Regulatory Arbitrage in Action

From the Washington Post:

[Scott] Polakoff [acting director of the Office of Thrift Supervision] acknowledged that his agency technically was charged with overseeing AIG and its troublesome Financial Products unit. AIG bought a savings and loan in 1999, and subsequently was able to select the OTS its primary regulator. But that left the small agency with the enormous job of overseeing a sprawling company that operated in 130 countries.

Is there another side to this story or is it really as simple as that?

Update: ProPublica had a good story on this back in November. Here’s one short excerpt:

Examiners mostly concurred with the company’s repeated assurances that any risk in the swaps portfolio was manageable. They went along in part because of AIG’s huge capital base . . . and because securities underlying the swaps had top credit ratings.

20 thoughts on “Regulatory Arbitrage in Action

  1. There IS another side to this story and I first saw it reported in the Washington Post thirty to seventy-five days ago in an article on AIG. The Gramm-Leach law that overturned Glass-Steigal SPECIFICALLY exempted credit default swaps (CDS) from state insurance and GAMING law regulation. Some lobbyist KNEW what these financial products could become and worked with Republicans and Democrats to make sure that “free market” capitalism would prevail. Bill Clinton signed the bill with the approval of Robert Rubin, Larry Summers and Art Levitt. Rubin, Summers, Levitt, Greenspan, Paulson, Geithner…its a bi-partisan witches’ brew. They’ll all in it together and the day we find out whose AIG’s counterparties will be the same day the Cubs win the World Series and hell freezes over.

  2. Lest there be any doubt as to what the TARP’s all about:

    In the normal course of events, a contract with a counterparty unable to perform is handled thru the courts — after its margin deposits have been liquidated — NOT by running to the Secretary of the Treasury and getting him to pry loose $750B from the federal coffers to prop up the failing counterparty. The failure of internal controls at these AIG counterparts is absolved by taxpayers and a Congress bamboozled by Executive-branch functionaries, who convince them we’ll have financial Armageddon if they don’t keep AIG whole.

  3. “because securities underlying the swaps had top credit ratings” –> It’s the d**n credit rating agencies. Until there’s some oversight of them (watching the watchmen?), bubbles of financial assets and real estate will continue to happen.

    Pardon my ignorance, but are there any alternatives to using credit rating agencies? Sounds like an obvious topic for econ researchers

  4. The bigger story here is the danger in mixing free market innovation with government guaranteed deposits.

    Clearly, from the massive failure, neither the regulators nor the financiers had accurate predictions for the payoffs on the new CDS instruments. That’s important to say. The regulators in many cases appear to have also failed to regulate, but the lack of predictable data on new financial instruments is different than the failure to regulate a predictable investment (e.g. the Madoff situation). As with any new approach to investing, smart people could guess at payoffs, but the point is these are guesses – until the new approach is tested for some time, the returns and risks are not known.

    The problem is mixing these unknown approaches with institutions backed by government. If small sums of private money had been wagered and lost on these new approaches, we wouldn’t care. What we have to avoid is private gain with government losses.

    Kirk Tofte points out that repeal of Glass-Steigal expressly prevented regulation of CDS markets. Worse by far though, the repeal meant that government backed money was available for speculation on a host of new financial instruments. Volker is finally getting back to this point btw. Free marketeers will say business needs to innovate, but if the government is paying for losses, innovation looks a lot like risk-free speculation.

  5. You are, I’m afraid, getting the causality backwards.

    Mixing innovation with govt. guarantees is not the issue. The govt. did not explicitly guarantee AIG’s obligations prior to the takeover.

    The govt. assumed responsibility for AIG’s obligations because letting AIG fail would have (in their view) taken down the entire financial system (not just in the US, but everywhere).

    Free market advocates have attempted to blame this on moral hazard arising due to govt. intervention. This is a flat out misrepresentation of truth.

    The issue with respect to AIG is not moral hazard. Unlike banks, AIG did not have an explicit guarantee prior to 2008. Arguably, it did not have a strong implicit guarantee (where was the precedent?).

    The real issue, therefore, is externalities, not moral hazard.

    That is to say, the impact of AIGs risk-taking behavior has an effect that extends well beyond its direct impact on AIG. (Just like the impact of Lehman extended well beyond Lehman.) It’s precisely because of these externalities that the govt. insures bank deposits (and, apparently, obscenely large insurance company contracts).

    Thus, the issue becomes “too big to fail”, as Simon Johnson has been arguing. Any institution whose failure would jeopardize the entire financial system inherently has an implicit guarantee from the federal government. Regardless of whether the federal govt. says this, or does not say this, it’s true because of the choices we confront when a really big bank is about to fail.

    That leaves four policy alternatives:

    1) Let private industry alone, and allow the financial system to disintegrate every few decades

    2) Let private industry alone, and throw a few trillion dollars of taxpayer money at it every few decades so the financial system doesn’t disintegrate

    3) Let big companies exist and guarantee losses, but regulate them to prevent risky transactions that could jeopardize the financial system and/or taxpayers and/or national security. This has the downside that it will stifle financial “innovation”. With all due respect, I think the world could do with a little less financial innovation, and perhaps a little more real innovation in areas like technology and health care.

    4) Prevent big financial companies from existing, but recognize that in doing so we are (possibly) ceding a competitive advantage to countries like Japan (with oligopolistic megabanks). (I do not know if I buy this argument…)

  6. It’s the alleged independence of the ratings agencies that’s been problematic. And that’s noit likely to change soon. The Federal Reserve will need the ratings agencies AAA stamp on the “good” colleteral (toxic assets) it will have a claim to when it levers the asset purchases by the investment management companies Geithner’s setting up. That rating on nonrecourse lending by the central bank will reflect nothing other than the govt’s sovereign power to tax. That is, all losses on Fed lending (beyond collateral) will have to be covered by the taxpayer.

  7. Very well said.

    I’ll take it further. We can peel away these obvious financial instruments of mutual assured destruction, but what still remains “baseline” of what we consider normal financial activity. That entire system is fatally flawed as well, and underpins the current crisis. Fractional reserve banking, deficit spending, 401K, pensions, securitization, GSE’s, ad infinitum.

    An economy cannot grow at 5% or even 3% forever. So you cannot guarantee those returns in monetary terms no matter how much you hedge or offload your risk. Mathematics –or should I say physics– dictates that the compounding exponential curve at some point will meet its natural boundary.

    This is that once in 100 year end result. That fact has not sunk into hardly anyone yet, and we think we can prop ourselves up somewhere way up on the curve. All the institutions, assets, securities –everything– holds a relative paper value that cannot be reconciled with reality.

    Moreover, it has reached a point so far gone where systemically it cannot be unwound with popping the entire thing. If Governments decide they will backstop everything it will only ensure that they too are participants in this mass unreality, and that their full faith and credit should also to be “re-priced.”

    At that point we don’t have economic problem anymore, we have a much more simpler and historically common problem of how to kill each other.

  8. Regulatory “choice” and “competition” was touted by the industry as a virtue. The OCC vs States debate on “pre-emption” was a way to find the most business-friendly consumer law strategy.

    Similarly, charter choice for “holding company” supervision likewise occurred. Witness the charter-flip of Countrywide from bank\Fed to thrift\OTS. Witness also the recent charter choices of the insurance companies as they seek “bank” status to accesss TARP funds

  9. I started trading options with EF Hutton in 1979. I am an MBA,B.S. Economics, set on the Streich lecture panel with Lester Thurow, Registered Securities Principal, and spent 30 years in Banking , Trust, and the Securities industry.
    the post by method man mentions “Fractional reserve banking,” In a course on money and banking you are taught the reserve requirement , how money is created etc , Banks typically use 9 to 1 leverage. Pick up a statement of condition in a healthy regional bank and you see capital is 10% and liabilities 90%.

    If you know anything about the relationship of Financial Leverage and then the inter-relationship with Operating Leverage , then you will understand why the Greed and lack of Compliance in the New York Banker’s Mindset allowed the thought that 30 to 1 Leverage was a good thing.

    When you have a system built on fractional reserve banking , 9 to 1, or 10 to 1, the regulators may be able to; or, have historically shown to handle it ,,, but 30 to 1 leverage , then your equity is nothing but a thin sheet – once the leverage goes against you, your equity on the balance sheet is gone. The executives knew this, ( or they were incompetent) and could not resist the leveraged profits while it worked. But quickly threw up their hands when the thin sheet of equity broke, leaving us with a huge negative equity problem.
    It won’t solve anything , put just a few public trips to the gallows, and the next set of executives will think further than just their D & O Liability Policies.

  10. The ways the entire regulatory system funds itself seems to have incentivized it to concentrate more on enforcement at the expense of prevention. Prevention does not pay. Huge problems ultimately are the ways and means to growing their businesses. The following more relevant to the handling/interpretation of the Madoff and Stanford cases at this point, but:

    December 1999 – “…there has been a quiet revolution in the theory and practice of law enforcement. Instead of simply closing rackets that generate illegal income, the central objective has become to attack the flow of criminal profits after they have been earned. Prodded on first by the U.S., then by the Financial Action Task Force of the G-7 countries, then, in more recent years, by the United Nations… many law enforcement agencies now host special units responsible for pursuing not malefactors, but bank accounts, investment portfolios, houses and cars; while officials of the justice system are made responsible for managing such sequestrated assets until they can be forfeited and sold… it sometimes seems as if what criminals do has ceased to be as important as how much they earn by doing it… the idea of seizing criminal proceeds and investing them in law enforcement, thereby relieving taxpayers of the responsibility… was clearly articulated in 1982 before the U.S. Senate Judiciary Committee by a senior official of the Attorney General’s office:
    Official: The potential in this area is really unlimited. My guess is that, with adequate forfeiture laws, we could …

    Senator: We could balance the budget.

    Official …There clearly would be millions and hundreds of millions available…”

    except it seems that they too didn’t think about competing claims on the proceeds – or if the ‘assets’ might not exist or tank in value as confidence in the entire system was wiped out.

    Dec. 21/08 “The FBI has had to shift agents from terror and other crime work to Wall Street investigations… “We have to work those cases which we think pose the greatest threat… In this case, it’s a threat to the financial system and Wall Street…”

  11. Harminder Singh asks… “are there any alternatives to using credit rating agencies? Sounds like an obvious topic for econ researchers.”

    Of course there are alternatives but that is not really the problem. The problem is that when the bank regulators in Basel decided that the minimum capital requirements for banks should be determined based on a so called “default risk” and that this risk was to be measured by the credit rating agencies they empowered them way too much.

    Credit Rating Agencies have been around for almost a hundred years and have been important but never before did the market follow them so blindly than after the Basel Committee told the world “If they are good enough for us, your supreme financial regulator, they have got to be good enough for you.”

  12. In May 2003, at a Risk Management Workshop, a full week event at the World Bank that attracted hundreds of international banking regulators and to which I got invited because at that time I was an Executive Director of the bank I said the following:

    “a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

    Knowing that the larger they are, the harder they fall, if I were regulator, I would be thinking about a progressive tax on size.”

    Thereafter, for many years, I never got invited to any discussion on banking regulations.

    That is also why I become slightly upset when I read about “the issue becomes too big to fail, as Simon Johnson has been arguing”. Excuse me, when did Simon Johnson argue that when he was at the IMF?

    It was the regulations that came out of Basel and that were fully supported by the IMF that set the world up to this mother of all systemic crises.

  13. Let’s be clear here, folks: All these banks and former investment banks (FIBs) have their own credit-rating departments in house. Often, they are at variance with the agencies in how they see particular credits, which, at times, means the internal credit rating is less than that of S&P or Moody’s. This can, when the internal credit folks view a counterparty as weaker than the ratings agencies, result in far lower trading lines than would be implied by a stout rating from S&P or Moody’s. These in-house agencies often provide “consulting” to the mainline agencies, helping them “understand” credits and instruments with which they might not be familiar.

    This whole notion that the entire blame for the massive fraud and reckless amassing of huge risk positions with a single counterpart (AIG) is just wrong-headed. The internal credit functions at the banks and FIBs were every bit as good, and likely better, than the best at S&P and Moody’s. Or not.

  14. C.K. Lee who ran the OTS’s Complex & International Organizations unit helped get that deregulation. From the OTS site:

    Lee began his career on Capitol Hill as an advisor to U. S. Senator Connie Mack of Florida, a senior member of the Senate Banking Committee. During his tenure with Senator Mack, Lee worked on the development and passage of the Gramm Leach Bliley Financial Services Modernization Act, debt relief for Highly Indebted Poor Countries, Permanent Normal Trade Relations with China, reform of the U.S. securities markets, and the restoration and protection of the Florida Everglades.

    The last bit is a nice touch. But the OTS is too shy about the existence of this unit. They canned it in April, 2008. Lee is doing his voodoo in Dallas now.

  15. Before dismissing the causality, consider how AIG became too big to fail and what drove the success of the CDS business at AIG.

    As pointed out by other writers, the CDS is essentially insurance against a specific financial outcome. When a customer (of a small or large insurance policy) buys insurance, they are paying now with the expectation that when the bad thing happens, the company is going to pay up. The demands trust.

    In theory, this trust could come from past performance. Namely, the company has been around for one hundred years selling insurance and so customers would come to trust that company. In practice, this has been insufficient and most insurance is heavily regulated. The regulations limit the risk that the insurance companies can take with the customer’s premiums as well as forcing insurers to keep a cushion for payouts. For some markets, insurers must also contribute to a shared pool intended to address catastrophic events and/or criminality. These regulations add to the cost of all policies and limit the upside for insurers. As a result of the regulation, insurers are supposed to be solid, but not exceptional performers.

    Until the mid 1980s, AIG was focused on insurance, growing the business internationally through acquisition. Beginning in the mid-80s though, AIG began to grow and acquire a large financial services component ranging from commercial aircraft leasing to financial derivatives. This side business initially reported great successes and then ended up killing the company.

    In many ways though, these new contracts were just another form of insurance. However, unlike other insurance contracts, these contracts covered an unregulated business. Also, these contracts were enormous. For example, Bloomberg points out that ( U.S. bailout funds are essentially pass through to very large contract holders to the tune of $50 billion. To sell such large policies, AIG needed to be big, but also to be stable. To prove it is trustworthy.

    Happily for AIG, the core insurance business does this very nicely. The formal regulations in the insurance world give a reliable and transparent report to CDS customers that show AIG can pay multibillion dollar losses without going belly up.

    However, the core business does more than this. Insurance business are regulated precisely because the regulations prove the trust required to create an insurance market. The government is implicitly promising purchasers that these policies will be upheld beyond the scope of a single company. Massive failure of insurance policies would have catastrophic effects on businesses and individuals, so the government takes steps to prevent that from happening.

    For purchasers of CDS vehicles from AIG, this relationship must have been clear. If the contract purchaser didn’t believe AIG would pay up, the contract would certain loss. The size of AIG’s core business in a regulated space deemed critical by the government acted as a risk hedge to buyers. Predicting that this wouldn’t be allowed is an easy bet.

    Put it another way, before AIG sold the CDS contracts that killed AIG, AIG was in a business that governments felt should never fail – insurance. AIG was too big to fail before selling a single CDS contract, but regulators around the world were inspecting the various divisions to ensure that each met the local standards to prevent failure. Moreover, without being too big to fail, AIG would not have been a reliable backer for the massive CDS contracts – contracts so large that default would create bank panics in Europe and the US (again according to today’s Bloomberg).

    So again, all this points back to the fundamental problem of allowing a company that has been designated as one that should not fail (and therefore must be regulated) to experiment in new financial instruments with untested chance of losses.

    The last bit of evidence is the structure of AIG itself. As this post first pointed out, the CDS vehicle were not sold or traded by the insurance divisions, but by AIG Financial Products. The insurance divisions did not sell CDS contracts. Why? My hypothesis is that that insurance regulators would have rejected the computer modeling behind the new contracts as offering unacceptable risk.

    As for the question of the role of OTS in all of this. It smells of a scapegoat. After all, the CDS market was legally unregulated. If OTS has not jurisdiction of the CDS market, how can OTS – or any other regulator – reverse AIG’s risk analysis. OTS did not have the power and jurisdictional reach of an insurance commissioner that could more directly prohibit more exotic investments.

    In the end, the problem doesn’t seem to be so much arbitraging regulators but allowing implicitly guaranteed business to treat separate and unregulated business units as if the subsidiary could fail without putting the regulated divisions at risk.

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