In addition to the pending Basel-based regulation on minimum leverage ratio (see post), US regulators are pushing to set the minimum supplementary Tier 1 leverage ratio for the eight "systemically important" US banks to 5%. Once again, this is expected to hit the repo market as well as other assets with low risk weights.
Source: Barclays Research
This action will achieve the following:
1. Disrupt the functioning of money markets by pushing larger banks out of secured deposits. Deposits collateralized by treasuries (reverse repo) is the only way many institutional palyers can place cash with banks without taking unsecured bank risk. Now these institutions will be forced take bank risk or buy treasury bills - which will likely go negative as a result.
2. Reduce liquidity in the treasury markets. As discussed earlier, treasury trading volumes follow repo volumes - and this is not a great outcome for either.
3. Increase fails and the overall volatility of the treasury markets by making it harder to borrow treasuries.
Barclays Research: - A significant reduction in repo
could reduce the ability of dealers to short securities without risk of being able to deliver,
raising the prospect of the fails charge being triggered. This should factor into how
aggressive they are at auction and actual auction pricing. Further, the possibility of
increased fails could mean greater volatility in rates around Treasury auctions.
4. Create similar headwinds as in #2 and #3 above in the MBS markets and potentially other markets that involve some form of securities lending.
Barclays Research: - Full effects likely to be more widespread. We believe the knock-on effects of these rule
changes are not likely to be limited to the Treasury and MBS markets. They would likely
filter through to other markets, including credit and equities, potentially reducing
liquidity and increasing volatility over time.
This regulation will certainly not reduce the risk of a systemic problem going forward - in fact it is likely to have the opposite effect. Banks will find other ways to make money, potentially by shifting to riskier assets. Ultimately it will be the end-users and market participants (mutual funds, ETFs, pensions, securities custodians, insurance firms, endowments, foundations, retail investors, etc.) who will feel the brunt of this regulation. Welcome to the world of "unintended consequences".
The debate around "too big to fail" of the US banking system is often infused with political rhetoric and media hype. Let's go through some Q&A on the subject and discuss the facts.
Q: Did large banks take disproportionate amounts of real-estate related risk vs. smaller banks prior to the crisis?
A: No. That's a myth. Smaller banks were much more exposed to real estate (see discussion).
Q: Which "too big to fail" banks were directly bailed out by the US federal authorities during the 2008 crisis?
A: While hundreds of banks were forced to take TARP funds, only Citigroup received an explicit bailout to keep it afloat (one exception is Bank of America who received significant incremental assistance largely to support the acquisition of failed Merrill Lynch). Note that Bear Stearns, Merrill Lynch, Lehman, AIG, GM/GMAC, Chrysler, Fannie and Freddie were not banks and would not be subject to any "too big to fail" legislation. Neither was GE Capital and other corporations who relied on commercial paper funding and requited the Fed's support to keep them afloat. Wachovia may have become the second such large bank if it wasn't purchased by Wells. Failed foreign banks like UBS and RBS also would not be subject to any US too-big-to-fail laws.
Q: Why did Citi fail in 2008?
A: Citi ran into trouble because of a massive off-balance-sheet portfolio the firm funded with commercial paper. In late 2007, when the commercial paper market dried up, Citi was forced to take these assets onto its balance sheet. The bank was not sufficiently capitalized to absorb the losses resulting from these assets being written down.
Q: What were the assets Citi was "warehousing" off-balance-sheet?
A: A great deal of that portfolio were the "AAA" and other senior tranches of CDOs that Citi often helped originate (including mortgage related assets). Rating agencies were instrumental in helping banks like Citi structure these assets and keep them off balance sheet in CP conduits.
Q: Why did Citi (as well as many other banks) hold so much off-balance sheet?
A: Because they received a significantly more favorable capital treatment by doing so (the so-called "regulatory capital arbitrage" - see discussion from 2009).
Q: Did Citi break any state or federal laws by doing what it did?
A: No. All of this was perfectly legal and federal authorities were aware of these structures.
Q: Did derivatives positions play a major role in Citi's failure? Were other large US banks at risk of failure due to derivatives positions?
A: No. That's a myth. The bulk of structured credit positions (tranches) that brought down Citi were not derivatives (just to be clear, CDOs are not derivatives).
Q: What has been done since 2008 to make sure the Citi situation doesn't happen again?
A:
The US regulators now have the ability to take over and manage an orderly unwind of any large US chartered bank. Banks are required to create a "living will" to guide the regulators in the unwind process. The goal is to force losses on creditors in an orderly fashion without significant disruptions to the financial system and without utilizing taxpayer money.
Large banking institutions are now required to have more punitive capital ratios than smaller banks.
Capital loopholes related to off-balance-sheet positions have been closed.
Stress testing conducted by the Fed takes into account on- and off-balance sheet assets, forcing banks to maintain sufficient capital to be able to take a hit. US banks more than doubled the weighted average tier-1 common equity ratio since the crisis (see attached).
Q: Do large US banks have a funding advantage relative to small banks?
A: Not any longer. According to notes from the meeting of the Federal Advisory Council
and the Board of Governors (attached - h/t Colin Wiles @forteology), "studies point to a significant decrease in any funding advantage that large U.S. financial institutions may have had in the past relative to smaller financial institutions and also relative to nonfinancial institutions at comparable ratings levels. Increased capital and liquidity, in addition to meeting the demands of many regulatory bodies, has largely, if not entirely, eroded any cost-of-funding advantage that large banks may have had."
Q: What is the downside of breaking up banks like JPMorgan?
A: Large US corporations need large banks to provide credit and capital markets access/services (Boeing is not going to use Queens County Savings Bank or a broker like Sandler O'Neill - great institutions, but way too small). Without large US banks, US companies will turn to foreign banks and will be at the mercy of those institutions' capital availability and regulatory frameworks. Foreign banks will also begin dominating US capital markets primary activities (bond issuance, IPOs, debt syndications, etc.) And in an event of a credit crisis foreign banks (who are to some extent controlled by foreign governments) will give priority to their domestic corporations, putting US firms at risk.
Q: How large are US largest banks relative to the US total economic output? How does it compare to other countries?
A: See chart below:
So before jumping on the "too big to fail" bandwagon, get the facts.
John Taylor makes an interesting point on his blog (here) with respect to the bloated government regulation in the US. Here are two charts that compare the recovery from the recession in the early 80s (during the Reagan administration) with the current economic recovery. One trend that really stands out is the number of federal workers employed in regulatory activities (excluding transportation security). The two trends are drastically different.
Source: Economics One
It shows how the US regulatory framework is becoming in many ways similar to the European governments' tactics. Regulate it all, ask questions later. Below is a comparison of the quarterly GDP during the two recoveries. Of course this could simply be a coincidence, but is it?
People often ask why it is taking this long to implement the new US derivatives regulation (part of the Dodd-Frank legislation). Well, it starts with zealous politicians who know all about the province of Kandahar in Afghanistan (because they are all about the "war on terror"), but know little about the global banking system or what a swap is for that matter. Then the implementation gets turned over to domestic regulators such as the SEC and the CFTC who themselves don't fully understand international banking. The CFTC had enough trouble regulating MF Global - and now they are asked to deal with Deutsche Bank's London subsidiary? The SEC has hundreds of hedge funds to register and audit while they can't even implement proper disclosure rules for public companies. It's no wonder that confusion has overtaken this derivatives regulation implementation.
Here are some basic questions that should have been addressed when the rules were designed, not during the implementation process.
Example 1: A US bank subsidiary doing derivatives business in the EU.
If a US domiciled bank owns another bank in the EU jurisdiction, does this other bank need to comply with the US rules? If yes, how would it compete with other banks in its jurisdiction that are not owned by a US bank? If no, the US bank would simply move some of it's derivatives business to the EU subsidiary to get a better regulatory treatment. Would the EU be able to synchronize its derivatives regulation with the US (to take out the loopholes) when EU members can hardly agree with each other? How long will it take?
Example 2: An EU domiciled bank owns a US subsidiary.
Clearly the US subsidiary will need to comply with the US rules. But should the parent bank as well? If yes, than the CFTC/SEC would have jurisdiction in the EU, really annoying EU bank regulators. If no, then how is JPMorgan to compete with Deutsche Bank within the EU when they are under different regulatory frameworks.
FT: US banks including JPMorgan Chase have warned that if their overseas subsidiaries are forced to adhere to US rules, they risk losing business to the likes of Deutsche Bank and Barclays. But foreign banks have warned that the language of US rules could subject them to worldwide supervision by US authorities.
Example 3: A US bank subsidiary doing derivatives business in the EU with an EU based client.
A derivatives client generally doesn't care where she executes a swap. A US based client for example could and often does execute swaps with a London-based bank (which may be a subsidiary of a US, a German, or a Swiss bank). A bank subsidiary is Brussels or Zurich could do just as well. Should there be a difference between US based clients and foreign based ones? What do you do with a hedge fund client domiciled in the Caymans? Nobody is even talking about Hong Kong or Singapore based subsidiaries with their own set of regulations and loopholes.
FT: ... the CFTC is examining whether a US bank’s foreign subsidiary transacting with foreign counterparties should be exempt from some new rules governing derivatives dealers if the subsidiary’s home country financial supervisors adopt robust oversight. A foreign bank’s derivatives desk also may be exempt from US rules if its national regulator employs rules closely mirroring those of the CFTC.
The CFTC is now under so much pressure in trying to resolve some of these issues, the agency has decided to postpone imposing some of the new rules on entities that are in foreign jurisdictions. Of course that includes the London swaps desks of JPMorgan for example - which basically means business as usual in London?
FT: The US Commodity Futures Trading Commission is looking to grant a temporary exemption to swap dealers that may fall under the jurisdiction of foreign financial authorities from complying with a host of post-financial crisis regulations governing derivatives transactions, people familiar with the matter said.
Confused enough yet? Well, seems so is the CFTC. Realizing the scope of the problem, the agency decided it is overwhelmed enough implementing the rules for the largest dealers. For now it simply can't deal with hundreds of smaller derivatives players.
Reuters: The CFTC originally said in December 2010 that firms would be counted as swap dealers if they traded more than $100 million in swaps over a 12-month period [numerous hedge funds trade 10 times that in a year].
That threshold set off a desperate push by energy companies and big commodity traders, who argued that they are using trades to hedge against market risks, and that their exposure does not endanger the broader financial system.
The final version released on Wednesday bumps the threshold up to $8 billion for most asset classes as an initial phase-in. Eventually, that threshold drops to $3 billion, unless regulators decide a different threshold is appropriate.
It was easy in 2009 to "regulate it all, ask questions later". Now the questions are being asked and the answers are not easy to come by. Some of this regulation will be so convoluted and confusing, it may create more risks than it originally intended to address. And as before, the dealers will find some loopholes because they can always afford better lawyers and structurers than the CFTC.
Structured correctly, a reduction in a bank's Risk Weighted Assets for certain corporate credits may still be possible, even under the new bank regulation.
David McKibbin (Scute Consulting) provides a case study. A more detailed write-up can be found here.
David McKibbin: With many bank credit risk mitigation techniques now being questioned by regulators and more and more corporate funding transactions coming back on balance sheet, new and effective solutions are required. Banks need to reduce RWA's, which must better reflect effective due diligence and ongoing risk.
The attached case study is aimed at the European IFRS market.
There is no shortage of ill-conceived regulation descending on the global financial industry. In some instances the new regulation will not only add little to improve the safety of the financial system but could actually destabilize it. One of Basel III rules for example is sure to create some potentially severe "unintended consequences".
As a bit of background, back in 2007, Citigroup was forced to take onto their balance sheet a significant amount of assets from "CP conduits" because the firm provided commercial paper (CP) "backstops" to these entities. The entities were funding themselves with asset-backed commercial paper while Citigroup effectively guaranteed that it will step in to finance the assets in case the entities could not roll their CP. And that is indeed what happened. All of a sudden Citi was saddled with large amounts of "AAA" CDO paper and other securities that weren't on their balance sheet before, even though Citi always had exposure to them. Citi was in fact financing this paper off balance sheet via their CP backstop commitment because it allowed the bank to reduce regulatory capital requirements and achieve higher returns on capital. In 2008 that action ultimately brought down the firm, with the US government forced to take a large stake in the company and providing it unprecedented financial support. RBS (taken over by the UK government) and Wachovia (taken over by Wells Fargo) both met with similar fate.
Instead of attempting to address this specific issue the
Basel III architects decided to use a blunt instrument. They put in place a simple rule stating that any unfunded contractual commitment to a financial institution must be treated as a fully funded commitment for the purposes of regulatory capital. It sounded great to many ivory tower bureaucrats, but few have realized the implications, particularly for the US. In the US the usage of revolving facilities is quite common both within and outside the financial industry. With this new rule banks will have to "put aside" the same amount of capital as they would for a fully funded loan. Therefore banks would have to charge the same interest on the undrawn amount as they would on the amount actually lent out. It's a bit like having to pay interest on your full credit card limit rather than just on the amount you borrow.
Consider a money market mutual fund for example. Often a large mutual fund would have a credit line with a bank for which it pays an unfunded commitment fee. Under the new rules funds would have to pay the full rate as though they have taken out a loan. That would be prohibitively expensive for a fund, making revolving facilities a thing of the past. Now imagine that a fund finds itself with large unexpected redemptions. Normally it would simply draw on the revolving facility to fund the redemptions and pay back the loan when its holdings of short term paper mature. Under the new regime it may be forced to sell the paper in the market at a great discount (secondary commercial paper does not trade well) and create losses for investors. A money market fund "breaking the buck" for example will panic other investors, generating more redemptions and so on. It is not at all clear how such a rule is making the financial system more stable.
Even beyond the problem of providing revolving facilities to mutual funds, Basle III will have significant implications for the corporate sector as well.
Journal of Global Finance: But the dilemma that all corporate treasurers face is in anticipating which particular financial services they will wind up paying more for—or earning less from. The Basel Committee of the Bank for International Settlements’ new rules will require all banks —including the 23 that International Paper does business with—to more than triple their core Tier 1 capital from 2% of risk-weighted assets to a minimum of 7% by 2019. Made up of common equity and disclosed reserves—or retained earnings—core Tier 1 is “the most expensive” type of capital that a bank holds, explains Peter Neu, a partner and managing director at Boston Consulting Group in Frankfurt....
...rather than rejoice at rules that are intended to reduce overall risk in the global financial system, senior managers of banks around the globe that are starting to comply with Basel III are quick to identify a litany of brutal impact points for their corporate clients, ranging from a drop in already-low interest rates on deposits to dramatic increases in interest rates on loans.
Even undrawn lines of credit will become more expensive and difficult to maintain. Banks will be required to treat 10% of short-term lines and 5% of long-term ones as if they were already drawn, according to Neu. The most that clients will be able to borrow from those lines will be 90% and 95% of their outstanding balances, respectively. “You cannot use this cash for other purposes. ...
The new rules will impact numerous business activities - from bank owned lease companies to trade finance.
Journal of Global Finance: In trade finance, where the liquidity ratio under Basel III would imply a fivefold increase in interest rates, some corporate treasurers are considering taking their business to insurance companies that issue surety bonds covering trade transactions. They are even looking at ways to serve as their own guarantors.
The bewildered public and some ignorant politicians continue to play the blame game for the slow economic growth and anemic hiring in the US. But at least a part of the answer can be found in the uncertainty associated with and the unintended consequences of the new regulation meant to cure all ills of the financial industry. Applying blunt instruments from Basel Switzerland to the US financial and corporate sector will damage numerous successful practices that served US commerce well for decades.
In the heyday of credit structuring the rating agencies had been far more successful in rating the securitizations of corporate debt than of mortgage debt. Collateralized Loan Obligations (CLO) tranches rated AAA had not lost principal during the 08-09 crisis (except for a couple of fraud cases), although often traded as low as 60-70 cents on the dollar because of uncertainties around corporate default rates. During the crisis banks like JPMorgan had bought significant amounts of the AAA tranches at large discounts and made enormous returns as the market began to realize that corporate defaults among leveraged companies will continue to stay subdued.
As a bit of background, between 2004 and 2007 CLO issuance had spiked tremendously as asset backed commercial paper (ABCP) issuance allowed banks to keep tranches in CP conduits and off their balance sheets using what used to be called "regulatory capital arbitrage". This allowed for ever larger leveraged buyout (LBO) transactions including firms like TXU and First Data.
CLO Issuance in $billion per year (source: LSTA)
As ABCP demand collapsed in late 2007 (driven primarily by concerns about subprime mortgages), CLO issuance collapsed as well.
ABCP outstanding (source: the Fed)
This year some CLO deals got done (about $13 bn) and the hope was that the business, in spite of being a fraction of pre-crisis levels, would continue to grow. But given the history of structured credit, the recent news that capital requirements will be increasing on AAA
CLO paper held by banks is not a surprise.
FT:
Under existing Basel rules, large banks using “internal-ratings based”
models are required to set aside just 0.56 per cent of the market value
of triple A rated CLO securities as capital against losses. That would
increase to a minimum of 1.6 per cent under the proposed US system, and
then jump to 8 per cent if cumulative losses on a CLO exceed 4 per cent.
Many new CLO deals have 25-30% subordination, making it nearly impossible to "pierce" the AAA, particularly given that most loans are senior secured corporate obligations. However over a few years most CLOs will accumulate losses of 4% or more - this is typical for a pool on non-investment grade loans. So the capital charge for holding the AAA tranche will suddenly become equivalent to holding some corporate loans directly. Yet these losses on the CLO will flow to the lower tranches, not the AAA. This new capital requirement will certainly make it capital inefficient to hold AAA paper on banks' balance sheets, particularly as it gets closer to maturity.
With CLO issuance in 2012 expected to be only slightly up from this year, the new regulation may significantly cut into this business. Banks tend to be the largest holders of the most senior tranches, making it almost impossible to structure a new CLO without a commitment from a large financial institution. In turn this will reduce demand for institutional loans (corporate loans of leveraged companies) that form the collateral pool for CLOs. When combining this regulation with new rules impacting the corporate bond market, funding costs for corporations, particularly the "middle market" (mid-sized) firms in the US will increase. This is yet another example of "unintended consequences" that some of the new regulation may introduce into the US economy.
The UK is getting ready to begin the process of separating the nation's banks' "investment" and "consumer" businesses, implementing the so-called John Vicker Independent Commission Recommendations. British politicians keep talking about solving the "too big to fail" problem with this new legislation, which is to go into effect in its final form by 2015 (4 years earlier than originally proposed).
In addition to the bank "breakup" provisions, the rules would impose a 10% capital ratio for banks with another 7-10% of debt that could be converted into equity if a bank were to run into financial trouble. It all sounds great in theory, but a number of questions remain.
1. Bonds that convert to equity when a bank is in distress are the worst type of instrument for investors. It has all the downside of an equity security but a limited upside of a bond. That means the yield on these should be at least as high as equity returns. Therefore banks will not only be issuing large amounts of equity to get to the 10% capital ratio, but will also try to sell these equity-like securities. The UK banks will be raising capital at exactly the same time as the eurozone banks will be flooding the markets. This is clearly going to present a challenge.
2. Since the new "consumer" portion of the banks will now be viewed as having implicit government support, it has the potential of creating "moral hazard". With competition growing over time, these units will provide consumers with below market funding - and we've seen how that movie ends.
3. The "consumer" unit will be responsible for small to medium size business loans. This would obviously include loans to real estate developers - because those tend to be medium sized businesses. In the US the bulk of FDIC insured bank failures have been due to commercial real estate loans to small and medium sized developers (single and multi-family housing projects, office buildings, shopping centers, etc.). Irish banks failed because of lending to construction firms in saturated markets - particularly in Dublin. Again we are setting up a system that will use its implicit guarantees to potentially create bubble markets.
4. The "investment banking" units will be immediately downgraded because they have no implicit support.
Bloomberg: Standard and Poor’s said Sept. 14 the elements of a bank outside the ring fence face a credit-ratings cut as they won’t be able to count on government support.
That's where all the loans to large corporations are housed. These units will have much more trouble funding themselves particularly in the current environment. This should make corporate loans relatively expensive - in spite of them usually being better credit than consumer loans. But large UK corporations do not have to borrow from or conduct capital markets business (bond issuance, IPOs, etc.) with UK banks and will simply go abroad to obtain credit. Swiss, German, US, Canadian, and Australian banks will have no trouble grabbing UK banks' market share for servicing large UK corporations. UK banks will simply end up shrinking or selling these divisions.
The UK's new financial services industry will look quite different - almost like a set of regulated power utilities. But it's not at all clear this industry will no longer be "too big to fail".
In their effort to remove proprietary trading from bank holding companies and increase capital requirements, regulators are destroying liquidity in the US corporate bond market. If you make markets (offer to buy and sell) in any product that has limited liquidity, you must run inventory. Baseball cards, antiques, or bonds - it's the same process. However between Basel III and the Volcker rule, the ability to maintain inventory is being undermined.
Barclays Capital: Increased regulation is a primary cause of this shift in dealer behaviour, in our view, in
particular Basel III and the Volcker rule. Basel III significantly increases the risk-weighted
assets associated with dealer balance sheets, thus making holding inventory more costly.
Several banks have cited this change when noting material decreases in their fixed income
balance sheets. For example, Credit Suisse announced that it plans to nearly halve the Basel
III risk-weighted assets in its fixed income division over the next three years. Uncertainty
about the implications of the limitations on proprietary trading included in the Volcker rule
have also led dealers to reduce inventories. While the rule-writing process on that front is
still ongoing, absent some substantial unexpected changes, the trend will likely continue
towards reduced capital devoted to market making.
The dealers have started pulling back on inventory ahead of new regulatory framework The chart below shows the levels of dealer inventory of corporate bonds, both High Yield (HY) and Investment Grade (IG) vs. mutual fund holdings.
Mutual funds tend to be "buy and hold" investors. Therefore price discovery in the corporate bond market comes from transactions facilitated by dealers or dealer quotes. As dealer inventories drop, transaction volumes decline and bid/ask spreads get wider. In other words if you can't add bonds to you inventory or have no bonds in your inventory to sell, you will have to find the other side of the trade before you can transact. If you don't have the other side of the trade ready (and usually market makers don't), you will make markets wide enough to compensate you for the risk of finding the other side later to unload your position.
Another troubling "unintended consequence" of the upcoming regulation is increasing concentrations. Dealers will only make markets in the largest, most liquid names because the smaller names would not justify the capital usage in the new regulatory framework. The next two charts show the transaction volumes for HY and IG bonds sorted from highest to lowest. The most liquid few issues account for the bulk of the volume.
Investment Grade
High Yield
Barclays Capital: As dealers shrink their corporate bond holdings and mutual funds demand higher liquidity, we
see an increased risk of volumes becoming even more concentrated than they are currently.
Indeed, in the first three quarters of 2011, of the nearly 628 tickers in the U.S. Corporate Index,
the 37 most liquid credits accounted for 50% of the volume; only 10% of the volume was in
the bottom 412 tickers (Figure 16). The volume concentration is even more pronounced in
high yield – 50% of the volume in the first three quarters of 2011 was in 46 tickers (out of
1,140), with the bottom 821 tickers accounting for only 10%
Who cares, you might ask. It's the medium-size businesses who are going to get hurt. Because liquidity in their bonds is going to dry up, investors will become concerned that they would not be able to sell these bonds when they need to do so. Therefore they will demand an increasingly higher yield to purchase such bonds (liquidity premium). And the medium size business - who tend to create a great deal of new jobs - will be the ones paying significantly more to borrow money.
Bloomberg: [FDIC chair Sheila] Bair, in a letter to lawmakers released today, endorsed a proposal that was added last week to the regulatory overhaul legislation making its way through the House Financial Services Committee. It would require secured creditors, like repurchase agreement lenders and the Federal Home Loan Bank system, to bear losses of as much as 20 percent to cover the costs of a systemically significant bank failure.
In addition to finding a supposed way to cover costs of winding down a too-big-to-fail institution (and possibly all banks), this portion of the financial overhaul legislation will have some other consequences:
1. It will make it significantly more expensive for these institutions to borrow funds even if they post treasuries as collateral.
2. Any negative news about a specific institution or the financial system as a whole will get lenders running for the fences forcing rapid unwinds. This will make Lehman look like a gradual process.
3. It may destroy the repo market. Repo is used by money market funds, corporations, pensions, etc. to place funds on a secured basis (taking in collateral). As an institution if you have short-term cash and you don't want to deposit it with a bank (unsecured), your only option is to lend it to a bank on a secured basis via repo (taking in treasuries as collateral for example). If this option is taken away, institutions will need an alternative such as the ability to deposit cash with the Fed.
4. This will give foreign banks an unfair advantage by funneling repo lending (secured deposits) to non-US banks, making it cheaper for those banks to fund themselves.
5. US banks will try to get around these laws by creating off-shore financing vehicles that are not subject to US banking legislation, making banking supervision that much more difficult.
As we discussed before, knee-jerk reaction regulation is not always the answer, but in this case could spell an absolute disaster for the US financial system. It behooves the US legislators to slow down their political posturing and try to understand how the finacial system actually works in practice.
Fidelity has sent a letter to the SEC (included below) to comment on the recent SEC proposal to regulate money market funds. Here are some highlights:
* Fidelity points out that the proposed SEC rules, if implemented without changes, will essentially force their money market funds to yield zero in the current environment.
...we estimate that the potential yield reduction could be as high as 25 to 43 basis points for an institutional non-rated fund, 19 to 32 basis points for a rated institutional fund and 14 to 31 basis points for a retail fund. In today's low-rate environment, the average taxable fund is yielding 0.18% and the average municipal fund is yielding 0.17%.
* Fidelity is pushing to keep the 90 days limit on the average asset maturity, which the SEC has proposed to shorten. Fidelity's point is that 60 vs. 90 day maturity is not the issue when it comes to the risk profile of a money fund.
* Fidelity is asking to include Government Securities as "Liquid Assets" to avoid being restricted on the amount of government paper they can hold in the "prime" money markets fund. With the dearth of eligible corporate assets, Fidelity needs this option.
* They are trying to keep the 10% bucket for assets that don't qualify as "liquid" securities. Their view is that the daily and weekly liquidity requirements the SEC is proposing should be enough.
* Fidelity wants the ability to buy some amount of paper from "second tier" issuers (smaller corporates). Again, their view is this was not what caused the problem in money market funds - the Reserve was destroyed because it had Lehman CP, which was a "first tier" issuer.
* One of the biggest problems for money funds has been a push by some, including the SEC, to mark the portfolio to market and have investors come in and out at NAV, like any other fund. That completely destroys the appeal of a money market funds, and Fidelity wants to keep money funds at one dollar NAV.
* Related to that, the SEC has proposed that money funds disclose the mark to market of their portfolio (Market Value Pricing). Fidelity doesn't like that at all. Their view is that if an investor sees the mark to market at $1.001, thew will jump in because they will be getting in at a dollar. But as soon as anyone sees a market value of $0.999, they will move out, pressuring the fund (potentially creating a run on the fund).
* Fidelity slammed traditional approaches to asset backed CP investing:
Fundamental to the analysis of whether an asset backed security represents minimal credit risk is an evaluation of the sources of liquidity available to repay the security when due. Examples of sources of liquidity that appropriately should be considered in making a minimal credit risk determination include third party committed liquidity facilities and the cash flows generated by the underlying assets. Taken alone, neither an issuer's sale of underlying assets at market value nor its continued access to the market to issue new securities is sufficient.
The Commission could consider requiring that, in order to be an Eligible Security, an issuer of an asset backed security cannot rely solely on the sale of assets at market value or continued market access.
This is a great summary from the FT, showing how financial regulation is shaping up.
It's interesting to see how it is categorized: systemic risk, bank capital, consumer protection, OTC derivatives, and hedge funds. Items excluded are money markets, securitization, off-balance sheet financing, rating agencies, and some other issues that may be just as critical.
Just to add to our post on hedge fund regulation, here is a paper sent to the SEC in November of 2005. It outlinces potential problems with the Madoff funds in great detail. A simple inquiry to the fund accountants would have done the trick.
This was in your face type analysis: the SEC was fed the questions; they just had to ask them. So what exactly will the SEC accomplish with the new sweeping registration requirements? Has the agency really changed so much that now all of a sudden it will spot problems like these? How about listening to what investment professionals are saying? How about hiring a few investment professionals instead of just the securities attorneys? How about just looking at return profiles? The new financial regulation proposed by the administration is just not addressing these.
With all the buzz on financial regulation and Obama's new proposal, people often miss the basics. Regulation of financial institutions (outside of securities and consumer protection regulation) should focus on two key items:
1. Capitalization. JPMorgan was involved in all the activities that Citi was. Securitization, mortgages, leveraged loans, investment banking, derivatives, etc. What put Citibank close to bankruptcy, while JPM got larger and potentially more profitable from the crisis (with Bear and WAMU acquisitions)? Citi was poorly capitalized relative to the massive risks they were taking.
2. Liquidity. Another critical issue that gets financial institutions into trouble is the inability to roll short-term liabilities that are used to finance illiquid longer term assets. Large entities holding long term illiquid bonds that are financed by commercial paper (short-term instrument) got Citi into huge trouble. Bonds financed via the overnight repo market got Bear into trouble. Examples of this are not limited to 07-08. Similar issues popped up in 98 and earlier. The inability to roll short term liabilities combined with difficulties liquidating the assets is a reoccurring theme. It's like buying a house with a one-year balloon mortgage. Corporate treasurers refer to this concept as Asset-Liability Management 101 – you must match your asset and liability profile.
The two issues above go hand in hand. If an institution is well capitalized, it can afford to take additional liquidity risk. If it matches assets and liabilities well (borrowing long-term to finance illiquid assets), it will not need as much capital.
One other regulatory item that is important to address has to do with derivatives. Institutions must maintain appropriate margin requirements on all derivatives transactions. If AIG was asked to put up margin (to institutions who bought protection) long before AIG got downgraded, the amount of CDS they had written would have been a fraction (if any) of the actual amount.
How does a regulator implement such requirements? A comprehensive set of stress tests that address deteriorating credit quality and/or market value of portfolios, inability to roll short-term debt, default of a major counterparty, etc. should do the trick. The stress tests would get adjusted periodically to pick up the latest trends. The rest is implementation and oversight to make sure institutions are applying the stress tests properly.
When it comes to regulation, conceptual simplicity is key. Creating thousands of complex rules and setting up layers of bureaucracy will only allow financial institutions to find another loophole. That’s what happened with the Basle Accord (see The holes of the BIS rule book.)
Unfortunately simplicity doesn’t get votes, and when you have an administration that runs a permanent campaign, populism sometimes becomes the mantra.
