Taming the Derivatives Tiger

The Obama administration asked Congress yesterday to move quickly on legislation that would allow federal oversight of derivatives like credit default swaps. Geithner said the measure should require swaps to be exchange traded and backed by capital reserves. The adminsitration is also seeking repeal of of major portions of the Commodity Futures Modernization Act of 2000 which kept derivatives mostly unregulated (endorsed, incidentally, by then Treasury Secretary Larry Summers). The new measure would give regulatory oversight to the CTFC and the SEC. ISDA issued its own comments in the wake of the news.

Geithner also stated that the administration would be laying out a comprehensive proposal to overhaul the regulation of the financial system. A centerpiece to the plan will be eliminating the ability of companies to pick the most favorable regulator.

So, will moving derivatives to an exchange help prevent future meltdowns? TMX Group CEO Thomas Kloet believes it can.

The links:

• Paul Kanjorski, the chairman of an influential House subcommittee said the federal government, not the states, should have the primary responsibility for overseeing the insurance industry. he said Congress must address insurance activities as part of the broader overhaul of financial regulations.
  
  
• The SEC moved to impose new rules on money managers to safeguard client holdings in the wake of Madoff's $65B Ponzi scheme. SEC commissioners voted 5-0 today on a proposal to subject about 9,600 investment advisors to annual surprise inspections by independent auditors to make sure they have adequate procedures to protect client assets.
  
  
• The Federal Reserve may revise rules that currently favor the established credit rating agencies. The Fed currently only accepts collateral ranked by the major NRSROs (Moody's, S&P, Fitch) and is conducting its review as the number of NRSROs is increasing.
  

• R.I.P Bill Seidman. The former head of the FDIC and RTC died yesterday in Albuquerque, NM at the age of 88.

The Compensation Tug o' War

"This is not going to be about capping compensation or micromanagement. It will be about understanding what is the best way to align compensation with sound risk management and long term value creation."

--Obama Administration official, 5/12/09

There it was this morning on the front page of the Wall Street Journal. Above the fold. "U.S. Eyes Bank Pay Overhaul". Just when it seemed that focus on compensation limits had begun to abate, news comes that the Obama administration has begun serious talks about how it can change compensation practices across the financial services industry. Yes, you read that correctly. Not just at TARP recipients, but also at institutions that received no federal bailout money. This is new ground for regulators, although they do currently have the (rarely exercised) power to sanction a bank for excessive comp structures. President Obama and Geithner have been critical of the quarter-by-quarter mentality that pervades the financial services business, and Bernanke said the Fed was working on rules that would more closely align compensation with longer term goals. Recently, FDIC Chairman Bair said regulators needed to examine comp pratices in the mortgage industry. One former regulator thinks it is a bad idea to regulate banker pay. Former SEC chairman Arthur Levitt thinks it is a slippery slope to try and regulate banker pay, saying "it has never worked and it cannot work." So what is the right answer? How do you achieve the goal of aligning compensation with risk management and long term value creation?

Links to recent news:

• Hedge funds get behind registration plan. MFA President Richard Baker told a congressional hearing that the organization supports a regime that would subject the vast majority of investment advisers, including the largest and those considered most systemically relevant, to the SEC's registration requirements.

• The SEC's Elisse Walter said that Financial Advisors should be regulated under a unified umbrella, which would help harmonize regulation. Should RIA's have their own SRO?

• Stephen Morse, managing director and head of compliance, operational risk and information risk at Barclays Capital has been named Compliance Reporter's Compliance Leader of the Year.

• Banks are bracing for a credit card write-off storm.

• What is the future of US financial regulation? Rob Cox at BreakingViews has some thoughts on that question.

The Future of "Too Big to Fail"

FDIC Chairwoman Sheila Bair addressed "Too Big to Fail" in front of the Senate Committee on Banking Housing and Urban Affairs. Bair urged lawmakers to consider a government regulatory framework to monitor global, systemic financial institutions thought to be “too big to fail.” Read the testimony here.

Stress Test results are out, and BofA's apparent need for $34B in capital has been this week's worst-kept secret. banks will need to raise at least $65B in new capital The WSJ has a helpful interactive graph comparing the 19 banks that were stress-tested. Also, WSJ's David Wessel explains what the stress tests will tell us about bank health.

Matthew Richardson and Nouriel Roubini write about a missed opportunity in the FT. The pair feel that insolvent banks should feel the wrath of the markets, asking "why keep insolvent banks afloat?" and invoke the concept of "creative destruction" first argued by Joseph Schumpeter. fellow Doom-and-Gloomer Nassim Nicholas Taleb calls the current global crisis "vastly worse" than the 1930s becaause the global financial system is so interdependent now.

The GAO criticized former SEC chairman Chris Cox and his regime for creating an atmosphere in which enforcement attorneys felt thay had been weakened in their ability to take action. New SEC chair Schapiro dicontinued Cox' "Pilot Program" which had instituted a pre-approval process for investigations.

Author Richard Posner writes that we should move the spotlight off the bankers for a bit and focus on goverment officials who failed in their role of assuring economic stability.

Regulators looking North for inspiration? Marie-Josee Kravis sets the record straight on why it wasn't regulation, per se, that has spared Canada's banks from the worst of the crisis. She credits prudent management, rather than regulation, which prevented the excesses that were commonplace in the U.S. banking environment.

Don't forget to visit GlobalComplianceJobs, the place for high profile regulatory and compliance career opportunities.

Senate Passes Ant-Fraud Measure

In a 92-4 vote, the U.S. Senate passed legislation giving the government more power to prosecute mortgage and financial fraud. The legislation would also create a commission to investigate the causes of the economic crisis. Some highlights:

• makes it easier to prosecute fraud in commodities futures trading - including options and debt derivatives.
• Authorizes $265 million over the next 2 years to hire more than 600 lawyers and investigators at justice department, SEC and other federal agencies.
• Extends anti-fraud law to cover private mortgage brokers and TARP recipients
• Examines the role of credit rating agencies.
  
• Creates a Senate committee to conduct its own investigation of the financial crisis.
  

Burning the Village in order to save it?

The WSJ has a strong Op-Ed piece this morning that takes a look at Federal tactics used to force BofA to complete the Merrill acquisition last December. They look at the BofA case and see Paulson and Bernanke forcing Ken Lewis to "blow up" Bank of America (maybe this is how Lewis earned his "mulligan" while Rick Wagoner caught one between the eyes...). Spreading systemic risk in the name of containing it....ordering the deception of shareholders, killing financial confidence in the name of restoring it...The Journal appears sympathetic to BofA and goes on to say that the Merrill-related bullying fundamentally increased systemic risk by "transplanting" risk from a Wall Street brokerage to one of the country's largest deposit-taking institutions. In addition, the WSJ states that Bernanke and Paulson undermined the transparency so vital to investor confidence in the capital markets. The collateral damage here seems to be the lukewarm response from most of the investor community and Wall Street to the latest federal initiatives like TALF and PPIP...For Caroline Baum's take on the same, check this out.

Here's word that Goldman Sachs is increasing risk taking at the fastest pace on the street. This should not be that surprising, although given Morgan Stanley's apparent pullback in risk taking, it is important. According to Bloomberg News, Goldman's VaR jumped 22% to $240 million in the 1st quarter - 2x that of Morgan Stanley. Consequently, GS reported 1st Quarter revenue of $9.4B to MS reporting $3.04B.

While the NYT reports Wall Street is unfazed by stress test details, many investors are simply waiting for the results to be released on May 4. Get the Fed white paper disclosing the stress test methodology at GlobalRiskJobs.

Regulators shift gears to focus on loan quality

As bank stress tests for "The 19" evolve, regulators are increasingly focused on loan quality, given the big disparity they are finding in underwriting standards at the banks. Subsequent to their initial due diligence, the feds have determined that lending practices have to be given at least as much weight as macro-economic scenarios in determining individual bank health. This is an important development because it makes it easier to separate vulnerabilities caused by bad management from those caused by factors beyond management's control. This criteria gives Geithner more leverage to make management changes at any banks coming back for more TARP cash.

G-20 moves forward on regulatory framework

The new era of finance is now dawning in earnest. Word from the G-20 meetings in London is that world leaders have agreed on a regulatory framework for countering excesses that led to the current global financial crisis. In particular, the group called for stricter limits on hedge funds, executive pay, credit-rating agencies and bank risk-taking. In addition, they pledged more than $1T in emergency aid to assist with collateral damage from the crisis. While countries will mainly be left to regulate their own markets and companies, the G-20 recognized a need for some global oversight by establishing a new Financial Stability Board to promote regulator cooperation and work with the IMF. Hedge funds defined as "systemically important" will be subjected to greater regulation and oversight. Pay and bonuses will be examined to create "sustainable compensation schemes". Accountants will need to improve valuation methods and creit rating agencies will need to meet a new code of standards.

Meanwhile, focusing back on the US, KC Fed President Thomas Hoenig endorsed the notion of the Federal Reserve becoming the regulator for systemic risk in US finance. In Geithner's recent proposal, such a systemic-risk regulator would have the authority to compel companies to boost their capital and curtail borrowing, as well as to seize companies get into trouble.

The Financial Stability Forum agreed to move towards creating stricter capital requirements for banks around the world, reversing their prior view of giving financial institutions more flexibilty in how they calculate reserves.

Ron Resnick, co-founder of financial consulting firm CounselWorks has an interesting piece on his views about government assumptions in the regulation of financial firms. He questions Treasury's new supervisory and regulatory foundation based upon the concept of "systemically important firms".