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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:
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.
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%.
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?
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?
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
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.
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.
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.
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.
I admit that I am still agog when I look at the residential mortgage-backed securities transactions from right before the crash. I know it sounds like I am, once again, excavating things best left interred, but that is not the case. Last week, Fitch gave a triple A rating to a new security called "JP Morgan Re-securitization Trust 2009-R10." The Fitch news release mentions that among the securities being "re-securitized" is "a 25% interest in Lehman Mortgage Trust 2007-7, class 6-A-4." "And what's that?" I wondered, you know, to myself (I'm a blogger so, I am alone).
Then, I went on Westlaw Business and found the prospectus. LMT 2007-7 was an $800 million pool of about 2,000 residential mortgages. It issued 19 different classes of securities. The securities were narrowly sliced to reflect specific parts of the large pool. First,the big pool was subdivided into three smaller pools based on the quality of the underwriting standards. 77% of the mortgages in Pool 3, composed mostly of mortgages originated by Lehman's banking sub Lehman Brothers Bank, were "no-doc" loans.
The Pools were further subdivided into "collateral groups" by interest rate. Series 6-A4 was paid out of collateral group 6, a collection of 700-or-so mortgages with a weighted average interest rate of 7.5%. The "A" and the "4" indicate payment priority - "A" securities got paid first, but within "A" 1 got paid before 2, or 4. Further confusing the payment priority picture, the 6-A4 securities are also described as "super senior."
LMT 2007-7 paid right on schedule until December of 2007-7 when it filed a form 15 to withdraw its registration on the grounds that it was held by fewer then 40 people.
Virtually all the LMT 2007-7 securities were initially rated triple A by S&P. When I checked their rating last week, they were all rated B+ or lower. When I checked today, the ratings were gone.
Is this what we're going to get instead of PPIP?
Please read the gloriously deadpan Death Plays in Barron's about my favorite new securitization. "We admit" says Alan Abelson "to a nagging concern or two."
As I mentioned in the last post in this series, in 2002 ISDA revised its Master Agreement to create a better way of determining who owes what to whom when an agreement goes into default. The 1992 Master Agreement provided two methods (with the creative monikers "First Method" and "Second Method") both of which proved unsatisfactory during bad market conditions. The 2002 Master Agreement replaced these mechanisms with a much more flexible method called "close-out amount."
Unfortunately, the 2002 Master Agreement was adopted only gradually. In a March memo, Manuel Frey and Jordan Yarett of Paul Weiss observed that, "since its introduction, the 2002 ISDA Master Agreement has become increasingly common in the market place, although the 1992 ISDA Agreement continues to be widely used." In a January article in Butterworths Journal of International Banking and Finance Law, Edmund Parker and Aaron McGarry second that: "Many Master Agreements still in use are based on the 1992 version, which contains the greatest weaknesses."
In addition to an understandable unwillingness to spend money amending thousands of contracts, reluctance to adopt the new Master Agreement also stems from the need to very closely match a hedge to the transaction being hedged. The fear is that hedging a transaction written on 1992 Master Agreement with a transaction written on the 2002 Master Agreement might cancel the value of the hedge.
The collapse of Lehman Brothers, with its 8,000 Master Agreements and 67,000 outstanding transactions, pointed out the folly of being so conservative (or lazy) and since then, there as been a concerted effort to ditch the 1992 settlement procedures. In August of 2008, most of the large OTC derivatives dealers signed the Close-out Multiparty Agreement which bulk-updated their existing 1992 Agreements to conform with the 2002 Agreement's close-out protocol. In February of 2009, ISDA published the Close-Out Amount Protocol, a standard-form version of the Multiparty Agreement. ISDA maintains a list of adherents to the Protocol.
Corporate Counsel blog on the SEC Inspector General's report on La Madoff. *sigh*
From Forbes (via CompliancEx) a call for securities arbitrators to explain their decisions. Here, here!
From the New Brunswick Business Journal (with thanks to Compliance Week for pointing it out) - a Canadian SEC? Egad.
At the center of the ISDA documentation architecture is the Master Agreement. The Master Agreement began life in 1985 as the Code of Standard Wording, Assumptions and Provisions for Swaps (it spells SWAPS - how cute is that?) and matured into its present acronym-free iteration as the 1993 ISDA Master Agreement.
The Master Agreement is made up of three discrete pieces - the printed form, the schedule, and any subsequent confirmations. The printed form and the schedule lay out the mechanics of the transaction. The printed form is a standard recitation of parties, addresses and other routine information - it is not generally amended. The schedule is a mechanism for customizing the printed form. It gives the parties the option of adding customized langauge and turning on or off some of the printed form's provisions.
The confirmation is a standard practice that predates the Master Agreement. The Master Agreement sets out general operating principles for a proposed derivatives transactions, but the transactions don't actually occur until a confirmation is sent. The confirmation contains the specific monetary terms of the transaction.
The 1993 Master Agreement provides two methods for determining payment in the event of default. Parties must choose one. During the Japanese banking crisis in the 1990's both mechanisms failed to provide equitable settlements. As a result, the ISDA revised the Master Agreement to provide a broader settlement mechanism. The new mechanism is the primary difference between the 1993 Master Agreement and the 2002 Master Agreement.
For a very thorough discussion of both Master Agreements, see 1397 PLI/Corp 51, Klein, Overview of the ISDA Master Agreement Forms.
Part 3: LEHMAN
Part 1
When he planned to steal our sunlight, he crossed that line between everyday villainy and cartoonish super-villainy.
- Smithers
Before I read today's New York Times, I felt slightly superior to people who ascribed evil motives to, for instance, Goldman Sachs. Business cares about making money - it doesn't make moral judgments. But, as today's Times article proves, there's no practical difference between being amoral and being immoral.
Some Wall Street banks, apparently, are planning to securitize viatical settlements thereby creating a way to invest in the probability that other people will die. Presumably, you could even speculate on the likelihood of your own death.
What if your pension fund were to invest? The risk factors should be a hoot, too - "in the event that AIDS is cured, you could lose your entire investment."
1995 ISDA Credit Support Annex
1995 ISDA Credit Support Deed (Security Interest – English Law)
2008 ISDA Credit Support Annex (Loan/Japanese Pledge)
1994 ISDA Credit Support Annex (Security Interest - New York Law)
The first time I was asked to pull one of the components of the International Swaps and Derivatives Association's "documentation architecture" I was pretty intimidated. I spent a few minutes in that forest of teensy, similarly-named pamphlets, chose what I thought was the right one and then, shortly, found myself back at the shelf taking a closer look because I'd pulled the wrong document. Eventually, I became more adept at navigating the ISDA waters, but I always felt a little at sea.
To understand why the ISDA documentation architecture is confusing (aside from the irritatingly similar names), I think it is helpful to remember that derivatives were devised as a hedging tool. A hedge is a way of protecting an investment against a worst-case scenario. For instance, if you owned a store in a seaside town and anticipated a hot, sunny summer you might buy more sunglasses than usual. If you're wrong and it rains, you won't make any money from your investment in shades. So, to hedge against that possibility you might buy umbrellas. If the summer is as you expect, you'll make lots of money, but if it rains every day, you can limp along selling umbrellas.
To be useful as a hedge your umbrella purchase must be precisely related to your investment in sunglasses. Hedging transactions are always associated with a primary investment and must be narrowly tailored to protect against a disaster without negating the primary investment's value. Thus, hedging transactions are always customized to accommodate the needs of both counter-parties.
If you are reluctant to get into the umbrella business, there are other ways to hedge your risky sunglasses play - you could invest in an umbrella company, short a sunglasses manufacturer, or you might want to try something more exotic: like investing in the price of umbrellas. That's where derivatives come in - they were developed as a way to hedge by investing in intangibles, like the price of wheat.
The ISDA documentation architecture was developed to institutionalize and standardize the process of writing these highly customized contracts. So when, in 1980's, the ISDA started working on a set of standard forms for derivatives transactions, they were faced with a daunting task: how do you create a standard agreement for an industry where every agreement is different?
Part 2: THE ISDA MASTER AGREEMENT
Last week, the CFTC withdrew two no-action letters which gave DB Commodity Services LLC (CFTC Ltr. No. 06-09, 2006 WL 1419398) and something known only as "Client X" (CFTC Ltr. No. 06-19, 2006 WL 2682362), exemptions from the position limits in Regulation 150.2 (17 C.F.R §150.2). These entities sought exemptions because they were buying small numbers of futures to create a virtual commodity index. The commodity index was a tool used to price their real product: commodity-linked notes.
The withdrawl of no-action protection from this apparently inocuous activity appears to be part of a general CFTC blitz on speculation. The CFTC limits the size of transactions which are not bona fide hedging (see this CFTC Backgrounder for more). The CFTC news release finds that transactions undertaken by DB Commodity Services and X do "not qualify for a bona fide hedge exemption under the Commission’s regulations," and given CFTC Chair Gary Gensler's belief that "position limits should be consistently applied and vigorously enforced," this seems like something of which we'll be seeing more.
Only two more days until the SEC and the CFTC begin their "harmonization" meetings. Okay, again from the top - and Mary, in E this time.
Today brings a wealth of interesting items (and lots of video) from around the interweb. To wit:
From Advertising Age: Pfizer's PR chief wishes that government regulators would come up with some kind of Twitter policy, already.
From The Compliance Exchange: Ron Paul says that Barney Frank is going to allow a vote on a bill that would let the GAO audit the Fed's monetary policy! Also, YouTube video of Mary Schapiro talking about restoring the SEC's reputation.
From Compliance Week: a podcast (subscription required) about the SEC's proposal, in release 33-9052, to change the proxy rules with an eye to getting better disclosure about the "relationship of a company's overall compensation policies to risk." The proposal would seek to illuminate compensation policies that "can create inadvertent incentives for management ... to make decisions that significantly, and inappropriately, increase the company's risk."
Finally, from the Corporate Counsel Blog: a roundup of all the commentary on the Rakoff / Merrill / B of A proceedings.
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