For the last four years, regulators and law makers have been focusing extraordinary efforts on ensuring that financial regulation is adequate to protect the financial system from risks emanating from the banking sector. However, it is only more recently that policy makers have turned their attention towards possible systemic risk related to entities which carry out similar functions to the banking sector or to which the banking sector is otherwise exposed. Such entities have, for convenience, been grouped under the heading of “shadow banks”, although no precise definition or description of shadow banking has yet been agreed upon by policy makers.

At their November 2010 Seoul Summit, the leaders of the G20 nations requested that the Financial Stability Board (FSB) develop recommendations to strengthen the oversight and regulation of the shadow banking system in collaboration with other international standard setting bodies, and in response to such request, the FSB formed a task force with the following objectives:

…continue reading: Out of the Shadows and Into the Light

Formulation of optimal regulation of asset-backed securities (ABS) markets has been hindered by the inability to identify specific market failures as well as the absence of well-defined social welfare objectives. In our paper, Skin in the Game and Moral Hazard, which was recently presented at Harvard University, we develop a tractable framework for analyzing social welfare in both regulated and unregulated ABS markets, accounting for moral hazard at the origination stage, private information at the distribution stage, and asymmetric information across ABS investors. We show originators operating in unregulated markets fail to internalize the costs they impose on investors if they utilize a common ABS structure (e.g. zero retentions) rather than credibly signaling positive information to the market via higher retentions. Further, originator effort incentives are reduced since those developing high value assets must either signal via high retentions or otherwise face underpricing of their securities. Mandated retentions have the potential to raise welfare by increasing originator effort incentives in an efficient way, accounting for investor-level spillovers.

The first important policy implication to emerge from the model is that regulators must choose between a “one-size scheme” under which all originators are forced to hold the same retention size (e.g. 5%) or a “menu scheme” under which originators must choose amongst multiple retention sizes (e.g. 4% or 8%). Both schemes can restore effort incentives. However, the menu scheme carries the added social benefit of allowing originators to signal positive information to investors via the choice of a larger retention. Signaling promotes efficient sharing of risks by mitigating the adverse selection problem confronting uninformed ABS investors. The weakness of the menu scheme is that it generally results in higher average retentions, resulting in lower originator fundraising.

…continue reading: Skin in the Game and Moral Hazard

In our paper, The Role of Accounting in the Financial Crisis: Lessons for the Future, which was recently made publicly available on SSRN, we discuss the causes of the financial crisis, with particular focus on the debated role of the relevant U.S. accounting standards, and summarize implications for accountants and accounting regulators based on the effect of these existing rules.

The Great Recession that started in 2008 has had significant effects on the US and global economy; estimates of the amount of US wealth lost are approximately $14 trillion (Luhby 2009). Various causes of the financial crisis have been cited, including lax regulation over mortgage lending, a growing housing bubble, the rise of derivatives instruments such as collateralized debt obligations, and questionable banking practices. In addition to these and many other reasons, we explain two factors that partially contributed to the crisis: certain management incentives and fair value accounting standards.

…continue reading: The Role of Accounting in the Financial Crisis

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.

…continue reading: Credit Risk Transfer Governance

The SEC recently proposed Rule 127B to implement the prohibition under Section 621 of the Dodd-Frank Act on material conflicts of interest between securitization participants of an ABS and any investor in the ABS. The proposed rule includes exceptions for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making. The proposed rule is available here.

Key provisions of the rule include:

Conditions Required for Application of the Proposed Rule

• Covered Persons. The proposed rule would apply to an underwriter, placement agent, initial purchaser or sponsor, or any affiliate or subsidiary of such entity, of an ABS.
• Covered Products. The proposed rule would apply to any ABS, as such term is defined in section 3 of the Exchange Act, including, for the purpose of the rule, synthetic ABS. The definition of ABS provided in the Exchange Act is much broader than the definition of ABS in the Securities Act Regulation AB. Both registered offerings and private placements would be covered by the proposed rule.

…continue reading: SEC Proposes Rule 127B to Implement Section 621 of the Dodd-Frank Act

Did mortgage securitization cause the mortgage crisis? One popular story goes like this: Banks that originated mortgage loans and then sold them to securitizers didn’t care whether the loans would be repaid. After all, since they sold the loans, they weren’t on the hook for the defaults. Without any “skin in the game” those banks felt free to make worse and worse loans until… kaboom! The story is an appealing one, and since the beginning of the crisis it has gained popularity among academics, journalists, and policymakers. It has even influenced financial reform. The only problem? The story might be wrong.

In this post we report on the latest round in an ongoing academic debate over this issue. We recently released two papers, available here and here, in which we argue that the evidence against securitization that many have found most damning has in fact been misinterpreted. Rather than being a settled issue, we believe securitization’s role in the crisis remains an open and pressing question.

…continue reading: Did Securitization Cause the Mortgage Crisis?

The working paper, Complexity, Innovation and the Regulation of Modern Financial Markets, which was recently made publicly available on SSRN, was motivated by two observations.

First, the perfect market assumptions underpinning the canonical theories of financial economics – modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model, and the efficient market hypothesis – are increasingly unreflective of how many modern financial markets work in practice.  More specifically, these theories share a common and highly stylized view of financial markets, one characterized by perfect information, the absence of transaction costs and rational market participants.  Yet in reality, of course, financial markets rarely (if ever) strictly conform to these assumptions.  Information is costly and unevenly distributed; transaction costs are pervasive, and market participants frequently exhibit cognitive biases and bounded rationality.  Despite these seemingly uncontroversial facts, however, the empirically (con)testable assumptions of conventional financial theory have been transformed into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources.

…continue reading: Complexity, Innovation and the Regulation of Modern Financial Markets

I thought I would try and give you some insight into what is happening on the ground, so to say, at the SEC as well as highlight some of the implications and implementation issues flowing from the new Dodd-Frank law. Some of these issues are worth closely noting because I believe they signal important shifts in how we have historically regulated our financial markets and raise serious questions about how such a shift will affect investor choice and protection, U.S. capital formation, innovation and competitiveness.

It’s early Spring in Washington, and while that means March Madness and filling out NCAA tournament brackets to most people, at the SEC it means filling out ambitious Dodd-Frank rulemaking mandates. Personally, I am a hockey fan, so I wouldn’t know better anyway.

That said, in many ways, I think it is hard for people to appreciate the enormity of what Dodd-Frank requires of federal regulators, and, in particular, the SEC. In terms of breadth and scope, Dodd-Frank is arguably the most significant financial legislation in modern history. The legislation ushers in a breathtaking amount of changes that will result in fundamental shifts in the legal, regulatory and policy landscape affecting our markets and our economy in a short period of time. These changes touch every aspect of our financial markets, from consumer credit to proprietary trading at financial firms, from OTC derivatives markets to securitization markets, and from private fund registration and regulation to corporate governance at public companies.

…continue reading: The Challenges of Implementing the Dodd-Frank Act

In its recently issued report, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, the Senate Permanent Subcommittee on Investigations considered the conduct of Goldman Sachs in several transactions, including the ABACUS 2007-AC1 collateralized debt obligation. The report “examines Goldman’s conduct in the context of the law prevailing in 2007,” [1] and it asserts that the Volcker Rule provisions of the Dodd-Frank Act, “if well implemented, will protect market participants from the self-dealing that contributed to the financial crisis.” [2] But what justification exists for the conflict of interest restrictions in the Volcker Rule provisions, and how would the Volcker Rule provisions have applied to the ABACUS CDO had the provisions been in force at the time?

In my paper, Conflicted Gatekeepers: The Volcker Rule and Goldman Sachs, I consider the conflict of interest restrictions in the Volcker Rule provisions. These provisions, namely Sections 619 and 621 of the Dodd-Frank Act, purport to impose fiduciary-like standards on banks in their arm’s length relationships with sophisticated counterparties. Section 619 generally prohibits banks from engaging in proprietary trading and affiliating with certain private funds; it permits some activities as exceptions to this general prohibition, but subjects such activities to the requirement that they not give rise to material conflicts of interest, including conflicts between banks and their “counterparties.” Section 621 purports to ban material conflicts of interest between banks (in their capacity as underwriters) and investors in offerings of asset-backed securities.

…continue reading: The Volcker Rule and Goldman Sachs

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).

…continue reading: Computerization and the Abacus: Reputation, Trust, and Fiduciary Duties in Investment Banking