The Times They Are A-Changin’ … Maybe: the Bailout and Disclosure
November 2008
IN THIS ISSUE
— The Regulatory Gang That Couldn’t Shoot Straight: Why Promised Disclosure Faltered
— Dear Fox, Please Care For My Henhouse: Congress Yields to Paulson
— In the next issue
GREETINGS!
Welcome to the November edition of our newsletter! In this issue, we were going to discuss how the bailout provisions would affect disclosure regulations in various lending markets, but a funny thing happened on the way to that thesis.
Which is to say, nothing happened.
So we’ll look at what was supposed to happen, why it didn’t, and what else didn’t happen.
THE REGULATORY GANG THAT COULDN’T SHOOT STRAIGHT: WHY PROMISED DISCLOSURE FALTERED
The subprime mortgage crisis that has badly damaged America’s financial markets has its roots in a simple problem: a failure to manage risk based on a near-total collapse in disclosure of an asset’s true value and the lack of truthful evaluation regarding the risks inherent in holding that asset. Both sides involved in these transactions, buyers and sellers, were steeped in an often willful denial of the “reality on the ground,” as politicians are wont to say. While the parties transacting business are at fault, a “dishonorable mention” ought to go to credit rating agencies that aided and abetted in the spiral of denial that exacerbated this situation.
The lack of disclosure has led to a lack of trust, the fundamental principle behind functioning credit markets. This pattern has only recently begun to ease, and will not be corrected quickly.
This situation would be a daunting one for any Congress, and members from both parties pledged swift corrective action, including increased transparency and disclosure. Democrats took the populist tact of insisting, especially to any television cameras present, that the pay for any senior executive whose bank was involved in the program be both capped and publicly disclosed.
Yet while Congress excoriated the tycoons who created this mess, they left almost all disclosure authority in the hands of Treasury Secretary Henry Paulson. In fact, the only party truly mandated to disclose its activities under the new plan is the government buying up the toxic assets — not the banks who packaged and sold the assets. Even those hedge funds whose short selling had battered the stock market were able to report their short positions to the Securities and Exchange Commission confidentially, rather than expose them to public scrutiny, during the SEC’s ban on short sales meant to restore confidence in battered investment markets.
DEAR FOX, PLEASE CARE FOR MY HENHOUSE: CONGRESS YIELDS TO PAULSON
What will the investing public — which is to say, every taxpayer who has “invested” in this program, whether they like it or not — learn about many of the troubled assets their hard-earned dollars have bought? The answer may be “not much.” As the final version of the bill reads, the Treasury “Secretary shall determine whether the public disclosure required for such financial institutions with respect to off-balance sheet transactions, derivatives instruments, contingent liabilities, and similar sources of potential exposure is adequate to provide to the public sufficient information as to the true financial position of the institutions.
“If such disclosure is not adequate for that purpose, the Secretary shall make recommendations for additional disclosure requirements to the relevant regulators.”
Note the phrase “derivatives instruments” — the key cog in this messy problem’s engine. In their most basic form, these were “side bets” placed by investors who did not invest in whether the banks packaging the loans would succeed or fail — rather, these investors wagered whether the bundles of mortgages sold across the globe by investment banks would perform or default. You may know how that turned out — but, unless Secretary Paulson deems it necessary, you won’t know what, if anything, has been done to regulate and provide accountability to the class of investments at the heart of this problem.
Independent oversight will be the key to compel transparency into the marketplace and provide incentives for parties to amend their trading and valuation habits. While the government will have its hands full, as we’ll discuss next month, independent fraud examiners and forensic accountants will likely be called upon to help sort out the details and provide accountability as execution of this plan takes shape.
IN THE NEXT ISSUE
In the December issue, we’ll look at how the government’s investigative agencies — notably the Federal Bureau of Investigation, various U.S. Attorneys and the Treasury Department’s investigators are probing how the problems happened, and what the patterns discovered can tell us about how best to prevent their recurrence.