So today, in celebration of the 80th anniversary of Black Tuesday, the Speculative Debauch is pleased to unveil its official new home at speculativedebauch.com Please adjust your bookmarks and, etc.
If you're hep to that internet jive and use one of the new-fangled technologies below, please click to:
Thursday, October 29, 2009
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Sunday, October 25, 2009
Hazards to Navigation
When I was a reference librarian, I would, pretty regularly, get a request for information about "The Black-Scholes Model" (Black-Scholes). Black-Scholes is a mathematical equation that uses the price of stock (and other known variables) to determine the value of an option to buy the stock. Building on work done by Robert Merton, Black and Scholes first laid out their theory in a 1973 paper titled "The Pricing of Options and Coporate Liabilites."
The utility of Black-Scholes turned out to be far broader than just pricing options. As John Lancaster pointed out in the the most erudite goof you'll ever read, Black-Scholes "enabled people to calculate the price of financial derivatives based on the value of the underlying asset."
That's right - when Black & Scholes adapted the heat equation to finance they enabled the creation of much more accurate financial derivatives. This was considered sufficiently important that Merton and Scholes won the Nobel Prize in economics in 1997.
I don't pretend to understand any of this - reading the 1973 article is like trying to understand philosopy by starting with Spinoza. I found a purported simple explanation in the Norton Bankruptcy Reporter - maybe it'll help you? (Ayer, GOOD NEWS FOR BLACK SCHOLES SUFFERERS, 1999 No. 1 Norton Bankr. L. Adviser 7)
If you need to price your options, there are online engines that will Black-Scholes your numbers. What'll they think of next? No - don't tell me.
And don't forget - we're moving.
The utility of Black-Scholes turned out to be far broader than just pricing options. As John Lancaster pointed out in the the most erudite goof you'll ever read, Black-Scholes "enabled people to calculate the price of financial derivatives based on the value of the underlying asset."
That's right - when Black & Scholes adapted the heat equation to finance they enabled the creation of much more accurate financial derivatives. This was considered sufficiently important that Merton and Scholes won the Nobel Prize in economics in 1997.
I don't pretend to understand any of this - reading the 1973 article is like trying to understand philosopy by starting with Spinoza. I found a purported simple explanation in the Norton Bankruptcy Reporter - maybe it'll help you? (Ayer, GOOD NEWS FOR BLACK SCHOLES SUFFERERS, 1999 No. 1 Norton Bankr. L. Adviser 7)
If you need to price your options, there are online engines that will Black-Scholes your numbers. What'll they think of next? No - don't tell me.
And don't forget - we're moving.
Friday, October 23, 2009
80 Years Ago Today
Was the day before "Black Thursday" the first of the four horsemen of the crash of 1929 (the others being Black Friday, Black Monday, and Black Tuesday - presumably the weekend wasn't a picnic, either).
In commemoration of these four, or possibly six, days of horror we're throwing ourselves, not off a building, but into a new website. Starting on Black Tuesday (October 29th), we'll be all moved out of this blog and into our new digs.
Although October 24th is the official first day of the crash, the erosion had begun more than a month before. The market hit its high (381!) on September 3rd and it was mostly downhill from there.
Roger Babson gets blamed for sending the market into its death spiral by, on September 5th, predicting a "terrific" crash. It is hard to imagine that one person, no matter how smart or respected, could wield that kind of power over a confident market.
In the days between the high and Black Thursday, as the market went down, investment companies started to get out and small investors booby-trapped the market by setting stop-loss orders and buying on margin.
The week beginning Monday, October 21st started with a loss and just got worse. At the end of the day on October 23rd, the NYSE was down 13%.
In commemoration of these four, or possibly six, days of horror we're throwing ourselves, not off a building, but into a new website. Starting on Black Tuesday (October 29th), we'll be all moved out of this blog and into our new digs.
Although October 24th is the official first day of the crash, the erosion had begun more than a month before. The market hit its high (381!) on September 3rd and it was mostly downhill from there.
Roger Babson gets blamed for sending the market into its death spiral by, on September 5th, predicting a "terrific" crash. It is hard to imagine that one person, no matter how smart or respected, could wield that kind of power over a confident market.
In the days between the high and Black Thursday, as the market went down, investment companies started to get out and small investors booby-trapped the market by setting stop-loss orders and buying on margin.
The week beginning Monday, October 21st started with a loss and just got worse. At the end of the day on October 23rd, the NYSE was down 13%.
Thursday, October 15, 2009
LIBOR +3
I just noticed that I have posted more than three hundred and fifty times on this blog. If posts were basis points, that'd be 3.5% - way better than today's LIBOR of .57%
Is it weird that that's the first thing I thought?
Is it weird that that's the first thing I thought?
BBA LIBOR on Twitter
That pretty much says it. Click to follow. Why is this weirder than the SEC or Westlaw taking advantage of what is now called "social media?" The Bank of England and the Federal Reserve do not tweet (although HM Treasury does).
Also, am I the only one who thinks "social disease" when they hear that polite descriptor? Oh. I am?
Also, am I the only one who thinks "social disease" when they hear that polite descriptor? Oh. I am?
Windy
Next week I shall be in Chicago presenting securities research master class part 2 (enforcement). I'm also hoping to throw in a sneak peek at part 3 (asset-backed securities and derivatives). If you're in town, and you have time, please join us:
West Librarian Relations Invites You
Securities Master Class 2 - Securities Enforcement
The current financial crisis has put the spotlight on securities regulation. Please join us and our guest speaker, Craig Eastland, Librarian Relations Practice Area Specialist, for the second of three Master Classes on Securities Research.
The West Securities Law Master Classes are designed to provide librarians with an overview of securities laws, a discussion of securities law practice areas and an exploration of West's securities research tools.
Part two will cover how securities laws are enforced. Using the story of the collapse of Enron as a starting point, the class will discuss the shareholder class actions, administrative enforcement proceedings and criminal prosecutions that can flow from violations of the securities laws. The discussion will also feature several research examples.
Tuesday, October 20th, 2009
Noon – 1:30 p.m.
The West InfoCenter
One North Dearborn - Suite 500
Columbus Room
Chicago, IL 60602
Wednesday, October 14, 2009
Sarbanes-Oxley and the Fallacy of Independence
Yesterday, I spent some time researching the directors of Enron. What I discovered made wonder whether the post-Enron reforms, particularly the Sarbanes-Oxley Act, are capable of doing what they were designed to do. It even made me think that the laws might be grounded on faulty reasoning.
The most significant product of the corporate scandals of the late 1990’s was the Sarbanes-Oxley Act of 2002 (“SOX”, PL 107-204). SOX, of course, apotheosized the idea of the independent director as watchdog. SOX section 301 requires a public corporation’s audit committee (SOX is only concerned with audit committees – broader requirements for director independence actually come from NYSE and NASDAQ rules) be composed entirely of “independent” directors. Independence means no extra payola and no affiliation with the issuer or its subsidiaries. Affiliation is a two-way street and it comes down to control. An affiliate is someone who controls or is controlled by the issuer. Control is the power to direct via ownership of stock or by contract (see: Bostelman, The Sarbanes-Oxley Deskbook, PLIREF-SAROX s 11:3-3).
In the SOX cosmology corporate officers are compromised by their emotional and financial investment in a corporation’s fate, and must be isolated from other management players like auditors and lawyers. In the words of Byron Dorgan, “There is something rotten going on inside some of these corporations,” (Cong. Rec. pp S5249 – 5251, 2002 WL 32054458). For instance, section 203 of SOX requires auditors be rotated to ensure that they don’t lose their objectivity by getting too friendly with management.
But, according to Woodrow Wilson scholar (and Enron board member) Herbert Winokur, Enron’s board *was* independent. As he told the Senate’s Permanent Subcommittee on Investigation, “Enron’s board was composed of 12 independent directors and 2 inside directors.” And, he’s right – according to Enron’s 2000 proxy statement (Def 14A, 5/2/00), of the 17 directors listed, only three are Enron employees (Lay, Skilling, and John Urquhart who is Lay’s “Senior Advisor”). If we expand the group to include anyone who’d lose their “independent” status under SOX 301 we get five more names (for a total of 8): Robert Belfer, Lay’s business partner and CEO of Belco, an Enron sub, John Duncan, director of Enron sub Azurix, Ken Harrison, CEO of Enron sub Portland Gas & Electric, Rebecca Mark-Jusbasche, CEO of Azurix, and Winokur himself, a director of Azurix.
Pretty cozy, right? You can just imagine the plotting of nefarious doings. But to assess whether SOX 301 can really improve corporate governance ask yourself this (or, allow me to ask it for you): if management’s financial and emotional investment is the problem and an independent board is the solution, does this law really make an independent board possible?
To answer that question, let’s look at the other people on the Enron board, circa 2000. Wendy Gramm and John Wakeham may not have been personally invested in Enron, but both staked their professional careers on the wisdom of deregulating the energy business. Gramm, an economist and wife of Senator Phil Gramm, was head of the CFTC under the first President Bush. Responding to an Enron petition, she, in the waning days of her tenure, exempted energy commodities and swaps from CFTC regulation (CFTC 3620-93, 1993 WL 13822). As Margaret Thatcher’s Secretary of State for Energy, Lord Wakeham was the man in charge of privatizing England’s electricity industry, and as the Independent observed, “Enron was the first US company to benefit from his work.” Gramm and Wakeham are independent by the SOX standard, but Enron’s success would prove the wisdom of their professional decisions.
Also on Enron’s 2000 slate are Charles Lemaistre and John Mendelsohn, respectively, the former and current directors of the MD Anderson Cancer Center in Houston. Enron was based in Houston, and it is certainly a possibility that Lay and Skilling knew Lemaistre and Mendelsohn socially.
I don’t mean to imply that Lemaistre, Mendelsohn, Gramm or Wakeham were in on the scam - quite the opposite. The officers of Enron were running a criminal enterprise and they cleverly populated the board with people who had built-in reasons for wanting Enron to succeed. They capitalized on personal connections and political agendas alike to create a passive overseer.
So, that’s my point – distinctions between inside and outside mean nothing when you’re dealing with a con. Con artists draw people in and then they use them - for money or just for their good name - and that’s already illegal.
The most significant product of the corporate scandals of the late 1990’s was the Sarbanes-Oxley Act of 2002 (“SOX”, PL 107-204). SOX, of course, apotheosized the idea of the independent director as watchdog. SOX section 301 requires a public corporation’s audit committee (SOX is only concerned with audit committees – broader requirements for director independence actually come from NYSE and NASDAQ rules) be composed entirely of “independent” directors. Independence means no extra payola and no affiliation with the issuer or its subsidiaries. Affiliation is a two-way street and it comes down to control. An affiliate is someone who controls or is controlled by the issuer. Control is the power to direct via ownership of stock or by contract (see: Bostelman, The Sarbanes-Oxley Deskbook, PLIREF-SAROX s 11:3-3).
In the SOX cosmology corporate officers are compromised by their emotional and financial investment in a corporation’s fate, and must be isolated from other management players like auditors and lawyers. In the words of Byron Dorgan, “There is something rotten going on inside some of these corporations,” (Cong. Rec. pp S5249 – 5251, 2002 WL 32054458). For instance, section 203 of SOX requires auditors be rotated to ensure that they don’t lose their objectivity by getting too friendly with management.
But, according to Woodrow Wilson scholar (and Enron board member) Herbert Winokur, Enron’s board *was* independent. As he told the Senate’s Permanent Subcommittee on Investigation, “Enron’s board was composed of 12 independent directors and 2 inside directors.” And, he’s right – according to Enron’s 2000 proxy statement (Def 14A, 5/2/00), of the 17 directors listed, only three are Enron employees (Lay, Skilling, and John Urquhart who is Lay’s “Senior Advisor”). If we expand the group to include anyone who’d lose their “independent” status under SOX 301 we get five more names (for a total of 8): Robert Belfer, Lay’s business partner and CEO of Belco, an Enron sub, John Duncan, director of Enron sub Azurix, Ken Harrison, CEO of Enron sub Portland Gas & Electric, Rebecca Mark-Jusbasche, CEO of Azurix, and Winokur himself, a director of Azurix.
Pretty cozy, right? You can just imagine the plotting of nefarious doings. But to assess whether SOX 301 can really improve corporate governance ask yourself this (or, allow me to ask it for you): if management’s financial and emotional investment is the problem and an independent board is the solution, does this law really make an independent board possible?
To answer that question, let’s look at the other people on the Enron board, circa 2000. Wendy Gramm and John Wakeham may not have been personally invested in Enron, but both staked their professional careers on the wisdom of deregulating the energy business. Gramm, an economist and wife of Senator Phil Gramm, was head of the CFTC under the first President Bush. Responding to an Enron petition, she, in the waning days of her tenure, exempted energy commodities and swaps from CFTC regulation (CFTC 3620-93, 1993 WL 13822). As Margaret Thatcher’s Secretary of State for Energy, Lord Wakeham was the man in charge of privatizing England’s electricity industry, and as the Independent observed, “Enron was the first US company to benefit from his work.” Gramm and Wakeham are independent by the SOX standard, but Enron’s success would prove the wisdom of their professional decisions.
Also on Enron’s 2000 slate are Charles Lemaistre and John Mendelsohn, respectively, the former and current directors of the MD Anderson Cancer Center in Houston. Enron was based in Houston, and it is certainly a possibility that Lay and Skilling knew Lemaistre and Mendelsohn socially.
I don’t mean to imply that Lemaistre, Mendelsohn, Gramm or Wakeham were in on the scam - quite the opposite. The officers of Enron were running a criminal enterprise and they cleverly populated the board with people who had built-in reasons for wanting Enron to succeed. They capitalized on personal connections and political agendas alike to create a passive overseer.
So, that’s my point – distinctions between inside and outside mean nothing when you’re dealing with a con. Con artists draw people in and then they use them - for money or just for their good name - and that’s already illegal.
Thursday, October 8, 2009
ISDA Documentation Architecture 4: Credit Support
As I've mentioned in the past, one of the hazards of derivatives transactions not executed through a clearinghouse is that the parties are responsible for policing each others credit. Each party must satisfy itself that its counterparty will be able to execute the transaction without defaulting.
In the 1980's parties began trying to control credit risk by taking collateral from each other. Basically, when one party is in a more tenuous financial position than the other, the shakier counterparty will pass some collateral (usually cash) to the stronger party as a guarantee. In its 1996 report, the ISDA Collateral Working Group identified three ways that collateral makes derivatives more attractive: it equalizes disparities in creditworthiness thus opening up a wider range of potential counterparties, it can reduce the interest charged to less creditworthy counterparties, and it may help regulated financial institutions reduce their capital requirements by lowering the risk weighting associated with the transaction.
OTC derivatives executed via the ISDA Master Agreement are structured using one of three ISDA credit support annexes to the Master Agreement schedule. All three establish the same framework for the operation of the collateral transfer - how collateral calls are calculated, when collateral can be substituted or exchanged, how disputes will be resolved, etc.
There are three of them because each is governed by the law of a different jurisdiction. The 1994 Credit Support Annex (security interest - New York Law) and the 2008 Credit Support Annex (Loan/Japanese pledge) create a lien on the collateral while the 1995 Credit Support Annex (Transfer - English Law) actually transfers ownership of the collateral to the other party. Each of the annexes has an explanatory "users guide" and the 1994 and 1995 annexes have standard conforming amendments to bring them out of the dark ages of the 1992 Master Agreement.
These collateral support agreements, of course, are what got AIG in trouble. Each time their rating was downgraded they found themselves facing many CDS-related collateral calls.
In the 1980's parties began trying to control credit risk by taking collateral from each other. Basically, when one party is in a more tenuous financial position than the other, the shakier counterparty will pass some collateral (usually cash) to the stronger party as a guarantee. In its 1996 report, the ISDA Collateral Working Group identified three ways that collateral makes derivatives more attractive: it equalizes disparities in creditworthiness thus opening up a wider range of potential counterparties, it can reduce the interest charged to less creditworthy counterparties, and it may help regulated financial institutions reduce their capital requirements by lowering the risk weighting associated with the transaction.
OTC derivatives executed via the ISDA Master Agreement are structured using one of three ISDA credit support annexes to the Master Agreement schedule. All three establish the same framework for the operation of the collateral transfer - how collateral calls are calculated, when collateral can be substituted or exchanged, how disputes will be resolved, etc.
There are three of them because each is governed by the law of a different jurisdiction. The 1994 Credit Support Annex (security interest - New York Law) and the 2008 Credit Support Annex (Loan/Japanese pledge) create a lien on the collateral while the 1995 Credit Support Annex (Transfer - English Law) actually transfers ownership of the collateral to the other party. Each of the annexes has an explanatory "users guide" and the 1994 and 1995 annexes have standard conforming amendments to bring them out of the dark ages of the 1992 Master Agreement.
These collateral support agreements, of course, are what got AIG in trouble. Each time their rating was downgraded they found themselves facing many CDS-related collateral calls.
Subtitle C: Improvements to the Regulation of Credit Rating Agencies
Subtitle C is the weirdest piece of the administration's proposed Investor Protection Act of 2009 because a lot of it is a spanking for the SEC.
It has been nearly 5 years since Congress gave the SEC explicit regulatory oversight of credit rating agencies, but the agency has had trouble imposing any control. Despite being implicated in the Enron collapse and, of course, in the current financial unpleasantness, credit rating agencies have managed to avoid any substantive oversight. They have evaded regulation of the content of their ratings by arguing that ratings are opinions and therefore protected speech under the First Amendment. They are free from public disclosure obligations, beyond form NRSRO, because they have convinced regulators that secrecy is essential to their business.
This then, is why section 932 of Subtitle C requires that, "The Commission shall establish an office that administers the rules ... with respect to the practices of nationally recognized statistical rating organizations," and why the Commission is directed to "conduct reviews required by this paragraph no less frequently than annually," and to make "[a] report summarizing the key findings of the reviews ... available to the public in a widely discernible format." Most embarrassingly, section 936 orders the Comptroller General to write a report assessing "the extent to which the rulemaking of the Securities and Exchange Commission has carried out the provisions of this Act." Ouch.
Subtitle C also imposes new obligations on credit rating agencies. For starters, they must promulgate a written conflict-of-interest policy and elect a Chief Compliance Officer to police same. For more see this one-page summary from Morrison & Forester.
The SEC has a slew of rules out that cover much of the same territory. It isn't clear whether Subtitle C and the SEC's proposal are coordinated. The SEC has "deferred" its plan to reduce the reliance placed on the NRSRO classification. Subtitle C would put this program where it belongs - with the President's Working Group.
It has been nearly 5 years since Congress gave the SEC explicit regulatory oversight of credit rating agencies, but the agency has had trouble imposing any control. Despite being implicated in the Enron collapse and, of course, in the current financial unpleasantness, credit rating agencies have managed to avoid any substantive oversight. They have evaded regulation of the content of their ratings by arguing that ratings are opinions and therefore protected speech under the First Amendment. They are free from public disclosure obligations, beyond form NRSRO, because they have convinced regulators that secrecy is essential to their business.
This then, is why section 932 of Subtitle C requires that, "The Commission shall establish an office that administers the rules ... with respect to the practices of nationally recognized statistical rating organizations," and why the Commission is directed to "conduct reviews required by this paragraph no less frequently than annually," and to make "[a] report summarizing the key findings of the reviews ... available to the public in a widely discernible format." Most embarrassingly, section 936 orders the Comptroller General to write a report assessing "the extent to which the rulemaking of the Securities and Exchange Commission has carried out the provisions of this Act." Ouch.
Subtitle C also imposes new obligations on credit rating agencies. For starters, they must promulgate a written conflict-of-interest policy and elect a Chief Compliance Officer to police same. For more see this one-page summary from Morrison & Forester.
The SEC has a slew of rules out that cover much of the same territory. It isn't clear whether Subtitle C and the SEC's proposal are coordinated. The SEC has "deferred" its plan to reduce the reliance placed on the NRSRO classification. Subtitle C would put this program where it belongs - with the President's Working Group.
Wednesday, October 7, 2009
Subtitle E: Improvements to the Asset-Backed Securitization Process
Today, I'm going to start looking at a neglected piece of the administration's reform proposal: title IX, the vast Investor Protection Act of 2009. The IPA is a grabbag of regulatory off-cuts ranging from asset-backed securitization reform to credit rating agency reform.
The centerpiece of Subtitle E, called "Improvements to the Asset-Backed Securitization Process," is the so-called "skin-in-the-game" regulatory fix. The idea is that the present securitization process provides no incentive for deal sponsors to create good-quality securities. The way sponsors make money is by getting fees. They pay themselves a fee for putting together the pool, for underwriting, and even for servicing the underlying debt. They don't invest. The sponsor is like a chef who won't eat at his own restaurant. The thinking is that if he has to eat what he peddles, his restaurant will improve.
So, section 952 of the IPA would require "securitizers" of ABS deals to retain 5% of the "risk." Securitizers would not be allowed to hedge this retained risk and the SEC would establish standards for the risk's "permissable forms" and "minimum duration."
The new law defines "securitizer" as an issuer or an underwriter. It cleverly hops right over the amorphous matter of trying to define "sponsor" and lands right where the sponsor gets its money - underwriting.
Of course, the ABS packagers, especially the residential mortgage monsters like Lehman and Bear Stearns *were* eating in their own restaurant. In fact, they were eating the leftovers (in the form of the lowest tranches of their offerings), and so, there's a funny sort of conversation that's been going on about whether the ABS sponsors were really avoiding the securities they created. What this argument boils down to is a disagreement about how stupid they were. Were they smart enough to know their ABS deals were crappy, but too stupid to get out in time, or were they completely oblivious to how risky these deals were? Skin-in-the-Game is only an effective deterrent if the ABS packagers are just a little stupid.
Subtitle E also gives the SEC power to create a disclosure obligation for ABS issuers that could not be extinguished by de-registering under section 15 and presumably would continue until the breaking of the world.
For a complete overview, see this Cadwalader memo and wonder along with them (and me) about why the law repeals s. 4(5) of the '33 Act.
The centerpiece of Subtitle E, called "Improvements to the Asset-Backed Securitization Process," is the so-called "skin-in-the-game" regulatory fix. The idea is that the present securitization process provides no incentive for deal sponsors to create good-quality securities. The way sponsors make money is by getting fees. They pay themselves a fee for putting together the pool, for underwriting, and even for servicing the underlying debt. They don't invest. The sponsor is like a chef who won't eat at his own restaurant. The thinking is that if he has to eat what he peddles, his restaurant will improve.
So, section 952 of the IPA would require "securitizers" of ABS deals to retain 5% of the "risk." Securitizers would not be allowed to hedge this retained risk and the SEC would establish standards for the risk's "permissable forms" and "minimum duration."
The new law defines "securitizer" as an issuer or an underwriter. It cleverly hops right over the amorphous matter of trying to define "sponsor" and lands right where the sponsor gets its money - underwriting.
Of course, the ABS packagers, especially the residential mortgage monsters like Lehman and Bear Stearns *were* eating in their own restaurant. In fact, they were eating the leftovers (in the form of the lowest tranches of their offerings), and so, there's a funny sort of conversation that's been going on about whether the ABS sponsors were really avoiding the securities they created. What this argument boils down to is a disagreement about how stupid they were. Were they smart enough to know their ABS deals were crappy, but too stupid to get out in time, or were they completely oblivious to how risky these deals were? Skin-in-the-Game is only an effective deterrent if the ABS packagers are just a little stupid.
Subtitle E also gives the SEC power to create a disclosure obligation for ABS issuers that could not be extinguished by de-registering under section 15 and presumably would continue until the breaking of the world.
For a complete overview, see this Cadwalader memo and wonder along with them (and me) about why the law repeals s. 4(5) of the '33 Act.
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