January 22, 2002
From the desk of Mindles H. Dreck:Derivatives and Regulation
Pundits continue to link the Enron debacle to a need for increased regulation, especially of derivatives. What most of these people (like the linked William Greider, who's finance background includes writing for Rolling Stone) don't appreciate is that regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship.
Investors and operating companies buy derivatives for two basic purposes: speculation and risk transfer. A derivative, (a financial contract based on the price of another commodity, security, contract or index) either eliminates an exposure, creates an exposure, or substitutes exposures. That last one, substituting exposures, is important to heavily regulated investors.
For example, insurance companies were a goldmine for derivatives salespeople in the last two decades, only slowing down in the late 1990s. The fundamental reason for this is not because insurance executives were stupid, but because they manage their investments in a thicket of proscriptive regulation. Insurance companies have to respond to their national regulatory organization (the NAIC), their home state insurance department and the insurance departments of states in which they sell or write business. They file enormous statutory reports every quarter using special regulatory pricing, and calculate complex risk-based capital reports and "IRIS" ratios regularly.
Even though the insurance industry has been heavily regulated throughout the entire post-war era, the incidents of fraud and financial mismanagement have been numerous and spectacular. Remember Marty Frankel? Mutual Benefit Life? For each of these cases that are in the news, there are many smaller ones you don't hear about. Some of that may be the nature of the industry, but it doesn't make a prima facie case for more regulation.
Regulators appear to spend far too much time looking at the instruments in insurance company portfolios instead of the portfolio as a whole. The rules vary by state, but insurance regulations generally penalize or forbid investing in lower quality corporate bonds and often equities. Generally, they distinguish between credits based on their S&P or Moody's rating (The NAIC has its own rating system, but it is about 95% consistent with the big agencies' ratings).
Insurance companies often need the yield of less creditworthy obligations. So derivative salesmen see an opportunity to engineer around the regulations. They package securities that substitute price volatility for the proscribed credit risk. Then the investor can be compensated for taking some additional risk, and the banker can be compensated for creating the opportunity. A simple example of this is the Collateralized Bond Obligation (CBO). A CBO is created by buying a bunch of bonds, usually of lower credit quality, putting them in a "special purpose vehicle" (SPV) and then issuing two or more debt instruments from the SPV. The more senior instruments can obtain an investment grade rating based on the "cushion" created by the junior debt tranche. The junior bond absorbs, for example, the first 10% of losses in the entire portfolio and only when losses exceed that amount will the senior obligations be impaired. The junior instruments, known as "Z-Tranches" become "toxic waste", suitable only for speculators and trading desks with strange risks to lay off (or, in a famous 1995 case, the Orange County California Treasurer).
A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing - they decrease frequency of loss but increase the severity. So they blow up infrequently, but when they do it's often a big mess. Ratings-packaged instruments are less risky than the pool of securities they represent but often riskier and less liquid than the investment grade securities for which they are being substituted. As a result, they pay a yield or return premium (even net of high investment banking fees). That premium may or may not be enough to pay for their risk. But they pass the all-important credit rating process and are therefore sometimes the only choice for ratings-restricted portfolios reaching for yield. Therefore, these transactions enrich bankers and can often lower the risk-adjusted returns of constrained investors relative to those who can purchase credit risk directly.
Frank Partnoy's book F.I.A.S.C.O. describes many such transactions in gory detail. It also discusses similar transactions driven by accounting rules, including one that purportedly earned Morgan Stanley $75 million for deferring billions of dollars of losses on Japanese Banks' financial statements. That transaction, as described by Partnoy, is not dissimilar from the CBO described above, although it sliced the bond tranches differently for accounting effect.
Partnoy is a former derivatives salesperson, and he clearly suggests that regulation is often the derivative salesman's best friend. Complicated rules encourage complex transactions that seek to conceal or re-shape their true nature. Regulated entities create demand for complex derivatives that substitute proscribed risks for admitted risks. If a new risk is identified and prohibited, the market starts inventing instruments that get around it. There is no end to this process. Regulators have always had this perversely symbiotic relationship with Wall Street. And the same can be said for the ridiculously complicated federal taxation rules and increasingly byzantine Financial Accounting Standards, both of which have inspired massive derivative activity as the engineers find their way around the code maze.
Regulations that focus on complete disclosure are much more effective than those that attempt to dictate behavior, and they impose less of a burden on the regulated entity. The SEC has been constructive in this regard. Their disclosure requirements assist the existing private sector watchdogs (e.g. Morningstar, Fitch, buy-side analysts, the press, etc.), and make useful qualitative information available to everyone. If Enron had to disclose the books of its many affiliates, they never would have entered into all of these accounting-driven transactions. Contrary to many pundits assumptions, weather and energy-based derivatives don't seem to have brought down Enron (nor did similar transactions bring down LTCM). The catalysts for Enron's downfall are as old as the hills: Leverage and Deception. In fact, many of the scandals that involve complex finance come down to some combination of those two ancient perils.
So the answer is not to add one more vaguely described activity to the long-as-your-arm list of "no-nos", but to shine an ever brighter light on the books and let the buyer discriminate. To paraphrase Churchill, it's an imperfect system, but its better than the others.
There are issues with disclosure regulations when the regulated entities' trading strategies are proprietary and constitute a competitive advantage - trading desks and hedge funds for instance. In other circumstances, however, more disclosure seems benign.
Posted by Mindles H. Dreck at January 22, 2002 10:11 PM | Technorati inbound links