There has been so much news and volitility over the past couple of weeks that it is hard to get a feeling of where things are headed. It seems pretty clear, however, that this in this brave new world of government sponsored capitalism there is likely to be more hedge fund regulation in the picture. Look forward to some interesting articles that we have coming up and this article on Chairman Cox’s statements to Congress.
This morning the Securities and Exchange Comission’s Chairm Christopher Cox testified to the Sentate Committee on Banking, Housing, and Urban Affairs regarding the current market events. Pertinent excepts from the speech follow:
On the new short sale rules
Last week, by unanimous decision of the Commission and with the support of the Secretary of the Treasury and the Federal Reserve, the SEC took temporary emergency action to ban short selling in financial securities. We took this action in close coordination with regulators around the world. At the same time, the Commission unanimously approved two additional measures to ease the crisis of confidence in the markets that threatened the viability of all financial firms, and which potentially threatened the ability of our markets to function in a fair and orderly manner. The first makes it easier for issuers to repurchase their own shares on the open market, which provides an important source of liquidity in times of market volatility. The second requires weekly reporting to the SEC by hedge funds and other large investment managers of their daily short positions — just as long positions are currently reported quarterly on Form 13F.
All of these actions relying upon the Commission’s Emergency Authority under Section 12(k) of the Securities Exchange Act remain in effect until October 2, and are intended to stabilize the markets until the legislation you are crafting becomes law and takes effect.t
The Commission’s recent actions followed on the heels of new market-wide SEC rules that more strictly enforce the ban on abusive naked short selling contained in Regulation SHO. These new rules require a hard T+3 close-out; they eliminate the options market maker exception in Regulation SHO; and they have put in place a new anti-fraud rule expressly targeting fraudulent activity in short-selling transactions.
On Bear Stearns
Recently the Commission brought enforcement actions against two portfolio managers of Bear Stearns Asset Management, whose hedge funds collapsed in June of last year. We allege that they deceived their investors and institutional counterparties about the financial state of the hedge funds, and in particular the hedge funds’ over-exposure to subprime mortgage-backed securities. The collapse of the funds caused investor losses of over $1.8 billion.
On monitoring the large investment banks
The SEC’s own program of voluntary supervision for investment bank holding companies, the Consolidated Supervised Entity program, was put in place by the Commission in 2004. It borrowed capital and liquidity measurement approaches from the commercial banking world — with unfortunate results similar to those experienced in the commercial bank sector. Within this framework, prior to the spring of 2008, neither commercial bank nor investment bank risk models contemplated the scenario of total mortgage market meltdown that gave rise to, for example, the failure of Fannie Mae and Freddie Mac, as well as IndyMac and 11 other banks and thrifts this year.
But beyond highlighting the inadequacy of the pre-Bear Stearns CSE program capital and liquidity requirements, the last six months — during which the SEC and the Federal Reserve have worked collaboratively with each of the CSE firms pursuant to our Memorandum of Understanding — have made abundantly clear that voluntary regulation doesn’t work. There is simply no provision in the law that authorizes the CSE program, or requires investment bank holding companies to compute capital measures or to maintain liquidity on a consolidated basis, or to submit to SEC requirements regarding leverage. This is a fundamental flaw in the statutory scheme that must be addressed, as I have reported to the Congress on prior occasions.
Because the SEC’s direct statutory authority did not extend beyond the registered broker dealer to the rest of the enterprise, the CSE program was purely voluntary — something an investment banking conglomerate could choose to do, or not, as it saw fit. With each of the remaining major investment banks now constituted within a bank holding company, it remains for the Congres.s to codify or amend as you see fit the Memorandum of Understanding between the SEC and the Federal Reserve, so that functional regulation can work.
On the CDS Markets
The failure of the Gramm-Leach-Bliley Act to give regulatory authority over investment bank holding companies to any agency of government was, based on the experience of the last several months, a costly mistake. There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit default swaps — double the amount outstanding in 2006 — is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market. This is an area that our Enforcement Division is focused on using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer outsized incentives to market participants to see an issuer referenced in a CDS default or experience another credit event.
Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. Certainly we