Category: Regulation

Regulation

IIROC Defends the Incompetent

The Investment Industry Regulatory Organization of Canada is defending the fundamental human right of lazy and incompetent traders to avoid punishment, in a Request for Comments titled Provisions Respecting Market Maker, Odd Lot and Other Marketplace Trading Obligations:

Under clause (d) of Part 1 of Policy 2.1, a Participant or Access Person may not when trading a security on a marketplace that is subject to Market Maker Obligations, intentionally enter on that marketplace on a particular trading day two or more orders which would impose an obligation on the Market Maker to:

  • execute with one or more of the orders, or
  • purchase at a higher price or sell at a lower price with one or more of the orders

in accordance with the Market Maker Obligations that would not be imposed on the Market Maker if the orders had been entered on the marketplace as a single order or entered at the same time. In essence, this provision stipulates that an order can not be “shredded” to intentionally trigger a market maker’s obligation to fill the “shredded portions” of the order.

IIROC would note that the examples listed in Policy 2.1 are not exclusive. IIROC is of the opinion that the intentional “shredding” of orders through the entry of multiple odd lot orders on a marketplace that has compulsory obligations on members, users or subscribers to execute against “odd-lot” orders is contrary to Rule 2.1.

So, in other words, if a market maker posts a bad price, he can only be punished by those not regulated by IIROC, not by other Participant or Access Persons – in other words, IIROC is seeking to continue the current practice of maintaining a heterogeneous market.

Rule 2.2 provides more protection for incompetent traders:

In addition, a Participant or Access Person shall not, directly or indirectly, enter an order or execute a trade on a marketplace if the Participant or Access Person knows or ought reasonably to know that the entry of the order or the execution of the trade will create or could reasonably be expected to create:

  • a false or misleading appearance of trading activity in or interest in the purchase or sale of the security; or
  • an artificial ask price, bid price or sale price for the security or a related security.

The new proposed rules will confirm these intrusive regulations:

The following is a summary of the most significant impacts of the adoption of the Proposed Amendments:

  • confirm that the “abuse” of an odd-lot dealer is a violation of the requirement to conduct trading openly and fairly;
  • confirm that Participants with contractual odd-lot arrangements are able to rely on various exemptions in UMIR principally related to short selling, client priority and trading during certain securities transactions; and
  • provide marketplaces with more flexibility in structuring their market making systems by:
    • allowing Exchanges and QTRSs to have Marketplace Rules that provide for an obligation to maintain reasonably continuous two-sided market and/or a guarantee of execution of orders which are less than a minimum number of units, or
      o allowing marketplaces (including an Exchange or QTRS) to provide for an oddlot arrangement by a contract.

It should be apparent that the main intent of these proposals is to give the regulators some more authority, so they can ensure they get proper respect from the regulated. It is in the interest of a fair and efficient market that bad prices be punished as quickly and effectively as possible – but then IIROC would have a little less power. Never mind that the bad price will, for the period of its existence, provide a false and misleading signal to observers regarding the potential for transacting at that price.

We’ve all seen situations where a security is quoted at, say, 19.10-15, with the offering only 100 shares and the next offer at 19.50 or more. If the Market Maker – or anybody else – wants to defend that level, let him; but if it’s a bogus level, then make it cost him money.

A problem might arise when the original market is, in fact, fairly quoted at 19.10-50. Then Sharp Traders Inc. comes along and posts an offer for 100 shares at 19.15, then shreds a buy order for 10,000 shares into 101 odd-lots. I don’t see a problem with this … if the Market Maker is not prepared to defend an offer of 19.15, then he can input an algorithm so that if he gets lifted for 99 shares, he lifts the board lot offer that he’s defending.

Better yet, have the Market-Maker input the prices he will defend, and allow the odd-lot market orders to execute directly against the board-lot limits within that spread.

Best of all, don’t give any special treatment to odd-lot orders. Why should one class of marketplace participants be favoured over other classes? If Granny wants to play with the big boys, well and good – but there shouldn’t be any special rules giving her special treatment.

The trouble with favouratism is that it leads to a tangled web of rules and regulations that serve no legitimate purpose other than the employment of regulatory personnel.

And what about the poor old board lot offerer, who legitimately offered 100 shares at 19.15 and got filled for 99? Well … boohoohoo. In this new era of $10 commissions and book-based holdings, it’s no disaster to be left with an odd-lot. Annoying at worst. The guys paying $100 minimums at full service brokers will be hurt – but then, they should be hurt! It’s all part of the joys of entering limit orders. If the full-service broker wants to offer guaranteed fills – or order types that convert to market at a certain time if partially filled about a preset minimum – let them.

Comments are due by 2010-6-24.

Update: It occurs to me … the regulatory distaste for trader games that have the effect of masking intentions (very common in the bond world) has probably been a major factor behind the development of dark pools. Every regulation has an unforseen consequence … which leads to another regulation …

Update: And anyway, the Market-Making rules should be strictly a matter between the Exchanges / ATSs and their members; I find it very difficult to understand why it should be a matter of regulation.

Update: If the full-service broker wants to offer guaranteed fills – or order types that convert to market at a certain time if partially filled about a preset minimum – let them. Perhaps the best solution of all! They know their clients, they can restrict the service to orders for all shares in custodial accounts only – no problem. The trades can be crossed on the exchange of their choice. This is an opportunity for brokerages to differentiate themselves, while at the same time eliminating a few layers of rules.

Regulation

OSFI Evades Question on Selective Disclosure

Assiduous Readers will recall that I sent the following query to OSFI regarding selective disclosure:

I note in a Financial Post report(
http://www.nationalpost.com/opinion/columnists/story.html?id=6bb93a4f-b0c0-4d2a-bcd7-be7e6750e212 ) the claim that “Despite the low yields, Nagel says the regulatory authorities have given their approval for rate resets to continue to count as Tier 1 capital. But he said the authorities have not been as kind for continued issues of so-called innovative Tier 1 securities.”

Is this an accurate statement of the facts? Has OSFI given guidance on new issue eligibility for Tier 1 Capital, formally or informally, to certain capital market participants that has not been released via an advisory published on your website? If so, what was the nature of this informal guidance?

I have received the following response:

Thank you for your e-mail of April 10, 2010, concerning tier 1 capital eligibility.

In response to your enquiry, no formal guidance has been issued recently on OSFI’s expectations in this regard; however, OSFI discusses capital with financial institutions on a regular basis, and offers informal guidance as part of our regulatory and supervisory processes.

I have now sent a follow-up:

What informal guidance has been given to issuers regarding the eligibility of various potential structures for inclusion in Tier 1 Capital?

If OSFI does not intend to make this guidance public, how does it justify the selective disclosure made to certain capital market participants and not to others? How does OSFI relate its policy in this matter to its professed desire for market discipline to be an element of financial stability?

What will happen next? A nickel says I get stonewalled.

Contingent Capital

Tarullo Speaks on Contingent Capital

Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, gave a speech at the Council of Institutional Investors meeting, Washington DC, 13 April 2010.

A second proposal that has received considerable attention is to require large financial institutions to hold so-called contingent capital, which is basically debt that converts to common equity as a result of some predefined triggering event. There are actually two distinct concepts that may be characterized as “contingent” capital. The first is a requirement for a specified kind of capital instrument to be issued by the firm – one that would have debtlike characteristics in normal times but would convert to equity upon the triggering event. The other is a requirement that all instruments qualifying as Tier 2 regulatory capital convert to common equity under specified circumstances, such as a determination that the firm would otherwise be on the brink of insolvency.

Frankly, the distinction between the two concepts is not immediately apparent to me!

The market discipline effects of both variants could be considerable, since holders of certain kinds of capital instruments would know that their debt-like interests in the firm would be lost if the firm’s financial situation deteriorated. However, there are also significant questions about the feasibility of both. The specification of the trigger is critical. If supervisors can trigger the conversion, investors cannot be certain as to when the government will exercise the trigger. That uncertainty would make it difficult to price a convertible capital instrument and diminish investors’ willingness to hold it. Tying the trigger to the capital level of the firm runs headlong into the serious problem that capital has traditionally been a lagging indicator of the health of a firm. Using a market-based trigger could invite trading against the trigger, which, in extreme cases, could lead to a so-called death spiral for the firm’s stock.

I am in full agreement with his identification of a major problem with supervisory triggers. I will add that if supervisors trigger conversion when the bank is merely in trouble, the triggering of conversion will almost certainly also trigger a run on the bank, converting trouble into the kiss of death.

Capital levels … I will add that capital levels can be manipulated. Lehman’s Repo 105 transactions, last discussed on March 17, are merely a glaring example.

Market based trigger … I agree that trading against the trigger could very well occur. However, extreme cases leading to a death-spiral will be avoided under my proposal which leads to conversion at a set price if the common trades below that set price. No death-spiral there! However, it is true that a cascade could occur: conversion 1 throws a lot of common on the street, which gets sold, lowering the price, triggering conversion 2 … it is not immediately clear to me, however, that this should be a regulatory concern: at the end of the process, you have a bank in which every single penny of capital has been converted to common equity. Isn’t that a good thing? However, a valid argument can be made that it will be harder to sell new common if it’s only a buck or two above the first of a series of conversion prices. Ain’t NUTHIN perfect!

Despite the work that has been done on contingent proposals, it is not yet clear if there is a
viable form of contingent capital that would increase market discipline and provide additional equity capital in times of stress without raising the price of the convertible debt close to common equity levels. The appeal of the concept is such as to make further work very worthwhile but, for the moment at least, there is no proposal ready for implementation.

But what is the alternative? If the trigger is too remote, it won’t get priced properly and will only be triggered way too late in process. If it’s triggered too late, it won’t help much, as S&P has commented.

Contingent Capital

S&P Comments on Basel 3

Standard & Poor’s has commented:

We understand that the Basel committee intends that Tier 1 capital should enable each bank to remain a going concern, with Tier 2 capital re-categorized as a “gone concern” reserve to protect depositors in the event of insolvency. We expect to assess the credit implications of the extension risk that may be created by the proposed introduction of a lock-in clause in respect of Tier 2 capital in the future.

The introduction of much stricter criteria for the inclusion of hybrid instruments into Tier 1 capital generally accords with our recent criteria refinement, under which our capital metrics would give only minimal equity content to certain types of hybrids that we do not view as providing sufficient flexibility to defer or suspend coupons. The loss absorption capacity provided by principal write-down or conversion features is not a condition for equity content under our criteria. (See “Assumptions: Clarification Of The Equity Content Categories Used For Bank And Insurance Hybrid Instruments With Restricted Ability To Defer Payments,” published Feb. 9, 2010.)

The proposals state that “innovative” capital instruments with an incentive to redeem through features like step-up clauses (currently limited to 15% of the Tier 1 capital base) will be phased out. We currently assign different levels of equity credit to some hybrids with step-up features (or equivalent features) depending on their individual features. As stated in our criteria, step-ups (and similar provisions) question the permanence of issues that incorporate them, and so undermine the equity content of a hybrid capital security. Such hybrids are in our view therefore a weaker form of capital than other hybrids included in our measures of capital, such as similar instruments without step-ups.

Contingent capital may address some of the demonstrated deficiencies of traditional hybrid structures. One of the difficulties in practice in our view, however, is how to assess whether contingent capital securities would convert into capital (through conversion or a form of write-down) early enough to help a bank experiencing capital pressures. Some triggers may be lagging indicators of the bank’s health.

As stated in our published criteria, we may take the view to deny equity credit to hybrid instruments even if regulators allow for grandfathering, based on our view of the fundamental characteristics of the instruments. We interpret the grandfathering proposals as being a method for regulators to enable banks to transition to a more conservative regulatory environment without requiring large capital-raising in the short- to medium-term. In our view, grandfathering can create inconsistencies and a lack of comparability in capital ratios that could remain for an extended period. Grandfathering could also result in hybrid instruments that have been demonstrated to be ineffective as a form of capital still being included in regulatory capital measures.
…
The proposal to discontinue regulatory adjustments for unrealized gains and losses on securities or properties we believe would likely exacerbate pro-cyclicality, which is already perceived as an issue under the Basel II regime.

Their emphasis on the need for contingent capital to have an effect early in a bank’s deterioration is sharply at variance with Flaherty’s position.

Contingent Capital

Flaherty Pushes Contingent Capital

Julie Dickson recently wrote an opinion piece for the Financial Times that was startling in its lack of rigour, absence of detail and non-existent support in OSFI’s published papers. This bumbling approach to a serious issue has now been adopted by Canada’s finance minister, her boss:

While some countries may choose to pursue an ex ante systemic risk levy or a tax, I do not believe that this would be an appropriate tool for all countries. Such a levy would remove capital from an institution to an external fund or to general government revenues, which could result in weakening an institution’s ability to absorb losses. A global levy could also result in excessive risk taking as a result of a perceived government guarantee against an institution’s failure. In my view, contingent capital is aligned with the principles above and should be considered. As noted in the attached Financial Times editorial by Julie Dickson, the Canadian Federal Superintendent of Financial Institutions, contingent capital would create a notional systemic risk fund embedded in the capital structures of financial institutions. Embedded contingent capital would force the costs of excessive risk taking to be removed from taxpayers and placed on to the right people – shareholders and subordinated debt holders – thus improving market discipline and significantly reducing moral hazard in the banking sector. Moreover, for the same reduction in credit intermediation, contingent capital has the advantage over a levy or charge of leaving capital available in the institution to facilitate a more stable provision of credit during economic downturns.

Contingent Capital

DBRS Addresses Contingent Capital

DBRS has announced a policy on contingent capital.

DBRS has today clarified its approach to rating a subset of hybrids and other debt capital instruments whose features include principal write-downs or conversions to lower positioned instruments, if certain trigger events occur. See DBRS Methodology, “Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks” April 2010.

“Principal write-downs” were used in the recent Rabobank issue. “Conversions to lower positioned instruments” (which, presumably, includes the possible conversion of Innovative Tier 1 Capital to preferred shares, which has been around for ages), is the mainstream proposal and was used in the ground-breaking Lloyds deal (which was poorly structured due to the high conversion price).

The DBRS Methodology: Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks notes:

This view that most hybrids are closer to debt than equity was evident in the global fi nancial crisis. Despite all their ‘bells and whistles’, most of these bank capital instruments could not be converted into equity to help struggling banks absorb losses and bolster their capital while they were still operating. The main benefi t for bank equity capital came when banks made exchange offers for hybrids, either at less than par or for equity instruments. The limited contribution to equity capital is consistent with DBRS’s perspective on the function of these instruments for banks. In analyzing the contribution of bank capital instruments to a bank’s capitalization, DBRS does not generally give any signifi cant equity credit for hybrid instruments, although we recognize their full value in meeting regulatory requirements.

They classify triggering events as:

In assessing the additional risk of these contingent features, an important factor is the ease of tripping the triggers that cause the adverse event to occur. The easier the triggers are to trip, the greater the additional risk for the hybrid holder. DBRS organizes the ease of tripping triggers into four broad categories:
• Level 4 “Very Hard”, e.g., Bank is insolvent or has been seized
• Level 3 “Hard”, e.g., Bank has exhausted most of its capital, but is not technically insolvent
• Level 2 “Easier”, e.g., Bank no longer meeting minimum regulatory requirements
• Level 1 “Easiest”, e.g., Capital ratio falls below a level set above minimum requirements
For those instruments where the trigger event requires the bank to be insolvent or seized by the authorities, DBRS views the risk as similar to debt instruments.

Julie Dickson’s op-ed advocated – eseentially – a Level 4 trigger – but, of course, she is trying to get something for nothing: equity capital priced like debt. The solution I advocate, a conversion into stock if the stock trades below a certain level, is a Level 1 solution; more expensive for the banks, but on the other hand, actually has a hope of accomplishing something. YOU CAN’T GET SOMETHING FOR NOTHING FOREVER! Hasn’t the last few years convinced anybody of that?

The fi rst step is evaluating the elevated risk posed by the specifi c features of each instrument. For some instruments, the combinations are relatively straightforward. An instrument with triggers that are hard to trip and resulting positions that are above preferreds is viewed as having elevated risk. For instruments with triggers that are easier to trip and resulting positions that are comparable to preferreds, the risk is viewed as being very elevated. Under DBRS’s approach certain instruments with contingent features can pose exceptional risk, if their triggers are the easiest to trip and the resulting position for holders is closer to common equity. One factor in rating these instruments below preferred shares could be that tripping the triggers could occur without preference shares being impacted or leave them in a preferential position relative to the converted instruments. Outside these straightforward combinations, there are a number of combinations that involve judgment in making the assessment of risk (See Exhibit 1). or those instruments where the write-downs or conversions to lower positioned instruments can be reversed, if the bank survives, the risk to investors remains largely the same as it would be in the absence of the feature. That is, investors face losses only if the bank is declared insolvent.

There seems to be acceptance of the idea that it will be possible for subordinated debt to leapfrog prefs and become equity; and I don’t understand this idea at all. Once you allow leapfrogging, investing becomes a lottery. Let all elements of capital have a mandatory conversion into equity at some point, says I; and make it clear that leapfrogging is not likely.

In my proposal, where prefs would trigger/convert at 50% of the common price at time of issue and sub-debt would trigger/convert at 25%, leapfrogging is sort of possible. You could issue a pref, wait a few years (decades?) until the common price doubles, then issue sub-debt. But that’s fine, that’s allowed. All the regulators should be worried about is the risk at the time of sale to the public.

DBRS also published a not-very-interesting Methodology
Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments. They used it when downgrading Dexia’s sub-debt today, amongst other actions.

Contingent Capital

Dickson Supports Regulatory Trigger for Contingent Capital

The Financial Post reports:

Ms. Dickson, head of the Office of the Superintendent of Financial Institutions, spelled out her case in the Financial Times yesterday. Her comments, along with those yesterday from Royal Bank of Canada chief executive Gordon Nixon, represent the latest attempts by officials to head off new global financial regulations that could be damaging to Canada.

In a Times opinion piece, Ms. Dickson noted proposals to impose a global bank tax or surcharges on “systemically important” banks have not been universally accepted, with Canada leading the way in opposition to a bank tax.

Instead, she suggested a new scheme in which bank debt would be converted into equity in the event lenders run into trouble. This “embedded contingent capital” would apply to all subordinated securities and would be at least equivalent in value to the common equity.

“This would create a notional systemic risk fund within the bank itself — a form of self-insurance prefunded by private investors to protect the solvency of the bank,” she wrote in the Times.

“What would be new is that investors in bank bonds would now have a real incentive to monitor and restrain risky bank behaviour, to avoid heavy losses from conversion to equity.”

The debt-to-equity conversion would be triggered when the regulator is of the opinion that a financial institution is in so much trouble that no other private-sector investor would want to acquire the asset.

It is very odd that Canadians are reading about Canadian bank regulation in a foreign newspaper. I can well imaging that the Financial Times is more commonly found on the breakfast tables of global decision makers than the Financial Post or the Globe and Mail … but I would have expected a major statement of opinion to be laid out in a speech published on OSFI’s website, which could then be accompanied by opinion pieces in foreign publications.

OSFI’s communication strategy, however, has been notoriously contemptuous of Canadians and markets in general for a long time. The same Financial Post article claims:

Some bank CEOs have grown impatient with Ms. Dickson and Jim Flaherty, the Minister of Finance, who have asked lenders to refrain from raising dividends and undertaking acquisitions — unless they are financed by share offerings that keep their capital ratios high — until there is greater certainty about new financial rules.

It would be really nice if there was a published advisory somewhere, so that the market could see exactly what is being said – but selective disclosure is not a problem if the regulators do it, right?

One way or another, I suggest that a regulatory trigger for contingent capital would be a grave mistake. Such a determination by any regulator will be the kiss of death for any institution in serious, but survivable, trouble; therefore, it is almost certain not to be used until it’s too late. Triggers based on the contemporary price of the common relative to the price of the common at the time of issue of the subordinated debt are much preferable, as I have argued in the past.

Ira Stoll of Future of Capitalism quotes the specifics of the piece (unfortunately, I haven’t read the original. Damned if I’m going to pay foreigners to find out what a Canadian bureaucrat is saying) as:

The second question is what triggers the conversion of the contingent capital. She writes, “An identifiable conversion trigger event could be when the regulator is ready to seize control of the institution because problems are so deep that no private buyer would be willing to acquire shares in the bank.”

in which case it is not really contingent capital at all; it’s more “gone concern” capital, without a meaningful difference from the currently extant and sadly wanting subordinated debt. The whole point of “contingent capital” is that it should be able to absorb losses on a going concern basis.

Update: On a related note, I have sent the following inquiry to OSFI:

I note in a Financial Post report(
http://www.nationalpost.com/opinion/columnists/story.html?id=6bb93a4f-b0c0-4d2a-bcd7-be7e6750e212
) the claim that “Despite the low yields, Nagel says the regulatory authorities have given their approval for rate resets to continue to count as Tier 1 capital. But he said the authorities have not been as kind for continued issues of so-called innovative Tier 1 securities.”

Is this an accurate statement of the facts? Has OSFI given guidance on new issue eligibility for Tier 1 Capital, formally or informally, to certain capital market participants that has not been released via an advisory published on your website? If so, what was the nature of this informal guidance?

We will see what, if anything, comes of that.

Update: I have just gained (free!) access to Ms. Dickson’s piece, Protecting banks is best done by market discipline, a disingenuous title if ever there was one. There’s not much detail; but beyond what has already been said:

The conversion trigger would be activated relatively late in the deterioration of a bank’s health, when the value of common equity is minimal. This (together with an appropriate conversion method) should result in the contingent instrument being priced as debt. Being priced as debt is critical as it makes it far more affordable for banks, and therefore has the benefit of minimising the effect on the cost of consumer and business loans.

She does not specify a conversion price, but implies that it will be reasonably close to market:

As an example, consider a bank that issues $40bn of subordinated debt with these embedded conversion features. If the bank took excessive risks to the point where its viability was in doubt and its regulator was ready to take control, the $40bn of subordinated debt would convert to common equity, in a manner that heavily diluted the existing shareholders. While other, temporary measures might also have to be taken to help stabilise the bank in the short run, such capital conversion would significantly replenish the bank’s equity base.

On conversion, the market would be given the message that the bank had been solidly re-capitalised with common equity, and not that it was still in trouble and its common equity had been bolstered only modestly.

I am very dubious about the claimed message to the market, given the conversion trigger. Frankly, this idea doesn’t look like much more than a regulatorially imposed, somewhat prepackaged bankruptcy – which is something the regulators can do already.

At the height of the crisis, how would you have felt about putting new capital into a company – as either debt or equity – that had just undergone such a process?

Update: I will also point out that the more remote the contingent trigger, the less likely it is to be valued properly.

Update, 2010-4-22: Dickson’s essay has been published on the OSFI website.

Regulation

SEC Proposes ABS Tranche Retention Requirement

The Securities and Exchange Commission has proposed a new rule, Asset Backed Securities:

We are proposing significant revisions to Regulation AB and other rules regarding the offering process, disclosure and reporting for asset-backed securities. Our proposals would revise filing deadlines for ABS offerings to provide investors with more time to consider transaction-specific information, including information about the pool assets. Our proposals also would repeal the current credit ratings references in shelf eligibility criteria for asset-backed issuers and establish new shelf eligibility criteria that would include, among other things, a requirement that the sponsor retain a portion of each tranche of the securities that are sold and a requirement that the issuer undertake to file Exchange Act reports on an ongoing basis so long as its public securities are outstanding. We also are proposing to require that, with some exceptions, prospectuses for public offerings of asset-backed securities and ongoing Exchange Act reports contain specified asset-level information about each of the assets in the pool. The asset-level information would be provided according to proposed standards and in a tagged data format using eXtensible Markup Language (XML). In addition, we are proposing to require, along with the prospectus filing, the filing of a computer program of the contractual cash flow provisions expressed as downloadable source code in Python, a commonly used open source interpretive programming language. We are proposing new information requirements for the safe harbors for exempt offerings and resales of asset-backed securities and are also proposing a number of other revisions to our rules applicable to asset-backed securities.

Some of this stuff is sort-of good, for example Our proposals would revise filing deadlines for ABS offerings to provide investors with more time to consider transaction-specific information, including information about the pool assets, but appears to intend a more stringent process for ABS than for actual bonds. When an institutional investor is offered a new issue, for example, only bare-bones information is available: generally just the coupon (perhaps expressed as a spread) and term. There might be some mention of special features.

However, for these offerings, documentation is simply not available. You want to read through the pricing supplement or the prospectus? Tough luck, Charlie, ain’t got it. You want some or not? If you wait for the documentation, the issue’s been sold out by the time you get it.

Thus, new issue bond investors are typically entirely reliant on the knowledge and good will of the underwriters’ salesmen or, to put it another way, new issue bond investors are fools.

Of more interest, however, is the tranche retention requirement: Our proposals also would repeal the current credit ratings references in shelf eligibility criteria for asset-backed issuers and establish new shelf eligibility criteria that would include, among other things, a requirement that the sponsor retain a portion of each tranche of the securities that are sold and a requirement that the issuer undertake to file Exchange Act reports on an ongoing basis so long as its public securities are outstanding.

Tranche retention has become the rallying cry throughout the crisis for those who believe that the world would be a much better place if only there were more rules. John Hull supports tranche retention but admits that tranche retention was already in effect throughout the crisis, albeit in different parts of the underwriting firm. The opposite approach, encouraging arm’s length sales to third parties, was urged by Krahen and Wilde in 2005, as cited in the story of the CDO meltdown. Note that a major problem that exacerbated the crisis was collateral substitution in CDOs in which – effectively – investment decisions for a CDO were made primarily for the benefit of the most junior tranche; mandatory tranche retention will exacerbate, not address, this problem; it should be noted in mitigation, however, that the SEC proposes to require that a portion of each tranche be retained.

Ain’t no substitute for forcing long term investors to think! Since the sell-side is congenitally incapable of such a thing, I continue to suggest that the regulatory regime focus on disaggregating the trading part of the street from the investing side; the Volcker Rule is overkill, but allowing financial institutions to choose – one choice per institution! – between regulatory capital regimes intended to penalize aged inventories for traders, and penalize trading activities by investors will go very far to actually accomplishing something.

However, back to the SEC’s proposal. As usual, the SEC (and other American institutions, such as the Fed) the SEC at least pays lip service to the idea that it takes two to make an argument, as opposed to the continuous intellectual dishonesty forthcoming from, for instance, OSFI. Thus – and I trust Assiduous Readers are sitting down – opposing viewpoints are discussed and heavily footnoted:

Risk retention requirements are being considered in the U.S. and internationally. In the U.S., proposals with such requirements have come in several different forms.108 Risk retention requirements have recently garnered support.109 On the other hand, some are concerned that mandatory risk retention will not necessarily result in improved asset quality, may not be calibrated to reflect the risk in any given pool and across different asset classes, and may conflict with various other goals and purposes of securitization.110

(110) See, e.g., comment letter from American Securitization Forum and comment letter from American Bar Association on the FDIC Securitization Proposal.

I believe that the American Securitization Forum’s letter is this one, similarly I believe that this is the ABA letter.

Regulation

Irish Bank Capital Requirements Skyrocket

The Irish Financial Regulator has announced new capital requirements after its Prudential Capital Assessment Review:

A target level of 8% core tier 1 capital should be attained after taking account of the realisation of future expected losses and other financial developments under a base case scenario. This test is designed to ensure the credit institutions are capitalised to a level which reflects prudential requirements and current market expectations, after taking account of forecast loan losses through to 2012. As a further prudent requirement, the capital used to meet the base case target must be principally in the form of equity, the highest quality form of capital, with 7% equity as the target level. In calculating the requirements, individually specified amounts have been added to the institutions’ estimates of expected losses to take account of the uncertainty of loss forecasts for particular portfolios.

A target level of 4% core tier 1 capital that should be maintained to meet a stress scenario or a portfolio level sensitivity analysis. This capital test, which is similar to that employed by US and UK supervisory authorities, is designed to ensure the credit institutions have a sufficient capital buffer to withstand losses under an adverse scenario significantly worse than currently anticipated.

This, together with worse than expected valuations of their loan books, has resulted in enormous capital requirement numbers:

Ireland’s banks may need at least 31.8 billion euros ($42.7 billion) in new capital after a real- estate slump left them crippled by mounting bad loans.

The fund-raising requirement was announced after the National Asset Management Agency, the country’s so-called bad bank, said it will apply an average discount of 47 percent on the first block of loans it is buying from lenders, and the financial regulator set new capital targets. The discount compares with the government’s initial 30 percent estimate.

Irish banks were last discussed on PrefBlog in the post Why weren’t Irish Banks Resilient?

Contingent Capital

Greenspan Endorses Contingent Capital

Alan Greenspan has lost a little of his mystique since McCain said he continue as Fed Chairman after death, but he’s still one of the most knowledgable people out there.

He has delivered a speech at the Brookings Institute that is of great interest.

I can’t find a copyable paper (update: Dealbreaker has one), so you’ll just have to read the speech yourselves or rely on my paraphrases!

He notes that not a single hedge fund has defaulted on debt throughout the crisis, though many have suffered large losses and been forced to liquidate.

The crash of 1987 and the dotcom bubble bursting led the Fed to believe that financial bubbles had disengaged from the real economy.

He strongly doubts that stability can be achieved in the context of a competitive economy.

Capital and liquidity address all the regulatory shortcomings that were exposed by the crisis. Capital has the advantage that it is not necessary to identify which part of the financial structure is most at risk.

The behaviour of CDS spreads in the wake of the Lehman default and TARP imply that the “well capitalized” requirement for total bank capital should be 14%, not 10%, subject to some Herculean assumptions. This will allow bank equity to earn a competitive return while not constricting credit.

The solution, in my judgment, that has at least a reasonable chance of reversing the extraordinarily large “moral hazard” that has arisen over the past year is to require banks and possibly all financial intermediaries to hold contingent capital bonds, that is, debt which is automatically converted to equity when equity capital falls below a certain threshold. Such debt will, of course, be more costly on issuance than simple debentures, but its existence could materially reduce moral hazard.

The global housing bubble was driven by lower long-term rates, not policy rates. Home mortgage 30-year rates led the Case-Shiller index by 11 months with R-squared of 0.511, compared with Fed Funds, R-squared = 0.216 and and eight-month lead. This makes sense because housing is a long-term asset.

Some people (silly people) get this muddled because the correlation between Fed Funds and 30-year mortgages is 0.83 (until 2002). But the relationship delinked, which was the Greenspan Conundrum, so up yours.

Taylor’s wrong. He equates housing starts (supply) with demand. But starts don’t drive prices, it’s the other way ’round. Builders look at housing prices, not the Fed Funds rate. What’s more the correlation between house prices and consumer prices is small to negative.

Some people (silly people) believe that low Fed Fund rates lowered ARM teaser rates and led to increased demand. But the balance of probabilities is that the decision to buy preceded the decision on financing. Anyway, the correlation of Taylor rule deviations with house prices is statistically insignificant (Dokko, Jane, et al., “Monetary Policy and the Housing Bubble”, Finance & Economics Discussion Series, Federal Reserve Board, Dec. 22, 2009)

Any attempt to instigate a “Systemic Regulator” is ill-advised and doomed to fail. Their models and forecasting ain’t gonna be any better than anybody else’s.