Infectious Greed (71 page)

The derivatives playing field is skewed in favor of Wall Street banks, thanks to financial-market lobbyists, especially ISDA, the International Swaps and Derivatives Association.
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In February 2002, Jeff Madrick, a financial expert writing in the
New York Review of Books,
expressed doubt that public pressure would lead government officials to change rules applicable to derivatives.
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He was correct, in part because derivatives were so difficult for people to understand. More recently, the media have paid some attention to derivatives, and the average investor has at least heard of swaps. Still, ISDA has waited quietly, ready to pounce on any serious regulatory proposals, just as it had pressed Congress to deregulate swaps in 2000.

Legislators and regulators need to understand that the more they listen to ISDA and carve up markets, the harder it is for anyone—regulators and corporate executives—to keep tabs on risks. Simply put, much of the $600-plus trillion derivatives market exists because private parties are doing deals to avoid the law. Regardless of whether you favor more or less regulation, that is an unhealthy result.

A similar and related problem is that regulators increasingly have emphasized narrow rules in an attempt to provide clarity to market participants. Accounting rules ostensibly tell parties exactly what they can count as revenue or what they must include as a liability on their balance sheets. Securities rules direct parties to disclose particular information every financial quarter. Elaborate guidelines specify how parties can satisfy these disclosure requirements, for example, by disclosing to investors a measure of Value At Risk (VAR)—the likely maximum one-day loss—for particular investments.

Market participants respond to these narrow rules by transacting around them. There have been numerous examples. Paul Mozer of Salomon engineered bids for clients in an attempt to satisfy the letter of the 35 percent maximum for U.S. Treasury auctions. The case against Mozer was successful only because he so brazenly bid more than 35 percent. Robert Citron of Orange County made huge interest-rate bets while technically in compliance with county investment guidelines, because he bought only short-term, AAA-rated, structured notes. Enron solicited outside investors to satisfy the three percent minimum, so that it could keep partnerships off balance sheet. Global Crossing followed accounting rules in booking up-front revenue from indefeasible right use (IRU) swaps. Specific rules made prosecuting officials of Enron and Global Crossing more difficult, because the executives could claim they were merely relying on an outside auditor's interpretation of the rule, or on counsel's advice that the rule permitted their actions.

Such narrow rules have two unanticipated effects. First, by clearly specifying what parties can and cannot do, the rules provide a safe haven for anyone doing something not explicitly covered by the rules. Absent a specific prohibition against doing so, companies increasingly recognize revenue up front, move liabilities off balance sheet, avoid disclosing important facts, or disclose misleading facts that arguably fit within the applicable rules. For example, Enron's VAR disclosures were so dubious that investors did not even flinch when the firm tripled its reported risk in 2000 and even admitted, in a footnote, that its previous VAR models had not worked properly.
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None of this mattered, because no one imagined that Enron's VAR disclosure was intended to do anything other than satisfy the applicable regulatory requirement.

Second, because specific rules are effectively carved in stone, they ensure that the regulatory regime will become obsolete, almost immediately. Rule changes take a great deal of time; the Financial Accounting Standards Board spent years debating changes to accounting rules for stock options and other derivatives. In contrast, financial innovation proceeds at a breakneck pace, with banks inventing new deals every day. Specific rules are inevitably left in the dust.

The lesson is that regulators need to shift away from narrow rules, which parties have shown skill in avoiding and exploiting, to broader standards, which would help encourage a culture of honesty.
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For example, a broad anti-abuse standard could prohibit companies from disclosing information contrary to economic reality, even if a technical accounting rule might permit them to do so. International accounting regulators have developed a few dozen general standards for parties to follow, the notion being that individual parties would exercise judgment to determine whether a particular accounting treatment was appropriate, given the standards. The SEC should follow suit.

It might seem at first that permitting financial actors to use their judgment in determining the regulatory treatment in specific cases would exacerbate the inaccuracies of financial reporting. Accountants, bankers, lawyers, and corporate executives have indeed spent the last decade exhibiting an eagerness to transact in order to avoid the law, in many cases being transformed from the professional “gatekeepers” of financial markets into horse traders and snake-oil salesmen. But one reason they have done so is that specific rules have given them cover. These actors have not needed to risk their own reputation for honesty; instead, they have relied on the bare letter of the law. In contrast, parties subject to a more general standard would be forced to rely on their own judgment about the fairness, risk, or economic reality of a transaction, and if those deals were later scrutinized, the parties would not be able to point to a specific rule as an excuse.

Recall the three percent rule—the rule that allowed companies to treat Special Purpose Entities as off balance sheet so long as an outside party bought at least three percent of the SPE's capital. Accounting regulators have debated whether some higher number—perhaps ten percent—would be more appropriate.
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But this path is a slippery slope. Would nine percent be appropriate for some deals? Would later rules specify what counted toward the ten percent? Or what type of outside investor was
truly independent? Instead of simply changing the percentage requirement of the specific rule, a better approach would be a general standard that requires companies to account for the value of their share of
all
outside investments, regardless of their ownership interest—including their share of the assets and liabilities of SPEs. To the extent a company wants to explain to investors why they shouldn't worry about the liabilities of a particular SPE, the company can do so in footnotes to its financial statements. But hiding liabilities should no longer be a valid reason to use SPEs. Outside the United States, international accounting standards are moving in this direction, but the U.S. approach remains unclear.

Likewise, proposed rules for calculating the amount of capital that financial institutions must set aside for particular risks—known as the Basel II proposal—include both specific rules and general standards, as in a provision for regulators to consider the core economic risks of credit-derivatives deals. This second approach—generalized standards based on economic reality—both discourages deals designed simply to avoid legal rules and encourages financial institutions to assess their own risks properly.

An approach using general standards could also require that companies publish their financial statements on the Internet and update them over time, according to changes in their businesses, rather than continue to focus on the strict requirement of reporting specified financial results once every quarter. If the reporting periods were more frequent, or perhaps were even staggered across different periods—a week here, a month there—investors and analysts would lose their obsession with end-of-quarter numbers, and the conflicts of interest associated with meeting quarterly expectations would dissipate.
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The idea of using broad standards in the financial context is not new. In 1969, the well-respected Judge Henry Friendly, in a case called
United States v. Simon
, found that accountants who technically had complied with Generally Accepted Accounting Principles could nevertheless be held criminally liable if the disclosures created a fraudulent or otherwise misleading impression among shareholders. In the
Simon
case, a footnote in Continental Vending's annual report had resembled the opaque disclosures in footnote 16 of Enron's 2001 annual report. As Judge Friendly put it, “the jury could reasonably have wondered how accountants who were really seeking to tell the truth could have constructed a footnote so well designed to conceal the shocking facts.”
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Unfortunately, the
Simon
case has influenced few market participants—in part because the defendants paid small fines and later were pardoned by President Richard M. Nixon.
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Nevertheless, Judge Friendly's reasoning is wise and powerful advice for regulators considering how to deal with the chaos of modern financial markets.

One specific instance of how regulators inadvertently created rules corrupting the financial markets is the pervasive power of gatekeeper institutions—accounting firms, law firms, banks, and credit-rating agencies—even given their abysmal performance in assessing and reporting risks. The securities laws recognize that managers of companies will always have an incentive to be aggressive in reporting their financial data. Instead of trying to dictate what managers can and cannot do, the U.S. regulatory regime creates and subsidizes these gatekeepers, who are supposed to monitor the inevitable conflict between managers and shareholders. This regime assumes that accounting firms actually do audits, law firms and banks actually perform due diligence, and credit-rating agencies properly analyze information about a company's debts. If the gatekeepers do their jobs, investors can look to them for an impartial, third-party perspective on corporate managers.

Gatekeepers benefit greatly from legal rules requiring that companies employ accounting firms to certify their financial statements, banks to underwrite their securities, law firms to examine the underlying documents and opine that they are legitimate, and credit-rating agencies to rate their bonds.
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Moreover, legal rules permit managers to insulate themselves from liability by involving gatekeeper firms in their transactions.

In other words, gatekeepers do not survive on the basis of their reputation alone, contrary to the assumptions of many academics. Economists have assumed a gatekeeper would not take advantage of investors, because if it did so, its reputation would suffer and no one would use its services. That view has proven as naïve as the belief that a twenty-dollar bill lying on the ground was not really there. During the past twenty years, gatekeeper institutions have performed unimaginably disreputable acts, but their reputations have suffered only a little—and their profits have not suffered at all. Gatekeepers will continue to earn substantial profits as long as rules supporting them persist. For example, no
matter how poor the credit-rating agencies are at predicting defaults, companies will still pay these agencies for ratings, because legal rules effectively require the companies to do so. (Recall the importance that Allen Wheat and CSFP placed on obtaining an AAA rating.) The same is true, to a somewhat lesser extent, for other gatekeepers.

One possible response to the failure of gatekeepers is to punish and reform them, as parents might try to change an unruly child. Beginning in 2002, the U.S. government attempted to do this for accountants, by imposing rules that constrained their behavior, and by prosecuting Arthur Andersen.

Such a punitive approach is doomed, unless it also addresses the oligopoly lock that gatekeepers have on their respective businesses. Put simply, gatekeepers do not have proper incentives to police corporate managers, because these institutions do not suffer sufficient reputational consequences even when they do a poor job of monitoring. The barriers to entry are too high: most corporate executives will not hire a low-cost competitor to Merrill Lynch, Ernst & Young, or Moody's, because the regulatory system punishes them for doing so, depriving them of an argument that they did their due diligence in a particular deal, or—in many instances—making their securities less attractive to outside investors by removing valuable regulatory entitlements. When prosecutors killed off Arthur Andersen, they only made the franchise associated with a top “Final Four” accounting firm more valuable. In the case of credit-rating agencies, only a few are approved for regulatory purposes, and the barrier to entry can be insuperable.

The bottom line is that reputation alone does not constrain the behavior of gatekeepers. They can acquire a bad reputation, so long as the structure of the financial system continues to require the use of their services. The legal rules that effectively require companies to hire gatekeepers are the answer to the oft-asked question about why gatekeepers make so much money.

There are two possible solutions. One is to eliminate the legal rules that effectively require that companies use particular gatekeepers (especially credit-rating agencies), while expanding the scope of securities-fraud liability and enforcement to make it clear that all gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements. This approach would require that Congress eliminate the regulatory reliance on credit ratings and remove the restrictions on securities lawsuits imposed during the
mid-1990s, so that gatekeepers could be held responsible for aiding and abetting financial fraud. Such changes would encourage new intermediaries to attempt to fill the shoes of the accountants, bankers, lawyers, and credit raters who have failed during the past decade.

The other possibility is to require that gatekeepers act in the public interest as “professionals,” and not merely for private gain. This suggestion might seem laughable to accountants and bankers, as the trend during the past decade has shifted from professionalism to profit. But if the markets are to be reformed without radical changes in law, then gatekeepers will need to improve practices on their own and prove they are deserving of their special place in financial regulation. Only then should the legal rules giving them such special status remain in place.