SeriousBull

Regulatory Protection and Public Trust. Time for Change?

Tags: Bear Stearns + Bonds + FINRA + Interest Rates + investing + SEC

US Financial companies (banks and brokers) continue to take write-offs for bad and risky loans. Exacerbating the credit crisis is the new, illiquidity of Auction Rate Securities (ARS)– fixed income securities issued by companies, municipalities, schools and hospitals with long term maturities that have variable interest rates that are typically reset every 7 - 35 days. Now because of growing concerns about credit worthiness of borrowers and the guarantees behind them, investors don’t want to buy ARS. The Fed in an attempt to thaw out the freeze in the credit markets, has begun to conduct Treasury Auction Factilities (TAFs) but illiquidity troubles have continued to persist requiring the Central bank to reoffer 28 day loans pending expiration and forcing issuers to finance their debt elsewhere.

Meanwhile FINRA, the merged NY Stock Exchange and NASD regulatory authority for broker dealers, issued  Regulatory Notice to Members # 08-08 (March 6, 2008) that required broker dealers to increase margin maintenance requirements on their customer’s ARS fixed income securities. Under the Notice to Members the margin requirement was raised to 25% of the current market value irrespective of whether or not the securities carry an investment grade. The same Notice raised the margin requirement on Auction Rate Preferred Securities (ARPS) issued by closed-end funds to 100% making them ineligible as collateral, yet already lent.  While both of these regulatory safeguards were certainly responsible requirements since the ARS and ARPS securities had reduced or no liquidity, the result of these new margin requirments adversely impacted  broker dealer net capital. Additionally the more stringent requirements further unsettled the ARS market and squeezed brokers already short of capital by requiring them to deduct the differential deficiency created by the increased margin requirements from their Net Capital computation. Essentially this meant that any credit extended by a broker dealer for ARS required a greater haircut and credit extended on ARPS fixed securities resulted in a 100% capital charge to the firm.

This change in margin accounting requirements pre-empted dire attempts to sell off ARS and particularly ARPS fixed income securities and ultimately resulted in Bear Stearns having to send emergency wire notifications to FINRA and the SEC that it had a Net Capital Deficiency; that it did not meet its net capital requirements to stay in business. Other member firms pleaded to FINRA for relief informing them that they were setting in motion a domino effect of failed credits such that their proposed medicine would kill the patient. FINRA listened and consulted with the SEC.  About a week later on March 11, FINRA memorialized its agreement with the SEC whereby temporarily relief from the 100% charge was granted recognizing the current inability of customers to liquidate their ARPS fixed income securities. Under revised margin (lending) requirements and based on the representations that banks [are?] willing to extend loans to broker dealers using ARPS as collateral for said loans, the SEC granted the relief brokers sought conditioned that:

• the ARPS pledged as collateral were rated in the highest rating category and not under credit review
• that the total amount of credit extended by the BDs to their customers is not greater than 25% of the BD’s excess net capital as of the most recent month end
• that no loan to any customer is greater than 50% of the value of the ARPS pledged
• that a bank loan is obtained by the BD for the total amount of the pledged customer only ARPS and that any/all bank loans carry a maturity of no less than six months
• that the total of all loans shall be treated as a scheduled capital withdrawal–meaning it is authorized but must be deducted from net capital
• the aggregate amount of ARPS loans extended to customers and financed by a bank loan are to be treated as a credit/debit on the BD’s books with respect to its Net Capital
• that BDs must report to FINRA monthly on the total amount of ARPS loans outstanding

When an auction fails, penalties kick in that causing issuers to pay hefty rates as high as 20%. According to Bloomberg more than 60% of all auctions held since mid February have failed.  These failures have caused more write-offs at banks and brokerage firms further adversely impacting their net capital.

The FINRA/SEC relief was not enough to save Bear Stearns. Bear Stearns would require access to the Fed’s Discount window and the Fed’s temporarily acceptance of alternative collateral to keep it afloat because the credit market to which it was highly exposed had collapsed. This extraordinary authority was finally also granted to BDs, but for Bear Stearns, the Fed action came exactly one day too late.  JP Morgan got a Fed guaranteed $29 billion loan to purchase Bear Stearns virtually protecting it against loss. Bear Stearns shareholder’s lost when public money was used to assist JP Morgan in taking it out–payback for Bear Stearn’s refusal to accommodate the Fed in when Long Term Capital Management failed in 1998?

Unfortunately, there are two different sets of accounting rules, one for banks and one for brokers. For example, unlike banks, BD’s can not legally circumvent marking  security prices held to the daily market price when  computing their capital reserves on hand by categorizing some investments as “held for investment purposes.” Nor can a BD spread their write-offs over several accounting periods.  Moreover, BDs do not have a rich uncle (Uncle Sam’s Fed) who will routinely lower their cost of money creating profitable loan spreads and grant them special favor when they make bad business decisions. A BDs only leverage is to get a shareholder loan and get it classified as a Secured Demand Note which can then count as equity capital, though the shareholder’s money is at risk as capital reserves. 

The point here is that we have a financial system of regulation without parity and its favors banks over brokerages in times of crisis. FINRA and the SEC moved to protect the public by raising capital reserve requirements at broker dealers and granted only limited relief conditioned upon sound and prudent guidelines. The Fed by contrast has yet to increase capital reserve requirements at banks, has lowered interest rates seven times to boost their profitability, has let their constituent banks gradually realize their losses, has opened up its purse providing billions of dollars in loans while accepting collateral to keep them in business that no one else will accept much less buy.

When faced with the trade-off between sound regulatory practices and collateral damage to private businesses we have two different regulatory systems with two different points of departure. FINRA and the SEC are fulfilling their mission to act prudently and protect the public accepting business failures as an acceptable consequence for excessive behavior. The Federal Reserve by contrast views its primary role as a protector of banks, a goal tied to its mission to safeguard the US financial system.  Two regulators charged with two different missions. The question is: because brokers and banks are now in the same business, should they have these distinct, separate missions when the regulatory framework seems to favor one financial type over another? Should we not now reform the missions of our regulatory bodies and have for one regulator responsible for both banks and broker dealer compliance and another entity charged with monitoring their financial risks and the risk to the financial system? 

    Ref: FINRA Margin Revision Notice 08-08

    Ref: FINRA Letter to SEC memorializing Relief

April 17, 2008 - Markets