Mike Konczal looks at a recent financial reform proposal by conservatives to use credit default swaps to help regulators do their jobs.

Christopher Papagianis at Economics 21 has some has some advice for Republicans on ways to make the Dodd financial reform bill better; use some insights from Oliver Hart and Luigi Zingales. It's worth reading all of it, but I'll try and summarize. First, he describes resolution authority in a smart way:

The Democrats’ “resolution authority” proposal needs to be thought of in two discrete time periods: the “crisis” period, when the firm is on the verge of collapse, and the “ordinary” period when the firm is able to access external funding and otherwise function normally. During the “crisis” period, resolution authority is quite useful as it provides the government with greater legal authority to assume control of a firm on the brink of failure. As the Treasury has argued, current law forces the Administration and Federal Reserve to choose between two unpalatable options: (1) government capital injections and financial guarantees (as occurred with AIG), or (2) a bankruptcy filing (as occurred with Lehman Brothers). In the first case, the government uses taxpayer resources to keep an insolvent firm afloat without the ability to alter contracts or otherwise wind-down the institution. In the second, the government takes a hands-off approach and allows an uncontrolled bankruptcy to occur with no ability to monitor or control the potentially significant collateral damage.

The problem is that this crisis period is very short in duration relative to the “ordinary” period when the firm is not on the verge of collapse. During the ordinary period, the resolution authority and the accompanying “resolution fund” are likely to distort prices and capital allocation decisions. The result is subsidies for larger institutions that could make it harder for small banks to attract debt finance and a less stable financial system.

The question at hand is how to deal with the detection part, the part where you go from ordinary to crisis, a question I worry about as well. What is to be done?

Instead of acceding to this plan, Republicans should get behind a variant of a proposal offered by distinguished academics Oliver Hart and Luigi Zingales. Hart and Zingales would use credit default swap (CDS) spreads as a market-based default probability metric. The “spread” or premium on a CDS contract represents the market price of providing a financial guarantee against losses from a firm’s default. A rising CDS spread is a market signal that the probability of default is increasing because it is getting more expensive to purchase protection against default. In the Hart and Zingales framework, once the CDS spread rises above a pre-specified “critical threshold,” the regulator would force the institution in question to issue equity (offer new stock for sale) until the CDS spread moves back below the threshold...

While Hart and Zingales choose the right instrument for their trigger, their proposed remedial step should be strengthened. Instead of having the regulator demand that the institution issue new equity, the debt of the institution could automatically convert into equity....If that failed to bring the CDS below the critical threshold, the other half of the junior debt would also convert to equity....The GOP should seize the opportunity.

If that doesn't make sense to you, essentially it means that credit default swaps on bank debt, or market expectations of credit risk, should be used as the trigger for when a systemically risky financial firm should be resolved (or moved further along in the process of resolution). Ok, several things: 1) This may not be obvious to people who weren't watching the House debate on financial reform, but one of the Republicans signature contributions to the debate is to say absolutely no changes need to be made to the credit default swap and over-the-counter derivatives market. None. Check out the House GOP Alternative plan (summary, derivatives). Nothing. And the Republicans are lining up to go to war against any attempt to bring any type of regulation to the credit default swap market. We aren't even talking about serious Gensler style derivatives reform. The Republicans are fighting against clearing requirements. Against post-trade price transparency reform, and pre-trade price transparency reform. No pressure on the derivatives dealers. Nothing. 88% of Republicans on the House Financial Services committee voted against bringing Title III, the derivatives act, out of the House. And that's the reform Frank retroactively thinks was weak! So the question for Chris right out the door is whether or not he can recommend pushing for credit default swaps to play an important role in our regulatory regime with the current OTC market, and if not what OTC changes would need to be made. I think the idea has a lot of potential, but with the derivatives market the way it currently is it could be a disaster, subject to an excessive amount of noise, distortion and manipulation. 2) Moving on, let's put the policy under a microscope. It's a resolution bill, not a bankruptcy bill. It doesn't wait until a firm can't make a payment on its debt to be closed, it has a predetermined event that has the firm taken into receivership like FDIC does with a bank. This is an important difference with the current GOP approach, which would be like waiting until someone can't get money out of their checking account to take over a failed bank. Getting in early allows for a smoother transition to a receivership like event. This is a new discussion on the Right, which has been focused on doubling down on bankruptcy law during the past year. 3) A big question is who gets to pull the trigger on a resolution event. Is it the regulator's discretion? Is it hard rules only? The Dodd Bill uses a combination of both similar to prompt corrective action to try and take advantage of regulator's knowledge (that the market will not have, especially with regards to debt tenor of a financial firm's books, important for shadow banking stuff) while also combating regulatory forbearance. Chris would have the credit default swap market make the call as to when to begin the resolution process. I like this idea in (financial) theory, though I'm not sure if the market can see much of the stuff that is quite important for making sure a financial firm isn't placing itself at risk for a shadow banking run. 4) One problem I would worry about is that it might be pro-cyclical, when regulation needs to be counter-cyclical going forward. So while Zingales says that the CDS market predicted the collapses in 2008 of many firms, he doesn't mention that the CDS prices on the collapsed financial firms in 2007 were at an all-time low. (See a graph of Lehman's CDS prices.) Regulators should have been harder on Lehman during the boom and easier on them during the crisis; this idea for resolution is certainly compatible with counter-cyclical regulation but it doesn't get there by itself. 5) I'm skeptical that CDS prices purely reflect default probabilities. As credit risk trader Sandrew has said: "Traders don’t buy CDS because they think the name will default; they buy CDS because they think the spread will widen...It follows that extrapolating any default information from wider CDS spreads can be misleading." Others worry that the prices reflect what a handful of broker-dealers want you to believe. Getting a better tracker with better price discovery might get us closer to this doing what it needs to, but we are a long way away from there. 6) A big problem with automatic, clearly displayed rules on a CDS tracker would be that it could radically amplify the death spiral financing risks that these kinds of things encounter. As the CDS prices gets closer to the trigger, there's more of an incentive for people to pile into the CDS to try and force a regulatory intervention. It would actually give quants an equation and reasonable data estimates for how much capital and energy it would take to trigger a profitable bank run; and since the CDS will actually trigger it, smart money wouldn't want to fight against them to retain the value of the firm but also pile onto the push. In general bank runs are not profitable for most of the people involved in them. But here triggering one could in fact make it very profitable for some of the players who also have nothing to lose. I need to think more about the #6 critique as a hard rule that must be followed, but I completely support the idea of regulators using CDS information as a major weapon in their toolbox. But there are some smart credit risk people who read this blog: what do you think?

Mike Konczal is a fellow with the Roosevelt Institute and a blogger at rortybomb.wordpress.com.

Speaking at the inaugural conference of the Institute for New Economic Thinking, Adair Turner shatters static conceptions of a rational, self-regulating market.

Adair Turner unleashed a fiercely eloquent call for a re-conceptualization of economic thinking and the free market in this video, insisting that:

"If new economic thinking rejects the idea that the market will naturally deliver a perfect equilibrium, it should equally be wary of believing that public policy can achieve it. But knowing that market liquidity, speculation, and price discoveries are not limitlessly and always beneficial, still implies a profound change of approach from the conventional wisdom that dominated in the pre-crisis years."

Paul Krugman recently commented on financial market reform and the problem of regulatory enforcement and follow-up. Acknowledging that the Administration and Congress had at least come up with a framework of re-regulation which could address most of the abuses which led to the recent crisis -- if vigorously implemented by vigilant, well funded regulators -- he raised the problem of future administrations (read Republican administrations or a Federal Reserve like the Greenspan-led Fed) which would be indifferent, even  hostile, to financial market regulation or totally captured by the financial services industry, and who would either negligently or intentionally jettison regulatory safeguards for financial markets.

Since the appearance of Krugman's column, New Deal 2.0 has been approached by several commentators suggesting an entirely different approach to regulatory capture or ideological hostility to financial market regulation to that suggested by Krugman: civil liability for fraud by financial market players and their enablers through investor law suits. As these commentators have noted, civil liability has been a part of the federal securities laws since their inception during the Roosevelt Administration in the 1930s. They point out that like financial market regulation, civil liability to investors has been substantially weakened by legislation and court decisions over the last 30 years by actions of Republican Administrations and Congresses.

Roosevelt Institute Braintruster Daniel Berger calls out recent articles by economist Robert Kuttner and four distinguished law professorrs, who explain why investors are on their own and must have legal rights to protect themselves:

Recently on HuffPo, economist Robert Kuttner describes the sad record of failure by the regulatory agencies, including the Fed and the SEC, to recognize and address the corporate fraud which led to the collapse of Lehman Brothers. The devastating 2,200 page report by the Lehman bankruptcy examiner released last month should, Kuttner believes, cause a serious rethink of the whole approach to financial reform as drafted in the Senate Banking Committee financial regulatory reform bill (primarily authored by Committee Chairman Chris Dodd, D-CT):

"Basically, Lehman cooked its books for a few days four times a year so that its quarterly reports would make the firm look far more solvent than it actually was." Kuttner believes the fact that regulators failed to detect this behavior and that it was made possible by the alleged knowing participation of Lehman's accounting firm and auditor, Ernst & Young, as well as seven bank counter parties and a British law firm, all of whom knew there was no legitimate business purpose to the transactions, highlights the failure of existing "systems that are supposed to protect investors, creditors and the larger economy from willful corporate fraud."

Neither the bill already passed in the House of Representatives nor the reform bill soon to be debated on the Senate Floor address this regulatory vacuum. Kuttner concludes that the bills in their present form allow incubation of "the next generation of bubbles...while we are still recovering from the damage of the previous one."  He observes that if investors could have sued them, "Ernst and Young would have thought twice about giving Lehman a clean bill of health".

Kuttner is among a growing number of experts who believe the best way to address the inherent failings of regulatory agencies is to restore the right of investors and creditors injured by corporate fraud to sue all those who knowingly participated in the fraud. He writes: "The original securities laws of the Roosevelt era envisioned that this kind of litigation -‘private right of action'- would keep both corporations, their auditors and the SEC honest."

But bipartisan legislation in the 1990s and two major Supreme Court decisions in 1994 and 2008 have effectively eliminated liability for aiding and abetting securities fraud. Kuttner notes that "You can be sure if this right were still available, Ernst and Young would have thought twice about giving Lehman a clean bill of health."

Kuttner's concerns were echoed by four distinguished law professors in an April 4th NYT op-ed, "How Washington Abetted the Bank Job" . The professors, Susan P. Koniak of Boston University, George M. Cohen of the University of Virginia, David A. Dana of Northwestern University and Thomas Ross of University of Pittsburgh, offer a ringing indictment of a corrupt financial culture involving mutual back-scratching -- from Enron up to the recent Lehman fraud and bankruptcy. These law professors track how Lehman is just the latest example of how "our banks had gone into the business of creating ‘products' to help companies, cities and whole countries hide their true financial condition...Now we discover that not only were our banks raking in huge profits helping others hide debt, but they also drank their own Kool-Aid".

And the reaction of our regulatory guardians? They took "a permissive approach toward the debt-dissolving financial products that our banks had been developing, hawking and using for themselves for years," the professors say. Clearly, "our bank regulators were not, as they would like us to believe, outside the disco, deaf and blind to the revelry going on within. They were bouncing to the same beat".

So if the regulators and Congress cannot reign in the banks, who can? The law professors conclude: "Congress needs to recognize that ‘regulatory capture', in which an agency becomes a pawn of the industry it is supposed to oversee, is real". And coming to the same conclusion arrived at by Kuttner, the professors state that "passing piecemeal fixes to outlaw each fraud-inviting instrument...will never be a substitute for restoring civil liability for abetting securities fraud. Innovation can too easily outstrip specific rules".

We encourage you to read these stories in full.

In addition to numerous law professors and economists like Robert Kuttner, restoring private aiding and abetting liability is supported by state securities law enforcement officers, as represented by the North American Securities Administrators Association, and other investor and consumer protection groups.

Roosevelt Institute Braintruster Daniel Berger is an attorney in the field of complex litigation, including securities and anti-trust litigation, and has a broad-based knowledge concerning the structure and functioning of the US economy and US financial markets. He practices in Philadelphia.

FCIC hearings continued yesterday, this time with former Citigroup execs and--what's that?--a call for substantive financial reform?

The second scheduled round of FCIC hearings fired up yesterday, with former Citigroup leaders Robert Rubin and Charles Prince facing the questions. Prince, former CEO of Citigroup and Rubin, former US Treasury Secretary and Citigroup board member, tried to explain how the company violated standards to ignore risk and essentially imploded,  requiring $45 billion in federal bailout funds.

The hearings were a little more promising than Wednesday's song and dance from Alan Greenspan, which amounted to nothing more than an exercise in revisionist history. Prince even started the day off with an apology:

"I can only say that I am deeply sorry that our management -- starting with me -- was not more prescient, and that we did not foresee what lay before us." He later said, "I'm sorry the financial crisis has had such a devastating impact for our country. I'm sorry about the millions of people, average Americans, who lost their homes."

This is about as close as we have come to an individual admission of guilt (or at least flagrant irresponsibility) from one of the most central culprits of the financial crisis -- Citigroup.

The far less contrite Rubin began his testimony speculating on the causes of the financial crisis -- which he cited as excessive risk, the complexity of derivatives, misguided AAA ratings, lack of regulation and, contrary to Greenspan's testimony -- low interest rates. Rubin acknowledged the need for public and private cooperation in solving the problem, and in his written testimony noted that:

[...] private solutions are only part of the answer. Financial reform is imperative and should include: (1) substantially increased leverage constraints, with one tier based on risk models and a second tier based on simpler metrics because models cannot fully capture reality; (2) derivatives regulation, reflecting my strong view from my time at Goldman Sachs that derivatives can create systemic risk and require appropriate regulation, as discussed in my 2003 book; (3) resolution authority to avoid the moral hazard of "too big to fail;" and (4) consumer protection primarily to protect American consumers, but also to protect the financial system.

At least on the surface, Rubin acknowledged what we here at the Roosevelt Institute have been championing for months, particularly with regard to consumer protection and ending the reign of too big to fail banks. The reforms, however, seem mostly toothless in the face of the blatant lies told by Rubin. As Felix Salmon points out, when it comes to risk,

"The fact is, as Rubin is clearly aware, that the risk management function at Citi failed spectacularly, not least in the way that senior executives weren't even told about Citi's monstrous subprime exposures until the end of 2007."

Rubin largely sounds unreconstructed. Both Rubin and Prince spent much of the time insisting that no one -- except maybe a very select few -- could have predicted the severity of the financial crisis. Prince denied that misguided AAA ratings contributed significantly to the crisis, a claim that contradicts Rubin's prepared testimony.

Aside from just touting financial reform in a congressional hearing, we need to figure out how to implement meaningful regulations and shift the paradigm of financial services in this country and globally because, in the end, this problem is a systemic one. Prince noted this challenge in befuddlement, admitting that,

"[...] the question really is, how could an industry, how could the control processes for an industry have missed something so universally, and how to you protect the next one?

And I don't know the answer to that. "

[Click here to watch Greenspan's testimony from Wednesday and to keep up with the current FCIC hearings].