-out netting for certain types of financial contracts, including “swaps,” which provide an exemption from the Code’s automatic stay, were supposed to mitigate systemic risk. In certain situations, though, these provisions may exacerbate it. The problem is that, if a large institution fails, its counterparties may all rush to sell the underlying collateral for eligible contracts at the same time, thus causing a market problem.
It is, however, not clear how the resolution authority would work for large institutions which are failing and which have significant foreign operations subject to the laws and regulations of different countries. It is also not clear in a financial crisis with more than one failing institution how long it would take for the FDIC to staff up sufficiently to handle multiple “resolutions.” Improvisation, as we have witnessed, may be resorted to once again.
Whether improvisation is a “bail-out” depend on what one means by this inexact term. Stockholders would almost certainly be wiped out, as they, to a large extent, have been for some of the large financial institutions, such as Citigroup. Some uninsured creditors would likely fare better than others. What happens to existing management is also a question. It is not, though, credible to say that the government will never step in with funds or guarantees in a financial crisis.
What the legislation does not do is address the problem of regulatory capture and turf wars. This is a serious problem about which I will have more to say.
Friday, May 21, 2010
More Trouble for Goldman – The Wolf at the Door
On Wednesday, The New York Times ran a long, devastating article about Goldman Sachs – “Clients Worried About Goldman’s Dueling Goals.” The article states that “ a former Goldman partner, who spoke on condition of anonymity, said that the company’s view of customers had changed in recent years. Under Lloyd C. Blankfein, Goldman’s chief executive, and a cadre of top lieutenants who have ramped up the firm’s trading operation, conflict avoidance had shifted to conflict management, this person said. Along the way, he said, the firms’s executives have come to see customers more as competitors they trade against than as clients.”
One of the episodes the article cites as an example of Goldman treating its customers badly involves a CDO called Timberwolf. Goldman underwrote this $1 billion CDO in March 2007, and “within months” the security had lost 80% of its value. Bear Stearns had bought $300 million for some funds it was managing, and this loss generated a lot of attention. Goldman, though, had taken a bet that Bear’s share price would fall (the article does not specify whether Goldman sold shares short or used derivatives). Bear ,of course, ended up failing and swallowed up by J.P. Morgan Chase with Federal Reserve assistance a year later.
This caught my attention since Timberwolf sounded like it might be related to the Greywolf CLO that Goldman put into the Abacus deal. In fact, they are related.
Matthew Goldstein of Reuters has been writing about this. As he writes in an April 24 article – “Abacus might have had other benefits for Goldman” – Greywolf Capital Management of Purchase, New York, is an “ management firm founded by a group of former Goldman distressed bond traders.” Goldman underwrote the Greywolf CLO for the firm in January 2007. The article explains that this security “was a $502 million collateralized loan obligation, a complex bond backed by debts often used to finance corporate buyouts. The deal was one of the first complex securities put together and managed by Greywolf, which later went on to do a $1 billion CDO backed by mostly subprime assets called Timberwolf 1.”
The SEC has not charged Goldman with doing anything wrong by putting Greywolf CLO into Abacus. But whatever the legalities, it is another part of the emerging evidence against Goldman in the court of public opinion. It is not clear whether Goldman did anything that violated securities laws, but it is losing its reputation. It can always pay a fine, but, if it wants to continue to have customers and not just be a hedge fund, it may find the reputational hit very costly.
One of the episodes the article cites as an example of Goldman treating its customers badly involves a CDO called Timberwolf. Goldman underwrote this $1 billion CDO in March 2007, and “within months” the security had lost 80% of its value. Bear Stearns had bought $300 million for some funds it was managing, and this loss generated a lot of attention. Goldman, though, had taken a bet that Bear’s share price would fall (the article does not specify whether Goldman sold shares short or used derivatives). Bear ,of course, ended up failing and swallowed up by J.P. Morgan Chase with Federal Reserve assistance a year later.
This caught my attention since Timberwolf sounded like it might be related to the Greywolf CLO that Goldman put into the Abacus deal. In fact, they are related.
Matthew Goldstein of Reuters has been writing about this. As he writes in an April 24 article – “Abacus might have had other benefits for Goldman” – Greywolf Capital Management of Purchase, New York, is an “ management firm founded by a group of former Goldman distressed bond traders.” Goldman underwrote the Greywolf CLO for the firm in January 2007. The article explains that this security “was a $502 million collateralized loan obligation, a complex bond backed by debts often used to finance corporate buyouts. The deal was one of the first complex securities put together and managed by Greywolf, which later went on to do a $1 billion CDO backed by mostly subprime assets called Timberwolf 1.”
The SEC has not charged Goldman with doing anything wrong by putting Greywolf CLO into Abacus. But whatever the legalities, it is another part of the emerging evidence against Goldman in the court of public opinion. It is not clear whether Goldman did anything that violated securities laws, but it is losing its reputation. It can always pay a fine, but, if it wants to continue to have customers and not just be a hedge fund, it may find the reputational hit very costly.
Saturday, May 8, 2010
Speculation and Gambling; Goldman and Abacus
When I began working on futures market issues in 1980, it was explained to me that there was an important difference between “gambling” and “speculation.” Gambling involves the creation of risk when none previously existed. Speculation involved the transference of risk which already existed. I thought about this and could see that a wheat farmer is long wheat and thus bears the price risk until harvest. He could transfer that risk to a speculator by using the futures markets. But, it seemed to me, that, when both the long and the short side are speculators, there is no risk transference. The response to that is that the speculators not only serve to take on the risks of others but also provide liquidity to make this possible. Obviously, while there is a legal difference, from the point of view of the speculator, there is little difference between what they do and gambling. As a matter of public policy, we exempt some types of speculation from state gaming laws and provide them with more favorable tax treatment than that afforded to gambling.
This came to mind when I read accounts of the Senator Carl Levin’s subcommittee hearings on Goldman Sachs. Senators compared Goldman to a casino; one even compared the firm unfavorably to the casinos in Las Vegas, because at least there the customers know that the odds favor the house.
At the center of this is a synthetic CDO that Goldman sponsored, ABACUS 2007-AC1. The SEC has charged that Goldman and one employee, Fabrice Tourre, committed securities fraud by failing to tell the portfolio selection agent, ACA, and potential investors that John Paulson, who was involved in the selection process was planning to enter into a credit default swap by which he would benefit if the securities in the reference portfolio experienced credit events.
To my mind, the SEC complaint, if true, presents outrageous behavior by Goldman. That is not to say, however, that the SEC can prevail in court. For a discussion of the difficulties that the SEC may have if this case is not settled before going to trial, one can read Sebastian Mallaby’s column on this in the Washington Post and former SEC Commissioner Joseph Grundfest presentation at Stanford. Nevertheless, what is legal is not necessarily right, and Goldman has already lost in the court of public opinion on this matter. As smart and savvy as the people at Goldman are, I don’t think they can change the public’s judgment on this.
What about the gambling charge? The offering circular and the “flipbook” for ABACUS 2007-AC1 are now publicly available on the web. Without going into excruciating detail, the way ABACUS worked is that investors buy securities issued by a Cayman Island corporation created solely for this transaction. The money raised is used by the corporation to buy a particular collateralized loan obligation (“CLO”) and in some cases other securities. The CLO is described on page 71 of the offering circular. Its name is GWOLF 2007-1A A and its CUSIP number is 398078AB1. Reuters has an article indicating that Goldman may have used ABACUS to unload this complex security it had underwritten, which seems problematical.
The CLO serves as collateral for a credit default swap (“CDS”) transaction and provides income to the corporation which is part of the cash flow passed on to investors. The corporation also enters into other derivatives transactions, including a swap to transform the income flow from the collateral security and a collateral put to be exercised in certain circumstances.
Th CDS references the portfolio of subprime residential mortgage backed securities. ABACUS sells protection to a counterparty, in this case Goldman. The protection buyer (Goldman) pays a premium at periodic intervals to ABACUS, which provides income to ABACUS to pay investors in its notes.
There are various classes of the notes. If there are losses on the CDS, the lower classes take a hit before the higher ones. The highest class is called “super senior” and the next class is called “A.” Both these classes have a priority that the rating agencies said merited being rated AAA, on the theory that only a certain percentage of the underlying mortgages will default. Goldman, as was the general practice, divided this higher tier into two. The rating agencies do not give a rating higher than AAA, but the issuers of synthetic CDOs maintained that the super senior piece was virtually without risk. Note that, because any losses that spilled into the category that the rating agencies rated AAA are first borne by the non-super senior piece, this division of the AAA piece in two makes that portion riskier than if the AAA piece had not been split in two. The reason to do this division was to provide the non-super senior AAA piece a higher coupon than it would have if this division had not been made. But even though the rating agencies put a AAA rating on this class, the reason it could get a higher coupon was that it was riskier than the super senior piece which got a lower coupon.
What appears to be the case with respect to the CDS involved in this transaction, Goldman entered into offsetting transactions with John Paulson’s fund and other entities. Darrell Duffie of Stanford has some charts that show this.
The reason that synthetic CDOs such as ABACUS were created is that, in a low-interest rate environment, the demand for relatively high income from a supposedly AAA investment could not be met with conventional CDS structures. Even with the amount of subprime mortgage loans that were being made, there were not enough to meet the demand. In fact, it was useful for the investment banks that there were parties such as John Paulson around, who wanted to short this market because they thought there would be a real estate market collapse. This enabled synthetic CDOs to be created.
One paragraph in the offering circular that should have warned potential investors of the risks they would be taking and the information asymmetry involved caught may attention:
“The Protection Buyer or its affiliates and/or the Portfolio Selection Agent or its affiliates may have information, including material, non-public information, regarding the Reference Obligations and the Reference Entities. Neither the Protection Buyer nor the Portfolio Selection Agent will provide the Issuer, the Trustee, the Issuing and Paying Agent, any Noteholder or any other Person with any such non-public information. In addition, neither the Protection Buyer nor the Portfolio Selection Agent will provide the Issuer, the Trustee, the Issuing and Paying Agent, any Holder of any Note or any other Person with any such information that is public (including financial information or notices), except in the case of information pertaining to one or more Credit Events with respect to each Reference Entity and one or more Reference Obligation(s) of such Reference Entity in connection with which the Protection Buyer is seeking payment of one or more Cash Settlement Amounts.” (p. 25 of the offering circular.)
Except for the possible exception of the investment in the CLO, this transaction does look like gambling, since neither the investors nor the ultimate “protection buyers” in the CDS transaction likely had an existing risk they needed to hedge. One side was betting that it could get high income because they did not think there would be a real estate crash serious enough to affect their investment; the other side was betting on a severe crash.
Whether or not this type of transaction should be permitted and given preferential treatment under federal law to casino gambling is a judgement call. Libertarians and free market advocates would say that these transactions should be permitted; people should be free to enter into what transactions they want. As to the allegation that Goldman was selling bad securities, they would say that even risky securities are worthwhile at a market determined price. That some people were concerned about the real estate market was widely known, and the facts about that market were generally available.
On the other hand, one can make the argument that unlike gambling in Vegas, where what happens stays in Vegas (more or less), the wrong bets in the synthetic CDS market resulted in collateral damage affecting us all. If that is not a convincing argument for prohibiting synthetic CDS structures, it is certainly an argument for better regulation.
At the moment, it may not matter much because I suspect the appetite for and issuance of synthetic CDS has gone way down. But no one knows what will happen over the next decades. The history of financial markets is that they do periodically get carried away and something nerve wracking happens, usually every few years. Memories are short and new people are constantly entering into these markets. It is not possible or even desirable to try to prevent all excesses, because one would be also prohibiting useful activity, but better regulation and tools are needed to make severe crises less likely and to handle those which do occur.
This came to mind when I read accounts of the Senator Carl Levin’s subcommittee hearings on Goldman Sachs. Senators compared Goldman to a casino; one even compared the firm unfavorably to the casinos in Las Vegas, because at least there the customers know that the odds favor the house.
At the center of this is a synthetic CDO that Goldman sponsored, ABACUS 2007-AC1. The SEC has charged that Goldman and one employee, Fabrice Tourre, committed securities fraud by failing to tell the portfolio selection agent, ACA, and potential investors that John Paulson, who was involved in the selection process was planning to enter into a credit default swap by which he would benefit if the securities in the reference portfolio experienced credit events.
To my mind, the SEC complaint, if true, presents outrageous behavior by Goldman. That is not to say, however, that the SEC can prevail in court. For a discussion of the difficulties that the SEC may have if this case is not settled before going to trial, one can read Sebastian Mallaby’s column on this in the Washington Post and former SEC Commissioner Joseph Grundfest presentation at Stanford. Nevertheless, what is legal is not necessarily right, and Goldman has already lost in the court of public opinion on this matter. As smart and savvy as the people at Goldman are, I don’t think they can change the public’s judgment on this.
What about the gambling charge? The offering circular and the “flipbook” for ABACUS 2007-AC1 are now publicly available on the web. Without going into excruciating detail, the way ABACUS worked is that investors buy securities issued by a Cayman Island corporation created solely for this transaction. The money raised is used by the corporation to buy a particular collateralized loan obligation (“CLO”) and in some cases other securities. The CLO is described on page 71 of the offering circular. Its name is GWOLF 2007-1A A and its CUSIP number is 398078AB1. Reuters has an article indicating that Goldman may have used ABACUS to unload this complex security it had underwritten, which seems problematical.
The CLO serves as collateral for a credit default swap (“CDS”) transaction and provides income to the corporation which is part of the cash flow passed on to investors. The corporation also enters into other derivatives transactions, including a swap to transform the income flow from the collateral security and a collateral put to be exercised in certain circumstances.
Th CDS references the portfolio of subprime residential mortgage backed securities. ABACUS sells protection to a counterparty, in this case Goldman. The protection buyer (Goldman) pays a premium at periodic intervals to ABACUS, which provides income to ABACUS to pay investors in its notes.
There are various classes of the notes. If there are losses on the CDS, the lower classes take a hit before the higher ones. The highest class is called “super senior” and the next class is called “A.” Both these classes have a priority that the rating agencies said merited being rated AAA, on the theory that only a certain percentage of the underlying mortgages will default. Goldman, as was the general practice, divided this higher tier into two. The rating agencies do not give a rating higher than AAA, but the issuers of synthetic CDOs maintained that the super senior piece was virtually without risk. Note that, because any losses that spilled into the category that the rating agencies rated AAA are first borne by the non-super senior piece, this division of the AAA piece in two makes that portion riskier than if the AAA piece had not been split in two. The reason to do this division was to provide the non-super senior AAA piece a higher coupon than it would have if this division had not been made. But even though the rating agencies put a AAA rating on this class, the reason it could get a higher coupon was that it was riskier than the super senior piece which got a lower coupon.
What appears to be the case with respect to the CDS involved in this transaction, Goldman entered into offsetting transactions with John Paulson’s fund and other entities. Darrell Duffie of Stanford has some charts that show this.
The reason that synthetic CDOs such as ABACUS were created is that, in a low-interest rate environment, the demand for relatively high income from a supposedly AAA investment could not be met with conventional CDS structures. Even with the amount of subprime mortgage loans that were being made, there were not enough to meet the demand. In fact, it was useful for the investment banks that there were parties such as John Paulson around, who wanted to short this market because they thought there would be a real estate market collapse. This enabled synthetic CDOs to be created.
One paragraph in the offering circular that should have warned potential investors of the risks they would be taking and the information asymmetry involved caught may attention:
“The Protection Buyer or its affiliates and/or the Portfolio Selection Agent or its affiliates may have information, including material, non-public information, regarding the Reference Obligations and the Reference Entities. Neither the Protection Buyer nor the Portfolio Selection Agent will provide the Issuer, the Trustee, the Issuing and Paying Agent, any Noteholder or any other Person with any such non-public information. In addition, neither the Protection Buyer nor the Portfolio Selection Agent will provide the Issuer, the Trustee, the Issuing and Paying Agent, any Holder of any Note or any other Person with any such information that is public (including financial information or notices), except in the case of information pertaining to one or more Credit Events with respect to each Reference Entity and one or more Reference Obligation(s) of such Reference Entity in connection with which the Protection Buyer is seeking payment of one or more Cash Settlement Amounts.” (p. 25 of the offering circular.)
At least in retrospect, this was more than mere boilerplate and should have warned investors off. Goldman was saying that the odds may not be in the investors’ favor.
Whether or not this type of transaction should be permitted and given preferential treatment under federal law to casino gambling is a judgement call. Libertarians and free market advocates would say that these transactions should be permitted; people should be free to enter into what transactions they want. As to the allegation that Goldman was selling bad securities, they would say that even risky securities are worthwhile at a market determined price. That some people were concerned about the real estate market was widely known, and the facts about that market were generally available.
On the other hand, one can make the argument that unlike gambling in Vegas, where what happens stays in Vegas (more or less), the wrong bets in the synthetic CDS market resulted in collateral damage affecting us all. If that is not a convincing argument for prohibiting synthetic CDS structures, it is certainly an argument for better regulation.
At the moment, it may not matter much because I suspect the appetite for and issuance of synthetic CDS has gone way down. But no one knows what will happen over the next decades. The history of financial markets is that they do periodically get carried away and something nerve wracking happens, usually every few years. Memories are short and new people are constantly entering into these markets. It is not possible or even desirable to try to prevent all excesses, because one would be also prohibiting useful activity, but better regulation and tools are needed to make severe crises less likely and to handle those which do occur.
The Hunt Brothers, Silver, and Exchange Trading
I began working on futures market issues for the U.S. Treasury in 1980. At the time, the Treasury was pondering how it should feel about the new financial futures markets, especially the contracts on U.S. Treasury securities. My real introduction to the world of futures, though, was the problems in the silver markets, in which the Hunt brothers figured prominently. This episode is long-forgotten, but it was scary then. The price of silver during this episode went from around $5 an ounce to about $50 an ounce. People were digging through their houses for silverware and jewelry, and house burglaries were also focusing on these items. The price of silver subsequently plunged; the Hunt brothers could not meet the margin calls on their silver futures positions; the capital of their futures commission merchant (broker), Bache Halsey Stuart Shields, fell to alarmingly low levels as it had to make good on the margin calls to the clearinghouses; and questions occurred to observers about whether the clearinghouses could fail. The stock market fell 50 points, which at the time was considerable.
I mention this episode because it highlights some points about the current financial regulatory reform effort. Forcing most derivatives onto exchanges does not solve all problems. A look at the history of the problems in futures markets demonstrates this, and the concentration of risk in one or two clearinghouses poses risks of it own. This is not an argument against forcing most derivatives on exchanges, but one should be aware that it won’t miraculously prevent future systemic problems, market manipulation, frontrunning, prearranged trades, etc. from occurring. Also, it should be noted that it benefits one financial industry segment over another. It does, though, enhance transparency, and makes it easier for regulators to figure out what is happening during a market crisis.
It would be good for the pros and cons of forcing most derivatives onto exchanges to be debated as consideration of financial reform goes forward. What we now have in many quarters is the knee-jerk reaction that any “loophole” for non-standardized contracts or for certain participants is a cave-in to Wall Street. Perhaps the exceptions to exchange trading should be minimized, perhaps not. But commenters should realize that “Chicago,” as well as “Wall Street,” has economic interests.
I mention this episode because it highlights some points about the current financial regulatory reform effort. Forcing most derivatives onto exchanges does not solve all problems. A look at the history of the problems in futures markets demonstrates this, and the concentration of risk in one or two clearinghouses poses risks of it own. This is not an argument against forcing most derivatives on exchanges, but one should be aware that it won’t miraculously prevent future systemic problems, market manipulation, frontrunning, prearranged trades, etc. from occurring. Also, it should be noted that it benefits one financial industry segment over another. It does, though, enhance transparency, and makes it easier for regulators to figure out what is happening during a market crisis.
It would be good for the pros and cons of forcing most derivatives onto exchanges to be debated as consideration of financial reform goes forward. What we now have in many quarters is the knee-jerk reaction that any “loophole” for non-standardized contracts or for certain participants is a cave-in to Wall Street. Perhaps the exceptions to exchange trading should be minimized, perhaps not. But commenters should realize that “Chicago,” as well as “Wall Street,” has economic interests.
Friday, May 7, 2010
The SEC, the CFTC, and Yesterday’s Stock Market Volatility
It is not clear as of this writing what the full story behind yesterday’s wild volatility, especially over a period of 20-25 minutes starting at 2:42 p.m. One of the explanations is that some market facilities, including the New York Stock Exchange, briefly stopped the trading of some stocks as the volatility started, which channeled orders to the automated systems that kept trading the stocks. There may have been some data entry by trader or traders that were errors. The fall of Accenture to about a penny from the $40 range and back up to around $40 does look like the result of an error or errors, as do the price movements of Procter & Gamble.
In response to the unusual market activity, the SEC and the CFTC issued a joint statement yesterday that they are working together and with other financial regulators and the exchanges on reviewing what happened and to make recommendations based on what they learn.
Whatever happened here, two points come to mind. First, market structure, including rules, are very important, and that very different rules among market places which trade the same thing or trade close substitutes may cause serious problems during times of unusual trading activity. The SEC may not have fully analyzed this with respect to the markets it regulates, and the SEC and the CFTC may not be coordinating as well as they should, which is admittedly difficult because the statutes the two agencies administer are very different.
The second point is that there is a great deal of overlap between what the SEC and the CFTC regulate. The case for merger of the two agencies continues to grow stronger. While the two agencies will no doubt cooperate in their review of yesterday’s market activity, rules might be better coordinated if there were only one agency.
Moreover, if the consensus is that the market for all derivatives, not just exchange-traded futures contracts, options on securities, and some other types of options under CFTC jurisdiction, should be subject to a market regulator as well as institutional regulators, then the case for merger becomes even more persuasive. Our balkanized regulatory structure has contributed to inconsistencies, regulatory capture, and, as the financial crisis has shown, regulatory failure.
In response to the unusual market activity, the SEC and the CFTC issued a joint statement yesterday that they are working together and with other financial regulators and the exchanges on reviewing what happened and to make recommendations based on what they learn.
Whatever happened here, two points come to mind. First, market structure, including rules, are very important, and that very different rules among market places which trade the same thing or trade close substitutes may cause serious problems during times of unusual trading activity. The SEC may not have fully analyzed this with respect to the markets it regulates, and the SEC and the CFTC may not be coordinating as well as they should, which is admittedly difficult because the statutes the two agencies administer are very different.
The second point is that there is a great deal of overlap between what the SEC and the CFTC regulate. The case for merger of the two agencies continues to grow stronger. While the two agencies will no doubt cooperate in their review of yesterday’s market activity, rules might be better coordinated if there were only one agency.
Moreover, if the consensus is that the market for all derivatives, not just exchange-traded futures contracts, options on securities, and some other types of options under CFTC jurisdiction, should be subject to a market regulator as well as institutional regulators, then the case for merger becomes even more persuasive. Our balkanized regulatory structure has contributed to inconsistencies, regulatory capture, and, as the financial crisis has shown, regulatory failure.
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