Friday, September 21, 2012

Jeff Connaughton: Why Wall Street always wins

ZeroHedge carried excerpts from Jeff Connaughton's book, The Payoff:  Why Wall Street Always Wins.

In the book excerpts, Mr. Conaughton discusses one aspect of the Financial, Regulatory, Academic Complex (FRAC).  He specifically focuses on how FRAC goes about maintaining a status quo where complicated regulations and regulatory supervision has replaced transparency and market discipline.

The Blob (it’s really called that) refers to the government entities that regulate the finance industry—like the Banking Committee, Treasury Department, and SEC—and the army of Wall Street representatives and lobbyists that continuously surrounds and permeates them. 
The Blob moves together. Its members are in constant contact by e-mail and phone. They dine, drink, and take vacations together. Not surprisingly, they frequently intermarry. 
Indeed, a good way to maximize your family income in DC is to specialize in financial issues and marry someone in The Blob. Ideally, you and your spouse take turns: One of you works for a bank, insurance company, or lobbying firm while the other works for a government entity that regulates, or enacts legislation for, the financial industry. 
Every few years, you reverse roles: “Sally Striver, staffer on the Senate Banking Committee,” so might read a typical notice in Roll Call, “today announced her departure to work for the Financial Services Roundtable”; inevitably, she’s replaced with someone from the financial industry because, so runs the justification, the committee needs people familiar with the issues. 
What you and your spouse do all the time is share information. After all, no lobbying restrictions yet promulgated can prevent pillow talk between Blob spouses. 
Actually, marrying The Blob isn’t even necessary. A Blob member can simply take his or her non-Blob spouse to Blob parties—convivial gatherings of lobbyists and Wall street emissaries, SEC and Treasury Department officials—to help gather and disseminate intelligence. It’s a weekly, and sometimes nightly, occurrence in Washington. 
Ted and I quickly learned that, when you take on Wall Street in Washington, you take on The Blob....
Please take the time to re-read the description of the Blob keeping in mind the Dodd-Frank Act.

Regular readers know that your humble blogger views the Dodd-Frank Act as written by and for the financial industry with the exception of the Volcker Rule and the Consumer Financial Protection Bureau.

The Act is 2,000+ pages calling for an enormous expansion in complicated regulation and regulatory supervision of the financial sector.  This is undoubtedly good for the Blob.

However, if the last 50 years have shown anything, it has shown that a financial system that is dependent on complicated regulations and regulatory supervision is an inherently unstable financial system prone to collapsing like it did in 2007.

The reason for this instability is that complicated regulations and regulatory supervision create opacity.  Where there is opacity, market participants cannot properly assess risk.  When risk is mis-priced, too much of it is created.

The Bank of England's Andrew Haldane used Basel capital requirements to make the point about creating opacity.  He points out that under Basel I, capital ratio could be calculated on an envelope and under Basel III, capital ratios require 19 million assumptions and a computer to calculate.

While I like this analysis, Mr. Haldane needs to go back one step further.  Why did we have Basel I?  We created Basel I to hide the fact that banks were increasing their leverage (this was sold to regulators as banks need a higher ROE if they are going to attract equity investors).

Why do I know this?  I worked on Basel I.
In August 2009, then Senator Kaufman wrote SEC Chairman Mary Schapiro to urge her to study how dramatic changes in our stock markets in only a few years time had led to an explosive growth in computerized trading. 
Ted's letter to Chairman Schapiro helped draw the media's attention to dark pools and HFT, which began to receive extensive (and concerned) coverage in the financial press. 
The letter also transformed Ted from a virtually unknown Senate newcomer into a brightly flashing blip on Wall Street's radar screen. 
In response, Wall Street scrambled an entire air wing of bankers and lobbyists to buzz Capitol Hill. Soon, squadrons were swooping into our office, anxious to thwart new regulations following the financial crisis and, particularly, to prevent a crackdown on HFT.  
They were numerous (we typically met with five high-level Wall Street executives at a time) and unanimous. 
Whether a megabank, broker-dealer, or a hedge fund, they all said they believed that the stock market had never functioned better. "Competition has driven down the costs of trading," said one. "The spread between a stock's asking price and offer price has never been so narrow," said another. "There's always enough liquidity -- even during times of market stress -- to ensure that trades will almost certainly be executed," said a third. The refrain "mom-and-pop investors have never had it so good" was intoned by nearly all of them. 
As a former lobbyist, I almost had to admire the way they unswervingly stayed on message. And the message was that the status quo was good for everyone and that Ted and I were wasting our time exploring whether market changes might call for statutory and regulatory changes. 
It would've been easy, and quite understandable, for us to be convinced by Wall Street's unanimous message....
I have had a very similar experience trying to bring transparency to banks and structured finance securities.

For example, I like to point out the 19 responses received by Committee of European Bank Supervisors (CEBS) on Article 122a of the European Capital Requirements Directive.  Article 122a requires commercial and investment banks to 'know what they own' when they purchase structured finance securities.

As confirmed by the NAIC white paper, in order to know what you own, structured finance securities need to provide observable event based reporting and before the next business day disclose any activities like payments or defaults involving the underlying collateral.

This compares to current reporting practices where activities involving the underlying collateral are reported once per month or less frequently.  An example of a security that reports once per month is the opaque, toxic subprime mortgage backed security.... hence its first name: opaque.

18 of the 19 responses came from the Blob and made the case that current reporting practices were adequate for knowing what you own.  Not only did they make this argument, but they showed that modern word processing does a terrific job at cut and paste as most of them used the same words to make the argument.
Our top priority was to get the SEC to identify (or, to use the industry term: tag) high-frequency traders and collect data about their trades. Under current rules, such data weren’t collected. So it’s impossible to track an order as it wends its way—if “wend” can apply to a journey that takes a microsecond—through the electronic trading labyrinth and is executed. 
In fact, the entire reporting system for the execution of trades is antiquated. The SEC doesn’t even monitor brokers to ensure they execute trades fairly. Oversight in this area has been outsourced to the Financial Industry Regulatory Authority (FINRA), of which Schapiro was the chairman and CEO from 2006 to 2008. A self-regulatory organization for broker-dealers, FINRA has often been criticized for being lax in policing the industry and generous in compensating its executives (Schapiro’s regular compensation for 2008 was $3.5 million).... 
For our part, we were determined to prove that a workable monitoring solution was possible. So we threw ourselves into composing another letter to the SEC. Attached was a five-page memorandum that detailed the obsolescence of the current reporting requirements and offered specific suggestions, gleaned from some of the top experts in the field, on how to update them. 
Meanwhile, the pushback from Wall Street was intense and multi-pronged. The Blob oozed through the halls of government, seeking, through its glutinous embrace, to immobilize the legislative and regulatory apparatus, thereby preserving the status quo. The executive jets of the Wall Street air force flew sortie after sortie, transporting high-ranking emissaries from new York to Washington to meet with the SEC, [Senator Chris] Dodd and [Senator Richard] Shelby staff, and the staff of other senators on the Banking Committee.... 
The research companies and market experts Wall Street employs also raised their voices against us. ...
Just like with derivatives, which blew up and nearly sank the country, we’ve got the same formula with HFT. I call it the Kaufman Formula. Whenever you’ve got a lot of change, a lot of money, no transparency, and therefore no effective regulation—watch out. Because the next thing you could hear is “boom.” 
There’s been a lot of change. The stock markets have transformed dramatically in only a few years time. There’s a lot of money. The daily market volume by high-frequency traders is now over 60 percent. And they’re making billions of dollars a year. 
There’s no transparency. The SEC has admitted you’re not collecting any data and you have almost no baseline understanding of HFT. And therefore we have a rapidly expanding market that’s operating completely in the dark, with no effective regulation. I’m very worried that this is a prescription for another disaster.... 
Please note that high frequency trading like structured finance and black box banks is simply a variant of Wall Street using opacity to make money even as it puts the entire financial system at risk.
On the other hand, we were well aware of the three main impediments to the SEC taking meaningful action. 
First, nearly all the data, evidence, and analysis the SEC uses to monitor the financial industry come from the industry itself, creating a temptation for the industry to spin the data in its favor (as we’d seen with the naked-short-selling data provided by Goldman Sachs). 
Second, The Blob oozes endlessly in and out of the revolving door of public service. According to the Project on Government Oversight, 219 former SEC staff members filed 789 “post employment statements indicating their intent to represent an outside client before the commission” between 2006 and 2010. In other words, 219 former government officials were representing Wall street clients on matters before the SEC. 
Third, because the SEC has been so slow to start collecting data about HFT, it’s still years away from being able to propose HFT regulatory rules that it can empirically justify based on hard data (as the federal courts will require it to do)....
When it comes to bringing transparency to banks and structured finance securities, the SEC no longer has to rely on Wall Street for evidence and analysis.

It is very well documented, see Financial Crisis Inquiry Commission for example, that market participants did not have adequate transparency to be able to value either banks or structured finance securities.

It has been empirically justified based on hard data with the benefit of bringing transparency to banks and structured finance securities starting at $2 trillion and increasing from there.

1 comment:

Anonymous said...

Bravo. Great posting. The title of the book and the description of FRAC as the "Blob" remind me of a quote from a Dr. Who episode, "The Waters of Mars:" The quote is, Water is patient. Water always wins."

The Blob is also patient. It works everywhere and gets to ever corner of the government and academia to win. Great descriptor.

This is the battle Richard has been fighting for over a decade as a lone voice of reason. It is encouraging to see others beginning to understand his message, but the forces of the Blob arrayed against ultra-transprency are immense.

The Blob. Going to remember that.