Tag Archives: economic crisis

Regulating Capital: the information challenge

stock market

During the financial crisis regulators discovered the hard way how little they knew about the risky derivatives portfolios built up by large financial institutions. Lehman Brothers, for example, was thought to have been a counterparty to about $5 trillion of credit default swaps. When they turned sour in 2008, it brought the financial system to its knees. In response leaders of the world’s main economies demanded in 2009 that derivatives deals should all be reported to “trade repositories”—vast central databases—to make it easier to identify and then reduce systemic risks.

On February 12th, 2014 European rules came into force requiring the reporting of all derivatives to one of six approved repositories. Similar rules have already been in place in America for about a year. But the effort, although concerted, is not consistent: the American and European reforms differ, making awkward transactions spanning the two jurisdictions. Moreover, even if these data can be reconciled, it is not clear what regulators will do with it.

The American regulations allow the reporting to be taken care of by one party to the trade. Yet Europe requires both parties to report. That means every fund manager or corporate treasurer trading derivatives has had to follow cumbersome rules, not just the banks that peddle most deals.  Getting both sides to report was originally seen as a means to ensure that every entity’s exposure could be rigorously monitored. But the complexities of obliging both parties to report trades, which then have to be reconciled with one another, have led many to question whether the additional burden is really worthwhile. “Dual reporting was required to avoid omissions in the data,” says Stewart Macbeth of the Depository Trust & Clearing Corporation, one of the approved repositories. But it “captures a lot of companies in the real economy that probably do not pose a systemic risk”.

The European rules differ from the American ones in other ways too. America staggered implementation of its rules over the course of several months as different sorts of contracts and counterparties were gradually brought within their scope. European regulators chose instead to have everyone start reporting everything on a single day. That created a bottleneck as participants rushed to put the necessary procedures and agreements in place.

Now that the deadline has passed, responsibility shifts to regulators, whose duty it will be to make sense of the torrents of data that are now flooding in. In America the Commodity Futures Trading Commission has openly acknowledged the problems it has already encountered coping with the deluge, with one commissioner blaming “inconsistencies and errors” in the rules. In Europe the problems are likely to be even worse as so many more counterparties are reporting data to multiple repositories. That will create an unfortunate opportunity for both omissions and duplications of data. In time the new reporting rules should reduce risks, but much work still needs to be done.

A paper published on February 4th by the Financial Stability Board (FSB) offers a solution. It proposes aggregating data from multiple repositories into one central one. That may iron out inconsistencies in the data—but it will not necessarily make it any more digestible.

Derivatives:  Data dump, Economist, Feb. 22, 2013, at 65

Rating Agencies on Fire

The ruling in the Federal Court of Australia on November 5th held Standard & Poor’s (S&P) jointly liable with ABN AMRO, a bank, for the losses suffered by local councils that had invested in credit derivatives that were designed to pay a high rate of interest yet were also meant to be very safe. The derivatives in question were “constant proportion debt obligations” (CPDOs). These instruments make even the most ardent fans of complex financial engineering blush: they are designed to add leverage when they take losses in order to make up the shortfall. S&P’s models, which the court said blindly adopted inputs provided by ABN AMRO, gave the notes a AAA rating, judging they had about as much chance of going bust as the American government.

S&P denies that its ratings were inappropriate, and plans to appeal. But evidence before the court suggests a world of harried analysts being outsmarted by spivvy bankers. It also indicated a disturbing lack of curiosity by S&P analysts and a desire to cover up for the firm’s failings even when they fretted about a “crisis in CPDO land” and worried that some buyers of these products were “in no hurry to stay in front of the truck”. Instead of warning investors that it had made mistakes, the court found that the firm continued to provide glowing opinions on new CPDOs coming out of the ABN AMRO factory.  There is nothing in the ruling to suggest the shoddy behaviour that took place in this instance was widespread across the firm. It would be a mistake to attribute all ratings that subsequently turn out to be wrong to negligence. Making predictions is hard, as Yogi Berra, a famously quotable baseball player, noted, especially when they are about the future.

But the Australian case does challenge a central part of the defence proffered by S&P and other ratings agencies (Moody’s and Fitch are the other two big ones) in some 40 ongoing cases worldwide alleging negligence. They argue that ratings are merely opinions and protected by constitutional safeguards on free speech, and that only imprudent investors would take decisions solely based on them.  This defence has already worked in a number of high-profile cases in America. Investment analysts and lawyers reckon that there is no sign that courts elsewhere are likely to follow the Australian ruling; it may not even survive the appeal. But the reasoning in the Australian case is persuasive. The judge argued that agencies could not wash their hands of all responsibility if investors took their ratings at face value and then lost money. “The issuer of the product is willing to pay for the rating not because it may be used by participants and others interested in financial markets for a whole range of purposes but because the rating will be highly material to the decision of potential investors to invest or not,” the judge wrote.

The tendency of investors to rely on ratings is reinforced by the privileged access that agencies have to information about issuers. The agencies’ defence that theirs is just an opinion wears thin when, having looked under the hood and kicked the tyres, they then tell investors to make up their own mind from a distance. It would help if regulators forced issuers of bonds and other rated securities to provide more public information. That would allow investors to do more of their own due diligence and enable more competition between agencies to provide the best analysis to investors rather than the best service to issuers.

Ratings agencies: Crisis in ratings land?, Economist, Nov. 10, at 74

__________________________________________________________

Italian prosecutors filed suit against five former employees of Standard and Poor’s (S&P) and two former employees of Fitch [corporate websites] for allegedly manipulating the market and abusing privileged information that led to the rating agencies’ downgrades of Italy. Though magistrates in Rome and Milan have refused to support the claim, prosecutors from the southern town of Trani contend that the agencies failed to respect European rules of transparency.-