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Rating Agencies, Financial Regulation and Goodhart’s Law

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It was only a matter of time given the focus on the Goldman-SEC case before someone decided to apportion some of the blame onto the ratings agencies. And sure enough, the New York Times has a story out on how the ratings agencies were an integral part of the problem because they gave banks free access to their models and ratings methodology. But this is true of all banking regulations – banking regulators too make their rules, models and methodology freely available to banks who then proceed to arbitrage these rules, primarily to minimise the capital that they are required to hold. This is not surprising given that ratings agencies are essentially an outsourced function of the banking regulatory apparatus. And the problem of arbitrage is also well-known – I have referred to it as the Goodhart’s Law of financial regulation.

The NYT article implicitly suggests that increasing the opacity and ambiguity around the ratings methodology would have resulted in a better outcome. This is similar to how Google tries to discourage people from trying to arbitrage its search algorithm by keeping it opaque. Just keeping the algorithm private is not enough as search-engine optimisers soon figure out the key features of the algorithm by experimenting with what works and what does not, which means that Google needs to continuously modify the algorithm to stay one step ahead of the arbitrageurs.

Maintaining a continuously updated, opaque algorithm is not a suitable strategy for ratings agencies. Even if a banker does not know the exact ratings methodology, he can easily figure out the key features just by running a large number of sample portfolios through the ratings system and analysing the results. Moreover, ratings methodologies that are unpredictable by design can create unnecessary ratings volatility and friction in financial markets. And last but not least, ratings agencies have no incentive to engage in such an arms race with the banks given that they get paid by the bank only when a deal gets done.

The role of ratings agencies in exacerbating the financial crisis has been exaggerated. As David Merkel puts it, “Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.” The mad rush to buy AAA bonds in the boom wasn’t as much a function of the irrational faith in ratings agencies as it was a function of the rational desire to obtain extra yield whilst not falling foul of internal and external rules and regulations. Even internal control functions in firms often limit the scope of investments by specifying minimum required ratings and then assume that this requirement makes all further supervision of the manager redundant. Unsurprisingly, the manager prefers even an expensive AAA to a cheap BBB bond.

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Written by Ashwin Parameswaran

April 24th, 2010 at 1:31 pm

Did Goldman Mislead ACA?

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Having reviewed Goldman’s extended submission to the SEC, I have to agree with Erik Gerding at the Conglomerate who concludes that “if the SEC can show Goldman misrepresented Paulson’s role to ACA, it wins.”

I speculated in my previous post that “much of the case will depend upon whether using the term “Transaction Sponsor” to describe Paulson was an act of deception” and Goldman seems to agree, devoting an entire page (pg 33) in their submission to counter this allegation. The arguments that Goldman presents are unconvincing – as Goldman asserts, it is indisputable that the term “Transaction Sponsor” is not “uniformly defined in the context of a CDO transaction, and it need not refer to an equity investor.” However, the real question is whether it is reasonable to refer to a hedge fund seeking to short the tranches without any long exposure to the CDO as a “Transaction Sponsor”. Even allowing for the admittedly wide ambit of the term, this is a generous interpretation. As I mentioned earlier, it is relevant whether there is any industry precedent for such a definition of the term – my hunch is that there isn’t.

Also relevant are Gail Kreitman’s non-response to Laura Schwartz of ACA’s request for clarification on Paulson’s role, and Fabrice Tourre’s description of the equity tranche as pre-committed” . The defence put forward for both are a little troubling. Essentially, Fabrice Tourre “testified that he had no recollection of its meaning” and Ms. Kreitman was just an intermediary who did not understand “the significance of Ms. Schwartz’s statements suggesting that she believed Paulson to be an equity investor”.

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Written by Ashwin Parameswaran

April 19th, 2010 at 3:40 pm

Posted in Financial Crisis

The “Abacus Affair” : Goldman’s Defence

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Goldman’s rebuttal of the SEC lawsuit raises some specific points that deserve further analysis.

Goldman Sachs Lost Money On The Transaction.”

Whether Goldman made money or not would have been relevant if they were just an investor like IKB. However Goldman is not just an investor, it is a market-maker. Whether a market-maker loses or makes money on a specific trade with a client is irrelevant. The market-maker’s role is to tailor the product desired by the client and hedge out the residual risk with other counterparties in the market. The ultimate loss or profit on one trade is irrelevant unless considered in the context of the exposures of the trading book as a whole.

In this particular case, the residual equity exposure could have been left unhedged because it was a natural hedge to other positions in the book. Else, it could have been dynamically delta-hedged in the market via CDS on the underlying. Or it could have been macro-hedged via a short position on an index. The point is that analysing the profit or loss on an isolated trade in the book of a market-maker is meaningless.

“Extensive Disclosure Was Provided…..These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.”

This is Goldman’s strongest rebuttal as sufficient disclosure on the asset pool was likely provided. Moreover, the argument that Goldman does not have to disclose that Paulson is on the short side is even stronger than most commentators realise. From the perspective of Abacus as a legal entity, the short side is Goldman itself. Paulson is only Goldman’s hedge against their exposure arising from Abacus. This is clear from slide 50 in the Abacus pitchbook which represents Goldman as the “Protection Buyer”.

What is unusual however is that Paulson was short the tranches themselves rather than the underlying bonds. From Paulson’s perspective, this makes sense as it enables him to short only the mezzanine and senior tranches and avoid the equity which would have been the most expensive tranche to go short (Shorting all the underlying bonds is equivalent to shorting all the tranches of the CDO). But nevertheless this is not common in structured products in any asset class. Most structured products involve the market-maker constructing a bespoke product for the client and managing the residual exposure via dynamic hedging. So in this case, Goldman would buy CDS referencing the underlying bonds, sell as many tranches as it can or wants to sell, and manage the residual exposure. In this case, that was the equity exposure and in many other cases as I have analysed before, it was the super-senior tranche. If exact matching hedges had to be found in the market for each product sold to a client, then the business of structured products would not exist. In this respect, Goldman’s assertion that each transaction includes a long and short side is technically accurate but a little bit disingenuous – most synthetic CDOs like most other structured products do not have a market counterparty other than the market-maker who is short exactly the same product. I suspect however that from a legal perspective, this is not relevant.

“ACA, the Largest Investor, Selected The Portfolio.”

The fact that ACA Asset Management was the “Portfolio Selection Agent” is Goldman’s best defense. But the assertion that ACA was the largest investor is true only in the most trivial sense. ACA Asset Management which selected the portfolio had no investment in Abacus. It was its parent company, ACA Capital which in the course of its normal business of insuring super-senior tranches had a $951 million exposure to the transaction. This may seem like an irrelevant distinction but it is not. The usual method of ensuring that the managers’ interests are aligned to those of the transaction would be to have the manager invest in the equity tranche of the transaction as ACA had done in the past. As per slide 31 of the pitchbook, ACA had over $200 million invested in the equity of the CDOs it manages.

All this tells us is that ACA Capital trusted that its asset management subsidiary had done a competent job and was more likely to guarantee against losses on the super-senior given the role of ACA Asset Management. But did this influence the incentives of ACA Asset Management and its asset managers? That seems unlikely given that it was ACA Capital’s prerogative to do its own due diligence even if its asset management subsidiary was the manager of the CDO in question and the decision to invest by ACA Capital was likely separate from, albeit influenced by the decision to manage the CDO.

Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor”

This is clearly the crux of the case. The SEC seems to assert that it was Goldman’s responsibility to disabuse ACA of the mistaken assumption it made that Paulson was an equity investor. The complaint also quotes an email from Fabrice Tourre to ACA where he explicitly refers to Paulson as the “Transaction Sponsor” (page 14 of the complaint). At best, this description is misleading. It is a stretch to describe a counterparty who is short the exact tranches being marketed to investors as a “Transaction Sponsor”. I suspect much of the case will depend upon whether using the term “Transaction Sponsor” to describe Paulson was an act of deception. In this respect, it is relevant whether there is any precedent of counterparties seeking to short the tranches being referred to in this manner. My suspicion is that Goldman’s definition of “Transaction Sponsor” does not have much precedent. None of this however absolves ACA of its share of blame – it should have obtained written clarification that Paulson was the equity investor failing which it should have refused to do the deal.

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Written by Ashwin Parameswaran

April 18th, 2010 at 5:17 pm

Posted in Financial Crisis

The Magnetar Trade

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The Magnetar Trade according to ProPublica’s recent article is a long-short strategy that worked due to the perverse incentives operating in the CDO market during the boom. According to Jesse Eisinger and Jake Bernstein, Magnetar went long the equity tranche and short the senior tranches and used their position as the buyer of the equity tranche to ensure that the asset quality of the CDO was poorer than it would otherwise be. If ProPublica’s account is true, then this is a moral hazard trade i.e. Magnetar buys insurance against the burning down of a house and uses its influence as an equity buyer to significantly improve the odds of the house burning.

However, there are some hints in Magnetar’s response to the story that cast significant doubt on the accuracy of ProPublica’s narrative. To understand why this is the case, we need to understand what exactly the Magnetar trade as described in the story would look like. Magnetar’s portfolio was most likely a “close to carry neutral” portfolio consisting of long equity tranche positions and short senior/mezzanine tranche positions. In order to be carry-neutral, the notional value of senior tranches that are shorted needs to be an order of magnitude higher than the notional value of equity tranches purchased. In option parlance, this is equivalent to a zero-premium strategy consisting of short ATM options and long OTM options.

There are two reasons to execute such a strategy – one, simply to fund a “short options” strategy and the second, to execute a market-neutral “arbitrage” strategy. The significant advantage that such a long-short strategy has over a “naked short” strategy a la John Paulson is the absence of negative carry. As Taleb explains: “A butterfly position allows you to wait a lot longer for the wings to become profitable. In other words, a strategy that involves a butterfly allows you to be far more aggressive [when buying out-of-the-money options]. When you short near-the-money options, they bring in a lot of cash, so you can afford to spend more on out-of-the-money options. You can do a lot better as a spread trader.”

However, Magnetar describe their portfolio as market-neutral and “designed to have a positive return whether housing performed well or did poorly”.This implies that the portfolio was carry-positive i.e. the coupons on the long-equity positions exceeded the running-premium cost of buying protection on the senior tranches. This ensures that the portfolio will be profitable in the event that there are no defaults in the portfolio.

If the Magnetar Trade was based upon moral hazard, then it would have to short the senior tranches of the same CDO that it bought equity in and the notional of this short position would have to be multiples of the notional value of the equity position. However, Magnetar in their response to ProPublica explicitly deny this and state: “focusing solely on the group of CDOs in which Magnetar was the initial purchaser of the equity, Magnetar had a net long notional position. To put this into perspective, Magnetar would earn materially more money if these CDOs in aggregate performed well than if these CDOs performed poorly.” The operative term here is “net long notional position” as opposed to “net long position”. A net long position measured in delta terms could easily imply a net short notional position in which case the portfolio would outperform if all the tranches in the CDO were wiped out. But Magnetar seem to make it clear in their response that in the deals where they were the initial purchaser of equity, the notional of the equity positions exceeded the notional of the senior positions that they were short. They also assert that “the majority of the notional value of Magnetar’s hedges referenced CDOs in which Magnetar had no long investment” i.e. of course the notional value of their short positions exceeded that of their long positions, but these short positions were in other CDOs in which they did not have a long position.

But what about the fact that Magnetar seemed to be influencing the portfolio composition of these CDOs to include riskier assets in them? Surely this proves conclusively that Magnetar would profit if the CDOs collapsed? To understand why this may not necessarily be true, we need to examine the payoff profile of the Magnetar trade.

As with most market-neutral “arbitrage” trades, it is unlikely that the trade would deliver a positive return in every conceivable scenario. Rather, it would deliver a positive return in every scenario that Magnetar deemed probable. The Magnetar trade would pay off in two scenarios – if there were no defaults in any of their CDOs, or if there were so many defaults that the tranches that they were short also defaulted alongwith the equity tranche. The trade would likely lose money if there were limited defaults in all the CDOs and the senior tranches did not default. Essentially, the trade was attractive if one believed that this intermediate scenario was improbable.

A distribution where intermediate scenarios are improbable can arise from many underlying processes but there is one narrative that is particularly relevant to complex adaptive systems such as financial markets. Intermediate scenarios are unlikely when the system is characterised by multiple stable states and “catastrophic” transitions between these states. In adaptive systems such as ecosystems or macroeconomies, such transitions are most likely when the system is fragile and in a state of low resilience. The system tends to be dominated by positive feedback processes that amplify the impact of small perturbations, with no negative feedback processes present that can arrest this snowballing effect.

It turns out that such a framework was extremely well-suited to describing the housing market before the crash. Once house prices started falling and refinancing was no longer an option, the initial wave of defaults triggered a vicious cycle of house price declines and further defaults. Similarly, collateral requirements on leveraged investors, mark-to-market pressures and other positive feedback processes in the market created a vicious cycle of price declines in the market for mortage-backed securities and CDOs.

So what does all this have to do with Magnetar’s desire to include riskier assets in their long equity portfolios? If one believes that only a small perturbation is required to tip the market over into a state of collapse, then the long position should be weighted towards the riskiest possible asset portfolio. Essentially, the above framework implies that there is no benefit to having “safer” long positions in the long-short portfolio. The fragility of the system means that either there is no perturbation and all assets perform no matter how low-quality they are, or there is a perturbation and even “high quality” assets default.

The above framework of catastrophic shifts between multiple stable states is not uncommon, especially in fixed income markets. In fact, the Greek funding situation is a perfect example. If one had to sketch out a distribution of the yield on Greek debt, it is likely that intermediate levels are the least likely scenarios. In other words, either Greece funds at low sustainable rates or it moves rapidly to a state of default – it is unlikely that Greece raises say 50 billion Euros at an interest rate of 10%. The situation is of course made even more stark by Greece’s inability to inflate away its debt via the printing press. Of course, the bifurcation exists in fiat currency issuing countries as well, but at the point when hyperinflation kicks in.

Bank incentives are the real problem

Even if my arguments are valid, it is nevertheless obvious that even if Magnetar may not have executed the moral hazard trade, someone else could quite easily have done so. But the moral hazard trade was only possible because there was sufficient investor demand for the rated tranches of the CDO and even more crucially, because the originating bank was willing to hold onto the super-senior tranche. As I have discussed many times earlier in detail, bank demand for super-senior tranches is a logical consequence of the cheap leverage that they are afforded via the moral hazard subsidy of the TBTF doctrine. If banks were less levered, many of these deals would not have been issued at all.

In fact, two of the hedging strategies that we know were implemented in banks – UBS’ “AMPS” strategy and Howie Hubler’s trade in Morgan Stanley – were mirror images of the Magnetar trade. It is not a coincidence that bank traders chose the negatively skewed payoff distribution and Magnetar chose the positively skewed one.

Disclaimer: The above note is just my analysis of the facts and assertions in ProPublica’s article. I have no additional knowledge of the facts of the case and it is entirely possible that Magnetar are being less than fully forthright in their responses to the story. The above analysis is more useful as an illustration of how the facts as described in the article can be reconciled to a narrative that does not imply moral hazard.

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Written by Ashwin Parameswaran

April 11th, 2010 at 4:19 pm

Diversity and the Political Economy of Banking

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From a system resilience viewpoint, there are many reasons why a reduction in diversity is harmful. But one of the lesser appreciated benefits of a diverse pool of firms in an industry is the impact it has in reducing the political clout that the industry wields. Diversity is one of the best defences against crony capitalism. As Luigi Zingales explains, commenting here on the political impact of Gramm-Leach-Bliley: “The real effect of Gramm-Leach-Bliley was political, not directly economic. Under the old regime, commercial banks, investment banks, and insurance companies had different agendas, and so their lobbying efforts tended to offset one another. But after the restrictions were lifted, the interests of all the major players in the financial industry became aligned, giving the industry disproportionate power in shaping the political agenda. The concentration of the banking industry only added to this power.”

There’s been a lot of discussion recently on the merits of breaking up the big banks and one of the arguments in favour of this policy is the perceived reduction in the political clout that the banks would possess. Arnold Kling, for example, lays out the thesis in this recent article. Breaking up the banks may help but I would argue that the impact of such a move on the political economy of banking will be limited unless the industry becomes less homogenous.

The prime driver of this homogeneity is the combination of the moral hazard subsidy and regulatory capital guidelines which ensures that there is one optimal strategy that maximises this subsidy and outcompetes all other strategies. This strategy is of course to maintain a highly levered balance sheet invested in low capital-intensity, highly-rated assets.

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Written by Ashwin Parameswaran

April 6th, 2010 at 4:21 pm

Maturity Transformation and the Yield Curve

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Maturity Transformation (MT) enables all firms, not just banks to borrow short-term money to invest in long-term projects. Of course, banks are the most effective maturity transformers, enabled by deposit insurance/TBTF protection which discourages their creditors from demanding their money back all at the same time and a liquidity backstop from a fiat currency-issuing central bank if panic sets in despite the guarantee. Given the above definition, it is obvious that the presence of MT results in a flatter yield curve than would be the case otherwise (Mencius Moldbug explains it well and this insight is implicit as well in Austrian Business Cycle Theory). This post tries to delineate the exact mechanisms via which the yield curve flattens and how the impact of MT has evolved over the last half-century, particularly due to changes in banks’ asset-liability management (ALM) practices.

Let’s take a simple example of a bank that funds via demand deposits and lends these funds out in the form of 30-year fixed-rate mortgages. This loan if left unhedged exposes the bank to three risks: Liquidity Risk, Interest Rate Risk and Credit Risk. The liquidity risk is of course essentially unhedgeable – it can and is mitigated by for example, converting the mortgage into a securitised form that can be sold onto other banks. But the gap inherent in borrowing short and lending long is unhedgeable. The credit risk of the loan can be hedged but often is not, as compensation for taking on credit risk is one of the fundamental functions of a bank. However, the interest rate risk can be and often is hedged out in the interest rate swaps market.

Interest Rate Risk Management in Bank ALM

Prior to the advent of interest rate derivatives as hedging tools, banks had limited avenues to hedge out interest rate risk. As a result, most banks suffered significant losses whenever interest rates rose. For example, after World War II, US banks were predominantly invested in fixed rate government bonds they had bought during the war. Martin Mayer’s excellent book on ‘The Fed’ documents a Chase banker who said to him in reaction to a Fed rate hike in 1952 that “he never thought he would live to see the day when the government would deliberately make the banking system technically insolvent.” The situation had not changed much even by the 1980s – the initial trigger that set off the S&L crisis was the dramatic rise in interest rates in 1981 that rendered the industry insolvent.

By the 1990s however, many banks had started hedging their duration gap with the aim of mitigating the damage that a sudden move in interest rates could do to their balance sheets. One of the earlier examples is the case of Banc One and the HBS case study on the bank’s ALM strategy is a great introduction to the essence of interest rate hedging. More recently, the Net Interest Income (NII) sensitivity of Bank of America according to slide 35 in this investor presentation is exactly the opposite of the typical maturity-transforming unhedged bank – the bank makes money when rates go up or when the curve steepens. But more importantly, the sensitivity is negligible compared to the size of the bank which suggests a largely duration-matched position.

In the above analysis, I am not suggesting that the banking system does not play the interest carry trade at all. The FDIC’s decision to release an interest rate risk advisory in January certainly suggests that some banks are. I am only suggesting that if a bank does play the carry trade, it is because it chooses to do so and not because it is forced to do so by the nature of its asset-liability profile. Moreover, the indications are that many of the larger banks are reasonably insensitive to changes in interest rates and currently choose not to play the carry game ( See also Wells Fargo’s interest rate neutral stance ).

What does this mean for the impact of MT on the yield curve? It means that the role of the interest rate carry trade inherent in MT in flattening the yield curve is an indeterminate one. At the very least, it has a much smaller role than one would suspect. Taking the earlier example of the bank invested in a 30-year fixed rate mortgage, the bank would simply enter into a 30-year interest rate swap where it pays a fixed rate and receives a floating rate to hedge away its interest rate risk. There are many possible counterparties who want to receive fixed rates in long durations – two obvious examples are corporates who want to hedge their fixed rate issuance back into floating and pension funds and life insurers who need to invest in long-tenor instruments to match their liabilities.

So if interest rate carry is not the source of the curve flattening caused by MT, what is? The answer lies in the other unhedged risk – credit risk. Credit risk curves are also usually upward sloping (except when the credit is distressed) and banks take advantage by funding themselves at a very short tenor where credit spreads are low and lending at long tenors where spreads are much higher. This strategy of course exposes them to the risk of credit risk repricing on their liabilities and this was exactly the problem that banks and corporate maturity transformers such as GE faced during the crisis. Credit was still available but the spreads had widened so much that refinancing at those spreads alone would cause insolvency. This is not dissimilar to the problem that Greece faces at present.

The real benefit of the central bank’s liquidity backstop is realised in this situation. When interbank repo markets and commercial paper markets lock up as they did during the crisis, banks and influential corporates like GE can always repo their assets with the central bank on terms not available to any other private player. The ECB’s 12-month repo program is probably the best example of such a quasi-fiscal liquidity backstop.


Given my view that the interest rate carry trade is a limited phenomenon, I do not believe that the sudden removal of MT will produce a “smoking heap of rubble” (Mencius Moldbug’s view). The yield curve will steepen to the extent that the credit carry trade vanishes but even this will be limited by increased demand from long-term investors, most notably pension funds. The conventional story that MT is the only way to fund long-term projects ignores the increasing importance of pension funds and life insurers who have natural long-tenor liabilities that need to be matched against long-tenor assets.

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Written by Ashwin Parameswaran

April 4th, 2010 at 5:54 am

Modigliani-Miller and Banking

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Alan Greenspan’s paper on the financial crisis calls for regulatory capital requirements on banks to be increased but also warns that there are limits to how much they can be increased. In his words: “Without adequate leverage, markets do not provide a rate of return on financial assets high enough to attract capital to that activity. Yet at too great a degree of leverage, bank solvency is at risk.” Greg Mankiw wonders whether the above assertion does not violate the Modigliani-Miller Theorem and is right to do so. Although Greenspan’s conclusion is correct, his argument is incomplete and misses out on the key reason why leverage matters for banks – the implicit and explicit creditor guarantee.

I explained the impact of creditor protection on banks’ optimal leverage in my first note. The conclusions which I summarised in a more concise form in this note are as follows: Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value. In a simple Modigliani-Miller world, the optimal leverage for a bank is therefore infinite. Even without invoking Modigliani-Miller, the argument for this is intuitive. If each incremental unit of debt is issued at less than its true economic cost due to deposit insurance or the TBTF doctrine, it “increases the size of the pie” and adds to firm value. In reality of course, there are many limits to leverage, the most important being regulatory capital requirements.

Indeed, the above is the main reason why we have any regulatory capital requirements at all. In the absence of regulation, a bank with blanket creditor protection will likely choose to operate with minimal equity capital especially when it has negligible franchise value or is insolvent. This is exactly what happened during the S&L crisis when bankrupt S&Ls with negligible franchise value bet the farm on the back of a capital structure almost completely funded by insured deposits.

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Written by Ashwin Parameswaran

March 30th, 2010 at 3:17 pm

Employee Whistle-blowers as an Effective Mechanism to Uncover Fraud

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One of the more predictable discoveries in Anton Valukas’ report on Lehman was the fate of the lone employee whistleblower and the reaction of the audit firm to the whistleblower’s allegations. Much ink has been spilt on improving the regulatory framework to avoid another Lehman (See for example TED). Improving the incentives for employee whistleblowers to come forward is an important regulatory imperative that has not received the attention that it deserves. All whistleblowers, not just employees, play a key role in uncovering fraud in corporations. The bulk of this post is derived from the excellent work done in this regard by Dyck, Morse and Zingales(henceforth DMZ) and Bowen, Call and Rajgopal.

Compared to other whistleblowers, employees have the best access to the information required to uncover fraud. They also possess the knowledge to analyse and parse the information for any signs of fraud. This is especially important in a field such as banking where outsiders rarely possess the knowledge to uncover fraud even when they possess the raw information – a key reason why the media is so ineffective in uncovering banking fraud compared to its role in other industries which DMZ highlight.

One might ask why auditors are so ineffective in uncovering fraud despite possessing the relevant information. One reason is the aforementioned lack of knowledge required to uncover fraud in complex situations. But a more crucial reason is that auditors are incentivised to ignore fraud. In DMZ’s words: “we find a clear cost for auditors who blow the whistle. The auditor of a company involved with fraud is more likely to lose the client if he blows the whistle than if he does not, while there is no significant evidence that bringing the fraud to light pays him off in terms of a greater number of accounts.”

So what prevents more employee whistleblowers from coming forward? As DMZ note, many whistleblowers prefer to remain anonymous because : “In spite of being selected cases (for which the expected benefit of revealing should exceed the expected cost), we find that in 82 percent of cases, the whistleblower was fired, quit under duress, or had significantly altered responsibilities. In addition, many employee whistleblowers report having to move to another industry and often to another town to escape personal harassment. The lawyer of James Bingham, a whistleblower in the Xerox case, sums up Jim’s situation as: “Jim had a great career, but he’ll never get a job in Corporate America again.”….. consequences to being the whistleblower include distancing and retaliation from fellow workers and friends, personal attacks on one’s character during the course of a protracted dispute, and the need to change one’s career. Not only is the honest behavior not rewarded by the market, but it is penalized.” i.e. employers prefer loyal employees to honest ones, just as they prefer loyal auditors to honest auditors.

SarbanesOxley contained many provisions aimed at protecting whistleblowers. Quoting from Bowen, Call and Rajgopal: “In response to Enron, WorldCom and other scandals, Congress passed the SarbanesOxley Act (SOX) in July 2002, which in part made it unlawful for companies to take negative action against employees who disclose “questionable accounting or auditing matters.” (See SOX section 806, codified as title 15 U.S.C., § 78f(m)(4).) Under the whistleblower provisions of SOX, employees who disclose improper financial practices receive greater protection from discrimination. (See title 18 U.S.C., § 1514A(a)(1).) SOX also ruled that every company quoted on a U.S. Stock Exchange must set up a hotline enabling whistle-blowers to report anonymously (Economist 2006).” DMZ offer many possible explanations for why these provisions have not succeeded: “One possible explanation is that rules which strengthen the protection of the whistleblowers’ current jobs offer only a small reward relative to the extensive ostracism whistleblowers face. Additionally, just because jobs are protected does not mean that career advancements in the firm are not impacted by whistle blowing. Another explanation could be that job protection is of no use if the firm goes bankrupt after the revelation of fraud.”

So what else can be done to encourage employees to come forward? Unsurprisingly, DMZ find that monetary incentives have a role to play and I agree. Employee whistleblowers play a more significant role in industries such as healthcare where Qui tam” suits are available. I would assert that monetary incentives have an even stronger role to play in uncovering fraud in banking. The extremely high lifetime pay expected in the course of a banking career combined with the almost certainly career-ending implications of becoming a whistleblower means that any employee will think twice before pulling the trigger. Moreover, the extremely specialised nature of the industry means that many senior bankers have very few alternative industries to move to.

The focus of SOX on making it harder to fire whistleblowers is misguided as well as ineffective. The focus must be not to keep whistleblowers from losing their jobs but to compensate them sufficiently so that they never have to work again. As it happens, the scale of fraud in financial institutions means that this may even be achieved without spending taxpayer money. The whistleblower may be allowed to claim a small percentage of the monetary value of the fraud prevented from the institution itself, which should be more than sufficient for the purpose.

The obvious objection to my proposal is that this will lead to a surge in frivolous claims from disgruntled employees. For one, the monetary reward is dependent on fraud being proven in a court of law and the likely career-ending nature of becoming a whistleblower should be enough to prevent any frivolous allegations. Indeed, DMZ find that the percentage of frivolous lawsuits is lower in the healthcare industry where “qui tam” suits are available.

As DMZ point out, “the idea of extending the qui tam statue to corporate frauds (i.e. providing a financial award to those who bring forward information about a corporate fraud) is very much in the Hayekian spirit of sharpening the incentives of those who are endowed with information.” This is even more crucial in uncovering fraud in a complex industry such as banking where even qualified outsiders may struggle to put the pieces together and informed insiders face such steep deterrents that prevent them from rocking the boat.

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Written by Ashwin Parameswaran

March 17th, 2010 at 5:13 pm

Posted in Financial Crisis

Notes on the Evolutionary Approach to the Moral Hazard Explanation of the Financial Crisis

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In arguing the case for the moral hazard explanation of the financial crisis, I have frequently utilised evolutionary metaphors. This approach is not without controversy and this post is a partial justification as well as an explication of the conditions under which such an approach is valid. In particular, the simple story of selective forces maximising the moral hazard subsidy that I have outlined is dependent upon the specific circumstances and facts of our current financial system.

The “Natural Selection” Analogy

One point of dispute is whether selective forces are relevant in economic systems. The argument against selection usually invokes the possibility of firms or investors surviving for long periods of time despite losses i.e. bankruptcy is not strong enough as a selective force. My arguments rely not on firm survival as the selective force but the principal-agent relationship between investors and asset managers, between shareholders and CEOs etc. Selection kicks in much before the point of bankruptcy in the modern economy. In this respect, it is relevant to note the increased prevalence of shareholder activism in the last 25 years which has strengthened this argument. Moreover, the natural selection argument only serves as a more robust justification for the moral hazard story that does not depend upon explicit agent intentionality but is nevertheless strengthened by it.

The “Optimisation” Analogy

The argument that selective forces lead to optimisation is of course an old argument, most famously put by Milton Friedman and Armen Alchian. However, evolutionary economic processes only lead to optimisation if some key assumptions are satisfied. A brief summary of the key conditions under which an evolutionary process equates to neoclassical outcomes can be found on pages 26-27 of this paper by Nelson and Winter. Below is a partial analysis of these conditions with some examples relevant to the current crisis.


Genetic diversity is the raw material upon which Darwinian natural selection operates. Similarly, to achieve anything close to an “optimal” outcome, the strategies available to be chosen by economic agents must be sufficiently diverse. The “natural selection” explanation of the moral hazard problem which I had elaborated upon in my previous post, therefore depends upon the toolset of banks’ strategies being sufficiently varied. The toolset available to banks to exploit the moral hazard subsidy is primarily determined by two factors: technology/innovation and regulation. The development of new financial products via securitisation, tranching and most importantly synthetic issuances with a CDS rather than a bond as an underlying which I discussed here, has significantly expanded this toolset.


The story of one optimal strategy outcompeting all others is also dependent on environmental conditions being stable. Quoting from Nelson and Winter: “If the analysis concerns a hypothetical static economy, where the underlying economic problem is standing still, it is reasonable to ask whether the dynamics of an evolutionary selection process can solve it in the long run. But if the economy is undergoing continuing exogenous change, and particularly if it is changing in unanticipated ways, then there really is no “long run” in a substantive sense. Rather, the selection process is always in a transient phase, groping toward its temporary target. In that case, we should expect to find firm behavior always maladapted to its current environment and in characteristic ways—for example, out of date because of learning and adjustment lags, or “unstable” because of ongoing experimentation and trial-and-error learning.”

This follows logically from the ‘Law of Competitive Exclusion‘. In an environment free of disturbances, diversity of competing strategies must reduce dramatically as the optimal strategy will outcompete all others. In fact, disturbances are a key reason why competitive exclusion is rarely observed in ecosystems. When Evelyn Hutchinson examined the ‘Paradox of the Plankton’, one of the explanations he offered was the “permanent failure to achieve equilibrium” . Indeed, one of the most accepted explanations of the paradox is the ‘Intermediate Disturbance Hypothesis’ which concludes that ecosystem diversity may be low when the environment is free of disturbances.

Stability here is defined as “stability with respect to the criteria of selection”. In the principal-agent selective process, the analogous criteria to Darwinian “fitness” is profitability. Nelson and Winter’s objection is absolutely relevant when the strategy that maximises profitability is a moving target and there is significant uncertainty regarding the exact contours of this strategy. On the other hand, the kind of strategies that maximise profitability in a bank have not changed for a while, in no small part because of the size of the moral hazard free lunch available. A CEO who wants to maximise Return on Equity for his shareholders would maximise balance sheet leverage, as I explained in my first post. The stability of the parameters of the strategy that would maximise the moral hazard subsidy and accordingly profitability, ensures that this strategy outcompetes all others.

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Written by Ashwin Parameswaran

March 13th, 2010 at 5:22 am

Stability and Macro-Stabilisation as a Profound Form of the Moral Hazard Problem

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I have argued previously that the moral hazard explanation of the crisis fits the basic facts i.e. bank balance sheets were highly levered and invested in assets with severely negatively skewed payoffs. But this still leaves another objection to the moral hazard story unanswered – It was not only the banks with access to cheap leverage that were heavily invested in “safe” assets, but also asset managers, money market mutual funds and even ordinary investors. Why was this the case?

A partial explanation which I have discussed many times before relies on the preference of agents (in the principal-agent sense) for such bets. But this is an incomplete explanation. Apart from not being applicable to investors who are not agents, it neglects the principal’s option to walk away. A much better explanation that I mentioned here and here is the role of extended periods of stability in creating “moral hazard-like” outcomes. This is an altogether more profound and pervasive form of the moral hazard problem and lies at the heart of the Minsky-Holling thesis that stability breeds loss of resilience.

It is important to note that such an outcome can arise endogenously without any government intervention. Minsky argued that such an endogenous loss of resilience was inevitable but this is not obvious. As I noted here: “The assertion that an economy can move outside the corridor due to endogenous factors is difficult to reject. All it takes is a chance prolonged period of stability. However, this does not imply that the economy must move outside the corridor, which requires us to prove that prolonged periods of stability are the norm rather than the exception in a capitalist economy.”

But it can also arise as a result of macro-stabilising fiscal and monetary policies. Whether the current crisis was endogenous or not is essentially an empirical question. I have argued in previous posts that it was not and that the “Greenspan Put” monetary policy did as much damage as all the explicit bailouts did. The evidence behind such a view has been put forth well by David Merkel here and by Barry Ritholz in his book or in this excellent episode of Econtalk.

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Written by Ashwin Parameswaran

March 7th, 2010 at 10:07 am