Derivatives and Regulation
Pundits continue to link the Enron debacle to a need for increased regulation, especially of derivatives. What most of these people...don't appreciate is that regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship.
Investors and operating companies buy derivatives for two basic purposes: speculation and risk transfer. A derivative, (a financial contract based on the price of another commodity, security, contract or index) either eliminates an exposure, creates an exposure, or substitutes exposures. That last one, substituting exposures, is important to heavily regulated investors.
For example, insurance companies were a goldmine for derivatives salespeople in the last two decades, only slowing down in the late 1990s. The fundamental reason for this is not because insurance executives were stupid, but because they manage their investments in a thicket of proscriptive regulation. Insurance companies have to respond to their national regulatory organization (the NAIC), their home state insurance department and the insurance departments of states in which they sell or write business. They file enormous statutory reports every quarter using special regulatory pricing, and calculate complex risk-based capital reports and "IRIS" ratios regularly.
Even though the insurance industry has been heavily regulated throughout the entire post-war era, the incidents of fraud and financial mismanagement have been numerous and spectacular. Remember Marty Frankel? Mutual Benefit Life? For each of these cases that are in the news, there are many smaller ones you don't hear about. Some of that may be the nature of the industry, but it doesn't make a prima facie case for more regulation...
Insurance companies often need the yield of less creditworthy obligations. So derivative salesmen see an opportunity to engineer around the regulations. They package securities that substitute price volatility for the proscribed credit risk. Then the investor can be compensated for taking some additional risk, and the banker can be compensated for creating the opportunity. A simple example of this is the Collateralized Bond Obligation (CBO). A CBO is created by buying a bunch of bonds, usually of lower credit quality, putting them in a "special purpose vehicle" (SPV) and then issuing two or more debt instruments from the SPV. The more senior instruments can obtain an investment grade rating based on the "cushion" created by the junior debt tranche. The junior bond absorbs, for example, the first 10% of losses in the entire portfolio and only when losses exceed that amount will the senior obligations be impaired. The junior instruments, known as "Z-Tranches" become "toxic waste", suitable only for speculators and trading desks with strange risks to lay off (or, in a famous 1995 case, the Orange County California Treasurer).
A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing - they decrease frequency of loss but increase the severity. So they blow up infrequently, but when they do it's often a big mess. Ratings-packaged instruments are less risky than the pool of securities they represent but often riskier and less liquid than the investment grade securities for which they are being substituted. As a result, they pay a yield or return premium (even net of high investment banking fees). That premium may or may not be enough to pay for their risk. But they pass the all-important credit rating process and are therefore sometimes the only choice for ratings-restricted portfolios reaching for yield.
...[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests that regulation is often the derivative salesman's best friend. Complicated rules encourage complex transactions that seek to conceal or re-shape their true nature. Regulated entities create demand for complex derivatives that substitute proscribed risks for admitted risks. If a new risk is identified and prohibited, the market starts inventing instruments that get around it. There is no end to this process. Regulators have always had this perversely symbiotic relationship with Wall Street. And the same can be said for the ridiculously complicated federal taxation rules and increasingly byzantine Financial Accounting Standards, both of which have inspired massive derivative activity as the engineers find their way around the code maze.
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