September 23, 2008

The drive to send the CDS market to London and Dubai continues, with Christopher Cox of the SEC jumping on the bandwagon:

U.S. Securities and Exchange Commission Chairman Christopher Cox said Congress should grant authority to regulate the credit-default swaps market amid concern the bets are helping fuel the global financial crisis.

Lawmakers should “provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets,” Cox told the Senate Banking Committee today at a hearing in Washington.
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Cox today said investors who buy swaps without owning the underlying debt may be similar to naked short sellers who sell stocks they don’t own or borrow. Such short sales can flood the market and illegally drive down stocks.

Similar to naked shorts of stocks? Well … hasn’t that been obvious from the beginning? The mechanics of CDSs have been discussed on PrefBlog; Mr. Cox’s full remarks have been posted at the SEC site.

The theory that Sarbanes-Oxley makes the US capital markets less attractive is one to which I subscribe; but there is a column on VoxEU by Craig Doidge, George Andrew Karolyi and Rene M. Stulz that takes the opposite view:

In a recent paper, we examined the 59 firms that deregistered in the six months after Rule 12h-6 was adopted.1 Our analysis shows that deregistering firms have poor growth opportunities and experienced poor stock return performance over a number of years before deregistration. Compared to other foreign firms cross-listed on US exchanges, deregistering firms also have a significantly lower “cross-listing premium”, the valuation difference between cross-listed firms and their home-market counterparts, and this lower cross-listing premium cannot be explained by an adverse impact of Sarbanes-Oxley.
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Overall, the evidence supports the hypothesis that foreign firms list shares in the US in order to raise capital at the lowest possible cost to finance growth opportunities and that, when those opportunities disappear, a US listing becomes less valuable to corporate insiders, so such firms are more likely to deregister and go home.

I’m not sure that the Sarbanes-Oxley is as easily excused as all that. I quite agree that companies will – in general – make a rational investment choice when listing in the US and will leave when the costs outweigh the benefits. If Sarbanes-Oxley is a cost, however, a decision to leave becomes more likely. More insidiously, and much harder to examine in an academically satisfactory way, is the initial decision to list.

For example, Marsh Carter of the NYSE stated in 2006:

Finally, foreign companies are unquestionably concerned about the costs and added regulatory burdens associated with the U.S. regulation, including Sarbanes-Oxley.
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Indeed, one of the underlying motivations for companies listing in the U.S. is the increase in value – which averages about 30 percent — that accrues as a result of adhering to the high standards of governance that the U.S. markets demand. But companies are increasingly viewing the costs associated with these regulatory requirements, as well as their impact on the speed with which they can reach the market, as outweighing the valuation premium they offer. The way that the requirements of Section 404 were implemented is perceived to have resulted in substantial cost and duplication of effort that has caused international companies to conclude that the additional costs of our regulatory structure outweigh the benefits.
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When the London Stock Exchange surveyed 80 international companies that conduced IPOs on its market, it reported that 90 percent of the companies that had listed on the LSE felt that the demands of U.S. corporate governance rules made listing in London more attractive. The Wall Street Journal recently reported that small U.S. companies are turning to London’s small-cap market, AIM, for a variety of reasons, including the regulatory costs of going public. The article noted that “one of the reasons most commonly cited is the strain of Sarbanes-Oxley regulations in the [United S]tates.”

Also in VoxEU, Jeffrey Frankel wants a piece of the bank action, not just Bagehot:

What Mallaby calls the core insight is also the crux of Krugman’s logic (“Cash for Trash”):

“…the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.”

This follows a call by Charles W. Calomiris for preferred stock buys rather than loans:

Instead of buying toxic assets, the US government should buy preferred stock capital in ailing banks that could raise matching private sector equity. This would avoid the intractable problems of how the government should value the toxic assets and directly address the banks’ immediate problem – a lack of bank capital.

I like that idea a lot better. Look, a lot of the problem here is simply that sub-prime paper is not being rationally priced and the owners are being forced to mark to market. I recently noted that Moody’s is projecting a 22% loss on 2006 vintage mortgages. As I have discussed at length, the AAA portion of subprime debt is subordinated by roughly 20% (the precise amount will depend on the deal). So, OK, the mezzanine and equity portions have been wiped out … but the AAA tranches are only a little impaired. But as was noted by the OECD paper previously discussed, the mark-to-market on these things is a discount of 14%!

I suggest that banks do not want to sell paper worth $98 for only $86. They want to hoard their cash, let the paper run off gradually, and get their $98. So they won’t want to sell to Treasury at “market price” and Treasury will not – politically – be able to come close to “intrinsic value”. Stand off. To fix the problem in a Bagehotish sort of way, allow the banks term financing at Fed Funds + 100bp … which is the old discount window + 50bp, and the new discount window + 75bp. This is similar to the preferred stock idea of Calomiris, but gets the capital threat to Treasury more deeply subordinated, particularly if there’s a nice stiff haircut in the loan value.

CEBS has released a rather bureaucratic Statement on the Current Crisis Situation with the main points (bolded in the original):

• In our view, banks’ exposures to Lehman Brothers are manageable and mostly non-material, compared to the banks’ total assets and capital base.
• …
• With respect to EU banks’ exposures on AIG: given the US government support provided to AIG, EU bank supervisors view that this counterparty risk can be sufficiently mitigated for the moment.

So we can all sleep better at night. C-EBS has spoken!

James Hamilton of Econbrowser makes an interesting point regarding Monday’s spike in oil prices:

The most striking thing about yesterday’s oil prices was the disparity between different futures contracts. The October contract, which expired yesterday, did indeed settle at $120.92, up more than $16. But oil for delivery in November closed at $109.27, an increase of only $6.62, and longer-forward contracts saw an even more modest increase. Unquestionably what was going on was a short squeeze, in which traders who had sold the October contract short were scrambling to close out their positions before expiration, and having a hard time finding people willing to take the other side.
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I’m guessing that part of the answer must be that some of these operators were following rules of thumb which usually work just fine in a properly functioning market, and weren’t alert to the profit opportunities at hand. I certainly would not expect a discrepancy of this magnitude to persist for as long as 24 hours.

But another possibility that suggests itself is some degree of local monopoly power in the Cushing market. If you’re selling that $121 October oil, you might not be anxious to cook the golden goose by bringing any extra oil to the temporarily thirsty market. This might be a reasonable case for the FTC and CFTC to investigate the mechanics of exactly what happened yesterday.

PerpetualDiscounts were off a bit today on average volume. The excitement of the day was Nesbitt’s crosses of BCE issues – some of them usually very sleepy traders.

There were twenty-two other index-included $25-pv-equivalent issues trading over 10,000 shares today