Bernanke-Panky - Congress is Shocked At Politics in High Places
SEC / CFTC - The Regulatory Smackdown
And: ETFs - We Don't Want To Say We Told You So... Actually, We Do!
"Paulson - BofA is the turd in the punchbowl."
This quote - reported in Friday's Wall Street Journal as "Jan. 9 note by participant in call among Fed, Treasury, OCC, FDIC" - is being waved under Fed Chairman Bernanke's nose as evidence of skullduggery on the part of the Gang of Two - Paulson and Bernanke - in their alleged manhandling of BofA CEO Ken Lewis. Lewis has stated under oath that he was "threatened" by Paulson and Bernanke. One comment we have not seen in this Brouhaha in a Brown Betty is the fact that, an out-of-work Ken Lewis is not exactly to be pitied.
"Threatened"? We recognize that, at over six feet, former football player Paulson is physically imposing. But what was he going to do to Lewis - beat him up?
Reality check: Wall Street Journal staff reporter Kate Kelley has come out with a book - Street Fighters - based upon the series of articles she wrote about Bear Stearns that ran in the WSJ last year. The book is a quick and lively read. It purports to chronicle the blow by blow of the last three days of Bear's independent existence and comes complete with personal portraits of key players. For all the excitement that fills its pages, we found by far the most important passage is a brief paragraph on pages 164-165, describing Treasury Secretary Paulson's discussions with Deutsche Bank Chairman Josef Ackermann.
Ackermann, whom Paulson considered a possible buyer for Bear, responded to Paulson's query by saying that Deutsche would be making no such offer. Further, Ackermann said "if those guys go down, we're not interested in doing business with any bank in the United States."
We thought that sentence worth the entire price of the book, and then some. Whether we agree or disagree with the program Paulson and Bernanke pursued, they certainly saw with crystal clarity that the entire US financial system - and with it, the American way of life - was on the line. Paulson may, in fact, have fully believed what he was saying when he told members of Congress, in his famous secret late-night call, that there would be rioting in the streets, nation-wide unrest, and martial law if the TARP were not passed and implemented. In light of the projections made in the latest IMF report, we fear Secretary Paulson's predictions may yet prove true.
Fast forward to BofA CEO Ken Lewis whining to New York AG Cuomo that Paulson and Bernanke "threatened" him over the Merrill acquisition. Then faster-forward to Thursday of this week, when Chairman Bernanke sat before a Congressional panel and took it on the neatly-whiskered chin.
Bernanke testified that the decisions at issue "were taken under highly unusual circumstances in the face of grave threats to our financial system and our economy" (WSJ, 26 June, "Bernanke Blasted In House"). Reality check, Part II: Lewis, Paulson, Bernanke - don't let the Ivy-League veneer fool you - these three guys are tough and smart, and they do not - repeat, Do Not - take "No" for an answer. Lewis and Bernanke, both having been well coached by their counsel, are walking the finest of lines - they have to balance avoiding perjury, with avoiding screaming back at Congress and asking why they are going through this self-serving Inqusition, instead of supporting those who did the dirty work of keeping the markets afloat.
For this Deluge in the Royal Doulton is nothing more than a self-serving exercise for Congress to distract public attention from the fact that they caved in to the pressure from the Dynamic Duo, giving Paulson and Bernanke carte blanche over... uhmmm... a really large amount of money.
If one believes - as Congress clearly did at the time - that the rescue of the US financial system depended on extraordinary measures, one can not have it both ways and now go after those who forced the issue.
As the quote from Josef Ackermann makes clear, the credibility of the US markets was mighty tenuous. The trillions thrown at the marketplace notwithstanding, the ice upon which we tread still seems perilously thin. For all its economic clout, China is not as much creating global events, as taking advantage of them, and the current campaign to uproot the US dollar as the world's reference currency is a sign that the tide has turned definitively away from our markets as the sole beacon for the global economy. The only questions now are, how much influence will the US lose, and how quickly will we lose it?
The failure of a deal to rescue Merrill Lynch would have blown a hole right through the hull of the US market and our economic ship would have been sunk for good.
What next for these hearings? Our nickel is on Mr. Bernanke for another term. He will surely get Geithner's vote - and it is clear that President Obama is giving Secretary Geithner enough rope to either tie down the monster, or hang himself and the Ship of State and all who sail in her. For all the screeching on the Hill, if Congress goes after Chairman Bernanke for his role in the BofA / Merrill deal, Congress itself will have to admit that they were reckless in approving the TARP and handing the money over to the Pair Extraordinaire.
As just one example of how this might have turned out differently, ranking Republican Darrell Issa went hellbent-for-leather after Chairman Bernanke for Bernanke's failure to report Merrill's undisclosed losses to the SEC. Lawyers can debate whether the Chairman should have done so, or at what point. But as a practical matter, we can think of no worse lapse of judgment than bringing Chris Cox into the mix as the deal teetered on the brink.
Ken Lewis is no pansy. He may have not known the full extent of Merrill's financial pain, but - not to be facetious - there isn't a hell of a lot of difference between $9 billion in undisclosed losses, and $12 billion in undisclosed losses. And when he went to Paulson and Bernanke, no doubt trembling with rage, we envision Paulson - football player, high-powered investment banker, all-around tough guy - telling him, "shut yer trap and quit yer whining, and don't expect us to bail you out if you go shooting off your mouth now in the middle of the deal." Paulson was right: BofA was the turd in that punchbowl. Where else were they to put it now?
Yes, under proper corporate governance standards, Lewis should probably have evoked the Material Adverse Condition clause. Yes, under proper regulatory and oversight standards, the public sector should not encourage the private sector to pursue highly irresponsible expenditures of shareholder capital. Yes, under the standards of free market capitalism, federal monies should not be offered to support these highly irresponsible transactions. And yes, under proper legislative procedures, Congress should not allocate a single dollar - much less nearly a trillion of them - without having heard full testimony and performing a thorough review of the uses to which the monies would be put, the persons and mechanisms in place to ensure proper management of the programs to be financed, and what measurements would be applied to determine success of the programs in question.
If Congress does not re-affirm Chairman Bernanke when President Obama nominates him for another term, who will answer for all of this?
Do you get it now?
The reigning market regulators - the SEC and the CFTC - are engaged in a careful minuet. Even as they embrace, it is not clear whether they are dancing with one another - and impossible to tell who is leading.
As SEC Chair Schapiro arms her minions, CFTC Chair Gary Gensler appears to be making a quieter bid for dramatically increased power - one he may well win with no fanfare.
Gensler's proposal makes sense, and may be the only practical way of achieving the public policy objective of market transparency and stability. The CFTC has a much lower public profile than the SEC. Their brief is to promote market efficiency and transparency - as distinct from the SEC, which is designated an investor protection agency. To most professional observers, the CFTC does its job fairly well - the SEC, in the past decade or so, not at all.
Gensler tells the Wall Street Journal (26 June, "CFTC Targets Derivatives Dealers") "The lack of regulation of dealers is 'one of the great lessons' of the financial crisis." Alternatives, such as Senator Harkin's proposed legislation requiring OTC derivatives to be cleared through regulated exchanges, may gum up the works because they fail to take into account the mechanics of the marketplace they seek to regulate.
The credit derivatives business is, by definition, a vast market of individual contracts. These contracts are not standard, and will thus not be amenable to exchange trading. As portfolio holdings, they are impossible to price in a mark-to-market environment, and traditional clearers will be hard pressed to take them into their systems, as there is nothing to hold. As Gertrude Stein said, "there's no there there." (She was speaking about the city of Burbank, CA. The way things are going, this comment may take on renewed meaning.) This makes exchange clearing more complicated than it needs to be - and still does not address the instruments at their heart, which is the issuers. Could it be that Senator Harkin is putting out a red herring, making himself look tough, while keeping hands off the investment banks that are sources of campaign contributions?
Chairman Gensler's proposal, to regulate the issuers, looks to go straight to the heart of the matter. Which is why it may face stiff opposition.
SEC Chair Schapiro, meanwhile, is gaining praise (Financial Times, 26 June, "Schapiro Gets Troops Ready For Regulatory Turf War"; Floyd Norris, 22 June, "Good News At The SEC") for her recent appointment of University of Texas law professor Henry Hu to "a senior risk position." Professor Hu has done recent work on the "empty creditor" problem - the phenomenon of investors who buy credit default protection, then force companies to credit events. The investors lose out on their equity or corporate debt holdings, but they make a multiple of those losses on cashing in their credit default swaps.
Critics are saying Professor Hu's work might be deemed more important if he had published at the start of this decade, on the heels of the Marconi restructuring. In the Marconi transaction, UBS insisted that the restructuring be packaged in such a way as to create an ISDA-defined "credit event", so it could collect on its default protection contracts. After considerable haggling, this finally transpired in 2002. Professor Hu published his first paper on the "empty creditor" problem in 2007. Still, this was as an academic, and not a market participant. We are willing to give Chairman Schapiro the benefit of this particular doubt and see how Professor Hu operates with his finger on a live pulse.
A loyal reader of this Screed has written: "Hey! I just want to know how many of those 'seasoned, Wall Street vets' Mary Shapiro has hired so far. THAT will tell you how much CHANGE we are going to have."
Point taken, my friend.
The cynic in us says that Chairman Gensler, with an imminently sensible proposal, will encounter tremendous resistance. Chairman Schapiro, by contrast, will find herself praised for her new appointment. After all, she is bringing in, not the UBS bankers who figured out how to force Marconi into bankruptcy, but the law school professor who wrote about it five years after the fact.
ETFs - Again?!!!
None of them along the line knows what any of it is worth.
- Bob Dylan, "All Along the Watchtower"
We have spent a fair amount of virtual ink, going back to the start of January, addressing what we see as critical issues in the ETF / ETN space. These issues focus around disconnects between the way the ETFs are advertised to work, and the way they actually do - or threaten to - act in the marketplace where, despite all representations to the contrary, they create additional volatility in the underlying securities, commodities and contracts on which they are based.
We have also been particularly vocal about the way ETFs have been marketed to retail investors, and the lack of apparent training - and especially the lack of regulatory oversight - in this end of the market.
Now that the biggest players in the world are getting into this business, with PIMCO issuing ETFs, and with BlackRock buying Barclay's iShares business, we believe the risks have gone to warp.
Now the regulators have finally gotten antsy about these instruments. This week saw an alert issued by FINRA about the marketing of these instruments to private investors. The Wall Street Journal (23 June, "Finra Urges Caution On Leveraged Funds") reports that FINRA "has reminded brokers and registered investment advisers about their fiduciary duties when selling ETFs that offer leverage, are designed to perform inversely to the index or benchmark they track, or both." Specifically, the article reports, FINRA "reminded the brokers and advisers that these instruments are complex and typically unsuitable for retail investors who plan to hold them longer than one trading session."
Looking into FINRA Release 09-31, we learn that, between December 1, 2008, and April 30, 2009:
"The Dow Jones US Oil & Gas Index gained 2 percent, while an ETF seeking to deliver twice the index's daily return fell 6 percent and the related ETF seeking to deliver twice the inverse of the index's daily return fell 26 percent.
An ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 percent while the index actually gained around 8 percent. The related ETF seeking to deliver three times the inverse of the index's daily return declined by 90 percent over the same period."
We find it noteworthy that FINRA itself makes no mention of any analysis a prospective investor should perform - such as reading the prospectus, or even asking one's stockbroker (Oops! Sorry, Guys. One's "Financial Adviser") to explain how these things work. Seemingly, FINRA itself also has not performed this analysis. If it had, we are confident it would have found - not two things, but one thing.
The one thing it would have found is that the typical ETF structure is about as complex as any OTC derivative contract, and beyond the patience, if not the ken, of the average investor.
There would be a second item to notice, which is that these ETFs reset daily, and that it is likely a bad plan to hold them for long terms. We do not believe FINRA would have arrived at that conclusion, which would require analysis of the ETF, because they are no smarter than any of us. To put it as gently as possible.
Heads up to you folks who are putting these instruments into your customers' accounts: the Notice refers to NASD Rule 2310, relating to Suitability. It starts by observing that, prior to soliciting the purchase of ETFs, a firm must first make a determination as to whether such an instrument is a suitable investment for any customer. Once it has passed this hurdle, the firm may then proceed to determine suitability investor by investor.
In other words, they are leaving it up to the firms that are marketing these things - and to investment advisors who are putting them into managed accounts - to determine whether they should even be touched with the proverbial ten-foot pole.
One of our contacts, who has served in senior compliance roles at the Exchanges, and at major trading desks, told us that his experience reading ETF prospectuses was every bit as confusing as reading the contracts that went along with complex OTC swaps, and in much the same way.
This immediately does not sound like a product that is suitable for any retail investor.
A friend out in the financial ether has recommended that brokers treat ETFs like options. We think this is a brilliant idea, for brokerages that want to continue to do this business.
ETFs and ETNs are new instruments, and they entail unique risks. Risks that have not been widely available in the marketplace heretofore. Just as with options, we recommend creating a separate Risk Disclosure Document, together with a separate suitability approval process for investors who wish to trade these instruments. They could be held in a separate account type, so they would be readily visible to branch managers and compliance officers charged with trade and suitability reviews.
The one concrete bit of guidance that FINRA hands out is that "While the customer-specific suitability analysis depends on the investor's particular circumstances, inverse and leveraged ETFs typically are not suitable for investors who plan to hold them for more than one trading session, particularly in volatile markets."
FINRA goes on to invoke IM-2310-2(e) (Fair Dealing With Customers with Regard To Derivative Products Or New Financial Products), and then to make specific mention of Communications With The Public, Supervision, and finally, Training of sales personnel.
If you are in the business of trading ETFs for your customers - or in your managed portfolios - you must read this Regulatory Notice in full and take it to heart. As we saw with earlier NASD / FINRA initiatives (you may remember the issues around the marketing of hedge funds prior to the SEC's requiring registration) the regulators are using the Sales end as the very large tail to wag a much larger dog.
ETFs originated as institutional contracts and were frequently issued for high-frequency traders to arbitrage against. It was, of course, inevitable that they should become a retail product. It is now inevitable that those who market them shall be smacked first.
We will have to see who will be first to flinch. We believe it will not be PIMCO or BlackRock - their money management arms are big enough to be major purchasers of their own ETF product - but suddenly Goldman and those other guys who dropped out of the bidding for iShares are looking just a bit smarter.
So, for brokers and bankers who want to find the next unregulated item to pump and dump, where will they turn? We have an abiding faith in the creativity of Wall Street. There will be diligent professionals who will create viable ETF strategies for their customers.
And there will be crooks who even now are working to bring you the Next Big Thing.
Last note: with the SEC proposing that a fiduciary standard be applied to brokers, this looks ready to become a hot button.