Posted tagged ‘disclosure’

Tips for a New Regulatory Structure

September 19, 2008

Since the candidates are making such a fuss about all these recent issues, and especially calling for more regulation, here are some helpful hints to ensure we all benefit…

1. Organize your regulatory structure like financial institutions organize their businesses. For example, instead of the C.F.T.C., M.S.R.B., N.A.S.D., and exchanges all regulating various parts of the financial infrastructure, build an overarching financial regulatory agency (you can even call it that, the F.R.A., I won’t charge you a quarter to use it each time). Have a division for banks and a division for broker dealers. In the division for broker dealers have the departments that oversee mergers and acquisitions, issuance of debt and equity, and trading in distinct units. Then, within each, subdivide it further–futures trading, exchanges, fixed income trading, etc. This is how firms organize their businesses. When a transaction crosses multiple areas, in the same way an investment bank would bring in multiple people “up the food chain” regulators can mimic that same structure and bring in people with similiar experience and oversight responsibilities.

A part of this is to merge banking oversight with broker-dealer oversight. This is because soon there will be no more standalone broker dealers… Ok, I’m kind of kidding… or am I? Another reason for this change is that, the same way large firms unite their operations and inter-weave their market activities, banks and broker dealers have become much more inter-connected. Let’s be honest, the average bank is less likely to be stable if it has a broker dealer that is massively leveraged and buying risky securities. Need an example? How about looking at Citi vs. J.P. Morgan Chase? Or E*Trade bank versus Commerce Bank?

2. Don’t let financial institutions lobby. Simple, right? Hank Paulson immediately put his boot on the throat of the Fannie and Freddy lobbying machine when bailing them out. Simple! With all the terrible things being said about lobbysists this cycle, you wouldn’t know politicians were running–so I’m sure there will be support for this kind of reform. Also, all things being equal, the average American is left worse off by lobbyists (hence the “reform” candidates all rail against lobbyists). Sadly, even the institutions the lobbysist were lobbying on behalf of seem to be in a situation where they would be better off had they not gotten what their lobbyists were lobbying for… Whew!

However, it must be difficult for a congressman to pass a law stopping a corporation from lobbying. It might even be illegal… not sure, I’m no lawyer. What I do know, however, is that if the governement decides to have their resources used to facilitate business for institutions, one could probably make the cessation of lobbying a condition. Would you rather put your money in an F.D.I.C. insured bank? Would you rather your bank could borrow at the discount window? Special tax breaks for profitable business lines? All these things should require the institution in question doesn’t lobby for, say, five years. I bet banks can get themselves into trouble often enough that, if they ask for help each time, a five year cessation of lobbying or hiring lobbyists will mean no more lobbying. Want to increase your leverage by borrowing freely from any of the Fed’s various sources of money? No lobbying.

3. Increase capital requirements for financial institutions. Make very strict rules for what counts as capital and how regulated ratios are determined. For example, perhaps holding Goodwill against sub-prime–backed C.D.O. squared’s isn’t the way to go. Or, maybe, allowing banks to book earnings from their credit deteriorating isn’t the way to go either. Suggesting that capital be better defined and more plentiful shouldn’t be a shock… this crisis of capital, with institutions begging investors to buy equity, is an issue with banks, capitalized as required, not having enough capital and failing (banks being used broadly). Lowering leverage lowers raises the economic margin of error. While lots of people will argue that an over-levered instution that invests in risky securities deserves to fail, why not avoid the over-levered institution that invests in risky securities in the first place? Actually, stop listening to me… Instead, for this, listen to The Deal Professor:

Lesson 4: Sometimes, You Can Only Raise Capital When You Don’t Need It

Lehman issued $4 billion in preferred stock in April — the share offering was oversubscribed. Even then, though, people whispered that the capital raise was a sign of weakness, reflecting Lehman’s anemic balance sheet. This paradox helped bring about the death of both Bear and Lehman: They needed capital, but raising it only made people more concerned about their state.

It is a Catch-22 for which we have yet to find a solution. And that is why, even to the bitter end, Lehman didn’t access the Federal Reserve’s emergency loan facility. If it had, everyone would have assumed it was in trouble.

The whole conundrum supports raising the capital reserve levels for investment banks. Ultimately, Lehman, Bear, Merrill and their balance sheets couldn’t stand the predicament

(Emphasis mine.)

See? Much more eloquent than I was…

4. Disclosure. One simple word. Require a lot more disclosure. How about setting well-defined scenarios that must appear and be spelled out in annual and quarterly filings? Report more sensitivities, using standard methods that are also disclosed, of assets to model parameters or market changes. If, for example, each investment bank was required to tell investors how their balance sheet would look if defaults ticked up to “5 CDR for life” there would be a lot less trouble today.

Also, force diclosures to occur more frequently. Make banks release some key metrics every Friday, for example. Having a 45-day delayed disclosure that is a snapshot from the last day of a 90-day period is completely ridiculous. We have computers now. One needen’t get out their abacus and punch cards to figure out earnings for a given period. Stop “month-end” dressing up of the balance sheet by requiring more frequent disclosure. Require banks to disclose maximums from the past x days. This way, if a bank tries to shrink it’s balance sheet purely to look like it’s done so, so that it can diclose soemthing that “looks better,” it will show up. Hiding information from shareholders or whomever else reads filings is not just troublesome, it shouldn’t be allowed.

These are just some of my random thoughts. I’m not sure they have merit, except where they are quoted from others. I’m no regulator, but if the next president needs and S.E.C. chairman, I suppose I can make myself available…

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Disclosure? I Call B.S.

August 20, 2008

Disclosure and financial filings seem to be topical today with the S.E.C. announcing the Investment Banking Analyst Mercy Initiative. So, I’ll play ball. I have read a bunch of things recently making claims about the ability of a diligent investor to know what they are “getting into” and what the risks are for investing in a public company that has disclosure requirements. Actually, I haven’t been doing this for decades, so let’s quote someone that has… Tom Brown:

No one, inside or outside the company, could accurately predict what … ultimate losses would be. But what they could do—and what financial services investors can do now, regarding the banks in general–is make reasonable estimates of ranges of losses, and estimate companies’ future earnings power, then compare that to their market values.

(emphasis mine).

I emailed Tom to clarify a few thing, but never heard back. So, as I am prone to do, I’ll assume I’m correct in my interpretation and move on. I’m assuming that this was also the case in the past–how else would people be able to buy into a financial institution in the past if Tom didn’t think his words were just as true two to three years ago? (Nothing has really changed in disclosure requirements, right?) Surely, in the past, the issue would have been taking a view on the performance of the various financial institutions’ assets as well.

I looked at three firms’ disclosure, from 2006, related to C.D.O.’s … what I could find. Now, in the interest of full disclosure, I’m not trained to do this. I’m just a person, with some financial experience, looking at some S.E.C. filings. I knew i was looking for C.D.O. exposure, especially in the context of figuring out what banks would need to be responsible for if the market had a severe dislocation. Let me explain what I mean by this. Remember all the liquidity put chatter? While mostly related to S.I.V.’s, this is still a relevant concept for C.D.O.’s. As in any syndicated deal, most common for selling bond or stock offerings related to corporations but also relevant for securitized products, when an investment bank agrees to do a securitization they have most likely (call it 80+% of the time) agreed to “take down” or purchase the securities they are unable to sell to investors. Easy enough, right? Those assets are what has generated a huge amount of writedowns. It’s very easy to see the relationship between market share in the C.D.O. and securitized products space and magnitude of writedowns.

These relationships, however, are very complex. Multiple investment banks could be selling an individual deal and each could be responsible for purchasing different parts or different percentages of leftover securitizations. These are individually negotiated for each transaction. As a firm is building up assets (for example, sub-prime mortgage-backed securities), before they have enough to actually securitize and create a C.D.O., the bank/investment bank could have all the risk of those assets losing value or defaulting–if the C.D.O. doesn’t get done then it becomes a big problem. It’s also a big difference what types of assets or structures make up the C.D.O. securities. One sees the problem growing. There is a lot of information that needs to be processed to come up with a reasonable estimation of losses. I would claim that it is completely insufficient for a bank, as they have been, to disclose exposures once they start to become a problem.

So, what did I find? Terrible disclosure. I was able to find almost no information. Certainly no information that would have helped come up with an estimate for losses from these firms based in any sort of logic or fact. Now, I’m not saying one should be suspect of current disclosure–I don’t know what is next to blow up or cause big problems and none of these firms are run by the same regime that decided the previous level of disclosure. What I am saying is that I wouldn’t have been able, even if I had known exactly what was going to happen, to know the magnitude of the losses.

First, I looked at Citi. Citi had a notion of participating or structuring. Those numbers were combined and reported together. This helps to determine market share, perhaps. This does nothing to disclose the risk on the balance sheet. This number ($110 billion) could be made up entirely of bonds were Citi is at risk. It could also be entirely made up of bonds where Citi has no risk and is taking fees. There is nothing I found in the 10-K’s to say anything more helpful. So we know losses, if these C.D.O.’s (named V.I.E. or Variable Interest Entities in the disclosure) were sold at 22 cents on the dollar, as Merrill reportedly did, the losses would have been between zero and $86 billion. Whew! Nailed it down… Now, knowing that, do you buy or sell Citi’s stock?

Second, I looked at Merrill. They state some numbers and then footnote saying they might, potentially, hold a financial interest in some of the securitizations. Same situation as Citi. No disclosure as to what kinds of bonds these are. How much was retained? How much in financing obligations exist related to these? What percentage would have had to be retained by Merrill if unsold?

Last I looked at Bear’s filing. Bear was a slight improvement. They actually stated some of what they retained and have some exposure numbers which one could back out some other information from. Still, if I was modeling the losses I would be asking for a lot more information–while an improvement, in my opinion, it wasn’t enough.

Below are the tables from the various filings. Also, if one was looking for C.D.O.’s, I put the number of instances the term of interest appeared.

Now, since the S.E.C. is mandating and revamping filings and disclosure, perhaps they can do something about this. Maybe financial firms should be forced to disclose risk numbers and sensitivities. I certainly don’t have all the answers, but I think it’s pretty clear that no one had the answers, nor did they have the specific questions, before this crisis occurred.

From the Citi 10-K (2006):

Mentions of the word C.D.O. : Thirteen (lucky!)

From Merrill’s 10-K (2006):

Mentions of the word C.D.O. : Zero

From Bear’s 10-K (2006):

Mentions of the word C.D.O. : Eight