Avoid Blame, Change the Game!

The asset-backed commercial paper (ABCP) debacle: who is to blame?  According to the National Post , it’s everybody and nobody.  I find myself in unusual agreement.  While I don’t wish to see likely criminals let off the hook, a better approach out of this mess is to change the rules of the game.

Last August, the Canadian market for non-bank ABCP was frozen after several large institutional investors in these financial instruments suddenly found themselves abandoned by buyers-of-last-resort (foreign banks) at the trading table.  Seeking a private sector solution, these investors set up the Pan-Canadian Committee (also known as the Montreal Accord) to hammer out a deal under which the market would reactivate.

This problem is complex: complex in its players (a heterogeneous lot), in its playing field (the technostructure of postmodern finance) and in the very instrument under scrutiny (the handiwork of financial engineers).  Brought together, a system has emerged characterized not by risk but by fundamental uncertainty.   Unknown unknowns lurk on the horizon. 

In a complex problem like this, it is a real challenge to assign ultimate responsibility.  Who is responsible?  The issuers of the ABCP, the brokers, the debt-rating agencies, the regulators, the investors themselves?  One obvious suspect would be the original issuer of the ABCP.  Charge them with fraudulent misrepresentation!  However, there has to be proof that there was intent to defraud the buyer. The issuer can easily plead that the investor just didn’t understand the risks associated with the instrument.  The ABCP broker can make the same case or plead that he too was ignorant of the risks.

It’s the structure of the market that is rotten. Here we have rules of the game biased toward the principle of buyer beware (where the buyer is wholly responsible for understandng the risks underlying the product) than by the principle of  duty of care (where the seller has the duty to inform the buyer of the product risks).  The information asymmetry is tilted towards whoever has the better understanding of the product, and this ultimately is the originator.

Investors are social animals.  We rely on our trust (or confidence) in others when transacting.  When trust falters, markets can collapse. Collective action, either competitive or cooperative, fails.  Moral hazard created by the system can lead the system to system failure.

Take for example the reported Alberta farmer who has $350,000 in retirement savings invested in ABCP; securities which currently can not be traded and will perhaps be written down.  Are we to judge this investor stupid?  He did, after all, put all his eggs into one basket of questionable reliability.  Or was he misled by his investment advisor to think that the non-bank ABCP was as safe as a GIC?

  

Trust needs to be restored to restore the market.  There are several processes underway, the outcomes of which may indicate how the game will be restarted.

The Montreal Accord has been working since August to hammer out deal which will face a vote by both institutional and retail investors on April 25.  As a private sector-led initiative, it seeks to restructure the terms of these instruments, giving them longer terms to maturity, as well as setting conditions on their tradability.  The asset values may also be marked down.  The thing about the Montreal Accord is that it only seeks to get investors back to the trading table.  Under the terms of the deal, players’ score sheets are being re-valued and the rules of the game are being slightly altered.  However, the fundamental structure of the game is left intact, leaving open the possibility that  this debacle could return under some altered guise.

On Thursday, April 10, the House of Commons Finance Committee will be conducting hearings on the ABCP issue.  Witnesses will be called, including Purdy Crawford, the lead negotiator in the Montreal Accord.   On Friday, April 11, finance ministers and central bankers of the G-7 nations will meet in Washington to address the global credit market situation.  Perhaps out of these two meetings we will hear calls to reform the credit market structure, including stronger regulations aimed at forcing greater transparency not only of market players but also of the financial instruments they trade.  It may reduce informational asymmetries, which is arguably the steam on which capital markets run, but the danger of having another crisis in trust will be dampened.

3 comments

  • The diagnosis is not at issue: moral hazard risks abound.

    The cure, then, will maximize the likelihood that gratuitous moral hazard is too impolitic.

    Historically, a job largely for the fourth estate (e.g., Jacob Riis, H.L. Mencken).

    How, then, to make it maximally profitable for the fourth estate of today to muckrake?

    Imho, the key insights:

    1) The introduction of particular online markets, starting with a new kind of market for the ad spaces on blogs, will provide people with new and improved ways to develop, showcase and profit from expertise.

    2) Owning popular markets of the aforesaid kinds is an ideal way to increase profits for an American media conglomerate that owns a broadcast TV network.

    3) The less benefit individual speculators can derive from moral hazard, the more they will utilize said markets.

    Details are online at http://www.loveatmadisonandwall.com.

    Given the above, the sooner media conglomerates start introducing/popularizing the aforesaid markets, the sooner a lot of top-quality entertainment programming will, in part:

    1) increase awareness of (proposed) public policies that (would) put taxpayers on the receiving end of gratuitous moral hazard (e.g., increase awareness via a next-gen Jed Bartlet channeling Jon Stewart and Vietnam-era Walter Cronkite)
    2) showcase elected representatives who protect taxpayers from gratuitous moral hazard

    Thoughts?

    Best,

  • ‘Post modern finance?’

    As in an anti-foundational claim to truth statements with respect to matters of financial products?

    Hmm, you might be on to something!

    But let us get serious.

    If you sell a product rated at triple A and you cannot, with any certainty, vouch for that product then it is fraud. If you classify a product as triple A but have no ability to verify your own rating then it is fraud. If you sell or rate any product as triple A when you know it is not then it is fraud. Anyway you slice it, it is fraud.

    Accountability states that those who occupy superior locations in systems, from simple to complex, should be held to account relative to their location in that system.

    Back to the blame game:

    Regulators and CBs: At least in the US the FED had been pushing securitization and thus green-lit the abuses. And there is evidence that higher order regulators in the US refused to move when lower level regulators were screaming about system wide fraud: Spitzer ring any bells.

    Originators: Gross negligence motivated greed. If doctors did this we would know exactly what to do. And we would not hide under what must be now considered the most grotesques of euphemisms: “informational asymmetries.”

    Sellers: Same as above.

    The respectable left: wake me up when you want to hold the more powerful actors in the system accountable. There once was a time when that was our mission.

  • Wenonah Bradshaw

    In reply to Travis, the point I was trying to make in my post was that the difficulties in decisively proving that an actor has committed fraud and holding this actor accountable in the judicial system are rather large given the current regulatory framework. The non-bank ABCP market in Canada was allowed to develop and flourish largely outside the sphere of regulatory oversight, including that of legal enforcement. Since the market freeze last August, there have not been any criminal proceedings, at least to my knowledge. A big reason why there haven’t been any is the lack of teeth our current legal system has in pursuing white collar criminals. No charges have ever been laid in the well-known cases of Nortel or Norbourg. That may change with a proposal by the RCMP’s Integrated Market Enforcement Team (IMET) to compell witnesses to testify in white-collar crime cases (refer to http://www.theglobeandmail.com/servlet/story/RTGAM.20080416.wrpowers16/BNStory/Business/). Stronger enforcement is a step in the right direction, I feel. So is strengthening the regulatory framework for the originating and trade of securities, one which favours greater transparency and stronger duty of care by the originator and seller. Perhaps a national securities regulator is needed to acheive this. I am not advocating that the actors responsible for this present debacle should escape scrutiny in media inquiry. Suspicion has been cast over several characters for some time now (e.g. DBRS, Coventree and the big banks), and there may yet be much revealed. But even if guilty in our eyes of fraud or of negligence, they will likely walk unpunished. That is why I am trying to turn attention to whatever proposed new framework will emerge from the processes underway (e.g. the Montreal Accord, the Senate Finance committee hearings). The key thing about whatever emerges is whether or not it will prevent another August 2007.

    Postmodern finance? I confess I was being stylish. The definitions of money maybe unstable but not the methods for investigating them.

    In reply to Frank Ruscica, the idea of a commuincations medium like the internet as a means to reduce informational assymmetries in an interesting one, one that has been touted in the past. I need to think about it further.

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