11 Dec3 Lessons about Product Liability
We have all heard about cars having defects and the likes of Toyota having to do a so called “recall”. When you read those stories, your thoughts may be similar to mine: “Fair enough, there is a recognised problem, they have to pay to put it straight.” Banking has its own “product liability”, which can be broadly categorised under “mis-selling.” In 2012, there is a lot of that about. In the UK, there are massive clean-up exercises around PPI, payment protection insurance, and swap mis-selling. The inspiration for this week’s post though comes from a case involving the US Attorney General and Credit Suisse.
Mortgages. These everyday things we take for granted were at the heart of the 2008 market meltdown. I have always thought that America has the best and the worst of everything. Mortgages proved no exception to that rule. The US has a great system for securitising assets; mortgages, and many other assets, are bundled into a group as the collateral backing for a bond issue. MBS or Mortgage Back Securities (For more on that market, I recommend Michael Lewis’ seminal book, Liars Poker). A specialised type of these are RMBS, Residential Mortgage Backed Securities. Residential meaning houses homed by John Q. Public. Excellent, America is good. Innovation, allowing a product and a market to develop. Now, if you have been following the stories of the US market’s travails, you will have read that in America mortgages were being given to people that really should not have had them. Famously there were even “No Doc” loans where there was less scrutiny by the lender on the borrower than of late by HSBC over their new accounts. Part of this was caused by the fact that the mortgages, once sold, were bundled and sold. So all those in the sales part of the chain could say: “Not my problem any more.” America is the worst; good ideas taken to excess.
Banks played a role as intermediary in all of this; packaging the mortgages together into a security and selling them to investors. Quite often these securities had AAA ratings from the accredited rating agencies; S&P Moody’s etc. Not a lot of diligence there either. Given how unreliable some of the borrowers were, it is no surprise that there were a huge number of so called delinquencies, or non-payments. Way more than “normal”. So the prices of the bonds collapsed and a lot of people lost a lot of money. When that happens, those who lose money are always going to look for somebody to suit to recover their money. This always happens, even if they were fools rushing in where angels fear to tread. And, of course, they will go after the folks with the deepest pockets.
Cross t’s and dot i’s. Over the years, I have been fortunate enough to work with some truly excellent leaders and real experts in their profession. One of them was Ed Watts at Goldman Sachs. Once we were discussing the private client business and Ed wisely told me that when there are unequal partners to a transaction, for example a bank or broker with private clients, then you cannot claim that “we are both big boys or grown-ups” and if something goes wrong, if the broker has made a mistake, the chances are that the law will side with the individual and give them a free put option at the issue price. “Put” meaning they can put the bonds back to the issuer. Actually, even though I did not realise it at the time, English Law has a concept for this: Duty of Care, which basically says if you hire a professional service, you can, or ought to be able to, rely on the provider of that service. So the professional has to get it right, which seems reasonable if you think about it like that. Passing years mean I forget the exact context of that lesson at Goldman Sachs, but the lesson to be learned was that you have to be extra careful to cross t’s and dot i’s when there are retail investors. This is a complementary thought to “widows and orphans”, which is a test about suitability. If you like the second test. The first test is this duty of care to do things correctly and the second, the widows and orphans test, is that even if you do things correctly, the product ought to be suitable.
The law often takes its time to do things. In recent weeks, that RMBS issue has entered another chapter. The US Attorney General has filed suit in an $11 billion case against Credit Suisse (see: Here is the City). There seem to be two major failings in this case:
Claiming to have done something you have not. “Credit Suisse failed to abide by its representations that the loans underlying their RMBS were originated in accordance with the applicable underwriting guidelines,” claims the suit. It seems that CS do not have an audit trail that showed the agreed procedure being followed. This is a problem and a bad practice, albeit not something that is traditionally an operations process or responsibility. However, the level of expectation is changing in terms of how the regulator expects the banks Operations teams to question the front-office.
Committing to do something you do not do. The loans were also supposed to be reviewed periodically. This is a form of asset servicing. Somewhere in the prospectus it said “the issuer will do a,b, & c.” Unfortunately, it seems there was no process in place to ensure that a,b & c were done. This is an interesting challenge; the action item has a date, but would not typically be the kind of product reference data that a bank would capture like it might do a coupon date or an interest rate. I have experienced this before in the heydays of warrants in the early ’90’s. At Goldman Sachs we had some front-office folk who issued warrants tied to FX rates that if exercised settled in cash. So you might have a USD / CHF put warrant at a strike of 1.10, allowing you to give $1 for CHF 1.10. You would exercise if the market rate was below 1.10 since you could swap that CHF 1.10 back into USD and have more than the $1 you started with. Well the geniuses that wrote the prospective said that for settlement the rate used would be: “.. the rate prevailing at the time of exercise.” This was very vague. Which rate where, what about if the holder exercised at 10:58 and we could only look up the rate at 11:02? I had the traders fix that one and set out something more precise and indisputable, so that we had a chance of doing what we had committed to. Somewhere in the process for these RMBS things, it would appear that either there was no operational process to deal with this on-going commitment or there was a procedure for it, but it was not followed.
If you have a commitment to do something, then this is a characteristic of the instrument and you need to set that up in your product master. If you are the issuer, rather than the holder, you need to be sure to do that task even if you do not hold any of the security. Typically, one way of ensuring this is to have an Issuer Account be short the size of the issue. That way, irrespective of whether you hold any of the issue or not, there will always be a position.
Lessons Learned: Three, that most convenient of numbers. Firstly, generally, be precise, be pedantic and check things; cross t’s and dot i’s. No different from what I have to tell my teenage kids about their homework or when taking a test. In the case of a prospectus, this means reading it through in draft and asking: firstly, have we done what we have said we have done? Secondly, can we do what it says we will do?
This will be the last installment for 2012. Happy holidays and all the best for 2013.
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