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02 April 2015

GARP - Value, Financial Innovation and Regulation

I went along to a GARP event on Monday night, held at the Harmonie Club in NYC. The event was introduced by Stefan Magnusson, chapter co-director of GARP and MD Market Risk Americas at Rabobank. Jeremy Josse was the main speaker, doing a talk entitled "Value, Financial Innovation and Regulation" loosely based around his book "Dinosaur Derivatives and Other Trades".

Jeremy started by a quick introduction to himself, describing how he has worked for many financial institutions during his career, but his educational background also included philosophy and economics too. He suggested that much of risk management was about the math and the technical aspects of risk management, whereas he was going to focus more on meaning rather than the underlying detail. Like many an Englishman (!) he almost seemed apologetic for suggesting this but to bare with him as he pulled various strands of thought together.

Starting with Dinosaur Derivatives, Jeremy wondered whether there could be value today in a derivatives contract or option to buy a Megalodon. Given that a Megalodon is an extinct species of giant shark, you would think not given that physical delivery might be a problem. That said, Jeremy thinks there could be a market in such an option due to:

  • Brokers - generating demand
  • Control of supply
  • Liquidity - some illiquid assets trade at a 30% premium to illiquid ones
  • Arbitrage - based on some expectation of selling at a higher price
  • Habit

Jeremy then listed off some other assets and considered their value:

  • Gold - no utility in this asset glass, reputed as a "safe-haven" asset
  • Diamonds - again no fundamental utility
  • $ - a fiat currency built on "trust" with no underlying asset, with fiat currencies being used first in China around 1000 years ago
  • Contracts for Difference - again no intrinsic value to this asset class
  • Internet/Social Media stocks - Jeremy thinks we are in internet bubble 2.0 with group think leading valuations astray

Looking at the Theory of Valuation then the comparison of market value versus intrinsic value is really analogous to technical analysis (charting/trending) versus fundamental analysis (balance sheet etc). Jeremy mentioned the Efficient Market Hypothesis (EMH) and said that anyone that has worked in the markets knows that EMH is not adhered to in the real world i.e. assets do not always reflect all information known about them. In particular Jeremy sees the work of Scheleifer and Shiller in behavioral finance as one of the most interesting areas of financial theory to work in, with the potential to quantify "irrationality". Jeremy put forward the following three choices that an individual could choose in terms of what money they would receive and what money another individual might receive:

  • $100 (me) and $0 (you) - some choose this but not all; we are not all greedy
  • $80 (me) and $80 (you) - most choose this but not all; we are not profit maximizers
  • $0 (me) and $150 (you) - a few choose this but not all; we are not all generous

Moving on to the Credit Crisis, Jeremy said that this was caused due to the mispricing of assets such as CDOs/CLOs and CDS. This mispricing was caused by complexity and a lack of transparency but such characteristics are fundamental to the nature of financial innovation. As an aside, Jeremy mentioned that smaller regional banks tend to trade at higher multiples than say universal banks due to investor perceptions of greater transparency of what is going on and what the risks are.

So moving on to Financial Innovation, Jeremy asked firstly what a financial instrument is?:

  • Rights - to future cashflows etc
  • Contractual strings/permutations - choice but leading to complexity
  • Epicycles upon epicycles - derivatives but more general dependencies and links
  • Some form of legal fiction - to arbitrage regulation and prohibitions

Jeremy talking around prohibition (aka modern regulation) being a driver of innovation, starting in history with the prohibition of usury leading financial innovation to find ways of replicating the returns of interest payments but without there being interest payments, so maybe leasing or buying goods receivable at discounts. Looking at the timeline of financial products through history:

  • Loans - available in Babylonian times
  • Stocks - available in Roman times
  • Convertibles - developed as a form of finance for the creation of the US railroads in the 19th C
  • Derivatives - back to Babylon again with property options
  • Securitizations - late '90s
  • CDS - late '90s

 Considering the Logic of Financial Innovation, Jeremy said that most professional disciplines used either Empirical Testing or Deductive Inference to innovate and check that something "worked" as such. But really there is no "social laboratory" for financial innovation or indeed for the regulation intended to control/shape it, so most things, including additionally macro economic policy, were implemented without prior testing. Jeremy said that financial innovation is both critical to our economies but also very vulnerable due to this lack of testing. 

Back to the Credit Crisis, Jeremy said that 10 years running up to the crisis were the social laboratory for CDO/CLO/CDS products but these were mispriced due to a lack of testing. This was a major cause of the crisis but such innovation (and lack of testing) is fundamental to the nature of financial innovation itself. Coming forward to today, securitization is now better understood, biases by rating agencies have been controlled and counterparty risk is being reduced through clearing. So put another way, financial innovation has a stormy creative period where a new product morphs and evolves and pushes the limits of what people, corporations and governments find attract or acceptable, until these limits are pushed too far and a crisis ensues - then finally maturity comes with experience and better understanding of the risks.

Jeremy is a collector of Antique Maps, which he says have become an interesting asset class and listed their history:

  • 1970s - emerged as a new asset class
  • Asset subject to wild price movements/patterns of behavior
  • Now an established art form

Initially dealers would visit libraries containing maps (notably Harvard in the US) and simply rip out pages from it. The market had misrepresentations of authenticity (lying), theft, short-selling, insider trading and many other dubious practices. This initial period of innovation was very destructive without regulation, but now antique maps are an established art form and asset class. So there is a real dichotomy between this destruction that eventually led to people seeing ancient maps as things of beauty, collecting them and hanging them on their wall. 

So why are Regulations needed? Jeremy said that regulation was needed to control:

  • Dysfunctional patterns of behavior
  • Extreme value fluctuations - primarily due to greed
  • Wealth distribution - implementing social justice
  • Bubbles
  • Financial innovation

But what is the Right Kind of Regulation? Jeremy said that we should not hand over "The rule of law to the rule of lawyers". He said there had been 100 years of regulation, with a lot of focus (particularly in the US) on rules that micro-manager what institutions can and cannot do, built up on closing the door after each fraud/incident. Here he talked of Dodd-Frank with all of its detail but particularly gave time to say he thought that the "Living Wills' regulation was a work of fiction and of little practical use - he quoted Hemingway who said that "You go bankrupt slowly then quickly".

Jeremy believes that Principles-Based Regulation is a better solution - although I would say that this proved no better looking at the UK vs US regulation through the crisis? He advocates taking politicians out of the rule making, with judges making decisions based upon case law as it builds up over history. The issue of enforcement seems to loom large here, even if principles could work, they will not work with enforcement. Jeremy pulled up a diagram showing arrows between Value, Financial Innovation and Regulation showing how intertwined they were. He suggested that "vexatious" litigation (the contract must cover every eventuality) was a problem in US regulation in particular. More fundamentally, creating regulation prior to knowing its effects was extremely difficult, since society and economies are not bounded games, unlike chess say where a computer can evaluate all possibilities. 

There were some audience questions, firstly on the viability of bitcoin which Jeremy was negative on, saying that without trust, value can disappear and that "our" electronic money only works because it is backed by governments. Another question talked about the SIFIs and Jeremy said he favored breaking them up over more regulation to control them.

In summary, Jeremy was a great speaker with some good ideas. As he said, most were common sense but I guess his main point was that financial innovation would not happen if it is regulated too quickly/too harshly. So new financial innovation can be destructive and painful, but regulation itself can stifle innovation and the creation of value and new markets.

 

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Hello Brian,

Last Monday at the GARP event where Jeremy Josse spoke, it great to see you. Thank you also for your summary of his presentation. I took copious notes of what he'd said, but you had a great idea to post a well-described review of his discourse.

One of my takeaways on what he said was that the US is over regulated and not in the right ways. That perhaps is what you are saying in part, however, when in learning that his co-workers had observed that the US has been in a 'Long March' of deregulation, he mentioned he was surprised and mystified by how that could be.

I mentioned that since Bush 1 was Reagan's Vice President when Reagan gave him oversight, and made him 'Czar' of deregulation over the financial system, we've been experiencing de-regulation and the problems of that and the way it's been done.

Beginning with Volcker at the Fed and the Reagan-Bush era of deregulation, we've had 3 craftily or clumsily orchestrated episodes of inflate/collapse. The increasing amount of what seems to be regulation, in reality is to obscure the hacking up of the US economy being put through de-industrialization, to soak up the many (and many types of) financial institutions that had enjoyed a robust existence in our huge state and federal commercial system, and to leave it easier for foreign enterprises to acquire US companies, and for favored US companies to acquire and grow into the US versions of 'national champions' as they're known in Europe.

Flawed multilateralism with the beginning of the worst that began with Bush 1, has delivered us to where we are today. His spurring (G8 meeting 1988/89?-90 and against the strong opposition of Thatcher and Mitterand) of Germany to reunify, and to encourage that, the US agreed to deindustrialize and 'liberalized' trade, by starting with 'free' trade agreements (violating the Constitution's Article 1 Section 8 - See Dr Simon Johnson's "White House Burning"), but also agreeing to allow or for the US to accept as regulation what was from Basel/BCBS Agreements and IASB accounting to 'globalize' the US into much of what Europe's many parts eventually were going to be 'regulated by' going into Germany's EU construct but to suborn the US economy to what Germany (and as the contemporary secular state for the Vatican to use for its long bloody history of Holy Roman Empire now cloaked in the 'clothe') was going to do in Europe.

The US is many years into this erosion and dissociation, including a plateau at the present time in our 3rd crisis in our financial system. The Fed and all these other organizations including other US regulators are all in the current stage of the results of their virtual inability to address and thwart the interests of an overarching framework at the G7,8,10,20 level, that which I characterize as flawed multilateralism.

Most analysts, economists, and business owners tend to observe that to which they have to attend in the short term or tend to not observe what results from obscured origins. In this case those obscured origins are the US commitments of sorts to flawed multilateral agreements, ie the G7,8,10, 20.

Because this was not only done at the Executive Branch level, this was done with the Bushes on the front end for the US, but with some of our other influential families somewhat in this camp in effect, to diminish the relative health and cohesiveness of US domestic commerce, our degree of global trade/commercial dominance, and further disrupt our relative balance domestically between the power of our states, their commercial health and the Federal System framed in our Constitution. Congress was strong armed with Bush influence on the republicans and Clinton as a Dem in the W/H strong arming the Dems.

People looking at what's happening with the financial sector are seeing the results of de-regulation - the Fed in 1993 taking de facto control as the main US financial regulator, a failure for the Fed since 1993 to continue Dealer Surveillance, which Corrigan suspended before he went to Goldman, and for an increasing amount of trouble in the US economy reflected on the balance sheets and off balance sheets in commitments of our many financial institutions.

Meanwhile in Europe, Germany's reunification costs were facilitated by our largest financial institutions engaging in all sorts of over-the-counter, non balance sheet contracts and contingent agreements. As credits (on balance sheet) eroded there and here while we were doing deindustrialization as spurred by 'free' trade, banks' contingent obligations became increasingly larger. US financial companies' balance sheets and off-balance sheet commitments were going to reflect this 'new economy' - remember that name?- of what was happening, and that foisted down on most of the US by from above the Davos Level but using that and the 'futurists' to read entrails about the future facing the US and the world benefitting from the US off-shoring production into it and hiding it in ad hoc contracts, contingencies, non CME cleared derivatives, and the voters' future pensions, 401ks, jobs, college educations, inheritances, homes, health and well-being, etc.

Again meanwhile, FASB's 133 Statement for Hedge accounting enabled management in some way to report and 'value' these contingent agreements, while their increasing amounts exposing our largest institutions to credit and market risk, were making the FDIC more nervous. Moreover these ad hoc contracts when legitimized would be on the balance sheet 'fair valued'. This for banks is bad; writing what were contingencies, but now these are legitimized to trade, are now recognized on balance sheet in trading portfolios and attached to loans as assets and forms of assets when these had been contingencies but now are fair valued ON BALANCE SHEET is a structural and operational form of unsafe and unsound banking practices with these as unsafe and unsound banking products. There was NO regulation or institutional framework including essential oversight when federal legislation legitimized these instruments to Trade. The FDIC also was somewhat constrained from examining and disciplining any of this. And remember Brooksley Born? Do a search on her name.

The FDIC had little turf power however against the Fed's turf and political power, in spite of the theater seen when the Chair has to testify before Congress.

Greenspan anyway was a slick political operator. While these OTC contracts and contingencies were pluming with the 'blessing' of Bush and a layer of influence above Greenspan's head, he expediently supported this era of semi-controlled/but de-regulated commercial and multilateral 'wilding', that was pluming swaps and other contingent agreements of any possible sort, labeling it as 'financial innovation' and having the Fed bless it, while holding the FDIC back from taking virtually any action against it.

Thus against the largest financial institutions and then during the Bush 2's time at in the White House, the FDIC virtually never enforced Prompt Corrective Action ("PCA"). This was the regulatory framework that came into existence with the legislation passed in 1991, known as Federal Deposit Insurance Corporation Improvement Act ("FDICIA"), which legislation already in effect FDIC practice of how it regulated, disciplined and 'resolved' miscreant, stumbling or sick financial institutions.

WE failed to effectively enforce what had been existing US regulation. My research for Basel III opposition (and comment letter for the US public due process) found this.

The FDIC was coming out of the 2nd financial crisis spurred by economic erosion and that in part from legislative changes beginning in the Reagan era, as well as de-regulation championed by Bush 1, but that 2nd thrift collapse of sorts which included the collapse or partial meltdowns also of many banks including Manufacturers Hanover, happened on his watch and by his Congress, their economy and their regulatory and legislative framework and Agreements to foreign interests in multilateralism and perhaps even his skull/bones white-is-black/black-is-white agenda.

Back to the GMO of the financial products world, what we're seeing today with the ability for the trading of these contingencies including the ad hoc contracts such as swaps and credit derivatives, came by way of flawed legislation and some would say that repealing Glass Steagall using Gramm Leach Bliley was flawed, but also allowing trading of these OTC contracts and derivatives legitimized by Commodity Futures Modernization act gets us to the ISDA amount today of notional over $700 Trillion, and non ISDA notional to another $500 Trillion. What is all of this tied up in? Even if 'hedged'... that's sum $600Trillion. Where is all of that? What assets are all of that connected to? In reality this is leverage many times over.

The way to understand it, came in part from the Capitol Hill hearings of the Financial Crisis Inquiry Commission, when one of the very smart commissioners observed that in the case of the mortgage paper, he counted that in the case of 1 mortgage that he tracked, was referenced I think he said 900 times when he tracked it through the tranches of the synthetic mortgage securitizations, like the CDO 'squareds'.

Run those numbers. Ramp up the image and that's where we are today and what we're seeing.

Jeremy Josse's observations about financial innovation (these contracts which I label as the GMOs of the financial products and in our financial system), and my characterization is that we're in white-is-black/black-is-white era in financial deregulation, calling instruments and ad hoc contracts that in reality are part of what is unsafe and unsound practices, as 'financial innovation' is somewhat like rearranging the deck chairs on the Titanic.

Now some may say that the Titanic in reality was its sister ship, which had had serious malfunctions and that its owners swapped the sick sister ship for the newer one and used that name and sunk it for the insurance money, but regardless, we're in an inflate/collapse scenario crafted at levels of the creepy little guys behind the curtain above the Oz Face Fed.

Because these only see the Oz face, the citizens of OZ are menaced and entranced or beguiled, bamboozled, but regardless, we've got inflate/collapse and what many people are co-opted, or beguiled or enriched by is part of the problem, not part of the solution.

The solution isn't quite breaking up of SIFIs as Jeremy suggested he supported. The Solution is different and 'painful' but different. In reality, hidden in and using 'crisis', it's a commercial strategy to grease the take over scenario obtaining and using "scratch 'n dent" assets. Now these swaps and other ad hoc contracts are really worth anything as Jeremey observed. That suggests my second observation and recommendation.

1. the US is to de recognize or withdraw commitments to G7,8,10,20. This means we are to stop (and repeal all that which supported) deindustrialization, especially that which violates the Constitution's Article 1 Section 8. Skull/Bones Bush 1 and 2 were not able to keep their oath of office to uphold the Constitution. Nor has or will any other person taking that oath of office if they're going to support and fail to repeal all non tariff'd trade agreements.

This also is what's contributed to wrecking the US economy while Germany has covered its reunification costs and now with the EU 'free' trade construct, rolling up the balance sheet of Europe that it would not be able to get away with another hot war. Cold war or asymmetric war now is the tactic. See what's going on for what it is.

2. We also are to withdraw support of what Germany is doing in Europe and its commercial and fiscal abuse in order to obtain fiscal domination. It distressed me to see the UK stay in the EU, or any country especially Greece to stay in the EU, rather than leaving it and restoring their currencies and tariffs on Germany exports such as BMW while those national champions have been keeping germans employed while many others in Europe have lost their jobs because those governments in order to join the EU eliminated their tariffs on imports from especially the national champions.

Additionally this also has facilitated the funding of the german war machine, now fully re-militarized. There should not be ANY WONDER WHY there is instability in Europe and elsewhere like the Middle east. Germany is looking to re emerge as a hegemon. And the EU 'free' trade zone and the backs and lives and resources of many Europeans and americans has indirectly facilitated this.

Meanwhile, in repealing that which has resulted in deindustrialization of the US economy, our banks will have a better economy into which to lend, and more americans will be employed and paying taxes into the system. More American companies also will be benefited by the positive ripple effect of better American commerce and those likewise will be paying more taxes, ie revenues back to the federal and state governments. BETTER FISCAL REVENUES to States' and Federal Gov.

3. Acknowledge inflate/collapse and unsafe and unsound banking practices and contracts for what they are. And by way of (1) above this gets us out of Basel and IFRS and we ARE to effectively enforce effective on the books US regulation, while repealing flawed legislation.

4. Restore full safety and soundness examinations by examiners of EVERY financial institution in the US. The FDIC had full subpoena power over any and EVERY subsidiary of a financial institution. My research for my Basel III opposition found this. That link is posted in my "Transactions/Projects" list.

In this restoration of US safety and soundness regulation, we also are to take US financial institutions out of ISDA protection.

5. Repeal flawed legislation such as the Commodity Futures Modernization act that enabled the swaps, and other ad hoc contracts to trade. This plumed the writing of them and thus the exposures and snaring of assets by these. Prohibit or repeal the trading and spur the unwinding so that these things diffuse over time. if in many cases they're written to offset and match book the other side on the balance sheet or elsewhere, then let them expire. That banks can trade them, inflated their balance sheets, enjoy fair value and mark to market gains on the balance sheets and through the income statement, run fees and fair value gains inflated by Quantitative Easing ie QE, has facilitated inflate/collapse.

Look at the whole thing and see the whole mess. Don't get confused by the mess; it is key to understand that the garbage of the FE - the 'financial innovation' - ie the GMO of the financial product world that is feeding the maggotry of the financial system, is dysfunctional and reflective of 'war' happening around us and involving us, co-opting us and slowly rather than like a neutron bomb, attempting to turn into garbage that which had been good so that those assets can be rolled up in to the hands of the few.

In 2003 I characterized this. Interestingly it was the son of a wealthy Saudi, a man called 'Osama bn Laden' who when the US was fire breathing to go into Iraq, he suggested this was a new 'crusade' by the US. I reflected on what he said and years before had ridiculed 'free' trade such as NAFTA and the 'new economy' as a form of plunder with more powerful enterprises enjoying that roll up of assets away from the many into the hands of the few.

OTC contracts facilitated, legitimized by flawed legislation, deregulation spurred by the conceited American wealthy in roles as public servants co-opted into serving seemingly friendly but in reality passively hostile foreign interests and a broken, oppressed, ignorant system domestically, that gets us to the bogus 'assets' such as the derivative and OTC contracts making claims and leveraging real assets.

6 reconstruct the US financial system to what it was before the Bank Holding Company Act 1956, but the FDIC also has to be changed. That culture is too facile to inflate/collapse. Hacking up a SIFI, gotten that way be deregulation and to 'compete' against the foreign national champions which under and in ISDA agreements enjoyed government backstops, so that Germany and its Grossbanken can get away with their taking on more leverage in order 'acquire' assets, ie roll up the balance sheet of Greece and other countries and those businesses into Germany Inc's balance sheet. Put that together with the contracts and mechanism that facilitates that.

This is what Jeremy Josse in part was discussing and what in some insightful and thoughtful ways he 'philosophically' observed in his book and his presentation, but the solutions are NOT philosophical. The solutions to address our PUS economy, will cut out the decay and serve as disinfectant to the PUS, which as I've said, like infection in a wound looks like 'growth' because it's hot and swollen, but it's infection and pus. Notice too our pus economy even has maggots ie pathological.

Pathology has to be addressed and eliminated. The writing and trading of instruments of inflate/collapse, instruments of deregulation, instruments of forms of asymmetric war that by leveraging are facilitating the concentration of assets into the hands of the few has to be arrested.

7. finding/identifying and holding accountable the creepy little guy/guys behind the curtain in "OZ" that is contorting the OZ face. It would be something like the US withdrawing support of what Germany is doing using the EU 'free' trade zone to take over Europe and attempt to obtain a global hegemon status.

It would mean rejected every US presidential, Senate, Congressional candidate idiotically or knowingly supporting any sort of non-tariff'd trade in any form, as this violates their oath of office to uphold the Constitution even before, God forbid they' been elected. If they lie and or they cannot even uphold THAT KEY Oath, then they do not belong serving on behalf of the voters and domestic commerce which looks to the Constitution for the quality of life and the look back history of that goose that laid the golden egg.

We had and had the ability and rights to own property, effective vote, savings and the ability to build wealth. Treachery has eroded and given over this to foreign and internal treachery interests which also has contributed to our pus economy and break down in the system accountable to the public and no longer worthy of public trust, ie what's now the 'Sustainability' system.

GMO of the financial products world and deregulation by way of those who didn't belong in positions of public trust have facilitated this.

Mat 3:10 And now also the axe is laid unto the root of the trees: therefore every tree which bringeth not forth good fruit is hewn down, and cast into the fire.

Luk 3:9 And now also the axe is laid unto the root of the trees: every tree therefore which bringeth not forth good fruit is hewn down, and cast into the fire.


Rev 6:14-17 And the heaven departed as a scroll when it is rolled together; and every mountain and island were moved out of their places. And the kings of the earth, and the great men, and the rich men, and the chief captains, and the mighty men, and every bondman, and every free man, hid themselves in the dens and in the rocks of the mountains; And said to the mountains and rocks, Fall on us, and hide us from the face of him that sitteth on the throne, and from the wrath of the Lamb: For the great day of his wrath is come; and who shall be able to stand?

Hi Andrea, I am not sure that thank you for your comment is sufficient given the length of what you have written up - I will take a read and see what I think. Best wishes Brian.

All,
If interested, you can find the full audio from this GARP Chapter Meeting here: https://www.youtube.com/watch?v=Z6G-A3C37-A&feature=youtu.be along with the PowerPoint presentation here: http://www.garp.org/networking/chapters/pdfs/ValueFinancialInnovationAndRegulationAnUnholyTrinity_JeremyJosse_033015.pdf

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