At the beginning of the decade of 1980 banks and lenders began to package mortgages and other predictable cash flows through securities issuance, up to an outstanding balance of three trillion dollars at the end of 2008. For years, in a low interest rate environment, they sold these securities aimed at generating higher returns to investors. But with the bearish spiral of the residential market and escalating leverage toxicity became clear, leading to a lack of liquidity of counterparts. In fact, compensations were based on volume of operations rather than on quality of borrowers or collaterals and many relied heavily on credit-agency ratings, while they had lack of data and experience.
Standard & Poor’s Ratings Services, Moody’s Investors Service and Fitch ratings charged the companies whose debt they qualified and that they maintained the investment grade of many financial institutions on the brink of failure or collapse.
US and Europe advocated changes in the global financial system in this regard and the president of the Federal Reserve, Ben Bernanke stressed the need for rules limiting risks to the financial system while the president of the European Central Bank (ECB) Jean-Claude Trichet reiterated appeal to changes in world finances. In fact, G-20 leaders in Pittsburgh anticipated measures. In particular, the White House Secretary of State wanted to increase responsibilities to oversee and regulate any financial company capable of jeopardizing financial stability, a proposal sent to the Capitol. To this is added that credit rating agencies must have procedures for managing and informing conflicts of interest. In addition, the supervisor of US financial Markets (SEC) was to pre-require investor brochure and determine improvement of understanding. Other measures included compulsory registration of hedge funds and venture capital and forcing derivative products into listed regulated markets.
These proposals reflected efforts of European Union’s White paper to adopt similar rules. In addition, the British financial markets Supervisor FSA established a new code of conduct, applicable to certain banks, to end practice of long-term incentives to managers without amount or limit and in case of non-compliance requirement of increasing provisions. The fact is that the British Government had to rescue big companies as Lloyds and Royal Bank of Scotland.
The Investors Working Group (IWG) wanted investor-oriented reforms. However, it considered the need for more daring reforms to restore confidence in financial markets and since summer of 2008 considered that the US Treasury Department’s legislative reform largely ignored the investor. This group was chaired by two former SEC presidents William Donaldson, CFA, and Arthur Levitt and sponsored by CFA Institute and The Council of Institutional Investors.
Flaws in scandalous legislation
IWG, formally created by February 2009, considered that flaws in legislation were scandalous: oversighting gaps that allowed abusive mortgages, complex derivatives and complicated products without regulated markets, supervisory authorities without resources and financial institutions too big to fall and too labyrinthine to be effectively regulated. It warned that some changes would take time: “The worst financial crisis since the Great Depression has toppled financial institutions, forced government bailouts and put markets on the verge of collapse. The debacle has annihilated retirement savings of millions of investors and paralyzed the economy. Broader, more effective legislation needs to be made that responds to requirements of investors, consumers and the system as a whole”.
IWG considered that the financial crisis had revealed that regulators lack the will, knowledge and resources to respond flexibly to rapid innovation and expansion of the financial market: “The financial crisis of 2008 meant taking of control of large and complex interconnected non-banking companies as investment banks Bear Stearns, Lehman Brothers or insurance company International Group (AIG). There was no mechanism to deal with such collapses, so bailouts became ad hoc and inconsistent, driving chaos further. A clear lesson is the need for an ongoing effort to add and analyse exposure to risk of companies, instruments, securities and markets. Oversight must be on par with financial innovation and coordinated with regulators outside US”.
However, it considered that the Federal reserve should not manage monitoring of systemic risk, but an independent supervisory board of government agencies and financial institutions, with full-time professional staff and own funding, empowered to inform the Congress, regulators and public. This would allow the Fed to focus on directing monetary policy and protecting nation’s payment system. It also considered that investors needed better tools to be able to control management, to be chosen by majority vote, with right to propose and vote on remuneration: “Legislation alone cannot address all abuses that led to the financial disaster. The discipline at service of shareholder is fundamental: too many approved rewards of excessive risk taking and short-term profitability”. Despite serious lack of information on asset-backed investment products -as high-risk mortgages- IWG recognized that investors need to be more diligent: “Some investors subcontracted due diligence to third parties, as credit rating agencies, without understanding the nature of the underlying warranty, purpose of the risk classification or conflicts of interest of the agencies. Often this information was insufficient and too complex and came when the sale had already been made”.
In this regard, it considered alternatives ways for credit rating agencies business model, where the debt issuer pays: “Only instruments for which there is adequate information should be qualified and fees must be based on credit ratings evolution and results corresponding debt performance”. Such qualifications should make it clear that they do not replace due diligence that investors must undertake to determine suitability of their investments. It also supported that all investment managers, including hedge and venture capital funds, should register at SEC and disclose positions to regulators: “Their ability to take huge indebtedness can endanger the market, foster asset price drops and liquidity contraction”. In fact, it advocated that all institutional investors annually public their voting and vote guidelines, investment guidelines, positions and returns. To this added that all standardized derivatives contracts had to quoted in regulated markets: “The contrary implies problems of lack of transparency, price, excessive influence, rampant speculation and lack of appropriate controls”.
Jose María Serrano-Pubul, CFA, Yesficom SL
