Greenspan Characterized Regulatory Arbitrage as Desirable

Henry C.K. Liu

This article appeared in AToL on June 24, 2009 as
False profits and prophecies and
on the website of New Deal 2.0, a project of the Franklin and Eleanor Roosevelt Institute as
Of Profits and Prophecy: Alan Greenspan’s Errors in Judgment

In my June 18, 2009 AToL article:
Tip-toe regulatory reform, I referred to George Soros, the speculator who broke the Bank of England over its defense of the pound sterling, as having said in the Financial Times that a requirement for lenders selling securitized loans as securities to retain 5 per cent exposure "is more symbolic than substantive".  This is because many institutions were playing the game of regulatory arbitrage, the practice of taking advantage of a regulatory difference between two or more markets.

The issue of regulatory arbitrage was discussed  in my recent article (
May 25, 2009) on my website: Mark-to-Market vs Mark-to-Model, an abridged version of which also appeared on the website of New Deal 2.0, a project of the Franklin and Eleanor Roosevelt Institute.

AIG Financial Products (AIGFP), based in London where the regulatory regime was less restrictive, took advantage of AIG statue categorization as an insurance company and therefore not subject to the same burdensome rules on capital reserves as banks. AIG would not need to set aside anything but a tiny sliver of capital if it would insure the super-senior risk tranches of CDOs in its holdings. Nor was the insurer likely to face hard questions from its own regulators because AIGFS had largely fallen through the interagency cracks of oversight. It was regulated by the US Office for Thrift Supervision, whose staff had inadequate expertise in the field of cutting-edge structured finance products.
AIGFP insured bank-held super-senior risk CDOs in the broad CDS market. AIG would earn a relatively trifle fee for providing this coverage – just 0.02 cents for each dollar insured per year. For the buyer of such insurance, the cost is insignificant for the critical benefit, particularly in the financial advantage associated with a good credit rating, which the buyer receives not because the instruments are “safe” but only that the risk was insured by AIGFP. For AIG, with 0.02 cents multiplied a few hundred billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the supposedly non-existent risk. Regulators were told by the banks that a way had been found to remove all credit risk from their CDO deals.

As an example, an investor buys a CDS contract from a triple-A-rated Bank to insure against the eventuality of a counterparty defaulting, by making regular insurance payments to the bank for the protection. If the counterparty defaults on its commitment anytime during the duration of the contract by missing an agreed interest payment or failed to repay the principle at maturity, the investor will be assured to receive a one-off payment of the insured amount from the bank whose credit rating is triple-A and the CDS contract is terminated. If the investor actually holds the debt from the counterparty, the CDS contract works as a hedge against counterparty default.. But investors can also buy CDS contracts on debts they do not hold, but as a speculative play, to bet against the solvency of one side of the any counterpary relationship in a gamble to make money if it fails, or to hedge investments in other parties whose fortunes are expected to be similar to those of target party.

If a counterparty defaults, one of two things can happen:
1) the insured investor delivers a defaulted asset to the insurer Bank for a payment at par value. This is known as physical settlement, or
2) the insuring Bank pays the investor the difference between the par value and the market price of a specified debt obligation after recovery to cover the loss. This is known as cash settlement.

The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional value. For example, if the CDS spread of counterparty risk is 100  basis points (1%), then an investor buying $100 million worth of protection from the insuring Bank must pay the bank $1 million per year. These payments continue until either the CDS contract expires or the target counterparty defaults, at which point the insuring bank pays the insured of outstanding value owed by of the counterparty.

All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a particular counterparty with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can impact the comparison. When spread skyrocket during a market seizure, insurers can fail  because they are not required to adjust  regular income statements to show balance sheet volatility. This was what happened to AIG which provided no reserves for its CDS contracts.

Systemic Risk and Credit Rating

There were two dimensions to the cause of the current credit crisis. The first was that unit risk was not eliminated, merely transferred to a larger pool to make it invisible statistically. The second, and more ominous, was that regulatory risks were defined by credit ratings, and the two fed on each other inversely. As credit rating rose, risk exposure fell to create an under-pricing of risk. But as risk exposure rose, credit rating fell to exacerbate further rise of risk exposure in a chain reaction that detonated a debt explosion of atomic dimension.
The Office of the Comptroller of the Currency and the Federal Reserve jointly allowed banks with credit default swaps (CDS) insurance to keep super-senior risk assets on their books without adding capital because the risk was insured. Normally, if the banks held the super-senior risk on their books, they would need to post capital at 8% of the liability. But capital could be reduced to one-fifth the normal amount (20% of 8%, meaning $160 for every $10,000 of risk on the books) if banks could prove to the regulators that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a collateral debt obligation (CDO) structure carried a Triple-A credit rating from a “nationally recognized credit rating agency”, such as Standard and Poor’s rating on AIG.
With CDS insurance, banks then could cut the normal $800 million capital for every $10 billion of corporate loans on their books to just $160 million, meaning banks with CDS insurance can loan up to five times more on the same capital. The CDS-insured CDO deals could then bypass international banking rules on capital.  To correct this bypass is a key reason why the government wanted to conduct stress tests on banks in 2009 to see if banks need to raise new capital in a Downward Loss Given Default.
CDS contracts are generally subject to mark-to-market accounting that introduces regular periodic income statements to show balance sheet volatility that would not be present in a regulated insurance contract. Further, the buyer of a CDS does not even need to own the underlying security or other form of credit exposure. In fact, the buyer does not even have to suffer an actual loss from the default event, only a virtual loss would suffice for collection of the insured notional amount. So, at 0.02 cents to a dollar (1 to 10,000 odd), speculators could place bets to collect astronomical payouts in billions with affordable losses. A $10, 000 bet on a CDS default could stand to win $100,000,000 within a year. That was exactly what many hedge funds did because they could recoup all their lost bets even if they only won once in 10,000 years.  As it turns out, many only had to wait a a couple of years before winning a huge windfall. But until AIG was bailed out by the Fed, these hedge funds were not sure they could collect their winnings.

Alan Greenspan, 
the former chairman of the Federal Reserve under whose watch much regulatory arbitrage took place, was not unaware of the problem of regulatory arbitrage, but he chose to permit it as he viewed it as "desirable".

In The Role of Capital in Optimal Banking Supervision and Regulation
(FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998 page 163) Greenspan wrote :
"It is clear that our major banks have become quite efficient at engaging in such desirable forms of regulatory capital arbitrage, through securitization and other devices."

Greenspan wrote that "a reasonable principle for setting regulatory soundness standards is to act much as the market would if there were no safety net and all market participants were fully informed. For example, requiring all of our regulated financial institutions to maintain insolvency probabilities that are equivalent to a triple-A rating standard would be demonstrably too stringent because there are very few such entities among unregulated financial institutions not subject to the safety net."

He went on: "We have no choice but to continue to plan for a successor to the simple risk-weighting approach to capital requirements embodied within the current regulatory standard. While it is unclear at present exactly what that successor might be, it seems clear that adding more and more layers of arbitrary regulation would be counterproductive. We should, rather, look for ways to harness market tools and market-like incentives whenever possible, by using banks’ own policies, behaviors, and technologies in improving the supervisory process."

And he went further: "Finally, we should always remind ourselves that supervision and regulation are neither infallible nor likely to prove sufficient to meet all our intended goals. Put another way,
the Basle standard and the bank examination process, even if structured in optimal fashion, are a second line of support for bank soundness. Supervision and regulation can never be a substitute for a bank’s own internal scrutiny of its counterparties and for the market’s scrutiny of the bank. Therefore, we should not, for example, abandon efforts to contain the scope of the safety net or to press for increases in the quantity and quality of financial disclosures by regulated institutions."

In other words, Greenspan looked to self regulation as the first line of defense and increased disclosure as the appropriate path, not supervision and regulation.

Greenspan concluded: "If we follow these basic prescriptions, I suspect that history will look favorably on our attempts at crafting regulatory policy."

Unfortunately, Greenspan was unjustifiably complacent about how history would judge him and his views on regulation.

June 22, 2009