Beyond our control
By Daniel M. Ryan
Last week, the Counterparty Risk Management Group issued its third report (CPRMG III) on how to prevent the hazards of derivatives from spinning out of control again. The headline name on it is former Federal Reserve Bank of New York governor E. Gerald Corrigan, although four of the sixteen policy group members are either chief or co-chief risk officers. Unsurprisingly, one of their recommendations is for every big financial firm in the derivatives market to appoint a Chief Risk Officer (CRO), who would report directly to the CEO and command some real clout in the organization.
The recommendation that got the most press notice was for a new clearing house for derivatives, particularly the new varieties of collateralized debt obligations (CDOs), so as to extinguish offsetting trades as much as possible. Doing so would immediately drop the notional value of total trades outstanding, to the extent that some specific trades offset other specific trades on the books of the same firm. As the report indicated, though, the netting out of non-mirroring trades, through a one-time lump payment per day from one member firm to another, will require reliable standardization of CDO contracts. It was this part of the report that the mainstream media tended to seize upon – because, I suspect, of the need for a new regulatory agency to oversee this new clearing-house initiative. Long-time observers of the MSM have a certain hunch that a proposal for more regulation would be the part that MSM reporters would consider most newsworthy.
Actually, that proposal does stick out because most of the recommendations are for greater internal controls and CDO-contract standardization. (I'm tempted to aver that a proposal for a new regulatory body is the standard cumshaw for getting around the antitrust laws.) The bulk of the recommendations revolve around participant players and dealers squaring off with the protocols and procedures recommended by the Basel II Accord. Oddly, the process of "soberization" that the report recommends reminded me a lot of the securities-and-banking regulatory setup in Canada. The Canadian approach has long relied on self-regulatory organizations, which are explicitly identified in provincial securities statutes, and on "moral suasion" between regulators and industry participants.
The philosophy of industry self-regulation, including constraints to keep out potential loose cannons, is very much part of this report. Recommendation V-22 – "The Policy Group recommends that the industry should consider the formation of a ‘default management group', composed of senior business representatives of major market participants (from the buy-side as well as the sell-side) to work with the regulatory authorities on an ongoing basis to consider and anticipate issues likely to arise in the event of a default of a major market counterparty" – although presumably based upon the Plunge Protection Team, bears a definite resemblance to business as usual between the provincial securities-regulatory bodies and investment dealers in Canada (particularly in Ontario.) Here, though, it's largely done on an ad-hoc basis through explicit solicitation of comments from investment dealers when a reg change is being promulgated.
As indicated above, though, the bulk of the report deals with how matters got out of hand in the CDO market. Although the terminology is arcane, arcane enough to require the non-specialist in the field to give his/her search engine (and Wikipedia) a workout, the underlying narrative is a familiar one in the securities industry. It confirms that the financial services industry is a cyclical one. This episode was a re-play of the old story of oversight standards being eroded as memories of previous systemic crises faded.
In the financials, though, the process revolves around the opportunity cost of skepticism. The "story behind the story" is about the trust-skepticism calculus changing as the possibility of bad times fades away.
In an optimal universe, there would be a set of decision technologies that quickly and reliably enabled a derivative buyer, seller or agent to spot a transaction that will go wrong. Since the future is unpredictable, what the previous sentence amounts to is a decision technology that catches all black-swan events while letting through all transactions that will not be affected by one. Since no such technology exists, the players have to use one of two heuristics: a bias towards turning down deals that may blow up, or a bias towards letting that kind of deal through. A bias towards skepticism, or Type II errors, or a bias towards trust, or type I errors.
When the industry's been burned, the bias towards skepticism settles back in. Entrepreneurial gains are then made though failing to reject deals that look suspicious but succeed anyway. Since the industry's still in the depressed phase, though, the total additional revenue to be gained through doing so isn't that much. Consequently, there isn't that much earnings to lose by shying away from those kinds of transactions.
As the industry recovers, and demand for its services increases, the gains from trustfulness and ‘yes-man'ing also increase. Consequently, the opportunity costs of skepticism also increase. As a result, the old-time suspiciousness erodes through competitive pressure heating up.
The larger force at work is increasing demand. As demand goes up, it's not only the price that shows a tendency to go up…it's also volume. The competitive squeeze in a cyclical industry – in any cyclical industry – results in procedure shortcuts that are needed to handle the increased volume of business. It's not primarily a question of costs; it's a question of capabilities. One of the effects of a boom is a scramble for personnel and system suites, which brings in relatively less experienced or skilled workers and relatively field-untested systems. Since no-one can know the precise moment when the downturn will begin again, and because the returns tend to be greatest just before the downturn, the industry captains settle on a "might as well make hay while the sun shines" approach. This process almost guarantees that there'll be another panic in the industry after times get hot again. The best that can be hoped for from implementation of the CRMPG III report is an avoidance of the specific mistakes made in the recent past.
In this sense, the mortgage CDO blowup is a lot like the back-office records crisis that erupted in Wall Street as of 1970. Back then, the solution proffered was computerization of records, as well as other kinds of standardization – and it took about a decade before the bugs were ironed out of the new and improved systems. Reform measures always bump into Murphy's Law – always – because they necessitate a change of habits, which always takes some time to see through. Until that habituation is complete, there will always be blind spots.
Really, there's no way to permanently reform the continual blow-ups that take place in the securities industry. Competitive pressures unique to a cyclical industry make permanent reform impracticable through private-sector means. Given this fact, the best that can be hoped for from private-sector reforms is a fixit job. Give the cyclicality of the industry, and the resourcefulness that goes with it, it's an easy call that today's reform measures will plant the seeds of tomorrow's crisis. The essence of resourcefulness, after all, is the turning of setbacks into opportunities. In this specific case, the recommendations towards bringing off-balance liabilities back on to the balance sheet mesh well with a future push to conglomeratization. The financial tricks that were used in the last wave of conglomeratization in the 1960s, although confined to Main Street industries back then, will resurface in the financial industry. The star of the next show will be the financial-services institution that racks up impressive earnings growth through adding items to the balance sheet, as well as to the income statement. It can be done most simply through one of the basic tricks of the conglomerateur: buying earnings growth at a discount. (This buy-up is effected by taking over companies with stable earnings whose P/E ratio is significantly lower than that of the acquirer, through common-stock-only offers.) Given this angle, it seems almost a certainty that the next regs to be strained are the ones that limit consolidation in the financial-services industry.
As long as there's an angle, private-sector reforms will resemble a patch-up job. So will governmental means, unless radical reform is used. The governmental measures that would put an end to the boom-bust-bailout process would involve a real slam-down, one that would be revolutionary in scope. There are only two governmental measures to get rid of the continual boom, bust and bailout sequence: either the promulgation and enactment of iron prohibitions on certain transactions that are deemed too shady to be borne, or the refusal to bail out any more firms. Cutting them off entirely, and confining any bailout measures to direct relief of small account-holders.
Both methods would make the financial-services industry a shadow of its former self. The first would do so through "mass unemployment by mandate," and the second would do so through wholesale bankruptcies. Interestingly, the latter approach is often deemed to be ‘theological'…even though it's the former measure that arbitrarily, if common-sensically, renders certain entrepreneurial activities taboo.
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