If the SEC's asleep at the switch, why not give them a chance? Paul Kanjorski introduced a bill (apparently HR 1212, but not on Thomas yet) that would extend the Public Company Accounting Oversight Board's examination power to the auditors of broker dealers. The draft bill is available from Scribd.
The New York Stock Exchange has applied to the SEC to temporarily suspend Listed Company Rule 802.01C. 802.01C requires a company be delisted if its stock trades below a dollar for 30 days in a row.
The new application extends last month's lowering of the market capitalization rules for continued listing in Listed Company Rule 802.01B.
Michael A. Conley has been named Deputy Solicitor in the Appellate Group of the SEC's Office of the General Counsel.
Commissioner Elisse B. Walter gave a speech before the PLI's corporate governance seminar titled "Restoring Investor Trust through Corporate Governance."
Kayla J. Gillan, a founding Board Member of the Public Company Accounting Oversight Board and former General Counsel for CalPERS, has been appointed Senior Advisor to the Chairman.
The Division of Corporation Finance has released guidance on Section 7001 of the American Recovery and Reinvestment Act of 2009, which amended Section 111(e) of the Emergency Economic Stabilization Act to "permit a separate shareholder vote to approve the compensation of executives." This is what those wags in securities land call "say on pay." Makes me think of Lyndon Johnson: "Hey hey, say on pay, how many kids did you kill today?"
The only teensy oversight in this provision is that it lacks an effective date. Chris Dodd sent a letter to the SEC expressing his opinion that this provision "became effective on February 17, 2009 and applies to preliminary or definitive proxy statements."
I've been looking at the pronouncements from the administration's inner circle searching for indications of what they think the SEC's place should be in a revised regulatory structure. I have found a preference for co-operation between agencies that suggests that the SEC may have to cede its place as the world's most important securities regulator.
The most significant indications come from a report called "Financial Reform: A Framework for Financial Stability" produced by the G30 Working Group on Financial Reform. The Framework is important because of who wrote it: Timothy Geitner, Paul Volcker and Lawrence Summers are all members of the Working Group. Volcker called it "a reasonable indication of the direction in which we might go." Uh huh - I'll take it anyway. Core Recommendation 2 calls for enhanced international coordination to "modify material national differences in standards" and "develop processes for joint consideration of systemic risks". This is in line with Lawrence Summers' expressed desire to prevent regulatory competition by curbing what he calls a regulatory "race to the bottom." The alternative, Summers suggests, is "global co-operation to raise standards."
John Thain wouldn't tell New York Attorney General Andrew Cuomo the names of Merrill executives who got big bonuses. He couldn't because, in the words of his attorney, "Bank of America directed us not to answer, on grounds of confidentiality." Cuomo sued to compel Thain's testimony (People of the State of NY v. Thain, NY Supreme Ct., 0400381/2009) and, Reuters reports, Cuomo won.
Legal Currents Extra has a rundown of lawsuits filed against credit rating agencies and Reuters reports that one of those cases (Teamsters v. Moody's) has survived a motion for summary judgement.
"Down, down down. Would the fall NEVER come to an end! 'I wonder how many miles I've fallen by this time?' She said aloud. Alice's Adventures in Wonderland
So far, Bloomberg reports, that the New York Stock Exchange may have to "temporarily ease" the requirement of Listed Company Rule 802.01C that all listed company stocks trade above ONE DOLLAR.
Far enough that many of the companies in the S&P 500 wouldn't be eligible for the list because they have insufficient market capitalization (via Bespoke Investment Group).
I didn't understand the psychology of bank CEO's who destroyed storied institutions by turning all their capital into risky securities until I played Monopoly with my four-year-old daughter. My daughter loves Monopoly, and even though she doesn't really understand it she usually wins. That's because after about half an hour, she gets bored and wants to stop. We add up the money and property and she often has the most. In our last game she tried a new strategy - she didn't buy anything. She still won. If you play for the very short term, Monopoly is essentially a game of chance. Whether you win depends entirely on when you stop. Finally, as my wife observed, if you play (markets, monopoly) for the short-term, you're not invested in the future - not committed to preserving anything, doing what's best to keep the institution going, etc.
The Treasury Department has been churning out important rules and guidance - the Homeowner Affordability Plan, a tough joint statement about bank liquidity. Even the Office of Management and Budget has released major guidelines relating to the various economic recovery plans.
And what has the SEC been doing? Enforcement. Look at the last week's worth of the"what's new" page on the on the SEC's website and you'll see SRO rulemaking and enforcement.
I know there's a rulemaking moratorium, but is it possible that we're seeing part of the administration's regulatory restructuring scheme? Is the SEC going to become mainly an enforcement agency?
The SEC has made a few, largely unsuccessful, stabs at regulating hedge funds and credit rating agencies and it now appears, from this Reuters report, that the head of the European Central Bank intends to propose global regulations for those types of entities. Jean-Claude Trichet said: "Let me stress that both initiatives on rating agencies and hedge funds warrant strong international coordination."
Maybe this is the new administration's real vision for the future of regulation: international cooperation between regulators. A system like this is already working in Canada. Even though each province has its own regulatory body, each body has enacted the same rules. These "national instruments" are mutually agreed upon and then enacted locally - almost like treaties. Disclosure documents are filed on SEDAR, a jointly-operated electronic filing system.
Since last April, when the Treasury released its proposed blueprint, the scalpel of reform has been poised over the corpus of securities regulation. At first blush it looked like the CFTC had caught something very serious, but now it appears to be on the mend and it’s the SEC that needs medical attention.
I did a survey of recent legislation to see what Dr. Congress thinks is wrong with our patient. I found no brave new reform proposals – the fixes coming from Congress are strictly of the tweaks and Band-aids variety.
You’ve overdosed on over-the-counter derivatives: * HR 977 – Bringing greater transparency to commodity markets. * S 3714 – Ensuring that all commodity transactions are carried out on regulated exchanges. * S 3691 – Requiring reporting and record keeping for credit default swaps * HR 6976 – Bringing greater transparency and accountability to commodity markets * HR 6921 – Providing oversight and transparency of the commodity futures markets
Register those hedge funds and call me in the morning: * S 3739 – Addressing the regulation of derivatives and unregistered hedge funds * HR 7266 – Enhancing oversight for certain derivatives and hedge fund dealers * HR 5712 – Registering hedge fund advisers under the investment co act
Speculation! Worst case I’ve ever seen. * S 447 – To prevent excessive price speculation with respect to energy commodities * S 3255 – To provide oversight of large trades of over-the-counter energy and agriculture contracts and prevent price manipulation and speculation
Oh sorry, that’s my sponge: * HR 384 – Reforming the Troubled Asset Relief Program * HR 7305 – Terminating the authority of the Secretary of the Treasury to purchase troubled assets * S 400 – Expanding the authority of the TARP oversight panel * S 383 – Amending EESA to increase the authority of the inspector general
Band-aids are so underrated! * HR 281 – Making SEC filings available on company websites * HR 6482 – Directing the SEC to decide which asset-backed deals are eligible for credit ratings * HR 607 – Directing the SEC to issue guidance on fair value accounting * HR 302 – Requiring the SEC to reinstate the uptick rule * HR 885 – Enhancing the legal authority of agency inspectors general
The Daily Deal has an interesting discussion of how an SEC exemption allowed a $50 billion "enterprise" to be audited by a three-person (one retired, one a secretary) accounting firm in New City, New York (a hamlet of the Town of Clarkson, whatever that means).
The Sarbanes-Oxley Act amended section 17(e) of the 34 Act to require SEC-registered firms be audited by accounting firms registered with the SOX-created Public Accounting Oversight Board. However, the SEC immediately exempted private firms from this requirement (Release 34-48281) and kept extending the waiver every year (34-50020, 34-52909, 34-54920) because it was, "consistent with the public interest and the protection of investors."
As reported by the New York Times, the latest ban was allowed to expire at the end of 2008. Just in time, too.
First, the Ninth Circuit has recently found that ponzi scheme investors are liable to later investors under the state's Uniform Fraudulent Transfers Act (Donell v. Kowell (CA9, 2008), 533 F3d 762 - appeal briefs at 2006 WL 3889907 and 2006 WL 3845685).
Second, a quick survey of readers' quiet period precedures.
Reuters reports that sovereign wealth funds, smarting from huge paper losses in the financial sector, are steering clear of buying stock in US companies. You just can't please some people.
The New York Times reports that Robert Stanford has been found in Virginia. The denoument of the manhunt was ... they served him with papers! Not exactly a shoot-out, but we take what we can get. In further Stanford-alia the SEC has put up some more pages - a "statement" and an investor information page.
Linda Thomsen is really, finally out and Robert Kzuhami is really, actually, totally in as SEC Director of Enforcement. I noticed Linda Thomsen's comments on the press release about Stanford. Does that explain the holdup?
Today's Harvard Corporate Governance Blog has a great post from my friend John Coates about the wisdom :) of giving TARP money to bank holding companies, instead of banks.
Have you been hearing the word "zombie" a lot lately? Me too. The imagery employed to explicate the banking crisis has taken a turn for the horrific. Zombie banks have been discussed far and wide. Although ex-IMF chief economist Simon Johnson uses temperate langauge on his blog, his suggestions have been characterized as "breaking the back" of or "decapitating" the banking elite.
The SEC appears to have uncovered another multi-billion-dollar "investment scheme." No one is using the Ponzi descriptor, yet. Click here for the SEC's press release, litigation release and complaint and here for the "Stanford Scandal in Pictures" on FT Alphaville.
I linked to a story (below) from the New York Times. In response, I got an email from Victor Teicher's lawyers regarding his trading ban. The letter is below. I hereby express no opinion on the whole thing.
In light of your article, I believe that it is important for you to be made aware of the letter sent by Victor Teicher’s legal council to the New York Times:
"We are counsel to Victor Teicher, who is referenced in a misleading and false way in a February 14, 2009 article about Ezra Merkin's lawsuit with NYU. We write to demand an immediate retraction of statements in that article which suggest directly or indirectly that Mr. Teicher acted in violation of a bar by the Securities and Exchange Commission when he provided services to certain of Mr. Merkin's funds in certain periods in the 1990's into the beginning of 2000.
Those statements are false because Mr. Teicher was permitted, pursuant to an express agreement with the SEC, to be associated with unregistered investment advisors such as Mr. Merkin, until a final, unappealable order was issued by the Courts that the SEC had jurisdiction over unregistered investment advisors. After that final ruling was issued in the beginning of 2000, Mr. Teicher observed his agreement with the SEC to the letter and promptly stopped working for Mr. Merkin's funds. Your statement that he continued to be associated with those funds until 2001 is also false.
Having falsely suggested that Mr. Teicher's association with Mr. Merkin's funds was illegal, your article goes on to suggest that Mr. Teicher's 2007 and 2008 applications to modify his industry bar falsely claimed that he had complied with the securities laws and did not disclose his supposed illegal association with Mr. Merkin's funds. All of those false statements are libelous per se, and must be immediately and prominently retracted.
We note that had your reporters followed proper journalistic practices and attempted to contact Mr. Teicher or his representative prior to publication of this article, they would have learned the true facts. The failure to seek comment or clarification from Mr. Teicher is inexcusable and Mr. Teicher will pursue all available remedies.”
Stillman, Friedman & Shechtman, P.C.
Here's the originial post:
The New York Times reports that one of Madoff-feeder-boss J Ezra Merkin's chief investment advisers was actually in jail for securities fraud while he was working for Merkin.
“Victor Teicher, a convicted felon, and his staff were the persons actively managing the majority of the Ariel assets, and that hundreds of millions of dollars of Ariel’s funds had also been delivered for management to Madoff — even though Teicher had warned Merkin than Madoff’s returns were not possible.”
That quote is from a document filed by NYU in its suit against Merkin (NYU v. Gabriel Capital Corp., NY Sup. Ct., 603803/2008).
For more on Victor Teicher see: US v. Teicher, 987 f2d 112 (1992), SEC v. Teicher, 1995 WL 326050; SEC v. Teicher, 1995 WL 95076; SEC v. Teicher, 1998 WL 65657, see also: 2008 WL 4587535, 2007 WL 3254806.
Regular readers of this blog know that I am fond of lists, tallies, and the like. In that vein, the American Lawyer has created a central law firm Layoff List. A useful resource for the schadenfreude-positive as well as those whose misery loves company.
Sirius XM announced that it secured last-minute funding and has been (possibly) saved from bankruptcy and from EchoStar.
Trump Entertainment wasn't so lucky. It filed for voluntary chapter 11 in the US Bankruptcy Court for the District of New Jersey (1:09-bk-13659). But, put those hankies away! A search for "trump" in the NJ bankruptcy court turns up 204 party names. They date back to 1990 and occur with reassuring frequency.
Luigi Zingales (from the University of Chicago - where Barak Obama used to teach) has prepared an extensive proposal. You can link to it from his post on the Harvard Corporate Governance Blog.
Compliance Week reports that The Council of Institutional Investors has empanelled a regulatory reform study group chaired by two former SEC Chairs.
To lighten the mood a little, let's talk about toxic waste. I'm reading a book about organized crime in southern Italy - Gomorrah, by Roberto Saviano. Saviano recounts the astonishing inventiveness of the illegal waste disposal industry based outside Naples. They bring toxins from all over Europe and dump them into any available space.
When the dumps fill up, they set a fire. When there's nothing left to burn, they cover everything and build houses. The houses must be built on concrete supports because the trash heaps are unstable. Another profitable tactic is mixing the waste with something else. For instance, it can be combined with compost and sold to farmers or mixed into cement and made into walls. In the end, a toner cartridge from Milan rains down on Capri, donates a few toxic grains to a bottle of Chianti and has something left to make a hotel in Rome carcinogenic.
Sounds sort of like what we did with subprime mortgages, doesn't it? One bad mortgage was packaged, borrowed against, insured and re-packaged until little bits of it were incorporated into every aspect of our financial system. Instead of making the toxins disappear, it made everything it touched a little more toxic.
The weird thing is, in southern Italy, just like in our banking sector, the bosses dumped most of the waste right near their houses. Saviano has a theory about why and maybe it applies with equal force to our investment bankers, "The bosses have no qualms about saturating their towns with toxins ... The life of a boss is short. In the here and now of business there are no negatives, only a high profit margin."
Thanks to the Investment Fraud Lawyer Blog for pointing out that at least two investors have sued the underwriters of Lehman Bros subprime-backed securities. See: City of South San Francisco et al v. Citigroup Global Markets Inc., ND Cal., 3:09-CV-00501 and American National Insurance Company v. Fuld et al, SD Tex., 3:09CV00020.
The 100-plus-page American National complaint contains a very through discussion of Lehman's mistakes and distortions as well as an overview of general sub-prime misfeasance.
Race to the Bottom reviews Mary Schapiro's first speech and finds it just right.
Stockbroker Fraud Blog notes that the SEC is asking for comments on a FINRA rule proposal regarding brokerage house liquidity requirements.
Jim Hamilton notes that the bailout bill repeals the very controverisal IRS Notice allowing banks to offset losses when they buy other banks. For more about IRS Notice 2008-38 click here.
NYT DealBook reports that Alan Greenspan says he was "mystified" by the subprime market. Why should he be different from anyone else?
Okay, permit me one Madoff - this also from DealBook - foundations that invested with Madoff may be subject to excise taxes for not vetting their investments properly.
Dow Chemical is negotiating to buy a chemical company called Rohm and Haas. The merger negotiations have became so acrimonious that Dow sued to get Rohm and Hass' lawyers disqualified. High praise indeed for Wachtell Lipton. But today, with the laughter of the Delaware Chancery Court ringing in their ears, Dow is going back to the negotiating table - essentially because the negotiations have been going on for years and Dow just noticed that Wacthell Lipton was actually their law firm. Click here to read the Deal Professor's analysis and see the decision.
New York Attorney General Andrew Cuomo has publicly released a letter, dated February 10th, to Barney Frank. The letter updates Rep. Frank on the progress of the New York AG's investigation of 2008 bonus grants at Merrill Lynch & Co. It is pretty shocking - in October the New York AG sent Merrill a letter asking for details of the company's 2008 bonus program. Cuomo says Merrill gave him boilerplate assurances and then "secretly" and "prematurely" handed out over three billion dollars in bonuses. Most of the money went to 700 employees (out of 39,000). Four employees got $121 million each and four others got $62 million each.
Coumo suggests that this could not have been done without the conniavance of Bank of America. He also wants to investigate whether the bonus grants were "timed to force taxpayers to pay for them."
The report, written by former SEC Secretary Jonathan Katz, concludes that "obtaining guidance or key decisions from the SEC through these processes is increasingly difficult and unpredictable," and recommends:
- clarification of review standards - firm statutory response deadlines - a more transparent process
This week I've been researching cross-border M&A transactions. I've found a lot of the information I need using Westlaw Business' Deal Maker Roundups.
I asked Rob Peters, WB Senior Manager for Business Law Research, to give me some background on how the information in the Roundups is gathered. He told me the Roundup search pulls data directly from two WB databases: M&A Transactions and Registrations & Prospectuses.
A Deal Roundup can be assembled for a particular advisor (lawyer, auditor, or underwriter) and further narrowed by transaction type (merger, debt, equity). The Roundup search can also create dynamic league tables.
Search results can be downloaded as a pdf.
WB's databases are updated continuously by specialized content teams. They review filings and press releases as they are issued. So, the Roundup search tool allows the creation of dynamic, up-to-date league tables and advisor reports.
A promised, Treasury Secretary Geitner has given a speech "introducing" the Treasury's Financial Stability Plan ...
"which will be available on a new website FinancialStability.gov, [and] will give the American people the transparency they deserve."
So far, the website doesn't have anything but the speech. Other highlights:
"First, we're going to require banking institutions to go through a carefully designed comprehensive stress test ..."
Second, ... we will establish a Public-Private Investment Fund. This program will provide government capital and government financing to help leverage private capital to help get private markets working again.
Third, ... we are prepared to commit up to a trillion dollars to support a Consumer and Business Lending Initiative.
Finally, we will launch a comprehensive housing program"
A loophole, that is. The House Agriculture Committee has posted a draft of Collin Peterson's Derivatives Markets Transparency Act of 2009 along with an outline of the bill. The bill mandates a CFTC-approved central clearing party for OTC derivatives transactions, but unlike the draft I blogged about last week, this draft gives the CFTC the power to exempt transactions from using the central clearing party.
The Treasury Department announced that it would delay until tomorrow releasing the details of the administration's "Financial Stability and Recovery Plan," TARP to you and me, because Secretary Geitner is spending today helping coax the Senate into passing the bailout bill (HR 1).
Click here to see the timetable for tomorrow's news conference.
Bloomberg surmised that the federal government may force GM and Chrysler into bankruptcy to ensure that bailout loans get priority over loans from other lenders.
The Congressional Budget Office has been busily assessing the cost vs. the value of stuff and publishing everything on their terrifically useful website. For instance, over the last couple of days they've assessed the long-term economic impact of the stimulus package that passed the House and the version being debated in the Senate. They have also estimated the value of the assets the Treasury bought (Treasury got ripped off).
The SEC announced that David Becker, currently at Cleary Gottlieb, will return as General Counsel and Senior Policy Director. Becker is widely respected and his return is getting good notices. For more see the NY Times DealBook and the Corporate Counsel Blog.
The Wall Street Journal is reporting that Mary Schapiro has chosen Robert Khuzami, a former federal prosecutor and currently a lawyer at Deutsche Bank, to replace Linda Chatman Thomsen as head of enforcement at the SEC.
This is getting confusing. Linda Thomsen hasn't officially been given the heave-ho, but the speculation has already provoked strong reaction - see: Linda Thomsen: Scapegoat at Race to the Bottom.
Elliot Ness-ification of securities enforcement seems to be the coming trend.
Update: late this afternoon, the SEC announced that Linda Thomsen is resigning.
Am I the only one who's fascinated by the unravelling of Madoff's ponzi scheme? Its like Star Magazine meets the Financial Times, except without the Financial Times part. For those that can't get enough Madoff, I offer a roundup of Madoff-specific blog posts.
The New York Times has turned the Madoff client list into a searchable database. I sh*t you not. Among Madoff's victims is his lawyer Ira Lee Sorkin. I don't even know where to start talking about that.
Harry Markopolos is in Boston and the Boston Globe has a good profile of the scandal's new star. Markopolos has provoked strong positive and negative reactions. It seems weird to me that many of the comments are so personal, especially considering how little has been said about Madoff's diagnosis (and you know he has one).
My conjecture is that in subtle ways Markopolos is making this about him: he's talked about his Army training and his fears for the safety of his family. He heightened the drama of his appearance by making Congress wait to hear from him (he had a cold).
It seems to me that commentators have, perhaps, fallen into the same trap as the SEC: they're having trouble focusing on his conclusions because of his personality. Even in his written submissions Markopolos comes off as self-dramatizing, "Very few people in the world have the mathematical background ... but I am one of them," and a bit of a crank, "I am worried about the personal safety of myself and my family." Read past that and you'll find concise language and irrefutable logic.
Am I the only one who wishes to never again hear the name Madoff? It is well and truly clear that the SEC's screwup was epic and few begrudge Harry Markopolos his I-told-you-so moment, but please, let's think about what comes next. For them that agrees with me, I offer a roundup of Madoff-free blog posts:
From John Carney, via Clusterstock, a cow-based explanation of AIG's collapse.
DealLawyers offers John Jenkins' discussion of Pfizer's huge reverse break-up fee (Pfizer/Wyeth merger agreement is attached to a Wyeth 8-K filed 1/29/09)
The Business Law Prof. analyzes the many questions raised by a Wall Street Journal article about the Bank of America / Merrill Lynch merger.
Race to the Bottom offers a great dissection of the executive compensation bits of HR 7321, the Auto Industry Financing and Restructuring Act.
Reuters DealZone has a post about how TARP banks are using tapayer money to take out newspaper ads in hopes of making themselves more loveable. Its working on me.
The Treasury has posted new executive compensation rules for TARP institutions. In addition to pulling the emergency brake on the whole excessive-executive-compensation thing, the Treasury release gives us new terms to learn: "generally available capital access" and "exceptional assistance." To quote:
The guidelines distinguish between banks participating in any new generally available capital access program and banks needing "exceptional assistance."
Banks falling under the "exceptional assistance" standard have bank-specific negotiated agreements with Treasury. Examples include AIG, and the Bank of America and Citi transactions under the Targeted Investment Program.
Executives at exceptional assistance banks: * can't make more than $500,000 total except for restricted stock (which doesn't vest until the government gets its money back) * are subject to "say on pay" * are subject to clawback for deceptive practices * must get board approval for "luxury expenditures"
Executives at generally available capital access banks (GACAB?) get a slightly easier time: * their $500,000 cap can be waived by shareholder vote
For a summary from an extremely authoritative source (Annette Nazareth - she wrote the old rules) see this memo on the Harvard Corporate Governance blog.
Securities Docket is reporting that the Washington Post is reporting that Mary Schapiro is looking for someone to replace Linda Thomsen as the head of the SEC's Division of Enforcement.
Registration of hedge funds was the reform du semaine last week. On January 29th, Chuck Grassley introduced S. 344, the Hedge Fund Transparency Act. In his introductory statement, Grassley described the bill this way:
It requires them [hedge funds] to register with the SEC, to file an annual disclosure form with basic information that will be made publicly available, to maintain books and records required by the SEC, and to cooperate with any SEC information request or examination.
The other bill, introduced two days before, is so short, I'm pasting it below:
HR 711 IH
111th CONGRESS
1st Session
H. R. 711
To amend the Investment Advisers Act of 1940 to remove the registration exception for certain investment advisors with less than 15 clients.
IN THE HOUSE OF REPRESENTATIVES
January 27, 2009
Mr. CAPUANO (for himself and Mr. CASTLE) introduced the following bill; which was referred to the Committee on Financial Services
A BILL
To amend the Investment Advisers Act of 1940 to remove the registration exception for certain investment advisors with less than 15 clients.
Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,
SECTION 1. SHORT TITLE.
This Act may be cited as the `Hedge Fund Adviser Registration Act of 2009'.
SEC. 2. REMOVAL OF THE PRIVATE ADVISOR EXEMPTION.
Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3) is amended by striking subsection (b)(3).
203(b)(3) is below
(b) Investment advisers who need not be registered ...
(3) any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts an an investment adviser to any investment company registered under subchapter I of this chapter
The New York Times reports that AlixPartners, the Madoff trustee, filed a list of entities who say they invested money with Bernie. As you know, Madoff's record keeping was ... relaxed.
There are known knowns. There are things we know we know. We also know there are known unknowns. That is to say we know there are some things we do not know. But there are also unknown unknowns, the ones we don't know we don't know.
It is a familiar tale: because it was backed by subprime mortgages, the ABCP investment became unsellable at the same time that the Caisse had to come up with cash to pay margin calls on foreign stock exchange futures. The Caisse ran out of cash and had to sell good assets at fire-sale prices. More than anything, this story reminded me of the bankruptcy of Orange County way back in 1994. For them that don't remember, 1994 was like a mini version of 2008. A number of large, reasonably sophisticated, investors (Orange County, Procter & Gamble, Barings Bank) experienced, as the SEC put it, "significant, and sometimes unexpected, losses in market risk sensitive instruments." (release 33-7250, 1995 WL 774656) In other words: derivatives.
Warren Buffet famously described derivatives as "weapons of financial mass destruction." A small movement in the price of the underlying asset can generate huge losses. As Linda Quinn and Ottilie Jarmel note over-the-counter derivatives are even more sensitive to risk than exchange-traded derivatives. They aren't as liquid because they "may not be settled for long periods." They are subject to scarier margin calls because they are "usually not collateralized." Finally, they have no safety net because they don't "have the benefit of an exchange that serves as a creditworthy counterparty." (DISCLOSURE OF DERIVATIVES TRANSACTIONS AND MARKET RISK OF FINANCIAL INSTRUMENTS, 1065 PLI/Corp 165 (1998))
That's why, in the wake of 1994, the SEC proposed changes to Regulations S-K and S-X designed to improve disclosure about the risk associated with derivatives. The proposing release noted, with characteristic understatement, that "public disclosure about these instruments has emerged as an important issue." In 1996 the SEC extended the PSLRA's forward-looking safe harbor to the proposed rules (33-7280, 1996 WL 163906) and in 1997, the rules became final (33-7386, 1997 WL 39324).
The changes to S-X required more disclosure about derivatives risk management in the "accounting policy" footnote and added item 305, "Quantitative and Qualitative Disclosures about Market Risk," to Regulation S-K. They also require "a discussion of limitations that may keep the quantitative information from fully reflecting net market risk." (DISCLOSURE OF DERIVATIVES TRANSACTIONS AND MARKET RISK OF FINANCIAL INSTRUMENTS, 1065 PLI/Corp 165 (1998))
The SEC rules, of course, aren't designed to protect companies from making bad investment decisions - they're designed to protect investors. These were supposed to give investors a window into the potential downside of opaque financial instruments. But, did this really happen? Was it even possible?
This is where Value at Risk (VaR) comes into the picture. VaR is an accounting tool for predicting the future behavior of a portfolio based on how the portfolio has behaved in the past. As the Globe & Mail article noted, "The statistical models, it turned out, had a fatal flaw. Using data series going back only a few years - a period of low volatility in asset prices - they failed to capture the risk of a market meltdown." The flaw was hardly occult - Lehman Brothers described it this way in their 2007 10-K: "VaR is not intended to capture worst case scenario losses and we could incur losses greater than the VaR amounts reported."
Would that send you running to your broker? Me neither. Maybe it needs a black box around it like the anti-smoking thingy on cigarettes. Predicting the future is, obviously, more art than science. Would it have even been possible to gather enough data about the past to create VaR that was useful? What about for financial instruments that no one understood? What about a housing market that was unlike any that existed before? It seems to me that even with all the available data worked in VaR wouldn't be much more useful than earthquake prediction.
My sister suggests instead of qual vs. quant we borrow a risk tool from rock climbing: subjective risk vs objective risk. Total collapse of housing prices? Objective. Getting your money out in time? Subjective.
A derivative is a financial instrument that derives its value from the value of something else. Essentially, a derivative is a bet on what the price of the underlying asset will do. There has been a fully-functioning derivatives market in the United States since the mid-nineteenth century. (see: Markham, “CONFEDERATE BONDS,” “GENERAL CUSTER,” AND THE REGULATION OF DERIVATIVE FINANCIAL INSTRUMENTS, 25 Seton Hall L. Rev. 1 (1994))
A fixed-rate contract with a heating oil company is a derivative. That’s because the contract itself has value, but its value depends on the price of heating oil. Heating oil is the underlying asset. Imagine you typically use 100 gallons of oil during the winter and you sign a fixed-rate contract when the price of oil is $4 a gallon. The following week the price goes down to $3 a gallon. Your heating oil company owns a contract worth $100 (the difference between the market price of oil and the contract price). If the price of oil stayed at $4, the contract would be valueless, and if the price of oil went up to $5 the contract would be worth $100 to you.
Derivatives are often used as a hedge. Hedging is essentially making a bet and, just in case, also making the opposite bet. It’s like betting $100 on the long shot and $30 on the favorite. The potential gains are less, but so are the potential losses.
The main species of derivative are:
Forwards - an agreement to sell the underlying item at a set time, place and price (our heating oil contract is a forward). Futures - like forwards, but with standard terms. Options - a right to sell (put) or buy (call) the underlying item at a set price. Swaps - an agreement to trade the cash flow from one transaction for another. Like this: 1. Party A borrows 30,000 US Dollars and party B borrows 15,000 UK Pounds. 2. A gives the 30,000 Dollars to B and B gives the 15,000 Pounds to A 3. A pays B's monthly payments and B pays A's monthly payments 4. At the end of the term, A and B exchange money again
The swaps market dwarfs the other derivative markets. Swaps exist in a constellation of sub-types: interest rate swaps (one party borrows money at a fixed rate the other at a floating rate), basis swaps (two different fixed rates), commodity swaps (one fixed, one based on the price of a commodity), and on and on. For more about derivatives I suggest:
Nagler, DERIVATIVES DISCLOSURE REQUIREMENTS: HERE WE GO AGAIN, 6 Cornell J.L. & Pub. Pol'y 441, (Winter 1997)
AN INTRODUCTION TO OTC DERIVATIVES, 848 PLI/Corp 121, (1994)
I've been working on a post about the growing banker bonus clawback cacophony, but D&O Diary has saved me the trouble (in addition to doing a much more comprehensive job) of gathering all the clawback-related noise, legislation and commentary. Thanks, Kevin!
Reuters reports that a Madoff feeder fund has sued its own auditors, "Maxam Absolute Return Fund LP, a hedge fund, on Friday said it filed a lawsuit against auditors Goldstein Golub Kessler LLP and McGladrey & Pullen LLP to recover losses suffered by its investors in investments held by Bernard L. Madoff Investment Securities LLC." Click here to see the docket.
The Daily Deal's DealScape blog keeps us up to date on how many banks have gone to that big vault in the sky (31).
The Corporate Counsel blog notes the publication of the adopting release for the XLBR rules and offers a guide on what to do now.
The Deal Professor offers an examination of how Bernie Madoff exposed the "Myth of the Sophisticated Investor."
Securities Docket has posted SEC Director of Enforcement Linda Chatman Thomsen's written testimony before the Senate Banking Committee about the merry Madoff mess.
*These figures alone will enable the economic historian of the future to describe the unhealthy prosperity of 1929 and the inevitable grief and suffering that followed in the succeeding years--grief and suffering that overwhelmed and carried away not merely the speculative gains of those who participated in the speculative debauch ... but eventually the operating profits of every business in the country no matter how unrelated to stock exchanges.
Sam Rayburn's introdution to H.R. Rep 73-1383, 73rd Cong. 2nd Sess. 1934, 1934 WL 1290
I didn't understand the psychology of bank CEO's who destroyed storied institutions by turning all their capital into risky securities until I played Monopoly with my four-year-old daughter. My daughter loves Monopoly, and even though she doesn't really understand it she usually wins. That's because after about half an hour, she gets bored and wants to stop. We add up the money and property and she often has the most. In our last game she tried a new strategy - she didn't buy anything. She still won. If you play for the very short term, Monopoly is essentially a game of chance. Whether you win depends entirely on when you stop. Finally, as my wife observed, if you play (markets, monopoly) for the short-term, you're not invested in the future - not committed to preserving anything, doing what's best to keep the institution going, etc.
Have you been hearing the word "zombie" a lot lately? Me too. The imagery employed to explicate the banking crisis has taken a turn for the horrific. Zombie banks have been discussed far and wide. Although ex-IMF chief economist Simon Johnson uses temperate langauge on his blog, his suggestions have been characterized as "breaking the back" of or "decapitating" the banking elite.
