The US Senate has started to debate the Financial Reform bill. This bill proposes the most sweeping changes to US (and, therefore, global) financial markets regulatory practices since the Great Depression of the 1930s.

So one might think this an extremely important bill, right? So all the Senators have read it? Dream on!

The bill presented to the Senate is 1,300 pages long. How many people will read all of it? And even those few souls who do manage to read all the way through, will they really digest it, thoroughly, all of it? Of course they won’t.

So here we have what is possibly the most important piece of legislation relating to financial services for decades, and nobody fully understands it. Isn’t that frightening?

Perhaps in clauses hundreds of pages apart there are disparities that will keep lawyers employed for years.

In addition to its length, another problem is the breadth of the subject matter. Whilst all of the bill relates to financial markets in the broadest sense of the word, there are sections that are barely related to each other. A key risk here is that concessions and watering-down will be agreed in one section in order to gain support for a completely unrelated section. So, for example, the agreement to the derivatives section might affect regulation of deposits, or comments on naked insurance might impact international wire safeguards. These are just possible examples, the Vox Sapiens team hasn’t read the bill.

The US has an opportunity to show real leadership to the world here. It should cut the bill up into smaller sections that allow proper understanding of the consequences of each clause.

As Tolstoy said: “There is no greatness where there is not simplicity.” Is there greatness in this bill?

Let us hope that debating this bill doesn’t encourage many Senators to snore so that others can fleece us.

The Icelandic Special Investigation Committee (SIC) yesterday (April 12th, 2010) delivered its report on the collapse of the three main banks in Iceland. It makes shocking reading.

It can be downloaded here.

At Vox Sapiens, our initial vision was of a couple Escher’s masterpieces.

“Ascending and Descending” depicts a monastery where half the monks are forever walking upstairs and half are forever walking downstairs.

“Waterfall” depicts a perpetual motion machine in which water runs forever downhill.

The business empires of the owners of the three large Icelandic banks – Landsbanki, Glitnir and Kaupthing – allegedly demonstrate similar features.

The banks’ owners are alleged to have borrowed money from their own banks, and to have used some of this money to buy shares in the banks, resulting in an increase in the share price. The SIC refers to this as “weak equity” and it grew to represent more than 25% of the banks’ capital base.

These shares were also used as collateral against loans, further leveraging the banks’ positions.

And the growth of the banks was out of all proportion when compared to the Icelandic economy and the ability of its officers to supervise the banks.

In seven years the banks grew to twenty times their size until their debt issuance exceeded the GDP of Iceland and grossly distorted the requirement for foreign currency reserves. The writedown in the value of the banks’ loans in 2008 was the equivalent of five years GDP.

At the same time, a country of only 320 000 people was not able to provide a sufficiently large and experienced banking oversight regime to handle three large banks.

Finally, there appears to have been insufficiently long arms when lending contracts were established. Not only were loans provided to the banks’ owners, but also to the owners’ other businesses. These other businesses also pledged icelandic shares when borrowing from foreign banks. As the icelandic share prices fell, the icelandic businesses had to repay the foreign banks, and the icelandic banks stepped in to replace this debt, further leveraging the icelandic economy. The SIC summary presentation at the press conference states that “these investment companies had an abnormally easy access to loans in the banks in the capacity of their ownership and influence within them.”

A sorry state indeed.

Note: These images are available for commercial reuse.
Ascending and Descending search
Waterfall search

They can be obtained from:
Waterfall: http://picasaweb.google.com/lh/photo/36X8UHueP5H6pycVt_JBEA and
Ascending and Descending: http://picasaweb.google.com/lh/photo/gwkazaD_DWA9EyY3W0LyfA

Greece uses the same currency as Germany. But Greek government bonds yield almost four per cent more than German government bonds, an all time record for the eurozone.

This is telling us something; really telling us something. The bond market is pricing in a high possibility of default by the Greek state.

Until recently, the market perceived barely any difference in credit risk between different European Union countries. The yields on bonds were pretty similar between countries – so low that some commentators suggested the differences should be greater. But the perceived wisdom was that the risk of default by an alleged profligate state (predominantly those with a mediterranean coastline) was very low, and that even if a default was imminent the other austere and prudent states would step in to help their prodigal sibling.

But Herr Brüderle, the German Economics Minister, put an end to those thoughts. First acknowledging, in a speech to German Members of Parliament (more similar to Representatives than to Senators), that “some euro states are showing dangerous weakness. This may have fatal effects on all states in the eurozone,” he then went on to add that “there should not be a collective bailout for lopsided developments at national level.”

There is likely to be plenty of coverage of the “will they, won’t they” predictions over the next few days. But say they won’t, and Greece defaults. What are the implications? Vox Sapiens will be following this closely and answering the question.

As a footnote, it is likely that the Ouzu crisis will appear as just a small ripple compared to the Shochu crisis. But that’s another post.

So McClatchy Newspapers has discovered that in late 2007 some analysts at Moody’s Investors Service were “downsized” for expressing concerns about the accuracy of the ratings being applied to some of the CDOs (collateralised debt obligations), especially those comprising MBSes (mortgage backed securities).

The news group alleges that Moody’s shuffled its internal employees, sidelining and/or firing those that were raising red flags and replacing them by structured finance specialists, in order to continue to provide the high ratings needed by the Investment Banks that were assembling the CDOs (see this story). The allegations are supported by quotes attributable to several former employees.

If true, the allegations reveal a deep weakness in the debt valuation process.

The story ends with the comment:

The ratings agencies were under no legal obligation since technically their job is only to give an opinion, protected as free speech, in the form of ratings.

Experts such as Columbia University’s [finance expert, John] Coffee think that Congress must impose some legal liability on credit rating agencies. Otherwise, they’ll remain “just one more conflicted gatekeeper,” and the process of pooling loans — essential to the flow of credit — will remain paralyzed and economic recovery restrained,” Coffee said.

As somebody involved in the equity valuation process, I find this absence of responsibility quite shocking.

In the equity valuation process, an analogous process to debt ratings would be VDD, or vendor due diligence. VDDs are employed to reduce disruption to a Seller’s business. For example, if a Parent company wishes to sell one of its business units (the “Target”), then every potential Buyer would wish to dispatch its own team of analysts to perform (buy-side) due diligence on the Target’s finances, including interviewing management representatives from the Parent and Target.

The VDD approach means that only one team of due diligence analysts is encamped at the Target, preparing a due diligence report. The Parent company contracts the due diligence provider, and pays for the work, and often attempts to suppress any negative commentary about Target business. However, when the transaction is completed, the vendor due diligence report is assigned to the successful Buyer, and the due diligence service provider assumes a duty of care to the Buyer.

This approach focuses the due diligence service provider’s mind on preparing an objective and factual report when confronted by the Parent company management’s intimidation.

This is very different to the “under no legal obligation since technically their job is only to give an opinion” scenario in which the debt rating agencies work.

Isn’t it time that the users of debt ratings demanded that the ratings agencies become more accountable for their “opinions?”