In an interview with the WSJ, Gary Gensler, Chairman of the Commodity Futures Trading Commission, said he believes the most critical change needed in the oversight of derivatives is the regulation of dealers involved in derivatives (see article). He goes on to say that "only through the dealer can we get the whole panoply" of information regarding derivative contracts. Such a move would require customized contracts traded over-the-counter (OTC) to go through a central repository, similar to an exchange clearing house.

Gensler believes that "central clearing will further lower risk," but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily. One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem. In the mean time, I guess at least the exchanges (NYX, NDAQ, CME) will be happy as the potential for increased order flow continues to rise.

Now that the Obama Administration has released its proposed Financial Regulatory Reform: A New Foundation for updating the regulatory structure of the financial system (pdf file of reform, WSJ article), the public debate will begin in earnest regarding the details and proposals in the document. Ironically, while the public seems open to new financial regulation, the release of the document is coming at a time when some citizens are starting to worry about growing deficits and government intervention (see WSJ/NBC poll article), with almost seven in 10 people surveyed saying that they had concerns about federal interventions into the economy. Nonetheless, finding ways to limit risk and prevent another credit crisis through added regulation of banks and hedge funds still rings a populist tone, and is likely to continue to receive support.

Like many others, I feel that there are aspects of the new regulations that seem appropriate and make sense, with others that seem counterproductive. As for those that concern me, I agree with some who point out that it seems odd that the Fed is going to be given greater power (and responsibility) to fix some of the very problems it may have caused or contributed to (see Larry Kudlow article). I also worry that the new proposed Consumer Financial Protection Agency could end up just adding new and potentially unnecessary regulations and red-tape paperwork, along with producing counterproductive limits on rates and fees that will do less to protect individual consumers and more to reduce the availability of needed products that are offered to such individuals. Such restrictions, if not properly crafted, are likely to reduce the earnings of financial services companies, and even worse, limit their ability to effectively manage risk (through fee and rate changes).

The idea of requiring companies to retain 5% of all structured product offerings also has me concerned, even though this specific proposal seems to be generating some of the most support, at least initially. Recently I wrote that I have worries about forcing companies to retain a stake in each securitized product they develop since I believe it could actually make companies more risky (since they cannot off-load and manage all their risk, see previous post). Furthermore, while I agree that forcing companies to have some "skin-in-the-game" would make it less likely that they would offer risky products, it also makes it more likely, in my opinion, that they would offer less structured products. While this may be a desired outcome for some, the impact of this would be less liquidity and available credit at a time when the country can least afford it.

Another area that is generating support involves the idea of controlling systemic risk. I too believe that this is a good idea in theory, but am unclear exactly how this would be measured and acted upon. As recently reported in the WSJ (see article), one potential area to start with is leverage. As the chart below illustrates, financial sector borrowing increased steadily between 2004-2007, before dropping in 2008 as companies began unwinding leveraged positions. It is now well known that banks, hedge funds, and average citizens were carrying too much debt, thereby helping to increase systemic risk, and trigger the credit crunch.

Source: WSJ, Fed data
Yale economist John Geanakoplos, who has studied leverage in the economy, believes that regulators need to gather daily data from all market participants and then publish aggregate data. The feeling is that if market participants knew that leverage values were getting to extreme levels, they would be more likely to begin backing-off their own debt and leverage levels in anticipation of eventual market corrections, or restrictions imposed by regulators. Focusing at least in part on debt and leverage seems to make sense.

Unfortunately, measuring system-wide daily leverage changes at banks and hedge funds may be difficult at best, and suspect at worst. Yet, maybe the focus does not need to be on the three person hedge funds that are investing $10-50 million in capital. Getting comprehensive data which includes smaller players may not be necessary. Risk manager Richard Bookstaber - whose book "A Demon of Our Own Design" is recommended reading - believes that focusing on just the largest financial firms and hedge funds would cover roughly 80% of the risk, allowing you to see systemic trends.

At this point it is unclear if such trending information on leverage levels would be enough. Other related areas that could also cause potential cascading effects, such as specific derivative use (i.e., CDS) and counter-party risk, should also be examine - although regulating that which has not yet been developed is obviously difficult. Nonetheless, looking for new ways to measure leverage might be a good place to start for spotting worrisome trends. Such a signal could allow investors, funds, and the Fed (or other regulator) to take action. Of course, what action they take is another area of debate, and potential new area of concern.

Hedge funds had a nice May, up 5.2 percent on average. While the recent market rally no doubt helped, hedge funds also appear to be benefiting from less competition (see Economist article), with approximately 1,500 funds liquidating last year. This follows a similar trend observed in the late 1990s when less competition for trading opportunities helped those funds that survived after the LTCM failure.

But as reported in the article, not everything is rosy. After poor performance in 2008, many investors are requiring a more fair fee structure, one that is either closer to 1-10 (instead of 2-20), or that phases in fees over a longer period, after the fund has outperformed a benchmark - with the benchmark closer to the general market, and not simply zero, or a non-negative return. Investors also seem to be asking for more managed accounts where they can see where their money is being invested, and can also withdraw it quicker (and without gate restrictions). If that was not challenging enough, one cannot forget the added government regulation is coming down the pike. Possibly the biggest loser will be the funds-of-funds, which tack on an extra level of fees for the expertise of picking the best funds. Their failure to outperform enough to compensate for the extra fees, along with the benefits of cheaper hedge fund replication clones (see previous posts here, here, here, and here), are also making their services less cost effective.

Private equity investors are starting to ban together to renegotiate terms of previous commitments (see Financial Times article). In particular, endowments and foundations, which have recently increase exposure to alternative investments, are looking for ways to scale back commitments after losing money and finding it difficult to meet their operating budget without dipping too deep into existing endowment funds.

The Lehman bankruptcy has apparently went better in the US (see Financial Times article). The UK FSA is even traveling to New York to see why the US insolvency regime has worked better than in Britain in the wake of the collapse of Lehman Brothers. Problem have caused many hedge funds to move assets to the US to avoid similar problems, causing London to worry about it status as a major financial center.

Interesting article about John Paulson and some other hedge fund winners this year (see Bloomberg article). The article is long, but worth the read. There is some variety in the strategies and approaches, but funds betting against subprime and housing did the best, not surprisingly. Even a quant fund did well.

It looks like the commodity crash is taking its toll on salaries and bonuses. The top paid metal and energy traders may "only" earn $1-1.5 million in salary and bonus this year, down from $5-8 million in 2007 (see Bloomberg article). Difficult times indeed. I guess there will be no more $1,000 ice cream sundaes and pizza for a while (see blog post).

According to Treasury Secretary Paulson, there is a need for a new regulatory system that will look "at the entire financial system." See Financial Week article. "Entire" in this case applies to countries, in addition to asset classes. So the plan is to have each country overseeing the regulation of another country's financial system - this should produce some interest debate.

Man Group says that banks, and not hedge funds, are more levered, and as a result are the main cause of asset price declines (see Reuters article). Man also puts hedge fund leverage at about one-third its levels in 2007. Expect future returns to also show similar trends.

There is an interesting article today in the WSJ regarding the recent short selling ban, along with its unintended consequences. While the effects on hedging, volatility, and widening bid-ask spreads have been discussed at length, what often gets lost in the discussion is the effect on market efficiency (see previous post). As quoted in the recent article:

"Why would regulators ban short selling in nearly 1,000 companies, effectively banning accurate information from the markets? By targeting short sellers as a way to prop up share prices, regulators clearly panicked. This in turn panicked financial professionals and individual investors who saw regulators losing faith in the system they oversee."

In a sense, by trying to stabilize stocks, current actions have made them more volatile. Even worse than affecting individual stocks, such bans have destabilized the confidence and structure of the market itself, and made information flow less transparent. Individual stocks can recover, or can be sacrificed, but confidence must be built. Market structure must be consistent and trusted. Hopefully we have learned our lesson over the last few weeks as we continue to watch greater than 5% daily swings, not to mention material market moves (often down) every time someone from Washington shows up at a press conference.

Market uncertainty is causing some hedge fund managers to stay on the sidelines (see WSJ article). Steven Cohen, John Paulson, and Israel Englander have move much of their funds into cash. In addition to general market uncertainty, many hedge funds are also worried about stricter regulatory requirements and short selling limits, the rules of which appear to be changing nearly every day. While it is not unusual for managers to not trade when they feel they do not currently understand the market, it is also not unusual for them to begin trading quickly once conditions improve and market dynamics are more clear. Unfortunately, even once the markets start to enter steadier waters, navigating the regulatory environment will no doubt continue to be a challenge going forward as the debate continues in earnest on how to prevent similar problems in the future. Funds may find that hedging such risk is just as important as guarding oneself against market risk.

The Financial Services Authority (FSA) in the UK is planning to conduct a "significant reappraisal" on how banks use securitization to free-up capital (see Financial Times article) given that mortgage bonds and other asset-backed securities are becoming more complicated than originally believed. This is important for US investors given that the FSA is the leading voice on the Basel Committee. Adjustment beyond current Basel II regulations and guidelines are already being discussed with regard to raising bank capital requirements. The problem is that as new products are developed, it is difficult to know exactly what risk are being created for all counterparties. Since the risk is often managed at the point of origination, or sold off, there has at times been less interest in formally quantifying the risk, leaving counterparties on the other side with a product that is less understood than others in terms of market and credit risk exposure.

One person close to the issue was quoted as saying that securitization of ordinary loans turned out to be "considerably more complicated than originally thought." Yes, but in many cases it was not that they were more risky than previously calculated, but that the risk was never really calculated or considered in the first place. As risk was sold off and transferred, there was often an assumption that someone else was bearing the risk. In the end, the risk was not only larger than some predicted, but it was not transferred to others as expected. Contagion in the system was not hedged away as expected.

While new regulation is a given, hopefully some type of clearing house for credit derivatives and related products will also be considered to help price these assets, which will in turn will allow the markets to observe the level of risk that is currently being reflected in market prices. Regulation that encourages such transparency would be a good and necessary first step. On the other hand, if new regulation is just another way to require extra regulatory capital without really developing a mechanism for understanding the risk of the assets in question, we will once again be back where we started - not fully understanding the risk will result in companies continuing to be under-capitalized and at risk, or forced to set aside too much capital for the current levels of risk exposure. Such an outcome will simply prevent the efficient flow of capital that is necessary to spur economic growth without really addressing the problem of knowing the true levels of risk and exposure.

New York is planning to bring parts of the credit derivative market under the control and regulation of insurance supervisors (see Financial Times article). One has to wonder whether this is in fact the proper regulator for credit derivatives, and whether adding another separate oversight agency is the best move. Such a move is being made at a time when plans for a central counterparty clearing house for the credit derivatives market are still being discussed (see Financial Times article). No doubt that such a clearing house would have its own regulator. The problem is that regulatory inconsistencies, which at times even produce regulatory arbitrage, may be contributing to the current problems as much as the lack of regulation. Hopefully a smart, comprehensive, non-complicated, and consistent agency and set of regulations will result. As recently stated by Robert Pickel, from the International Swaps and Derivatives Association: “The state ... should proceed very cautiously and in consultation with federal regulators before acting in a way that may ultimately cause more harm than good.” We can only hope. Unfortunately, time is not on our side for some of the current market problems.

The current problems with Lehman Brothers, AIG, and Merrill Lynch are uncovering a number of issues that will no doubt change the way we look at the health, valuation, of operations of businesses going forward. Of interest is how the current environment has resulted in Lehman Brothers being a company with liquidity that is not solvent, compared to AIG that may be solvent (for now), but has a liquidity issue. Just last week the WSJ Deal Journal blog highlighted some of the various anomalies between Lehman's valuation and its apparent asset values as its stock price plummeted. As of Friday, the closing price of Lehman put the market capitalization of the company at around $3 billion. Yet, many analysts highlighted that the current price reflected little on the true value of the company. Analysts expected the company to receive about $3 billion for a 55% stake in Neuberger Berman - as much, if not more than the value of all of Lehman. The bonus pool for Lehman's 24,000 employees itself was estimated to be around $3 billion. On the other hand, the company has $25-30 billion in toxic real estate assets to deal with, and there-in lies the issue for Lehman. How much is the exposure, how much are they worth, and what are the potential losses? Even with the ability to spin off the real estate into another company, and further inject it with $5-7 billion in liquidity, solvency was still not guaranteed. As Ken Lewis, the CEO of Bank of America stated today, the difference between the balance sheets of Merrill and Lehman was "night and day". Time will tell on BAC's move on Merrill. In the mean time AIG is scrambling to find capital to sure up its balance sheet and keep from getting a ratings downgrade, and subsequent higher cost of capital - as if selling off assets was not a high enough cost. The Fed window may stay closed to AIG, but funds might travel out the back door before all is said and done (New York is already granting permission to access $20 billion in capital from subsidiaries, see WSJ article).

So, are the issues with Lehman, AIG, and even Merrill a result of bad risk management, lack of good regulation, poor accounting rules, circumstance, or some combination of each. The easy answer is some combination of each, but the situation is of course more complicated than that. Good risk management should help us to avoid failure, if not excessive loss when circumstances go against us, but there are no guarantees. Regulation can force us to set aside risk capital, even when we don't want to, but again, it could be argued that a good risk management system that is actually both honest and honestly followed could serve a similar purpose (whether it does and would be followed, and whether that is why regulations exist in the first place is another issue and debate). That leaves of course accounting, and I suspect this area in particular will receive a lot of attention in the coming months, especially with regard to mark-to-market. The questions of whether each of these companies would have the same liquidity issues if accounting rules were different will certainly get some play, causing it to be a busy fall, possibly followed by an busy winter, spring, and summer. For all the regulators and agencies tasked with these problems, they may come to question the validity of the old proverb: "may you live in interesting times." Right now, something a little more boring would be nice.

Update: On another site a reader responded that leverage was the problem, and any new regulations will probably overstep. I could not agree more. Just looking at things a little down stream. In fact, the mark-to-market issues may be nothing more than an identification / realization of the leverage problem. Nonetheless, I suspect the regulators will be busy trying to prevent a similar problem. Hopefully, any changes will be measured and focused with few unintended consequences.

As reported in a Reuters article and elsewhere, the SEC is expected to propose a new short selling rule in the next few weeks that will be broader than the original temporary order that protected 19 financial stocks (17 major Wall Street firms, along with Freddie Mac and Fannie Mae). SEC Chairman Cox is quoted as saying the proposed rule "will focus on market-wide solutions," implying not only larger breadth, but possible other restrictions or changes affecting the markets that reach beyond just widening the number of stocks and sectors affected. One possible change is to require investors to publicly disclose large short positions, similar to the current requirements for disclosing large long positions. Whether a more encompassing rule will prop-up the markets longer-term and give some non-financial stocks a boost is difficult to predict. Even with crude oil continuing to sell-off, the Financial Select Sector SPDR (XLF) has given back some of its gains and is near short-term, yet technically-weak support. With the S&P 500 having trouble getting above 1,300, and the DJIA having difficulty around the 11,750 level, another SEC-induced short covering rally that is now more inclusive may be just what the market needs short-term to break resistance, even if not the original goal of the SEC. While potentially beneficial short-term, one can only hope that any new regulation will not have any harmful or unintended consequences for the market long-term. Then again, sometimes hope is all you have to work with.