Explaining the Rules

From the Fall 2011 edition of Vanderbilt Business

For the past 24 years, the Financial Markets Research Center (FMRC) at the Owen School has hosted a spring research conference designed to facilitate discussion between academic researchers and business practitioners. Starting with the 1987 Wall Street crash, many of the best minds in finance have assembled at the annual event to analyze topics ranging from globalization to securitization.

This year was no exception. Brett Sweet, Vice Chancellor and Chief Financial Officer at Vanderbilt, chaired presentations on regulating risky banks, while Margaret Blair, the Milton R. Underwood Chair in Free Enterprise at Vanderbilt Law School, led a session about the federal rule-making process.

The primary focus of this year’s FMRC conference, held May 5–6, centered on implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Almost a year after the bill was signed, federal regulators continue to draft new rules overseeing hundreds of trillions of dollars’ worth of activity that touches everything from the credit-default swaps that played a role in the 2008 financial crisis to overhauling Fannie Mae and Freddie Mac. In fact, the task of implementing the law has proven so massive that regulators have pushed many of its deadlines back six months to Dec. 31, 2011.

Even as regulators finish their work, however, many questions remain (including from those within the government) about the law’s ultimate impact.

Mortgage Reform

Edward DeMarco talked about mortgage reform in his keynote speech at the FMRC conference.
Edward DeMarco talked about mortgage reform in his keynote speech at the FMRC conference.

Regarding home mortgages, Edward J. DeMarco, Acting Director of the Federal Housing Finance Agency (FHFA), said in his FMRC keynote speech that keeping Fannie and Freddie in an indefinite state of conservatorship—which has stretched on for more than three years—poses risks to an already fragile sector. Total taxpayer support of the companies could climb to $363 billion by 2013, according to FHFA estimates, and so far none of the reform proposals put forth by Congress and the White House have gained much political traction.

“The only thing Congress can agree on is not renewing their original charters,” he said.

Whatever plan does finally emerge for Fannie and Freddie, DeMarco indicated that there are at least three elements that any framework must include:

  • Uniform mortgage standards: From collecting borrower data to developing guidelines for home appraisals, he said the industry needs consistency and transparency throughout the life of a loan. Without these elements, the world of private capital won’t be able to price and evaluate risk correctly.
  • Diversity of product offerings: Lenders shouldn’t lock themselves into offering only traditional 30-year fixed-rate mortgages just because data standardization is needed. “This is a big country with lots of people in many different situations,” he said. “The mortgage market of the future really needs to be not just liquid and stable, but it needs to have an appropriate diversity of offerings.”
  • Clarity about the role of the taxpayer: To properly calibrate how risk is assigned, priced and managed, DeMarco said it’s imperative that investors fully understand the role of the taxpayer in any future mortgage finance system.

Derivatives Oversight

There’s a climactic scene in Michael Lewis’ bestselling book The Big Short in which Dr. Michael Burry, the neurologist-turned-investor, finally sees his $1.9 billion bet against subprime mortgages start to pay off—that is, until he contacts his counterparties and tries to collect.

Under the Dodd-Frank Act, federal regulators drafted new rules overseeing trillions of dollars’ worth of financial activity in the U.S.
Under the Dodd-Frank Act, federal regulators drafted new rules overseeing trillions of dollars’ worth of financial activity in the U.S.

As it happened, the very banks from which Burry purchased the products that, in theory, should have been making him rich were also the same institutions responsible for pricing his investments.

“It was determined by Goldman Sachs and Bank of America and Morgan Stanley, who decided each day whether Mike Burry’s credit-default swaps had made or lost money,” Lewis wrote.

Under the Dodd-Frank Act, many of those kinds of privately traded derivatives—worth as much as $600 trillion—will now be transparently priced and exchanged through a central clearinghouse. In addition, the Securities and Exchange Commission (SEC) will split oversight of these financial instruments with the Commodity Futures Trading Commission (CFTC).

Joanne Moffic-Silver, Executive Vice President and General Counsel for the Chicago Board of Options Exchange, told FRMC conference participants that her company is interested to see how the two federal overseers handle these new regulations.

“One question with the Dodd-Frank Act is: Will having two agencies split jurisdiction over functionally equivalent products work?” Moffic-Silver said. “Ideally, and this is my personal opinion, there should be little or no difference between the SEC and CFTC on swaps rules.”

As written in the new law, the SEC will handle swaps that are backed by securities like a single or narrow group of stocks; the CFTC will manage the rest, including 22 listed categories that include interest-rate, credit-default and currency swaps.

But Moffic-Silver said Dodd-Frank includes a number of possible exceptions that would exclude various swaps from being traded through a clearinghouse. In addition, the new law allows for the creation of a new “Swap Execution Facility” (SEF) that would be an alternative to listing on an exchange. Current proposals from both the CFTC and SEC differ on some of the specifics of how these SEFs would operate, Moffic-Silver pointed out.

“The rule-making process has been interesting. The SEC and CFTC do talk, they do meet, and they have a current memorandum of understanding where they are supposed to coordinate regulation of similar products,” Moffic-Silver said. “But the proposals have differed in some very important areas.”

‘Bail-ins’ instead of Bailouts

On Sept. 15, 2008, the world awoke to what Andrew Ross Sorkin, writing in The New York Times, called “one of the most dramatic days in Wall Street’s history.”

The storied brokerage firm Merrill Lynch was sold for $50 billion, just half of what it had been worth the previous year; and after failing to find a buyer, Lehman Brothers filed the largest bankruptcy on record, culminating in a painful $150 billion liquidation.

“When an airline goes out of business, air traffic control doesn’t go haywire. When a phone company goes down, we can still make phone calls. But when banks go down, it’s different.”

—Wilson Ervin

After those catastrophic events, Congress approved a $700 billion bailout several weeks later to help banks unload their “toxic” mortgage-related assets to prevent further shocks. Now, instead of once again using taxpayer money to help prevent a contagion risk that could bring down the banking world, there’s discussion about designing a “bail-in” mechanism.

Wilson Ervin, Managing Director at Credit Suisse, explained in a presentation at the FMRC conference that a “bail-in” would give regulatory officials the authority to impose a resolution designed like a prepackaged bankruptcy. “Think of a Chapter 11 bankruptcy on steroids,” he said.

“When an airline goes out of business, air traffic control doesn’t go haywire. When a phone company goes down, we can still make phone calls,” Ervin said. “But when banks go down, it’s different.”

Using the case of Lehman Brothers as an example, Ervin said by writing down assets and converting a portion of the debt to new equity, the bank could have preserved a capital base of more than $40 million, giving it some hope to raise additional investment from other financial services firms.

“The process would not be pretty, but overall investors should be relieved by the result,” Ervin wrote in an Economist essay he co-authored on the subject. “In [the Lehman] example the bail-in would have saved them over $100 billion in aggregate, and everybody—other than short-sellers in Lehman—would have been better off than today.”

New Vanderbilt Research

In addition to the speakers from government and private industry, several members of the Owen faculty presented new research, including Bob Whaley, the Valere Blair Potter Professor of Management, who discussed his collaboration with Jacob Sagi, the Vanderbilt Financial Markets Research Center Associate Professor of Finance, in launching NASDAQ’s Alpha Indexes. Also Nick Bollen, the E. Bronson Ingram Professor of Finance, shared results from a recent paper investigating hedge fund investment strategies, while Hans Stoll, the Anne Marie and Thomas B. Walker Jr. Professor of Finance and Director of the FMRC, presented new research with Thomas Ho, the FMRC Research Professor of Finance, examining the interaction between financial markets and regulations.