Innovation Destruction and Credit Market Reform in the Bubble Era

							                 Presented by
           Michael J. Aguirre
Aguirre, Morris and Severson
   One year ago US had 5 major investment
    banks. Today one (Lehman Brothers) is
    insolvent; two (Merrill Lynch and Bear Stearns)
    were on the brink of insolvency. The
    remaining two (Goldman and Morgan Stanley)
    have converted into bank holding companies.
    10 March 2009 US Senate Banking Committee Testimony of
    Professor John C. Coffee, Jr. Adolf A. Berle Professor of Law
    Columbia University Law School




                                                                    2
   Rapid financial innovation outpaced private
    sector risk management and supervision,
    disclosure, and regulation
   Resulted in excessive risk-taking, weak
    underwriting, maturity mismatches, and asset
    price inflation.




                                                   3
   19 November 1987 - Greenspan Calls for Repeal
    Of Glass-Steagall Bank Law
   January 22, 1993 - The CFTC exempted "certain
    swap agreements and hybrid instruments from
    regulation under the Commodity Exchange Act."
   February 24, 1994 - Long-Term Capital
    Management (LTCM) began trading.
   May 25, 1994 - Greenspan tells Congress there
    was "negligible" risk financial derivatives might
    someday require a taxpayer bailout. Netrootsmass Financial
    Regulation Timeline




                                                                 4
   NYT, May 19, 1994 - G.A.O. Seeks Sweeping
    Rules for Derivatives A two-year Congressional
    study of the explosive growth in financial
    derivatives that was released yesterday calls for
    sweeping new regulation of the companies that
    create these often complex financial products
    and the companies that use them.
   December 6, 1994 - Orange County, California
    was forced to declare bankruptcy due to the loss
    of over $1.5 billion in derivatives by treasurer
    Robert Citron. Netrootsmass Financial Regulation Timeline


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   May 25, 1994 - Greenspan told House
    Subcommittee on Telecommunications and
    Finance he strongly disagreed with the GAO
    report. He said there was "negligible" risk that
    the rapidly growing market for financial
    derivatives might someday require a taxpayer
    bailout. (NYT, May 26, 1994 - Derivatives Get a Key Supporter)
   March 1995 - Less than 2 months after
    becoming Secretary of the Treasury, Robet
    Rubin asked Congress to repeal the Glass-
    Steagall Act and to change the Bank Holding
    Company Act of 1956. Netrootsmass Financial Regulation Timeline


                                                                      6
   March 1997 – Arthur Levitt‘s SEC exempted
    some of Enron‘s partnerships from
    accounting controls of the depression era
    Investment Company Act of 1940.
   April 1998 CFTC Chair Brooksley Born
    proposed to regulate derivatives
   7 May 1998 Rubin, Greenspan and Levitt
    issued a joint statement expressing "grave
    concerns about this action and its possible
    consequences.― Netrootsmass Financial Regulation Timeline


                                                                7
   September 1998 - After losing $4.6 billion in
    less than four months, Long-Term Capital
    Management, was bailed out in a deal organized
    by the Federal Reserve Bank of New York.
   October 1998 – Pres Clinton signs into law
    H.R.4328, Emergency 1999 appropriations bill.
    The law has an obscure reference to the CFTC
    (section 760): "During the restraint period, the
    Commission may not propose or issue any rule
    or regulation, or issue any interpretation or
    policy statement, that restricts or regulates
    activity in a qualifying hybrid instrument or swap
    agreement.‖ Netrootsmass Financial Regulation Timeline


                                                             8
   13 November 1999 Pres Clinton signed law
    repealing Glass Steagal NYT
   21 December 21, 2000 – Pres Clinton signed
    H.R. 4577, the Commodity Futures
    Modernization Act of 2000 that exempted
    credit swaps from regulation
   Jan 2001 President Bush assumes office
   3 August 2005 - Christopher Cox was sworn
    in as Chairman of the Securities and
    Exchange Commission Netrootsmass Financial Regulation Timeline

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   Structured Finance Operating Companies
   Credit risk transfer (credit default swaps)
   Credit tranching
   Securitization
   Originate to distribute
   Dynamic leverage
   Subprime, Alt-A loans
   Off balance sheet
Lancaster, Brian P., Schultz Glenn M., Fabozzi Frank, J., Structured Products and Related
    Credit Derivatives



                                                                                            10
   A SFOC can be seen as an operating finance
    company with structured finance
    characteristics. Promoters manage its assets,
    liabilities, and liquidity.
    Global Legal Group, The International Comparative Legal Guide to:
    Securitization 2007




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   Financial entities engage in credit risk
    transfer by selling loans, syndicating loans,
    issuing collateralized loan obligations
    (CLOs), credit default swaps (CDSs), and
    credit derivative product companies.

   The global credit explosion and subsequent
    crunch were the products of the new era of
    credit risk transfer ("CRT").
    Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED FINANCE AND CREDIT
    MARKET REFORM IN THE BUBBLE ERA, 5 Hastings Bus. L.J. 53,57




                                                                             12
   Entities were structured to transfer the risk of
    default on assets like subprime loans to investors
    through securitization

   These securitizations were supported credit
    enhancements all of which were rated by
    nationally recognized statistical rating
    organizations like Moody‘s Investor Services.
    Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED FINANCE AND CREDIT
    MARKET REFORM IN THE BUBBLE ERA, 5 Hastings Bus. L.J. 53




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   1. The rating agencies, the main arbiter of
    asset and bond credit quality, get it wrong;
   2. The originators of the original asset turn
    into ‗toll takers,‘ not caring about credit
    quality buy -- only fees;
   3. The investors don‘t understand the risk
    and opportunities embedded in the securities
    they are acquiring; and
   4. Risk transfer and dispersion is not as clear
    cut as originally expected.
   Lancaster, Brian, P., Schultz, Glenn M., Fabozzi, Frank J., Structured Products and Related
    Credit Derivatives, p. 4.




                                                                                                  14
   Over the last two decades, bank credit has
    evolved from the traditional relationship
    banking model to an originate-to-distribute
    model where banks originate loans, earn their
    fee, and then sell them off to investors
    through securitization.




                                                    15
   Investors were sold on the idea that they
    could avoid risk by credit tranching, meaning
    any credit losses would be absorbed by the
    most junior class of bondholders until the
    principal value of their investment reaches
    zero. Wikipedia




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                           Cash
Originator                            Mortgage
                          Mortgages
                                      Borrowers
                                                                              CDS Counterparty
                                                            Negative
                                                          Basis Trade           Credit
                                                                                                30 bps
                                                                            Protection
             Mortgage
             Backed                                                           Investment Bank
             Securities

                                                                                          Senior (L+50)
                                      Investment Manager                                       Sr Mezz
                         Senior                   Management                                    Jr Mezz
                     Sr Mezz                      Agreement

                   Jr Mezz            Mortgage CDO             Securities


                  Sub                                                                            Sub




                                                                                     17
    By the early 1990s, technological advances
    made it possible to estimate and price the
    risk of subprime home loan pools, paving the
    way for subprime securitizations.

   In 2005, total securitizations of subprime and
    home equity loans ballooned to an estimated
    $ 525.7 billion. Kathleen C. Engel and Patricia A. McCoy, TURNING A
    BLIND EYE: WALL STREET FINANCE OF PREDATORY LENDING ,75 Fordham L. Rev. 2039




                                                                                   18
   Those securitizing mortgage-backed
    securities avoided heightened default risk of
    subprime loans and predatory loans by using
    credit risk transfer devices to shift the risk to
    others. The "lemons" were simply passed on.
    Engel, Kathleen C., McCoy Patricia A., Turing a blind Eye: Wall Street Finance of Predatory

    Lending, 75 Fordham L. Rev 2039, 2040-2041 (March 2007)




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   Off-Balance Sheet Derivative Contracts:
    Derivative contracts that generally do not
    involve booking assets or liabilities (i.e.,
    swaps, futures, forwards, and options).

    Off balance sheet (Glossary Office Comptroller of the
    Currency)




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   Credit Rating Agencies (CRAs) were relied
    upon to evaluate the risk of default. However,
    these ratings have turned out to be self-
    serving, allowing market participants (and the
    CRAs) to earn profit and fees, while offering
    very little informational value about risks.
    Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED
    FINANCE AND CREDIT MARKET REFORM IN THE BUBBLE ERA, 5
    Hastings Bus. L.J. 53,65-66.




                                                            21
   Moody‘s Investor Services issued its rating
    methodology for SFOCs in 2005
   Moody‘s Ratings Methodology A Framework for Understanding Structured Finance
    Operating Companies (April 2005) p. 1; Lancaster, Brian P., Schultz Glenn M.,
    Fabozzi Frank, J., Structured Products and Related Credit Derivatives, p. 12




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   Structured Finance Issuer Ratings are
    opinions of an entity's general financial
    capacity to ultimately honor its contracts and
    financial obligations.

    Moodys Structured Finance Issuer Ratings Definition




                                                          23
   As of December 2008 Moody‘s Investor
    Services has rated and currently monitors
    ratings on approximately 109,000 structured
    finance obligations.
    Moody‘s 2008 10K p. 1




                                                  24
   As of 2006, structured finance accounted for 54
    percent of Moody‘s rating revenues, with the
    largest contributions coming from mortgage-
    backed securities and CDOs

   ―Global structured finance revenue was $890.6
    million for 2007, an increase of 1.1%, or $10.0
    million, from $880.6 million in 2006.‖
    Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED FINANCE AND CREDIT MARKET
    REFORM IN THE BUBBLE ERA, 5 Hastings Bus. L.J. 53,65-66; Moody‘s 2007 10-K p. 23




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―Within the ratings business, global structured finance
revenue totaled $92.2 million for the fourth quarter of 2008,
a decrease of 42% from a year earlier. U.S. structured finance
revenue decreased 57%, driven by declines in issuance across
all asset classes. Non-U.S. structured finance revenue
decreased 26%, led by declines in European commercial real-
estate finance and credit derivatives.‖

Moody‘s Press Release 5 Feb 2009: ―Moody‘s Corporation Reports Results for Fourth
Quarter and Full-Year 2008‖




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   ―Financial derivatives for market and credit risk,
    asset-backed securities with customized cash flow
    features, specialized financial conduits that manage
    pools of assets, and other types of structured finance
    transactions serve important purposes, such as
    diversifying risk, allocating cash flows and reducing
    cost of capital.

   As a result, structured finance transactions, including
    the more complex variations of these transactions,
    now are an essential part of U.S. and international
    capital markets.‖
    The Fed Reserve Board and other banking agencies have issued an Interagency Statement regarding
    sound practices in dealing with the elevated risks associated with complex structured finance activities.
    72 Fed. Reg. 1377 (2007)




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   We have entered a new economic era where
    financial innovation is replacing production
    as the engine of growth. In 2005, global
    financial assets (including banking assets,
    stock market capitalization, and bond market
    value) were calculated at US $165 trillion – a
    sum nearly four times the global GDP.
    Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED FINANCE AND
    CREDIT MARKET REFORM IN THE BUBBLE ERA ,5 Hastings Bus. L.J. 53,56-58.



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   The notional value of derivatives, which
    equals US $454.4 trillion -- more than ten
    times the global GDP and three times the size
    of all financial assets.

    Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED FINANCE AND
    CREDIT MARKET REFORM IN THE BUBBLE ERA, 5 Hastings Bus. L.J. 53,56-58.




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   There was a collective failure to appreciate
    the extent of leverage taken on by a wide
    range of institutions—banks, monoline
    insurers, government-sponsored entities,
    hedge funds—and the associated risks of a
    disorderly unwinding.




                                                   30
   The ten largest market makers account for
    close to 90% of the $45 trillion outstanding
    notational value of CDS as of 2007.
    IMF Report Global Financial Stability Report 2008, p. 17 fn 32




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   Hedge funds generate more than 55% of US trading
    volume in liquid or "flow" derivatives with investment-
    grade ratings, and more than 80% in high-yield
    derivatives, more than 85% of US trading volume in
    distressed debt, nearly 55% of US trading volume in
    emerging-market bonds, and more than 40% of US
    leveraged loan trading volume.

   In structured credit, hedge funds generated nearly half the
    trading volume reported in the US over the past 12
    months," says Greenwich Associates consultant Frank
    Feenstra.

   Hedge funds Become the US Fixed-Income Market,
    Helen Avery ,Sept 2007


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   Combination of unregulated financial
    innovation and human greed

   Tremendous economic expansion due to
    historic asset bubble

   Financial institutions earned immense profits




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   Dynamic leverage depends on the difference
    between the fund's net asset value and its critical
    liquidation level. The critical liquidation level is
    the level of net asset value loss from which the
    fund manager could not recover and the fund
    would need to be liquidated to meet margin calls
    and redemptions. At some intermediate critical
    level (above the liquidation level), efforts to
    reduce risk have little influence on the chance the
    fund will hit the critical liquidation level.
    Clifford De Souza; Mikhail Smirnov , Dynamic Leverage (Fall 2004) THE
    JOURNAL OF PORTFOLIO MANAGEMENT




                                                                            34
   Perhaps the greatest system threat facing the
    global economy is the risk that counterparties
    to credit risk transfer agreements will default

   Credit risk transfer agreements exceed $50
    trillion




                                                      35
   In April of 2008, the International Monetary
    Fund ("IMF") reported prospective losses at
    the $1 trillion mark.
    International Monetary Fund, Global Financial Stability Report: Containing
    Systemic Risks and Restoring Financial Soundness, (April 2008), available at
    http://www.imf.org/external/pubs/ft/gfsr/2008/01/ index.htm ("IMF").
    More recent predictions have reached the $2 trillion mark. See, e.g., RGE
    Monitor, Roubini Pegs Credit Related Losses at $ 2 trillion!, RGEMONITOR,
    Aug. 5, 2008, http://www.rgemonitor.com; Unterman, Aaron, INNOVATIVE
    DESTRUCTION--STRUCTURED FINANCE AND CREDIT MARKET REFORM IN THE
    BUBBLE ERA, 5 Hastings Bus. L.J. 53,57




                                                                                   36
   ―Simply stated, the bright new financial
    system - for all its talented participants, for
    all its rich rewards - has failed the test of the
    market place.― Paul Volcker, April 8, 2008
    Wolf, Martin, Seven Habits That Finance Regulators Must
    Acquire




                                                              37
   Throughout this reshaping of the
    international financial system, authorities
    remained on the sidelines, trusting market
    forces and sophisticated institutions to
    maintain growth and stability.

   When financial crisis struck, the same
    government that sat idly while firms profited
    from financial manipulation came to rescue of
    irresponsible corporations
     Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED FINANCE AND CREDIT
    MARKET REFORM IN THE BUBBLE ERA, 5 Hastings Bus. L.J. 53,81.



                                                                              38
   The OCC‘s primary supervisory objective is to
    assess each bank‘s ability to identify,
    measure, monitor, and control risks through
    its risk management systems.
    OCC Guide to National Banking System p. 18




                                                    39
   1. Determine whether the bank's derivative
    activities are conducted in a safe and sound
    manner.

   2. Determine the adequacy of board and senior
    management supervision of the bank's derivative
    activities.

   3. Determine compliance with laws, regulations,
    regulatory guidelines, and established policies
    and procedures.
   Risk Management of Financial Derivatives, Comptroller‘s Handbook
    January 1997


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   There is a tremendous moral hazard
    associated with bailing out institutions who
    have profited from excessive risk taking
    without meaningful legal reforms

   Without meaningful legal reforms, the current
    cycle of financial crisis will continue and
    become more devastating.
    Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED FINANCE AND CREDIT MARKET
    REFORM IN THE BUBBLE ERA, 5 Hastings Bus. L.J. 53,72.




                                                                                    41
   ―Coordinated central bank actions have
    continued to aim at reducing risks to
    systemically important financial institutions.
    However, funding and liquidity strains remain
    high, as reflected in persistently wide
    interbank spreads and liquidity premia and
    have recently risen even further.‖ (2008 IMF Global Financial
    Stability Report p. 5; GAO Report TROUBLED ASSET RELIEF PROGRAM Additional Actions Needed to
    Be tter Ensure Integrity, Accountability, and Transparency, Dec 2008 )




                                                                                                   42
   As of July 2008 there were at least 128
    subprime and structured finance-related
    class action lawsuits filed in US Courts

   Most of the major securities issuers are
    named as defendants
    Unterman, Aaron, INNOVATIVE DESTRUCTION--STRUCTURED FINANCE AND CREDIT
    MARKET REFORM IN THE BUBBLE ERA, 5 Hastings Bus. L.J. 53,79




                                                                             43
◦ Require bank board that engaged in reckless
  financial behavior regarding derivatives to sign a
  formal written agreement setting out in an article-
  by-article form necessary corrective action. The
  agreement is backed up by a cease and desist order
  (12 USC 1818)

◦   OCC- An Examiner's Guide to Problem Bank Identification, Rehabilitation, and Resolution
    pp. 28-29




                                                                                              44
   John Maynard Keynes argued that "when the
    capital development of a country becomes a
    byproduct of the activities of a casino, the job
    is likely to be ill done".
     Wolf, Martin, Seven Habits That Finance Regulators Must Acquire




                                                                       45
   Structured Finance Operating Companies
   Credit risk transfer (credit default swaps)
   Credit tranching
   Securitization
   Originate to distribute
   Dynamic leverage
   Subprime, Alt-A loans
   Off balance sheet




                                                  46
   Repeal the repeal of Glass-Stegal
   Arm and empower the SEC, and State Securities
    enforcement agencies
   Repeal the Private Securities Litigation Reform
    Act of 1995; reinstate protection of securities
    laws
   Repeal the CFTC exemption for credit default
    swaps and related financial products
   Fully empower investors with federal protection
    laws and permit states to add protections


                                                      47
   Repeal the CFTC exemption for credit default
    swaps and related financial products
   Fully empower investors with federal
    protection laws and permit states to add
    protections
   Extend due diligence laws for assignees of
    predatory or otherwise unlawful, fraudulent,
    or unfair loans or assets



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