JANUARY 24, 2010
At SEC, a Scholar Who
Saw It Coming
To protect the financial system from the next
potentially toxic innovation or the next Bernard Madoff, the Securities and
Exchange Commission has turned to a college professor who warned back in
1993 that derivatives could cause major problems for financial firms.
Henry Hu, who studied biochemistry and worked
as a deal lawyer, has made a specialty of figuring out how finance can go
awry in unexpected ways. "It's the low-probability catastrophic event that
can kill a bank," said Mr. Hu in an interview.
His critics say Mr. Hu's imagination
sometimes runs beyond reality, and charge that his theories could lead the
government to meddle too much in Wall Street's affairs.
But the professor's out-of-the-box thinking
is what attracted SEC Chairman
Mary Schapiro to recruit him to run the agency's first new division in
37 years. She called him out of the blue to offer the job heading the
Division of Risk, Strategy and Financial Innovation, or RiskFin, after
reading an opinion article he wrote on the near collapse of American
Brendan Smialowski for The Wall Street
PEERING INTO THE FUTURE:
Henry Hu, now working for the SEC to monitor financial risk, warned in
1993 about problems with derivatives
His job, she said in an interview, is "to
help us really rethink risk management and help us attract different skill
sets to the agency as we try to remake the organization."
To help with the task, Mr. Hu brought in
another well-known critic of financial innovation, Richard Bookstaber. The
former risk manager for large hedge funds is focusing on how to better train
SEC staff and marshal the data the agency collects.
Mr. Bookstaber, whose 2007 book warned of a
looming financial crisis, told Congress that derivatives are "vehicles for
gambling," and he has urged a "flight to simplicity" in financial products.
Because RiskFin isn't actively writing rules,
"they're a little bit of a think tank in some ways," said Ms. Schapiro.
"Sometimes a person comes in and is looking at something for the first time
and asks the basic questions...that people who are experts have stopped
In the back of everyone's mind are the twin
breakdowns at the SEC that emerged in 2008. The agency was flat-footed in
oversight of Wall Street firms that made risky bets on mortgage securities
and missed the decades-long Madoff fraud.
Staffers from Mr. Hu's division are shadowing
SEC examiners. "Once we know what it is they're actually doing, we can
figure out what is the best way to train them, rather than pulling a book
off of a shelf," said Mr. Hu.
Mr. Hu is also advising Ms. Schapiro as the
SEC plans for a possible regulatory overhaul by Congress that would give it
more power to regulate derivatives. Mr. Hu is pushing for strong steps,
saying the legislation should "prevent a gaming of rules that really should
apply to everybody."
The Taipei-born 53-year-old studied
biochemistry at Yale, worked as a deal lawyer, and then spent 20 years at
the University of Texas in Austin, delving into the hard-to-understand
products that define modern finance. He acts more like an enthusiastic
professor than a jaded Washington bureaucrat, waving his arms and
emphasizing points with "boy" and "wouldn't that be neat."
In his 1993 article "Misunderstood
Derivatives: The Causes of Informational Failure and the Promise of
Regulatory Incrementalism," Mr. Hu described how financial innovation could
lead Wall Street astray. When financiers dream up new products, he wrote,
they have an incentive to downplay the risks and use them to generate
short-term profits—as well as big bonuses.
In particular, he warned about what he called
low-probability catastrophic events. That was a premonition of AIG's
near-collapse in 2008, triggered partly by the firm's use of certain types
of derivatives that were tied to mortgages. Financial institutions such as
AIG hadn't predicted credit and liquidity for the products would dry up so
"He's been a Cassandra," said federal judge
Patrick Higginbotham in Dallas, a former boss.
Mr. Hu and a colleague have written about a
scenario in which a bank lends money to a company but uses derivatives to
eliminate any exposure if the company goes bankrupt. Mr. Hu calls the bank
in such a case an "empty creditor," and says it is dangerous because it
undermines a basic assumption in financial markets: that creditors act in
the interests of the debtor's survival.
In a Wall Street Journal opinion article in
April 2009—which Ms. Schapiro says prompted the job offer from the SEC—Mr.
Goldman Sachs Group Inc. used a kind of derivative called a credit
default swap to turn itself into an empty creditor of AIG. He wrote that
this may have encouraged Goldman to push for extra collateral from AIG, even
when that threatened AIG's existence.
Lucas van Praag, a spokesman for Goldman
Sachs, said for a number of reasons the bank "doesn't think that its
transactions with AIG are appropriate examples of Prof. Hu's thesis."
The derivatives trade association, the
International Swaps and Derivatives Association, later criticized the
research, saying the empty-creditor hypothesis is "appealing on the surface"
but "is not consistent with either the way credit default swaps work nor
with observed behavior in debt markets."
Kara Scannell at
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