Before the markets could move to the next game, the financial crisis demonstrated that the hands-off approach to the regulation of derivatives had been a mistake. For years, regulators had believed banks used derivatives primarily to reduce and manage their risks. Alan Greenspan and his compatriots had been overjoyed by growth of the $60 trillion market for credit derivatives. They thought banks were using collaterized debt obligations and credit default swaps to toss risk off their balance sheets. But Greenspan and his compatriots were wrong.
In reality, the banks had used credit derivatives to load up on more than a trillion dollars of hidden side bets based on risky subprime mortgages. The banks initially might have tossed risk away, but they later took back even greater risks, in highly concentrated, complicated, and secret form. The losses were so large that many of the banks were technically insolvent; the government stepped in to rescue most of them.
The scale of the recent collapse might have been unprecedented, but the risk-shifting story wasn’t new and the role of complex financial instruments and deregulation shouldn’t have been surprising. The financial crisis was the inevitable result of the transformations that began at Bankers Trust during the 1980s and continued through the collapse of dozens of major financial institutions during the following two decades. It was simply the biggest of the many dots connected in this book.
The key issues behind the recent financial crisis are the complex instruments used to skirt legal rules; the rogue employees whom managers and shareholders cannot monitor; and the incentives for managers to engage in financial malfeasance, given the deregulated markets. The antiquated system of financial regulation, developed in the 1930s and designed to prevent another market crash after 1929, no longer fits modern markets. Efforts to deregulate pockets of the markets, at the urging of financial lobbyists, have created an admixture of strict rules governing some dealings and no rules governing others. As a result, the markets are now like Swiss cheese, with the holes—the unregulated places—getting bigger every year, as parties transacting around legal rules eat away at the regulatory system from within.
The information and sophistication gap between average investors and the companies whose shares they buy is now bigger than ever, thanks to the changes in markets, law, and culture since the late 1980s. Accountants, bankers, and lawyers continue to use derivatives to avoid regulation. Corporate executives, securities analysts, and investors continue to focus more on meeting quarterly estimates of accounting earnings than on the economic reality of their businesses.
Media coverage of the stock market is as intense as ever, and though investors are bombarded by information, increasingly they cannot filter it or find anyone who will tell the truth about a particular company. In the past, when investors followed the hype about technology companies, markets soared in response, in part because of limits on betting against stocks. More recently, investor fear helped slice the market’s value in half. Whether the stock markets are going up or down, they are not nearly as efficient as a generation of economists had taught corporate and government leaders they would be.
Sometimes, markets respond quickly to new information. During the first sixty seconds after the first plane hit the World Trade Center, the German stock market fell five percent. In recent years, the values of many stocks were quartered within one day of the announcement of bad news. But often, the markets respond sluggishly, seemingly unsure of whether corporate news is credible. Just as it took securities analysts months to digest Enron’s publicly filed documents during 2001, it took investors most of 2002 to abandon their practice of buying stocks on the basis of a whim, myth, or rumor. The financial market crisis of 2007-2008 took place in slow motion, one company at a time, as investors learned it was virtually impossible for them to understand many of the companies whose stock they had been buying.
Until recently, the markets withstood losses at Bankers Trust, Procter & Gamble, Orange County, Barings, Long-Term Capital Management, Enron, and others, largely because these collapses did not create widespread panic among investors. Regulators, too, remained composed, in part because they believed that banks, which used credit derivatives to reduce their risks, had virtually eliminated the threat of a systemwide banking collapse, the primary concern of regulators in the United States.
However, regulators were wrong about where the risk went. Although many banks appeared to toss credit exposure off their balance sheets, that risk secretly swung back to them, like a financial boomerang, through complex credit derivatives. By the time regulators understood that a sharp housing price decline would destroy the major banks, it was too late.
Regulators also misunderstood the dangers of shifting risks to insurance companies, particularly American International Group (AIG). In addition to being the world’s largest insurance company, AIG was also the counterparty to half a trillion dollars of swaps with major banks throughout the world. Yet incredibly, AIG slipped through the cracks. It had quietly and cryptically disclosed its credit-derivatives exposure, in financial statement footnotes that resembled Enron’s. No one noticed.
Unfortunately, when banks pass credit risks along to insurance firms and industrial companies like AIG, these other companies become de facto banks, and the rules and oversight that have kept banks safe for decades do not cover these firms. As investors began to understand credit derivatives and the hidden risks within these nonbank firms, they panicked. When the government allowed Lehman Brothers to collapse in September 2008, investors rushed for the exits. The credit markets seized with fear. Regulators tried to rescue AIG and hurriedly helped crippled banks merge into larger, supposedly healthier ones. Federal accounting regulators tweaked their rules so banks could avoid recognizing losses. That bought some time. Yet soon it became apparent that even behemoths such as Citigroup were probably insolvent, and the markets crashed.
In November 2008, Bernard L. Madoff was arrested in New York and confessed to a $50 billion-plus pyramid investment scheme. For more than a decade, Madoff had sent his clients written statements indicating that year after year, they had earned double-digit returns from money they had invested with him. In reality, Madoff hadn’t been making any money. In fact, for thirteen years, he hadn’t even bought or sold any securities.
Madoff’s fraud was outrageous, but at its core, his scheme was not so different from what the banks had done. Both Madoff and the banks operated in the shadow of the law. Both made bad bets on complex financial instruments. Both used dubious means to hide losses from investors. As news spread about problems at the banks, the apparent gap between these institutions and Madoff narrowed, and the faith of investors, which had sustained the modern financial system, evaporated.
Regulators and investors need to rethink their approach, or the financial markets will find a new derivatives game and repeat the cycle of mania, panic, and crisis. The six recommendations that follow are drawn from the major lessons of the intertwined financial fiascos of the past twenty years. Ultimately, the health of financial markets will depend on whether credible intermediaries and new regulatory approaches can bridge the gap between investors and corporate executives, reducing the costs of the separation of ownership and control of companies, instead of providing tools and incentives for some executives to bilk their shareholders. Without a change in view and a shift of priorities, the financial markets will continue to teeter on the edge. The end of the most recent crisis will be merely the end of the beginning.
1. Treat derivatives like other financial instruments.
During the past two decades, regulators have treated derivatives differently from other financial instruments, even if they were economically similar. Different rules led parties to engage in “regulatory arbitrage,” using derivatives instead of securities simply for the purpose of avoiding the law.1 There were numerous instances of the differential treatment of derivatives and equivalent financial instruments: stock options were accounted for differently from other compensation expenses, prepaid swaps and other of
f-balance-sheet deals were recorded differently from loans, over-the-counter derivatives were exempt from securities rules applicable to economically similar deals, swaps were regulated differently from equivalent securities, and credit default swaps were treated differently from insurance. The result was a split between perceived costs (the numbers reported on corporate financial statements) and economic reality (the numbers reported in incomplete or misleading footnotes, or not reported at all).
Derivatives and financial innovation generate great benefits, enabling parties to reduce risks and costs. In theory, some derivatives markets might appropriately be left unregulated. But you can’t forget that some derivatives are economically equivalent to other financial instruments. Andy Krieger made money trading options, in part because other traders thought he had sold when he really had bought in a different market. Bankers Trust sold swaps that were really complex trades based on interest-rate indices. CSFP’s structured notes were really currency bets. Salomon’s Arbitrage Group and Long-Term Capital Management bought cheap options embedded in bonds and then sold equivalent options in a different market. Nick Leeson of Barings bought and sold futures indices on the same Japanese stocks in both Osaka and Singapore.
The problem is that when similar financial instruments are regulated differently, parties are encouraged to use the less-regulated version to hide risks or to manipulate financial disclosures.2 As long as “securities” are regulated, but similar “derivatives” are not, derivatives will be the dark place where regulated parties do their dirty deeds. The only way to reverse the trend is for regulators to apply various rules—prohibitions on fraud, disclosure requirements, banking regulations, and so forth—on the basis of the economic characteristics of the financial instrument, not on whether the instrument is called a derivative.
Moreover, it is foolish to deregulate markets simply because large institutions, instead of individuals, are involved.3 Ultimately, individuals are at risk, as the owners of institutions, and the relevant question should not be the size or wealth of an institutional investor, but rather its sophistication relative to the firm selling the derivatives it was buying. As Gibson Greetings and Procter & Gamble have shown, large companies can be babes in the woods compared with Wall Street bankers. A well-established economic principle is that markets with large gaps in sophistication and information—such as the market for used “lemon” cars—do not function very well. It isn’t that Procter & Gamble was defenseless when approached by Bankers Trust’s nerdy sales force; it is that the costs of an unregulated market were too great, given the sophistication and information gaps between Procter & Gamble and Wall Street bankers. “Suitability” rules are designed to cover trades with institutions as well as individuals.4 Bankers often deny this intent, however, and courts sometimes believe them.5
The derivatives playing field is skewed in favor of Wall Street banks, thanks to financial-market lobbyists, especially ISDA, the International Swaps and Derivatives Association.6 In February 2002, Jeff Madrick, a financial expert writing in the New York Review of Books, expressed doubt that public pressure would lead government officials to change rules applicable to derivatives.7 He was correct, in part because derivatives were so difficult for people to understand. More recently, the media have paid some attention to derivatives, and the average investor has at least heard of swaps. Still, ISDA has waited quietly, ready to pounce on any serious regulatory proposals, just as it had pressed Congress to deregulate swaps in 2000.
Legislators and regulators need to understand that the more they listen to ISDA and carve up markets, the harder it is for anyone—regulators and corporate executives—to keep tabs on risks. Simply put, much of the $600-plus trillion derivatives market exists because private parties are doing deals to avoid the law. Regardless of whether you favor more or less regulation, that is an unhealthy result.
2. Shift from rules to standards.
A similar and related problem is that regulators increasingly have emphasized narrow rules in an attempt to provide clarity to market participants. Accounting rules ostensibly tell parties exactly what they can count as revenue or what they must include as a liability on their balance sheets. Securities rules direct parties to disclose particular information every financial quarter. Elaborate guidelines specify how parties can satisfy these disclosure requirements, for example, by disclosing to investors a measure of Value At Risk (VAR)—the likely maximum one-day loss—for particular investments.
Market participants respond to these narrow rules by transacting around them. There have been numerous examples. Paul Mozer of Salomon engineered bids for clients in an attempt to satisfy the letter of the 35 percent maximum for U.S. Treasury auctions. The case against Mozer was successful only because he so brazenly bid more than 35 percent. Robert Citron of Orange County made huge interest-rate bets while technically in compliance with county investment guidelines, because he bought only short-term, AAA-rated, structured notes. Enron solicited outside investors to satisfy the three percent minimum, so that it could keep partnerships off balance sheet. Global Crossing followed accounting rules in booking up-front revenue from indefeasible right use (IRU) swaps. Specific rules made prosecuting officials of Enron and Global Crossing more difficult, because the executives could claim they were merely relying on an outside auditor’s interpretation of the rule, or on counsel’s advice that the rule permitted their actions.
Such narrow rules have two unanticipated effects. First, by clearly specifying what parties can and cannot do, the rules provide a safe haven for anyone doing something not explicitly covered by the rules. Absent a specific prohibition against doing so, companies increasingly recognize revenue up front, move liabilities off balance sheet, avoid disclosing important facts, or disclose misleading facts that arguably fit within the applicable rules. For example, Enron’s VAR disclosures were so dubious that investors did not even flinch when the firm tripled its reported risk in 2000 and even admitted, in a footnote, that its previous VAR models had not worked properly.8 None of this mattered, because no one imagined that Enron’s VAR disclosure was intended to do anything other than satisfy the applicable regulatory requirement.
Second, because specific rules are effectively carved in stone, they ensure that the regulatory regime will become obsolete, almost immediately. Rule changes take a great deal of time; the Financial Accounting Standards Board spent years debating changes to accounting rules for stock options and other derivatives. In contrast, financial innovation proceeds at a breakneck pace, with banks inventing new deals every day. Specific rules are inevitably left in the dust.
The lesson is that regulators need to shift away from narrow rules, which parties have shown skill in avoiding and exploiting, to broader standards, which would help encourage a culture of honesty.9 For example, a broad anti-abuse standard could prohibit companies from disclosing information contrary to economic reality, even if a technical accounting rule might permit them to do so. International accounting regulators have developed a few dozen general standards for parties to follow, the notion being that individual parties would exercise judgment to determine whether a particular accounting treatment was appropriate, given the standards. The SEC should follow suit.
It might seem at first that permitting financial actors to use their judgment in determining the regulatory treatment in specific cases would exacerbate the inaccuracies of financial reporting. Accountants, bankers, lawyers, and corporate executives have indeed spent the last decade exhibiting an eagerness to transact in order to avoid the law, in many cases being transformed from the professional “gatekeepers” of financial markets into horse traders and snake-oil salesmen. But one reason they have done so is that specific rules have given them cover. These actors have not needed to risk their own reputation for honesty; instead, they have relied on the bare letter of the law. In contrast, parties subject to a more general standard would be forced to rely on their own judgment about the fairness, risk, or economic reality of a transaction, and
if those deals were later scrutinized, the parties would not be able to point to a specific rule as an excuse.
Recall the three percent rule—the rule that allowed companies to treat Special Purpose Entities as off balance sheet so long as an outside party bought at least three percent of the SPE’s capital. Accounting regulators have debated whether some higher number—perhaps ten percent—would be more appropriate.10 But this path is a slippery slope. Would nine percent be appropriate for some deals? Would later rules specify what counted toward the ten percent? Or what type of outside investor was truly independent? Instead of simply changing the percentage requirement of the specific rule, a better approach would be a general standard that requires companies to account for the value of their share of all outside investments, regardless of their ownership interest—including their share of the assets and liabilities of SPEs. To the extent a company wants to explain to investors why they shouldn’t worry about the liabilities of a particular SPE, the company can do so in footnotes to its financial statements. But hiding liabilities should no longer be a valid reason to use SPEs. Outside the United States, international accounting standards are moving in this direction, but the U.S. approach remains unclear.
Likewise, proposed rules for calculating the amount of capital that financial institutions must set aside for particular risks—known as the Basel II proposal—include both specific rules and general standards, as in a provision for regulators to consider the core economic risks of credit-derivatives deals. This second approach—generalized standards based on economic reality—both discourages deals designed simply to avoid legal rules and encourages financial institutions to assess their own risks properly.
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