Monday, 3 January 2011

Should Regulators Be Short?

As the ebbing economic tide exposes more and more fraud, it's striking to see how long the authorities have been aware of some problems before attempting to correct or publicise them. How are investors protected in the meantime? Shouldn't they be given a chance to cut their losses and switch to better investments as soon as problems are detected? Should new investors be compensated for transactions they would not have entered into had they been aware of the misconduct and/or a firm's diminished reputation?

A review of various accounting, debt and pension scandals suggests that, rather than banning short-selling "to protect the integrity and quality of the securities market and strengthen investor confidence", regulators would be more effective if they were to publicise their own short selling as a tool to identify and punish errant firms and companies and to promote market confidence.

Lack of timely regulatory response to financial problems is perhaps best illustrated in books like "Fooling Some of the People All of the Time" about the six years of foot-dragging over Allied Capital's creative accounting and The Big Short, about the few players who got ahead of the sub-prime debt crisis. It's also emerged what a poorly kept secret Madoff's fraud was, yet nothing was done officially until it was too late. Meanwhile, Ernst and Young are being taken to task over Lehman's use of so-called "Repo 105" transactions to take certain assets of its balance sheet at each quarter-end. Other specific examples have been given in defence of short-selling before.

Some recent, comparatively trifling, examples closer to home are also instructive. In May 2009, Aegon (then known as Scottish Equitable) informed the FSA of 300 "issues" amounting to £60 million of consumer detriment. Yet this was only presented to the marketplace on 16 December 2010, with a 30% reduction in Aegon's fine, from £4 million to £2.8million. In April 2010 various trading firms were fined £4.2 million, for failing to "provide accurate and timely transaction reports to the FSA." Yet only now are we told that:
"Each firm could have prevented the breaches by carrying out regular reviews of its data. Despite repeated reminders from the FSA during the course of 2007 and 2008, none of the firms did this."
While civil enforcement authorities tip toe around the edges of market problems, things are no better on the criminal enforcement side. UK judges are understandably reluctant to approve US-style 'plea bargains' that result in smaller fines and no admission of illicit conduct. A recent case in point was Mr Justice Bean's reaction to the tiny 'settlement' to emerge from the notorious BAE Systems saga.

Why all this regulatory timidity?

One justification for restraint, co-operation behind the scenes and discounted fines is that it encourages firms to report their own misdeeds rather than hide them - yet the misconduct does remain hidden from customers by the regulators. And informal regulatory discussions can be problematic. Witness the concern around the FT's report that UK banks' auditors may have factored assurances of government support into their opinions as to whether the banks were going concerns in 2008. Worryingly, the FT notes that "auditors are likely to be encouraged to have more private chats with regulators to help prevent another crisis."

In cases of corporate fraud, the justification for restraint is similarly misplaced, as David Einhorn explains in "Fooling Some of the People All of the Time":
"The authorities really don't know what do do about fraud when they discover it in progress... It seems the regulatory thinking... is that shareholders should not be punished for corporate fraud, because... they are the victims in the first place... This thinking may be politically expedient in the short term, but creates a classic moral hazard - a free fraud zone. If regulators insulate shareholders from the penalties of investing in corrupt companies, then investors have no incentive to demand honest behavior and worse, no need to avoid investing in dishonest companies... If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said [and] allocate their capital more carefully. This sensitivity and other consequences will, in turn, deter dishonesty."
On the flip-side, as Sy Jacobs has observed (quoted in The Big Short) "Any business where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people..." .

Regulators also often cite their own statutory boundaries as the basis for ignoring firms' extra curricular activities. This may be a good technical defence, but feeble given that the financial markets are inter-connected globally, can dwarf the regulated sphere and are populated by subsidiaries of regulated holding companies, as the New York Fed recently admitted in its report on 'shadow banking'.

Finally, unlike a typical approach to risk assessment, the authorities are not able to extrapolate from problems found in a sample of cases to reach a view on a portfolio basis in enforcement actions (see Financial Services and Markets Tribunal decision concerning Legal and General's Flexible Mortgage Plans. But if the material facts were in the market, at least investors would be able to decide for themselves.

What distinguishes the short sellers' approach?

The literature suggests that, firstly, short sellers think more deeply and critically than the financial authorities about the limits of the various models used in and around the financial markets. Perhaps this is because the short sellers' first instinct is to question the status quo, whereas the regulators first instinct is to support it. Secondly, once short sellers detect a potential anomaly, they investigate it with a view to trading - and so putting themselves at real risk - potentially over a long period of time. Whereas the authorities merely commence an investigation with the vague intention of possibly activating a more formal, lengthy investigation, which might eventually end in a fine or settlement without any admission of wrongdoing. So the short sellers' are driven by a strong sense of anxiety about being wrong, while the authorities are not really 'driven' at all.

Adding short-selling as a regulatory tool may be controversial. But it would enable regulators to learn the same disciplines as the most critical market participants, and remove the time lag and lack of transparency associated with civil and criminal actions. Publishing their short positions would also serve as an instant early warning of the underlying issues - and maybe pay for the ensuing enforcement activity.

Image from Mises Daily.


Unknown said...

The problem is though that "the regulators" don't WANT to know about any sort of fraud or do anything much about it because looking the other way is a sure-fire way to get a better paying job working for the private (financial) sector (aka "regulatory capture").

Pragmatist said...

Thanks, Candice. That's one view, but I think unduly cynical ;-). If getting a job elsewhere were a motivation, then surely doing a cracking job as a regulator is what might get you lured away?

Adrian said...

Simon, very interesting. Do you mean literally inviting (or even requiring) the Regulator to take a position in the market? Or is your 'short' a theoretical position used as a warning only? Yes it is sadly true that the (sometimes better resourced) investor will apply itself to a specific analysis with more vigour and rigour. I can think of a number of possible reasons for this. The one area, however, where the Regulator is likely to apply more rigour is the procedural and probative aspects of the analysis. When you are bound by the rules of procedural fairness and your decisions are subject to judicial review, you probably move a lot slower than the investor. I assume that, regardless of the strength of the evidence you are in the proces of gathering, or the credibility of your whistle-blower, you would still need to complete your investigation in accordance with the procedural and evidentiary rules before you short the company. Though I'd be interested to hear what you or one of the barristers thinks about this? Perhaps an independent 'investor' that publishes it's investment decisions? But this sounds like Einhorn and nobody listened.

Pragmatist said...

Hi Adrian, thanks for the comment.

We are clearly on fresh ground here and there's bound to be all sorts of controversy. But I'm suggesting that the regulator (or yet another independent authority?) be empowered to take and publish a short position of its own volition in parallel with (independently of?) any investigation or enforcement activity. If it's wrong then it stands to lose money, but at least it's belief/suspicion is actually visible in the market for others to consider. You're right that Greenlight (Einhorn's fund) was short Allied Capital (and Lehman) and few listened - though short selling by an 'independent' authority may have more weight. But the real point is that Einhorn was only alert to the problems in the first place because he was approaching the market as a short seller. And his committed position encouraged whistleblowers to help. It seems regulators didn't believe him because they lacked his acute perspective, understanding and commitment. Nor did they seem to understand the full significance of him being right. They weren't standing in the shoes of potential investors (though perhaps they were in the shoes of the existing investors who'd already been duped).

Maybe the authorities don't need to actually trade, but I'm not sure there's an alternative way to acquire the right perspective (or incentivise people with decent short-selling experience to join the authority).

The authorities should be happy if taking a short position provokes a claim for judicial review, as the matter would be brought to a head.

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