I don’t know and don’t pretend to know what the long term effects of the UK leaving the European Union will be. We saw in the short term that it sent the financial markets into turmoil and send the British pound to the lowest levels in years. The U.K property market looks like it is now suffering the fallout from Britain’s vote to leave the European Union.
M&G Investments stopped trading in a £4.4 billion U.K. property fund. Aviva Investors suspended trading in a U.K. property fund. Standard Life Investments was the first to cancel trading in its U.K. Real Estate Fund.
The funds were receiving an increase in redemption requests. At some point the funds would need to start selling assets to meet the redemption requests. Investors these ‘open-ended’ funds can get redemptions even though the underlying buildings will several months or longer to sell.
The compliance aspect is the same as that for any fund that can put gates in place to halt redemptions. The key is that a gate is allowed by the fund documents. Then the fund manager needs to make sure that the gate is being lowered to protect the investors overall. I assume the fund managers are taking the position that forced sales for liquidity will depress asset prices and hurt the fund as a whole.
The first step in figuring out if a financial company is too big to fail, is to figure what it means to be “big”. Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act authorizes the Financial Stability Oversight Council to determine that a nonbank financial company will be subject to supervision by the Board of Governors of the Federal Reserve System and prudential standards. It’s up to the FSOC to determine whether material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company, could pose a threat to the financial stability of the United States.
The FSOC has come up with a three stage process. First, based on quantitative criteria, the FSOC narrows the universe of nonbank financial companies by de facto defining “big”.
The Too Big to Fail thresholds are—
$50 billion in total consolidated assets;
$30 billion in gross notional credit default swaps outstanding for which a nonbank financial company is the reference entity;
$3.5 billion of derivative liabilities;
$20 billion in total debt outstanding;
15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; and
10 percent short-term debt ratio of total debt outstanding with a maturity of less than 12 months to total consolidated assets (excluding separate accounts).
In the second stage of the process, the FSOC will conduct a comprehensive analysis, using the six-category analytic framework, of the potential for the nonbank financial companies identified in Stage 1 to pose a threat to U.S. financial stability. In general, this analysis will be based on a broad range of quantitative and qualitative information available to the FSOC through existing public and regulatory sources, including industry- and company-specific metrics beyond those analyzed in Stage 1, and any information voluntarily submitted by the company.
Based on the analysis conducted during Stage 2, the FSOC intends to identify the nonbank financial companies that the Council believes merit further review in the third stage. The FSOC will send a notice of consideration to each nonbank financial company that will be reviewed in Stage 3, and will give those nonbank financial companies an opportunity to submit materials within a time period specified by the FSOC .
The FSOC will determine whether to subject a nonbank financial company to supervision by the Fed and the prudential standards based on the results of the analyses conducted during the three-stage review process.
Looking at those thresholds from the perspective of the private equity industry, it’s the $20 billion in debt threshold that most concerns me.
I’m looking for guidance on whether it should be aggregated across funds and from the portfolio companies. It would seem that debt in a portfolio company should not be consolidated to the fund if it’s not recourse to the fund. Similarly, debt in separate funds should not be consolidated since the debt will not be recourse from one fund to another.
Of course the FSOC could take the opposite view and consolidate all of the debt under a fund manager together for purposes of clearing the Stage 1 hurdle and then work on the “too big to fail” analysis in Stage 2.
In jest, I wrote that we should occupy the SEC, but noted that they are very open to comments and influence by the public. One of the comments to that story was from a group organized as Occupy the SEC and they were planning to comment on the Volker Rule.
They submitted a massive comment letter attacking not only the proposed regulation. It is a 325 manifesto.
“We believe the Volcker Rule is important to the future of the banking industry and, if strongly enforced, will help move our financial system in a more fair, transparent, and sustainable direction. Prohibiting banking entities from engaging in proprietary trading and banning their sponsorship of covered funds are key elements to regulating the financial system and giving force to the Dodd-Frank Act. At its core, the Volcker Rule seeks to make sure that if a banking entity fails, it does not bring down the whole system with it. We appreciate the momentous challenges that the Agencies continue to face in effectively implementing the Rule, and we present these comments to assist them in their task.”
Like most commenters, and even Mr. Volker himself, Occupy the SEC labels the proposal a “500-page web of complexity”. But rather than complain and make some generic statements, Occupy SEC provides very detailed comments on the text of the rule, specific textual changes to the regulation, and answers to hundred of the questions presented in the proposed rule.
From the perspective of private equity funds, Occupy the SEC wants to make sure the rule is broad enough to cover a broad scope of entities by making some changes to the definition of “covered fund” and “ownership interest”.
The comment letter is an impressive piece of work.
Bryan Burrough, William D. Cohan and Bethany McLean have a piece in this month’s Vanity Fair on Jon Corzine, the man behind the spectacular crash of MF Global. It doesn’t provide much insight into what happened at MF Global or where the missing money went. But is does paint an interesting picture of the captain of the ship.
Unlike a nautical captain who drowns when his ship sinks, Corzine may escape. According the article, he had only a small percentage of his wealth in the firm. His wealth did not vaporize. The lawyers and class action suits against Corzine will likely take a big chunk of his remaining wealth. His career as a trader and money manager are likely over.
In piecing together earlier episodes in his career, one stuck out at me from a compliance and risk perspective. While a young trader at Goldman Sachs, Corzine was involved in a screwed up trade that was mishandled and exceeded the firm’s risk limits. In the end, the trade ended up making money, but that won no accolades. The trade violated compliance and risk policies and was non grata. We generally only hear about rogue traders when they lose money. At the time, at least according to the article, Goldman took a dim view on rogue traders who made money.
The other item that emerged is the Corzine was self-made. He is certainly part of the 1% now, but didn’t start out that way. One thing that has bothered me about the Occupy Wall Street movement is a somewhat misguided rage against the 1%. When looking at the income discrepancies over the last twenty years, I think people miss the fact that the people in the 1% are not all the same people that were int he 1% twenty years ago.
Unlike aristocracy, you do not need to be born into the 1% to become part of the 1%. (Sure, it usually helps to start off well-to-do.) It seems to me that combining lots of hard work, lots of education, and little bit of good luck can get you an entrance ticket to the 1%.
Sources:
Jon Corzine’s Riskiest Business by Bryan Burrough, William D. Cohan and Bethany McLean in Vanity Fair The full text of the article is not currently on-line.
The most dangerous parts of managing risk are the risks you don’t expect. Looking back at my old four-box analysis, there are really two types of unexpected risks, the risk that you know that you don’t know and the risk that you don’t know that you don’t know. In the first case you know there is an unexpected risk. In the second, you missed that there was an even a risk.
The second case has been labeled the Black Swan. Those type of risks are well written about by Taleb.
While staying up late and watching some Monty Python, I came to the conclusion that the first case is the “Spanish Inquisition.” You know the Spanish Inquisition is out there roaming the countryside. You just don’t now when or where they will appear.
You also don’t know the danger. Their two weapons are fear and surprise…and ruthless efficiency.
The hard work has begun as federal regulators are trying to implement the provisions of Dodd-Frank. The law pushed lots of the detail out to the agencies so there are lots of unanswered questions.
One of the hot button issues was what to do with financial institutions that were too big to fail. Dodd-Frank came up with the concept of “systemically important.” They created a new entity, the Financial Stability Oversight Council to come up with a definition, figure who should get that designation and design safeguards for those designees.
Private equity lost the battle to get an exemption from registration under the Investment Advisers Act. It may have to fight another battle to avoid the “systemically important” label.
The Independent Community Bankers of America, a major trade group for community banks, said General Electric Co.’s GE Capital and private-equity firms Carlyle Group, KKR & Co.’s Kohlberg Kravis Roberts & Co. and Blackstone Group LP should be tagged as systemically important.
Private equity doesn’t belong in that group, shot back Blackstone spokesman Peter Rose. “We do not trade, we have no leverage at the parent-company level, our investments are clearly disclosed and transparent, our investors are with us for the long term,” he said. “Therefore there is no possibility of a, quote, ‘run on the bank.’ ”
may determine that a U.S. nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards, in accordance with this title, if the Council determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.
The term “U.S. nonbank financial company” means
a company (other than a bank holding company, a Farm Credit System institution chartered and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), or a national securities exchange (or parent thereof), clearing agency (or parent thereof, unless the parent is a bank holding company), security-based swap execution facility, or security-based swap data repository registered with the Commission, or a board of trade designated as a contract market (or parent thereof), or a derivatives clearing organization (or parent thereof, unless the parent is a bank holding company), swap execution facility or a swap data depository registered with the Commodity Futures Trading Commission), that is–
(i) incorporated or organized under the laws of the United States or any State; and
(ii) predominantly engaged in financial activities, as defined in paragraph (6).
[102(a)[4)]
A company is “predominantly engaged in financial activities” if–
(A) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, from the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated annual gross revenues of the company; or
(B) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, related to the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated assets of the company.
[102(a)[6)]
Those are some very wide open definitions for who could be considered “systemically important.”
(A) The extent of the leverage of the company;
(B) The extent and nature of the off-balance-sheet exposures of the company;
(C) The extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) The importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
(E) The importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) The extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H)The degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
(I) The amount and nature of the financial assets of the company;
(J) The amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
(K)Any other risk-related factors that the Council deems appropriate.
[113(a)(2)]
Hearing
Then it takes 2/3 of the voting members of the Council, including the Chairperson, to make the designation [113(a)(1)]. Then the financial company designated as systemically important has 30 days to request a hearing and another 30 days to submit material. [113(e)(2)] The Council has 60 days to make a final determination.
Too Big to Fail
This provision of Dodd-Frank is the Anti-AIG and to some extent the Anti-Lehman Brothers portion of the law.It is one of the many ways the law tries to address Too Big to Fail.
Capital has many forms and is made available in many ways. The U.S. government thought AIG was too big to fail because of its size and interconnectedness. They didn’t think Lehman Brothers was too big to fail, but I think they were wrong about that.
Back to the Finger Pointing
Now that the Financial Stability Oversight Council is trying to define Too Big to Fail as systemically important, the finger pointing has begun. Industries and companies are saying “not me” and saying that others should be included.
The problem is that once you are designated “systemically important” it’s not clear what additional burdens will be placed on you and whether there will be any benefit to the designation. It seems the Council has the flexibility to craft different requirements for different companies and different industries.
It may boost your ego to be considered “systemically important” but it will also lead to a regulatory headache. Private investment firms are not exempt from the designation and could be tagged.
Eight securities class actions were filed in 2009, compared with the 10 filings in 2008.
There are now more than $14.7 billion in outstanding plaintiffs’ claims in Canadian securities class actions.
In 2009, six cases settled for total payments of approximately $51 million
These are not big numbers compared to the securities class action activity in the United States. (Which is a good thing from the corporate perspective.) But this is still a new area for Canadian law.
“The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.”
For me, when looking for blame, I tend to focus on the rating agencies. As the report points out, the raters were paid by the the issuers not the purchasers of the securities. That results in a misalignment of interests. Of course, they may have just gotten wrong.
Looking at the chart below you have to be impressed by how spectacularly wrong they were:
Hopefully, we will learn some lessons from the financial crisis. We should have learned by now that the next crisis will be caused by something different so we need to be able to recognize and deal with the unexpected.
The “drunkard’s walk” refers to the Brownian motion, the seemingly random movement of particles suspended in a fluid. The original thought was that you might be able to calculate the movement by measuring and calculating the interaction. It proved impossible. There are too many factors and too many interactions.
Small changes in a system can dramatically affect the outcome. This is the butterfly effect. The origin cam from a meteorologist who was using a computer model to rerun a weather prediction and one of the numbers he used was shortened from six decimal points to three decimal points. The result was a completely different weather scenario. It’s not that a butterfly can cause the problem. It’s that a seemingly inconsequential random event can lead to a big change in an outcome.
He explores his concepts using the backdrop of Pearl Harbor. In hindsight there were many signs pointing to the eventual attack. “In any complex string of events in which each event unfolds with some element of uncertainty, there is a fundamental asymmetry between past and future.” It’s nearly impossible to predict before the fact, but relatively easy to understand afterward. We have seen the same 20/20 hindsight with the 9/11 attacks.
That’s why it is easy to explain why the weather happened three days ago, but have trouble getting the weather forecast right three days into the future.
Mlodinow never mentions it, but for me the next step is the theory of the Black Swan. How do you end up with high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations?
Combining the Black Swan with the Drunkard’s Walk and the Butterfly Effect, you see that a combination of small events can lead to an over-sized outcome. We get used to being able to calculate and measure so many things. There will always be factors that we miss, or overweight or underweight.
Not to be depressing. The Drunkard’s Walk leaves you feeling in less control than when you started. But there is a factor you can control: the number of chances that you take. “Even a coin weighted toward failure will sometimes land on success.” Keep flipping the coin.
. (I mentioned the book previously in 