In an earlier article for Asia Times Online,
Tip-toe regulatory reform [Jun 18], I referred to George Soros -
the speculator who broke the Bank of England over a defense of the pound
sterling - as having said in the Financial Times that a requirement for lenders
selling securitized loans as securities to retain 5% exposure "is more symbolic
than substantive". This is because many institutions were playing the game of
regulatory arbitrage, the practice of taking advantage of a regulatory
difference between two or more markets.
The issue of regulatory arbitrage was discussed in my recent article on my
website: "Mark-to-Market vs Mark-to-Model" [1], an abridged version of which
also appeared on the website of New Deal 2.0, a project of the Franklin and
Eleanor Roosevelt Institute. [2]
AIG Financial Products (AIGFP), based in London, where the
regulatory regime was less restrictive than in the US, took advantage of AIG's
statute categorization as an insurance company and therefore not subject to the
same burdensome rules on capital reserves as banks. AIG would not need to set
aside anything but a tiny sliver of capital if it would insure the super-senior
risk tranches of collateralized debt obligations (CDOs) in its holdings.
Nor was the insurer likely to face hard questions from its own regulators
because AIGFP had largely fallen through the inter-agency cracks of oversight.
It was regulated by the US Office for Thrift Supervision, whose staff had
inadequate expertise in the field of cutting-edge structured finance products.
AIGFP insured bank-held super-senior risk CDOs in the broad CDS market. AIG
would earn a relatively trifling fee for providing this coverage - just 0.02
cents for each dollar insured per year. For the buyer of such insurance, the
cost is insignificant for the critical benefit, particularly in the financial
advantage associated with a good credit rating, which the buyer receives not
because the instruments are "safe" but because the risk was insured by AIGFP.
For AIG, with 0.02 cents multiplied a few hundred billion times, it adds up to
an appreciable income stream, particularly if no reserves are required to cover
the supposedly non-existent risk. Regulators were told by the banks that a way
had been found to remove all credit risk from their CDO deals.
As an example, an investor buys a CDS contract from a triple-A-rated bank to
insure against the eventuality of a counterparty defaulting, by making regular
insurance payments to the bank for the protection. If the counterparty defaults
on its commitment at any time during the duration of the contract by missing an
agreed interest payment or failing to repay the principle at maturity, the
investor will be assured to receive a one-off payment of the insured amount
from the bank - whose credit rating is triple-A - and the CDS contract is
terminated.
If the investor actually holds the debt from the counterparty, the CDS contract
works as a hedge against counterparty default. But investors can also buy CDS
contracts on debts they do not hold, as a speculative play, to bet against the
solvency of one side of the any counterparty relationship in a gamble to make
money if it fails, or to hedge investments in other parties whose fortunes are
expected to be similar to those of the target party.
If a counterparty defaults, one of two things can happen:
1. The insured investor delivers a defaulted asset to the insurer bank for a
payment at par value. This is known as physical settlement.
2. The insuring bank pays the investor the difference between the par value and
the market price of a specified debt obligation after recovery to cover the
loss. This is known as cash settlement.
The spread of a CDS is the annual amount the "protection buyer" must pay the
"protection seller" over the length of the contract, expressed as a percentage
of the notional value. For example, if the CDS spread of counterparty risk is
100 basis points (1%), then an investor buying $100 million worth of protection
from the insuring bank must pay the bank US$1 million per year. These payments
continue until either the CDS contract expires or the target counterparty
defaults, at which point the insuring bank pays the insured of outstanding
value owed by of the counterparty.
All things being equal, at any given time, if the maturity of two credit
default swaps is the same, then the CDS associated with a particular
counterparty with a higher CDS spread is considered more likely to default by
the market, since a higher fee is being charged to protect against this
happening. However, factors such as liquidity and estimated loss given default
can impact the comparison. When spread skyrockets during a market seizure,
insurers can fail because they are not required to adjust regular income
statements to show balance sheet volatility. This was what happened to AIG,
which provided no reserves for its CDS contracts.
Systemic risk and credit rating
Thus there were two dimensions to the cause of the current credit crisis. The
first was that unit risk was not eliminated, merely transferred to a larger
pool to make it invisible statistically. The second, and more ominous, was that
regulatory risks were defined by credit ratings, and the two fed on each other
inversely. As credit rating rose, risk exposure fell to create an under-pricing
of risk. But as risk exposure rose, credit rating fell to exacerbate a further
rise of risk exposure in a chain reaction that detonated a debt explosion of
atomic dimension.
The Office of the Comptroller of the Currency and the Federal Reserve jointly
allowed banks with CDS insurance to keep super-senior risk assets on their
books without adding capital because the risk was insured. Normally, if the
banks held the super-senior risk on their books, they would need to post 8%
capital. But capital could be reduced to one-fifth the normal amount (20% of
8%, meaning $160 for every $10,000 of risk on the books) if banks could prove
to the regulators that the risk of default on the super-senior portion of the
deals was truly negligible, and if the securities being issued via a CDO
structure carried a Triple-A credit rating from a "nationally recognized credit
rating agency", such as Standard & Poor's rating on AIG.
With CDS insurance, banks then could cut the normal $800 million capital for
every $10 billion of corporate loans on their books to just $160 million,
meaning banks with CDS insurance could lend up to five times more on the same
capital. The CDS-insured CDO deals could then bypass international banking
rules on capital. To correct this bypass is a key reason why the government
wanted to conduct stress tests on banks in 2009 to see if banks needed to raise
new capital in a downward loss-given default.
CDS contracts are generally subject to mark-to-market accounting that
introduces regular periodic income statements to show balance sheet volatility
that would not be present in a regulated insurance contract. Further, the buyer
of a CDS does not even need to own the underlying security or other form of
credit exposure. In fact, the buyer does not even have to suffer an actual loss
from the default event - only a virtual loss would suffice for collection of
the insured notional amount. So, at 0.02 cents to a dollar (1 to 10,000 odd),
speculators could place bets to collect astronomical payouts in billions with
affordable losses. A $10,000 bet on a CDS default could stand to win
$100,000,000 within a year. That was exactly what many hedge funds did because
they could recoup all their lost bets even if they only won once in 10,000
years.
As it turns out, many only had to wait a a couple of years before winning a
huge windfall. But until AIG was bailed out by the Fed, these hedge funds were
not sure they could collect their winnings.
Alan Greenspan, the former Federal Reserve chairman, was not unaware of the
problem of regulatory arbitrage, but he chose to permit it as "desirable".
In the October 1998 article, "The Role of Capital in Optimal Banking
Supervision and Regulation" [3] Greenspan wrote: "It is clear that our major
banks have become quite efficient at engaging in such desirable forms of
regulatory capital arbitrage, through securitization and other devices."
Greenspan wrote that "a reasonable principle for setting regulatory soundness
standards is to act much as the market would if there were no safety net and
all market participants were fully informed. For example, requiring all of our
regulated financial institutions to maintain insolvency probabilities that are
equivalent to a triple-A rating standard would be demonstrably too stringent
because there are very few such entities among unregulated financial
institutions not subject to the safety net."
He went on: "We have no choice but to continue to plan for a successor to the
simple risk-weighting approach to capital requirements embodied within the
current regulatory standard. While it is unclear at present exactly what that
successor might be, it seems clear that adding more and more layers of
arbitrary regulation would be counterproductive. We should, rather, look for
ways to harness market tools and market-like incentives whenever possible, by
using banks' own policies, behaviors, and technologies in improving the
supervisory process."
And he went further: "Finally, we should always remind ourselves that
supervision and regulation are neither infallible nor likely to prove
sufficient to meet all our intended goals. Put another way, the Basle standard
and the bank examination process, even if structured in optimal fashion, are a
second line of support for bank soundness. Supervision and regulation can never
be a substitute for a bank's own internal scrutiny of its counterparties and
for the market's scrutiny of the bank. Therefore, we should not, for example,
abandon efforts to contain the scope of the safety net or to press for
increases in the quantity and quality of financial disclosures by regulated
institutions."
In other words, Greenspan looked to self regulation as the first line of
defense and increased disclosure as the appropriate path, not supervision and
regulation.
Greenspan concluded: "If we follow these basic prescriptions, I suspect that
history will look favorably on our attempts at crafting regulatory policy."
Greenspan was unjustifiably complacent about how history would judge him and
his views on regulation.
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