May 24, 2004
The OCC, OTS, Federal Reserve, FDIC and SEC are worried. On May 13th, the five regulators issued a joint statement and request for public comment on a proposed new round of internal controls and risk management procedures to reign in financial institutions that engage in complex structured finance activities (aka “derivatives”). Here is the draft proposal and below our take on this technical but significant pronouncement. After having encouraged the use of imaginary securities in the 1990’s as a way to offset risk in volatile markets, regulators now evidence a degree of alarm. The proposed statement is a grim admission that Elvis has left the building. For example: “In light of recent events, the OCC, Board, and SEC conducted special reviews of several banking and securities firms that are significant participants in the market for complex structured finance products. These reviews were designed to evaluate the product approval, transaction approval, and other internal controls and processes used by these institutions to identify and manage the legal, reputational, and other risks associated with complex structured finance transactions.” The proposed text seems focused on the idea that the banks have gone too far with existing activities. Most of the language is about reigning in the troops and making managers and directors accountable a la Sarbanes-Oxley. Yet the proposed statement suggests that the SEC and other regulators consider derivatives dealing activities appropriate and, indeed, co-equal with the other activities a financial institution may conduct. This is like equating casino gambling with productive employment and commerce. Have our standards fallen so far that we wish to publicly embrace this view? Derivatives shift wealth opportunistically. The theory behind them is to stabilize risk in volatile markets by providing a means to rectify a portion of the losses incurred in less liquid activities. However, every transaction produces a winner and a loser. In other words, 50% of market activity results in a realized loss to one party. Thus derivatives enable smarter firms with deeper talent pools to exploit lesser players. Herein lies the flaw for the financial industry. While volatility is stabilized for a few, the net effect on the system is that the losses are merely passed to the dumbest player at the table. The reality is that most banks and non-bank financial institutions do not have the scale, internal systems and, most important, human resources needed to profitably play at the derivatives table. If organizations the size of Fannie Mae (NYSE:FNM) cannot manage the duration risk of a mortgage portfolio, what makes the regulators think that the vast majority of smaller institutions can do any better playing in the world of customized derivatives contracts, the type of dealings made infamous by Enron? Why are the SEC and other agencies publishing this ridiculous proposal? Because the derivatives markets feed on a steady flow of new, inferior players, as in the case of smaller financial institutions less adept than the larger dealer banks. When the SEC and other regulators propose to issue guidelines for how financial institutions can “safely” engage in derivatives dealing activities, they are effectively acting as shills for the largest money center banks, bringing new suckers to the derivatives table to keep the game growing. Because derivatives are so important to the profitability of large dealers like JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC) and Citigroup (NYSE:C), regulators have no choice but to encourage the use of imaginary securities. Yet spreads have collapsed and three big banks now control most of the market. These banks measure their “notional” profits in mere basis points. Rather than encourage financial institutions to deploy capital in derivatives activities, the regulators instead should consider why the business models of the major financial houses seem to be increasingly focused on gaming in the first place.
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