Robert Citron, the infamous former treasurer of Orange County, died last Wednesday at the age of 87. In 1994 he singlehandedly bankrupted the affluent county in sunny southern California by over leveraging his $20bn fund using repo markets and structured OTC derivatives with a $1.6bn paper loss…sound familiar?
As a municipal employee he did not reap personal gain from his actions, and some say he was motivated by ego. Whatever the motivation, his actions and behavior ultimately helped form some of the tenets of FAS 133 as, at the time, OTC derivatives were off balance sheet and not marked-to-market. Any of his speculative activity to create yield would have hit P&L and presumably would not have been kept under cover as long as it did. Depending on the controls around financial reporting at the time, it’s possible that with FAS 133 he either would not have entered into some of the OTC derivatives to begin with or maybe the extent of the losses associated with the speculative derivative positions could have been curtailed.
Also looking back, would Dodd-Frank have stopped this bankruptcy? As an active speculator to leverage his $20bn investment portfolio, Orange County would not have qualified for any end-user exemptions and most likely would have had to post margin against its derivative positions, which also may not have been easy to clear. However that leverage was reportedly only two times, which although surprising at the time for a municipality, is paltry compared to 2008 leverage ratios of thirty times. Presumably he would have been allowed some threshold on collateral agreements, and given the relative low leverage ratio, it’s hard to know if the extent of the loss could have been prevented by margining requirements alone.
During his grand jury hearing, Mr. Citron claimed he was an unsophisticated victim of banks selling him complex instruments and he didn’t understand the risks. Although probably not true, Merrill Lynch had to pay $400MM to settle with the county. Dodd Frank does have several business conduct rules that deal with knowing your client and explaining and documenting the risks. Some of the requirements were watered down in the final rules, for example transparency in the valuation methodology being only on request instead of being in the documentation sent to the client. However, by all accounts Mr. Citron was very sophisticated and it would be hard to see a Swap Dealer today that would not have had a problem meeting the Business Conduct rules.
Stringent accounting rules and Dodd Frank regulation would have gone a long way towards stemming the losses, but when you combine weak internal controls (Mr. Citron was able to deftly move money between accounts) with an individual intent on creating amazing market returns, a recipe for financial disaster is ready to be baked.
This week the CFTC issued its definitions around the controversial Major Swap Participant (MSP) category required by the Dodd-Frank bill. The intent of the bill was to capture previously unregulated (i.e. non bank) active swap participants who could cause systemic risk. The challenge was to define a set of rules that can encompass this group without the CFTC having to go in an audit every hedge fund, insurance company or active corporate end-user or to create a public list of MSPs.
The rules now pending a 60-day public comment period will require many active swap participants to beef up their systems to properly handle valuations, manage collateralized swaps, track FAS 133 (ASC 815) compliant swaps or bona fide hedge documentation, netting and calculating potential future exposure. The reason is, in order to avoid being tagged an MSP, the swap user has to perform two tests to see if they breach asset class defined position limits that would otherwise require them to register as an MSP, and therefore essentially mirror some of the strict Swap Dealer regulations.
The first step an MSP must take is to not include any hedges of commercial risk. Thankfully the CFTC has allowed a fairly broad array of methods to choose from, but for those entities already in compliance with FAS 133, you are allowed to leverage the standard and existing documentation and systems in place. Not often that a new benefit of FAS 133 comes your way so take advantage of it!
For the remaining positions, you have to perform two tests on determining if you breach the Substantial Position threshold. The first is after you calculate the valuations, you can deduct out those positions that are collateralized and those offset by netting. The threshold for this test is a healthy $1bn in exposure for FX and commodities and $3bn for interest rate exposure. The second test is to measure the potential future exposure of the uncollateralized positions. There is a simple mathematical formula applied that makes intuitive sense but will still require systems to handle the new matrix and discounting requirements. The threshold for potential future exposure is double the first test. Both tests have to be performed on a daily average notional which is required to avoid any buy/sell games to reduce the notional right before the tests are performed.
Go to www.cftc.gov to read the details of the rules in the Federal Register and write in your comments. Simultaneously, if you think you may be close to those thresholds, then the clock is ticking on getting systems in place to calculate the threshold tests and to prepare to comply with being a registered MSP.
In my Risky Business blog of February 4, 2010, I wrote about the IASB’s continued intent to converge with the FASB by June 2011, under the MOU outlined by the G20 in September 2009. It was anticipated that the IASB was on track to come out with an Exposure Draft (ED) on changing hedge accounting under IAS 39 ahead of the FASB, which had a failed attempt at changing FAS 133 a few years prior. Instead, the FASB came out with an ED on Financial Instruments this summer, and it just closed its comment period receiving over 3,000 comment letters (apparently over five times the record on any ED). Although most of the letters were reactions to fair value approaches, there were several concerns expressed to potential changes to FAS 133.
With the last meeting on hedge accounting completed by the IASB, it is widely expected that at long last Phase III of IFRS 9 ED will be released in the coming weeks. From what we are hearing, there are several dramatic divergences from what the FASB has proposed for changes to FAS 133. Here are some of the expected key differences under the IASB’s pending ED:
The IASB does make some good progress to promote more economic hedging, but it is very different from the FASB approaches all along. So will the FASB re-issue again a new ED to better line up with IFRS 9 or will companies with reporting entities under different regimes have to report under two completely different standards and systems? So much for the MOU.