Tag Archives: Financial Regulation

A Case of Regulatory Capture: OTS deconstructed

30 Jul

The Office of Thrift Supervision: A case of Regulatory Capture

Created with fan fare and removed with disdain, the Office of Thrift Supervision ceased to exist after 22 years of existence. President George Bush Sr. signed the law which created the OTS  in the wake of the Savings and Loan disaster of the 80s and the failure of their previous regulator, the Federal Home Loan Bank Board (FHLB).  In typical congressional action, the OTS staff have been absorbed into the FDIC, OCC, Federal Reserve Board and FHFA.  Like OTS, FHLB didn’t actually go away until it was merged with the Office of Federal Housing Enterprise Oversight (OFHEO) to create Federal Housing Finance Agency (FHFA). The OTS represents how legislative good intentions and economic incentives led a regulator to become a slave to the industry.

Former OTS Building

Letters removed after 22 years

The Savings and Loan business model was to  fund on the short end of the curve (through CDs) and buy assets on the long end. As long as the curve doesn’t invert, they made great money. As long as members kept buying CDs and their long dated commercial loans kept paying, money grew on trees. Even the politicians were involved to make sure the business continued without government interference. Let’s not forget the Keating 5 (which included Deer-in-the-Headlights Senator John McCain). As students of financial history know, the curve inverted, commercial loans stopped paying and short end funding costs soared.

President Bush Sr said “never again will America allow any insured institution operate without enough money” when signed the law which created the OTS. (I guess Jr missed that speech.) Since the GOP doesn’t believe in requiring taxpayers to be taxed for anything (except military based activities), the OTS was funded by a tax on the very institutions they regulated based on the size of company’s assets. Hence, OTS could hire more examiners, have nicer office furniture, and increased regulatory prestige if they could grow their portfolio of regulatees. Initially, the first real leader of the OTS, T. Timothy Ryan (now running the Wall Street lobbying group SIFMA), shut down thrifts and OTS suffered as they lost “clients”.

In the mid 1990s, OTS management, especially OTS Director James Gilleran, made a concerted effort to market themselves as the easier softer regulator. He even brought a chainsaw to a Thrift industry event. Just imagine what their marketing must have been like:

“Capital requirements got you down? We will beat any other regulator’s requirements by 50 bps!”

“No interest rate or credit risk model capabilities? No problem! At the OTS you can use ours!

“Our regulators await your call! Free up capital for those BBB CDOs you want to buy NOW!”

Countrywide and others headed their call. In 2005, Countrywide switched their charter and became a Thrift. At the same time both EMC (a Bear Stearns mortgage originating sub) and Lehman Brothers’s mortgage unit also became Thrifts. OTS staff nearly doubled by the time the economic crisis hit. When Countrywide spun off IndyMac, guess which regulator they chose? OTS of course! Ka-Ching!

As early as 2003, mid level OTS examiners starting finding major issues with thrifts like IndyMac, Countrywide, EMC, AIG and WashingtonMutual and raised them to senior management. These earnest folk actually wanted to reign in these thrifts to protect them.  These examiners were no match for the Thrift lobbyists and incompetence of senior management.  Even the FDIC couldn’t get past OTS management to protect “their” thrifts.

At the end of the day, OTS was doomed from the start due to its mission and economic incentives. It’s a model for how not to set up a financial regulator. OTS’s failures are well known and thousands of pages of text have been written about it. Regulators are supposed to be the last line of defense when financial institution management goes off the deep end and OTS just furthered their insanity. OTS had lost its way.

In the same vein, assuming the Consumer Finance Protection Board ever gets off the ground (and in a twist of irony are moving into OTS’s old offices) they too will be captured by the industry (and the lobbyists) they are supposed to regulate if incentives are misaligned and independence isn’t protected. (Which may not be a bad thing if you a member of the Banking Lobby).

Further Reading on this topic:

Requiem For A Regulator

 

Senate Financial Crisis Report (161-242)

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The Securities and Exchange Commission of La Mancha

14 Jul

I’ve long been a critic of the ridiculous regime created by NRSRO legislation, that is, the Rating Agencies, or really, S&P, Moody’s, and Fitch.  There are so many problems from top to bottom, left to right that I’m not even going to begin to list them here.  I will, however, quote what I think is a rather eloquent description of the core problem from a man far smarter than I: David Rowe in a post he wrote on the Kamakura Corporation blog (emphasis mine, as usual).

Currently, the US Securities and Exchange Commission (SEC) is soliciting comments on various proposals to reform the institutional framework of credit ratings. The supervisor wants to ensure effective ratings, as if there is some objective truth that can be discovered as long as the right incentives are in place. In fact, when dealing with innovative, highly complex and historically untested structures, no such objective truth exists. The perceived credit quality of such instruments can be as diverse as views on whether a given company’s shares are a buy or a sell. Imposing a one-size-fits-all rating scheme risks unrealistically homogenising market perceptions that should be highly diverse if adequate information for detailed analysis was widely available. Furthermore, it is just such homogenised perceptions that can lead to herd behaviour and major market dislocations when broadly shared expectations prove to be unfounded.

Trying to reform market structure in search of a non-existent objective measure of credit quality and associated risk amounts to a mission impossible. It is bound to bureaucratise and homogenise ratings, thereby creating an inflexible structure that is vulnerable to a systemic crisis. In fairness, the SEC is only doing what was mandated by the US Congress. Nevertheless, what should be done is to seek a framework that will make all the relevant data underlying such securities readily available in a standard format to a broad community of analysts.

Attacking the independence and objectivity of the ratings agencies due to their business model is easy, but it largely ignores the deeper problem Rowe describes above.  The ratings agency approach to credit analysis is inherently and impossibly broken, and efforts to reform it merely amount to tilting at windmills.

However, while hardly perfect – far from it – I think the equity model and the equity-research-centric approach currently adopted by the SEC would be largely instructive for how to reform the credit research industry.  A not insignificant amount of the information needed to analyze a firm’s credits is already included in the filings publicly-traded firms already make to the SEC.  Why not align the reporting requirements for debt and equity issuers?  Why not incentivize a movement to democratize the credit market just as the equity market was over the past 30 or so years?  Seeds of revolution (or rebellion, depending on your perspective) have long-since been planted with exchange-traded hybrid securities, ETNs, and a myriad of other products and services.

I realize the Herculean (if not downright Sisyphean) effort facing regulators with their current responsibilities from Dodd-Frank, but why not kill several giant birds with one stone instead of ignoring keeping the blinders on until the next inevitable crisis?

Why Levered ETFs Don’t Need to Be Banned

1 May

Felix Salmon wrote a post today in response to both my, and Kid Dynamite’s posts in response to his original post, wherein he said the SEC needs to do more to protect retail investors from blowing themselves up with levered ETFs.  I certainly appreciate the open debate (and I hope our readers do as well!), but it seems like Felix is still missing a few things, and making a few factual leaps of faith, which I’d like to discuss here.

He begins by asking how laymen could possibly understand these securities if an (apparently, I’m not familiar  with the gent mentioned) qualified financial journalist doesn’t understand how they ETF’s work:

Except, if you go back a month to when KD last wrote about these things, you’ll find him linking to a column by Dave Kansas — the founding editor of thestreet.com, and about as veteran and admired a markets journalist as it’s possible to find. And he got it wrong, as the correction at the bottom of the column attests.

I’ve read the article, wherein the author said:

Conversely, the ProShares UltraShort S&P 500 (SDS), which makes a double bet against the S&P 500, is down 40% in the past year, which compares to a 13% gain for the S&P 500. That means the “double” bet against the index is doing worse than promised, highlighting another risk for such funds: They often fail to track their stated performance goals.

As the correction added after publication (almost) admits, this is an egregious mistake if it was made honestly, and a gross misstatement if not.  Either way, I can’t find any way to excuse such ignorance from the WSJ, The Financial Paper of Record, even with the correction.  Everyone makes mistakes, of course, but this isn’t some casual blog post, or tweet; its THE Wall Street Journal!  Perhaps (some) financial journalists should check with their sources and/or take a few more minutes to learn about what they’re writing before they hit the “publish” button, but that’s neither here nor there…

As both KD and I have explained, the sponsors of these ETFs go to significant lengths to explain they are designed to target 2 or 3x the DAILY return of the index, therefore, comparing returns of the ETF and the index on a longer time period is at best, apples and oranges.   Felix continues:

My point here is that if you want to find out how easy and obvious something is, you don’t first look for someone who understands it and then ask them whether understanding it is easy. Instead, you look at a broad audience of people who ought to understand it, and look to see what percentage of them actually do.

While I agree that you don’t ask your friend who’s a Quantum Physicist to explain how easy classical physics is to understand, if we look at the “broad audience of people who ought to understand it” that Felix mentions, they should, in fact, be able to understand concepts that could be the basis for questions on the TV show “Are You Smarter Than A Fifth Grader?”  If adults with brokerage accounts who can get the approval I mentioned in my last post from their broker to buy levered ETF’s (which usually requires a relatively substantial amount of money and long-ish relationship) can’t understand arithmetic, then we have a MUCH bigger problem to discuss than whether levered ETFs are or are not a good idea!

Felix’s next non-sequitur is equally confusion:

And if you look at the people who are investing in TBT, it’s clear that the vast majority of them do not understand how it works. For all that there are prominent disclaimers in the abbreviated summary prospectus about such things, those disclaimers are not preventing people from making long-term investments in a security which should never be held for longer than one day. They’re not working.

In his initial post, Felix said that since TBT (and thereby all levered ETFs) are “intraday-only” trading instruments, the fact that the average daily volume is only ~1/10th of the shares outstanding, that means 90% of shares are held by people who aren’t using them properly.  This is also a non-sequitur in and of itself, as  example, see this paper on trading leveraged ETF’s from NYU (pdf), which says:

The study also shows that leveraged funds can be used to replicate the returns of the underlying
index, provided we use a dynamic rebalancing strategy. Empirically, we find that rebalancing frequencies required to achieve this goal are moderate, on the order of one week between rebalancings. Nevertheless, this need for dynamic rebalancing leads to the conclusion that leveraged ETFs as currently designed may be unsuitable for buy-and-hold investors.

That’s only from the abstract to the paper, but the point is that while 90% of the fund float may not be turned-over each day, suggesting that is entirely from naive buy-and-hold retail investors is itself incredibly naive.  In a simple regard, an investor can hold levered ETF’s on a greater-than-daily basis to make a longer-term bet on sector volatility, instead of whole-market vol (see VXX, etc).  Levered ETFs also give a trader/investor the ability to get levered returns without having to deal with margin calls, which in volatile markets is a great comfort, to say the least.  One does not need to be a professional trader to put-on such a trades, I promise, as I’m not myself a professional trader (although I suppose a decade+ in/out of markets, BS in Finance, and a few years working does make me slightly more experienced than the average Joe…).  I can’t quantify to what degree these levered ETFs are used by non-amateurs, but I can all but guarantee that it is much greater than 0%, as there are several reasons to hold them for greater than intraday.

Felix then says he’s concerned that ETFs are a problem because the same rules that are applied to stocks – which have a positive social value in that they represent ownership of tangible assets and help firms raise funds – are being applied to ETFs, which have no such implicit value, social or otherwise.  He also says that these vehicles are mathematically guaranteed to go to zero, which is not the case at all, at least not in the way he puts it, which assumes that is the only option (over a long-enough period of time this may very-well be true, but we are not talking years upon years here).

To see how levered ETFs actually behave, recall the graph from my last post of FAZ, the ultra-short financial ETF v. the Financial SPDR, XLF***, which showed as XLF increased over the past two years, FAZ decreased by even more.  If we zoom in on just the first three months of that series, we can see just exactly what it takes for a levered ETF to “go to zero:” relatively large swings and/or a relatively short period of time.

In this case, it was both large swings AND a short period of time.  FAZ lost 47% of its value after just 5 trading days, over which FAZ’s average daily return was 2.7x that of XLF!  You can see that during these three months, there were some relative large corrections in the opposite direction of the trend, for example after the first initial dive to almost -50%, FAZ went up so that it was only -~30%.  Because FAZ was already beaten-down and returns are compounded, smaller decreases in the index resulted in even larger gains for FAZ, driving it back up almost as quickly as it dropped.

Generally speaking, only way for an ultra-long ETF to go to zero is for the index upon which it is based to trend downward over a period of time, with few and small upward corrections relative to the downward ones.  For an ultra-short ETF to go to zero, as is almost the case with FAZ, the underlying index needs to march steadily upward, with little downward corrections relative to the upward ones.

Felix then says that since these securities trade on the same exchanges as stocks, and have symbols like stocks, its easy to confuse the two.  I’m not even going to dignify that bullshit excuse with a response.

Felix’s ultimate concern is that he doesn’t see why these levered ETF’s should exist.  He says:

What purpose do they serve? If you want to make a leveraged bet on a certain asset, you can buy it or short it using borrowed money. These things are obviously harming a lot of people — the investors wielding billions of dollars who are holding them for long periods of times. Who are they benefiting? It seems to me that the cost of leveraged ETFs is greater than the benefit; that’s why I think the SEC should look into them.

Well, as I briefly discussed above, there are legitimate ways to use levered ETF’s as part of a reasonable, well-thought-out trading/investing strategy.  They can also be used for rank speculation, and there is NOTHING WRONG WITH THAT, so long as anyone using them for that purpose understands the possible consequences of so-doing.  Second, I have yet to see any conclusive evidence that any remotely significant and/or widespread damage has been done to Joe & Jane Investor.  Third, I just don’t see any sort of proof that the cost of levered ETFs outweigh their benefit.

The fact of the matter is that retail investors can’t just put on the same trade as a levered ETF without them; Reg T prohibits it by limiting initial leverage.  To (over)simplify, retail accounts must put up at least 50% of the value of purchases in their brokerage account within a certain amount of days, otherwise they will have the position sold-out.  Clients could gain greater leverage by buying options, but I fail to see how that would be a less inappropriate strategy for retail investors, as they have the same potential loss – 100% of the investment – but are even more difficult to understand than ETFs!

So long as levered ETF’s are not being sold by predatory brokers trying to juice their commissions off unsuspecting and unsophisticated clients, I don’t see anything wrong with levered ETFs, which as I said in my previous post, give clients the option to share in the gains – as well as the losses – available to professional traders.  I’m glad Felix is asking these questions because apparently they have not yet been sufficiently addressed, and its clear he is not the only one out there who’d like some answers.  However, just because he – and others – don’t have the answers, that doesn’t make his conclusions logical, let alone right.

I’m all for investor education and protection from both unscrupulous tactics and illegal information asymmetry, but neither of those things are part of Felix’s argument for greater regulation.  Retail investors constantly complain they don’t have the same profit-making opportunities as professional traders and investors, but look what happens when they do (if Felix’s arguments are to be believed); they not only squander and abuse it, but in so doing, shirk responsibility and accountability for the consequences of their actions.

News flash: With great opportunity for profit comes great opportunity for loss.  There is no such thing as a free lunch.  There is no risky return without the risk, etc, etc, you get the idea (I hope!).  If retail wants the opportunity to get rich through “smart” investments and trades, they necessarily must accept the fact that they may very-well get poor the same way.

*** XLF is not the index for FAZ but it is extremely close, so its used as a proxy for the Russel 1000 Financials

A Wolf In Sheep’s Clothing

18 Apr

Much has been written about Goldman and the Timberwolf deals since the now infamous “shitty deal” showdown between Senator Levin and GS officials last fall. In reading the majority/minority report issued last week in its entirety, there’s a few things that really stuck out to me. Continue reading

On Wachovia, Whistle-Blowers, and Incentives

3 Apr

I just read a very good article in the UK Guardian/Observer about how Wachovia enabled hundreds of millions (if not billions) of dollars of dirty money to flow through its various international operations.  I’ve seen much outrage (via twitter and other blogs) about this debacle, especially since the article relates the plight of one diligent whistle-blower who was silenced, and who experienced great personal distress for his efforts.  I wish I could say such secretive, illegal behavior on the part of Wachovia was unique to that firm, but unfortunately, it is not.  No.where.close.

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Why Academics Need to Venture Out of the Ivory Tower, Part 76,198

22 Mar

Sure, Financial services, specifically Hedge Funds, are going to feel some pain from the Rajaratnam trial. To suggest that hedge funds should proactively disclose their strategies to remove this taint  is simply naive, at best:

Hedge funds should publicly report all past trades that are at least two years old. Such delayed disclosure would not weaken their competitiveness, since the half-life of most trading strategies is very short, but it would give them the credibility that comes with having nothing to hide.

I think you’d be fairly hard-pressed to to find any major hedge fund managers that would voluntarily disclose their trades, however aged.  Contrary to what Herr Professor says, 2 years is at best an arbitrary time period.  This would be analogous to suggesting (although not perfectly) that Coca-Cola voluntarily discloses older versions of the formula for it’s flagship soda to proactively stave-off criticisms and potential regulatory burdens.

It just ain’t gonna happen.

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Lessons Un-Learned From the Financial Crisis

7 Feb

Seems like there’s been alot of things going on lately that indicates few people – investors, bank executives, regulators – learned anything from the Financial Crisis.

The FDIC recently issued a rule on incentive pay at financial institutions.  I’m all for anything that seeks align pay incentives with risk taking, but I think this rule just doesn’t go far enough.  Emphasis mine:

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