We're in an Opacity Crisis

“The wise man bridges the gap by laying out the path by means of which he can get from where he is to where he wants to go.” 

-- John Pierpont Morgan

I’m giving a talk in Washington this week entitled “U.S. Bond Market Basics & Recent Events" - how timely.

I’ve been developing some thoughts about the regulation of fixed income markets.

Fixed income markets are very “murky” and the stability of the US and global financial system would benefit from an increase in transparency. Recently financial firms have been challenged to accurately price their mortgage backed securities and collateralized debt obligations. This has created a lack of confidence in the balance sheets of many firms.

Price transparency in fixed income markets would improve the ability of firms to mark assets to market, price transparency would protect investors, and enhanced disclosure would strengthen confidence in the health of institutions.

We are in an “opacity crisis” and we need more light.

I’ll leave unspoken the issues related to excessive levels of liquidity in the system and matters such as accounting rules and banking regulation.

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As a general premise I believe that financial markets must be overseen by a law enforcement agency (i.e. the SEC). I believe that it is necessary to have effective enforcement tools, like civil and criminal penalties, available to discipline market participants. 

I believe that the securities laws currently in place must be more rigorously enforced and possibly extended to other market participants (hedge funds).

Markets are very concentrated and a small number of financial institutions have inordinately large balance sheets and risk profiles. The failure of Lehman Brothers and the partial nationalization of AIG demonstrate how institutions “too big too fail” can destabilize the global financial system.

The failure of all these institutions is due to poor management and the lack of transparency. These firms collapsed in the “opacity crisis“.

The fixed income markets must have enhanced disclosure and price transparency.

The derivatives markets also should be made more transparent and regulated.

Lawmakers and regulators should examine the concentration of control in the fixed income, foreign exchange, commodity and derivative markets.

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The instability that comes from excessively concentrated prime brokerage activities (e.g. Bear, Lehman, Morgan Stanley (MS) and Goldman Sachs (GS)) must be reviewed. Prime brokerage activities were highly profitable in periods of excessive liquidity but expose highly leveraged prime brokers to significant risk in unstable market conditions.   

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I’m opposed to either the US Treasury or the Federal Reserve regulating financial markets. These organizations have never held this responsibility and I believe that their mandates should focus on issues related to fiscal and monetary policy.

I’m opposed to regulation which enshrines “market stability” as a central organizing premise. This would be an extension of approach that the Federal Reserve has taken in regard to their primary dealers.

The most obvious example of the failure of this approach was the multi-year attempt at coordination with the major dealers on a central clearing mechanism for credit default swaps. This effort went nowhere, and now the global financial system is severely destabilized as this asset class deflates.

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The investment banks and dealers do not value “market stability” over their own competitive and profit incentives… it’s folly to imagine any securities dealer would put an abstract value ahead of their bonuses, EPS or ranking in the league tables…

The elevation of “market stability” as a central regulatory premise would represent a landmark shift in our approach to regulating the securities markets.

The ‘33 and ‘34 Acts embody the principles of disclosure, transparency and the varied responsibilities that parties operating in the markets have towards each other.

Granting a regulatory entity the responsibility for “market stability” was not the focus of lawmaking in the aftermath of the Great Depression.

We can assume that Congress and the Roosevelt administration believed that financial markets would inherently regulate their own stability if they operated in an open and transparent manner.

If markets are going to regulate their own stability the truth is that some firms will fail through difficult parts of a credit cycle.

Markets naturally create successful and unsuccessful firms and the failure of Bear Stearns, Lehman Brothers, and AIG can be considered ordinary, although difficult, market events.

These firms' counterparties and creditors acted on their belief that the firms were over-leveraged and unstable.

The counterparties sought additional collateral or compensation for the risk of transacting or in many instances “backed away” from lending and trading which they had formerly engaged in. Prime brokerage clients moved their accounts en masse from the unstable firms.

Bear’s, Lehman’s and AIG’s counterparties, who trade and lend to the firms on a daily basis, were in the best position to judge their stability.

The firms’ counterparties were in a much closer relationship to judge the creditworthiness and stability than a regulator who operates on secondary and delayed information.

No regulatory structure can eliminate the possibility of a financial firm failing. Commercial banks fail on a regular basis. Because financial firms innovate and concentrate risk there will always be firms which collapse.

The regulation of financial markets must continue to focus on ensuring disclosure, transparency and the protection of investors.

Recommendations for additional regulation of the fixed income markets:

• Expand the TRACE trade reporting system to incorporate all cash fixed income securities.

TRACE has made an outstanding contribution to increasing price discovery in the corporate bond market. This price dissemination system should be expanded to include all cash fixed income securities traded OTC or on an exchange. Securities to incorporate include Treasuries, MBS, repo, agencies, structured finance products and money market instruments.

• Open source the CUSIP nomenclature system.

The CUSIP system should be made into an open source system. This will be the foundation for the development of a vast body of information and disclosure for fixed income securities. 

• Expand “equivalent disclosure” to all asset classes rated by NRSROs.

All issuers of securities rated by Nationally Recognized Statistical Rating Organizations should be required to share non-public information with all NRSROs not just those compensated to rate the issue. For example, Lehman Brothers and AIG should have provided non-public information to all NRSROs rather than the few they compensated. The SEC should examine whether Lehman and AIG were “ratings shopping” leading up to their failures.

• Require public entities to maintain a public XBRL file detailing their outstanding securities and where these are traded (exchange, ATS or OTC).

All entities issuing public securities should file detailed disclosure with the SEC outlining all securities outstanding and the exchanges, ATS, ECN or OTC markets on which the filing company has securities. This would give market participants the information to assess the full capital structure and risk profile of the issuing entity. With this level of disclosure it would be possible to assess the liquidity of an issuer's securities. This would provide critical information to market participants.

• Create a facility for retail investors to purchase Treasury securities from the Federal Reserve.

The Treasury Department, through the Federal Reserve, should make Treasury securities available for sale and purchase on an ongoing and regular basis to retail investors similar to their sales to primary dealers.

• Develop more oversight and transparency for all trading venues (ATS, OTC, crossing networks).

The SEC should require more disclosure of the various alternative trading systems, over-the-counter liquidity platforms and crossing networks. Access to these platforms should be made more universal. Trading venues should publish liquidity statistics for securities traded.

• Require all cash and derivative products to trade and clear through central utilities.

An integrated multilateral trading and clearing model will offer the best route to improved risk management and enhanced efficiency for all participants in the credit derivatives market and also for the underlying companies on which credit derivatives are based.

Additionally this will offer regulators the immediate information and transparency they need to prevent fraud, manipulation and market abuse. 

These central utilities will greatly reduce significant information asymmetries in the credit markets and protect the broader financial markets against systemic risk.

• Repeal the Tower amendment to improve municipal disclosure

A recent study says about 25% of municipal issuers are chronically delinquent in filing their disclosure documents.  The Congress should consider means of enhancing disclosure. Information flow is vital for healthy markets and the protection of investors.

Stock position: None.

Comments

[venividivici:]

It all sounds good but all this enhanced regulation won't make any difference at all if the people you put in charge simply do not do their job.
What you find is that the smartest people out there are invariably engaged in finding ways to get around or exploit whatever regulatlions are put in place. And often the people who have been engaged in administering the regulations leave for the big money available on the other side of the fence to assist in this process.

2008 Oct 12 07:38 AM

[AnonymousAlso:]

Maybe the SEC should make a bunch of their regulation that is voluntary – required? Like the oversight of investment banks was? Like the oversight of NASDAQ is? They just have been too busy to write the rule.

Isn’t the Treasury Direct programming a way for retail investors to purchase Treasuries?

Require all derivative products to trade thru a central exchange after a product has reached a certain size. For instance say $100 billion in notional size would have bought the CDS under supervision in 1998-1999. (When this was first discussed but various federal agencies couldn’t decide who should do it.)

2008 Oct 12 08:43 AM

[AlexS:]

I think a lot of this problem was that whatever regulations were in force were overshadowed by the political goal to allow many more lower income people to own their own homes, which here meant lowering standards for lending. Standards are standards for a reason but in this case there was a paradigm shift to say that such standards were obsolete. A large membership of Congress backed that shift. Regulators are very sensitive to this - they don't want to be hauled in front of some Congressional committee and asked why they are standing in the way of more housing for the poor. So they went along, as they usually will.

2008 Oct 12 10:03 AM

[TheBookkeeper:]

Hi Cate,
All that you hope to see in the way of transparency and control will return when business entities of every description return to a proper double-entry bookkeeping framework of rules. Such rules were customarily used by all business entities prior to computer software. The proper framework was never programmed into software. It will soon have to be because there is no other framework of rules that will get the present cultural collapse back on track and subject to the return to a constitutional government. The 650 year old double entry bookkeeping framework of rules supervised commercial trade since the middle ages. It is not only the de facto language of commercial trade. It is the only language of commercial trade.

If you wish to put my words to a test, find the best accountant you know. Ask him or her to define a debit versus a credit. Send me their answer and I will send you the proper definition. You will be quite surprised to learn how little accountants know about the double-entry framework of rules.

2008 Oct 12 11:43 AM

[short WFC:]

I agree with most of it, just want to add the dire requirement for broad, and strong accountability enforced at top level administrators of gov , GSE and private entities.

no accountability=no long term success of policy.

2nd point is that governements role in breakig up provate monopoly shold be expanded to include 'too big to fail' organizations.

these two ideas if strongly enforced will go a long way to protect stability, economic policy, and taxpayers

2008 Oct 12 02:05 PM

[Moon Kil Woong:]

100% right on. If you want trust you must be transparent. The SEC over the weekend just did the opposite allowing banks to give any value they want to illiquid securities. I assume this is to prevent the valuation of Lehman's CDS contracts at $0.10 from triggering an accounting event that would make every large bank bankrupt. However, given that fact, I can't see why anyone should want to lend to them. It's a black box again but everyone saw the monster inside.

Ny own suggestion is to let all the banks go bankrupt as new ones that don't have CDS contracts or other risky trash spring up. It may take 10 years but that seems faster than letting the existing banks suck every last asset out of the US to pay for their losses over 30 years.

2008 Oct 13 12:39 AM