Lawbitrage

Lawbitrage Links 1/14/13

Statement By Commissioner Scott D. O’Malia - Approving Portfolio Margining of Swaps and Security Based Swaps in 4d(f) Accounts (CFTC)

Court of Appeals Affirms Validity of New York Choice-of-Law Provisions (JD Supra)

Wall Street Returns to Property CDOs in Yield Hunt (Bloomberg)

Financial Technology Start-Ups: Can They Compete? (Mondato)

Bruce Brittain on hedge fund due diligence given the "new normal." (PIMCO)

Researchers Risk Insider Trading (The Scientist via Securities Docket)

BOE Proposes Power to Target Risks in Mortgages, Derivatives (Bloomberg via Derivalert.org)

CFTC Follows SEC in Permitting Offsets for Cleared CDS at ICE (Dow Jones Newswires)

FINRA Proposes to Tighten Definition of "Public Arbitrator" (Securities Law Prof)

Brazilian states break financing mould (Reuters)

Hedge Fund "Sharks Going After' Paulson: (HITC Business)

Comptroller Curry discusses 2013 opportunities and challenges (OCC.gov)

How iPhone Sales Could Fuel Derivatives Trades

"Highly interconnected" aptly describes the modern financial system and motivates widely shared concerns about it.

Former banker and fund manager Richard Bookstaber, for example, views the "tight coupling" of various aspects of the financial system as fraught with risk and prone to crashes. Lawmakers and regulators, for their part, do not want institutions to become too interconnected to fail.

But it seems that the evolution of financial markets and the effects of financial reform may result in markets becoming more interconnected than ever. Or least interconnected in new ways when it comes to the all important issue of collateral.

To help make the most out of scarce, high-quality collateral, banks and other financial firms have been increasingly focusing on collateral management. But regulatory reforms mandating the use of high-quality collateral for derivatives trades and other transactions has also spurred the activity known as collateral transformation, which involves trading lower quality collateral, such as risky corporate bonds, for higher quality collateral like government bonds or cash.

Estimates of how much collateral will ultimately be required to comply with new regulations vary greatly and range from $500 million to $2.6 trillion, as noted by Bloomberg. Proposed Basel III bank capital regulations, for example, would require bilateral over-the-counter derivatives trades to be collateralized with cash, high quality bonds and equities, or gold. Firms lacking the qualifying collateral could trade up to comply. 

A potential source of high-quality collateral may come from outside the banking system--from corporations flush with cash. In summarizing the November 6th, 2012 remarks of Vanaja Indra, Risk.net reported that

Cash-rich corporates could ride to the rescue...Many of these have enjoyed high profitability over the past few years and have stockpiled cash to defend ratings or build takeover war-chests. Apple, Microsoft, Cisco Systems, Google and Pfizer had a combined cash balance of $276 billion at the end of 2011, according to one report from Moody's Investors Service.

By removing some of the funding risk outside of the banking system, corporate cash lending may reduce systemic risk. But if corporations begin seriously lending their cash in exchange for lower quality assets, the real economy will become interconnected with the financial system in an unprecedented way.

So who knows, maybe sometime soon your next iPhone purchase will help to fund a derivatives trade.

Dodd-Frank May Not Be a "Kiss" to Big Banks, But it's At Least a Hug

Republican Presidential candidate Mitt Romney stirred controversy after last week's presidential debate where he referred to the landmark Dodd-Frank Act of 2010 as "the biggest kiss given to New York banks I've ever seen" because it "designate[s] five banks as too big to fail and give[s] them a blank check."

Critics of Romney's position, such as Rep. Barney Frank (D-Mass.), responded by asserting that Dodd-Frank's new resolution authority for winding down failed banks actually prohibits bank bailouts and that any government funds used to assist banks must be repaid by an industry-wide assessment fee.

Dodd-Frank Allows the Government to Bail Out Banks

While it is certainly true that Romney greatly exaggerated his point in the debate, he did identify an important truth: Dodd-Frank still allows government bailouts of systemically important financial institutions.

Although Dodd-Frank fortunately makes it more difficult for failed or troubled financial institutions to receive government support, the Act does permit government bailouts or fails to prohibit them entirely:

• Dodd-Frank permits the Federal Deposit Insurance Corporation (FDIC) to bail out short-term creditors of financial institutions, including their commercial paper and repo lenders. The FDIC may obtain funds to lent to short-term creditors from the Treasury Department, and in an amount that is largely determined by what the FDIC deems as being the "fair value" of a failed institution's assets. And while it's true that the FDIC must repay the Treasury by charging a fee to other financial institutions, the fee is assessed only after a bailout takes place. This ex-post funding creates an implicit subsidy on risk taking because it is unlikely that the assessment will be able to be fully paid after a financial crisis, and certainly not by the firm that failed.

• Dodd-Frank does not prohibit the FDIC from borrowing up to $100 billion from the Treasury for "insurance purposes" to protect unsecured creditors. This regulatory power is given to the FDIC under 12 U.S.C. § 1824(a) and would require the FDIC's funding to take place outside Dodd-Frank's liquidation authority.

• Dodd-Frank allows the FDIC to provide full protection to a financial institution that owns a failed bank under the systemic risk exception to the Federal Deposit Insurance Act. This type of bailout is limited to situations where overall financial stability is at stake and approval has been obtained from the Treasury Secretary and the Federal Reserve.

• Dodd-Frank permits troubled financial institutions to borrow under the Federal Reserve's section 13(3) authority, so long as the Treasury Secretary approves and the funds are made available broadly and only to financial institutions deemed to be fundamentally solvent.

• Dodd-Frank still permits troubled institutions to borrow on an individual basis from the Federal Reserve's discount window or the Federal Home Loan Bank.

Professor Arthur Wilmarth explains these Dodd-Frank loopholes in detail in an insightful March 2012 article arguing that bank activities should be highly circumscribed by law.

The Market Believes Future Bailouts Will Take Place

Would the foregoing potential sources of government funds for failed or troubled financial institutions be used? In the midst of another financial crisis, it is difficult to imagine that these sources would not be used, especially if beneficial politically.

Indeed, a 2012 study by International Monetary Fund researchers Kenichi Ueda and Beatrice Weder di Mauro estimated that the expectation that governments will provide assistance to large financial institution creditors decreases the institutions' borrowing costs by 0.8 percent. And as Bloomberg's Christine Harper and Hugh Son recently noted, federally insured funds in the form of deposits subsidize risk taking by banks and their affiliated financial institutions on an ongoing basis.

It's hard to characterize Dodd-Frank as a big kiss to banks since it imposes costly regulation on all of them, and most especially on the ones deemed too big to fail. But Dodd-Frank does leave the door open for the creditors of large banks and other financial institutions to receive government support. So while Dodd-Frank is not really the kiss that Romney described, it should at least be viewed as a governmental embrace of certain financial creditors.

As Credit Markets Evolve, Banks and Derivatives Take a Back Seat

Credit markets continue to evolve in light of lessons learned from the 2008 financial crisis, more stringent regulation, and technological improvements.

Whatever ultimate impact the foregoing changes have on credit markets, they are likely driving two important trends.

The first trend is commercial banks playing a smaller role in the economy. A good reflection of this trend is the shrinking share of banks as investors in loans made by multiple lenders (i.e., leveraged/syndicated loans). As Steve Miller reports, bank participation in leveraged loans relative to that of non-banks hit a record low in the third quarter of 2012, down to 13%. The following chart from the story shows significantly reduced bank participation in the leveraged loan market since 2009 (and also that this trend is the culmination of a phenomenon underway for nearly two decades).

A second important trend in credit markets is the reduced use of credit derivatives. The September 2012 quarterly report by the Bank for International Settlements contains the following chart that shows the decline in the notional value of credit default swap (CDS) derivatives since 2008.

CDS trading is also decreasing. As Stephen Folely recently reported in the Financial Times, so far in 2012 "trading in individual corporate CDS is down 23 per cent." 

Additional regulatory requirements are likely driving the steady decline of CDSs, which will soon not offer banks the capital relief they once did--quite the opposite. But the ability to transfer credit risk through other means is also likely behind the decline. The willingness of investors to buy bonds backed by corporate debt (i.e., collateralized loan obligations) at prices attractive to issuers decreases the benefit of transferring that same risk through the use of derivatives.

If these trends hold, we can expect that banks and credit derivatives will play a smaller role in the financial system of the future. The key question is what will take their place.

Don't Be Afraid of Your Own Shadow: How Securitization Increases Transparency

Securitization vehicles are a central component of what is often referred to as the "shadow banking" system. As the name implies, shadow banking is not a part of the financial system that's generally considered to be transparent. Indeed, increasing shadow banking transparency was at the top of Fed governor Daniel Tarullo's list of policy prescriptions in a June 2012 speech:

First, we should create greater transparency with respect to the various transactions and markets that comprise the shadow banking system. For example, large segments of the repo market remain opaque today. In fact, at present there is no way that regulators or market participants can precisely determine even the overall volume of bilateral repo transactions--that is, transactions not settled using the triparty mechanism.

There seems to be growing recognition, however, that the securitization aspect of shadow banking actually increases financial market transparency by moving out into the open assets that are hidden beneath opaque bank balance sheets.

For example, a March 2012 study (p.11) on shadow banking by ICMA's European Repo Council, which itself drew upon a 2010 New York Fed paper, noted that by removing assets from banks,

Securitisation potentially involves the market in the supervision of banks, by providing third-party discipline and the market pricing of assets that would be opaque if left on a bank balance sheet.

In a July 2012 Financial Times op-ed, Sebastian Mallaby likewise noted that

Before securitisation, banks made loans and held them; investors who bought bank shares got an opaque bundle of exposures. Now, thanks to securitisation, investors can cherry-pick the risks that suit them.

And as picked up on by Dealbreaker's Matt Levine, in an August 2012 paper William Bratton and Adam Levitin more generally argued that

Even though the conventional operating company’s debt can be issued pursuant to a much simpler contract, market’s overall analysis will have to grapple with the factual complexity of the company and its business; there will be inevitable opaque patches in its profile....A synthetic [read really "structured product"], in contrast, is completely transparent — the assets are there on a list for all to see, each rated by a credit rating agency.  

But what about the reputation for opaqueness that securitization vehicles in the form of mortgage-backed collateralized debt obligations (CDOs) earned after the financial crisis? That reputation is undeserved, according to Philadelphia Fed researchers:

One of the enduring myths of the crisis is that loan-level data on the mortgage securities in these CDOs were not available to properly value these CDOs. Loan-level data were available on most securities directly through Intex, with data on most others available from third-party vendors. Disclosures on securities recommended in the reforms by the IOSCO Technical Committee...were already mostly available for the [structured finance asset-backed security] CDOs. For investors, it was all available upon request.

So while aspects of the shadow banking system are certainly less transparent than traditional banking, it is a mistake to think that shadow banking vehicles in all instances reduce transparency. When it comes to banks and other credit originators, a core element of shadow banking--securitization--increases the market's ability to scrutinize assets that would otherwise be held by originators.

The implication of this insight for bank investors is to ask themselves why they would buy bank bonds as opposed to those issued by securitization vehicles. For regulators, an implication is that a possibly overlooked consequence of reforms that reduce securitization activity is undermining the ability of investors to price financial assets more accurately.