U.S. financial regulators found themselves on the receiving end of an outpouring of concern from law makers last Wednesday about the risks to the banking sector and debt markets from the treatment of collateralized loan obligations (“CLOs”) in the Volcker Rule final regulations. Regulators and others have come to realize that treating CLOs as if they were hedge funds is a problem and we now understand from Governor Tarullo’s testimony that the treatment of CLOs is at the top of the list for the new interagency Volcker task force. But what, if any, solutions regulators will offer—and whether they will be enough to allow the banking sector to continue to hold CLOs and reduce the risks facing debt markets—remains to be seen.
Posts Tagged ‘CDOs’
Earlier this evening [January 14, 2014], the Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency (the “OCC”), Federal Deposit Insurance Corporation (such three agencies together, the “Banking Agencies”), Securities and Exchange Commission, and Commodity Futures Trading Commission (the “CFTC” and, collectively, the “Agencies”) issued an interim final rule (the “Interim Final Rule”) regarding the treatment of certain collateralized debt obligations backed by trust preferred securities (“TruPS-backed CDOs”) under the final rule (the “Final Rule”) implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), commonly known as the “Volcker Rule.” The Volcker Rule imposes broad restrictions on proprietary trading and investing in and sponsoring private equity and hedge funds (“covered funds”) by banking organizations and their affiliates.
In Limits of Disclosure recently posted to the SSRN we examine the shortcomings of disclosure. Claire Hill and I do so by exploring two areas where disclosure arguably failed, albeit for very different reasons: synthetic collateralized debt obligations (CDOs), such as Abacus and Timberwolf, sold in the years immediately leading up to the financial crisis, and executive compensation.
One big focus of attention, criticism, and proposals for reform in the aftermath of the 2008 financial crisis has been securities disclosure. Many commentators have emphasized the complexity of the securities being sold; some have noted that disclosures were sometimes false or incomplete. What follows, to some commentators, is that whatever other lessons we may learn from the crisis, we need to improve disclosure. How should it be improved? Commentators often lament the frailties of human understanding, notably including those of everyday (retail) investors: people do not understand or even read disclosure. This leads, naturally and unsurprisingly, to prescriptions for yet more disclosure, simpler disclosure, and financial literacy education.
In the paper, Credit Risk Transfer Governance: The Good, the Bad, and the Savvy, which was recently made publicly available on SSRN, I examine credit risk transfer (CRT) transactions and focus on credit default swaps (CDSs), collateralized debt obligations (CDOs), and other securitization transactions.
Governance research often focuses on the role of equityholders and directors at the institutional level. My paper, however, draws upon creditor governance scholarship and extends its insights to CRT at the transactional level. By examining CRT instruments such as CDSs and CDOs within the framework of creditor governance, it becomes possible to distinguish between good and bad CRT governance.
CRT governance consists of the transaction structures and practices that protect investors (and counterparties) against losses from the underlying credit risk being transferred. Good governance requires governance mechanisms to reduce the informational asymmetries and incentive misalignments of particular CRT transactions—the agency costs of CRT. Good CRT governance can protect investors (and counterparties) from losses even if the underlying assets whose credit risk is transferred experience significant losses. Bad CRT governance, by contrast, creates transaction structures that leave parties with highly sensitive exposures to losses in underlying credit assets. Savvy CRT transactions are those that produce gains for one side at the expense of the other because one side better understood how the governance of a particular CRT transaction should be priced, and positioned itself accordingly. Certain savvy hedge funds used synthetic CDOs to profit from the ultimate bursting of the housing bubble.
In our essay Computerization and the Abacus: Reputation, Trust, and Fiduciary Duties in Investment Banking, recently posted to the SSRN, we analyze the 2007 synthetic collateralized debt obligation transaction, ABACUS 2007-AC1 SPV (ABACUS) and the subsequent SEC civil complaint against Goldman Sachs in connection with the ABACUS transaction. We use this analysis as a touchstone to examine the debate over whether to impose fiduciary duties or other heightened regulation upon investment bank/counter-party transactions, the subject of a recently released SEC study (available here).
What began in late 2006 as a disruption in the market for subprime mortgage-backed securities, collateralized mortgage obligations (“CMOs”), and collateralized debt obligations (“CDOs”) has metastasized into a global financial crisis that has plunged much of the world into recession and brought down some of the world’s largest financial institutions. These adverse developments have generated a wave of private securities litigation, as well as regulatory inquiries by federal and state authorities.
In September 2008, the government takeover of mortgage giants Fannie Mae and Freddie Mac was followed by the collapse of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and an $85 billion (and now $170 billion) government investment in American International Group. With the stock market in freefall, the Treasury Department proposed a $700 billion “Troubled Asset Relief Program” (“TARP”) to buy toxic assets from the nation’s banks in order to shore up their balance sheets and restore confidence to the financial system. The proposal was initially rejected by the House of Representatives, but passed in early October in a modified form that initially released $350 billion, with Congress retaining the discretion to release or withhold the remainder. As of February 6, 2009, nearly 400 financial institutions had received assistance under this program.
Concluding that prior government responses to the financial crisis were “late and inadequate,” the Obama administration in February 2009 announced a comprehensive “Financial Stability Plan.” The plan provides for the establishment of a Financial Stability Trust, a Public-Private Investment Fund designed to “cleanse” financial institutions’ balance sheets of legacy assets, and initiatives to support loan securitization and community lending while preventing foreclosures. The Financial Stability Plan also promises to impose accountability and transparency on financial institutions that receive government aid by subjecting them to a “stress test” before they may participate in the Financial Stability Trust and requiring them to limit executive compensation and dividends, mitigate foreclosures and expand public reporting. The initial reaction of the markets to the Financial Stability Plan was underwhelming. On the day the plan was announced, the Dow Jones Industrial Average dropped 4.6%.
On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act (the “Stimulus Act”), which provides $787 billion in government spending and tax cuts and also codifies (and in some cases expands) the Treasury Department’s restrictions on executive compensation. Under the Stimulus Act, recipients of TARP funds must eliminate incentives that encourage executives to “take unnecessary and excessive risks” or manipulate reported earnings; recover any bonus or other compensation awarded based on financial statements later found to have been materially inaccurate; eliminate “golden parachute” payments to top executives; limit most bonuses to top executives to one-third of an executive’s total annual compensation; and permit nonbinding shareholder votes on executive compensation. Originally, all recipients of TARP funds were to be subject to the Stimulus Act’s executive compensation restrictions. Following the signing of the Stimulus Act, the Treasury Department announced that the requirements would not apply to recipients of TARP funds through the Term Asset-Backed Securities Loan Facility (“TALF”), which is designed to increase lending to consumers and small businesses on more favorable terms by encouraging investment in highly-rated asset-backed securities. The decision to exempt TALF participants from the Stimulus Act’s executive compensation restrictions appears to have been made out of concern that the requirements could chill participation in TALF. Following the signing of the Stimulus Act, the Obama administration announced it also would spend $75 billion to encourage home mortgage lenders to modify loans for borrowers in foreclosure or at risk of foreclosure, and up to $200 billion to allow homeowners to refinance through Fannie Mae or Freddie Mac.
In the meantime, activist shareholders are on the warpath. In December 2008, after the Securities and Exchange Commission (“SEC”) concurred in the exclusion of shareholder proposals seeking greater disclosure of risks related to mortgage investments at Washington Mutual, a coalition of over 60 investors called on then President-Elect Obama to limit the ability of companies to exclude shareholder proposals related to corporate risk evaluation. The corporate governance challenges for the companies being targeted by these activist shareholders no doubt will be intense for the foreseeable future.