The Lethal Mixture of Uncontrolled Leverage, New Derivatives, and Benign Regulators
One of my industry colleagues analyzed the current credit crisis in an intriguing manner:
Remember the dividend roll transactions? If you do, then you should recall that most of the borrows that were "affirmed" on Trade Date were amazingly "dropped" by settlement date. These guys were very creative, I think that the people who were affirming the borrows with the contra-parties were effectively using those same borrows for multiple shorts. One issue that I had with the Securities and Exchange Commission staff, was my belief that in addition, to the maintenance margin requirements being circumvented, "open short interest" was being understated. The big B/Ds were facilitating hedge funds' short selling by moving the short sales offshore to London. The open "short sale" transaction would then be carried on London's books as a loan rather than a short sale.
It's interesting. The ability for the big boys to leverage themselves to the hilt and brokers to extend credit to them is very profitable for both. As with dividend rolls: If there is a will, a large enough profit, and a good Reg T lawyer, then there will always be a way to get it done. All the impediments to this circumvention (the uptick rule; avoiding SRO maintenance margin rules; and many of the arranging provisions of Reg T) were changed, eliminated or with the help of some very savvy lawyers, legally navigated around.
My point is that in the name of profitability, market liquidity and global competitiveness, the Street, Customers and Regulators spent the last 20 years trying to facilitate these transactions by eliminating the controls. It's no different than what was done with the net capital rules by defaulting marketability to the rating agencies, internal risk models and issuance size."
I believe that the writer of the above commentary sees through the confusion of the present crisis. There is much truth in what he writes, and the problem was initially created when swaps were declared to be non-securities in the mid 80's. See, Professor Frank Partnoy's (a former derivatives trader at Morgan Stanley and First Boston) explanation of the roots of our current financial crisis in http://www.npr.org/templates/story/story.php?storyId=102325715
Starting in the mid-80s, the banks were perceived to have a huge leverage advantage and the securities industry began to use more leverage primarily through the holding companies and overseas affiliates (and honed to a fine point with some creative lawyering). From the BDs' standpoint, it was a competitive survival issue and 20 years later the banks have won the war. Except winning is a somewhat relative term these days. After all, the five major Broker-Dealers are now bank holding companies, and regulated by the Fed. The way I see it, the BDs lost. This leverage facilitation occurred under both administrations and many different SEC Chairmen.
During this time period, the greatest and most profitable service a lawyer could provide was opining on how to remove a product from the jurisdiction of broker-dealer regulation and its attendant Net Capital requirements and limitations. The removal of credit default swaps for unlimited leverage was the ultimate goal. Read George Soros' explanation of this effort: http://www.foxbusiness.com/story/markets/soros-credit-default-swaps-spurred-aigs-failure/
Finally, the benign neglect of naked short sales was another good example of how Wall Street obtained increasing leverage. In 2003 the SEC hired Dr. Leslie Boni from the University of New Mexico to investigate the issue of Fails to Deliver (FTD). Her research revealed that massive numbers of FTDs were not merely the result of harmless mistake but of an "intentional/strategic" nature meant to intentionally depress share prices. Regrettably, the regulatory community did not react to Dr. Boni's alarm or findings, and the naked short selling issue remained written off as the crusade of crackpots and malcontents.
My point here is that the leveraging of Wall Street was intentionally allowed so that the BDs could compete with the banks--but the banks won...or so it seemed. In the middle of this battle, AIG created its own status as neither bank nor broker. In my short stint at the SEC, a well respected senior staffer once said to me, "You know, Peter, AIG is probably doing more derivatives then the rest of the street combined." Who knew the terrible truth of that observation?
So the story ends. To my veteran eye, there are few, if any, winners. The one certainty I know is that the unbridled pursuit and the benign regulation of leverage proved lethal.
About the Author:
has 30 years of experience in both the public and private sectors of the securities industry. He has worked for the National Association of Securities Dealers (NASD) and U.S. Securities and Exchange Commission (SEC), as well as a private law firm and a major international investment bank. He is familiar with all aspects of broker-dealer and hedge fund regulation, including broker dealer operations and stock loans.
Chepucavage was also heavily involved in the post-9/11 efforts by the securities industry to strengthen their resilience to terrorist attacks. He is a General Counsel to the firm and the head of its broker-dealer/hedge fund compliance and expert testimony sections.
Chepucavage most recently worked as an Attorney Fellow in the SEC's Division of Market Regulation where his main projects were post-9/11 resiliency and short sales, including the drafting of Reg. SHO. Prior to his position at the SEC, he practiced at Fulbright & Jaworski in New York city. At various times between 1984-1997, he was a managing director in charge of Nomura Securities' legal, compliance and audit functions and served on its management and credit committees. He also worked with its derivatives' affiliate.
Mr. Chepucavage has been a member of many Securities Industry Association (SIA) and other regulatory and legal securities industry committees and written extensively about regulation. One of his main interests is the effect of regulation on small businesses and he provides regulatory advice to small and medium enterprises, including Washington representation. Mr. Chepucavage also served as an Assistant General counsel with the NASD, a law clerk to Judge George R. Gallagher (D.C. Court of Appeals), and as an infantry officer in South Korea.
Peter Chepucavage is also a member of the advisory board of The Public Company Management Corporation (OTCBB:PUBC), an emerging company providing consulting and advising services to companies seeking to access public capital markets.
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