The Financial Crisis II: Everything Old is New Again

The Pennsylvania family I mentioned in my last post can add to their accomplishments causing a constitutional crisis in Canada, nearly wiping out the North American auto industry and prompting a purportedly conservative U.S. government to effectively nationalize many companies. On the bright side, it seems they also caused Bernie Madoff's alleged record-breaking fraud to be exposed.

The crisis has also triggered regulatory responses. Some of these were taken from playbooks of yesteryear, such as imposing restrictions on short sales. Some were the opposite of actions taken in the past; the Glass-Steagall Act was passed in 1933 mandating the separation of banking functions so that customer deposits could not be put at risk by investment banking activities. This year, the remaining independent investment banks were allowed to become bank holding companies, shoring up their capital base in return for greater government prudential oversight.

The finger-pointing has already begun, with an unseemly rush by regulators to blame other regulators for the fallout. The Federal Reserve argues it didn't have the authority to prevent the collapse of Lehman Brothers, while the SEC argues its mandate is investor protection, not prudential regulation. It is clear that at least two significant gaps are in the regulatory regime. There are significant transactions taking place in a completely opaque, unregulated environment. To make matters worse, no single regulator could see the potential impact of these transactions on regulated entities.

The Overall Regime

How these will be addressed is far from certain, but I will venture a few predictions. The first is that the regulatory regime in the United States will be overhauled (there is less need of a comprehensive overhaul in Canada). Regulation of derivative trading has traditionally had a light touch (except for a ban on trading onion futures) on the basis that everyone in the market was a sophisticated player. Clearly, they are not sophisticated enough. Therefore, I predict that the coming year will see more comprehensive regulation of option, futures and insurance contracts, possibly with a requirement to clear all over-the-counter trades through a new central clearing house that would establish maximum risk parameters. There may be a merger of the SEC and the CFTC, but more effective would be a single prudential regulator overseeing the financial health of banks, broker dealers and insurance companies. This will be coupled with greater financial disclosure requirements and stringent requirements to stress test various potential scenarios regardless of their likelihood.

This will create a tension as prudential and traditional securities regulation will sometimes be at cross-purposes. If a bank is experiencing difficulty, a prudential regulator may want it kept quiet to avoid a run on the bank while it attempts to shore up its capital. A securities regulator would insist on immediate disclosure.

In Canada, the banks and brokerages are in much better condition, perhaps because of greater conservatism. That being said, the crisis should bolster the call for a single national regulator that will have jurisdiction over the entire brokerage industry.

The crisis should also provide a stimulus for harmonization of international bankruptcy rules regarding things such as set-off rights.

Other Regulatory Responses

I will state for the record that I am unconvinced that the restrictions on short selling are necessary. I have seen nothing that convinces me that short sales have exacerbated the downward spiral of the markets, and removing exemptions for market makers will only hinder their ability to smooth-out price swings. That being said, the position of regulators world-wide appears to be entrenched and I doubt we will see any easing of restrictions on short sales any time soon.

We will probably also see a clamp-down on sales practices and not just in the brokerage industry. In Canada and the United States, selling asset-backed securities on the basis that they are as safe as houses has tied up a lot of people's savings indefinitely, and predatory mortgage lending in the U.S. has rendered houses considerably less safe. We can probably expect a tightening up of exempt transactions along with more detailed and focused risk disclosure requirements.

In Canada, sales of asset-backed securities were exempt if the securities had a credit rating. Credit rating practices have been called into question, and we can expect to see credit rating agencies subject to greater regulation and possibly self-regulation.

We may also see new financial certification coupled with stress testing requirements for public companies. This may be counterproductive; arguably one of the causes of the current mess is that the Sarbanes Oxley Act has forced management to focus on the wrong things.

The Financial Crisis I: It's the Governance, Stupid!

We are seeing the butterfly effect writ large: a family in suburban Pittsburgh can't pay their mortgage, so Iceland goes bankrupt. Or perhaps a better analogy is the 1970s PBS show Connections, where James Burke showed how new inventions are based on older ones (and we wouldn't have modern telecommunications if the Normans hadn't worn stirrups at the Battle of Hastings).

Much has been written about the failure of legislators and regulators, and in a subsequent post I'll be playing pundit and make fearless predictions about regulatory responses. But in this post, I want to look at the failure of governance.

All Risk, No Reward

The current recession/depression (call it what you will) came about largely because there were incentives to take huge risks with very little apparent downside.

People bought houses they wouldn't be able to afford when their mortgage interest rate reset because they were told that they would have no trouble refinancing at a more attractive rate when the time came.

Mortgages were packaged and resold to investors, including banks. Normally, this would be a prudent thing, as having a large portfolio of mortgages should mean that most of them are sound and the few that will fail won't have a material impact on the value of the portfolio. What happened was anything but prudent: Because the lenders no longer owned the mortgage (and the risk of default), they were encouraged to lend to everyone in sight, whether or not they were creditworthy. In a recent article in the New York Times, Gretchen Morgenson reports that a mortgage loan underwriter at Washington Mutual was put under intense pressure to approve loans she strongly believed should be turned down.

Companies made investments in complex derivatives. Again, this could be a prudent move, as derivatives can be used to offset risk. However, many companies used derivatives to increase their risk. Although they potentially had good returns, they also had a huge downside risk. In part this was due to the decoupling of compensation from performance and lack of effective board oversight. Executives got substantial bonuses even though the company's stock performed badly. In a worst-case scenario they would be fired and collect huge golden parachute severances.

The net result is a financial crisis that is engulfing companies with exemplary governance practices. The gut response is to take a very cautious attitude and attempt to eliminate all risk. This is neither desirable nor practical. Things will get worse if there is no credit for worthy borrowers. Derivatives, even complex ones, can be an important tool to mitigate risk if used properly.

What to Do? What to Do?

The problem for boards, and audit committees in particular, is how to tell if a financial product is being used properly. This can be daunting when the investment is so complex you need postdoctoral studies in mathematics to understand them. That doesn’t mean they should be necessarily avoided, but they must be carefully scrutinized.

That said, what is a poor audit committee member to do? My advice is simple: don’t be afraid to look stupid. Keep asking questions. It is not necessary that you fully understand the product, but you need to satisfy yourself that management does. Ask questions such as:

• What is the maximum downside if everything that can possibly go wrong happens? Don’t accept an answer that a worst-case scenario will never happen. We’ve just seen that it does. If the worst-case scenario is insolvency, the product should either be avoided entirely or only a small investment made.


• What other individual factors can affect performance? In other words, what is the total risk involved and is it justified by the return.


• How is the risk being monitored? The more significant the risk, the more closely it must be managed. This may mean real-time risk management.


• What are the market signals that will indicate a position should be unwound? How easily can that be done? What if there is no liquidity in the market at that time?
  

These are just a few of many questions. If answers are evasive or unclear, it may either indicate that management knows the position has more risk than the board will be comfortable with or that they don’t fully understand the risks themselves. To turn an old cliché on its head, in these cases it is far better to speak up and be thought stupid than to remain silent and remove all doubt when the company goes under.