The Proof is in the Shadow

We did some work last year detailing the dynamics of the multi-billion dollar negative basis trade, the off-balance sheet trade that helped bring several insurers to their knees, as well as a number of banks including UBS (as soon as the trade was forced back onto their balance sheets).

The lack of financial reporting transparency was only one of the problems.  Some parties, of course, had insight into the multi-trillion dollar shadow banking system. But two other major pitfalls spring to mind: the lack of asset transparency (that is the ability to understand what is being referenced) and the lack of pricing transparency (that is the ability to know the value of an opaque asset).

The lack of transparency is entirely convenient to those in the know: it creates numerous opportunities to take advantage of those with less information. We call this imbalance an "informational asymmetry."(Click here to visit the appropriately titled Fed's report "Could Asymmetric Information Alone Have Caused the Collapse of Private-Label Securitization?"

While 2010's Dodd-Frank Act attempts to add asset transparency in various forms, it was interesting to note Frank's disheartened tone, yesterday at the House Committee Hearings on Financial Services, when speaking of the other "transparencies."  Here's an excerpt of his commentary (emphasis added):

"Hedge funds will remain uncovered.

We gave the CFTC the mandate to begin to regulate derivatives, including mostly -- including for end-users, making public the price. Not for end-users in any other way regulating them. What we did then was both derivatives and with regard to hedge funds and private equity was to get some more information. People have been talking about the shadow banking system. Well, one of the things we did in the bill was to try to bring that out of the shadows. But as a result of the Republican budget, neither the SEC nor the CFTC will have the money to do that.

And so we will back, I from time to time talk about old radio programs. I think we have another one.

Who will know what risk lurks in the heart of the financial system?

And the answer is, the shadow will know. But nobody else.

Because our efforts to put some light on the shadow banking system, by having hedge funds register with the SEC and have them be able to calculate what's up, and having derivatives regulated by the CFTC, those won't happen."

Risk - Discombobulated

Investing brings with it many risks. When things go wrong, they often tend to go wrong in concert: credit risk and market risk and illiquidity risk and complexity and legal and operational risks can all be confused and are often indistinguishable, especially when they need to be realized.

Certain rating agencies have specific ratings for these "non-credit risk" measures. One can get a liquidity rating, a market risk rating, even a trustee quality rating or a hedge fund operational quality rating.

But credit risk doesn’t exist and typically isn’t measured in a vacuum – at least not according to recent ratings criteria. When a product is exposed to operational risk, for example, failures in operational quality can bring down the credit rating itself, making it very difficult for an investor to separate the different risks being measured.

For example, Moody’s today announced that its soon-to-be-released operational risk guidelines could result in rating actions (primarily downgrades from the sounds of it) on the senior ratings of up to 200 structured finance ratings.

"The performance of a securitisation transaction depends not only on the creditworthiness of the underlying pool of obligors, i.e. the quality of the collateral, but is also closely linked to the operational performance of various transaction parties such as the servicer, trustee and cash manager"

With investors looking increasingly to non-traditional investments for heightened returns, and with banks pushing risky activities into the opaque shadow banking system (to minimize regulation and oversight), it’s high time we all started to manage our risks out of one centralized division. That way credit risk doesn’t escape the market risk team, and funding risks don’t escape the credit guys.