Monday, August 6, 2012

Cost-Benefit analysis by SEC major factor in financial crisis

Dennis Kelleher, Stephen Hall and Katelynn Bradley of Better Markets wrote a very interesting white paper on cost-benefit analysis and financial reform at the SEC.

In the paper, they make the critically important point that the SEC is specifically excluded from having to factor in a cost-benefit analysis when they introduce a rule.  What the SEC must consider is does the rule protect investors and the public interest.

While the authors do not say it directly, the common sense reason that the SEC is exempted from worrying about a cost-benefit analysis is that the cost of a financial crisis is far greater than the cost of any single rule or combination of rules that might be applied on the financial industry.

Regular readers know that your humble blogger has been very active in trying to bring transparency to structured finance securities.  Specifically, I have both talked with individuals at the SEC about the revision of Reg AB (the regulation that lays out the disclosure requirement for structured finance securities) and provided input through a response to their public consultation.

My recommendation has been that all structured finance securities, including covered bonds, be required to report on an observable event basis any activity that occurs with the underlying collateral before the beginning of the next business day [as opposed to the sell-side's preferred once per month reporting after the end of the month].

In addition, the disclosure should include all data fields tracked by the originators, billers and collectors while protecting borrower privacy consistent with HIPAA standards [as oppose to the sell-side's preferred data templates that exclude valuable data fields].

With that background, now to the role that cost-benefit analysis played in the financial crisis.

During one of my conversations with a senior SEC staff member, the subject turned to the cost-benefit analysis that was done when Reg AB was originally mandated in the mid-2000s.  According to the staff member, while the SEC knew that disclosure should include all data fields and be made on an observable event basis, it could not justify this requirement based on their internal cost-benefit analysis.

Let me repeat that:  based on the results of its cost-benefit analysis, the SEC knowingly backed off of requiring transparency and instead issued a rule saying that then existing disclosure practices that were inadequate for valuing individual structured finance securities (see the Brown Paper Bag Challenge) were adequate.

Shortly after the financial crisis began, the Bank of England's Andy Haldane estimated that the losses on structured finance securities from investors not being able to value these opaque securities exceeded $1 trillion.

My bet is that the SEC's cost-benefit analysis did not place the benefit of being able to value the structured finance securities at over $1 trillion.  Hence, the reason that the SEC did not require transparency when it promulgated Reg AB.

However, now that we know the benefit is over $1 trillion, an annual cost of $10 billion to provide investors with disclosure of all borrower privacy protected data fields on an observable event based reporting basis under a revised-Reg AB can easily be seen as money well spent.

The fact that the SEC's internal cost-benefit analysis did not include the benefit of avoiding over $1 trillion in losses reaffirms the common sense reason for not subjecting any single rule or combination of rules from the SEC to a cost-benefit analysis.

Common sense says that if the SEC does not perform a cost-benefit analysis, there is no chance that doing a cost-benefit analysis incorrectly will result in a rule that doesn't protect investors and the public interest.

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