Abstract

Wall Street’s House of Cards

By Ann Lee
Finance Professor, Lubin Business School of Pace University

The paper draws attention to the disturbing developments in the structured products
market--CDOs, CLOs, MBSs, ABSs, credit derivatives etc.-- that have been responsible
for the consistently outsized earnings of Wall Street firms –but include risks that can
make the current subprime mortgage meltdown look like a minor event. It will explain in
layman’s terms the highly technical and esoteric world of structured products and detail
how these financial engineering innovations create conflicts of interest and moral
hazards. It concludes with proposed policy and market reforms.

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 Wall Street’s House of Cards

Copyright 2006 Ann Lee

For the last few years, large banks on both sides of the Atlantic have been selling

complex financial products called “structured products,” which have fueled years of easy

lending and borrowing in not just subprime but across all credit sectors. According to the

Bank of International Settlements, the notional value of structured products exceeded $26

trillion in 2006, equal to roughly six times the U.S. gross national product, and was the

fastest growing investment product. The losses that could result from this unbridled

proliferation could rival the S&L bailout given the large volume.

At their core, structured products are financially engineered vehicles that allow

financial institutions such as banks to transfer credit risk to other institutions or investors.

Credit risk, which is the likelihood that borrowed money will be repaid, has been

financially engineered and repackaged into structured products that are inexpensive to

create and easy to buy and sell. By using structured products, financial institutions can

treat credit risk like a hot potato, buying and selling credit risk between themselves and

investors with the goal of making a profit. Structured products can be built with many

types of underlying collateral, ranging from home mortgage loans to credit card

receivables to junk bonds to corporate bank loans. The construction and sales process for

structured products is opaque, and no one really knows what credit risk is transferred to

whom and who is left holding the credit risk bag, certainly not regulators, who lack

access to the necessary information.

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 There are a number of reasons why structured products have become so prolific.

With the rise of hedge funds, more and more money have been chasing fewer and fewer

investment opportunities, thus pushing down investment returns. With potential returns

being lackluster, the appetite for investors to use more leverage to amplify returns has

increased. Banks and investment banks invent new and falsely attractive investment

opportunities through structured products that incorporate greater and greater degrees of

leverage. Structured product sellers’ margins are fat and buyers believe they will earn a

high rate of return (although in reality, they may be manipulated by the seller through

opaqueness). Structured products essentially provide easy money for both sellers and

buyers--until unexpected (but likely to occur) losses in the structured products’

underlying assets appear. For example, an increase in home mortgage defaults can

produce sudden and large losses for investors in structured products built on home

mortgage loans.

These financial innovations have allowed banks to increase diversification in their

portfolios, resulting in regulators permitting increased leverage by banks and in banks

creating a massive fee stream for themselves. While there are clearly benefits for

spreading credit risks amongst a broad investor base, nothing comes without a price tag.

The complexity and opaqueness of these products has created two major problems that

can lead to a systemic financial crisis: 1) they create incentives for potential fraud and

conflicts of interest, and 2) they exacerbate concentration and liquidity risks for all

market participants due to their inherently high embedded leverage and tranching.

How Structured Products Breed Conflicts of Interest That Rise To Fraud

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 The opaqueness of structured products is precisely the reason they are so

potentially dangerous. Structured products often include hidden or open conflicts of

interest whose potential impact may not be understood by their buyers. Because of their

opaqueness, structured products are also difficult to price, and neither buyer nor seller

may know if the price of a structured product is fair. Furthermore, the complexity of

structured products makes them an ideal tool for persons with fraudulent intent.

The secondary market provides some examples of how these products can also

abet conflicts of interest and potential fraud. The large banks own or control to a great

extent all the components of the structured products market: confirmations, valuations,

brokerage, and electronic trading. With so much control, the move to automate the

markets has been slowed significantly as banks have no desire to increase transparency

which can erode pricing power and margins.

On trading desks, banks who are the sole underwriter of a structured product may

even mis-price the tranches for their own benefit by using a theoretical, model-based

price rather than a market price because of low trading volume. There are also competing

proprietary models which may each determine a different price for the same financial

product, allowing banks easier ability to cover up fraud. An example was the case when

Bankers Trust was the only bank with an advanced derivative model at one time that

enabled employees there to mis-price their products to many customers before being sued

by P&G and Gibson Greetings.

Mark-to-market (MTM) is the price at which a trade can be executed, but without

readily available market data, banks can easily manipulate these prices. If a financial

product is overvalued and mis-priced, or if people learn that the model is wrong, it can

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experience a sudden and dramatic decline in value when the product’s underlying

collateral experiences a higher than expected default rate or a reduction in credit quality,

resulting in a declining rate of return for the financial product. A sudden decline in

market value for a financial product is also likely to result in a loss of the product’s

market liquidity. Dramatic declines in value and liquidity together can generate systemic

levels of market disruption.

Another conflict of interest lies in bank loans. Bank loans are an important and

significant component of the credit markets and provide financing for both individuals

and business enterprises. However, today banks can offload these credit risks by selling

loans to structured products or by buying credit default swaps (CDS) which act like

insurance contracts against defaulting credit products. As a result, their concerns about

the long-term credit worthiness of the loans they underwrite are limited. Instead, the

banks become more interested in the fees they can make from origination because if they

don’t ultimately keep the loans in their portfolio, they have no other reason for

underwriting. Since banks are no longer responsible for the risk of the loans they

underwrite, the rapid disintermediation of credit risk between lender and creditor often

results in weakened underwriting practices such as looser covenants and insufficient due

diligence. Such self-interested and short horizon decisions can create the seeds for

systemic market risk.

A concrete example of such lending practices is sub-prime lending to individuals.

Sub-prime mortgage structured products, which provide financing for sub-prime

mortgages to individuals, have exploded over the past few years according to SEC

filings, increasing from $48 billion in 2000 to $464.9 billion in 2005. Sub-prime loans

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are, by definition, risky, and as their volume radically increases, there is potential for

significant increases in the risks borne by financial market participants.

Subprime lenders such as Fremont used the capital extended by the large banks

such as UBS or JP Morgan to underwrite. Once the subprime mortgages were

underwritten, the loans were packaged into structured products and sold to investors by

the large banks. The money collected from selling the structured products was then used

to repay the loans originally extended by the large banks. The large banks made huge

profits from putting the structured products deals together. While these structured

products were marketed to investors as relatively safe investments because they used

historical subprime default rates from good economic cycles to make predictions about

future default rates, the underwriting standards for the underlying subprime loans became

progressively worse. All kinds of new mortgage loans whose default rates could not be

accurately reflected or predicted by historical data such as Alt A loans which didn’t

require proof of income or wealth were being underwritten and thrown into structured

products.

Greentree Financial provides an example of what can happen when sub-prime

lending increases rapidly. Greentree’s primary business was financing manufactured

housing, a sub-prime market. After Greentree’s acquisition by Conseco, the market for

manufactured housing loans suffered great losses, eventually resulting in Conseco’s

bankruptcy. Greentree’s lending decisions were based upon a need for volume, to create

more loans that could result in gain-on-sale accounting for Conseco, as opposed to a

concern for the credit worthiness of the loans. When the manufactured housing loan

market subsequently suffered great losses, Greentree’s gain-on-sale accounting was

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exposed as fictional, and both Greentree and investors in financial products created by

Greentree suffered large losses. The sub-prime loan market has similar incentives for

lenders to the manufactured loan market that brought down Greentree, but the sub-prime

lending market is much larger than the manufactured housing loan market ever was.

Such sheer volume involved in just this segment of the structured products market alone

could result in the potential for institutional failure leading to financial contagion.

Besides lax underwriting of the collateral that go into structured products, active

mis-pricing can also occur in deal terms of the structured products themselves. Since

these products are not standardized like other derivative products such as foreign

exchange contracts, structured products underwriters can discreetly create opaque

products. According to a senior manager at Tricadia, an institutional investor, UBS

allegedly marketed a deal called “Buchanan,” by intentionally mis-pricing it as a typical

credit-linked note, a type of “standard” structured product, as opposed to a customized

one. Unless investors read and understood the fine print regarding the definition of how

loss amounts were unusually allocated on page 7 of the memorandum, he believed that

the deal was potentially sold under false assumptions and misleading representations and

thus may have been mispriced by some investors.

Clearly, institutional investors have the fiduciary responsibility to read the

documents carefully, but when deals come at a rate on average of 2-3 a day, rarely do

portfolio managers ever spend the time to read through 200-page prospectuses before

investing in these deals. If enough institutional investors shirk their responsibilities,

there could be many more ticking time bombs in the pipeline as their risk management

could be based on false assumptions when these deals rapidly default and lose value

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without sufficient capital or liquidity to cushion these blows. These portfolio managers

are, in a sense, playing Russian roulette thinking there is only one bullet in the barrel as

opposed to five and praying that they made the correct bet.

Another concrete example of active mis-pricing of structured products occurred in

the portfolios of Freddie Mac and Fannie Mae. Since both of these entities are exempt

from the 34 Act and therefore were not required to disclose their financials in offering

documentation, the management at these entities misapplied accounting rules for years to

the public in order to meet stock incentives. The limited disclosure required of these

entities made it difficult for analysts and investors to decipher their true financial state,

especially because of the sheer size of their portfolios which ran in the hundreds of

billions of dollars. Small mistakes in hedging such large sums of money could have

enormous implications.

Another major related conflict of interest lies in the codependency between

dealers and structured products managers. It is an incestuous machine that feeds upon

itself, as structured product managers must buy deals from dealers, and the dealers can

only do deals if structured products managers buy from them. The structured products

must be warehoused at the dealer until the structured product vehicle has been filled with

collateral by the designated structured products manager. The collateral can be almost

anything, and increasingly has become synthetic in nature, meaning it doesn’t reference a

real asset but rather a contract created by a bank, such as a credit default swap (CDS) or

even other structured products which could be managed by the same manager, creating

circular logic.

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 The latter situation is called “CDO squared” because it is a collateralized debt

obligation (CDO), which is one form of a structured product, with other CDO- issued

securities as collateral, but since each CDO-issued security can reference other CDO-

issued security as collateral, the number of CDOs embedded within one CDO-issued

security can be several layers deep. Due to the potential for significant overlap in these

CDOs, a CDO manager or investor may each think he has achieved diversification in the

underlying collateral when in fact, the opposite may be true. For example, multiple

CDOs may have GM loans as underlying collateral. A CDO squared may purchase

different CDOs thinking that it will achieve a diverse underlying portfolio when in fact,

the concentration risk for GM loans may be exponentially compounded. When it is

virtually impossible for an investor to figure out where the money is coming from, the

uncollectible debts underlying the structured products make these investments become

essentially worthless even though the banks who sold them have made a killing from

their sale.

The other circular logic occurs when one division of the bank sells a specific

credit derivative swap (CDS), a type of derivative that acts as insurance against the

reference credit instrument, and a different division of the bank buys it. For example, the

brokerage division of a bank could sell CDS on a CDO while the bank’s asset

management division that owns CDOs in its portfolio may buy that same CDS because

they manage separate profit and loss responsibilities and respect informational barriers,

meaning that the divisions are not supposed to communicate with each other to avoid

insider trading. In this case, the bank will have created insurance for itself, an absurd

situation, but it theoretically can happen.

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 How Leverage In These Markets Can Create A Systemic Crisis

The high embedded leverage of structured products compounds the problem of

opaqueness. Leverage is a way to use borrowed money to amplify potential gains at the

risk of amplified losses, thus magnifying the credit risk for buyers of structured products.

A good example of financial leverage is an investment in an index mutual fund. If you

invest a dollar without leverage, and the fund declines by 10%, you then lose ten cents.

However, if you invest a dollar in the same mutual fund with 10 times leverage, and the

fund declines by 10%, then you lose the entire dollar. In the case of structured products,

many include leverage of 10 times or more, and 100 times is common. As a direct result,

the magnitude of an unexpected or poorly understood potential loss of structured products

can have far greater impacts to the financial system and the economy.

In a way, “CDO squared” structured products enable banks to create money

practically out of nothing because they are so synthetic in nature that the ultimate

underlying collateral is unknown. Each tranche incorporates leverage and each investor

is permitted leverage, sometimes as high as a hundred times, against CDO collateral to

buy more CDO tranches. Even small market movements or inaccurate estimates of

defaults can amplify losses quickly and trigger liquidity crises that could result in a

cascading avalanche that overwhelms our financial system.

Leverage by itself is not dangerous, but combined with conflicts of interest, it

becomes lethal. For instance, some banks pressure CDO managers to buy CDOs that the

bank couldn’t sell from prior issuances or structure a CDO to provide insurance on the

bank’s own portfolio, thus increasing systemic risks because bad credits become more

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concentrated and leveraged while remaining hidden and marketed to unsuspecting CDO

investors.

This elite circle of buyers and sellers of structured products collateral is small

relative to other financial markets, perhaps a few hundred worldwide, although the dollar

amounts exceed those of the equity markets. As a result, if either party decides to exit the

market, the foundation for these arrangements, amounting to trillions of dollars, can

quickly unravel given the small community, destroying the house of cards. Up until

recently, the risk of one player leaving the party has been largely ignored because the

deals were far too lucrative, and defaulting collateral has not been an issue in a benign

economic environment. However, should investors shun these products or dealers get

nervous with the market outlook, the warehousing mechanism could halt at any time,

causing panic and a domino effect in trading that could lead to enormous losses for

banks, potentially evaporating their entire capital base in a very short time frame, leaving

little time for a solution to be implemented.

Moreover, from a liquidity and concentration perspective, structured products also

create systemic risks that are unlike other financial products due to their complexity and

leverage characteristics. While the institutions that traffic in these instruments tend to be

large financial firms such as commercial banks, investment banks, insurance companies,

and hedge funds, it is not safe to assume that they have the systems sophisticated enough

to understand and manage all the risks associated with these products.

In fact, risk management of these products has lagged far behind the innovation of

these products. Although most of the major banks now have credit risk management

tools that are more robust than ever before which monitor credit risk at a federated level

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and explicitly manage/hedge credit risk and stress test for liquidity and dealer exits, the

growth in these markets and instruments has still outpaced the developments in risk

management, documentation, back office facilities, models, and risk management

safeguards. The quality of pricing data, data integrity, their dissemination, and the ability

to perform “what if” analysis all have lagged the growth of these products and strategies,

increasing systemic risk. Any risk management official at a bank will readily admit that

no perfect hedge exists for structured products. Risk management for tranched credit

portfolios in particular, is by far more difficult from a theoretical and practical

perspective than risk management for other products, and to this day, no general market

consensus has been established on how those risks should be measured. It is therefore

likely that these market participants did not transfer the risk they were supposed to

transfer or thought they transferred.

What To Do

The public has a right to be worried about these developments and demand

regulation in this unregulated market because if one or more of these large institutions

fail due to these products, the financial damage could be extensive not only to the Federal

Deposit Insurance Corporation (FDIC), but could have a ripple effect throughout our

economy similar to the aftermath of the S&L crisis or even the 1929 stock market crash.

Even Gerry Corrigan, the former New York Federal Reserve President and Vice

Chairman of Goldman Sachs, has called structured products “financial instruments of

mass destruction.”

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 As everyone knows, the stock market crash of 1929, loose credit markets, and

flawed trade policy contributed to the Great Depression, an example of financial markets

failing to self-regulate, resulting in widespread economic consequences for every sector

of society. Today, excessive leverage and speculative trades in the structured products

market threaten to repeat history. The financial institutions’ collective desire to reap

enormous short-term profits conflict with society’s collective need to maintain stable,

fair, and functioning global financial markets.

The New York Fed has begun to consider these issues by (a) pushing banks to

expedite trade confirmation and document and reduce mountain-like backlogs, (b) saying

it wants to measure individual and aggregate counterparty risk exposures, (c) trying to

estimate the domino effect to the financial system of a few counterparty failures, and (d)

attempting to coordinate such tracking/measurement efforts with foreign regulators,

namely the Financial Services Authority (FSA) in the UK.

Through the Report of the Counterparty Risk Management Policy Group II

published in July 2005, private sector participants led by Gerald Corrigan, Vice Chairman

at Goldman Sachs and former New York Fed President, also acknowledged problems

with these new class of financial products and proposed solutions for addressing some of

the shortfalls. At the time the report was issued, tens or hundreds of thousands of credit

derivative transactions remained unsettled for weeks given that these transactions were

processed by hand. When the Fed and the media learned of this operational failure,

broker/dealers began hiring more operational employees to process the trades.

But these efforts fall woefully short of what is needed. The 200-page

Counterparty report acknowledged outstanding issues that needed fixing such as faster

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transaction processing, but focused on operational risk, not financial and credit risk.

Concern over operational risk is understandable since operational failure in the settlement

process for equity trades in the late 1960’s became serious enough to produce systemic

risk. However, the counterparty report did not address all the problems, especially the

ones highlighted in this article.

In reality, meltdowns are much more likely to occur when banks and broker

dealers suffer tremendous losses, to the tune of billions of dollars, due to market

corrections after years of mis-pricing, as opposed to the timing of back office settlements.

Measuring domino effects/risks to the financial system from structured products,

for instance, often demands accurate and timely information different from what is

currently provided to the Fed. Currently, banks and broker dealers issue “call reports”

only on a monthly basis. Such information could not possibly help the Fed respond

rapidly to any crisis given that the risk profiles of banks and brokerage firms change by

the hour.

Our current regulatory system is ill-equipped to address the issues and concerns

posed by these new financial engineering innovations. It is too fragmented, and most

regulators do not have the appropriate skill set to understand and sniff out potential

problems generated by these instruments. While all financial institutions are linked

together through investment and trading in the same structured products, different

regulators oversee the different counterparties so that no one has complete authority over

this area. Banks, insurance companies, and investment banks all have different

regulators, but does it make sense for an insurance company and a bank that are

counterparties in the same structured products transaction to have different regulators?

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After Glass-Steagall was dismantled, these businesses now significantly overlap, making

our current regulatory structure particularly unwieldy, outdated, and ill-prepared to

address the problems these new financial innovations present.

Self-regulation by trade associations have also proven inefficient in setting

standards and ineffective in bringing more transparency to these markets. The

International Swaps and Derivatives Association (ISDA), an important trade association

that has offices worldwide, has difficulty persuading its members to accept a standardized

format for settlement after years of a product being traded. Standardized loan-only CDS

documentation, for example, took several years to develop with many prior trades done

on varying legal documentation. With multiple legal agreements being used for the same

product, the potential for loopholes, confusion, and disputes also increases, thus further

increasing the loss of investor confidence in the markets.

Regulation entails costs and benefits; the trick is finding the right balance so that

costs of unintended consequences such as stifling innovation do not overwhelm the

benefits. The role of a good democratic policy should be to protect basic human rights

and property. But presently, the government arguably is failing to adequately protect its

citizens by allowing financial institutions to undertake and engage in undue risk and

permit breeding grounds for fraudulent practices that could subvert our entire financial

marketplace. Although regulators have acknowledged the problems and risks posed by

structured products, not enough has been done to date and no comprehensive solution has

been proposed. Any solution must increase transparency for sellers, buyers and

regulators and impose limits to ensure that market participants do not assume more risk.

At the very least, the government should do the following:

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 1. IMPOSE LIMITS ON LEVERAGE AND COUNTERPARTY RISK AND

IMPROVE DATA TRANSPARENCY AND REGULATORY FILINGS. Naturally, in

order to research the appropriate amount of leverage allowed in the financial system, the

Fed needs transparency into the leverage extended by banks and broker-dealers. When

the Fed announced in March 2006 that it will no longer report M3, the measure of money

supply that would include all such leverage, it essentially chose to ignore the high

existing levels of leverage. Measuring only M1 and M2 means the Fed is only counting

paper money, checking accounts, and savings accounts less than $100,000. All the

money outside of these parameters is not counted, which means the Fed is assuming that

at least half or more of the money supply outstanding does not exist or matter and is

operating monetary policy based on that belief.

At the very minimum, the Fed should restore reporting M3. But in order to

measure leverage in a meaningful way, it must also have visibility into where the risks

lie. As such, the Fed should also require all financial institutions to report, on a real time

basis, risk reports including leverage, rather than the monthly call reports that are

presently used but are of limited utility. The Fed should also require companies to report

their true value at risk (VAR), their solutions to it, their top 25 counterparty exposure, the

kind of products to which they have exposure, and transaction documentation for all

material transactions. Only with up-to-the minute information can the government

develop a rapid response system that could minimize damage if a systemic market failure

should occur.

2. REGULATORY AGENCY CONSOLIDATION. Enforcement is another

issue. Once limits have been determined and agreed upon, they must fall under the

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purview of some regulatory agency. Since current and future financial products do not

neatly conform to traditional definitions and distinctions that led to separate regulatory

authorities in the first place, a regulatory environment needs to evolve to reflect the

realities of the new financial landscape if it is be effective. Specifically, since the

elimination of Glass-Steagall restrictions, all financial firms are increasingly performing

the same or similar functions. It follows that only one financial regulator should be in

place to oversee all the activities so that new developments do not fall through the cracks.

3. HARSH PENALTIES FOR THOSE WHO CHEAT AND REWARDS FOR

WHISTLE BLOWERS. Moral hazard must be addressed. Today, no real penalties exist

for individuals or firms that undertake too much risk except for the possibility of losing a

job and the temporary loss of reputation. However, these risks are far outweighed by the

potential for enormous wealth in very short periods of time. As many Wall Streeters

know, hundreds, perhaps thousands of young traders under the age of thirty can make

many millions of dollars in a single year. Seasoned professionals like George Soros have

earned almost a billion dollars in a single year. Unless there are stiffer penalties for

taking undue risks that could have the unintended consequence of bankrupting large

financial firms, resulting in significant market disruption and losses for individuals and

possibly even the government, many financial professionals will be prone to reckless

speculation because of the current risk/reward payoff. The American people should

demand to remove or limit moral hazard from developing by forcing the government to

ensure the sellers and purchasers of structured products and credit derivatives bear the

costs of a financial crisis that damages the bank insurance deposit fund system. For

example, sellers of loans to structured product vehicles who reduce retained credit risk

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could be required to make a premium contribution to the bank insurance deposit fund.

Only by holding them responsible will our country have the best hope of aligning the

interests of banks and the public and prevent such speculative activities from growing out

of control.

4. INCORPORATE THESE STANDARDS INTO BASEL III. Work has already

begun on Basel III, following the second Basel Accord which represented

recommendations by bank representatives and central bankers from 13 countries to revise

international standards for measuring bank’s capital adequacy. Basel II was designed to

address the weaknesses in Basel I, and Basel III will further refine the definition of bank

capital, quantify further classes of risk, and improve sensitivity of risk measures. Now is

an ideal opportunity to enlist international support and coordination in developing

banking and brokerage standards so that regulatory arbitrage can be minimized. Foreign

regulators have just as much incentive to limit economic destruction of systemic risk. If

they know that the standards will be uniform in the international banking community,

they will find it more palatable to comply. If all countries agree to the same laws and

cooperate, no financial firm will have an incentive to move their business, and there will

be no “race to the bottom” by various countries.

Critics will likely claim that such regulation will only drive the structured

products business as well as all other OTC derivatives business to other jurisdictions

where regulatory burdens are not so heavy. They will claim the current U.S.

competitiveness in financial markets will be eroded while not reducing systemic risks.

They have used similar arguments as reasons to repeal Sarbanes-Oxley, because many

IPOs have moved offshore.

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 Such arguments seem specious when a company’s decision where to launch an

IPO involve other factors besides regulatory burdens. Offshore offerings may be at least

driven by increased capital availability in emerging markets and would happen even if

Sarbanes-Oxley was never implemented. More likely, SEC Chairman Christopher Cox

rather than Sarbanes-Oxley is the reason why foreign companies have chosen to list on

other exchanges. These companies feared the political risk of dealing with capricious

U.S. lawmakers, not increased transparency.

Opponents of regulation of this market cite that there is lack of empirical evidence

of wrongdoing. They will also point out that there have now been several credit events

which while operationally intensive, did prove the sustainability of the market.

In most hypotheses, counter examples often exist, but that doesn't necessarily

negate the overall theory. Arguably, most things in life are difficult or impossible to

prove, but the evidence could be so consistent with the hypothesis that it would suggest a

causal relationship where a strong correlation exists. For instance, there was no direct

evidence that Salomon Brothers cornered the bond market, but the behavior was strongly

consistent in support of that conclusion. No one can directly point to greenhouse gases

as the cause for global warming, but enough evidence has convinced the majority of

scientists that it is conclusive. In the case of structured products, no banker will ever

admit that he or she was stuffing bad loans into these financial vehicles. Even with

complete data and all the time in the world, it would be a difficult study from which to

extract empirical data and still probably no one would do it. However, it is well

understood that underwriters always have inventory that they cannot sell. It is widely

accepted that there are clear financial incentives for these underwriters to place them with

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less sophisticated managers. The widespread subprime mortgage meltdown suggests

that the conflicts of interest are indeed pervasive.

Another anti-regulatory argument is that more regulation would disrupt markets

because of the increased legal liability exposure for investors, both real and perceived.

Traders in money losing transactions may simply not honor their trades if they believed

that the transactions would be deemed illegal under a new regulatory regime. With any

change in rules, disruption is expected to happen, but that alone is a poor reason not to

correct abuses. One solution could be to smooth the transition period by announcing a

future date that new rules would be effective which gives plenty of lead time for market

participants to adjust their strategies and positions without causing panic in the

marketplace. Perhaps the unintended effect may even result in stronger volume growth

and wider participation, since the global markets will be assured that our government is

not ignoring market developments and innovations.

Some business leaders have promoted the notion of “principles-based” rather than

“rules-based” governance as the best way to protect the integrity and competitiveness of

our markets. They argue essentially that it is better to avoid enacting laws and simply

trust corporate management to exert moral leadership. The Delphi credit event in which

the market was able to avoid a bond squeeze by agreeing to some principles that worked

well suggests a case of professionalism over regulation. However, this idea is convenient

for management, but may not be realistic in the long run. It is possible that not one but

multiple major defaults could happen simultaneously in the future in which orderly

professionalism may not succeed when much more capital is at stake. The Delphi

example in reality may be simply a close call because it happened during a benign

20
economic environment and should be seen as a warning shot to regulators that a more

rigorous system should be put in place in the event several major defaults happen during

a weak economic backdrop. Without the requisite public constraints, corporate economic

corrupt activity, both legal and illegal misappropriation of wealth and income, can make

it difficult for our markets to survive the fallout.

Instead, a hybrid approach of principles and rules-based governance should be

adopted. Principles-based governance is needed so that participants can’t evade the law,

and rules-based governance should be implemented simultaneously so that participants

have guidance for the principles. While the FSA uses more of a principles-based

approach, the British system differs from the U.S. in that it is harder to litigate there, and

it is easier for them to change laws since they don’t have a system of checks and balances

similar to ours. An analogous situation would be taxes. Principles-based governance

would say that everyone who can afford to pay taxes should pay at least 20% in income

taxes. However, rules-based governance is required so that taxpayers would understand

what constituted income and understand how to interpret the law when uncertainties

arise. Principles-based governance works well only if everyone can agree on the

prohibited outcome so that methods are irrelevant. In some ways, existing laws such as

the 33 Act are short principles-based legislation, yet they are difficult, cumbersome, and

confusing to apply.

Defenders of the present system also complacently believe that no systemic risks

will result from any major market disruption in this area. Monetarists, popularized by

Milton Friedman, contend that something akin to the Great Depression can be avoided

simply by pumping more money into the system to avoid a liquidity crunch. Fed

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Chairman Ben Bernanke has stated that the Fed under his watch will “have the keys to

the printing press, and we are not afraid to use them.” The quote was used in the context

of his argument that monetarism will respond to zero interest rate conditions. However,

injecting money into the system does not necessarily create more capital for financial

institutions in crisis. Evidence from the Japanese stock market crash that doomed Japan

to a decade of recession despite monetary stimulus of zero interest rates may suggest that

aggressive monetary stimulus will not be enough. Worse, if the rest of the world knows

that the U.S. will simply print more money rather than correct abuses and structural

problems, confidence in the U.S. dollar and thus in the U.S. government will disappear,

causing even further economic damage. “Not worth a continental” referred to the

worthlessness of U.S. currency during the American Revolution because of government

overprinting; we do not need a 21st century repeat of that 18th century fiasco.

Since this is a complex problem, no solution will be free from criticism. In fact,

previous proposals such as those from CFTC Chairman Brooksley Born who advocated

increased regulation of over-the-counter (OTC) derivatives were rejected and maligned

by financial circles and their Capital Hill supporters. Even the collapse of Long Term

Capital did not redeem her progressive calls for action, because the political power was

too beholden to private financial institutions unwilling to surrender their pecuniary

interest for safer, more stable markets.

Bottom line, self-regulation has not worked well. In a paper titled, “Cautious

Evolution or Perennial Irresolution: Self Regulation and Market Structure During the

First 70 Years of the Securities Exchange Commission,” Joel Seligman, considered the

nation’s foremost expert on securities law, comments that self-regulation prompted “the

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most serious failure in securities industry, a collapse of industry regulatory controls so

complete, it permitted, in the agency’s retrospective view, ‘the most prolonged and

severe crisis in the securities industry in forty years.’”

Our financial markets will always attract the foolish and the greedy—even the

fraudulent-- and no amount of regulation can completely eliminate fraud and reckless

behavior. But if we want to ensure financial market integrity and stability, then we

should consider the ethical obligations to move beyond a system of self-regulation.

While possibly no perfect solution exists, society should still seek to remedy what are

clear abuses to the system. Through public education and by taking steps to safeguard a

dynamic financial market through improved market transparency and balanced

regulation, we can prevent these problems from reaching systemic levels.

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