Thursday, May 01, 2008

Regulator Cage Fight Round 1

I didn't want to sidetrack the earlier "Bailing Wire" post by getting into the passive-aggressive Fed-SEC situation, but in case you're interested, there's a pretty simple example of what drives them nuts. By now we all know and love mortgage-backed securities (MBS) and credit derivatives. Contrary to pop media, these are:

  • NOT the root of all evils
  • NOT black boxes of snake oil where banks hide their woes
  • NOT miracles of math only understandable to Nobel laureates

They're simply contracts between two willing partners. At the risk of grossly over-simplifying:

  • An MBS is where a bank says "Wanna go in together on some loans to people for their mortgages?"
  • A credit derivative is insurance a bank buys in case one of their (corporate) customers can't pay back a loan.

The Fed always tries to see the above as basically mutated loans with some collateral. Not surprising since all their examination methods and risk math and prudence have root in loans and collateral. They recognize that banks do "the trading thing" but honestly I don't think I've ever seen a Fed regulator on a trading floor. Good thing I suppose - kinda like taking your grandma to a rave. When grandma & co show up at the bank, they want to know that the loan was given a credit rating, that the collateral is sitting in the vault, that the bank didn't discriminate on the basis of race in extending the loan, that the customer got checked against the OFAC list of druglords and terrorists.

The SEC guys, on the other hand, are clearly all ex-DJs who are most at home dancing sweatily at a club at 3am with plenty of foreign substances in their bloodstream. They come from a trading background and insist that everything they see is a security like a stock or bond. So, when they look at an MBS or a credit derivative, they see a bond. Their focus making sure that the bond got marked to market this week, that it was not subject to insider trading, that the salesdude's Series 7 license is current and that he has pissed in a cup recently, and that the required quarterly reports got filed (into the ether).

Notice that neither really "gets it." Neither is wrong, by the way, but they both have blind spots. Both, of course, are too smart not to pay lip service to the others' focus. "Yeah, we do that too" they'll assure. SEC guys are particularly good at beating their A-type chests in lieu of giving facts when their methods are questioned. When that doesn't work, they duck into their fortress of Ivy League lawyers. Fed guys prefer to hide behind politicians, but otherwise the behavior is just as bad.

Too bad they can't come together to look at the same instrument holistically and apply a comprehensive set of tests. Coming from a corporate banking background which became an i-bank via merger, I've had more than my share of banker-vs-trader fights where grown adults play a game of "Son, this is how the family has ALways done it!" vs. "Aww, Dad, that's so yesterday. This is how all the cool kids are doing it!" Having been on the side of the "dads" I always fought hard but secretly felt that the kids prolly were on to something. They, at least in their lip service, talk about multiple forms of risk:

  • Counterparty Risk
  • Liquidity Risk
  • Interest Rate Risk
  • Market Risk
  • Country Risk
  • Settlement Risk
  • Credit Risk

They unfortunately neglect that last one most of the time. It's not sexy and they figure that nobody would ever actually hold a security long enough for it to actually spoil. Plus, if, perchance, they ever lose the perpetual game of asset hot potato, they just whip out their lawyers.

On the bank side, Europeans, unusually, are ahead of the curve in that they've long supported the Basel accord on capital adequacy. Basel II recognizes 3 types of risk:

  • Market Risk - meant to take all of the above into account, but which they shortsightedly break into:
    • Equity Risk
    • Interest Rate Risk
    • Currency Risk
    • Commodity Risk
  • Credit Risk
  • Operational Risk

It challenges banks to be able to quantify and constantly measure their risk along the three axes. It's a start. Most US banks don't really "get it" either, but their banking execs round out the list above by talking about Reputational Risk and Regulatory Risk, both of which can arguably fall into the last category above.

I know "these things take time" and all that jazz. I'm chronically impatient. I don't understand why people spend man-years of time and energy fighting and blustering and sabotaging change when the answers are right in front of them. Seems straightforward to me that you can measure the risk quantitatively of an MBS along the various axes above and cover both the SEC and Fed viewpoints. It's just a question of weights and probabilities:

MBS RISK = [total $ value of MBS you hold] *
(chance you can't sell your MBS for what you want, when you want * weight of MBS market risk)
+ (chance the underlying mortgage goes belly-up and you can't sell the property for what you want, when you want * weight of mortgage market risk)
+ (chance the underlying mortgage goes belly-up * weight of mortgage credit risk)
+ (chance playing around with MBSes gets your name smeared in the news or gets you fined 'cause of something you did * weight of internal operational risk)
+ (chance playing around with MBSes gets your name smeared in the news or gets you fined 'cause of something that impacts the whole market * weight of external operational risk)

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