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Lynn Turner notes: The Honorable Senator Charles Schumer’s efforts described in this letter to the Big 4 are greatly misplaced (ed. note: the letter is posted in our “Credit Arrangements” Practice Area). Auditors did not make the problematic subprime loans, did not rate them or decide the terms on which the loans were made and certainly do not collect the loans. Now the Senator thinks auditors should fix the problem of subprime loans through greater obfusction and a lack of transparency by keeping these loans “off-balance sheet” in SPEs when the loans are restructured, as he pushes new accounting positions taken as a result of the credit and liquidity problems affecting the markets. He is also arguing auditors should get into the management of the loan portfolio and insist the loans be restructured. A unique role for independent auditors.

The Senator has jointly issued a report saying the US capital markets are not competitive. The current crisis also indicates they do not always act in a reasoned fashion, with appropriate pricing of risks. As a result, they are now requiring federal government intervention.

Unfortunately, some home owners and investors are both being hurt by the recent developments. Yet the reality of it is that borrowers will either have the ability to repay the required cash payments or some portion of the payments, or go into full default. If the borrowers can’t pay all the required payments, someone (the ultimate lendor/investor) has incurred a loss, which is less than transparent in these SPEs. If a home owner in default doesn’t make their payments, there is no way it doesn’t result in an economic loss for investors.

(Interestingly, it was Senator Schumer who inserted the language into Sarbanes-Oxley requiring a study of off-balance sheet financings and their magnitude so there would be increased transparency. He initially discussed language that would have required all the SPEs to be on the balance sheet, but ultimately went the study route.)

When it comes to contributing factors to the subprime credit and liquidity problems, it was the Senate Banking committee – of which the Senator is a member – that stood idly by, after being forewarned a year ago about the lax underwriting standards that existed and which have directly contributed to the problem. Unfortunately, it is perhaps worth remembering that USA Today reported that Senator Schumer took very substantial sums of money from Enron – and returned it after being embarrassed by the company’s scandal.

Perhaps even more important, on a going forward note, the banking regulators are considering a new regulation that will determine the amount of capital banks keep on hand, which provides them with a “cushion” of assets in the event of a financial crisis. This new regulation is called Basel II. However, the Chairman of the FDIC, which uses the backing of taxpayers to ensure deposits, has warned the new regulations if adopted without safeguards will INCREASE – not DECREASE – the susceptability of the financial system to a future crisis.

Will the Subprime Meltdown Affect the D&O Marketplace?

I feel like I could blog about the subprime meltdown continuously for weeks. Kevin LaCroix continues to do a great job as he analyzes how the meltdown might impact the D&O insurance market in his “D&O Diary” Blog.

Next Financial Crisis Starts Here

This Financial Times column by Clive Crook from last Thursday is worth reading:

“Washington is deserted in August, so demands for a political response to the financial-market debacle have been muted. Rest assured, this will change. The problem will not be dealt with by next month – things could easily get worse before they get better – and some appealing suspects are just asking for a regulatory beating. Enron and the other corporate scandals begat Sarbanes-Oxley. What will the subprime mortgage meltdown bring forth?

Observers of the subprime mortgage business (not counting those who work for it) had been predicting a breakdown for quite a while. Regulated banks do little if any such lending. Bank affiliates or independent mortgage companies have built the business – and they are, respectively, lightly regulated or virtually unregulated. They lent eagerly to borrowers of limited means, often on patently reckless terms (initially low “teaser” rates switching to expensive variable rates; interest-only loans; loans whose principal increased over time). Everything was premised on perpetually rising house prices.

The Federal Reserve was worried, but mainly on consumer-protection, not systemic-risk grounds. Lacking the will and the authority, it mostly failed to act and the business boomed. A lot of people who otherwise would have been unable to buy a house did so, which is good. How many of them hang on to their houses as this credit cycle unwinds, however, remains to be seen. Legislation will be needed to bring all mortgage lenders under the Fed’s supervision, so that basic standards of prudence can be enforced. This much seems likely to happen.

The harder question is whether new rules are needed for the wider financial system. On the face of it, the answer is Yes. One rationale for excluding non-bank lenders from Fed scrutiny is that they pose no systemic risk. So much for that. Wall Street financed the subprime boom by buying the loans – repackaged as securities, stamped AAA by the credit-rating agencies – and selling them on. This model, of course, made the original lenders even less attentive to loan quality. On the other hand, it spread the risk throughout the system, which was also thought to be a good thing – until the loans started to go bad. Then, it turned out, investors wanted to know where the risk was and nobody could say. Arriving as if from nowhere, that fear led to the freezing up of the credit system.

How are regulators to grapple with this? If the opacity of the system is the problem, then new scrutiny and disclosure requirements for secretive investors such as hedge funds and private-equity firms must be part of the remedy. But it could be that complexity, more than lack of transparency in its own right, is the issue. The accelerated pace of financial innovation and the ever-proliferating complication of modern financial instruments seem to defy the ability even of the products’ designers to fathom what is going on. And the new instruments are often thinly traded, if at all, so values are guessed by simulation or calculation, not in the market. Sophisticated investors are left poorly informed about the risks they are bearing; unsophisticated investors have not got a clue. Desirable as fuller disclosure by hedge funds and private equity firms may be, it is hard to believe that it will be enough.

In other words, financial innovation itself is the problem. This poses a dilemma. The benefits of modern finance are real: as its champions rightly say, it deserves much of the credit for the relative stability of the world economy in the past two decades. Stifling this innovation, or attempting to manage it, looks unpromising.

Part of the answer – and, along with fuller scrutiny, perhaps the best that can be done – is to create a climate where excessive risk-taking is more effectively discouraged, and punished when things go wrong. Here the role of the Fed is crucial, both in the boom phase of speculative cycles and in the bust. Fast-rising house and other asset prices have been buoyed by very low interest rates. It was enough for the Fed that consumer-price inflation was low; asset prices, in their own right, were not its concern. This set the scene for America’s remarkable debt-fuelled house-price surge – whose inevitable end was the proximate cause of the subprime collapse. The Fed’s long-maintained reluctance to weigh asset prices in its monetary policy calculations needs to go.

Then, when financial markets seize up, the Fed must take care, as far as possible, to avoid bailing out the culprits. As the economists, Willem Buiter and Anne Sibert, have argued, the Fed was wrong to cut the discount rate last week, and will compound the error if it soon cuts the more important Fed funds rate as many now expect – unless there is evidence of harm spreading to the real economy. Instead, honouring Walter Bagehot’s maxim, it should provide liquidity at a penalty rate (against conservatively valued collateral) to those so lacking in liquidity that they are willing to pay it. That memorably costly help should be available not just to banks, as now, but to hedge funds and other financial firms willing to accept the Fed’s terms.

It is a cliché, but nonetheless true, that the end of each financial crisis sows the seeds of the next. Better regulation has a place, but the Fed is the key to attacking that cycle.”

– Broc Romanek