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June 17, 2008

Regulators, Saddle Up!
by Brady Willett

Having watched the Financial Accounting Standard Board (FASB) grapple with the unexpensed stock options problem for more than 3-decades, and still forced to watch the consulting-crazed SEC settle case after case without forcing the wrongdoers to admit culpability, a strange sense of satisfaction arrived last week when the Financial Services Authority (FSA) attacked short sellers. To recap, the FSA said that since short sellers may be ganging up on companies undertaking rights issues the shorts will need to start disclosing their positions in a week. Not in a few month or years after the financial service lobby has severely watered down the original rule. Rather, if you short more than 0.25% during the rights issue process you will disclose your position starting June 20. Period.

Immediately following the FSA's shocking announcement there was an outcry from hedge fund and investment managers. As one lawyer put it, "The FSA might as well tell hedge fund managers and other investment managers to publish their strategies and place them on their websites". Needless to say, the voices not heard amidst this wave of protest were that of average investors, or the passive shareholders that usually buy and hold stocks/funds and do not care one way or the other how great a regulatory burden hedge funds suffer. For these investors greater transparency in the marketplace is almost always welcomed, even if regulators are so rarely capable of providing it.

The Real Role of Financial Market Regulators

Local banks install locks on the front doors, operate multiple cameras and alarms, house assets in impenetrable lock-boxes, and post security guards at the entrance. Few would deem these safeguards as extravagant or unnecessary. After all, banks still get robbed from time to time.

In the financial markets safeguards are also in place. For example, in the U.S. FASB drafts accounting standards, the SEC enforces standards and punishes criminal activity, and the Federal Reserve Board supervises and regulates a wide range of financial institutions and activities. However, whereas a bank usually contracts firms to install and/or maintain their security apparatus, the major financial market regulators have the duel mandate of regulating/policing the marketplace as well as promoting policies that aim to ensure the health and integrity of the marketplace. The potential for conflicts of interest under this structure are easily observed. For example, if Citigroup is breaking the rules by inflating a few accounting lines should the SEC immediately inform the public of this behavior and potentially hurt C's stock price or wait until the company recapitalizes its balance sheet? For that matter, if rating agencies would be immediately forced to downgrade swaths of financial assets if much needed regulations were passed should the SEC act immediately and risk a market meltdown or drag the process out until the credit/housing crisis has passed? Suffice to say, that regulators are concerned about how their actions will impact the marketplace lays the groundwork for regulatory inaction and hesitation. To wit, why didn't the Fed try to stop blatant fraud in the mortgage markets during the real estate bubble years? Why did it take FASB 30-years to get stock options expensed? Why is the SEC gingerly releasing credit rating regulatory proposals that by the time, and if, they are enacted will lack any real bite?

If the security guard at your local bank is deeply concerned about whether or not a robber has enough money to feed his family perhaps he does not do his job as effectively. Regulators, for the most part, are worried how their rules will immediately impact the marketplace, which is why a more transparent marketplace is a difficult proposition.

How Regulatory Windows Open and Close

Following the Enron debacle FASB and the SEC had a brief opportunity to exact significant change. To be sure, if FASB had said that all off balance sheet interests must be fully consolidated immediately there is a good chance that such a rule would have come to fruition. This was the case because for a brief period in 2002 the carnage in the financial markets was so severe that creating tough new accounting standards could have been passed as a way to bring confidence back the markets.

In other words, when times get bad enough the regulators face less road blocks in pushing through worthwhile change. This theme is threatening to play an important role during today's challenging times, with the Fed jockeying to broaden its super-regulatory powers, the SEC (once again) butting heads with the credit rating agencies, and FASB (once again) digging into the off balance sheet mess.

Incidentally, despite their window of opportunity in 2002 U.S. regulators dragged their heels (and Congress wasted their energies passing SOX), eventually passing a convoluted set of new rules that increased the volume of information in 10Ks but not the clarity. For example, bank balance sheets are still riddled with off balance sheet unknowns and - thanks entirely to FASB - balance sheets now sport new and potentially worthless 'level 3' assets.

Could the FSA's Wild Action Be Repeated?

Unlike the post-Enron years, one can only hope that today's financial crisis will compel regulators to enact new rules that simply favor transparency. However, the sense of urgency and direction regulators are displaying is hardly encouraging. Rather, there is currently a lot of regulatory debate directed towards stopping speculation in the commodities markets and FASB is trying to get 'qualified special purpose entities' back onto the balance sheet hopefully within a year (history suggests that within a year any would be FASB solution will already have been replaced by another major problem.) As for the SEC, having failed miserably to curtail blatant rating agency transgressions since 2000, consider the following statement pertaining to the rating agencies:

The first part of the Commission's rule proposal would: Prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available.

In response to the subprime/credit crisis the Federal Reserve has gone through an unimaginable transformation in less than a year to try and bailout the markets. That the SEC needs to take the time to say that credit rating agencies should not be allowed to rate products whose assets are unavailable for scrutiny is telling of just how much work needs to be done. It could also be telling that SEC is concerned about the potential market fallout after credit rating regulations are passed.

In short, while the firebrand FSA may or may not have been right to attack short sellers, it was nonetheless refreshing to witness this non-governmental body extend their regulatory arm based upon a hunch and without a consult period. Do not expect this type of regulatory expediency in the U.S., because while the regulators have indeed saddled up how fast and far they can ride before their proposals get shot down or diluted depends primarily on the perceived benefit of regulatory change. And given that the voice of individual investors will remain largely silent unless they start pulling funds out of the markets, corporations, financial institutions, and hedge funds, are the ones dictating whether regulators walk, trot, or canter going forward.

As for the FSA-type regulatory gallop, it will forever remain one of the most impressive regulatory leaps in history, even as its originally scope has seemingly taken only days to be broken:

Short sellers will only have to declare their positions once under a UK regulator's new disclosure regime - regardless of how the positions change - in a move that underlines how much the rule changes are directly related to the current market turmoil. Financial Times ~ June 17, 08

Brady Willett
FallStreet.com

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