Inefficiencies in the information thicket: a case study of derivative disclosures during the financial crisis.

• Author: Bartlett, Robert P., III

1. INTRODUCTION II. BACKGROUND: MONOLINE INSURERS AND THEIR DERIVATIVE DISCLOSURES III. UTILIZATION OF DERIVATIVE DISCLOSURES: EVENT STUDY ANALYSIS A. Event Study Framework: Overview B. Market Reactions to the Downgrade of Pacific Gas & Electric in 2001 C. Market Reactions to Downgrades of Multi-Sector CDOs in 2008 IV. CDO DOWNGRADES AND ARBITRAGE ACTIVITY A. Short Selling Activity in Ambac's Common Stock B. Changes in the Price of Insuring Ambac's Senior Indebtedness C. Case Study of Pershing Square Capital V. ASSESSING THE EFFECTIVENESS OF DERIVATIVES DISCLOSURE VI. CONCLUSION I. INTRODUCTION

   It is now accepted wisdom that a principal contributing factor to the destabilization of the financial system in 2008 was the notable lack of transparency in what has colloquially been dubbed "the shadow banking system." (1) Starting in the early 1990s, this broad swath of non-bank organizations--including investment banks, insurance companies, and hedge funds--created a significant network of financial intermediaries and investors that was capable of funding and trading any number of loan products that had traditionally been in the domain of commercial banks, including credit card receivables, commercial loans, and most notably, residential home mortgages. Through securitization, an investment bank could form a collateralized debt obligation (CDO) to acquire a portfolio of loans from one or more loan originators, the funds for which would be raised through the CDO's issuance of multiple tranches of notes to institutional investors. However, because both the issuance of notes and their subsequent acquisition were generally exempt from the reporting requirements of U.S. securities laws, it was often unclear where the financial risk of these investments ultimately resided. (2) When real estate losses began to mount in 2007, this uncertainty regarding firms' derivative exposure to these losses brought inter-firm lending to a halt, eventually producing the de facto bank runs that would destroy both Bear Stearns and Lehman Brothers. (3)

   The opacity with which financial institutions accumulated significant exposures to credit derivatives has naturally led to a variety of U.S. and international reform proposals aimed at casting light on this important corner of the financial sector. (4) Consistent with conventional securities regulation policy, these proposals generally assume that requiring greater, more granular disclosure of a firm's derivative credit exposures, together with more detailed disclosures of the assets underlying these exposures, should enable investors to conduct the type of independent analysis of a firm's derivative exposure to credit risk that was arguably missing during the credit boom of 2003 to 2007 and the financial turmoil of 2008. Rather than rely on a firm's own assessment of its balance sheet or the credit rating assigned to it by a potentially conflicted credit rating agency (CRA), investors could utilize these disclosures to build their own credit models, thereby bringing greater market discipline on a firm's credit derivative activities while minimizing uncertainty about credit risk during periods of financial stress.

   A central challenge facing these proposals, however, is understanding the extent to which market participants will actually use these additional disclosures. Valuing even a single CDO investment--let alone a portfolio of such investments--requires a multifaceted analysis of a considerable amount of both legal and financial data, ranging from an estimation of the default and prepayment risks of hundreds, potentially thousands, of underlying loans, analysis of the particular overcollateralization and subordination provisions attaching to particular tranches of CDO securities, and an assessment of potential counterparty risk of the CDO's various hedge counterparties. For this reason, academic commentary on the effect of enhanced derivative disclosures has frequently been skeptical of the benefits of enhanced disclosure, suggesting instead that the complexity of many credit derivatives--especially those tied to structured finance vehicles such as CDOs--may make it impossible for markets to incorporate additional information in a meaningful way. (5) To the extent that this is the case, enhancing derivative disclosures will simply add to the burden of periodic reporting requirements for financial institutions, potentially driving finance to use less efficient forms of organization. From a regulatory design perspective, overestimating the potential for market participants to police credit derivatives may also detract from other, more effective regulatory initiatives. (6)

   To understand better whether enhanced derivative disclosures can play a role in systemic risk regulation, this Article turns to a unique corner of the financial sector that is ideally suited to study how greater derivative disclosures might have affected the Financial Crisis of 2008. Alternatively known as the "monoline insurance" or "financial guarantee industry," from 2005 to 2008, this industry was both deeply exposed to complex credit derivatives tied to residential home mortgages and subject to considerable disclosure obligations regarding its credit derivative activities. (7) To date, however, regulators and scholars alike have largely overlooked the disclosure experience of the industry notwithstanding its critical role in the Financial Crisis. Although traditionally focused on providing insurance against the default of municipal bonds, monoline insurers expanded during the 1990s to guarantee the principal and interest on bonds issued by structured finance vehicles, and by 2005 they were increasingly selling credit default swaps on bonds offered by multi-sector CDos backed by prime and sub-prime mortgages. (8) Indeed, by 2007 the two largest monoline insurers--Ambac Financial Group (Ambac) and MBIA--had each sold credit default swaps on approximately $30 billion of bonds issued by multi-sector CDos making their combined exposure to these instruments approach that of AIG Financial Products. (9)

   Yet in contrast to AIG's portfolio of credit default swaps--the details of which were not disclosed publicly until January 2010--a combination of the statutory accounting rules that apply to financial guarantee companies and the voluntary disclosures made by Ambac and MBIA during the Financial Crisis resulted in the quarterly disclosure of their largest exposures, including their multi-sector CDO exposures. At the same time, a peculiar coincidence involving European regulatory developments, offering practices within the CDO market, and the particular timing of the insurers' entry into the CDO market had the effect of making available to the public a large amount of legal and financial data on each insured CDO. As a result, for almost every CDO in Ambac and MBIA's portfolio during the run-up to the Financial Crisis in 2008, it was possible to obtain a complete description of the specific indenture provisions pertaining to the tranche of notes guaranteed (such as overcollateralization provisions and default protections), information about portfolio composition, and the identity of critical third parties such as swap counterparties, liquidity providers, and indenture trustees. (10) Equally important, investors could use this information to obtain from the indenture trustee's website the CDO's monthly remittance reports, which provided detailed financial information concerning each security in the CDO's portfolio, the portfolio's overall performance, and the monthly cash flows to the particular tranche of notes guaranteed. In short, the unique circumstances that applied to Ambac and MBIA in 2008 permitted market participants to engage in precisely the type of fundamental analysis of a firm's credit derivatives that was not possible with firms such as AIG or Lehman Brothers.

   For similar reasons, examination of the monoline industry also permits a case study of how investors might use enhanced derivative disclosures to alleviate the uncertainty associated with assessing the risk of a complex derivative such as a CDO. That is, to the extent greater disclosure by a financial firm of its derivatives positions can reduce uncertainty in times of financial stress, evidence of this effect should have appeared in the asset pricing of monoline insurance companies during the Financial Crisis of 2008. Conversely, if derivatives such as CDOs are in fact too complex for market participants to analyze in a reasonable period of time, evidence of this type of informational inefficiency should also have appeared in the behavior of monoline investors. In particular, the failure of monoline investors to respond to an abrupt change in the credit risk of an insured CDO or an announcement by an insured CDO's trustee that it has commenced liquidation might each suggest inefficiencies in investors' ability to process disclosures about the type of complex credit derivatives that were at the epicenter of the Financial Crisis.

   To assess which of these two scenarios applied to the monoline industry during the Financial Crisis, this Article uses two principal strategies. First, to examine whether the insurers' derivative disclosures might have produced more efficient asset pricing, I turn to an event study framework of one of the largest monoline insurers, Ambac Financial. Given the emphasis on the role that complexity might play in impeding effective disclosure, the analysis begins by examining the effect of the firm's derivative disclosures in the context of its traditional bond underwriting business. As shown below, analysis of the bankruptcy of Pacific Gas & Electric (PG&E) in 2001--one of the few instances when monoline insurers experienced a significant loss payout in their insured bond portfolio--indicates that investors could be quite sensitive to news affecting the credit risk of ordinary bonds insured by monoline insurers. The initial...