Capital markets, derivatives and the law

capital markets, derivatives and the law This page intentionally left blank capital markets, derivatives and the law alan n rechtschaffen 1 Oxford University Press, Inc., publishes works that further Oxford University’s objective of excellence in research, scholarship, and education Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Mexico City Nairobi New Delhi Shanghai Taipei Toronto Madrid Melbourne With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Copyright © 2009 by Oxford University Press, Inc Published by Oxford University Press, Inc 198 Madison Avenue, New York, New York 10016 Oxford is a registered trademark of Oxford University Press Oxford University Press is a registered trademark of Oxford University Press, Inc All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press, Inc _ Library of Congress Cataloging-in-Publication Data Rechtschaffen, Alan N Capital markets, derivatives and the law / Alan N Rechtschaffen p cm Includes bibliographical references and index ISBN 978-0-19-533908-6 ((hardback) : alk paper) Financial instruments—Law and legislation—United States Securities—United States Capital market—Law and legislation—United States Securities industry—State supervision—United States Securities industry— Deregulation—United States Stock exchanges—Law and legislation—United States I Title KF1070.R42 2009 346.73’096—dc22 2009013421 _ Printed in the United States of America on acid-free paper Note to Readers This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is based upon sources believed to be accurate and reliable and is intended to be current as of the time it was written It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services If legal advice or other expert assistance is required, the services of a competent professional person should be sought Also, to confirm that the information has not been affected or changed by recent developments, traditional legal research techniques should be used, including checking primary sources where appropriate (Based on the Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations.) You may order this or any other Oxford University Press publication by visiting the Oxford University Press website at www.oup.com To the Source of all that I have to be thankful, and to my beautiful wife Miera who is my light; to my daughters Ronit Florence and Eve who make me so happy, and to my parents who have given me so much Thank all of you I love you very very much This page intentionally left blank contents Foreword xvii Preface xix Acknowledgments xxiii Introduction xxvii chapter the financial crisis I II III IV V VI VII Origins Subprime Lending Government-Sponsored Entities The Liquidity Crisis and the Fed’s Reaction Providing Liquidity and Stabilizing the Financial Markets The Emergency Economic Stabilization Act 10 Results 12 chapter financial instruments in the capital markets 13 I The Capital Markets 13 A Primary vs Secondary Markets 15 B Long-Term vs Short-Term Marketplaces 15 C Case Study: The Auction Rate Securities Market (ARS) 16 II Financial Instruments 17 A Types of Financial Instruments 17 Equity-Based Financial Instruments 17 Debt-Based Financial Instruments 18 Derivatives 19 B Distinction between Debt and Equity 20 C Federal Regulation 23 III The Evolving Role of the Attorney 25 A Competent Representation 25 B Duty to Advise Client 25 C Drafting Financial Instruments 26 D Regulatory Compliance 26 E Liability to Third Parties 27 F The Attorney as Business Partner 28 chapter using financial instruments 29 I Goal-Oriented Investing 29 A Using Financial Instruments to Hedge Risk 30 viii contents B Using Financial Instruments to Enhance Yield 31 C The Economy’s Impact on Financial Instruments 32 II Achieving Investment Goals 33 A The Investor’s Perspective 33 B Financial Instrument Objectives 35 III Managing Risk 37 chapter securities regulation 39 I Regulatory Overview 39 A The Securities and Exchange Commission 41 Jurisdiction 41 B What Constitutes a “Security” 42 Stocks 43 Notes 45 Investment Contracts—The Howey Test 51 a Control and Splitting the Transaction 57 b Prepurchase Efforts 59 c State Regulation and the Hawaii Market Test 61 C Sellers’ Representations 63 D Consequences of Securities Violations 64 Preliminary Injunction 65 Disgorgement 65 Permanent Injunction 65 Antifraud Statutes 66 Attorney’s Potential Liability 67 E Hedge Funds 67 The Investment Company Act 69 Investment Advisers Act 70 Securities Act 71 Other Regulations 72 Appendix A: Checklist for Stocks, Notes, and Investment Contracts 73 Appendix B: Derivative Product Regulation 74 chapter understanding interest rates and the economy 79 I The Federal Reserve 79 A Recent Market Turmoil and the Fed’s Reaction 80 B Background 83 II The Role of the Federal Reserve in Domestic Capital Markets 87 A The Federal Reserve Banking System 87 contents ix Composition 87 Purpose 88 Responsibilities 88 B Federal Funds Transactions 89 C The Federal Funds Rate 90 D Banks and Federal Funds 91 III Economic Indicators and Interest Rates 93 A The Economic Calendar 93 B Key Economic Statistics 93 C Asset Pricing and Short-Term Interest Rates 97 D Monetary Policy Decisions 98 IV The Role of the Federal Open Market Committee 99 A Affecting the Federal Funds Rate 99 B Treatment of Federal Funds 101 C Implementing Monetary Policy 102 D Open Market Operations 103 E Targeting the Federal Funds Rate 105 F How the Federal Reserve Talks Up the Market 106 G Inflation Targeting 107 Appendix A: Sample FOMC Minutes 109 Appendix B: FAQs: MBS Purchase Program 120 chapter asset valuation 123 I The Use of Interest Rates in Asset Valuation 123 II Interest Rate Yield Curve 124 A Types of Yield Curves 125 B Why the Yield Curve May Be Flat or Inverted 127 Increase in Market Demand for Long-Term Securities 127 Long-Term Yield Affected by Federal Reserve Monetary Policy 128 chapter united states treasury securities 129 I Purpose and Goals 129 A Risk-Free Nature 130 B Primary Dealers 131 II Description of U.S Treasury Securities 132 A Types of Treasury Securities 132 Treasury Bills 132 Treasury Notes and Bonds 132 338 appendix index A AIG, 9, 23 access to capital markets, CDS obligations of, 188 credit derivatives and, 173 compensation practices at, 235 failure, 162 Federal bailout, 162, 173 Federal Reserve emergency credit granted to, government involvement, 174 implosion at, 173 risk and, 222 stock prices, unethical behavior, 235 Amaranth Advisors, LLC, 215–18 American economic crisis, xvii–xxix, 23, 173 American International Group See AIG Antifraud provisions of the federal securities laws, 273–74 section 10b of the Exchange Act and, 273 suitability obligations sources, 265 unsuitability, 273–74 Arbitration, 209, 265 breach of fiduciary duty, 265 customer disputes with brokers and, 261 functions of the NYSE, 268 futures related disputes, 209 mandatory, 265 Asset backed commercial paper, backed securities, coverage, 16 illiquid, mortgage related, 9, 11 pricing, 5, 123 ratings, sales, 5–6 troubled, 11 true value of, 124 underlying, 19 valuation, xxviii, 123 valuation formula, 124 Asset pricing See Asset valuation Asset valuation longer-term, 128 models, 123–4 short interest rates and, 97–98 Auction process auction rate securities and the, 16 floating rate securities issued in the, 138 manipulation of the, 136–38 U.S treasury bonds issued in the, 135 Auction rate securities market (ARS) 16–17 B Bank for International Settlements, 172, 222 Banking system, 10, 228, 316 aggregate reserves, federal, 23, 87–93 global reserves, liquidity, 5, 18 losses, 318 national, 279 regulation and, 49 Bear Sterns acquisition, bankruptcy, Bear Sterns International Limited (BSLI), 183–187 buyout, 5, 7, 162 counterparties, 160–62 fear of implosion of, 160, 162 J.P Morgan purchase of, 160 private-label mortgage-backed securities created by, sale of, 5, 7, 160 Bernanke, Ben S., xxii, 5, 8, 11, 69, 80, 88–89, 103, 105–7, 125–27, 139, 162 340 index Black-Scholes model assumptions, 293 authority of, 296 components of the option, 290, 301 defined, 171 formula, 301, 304 option pricing, 290, 290–93 origins, 292 required data, 293 volatility, 293–94 Blueprint for a Modernized Financial Regulatory Structure, 23 Board of Governors of the Federal Reserve System, 189 Bond auctions effect on price of, 135 interruption of supply, 135 Bond, price/yield relationship, 134 Bond rating agencies, 147–49 AAA rated, defined, 147 ratings, 148 regulations of, 149 role in the mortgage–backed securities meltdown, 148 Bonds Argentinean, 176 auction, 135 call option, 146 classification, 146 corporate, 19, 114, 138, 146, 281, 331 coupon rate, 140–42, 146 debentures and, 45, 74 defined, 132, 145, 146 description, 145 features of, 146 federal agency, 146 fixed rate, 176 floating, 176 government, 95, 143 historical example, 304 illiquid, 182 indentures, 147 in secondary market, 135 issued by sovereign nations, 18 long-term, 125, 127 long-duration See Bonds, long-term lower interests and, 129 market for, 140 mortgage backed, 1, 33, 83, 281 municipal, 19, 146 par value, 146 performance, 211 pricing of, 129, 133–35, 142 put option, 146 rating agencies, 147–49 stocks and, 42, 74 STRIPS, 142–43 tax exempt status of, 67 thirty-year, 136 trade, 133 trading at a premium, 135 trading under face value, 135 treasury notes and, 19, 83, 85, 129, 132–33, 140 See also Treasuries types of, 146–47 valuation, 148 yield to maturity in, 133 Bush, George W., xx, 10 C Call options, 171 defined, 289 premium, 289 strike price, 289 value of, 289 Capital markets, 80, 145 domestic, xxvii, 40, 87–93 interconnectivity of, xvii liquidity, 92 longer-term, 86 mortgages and, participants, 86 participation, xxvii–xxviii, 14, 27–28, 39–44, 335 reaction to lower interest rates, 97 systemic threats to, trading activities, xxvii–xxviii, 222, 230–31, 233–36, 238 trading systems, 190 Categories of risk See Risk Categories CCP, 189 CDOs, 280 CDS See Credit-default swaps CDS contracts, 189 CDS markets, 180 CFTC See Commodity Futures Trading Commission (CFTC) CFTC v Amaranth Advisors, LLC, 215–18 index 341 CFTC Reauthorization Act of 2008, 192, 207, 253, 259, 278, 300 CFTC v Co Petro Marketing Group Inc See Co Petro CFTC v Intertrade Forex Inc 202, 206–207 CFTC v National Investment Consultants Inc 202–3 CFTC v Zelener, 201, 218–19 Chicago Board of Trade (CBOT) rulebook, 211 powers, 211 Churning defined, 243 prohibition against, 242 rule 10b-5 and, 243 CMOs See Collaterized mortgage obligations Collar, 301 Collaterized Mortgage Obligations, 4, 120, 153–54, 274–75, 282 COMEX, 212 Commercial banks, 46, 88–89, 100, 245, 298 Commercial paper, 6, 18, 79–80, 87, 97, 114, 155 Commodity exchange Act of 1936 (CEA), 192–93, 200, 276, 278 antifraud provision, 259, 278 illegal off-exchange trades claims, 259 Commodity Futures Trading Commission (CFTC), 192–93 administrative sanctions, 209 current and emerging issues, 214–15 disciplinary action, 209 disclosure rules, 275 division of clearing and intermediary oversight, 208 division of enforcement, 208–9 division of market oversight, 208 jurisdiction, 204 jurisdictional disputes, 195 jurisdiction over futures on exempt securities, 198 lists of reparation sanctions, 209 mandatory disclosure rule, 276 office of the chief economist, 209 origins, 207 regulation, 200 regulatory authority of the, 214 regulatory jurisdiction, 214 role of, 208 rules, 209 structures, 208, 220 Commodity Futures Trading Commission Act, 206–7 Commodities Futures Modernization Act of 2000 (CFMA), 199, 275, 300 authority, 276 derivates clearing organizations, 213 derivates transaction execution facilities, 213 designated contract markets, 213 exclusions, 196–97 Exempt Boards of Trade, 213–14 further purposes of the, 194 jurisdiction, 204 markets created by the, 213 three-tiered system, 195–96 stated goals of, 194 Commodity futures markets, 275 Commodity options, 275 Commodity Pool Operator, 72, 208 Commodity Trading Advisor, 208 Common law theories, 245–252 breach of fiduciary duty, 248–51 Contract Theory, 252 common law fraud, 251 Shingle Theory, 251 Tort Theory, 252 Consumer Financial Protection Agency, proposed, xxi Consumer price index (CPI), 95 Consumer spending, 11–12, 96–98, 105–6, 111, 115 Co Petro, 200 Corporate bond rates, 124 Corporate bonds, 138, 146 Counterparty Credit Risk, 162, 332 Covered call, 300 CPO See Commodity Pool Operator Credit crisis low-interest rates, 97 recent, 97 Credit crunch, 22, 222 Credit-default swap market, 180 current, 188 342 index Credit-default swap market (cont.) regulators’ interest in, 188 regulatory action, 187–190 risks, 188 Credit-default swaps (CDS), 178, 181 defined, 179 importance of clearly defined terms in, 180–81 market, 189 other issues, 187 protection, 179–80 purpose and function, 179 timetables and deadlines in, 187 transactions, 189 settlement, 187 Credit-default swap agreement, 182 Credit derivatives, 173–74 credit event, 181 Credit market(s), xxvii–xxviii, 12, 18–19, 84–85, 98, 101–2, 105–6, 188 Credit rating agencies, 149 Credit rating agencies Reform Act of 2006, SEC Rule I7g-6, 149 Credit risk, 2–3, 6, 38, 81, 84, 89, 160–62, 304 CTA See Commodity Trading Advisor Currency swap agreements, 177 Currency swaps defined, 177 leverage, 178 spot rate, 178 D Debt instruments, 303 Debt securities, 145 Delta hedging defined, 296 market risk in, 297 Department of Housing and Urban Development See Housing And Urban Delvelopment, U.S Department of Department of the Treasury See Treasury, U.S Department of Derivative contracts, 170 Derivative interest rate swap, 177 Derivatives basis risk, 164–65 carry costs, 164 commodities-based, 275–78 components, 304 counterparties, 160, 162–63 counterparty credit risk, 160–62 credit, 173–74 defined, 159 description, 159–63 effective tools of risk management for, 165 equity, 268 exchange-traded, 162–63 introduction, 159–60 market price, 164 market risk, 165 markets, 90, 275 misuse of, xix mortgage, 120 new products, 195 over-the-counter (OTC), 162–63 products, 205 regulation, 192 as risk tools, xix shifting risk in, 163-64 specific, 253 spot price, 164 types of, 159, 165–74 Derivatives markets regulated organized, 275 unregulated, 275 Disclosure, 224 Disclosure rules, 275 Discount rate, 124 Discount window, 7–8, 82–83, 88, 91–92 borrowing rate, 91 changes of the, 82 Distinction between forwards and futures, 168–69 E ECNs (Electronic Communications Networks), 212 Economic calendar, 93 Economic crisis, xxiii–xxiv, 23,173 Economic indicators and interest rates, 93 Economic recovery, 12, 85, 128 Electronic Communications Networks (ECNs), 212 Equities, 268 Equity swap, 177 index 343 Erlanger (cotton) bond, 306f Exchanges defined, 210–11 demutualized, 212 demutualized model, 212 examples, 212 historical background, 210–11 member-based structure, 212 membership associations, 211 public, 212 traditional model for, 211 types of, 210 Exchange Act, 155 Rule 10b-5, 241, 271 Rule 2310, 270–271 Exchange-traded derivatives, 163 Exchange-traded option strike price, 299 terms, 299 Excluded commodities, 196 Exempted commodities, 196 F Fannie Mae, 3–5, 152, 307 FDIC See Federal Deposit Insurance Corporation (FDIC) Fed See Federal Reserve Federal agency bonds, 146–147 Federal Deposit Insurance Corporation (FDIC), 12, 18, 49, 311, 316 Federal IOU’s, 84 Federal Funds banks and, 91–93 treatment of, 100–2 Federal Funds Rate, 138 affecting the, 99 approaches, 91 buying decisions and, 100 current, 124 defined, 90 policy stimulus and the, 101–2 targeting the, 103 targets, 90 Federal Funds Rate Target, 7, 9, 80, 85–86, 90, 99, 101–2 Federal Funds Transactions, 89 Federal Home Loan Mortgage Corporation See Freddie Mac Federal Housing Finance Board, Federal National Mortgage Association (Fannie Mae), 3–4, 152, 307 Federal Open Market Committee, 84, 86 main goal, 99 role of the, 99 target range, 105–6 trading desk, 131 Federal regulation, 269 Federal Reserve, 90, 91, 105, 160–61, 174 Act §2a, 12 U.S.C §225a, xxviii actions, 83 activities of the, 86 available tools, 85 banking system, 87 balance sheet, 85 Bear Stearns buy out and, Board of Governors of the Federal Reserve System, xxvii–xxviii, 1, 189 borrowing from, 5–6 Capital Markets Trading Manual, changes in interest rates, 97 communication with the public, 106 concerns See Federal Reserve, mandates control over the growth of economy, 86 courses of action, 82–83 defined, 79 discount rate, 82 discount window See Discount window duties, 80 effect of providing access to liquidity, 92–93 emergency lending authority, 91 federal funds rate and, 7, 85 Federal Open Market Committee of the, 84 financial instruments affected by actions of, xxviii FOMC minutes, 109–119 forming monetary policy, 98–99 funds rate, 83 goals See Federal Reserve, role of hybrid instruments and, 205 inflation targeting process, 106 interest rates and See Federal Reserve, role of interest rate bias, 86 interest rate decisions, 123 344 index Federal Reserve (cont.) interest rate move at the, 97 liquidity crisis, 80 liquidity provision by, longer-term interest rates, 86 long-term yield affected by, 128 lowering short-term interest rates, 83 lower interest rates, 123 monetary policy, 83, 128 monetary policy objectives, 99 open-market operations, 82, 85 openness, 105 origins, 79 primary dealers and the, 131 processes and decision making, 105–6 program to purchase direct obligations of housing-related, 86 purchasing longer term securities, 83 reaction to lower interest rates, 97 recent market turmoil and reaction to by the, 80–83 role of, xxvii–xxviii role of domestic capital markets and, 87–93 role of preventing systemic failure, 80 short-term monetary policy of the, 128 spread between the federal funds rate, 82 stress testing and, 227 supply of liquidity, system, xxviii, 2, systemic failure prevention by See Federal Reserve, role of TAF, 83 target for the federal funds rate, 80 target interest rates, 105–106 targeting of the federal funds rate, 84 Term Auction Facility, 7, 80, 83, 91 tools available to, trading and capital markets activities manual, 307 transparency, 105 Federal Reserve Act, 79 Federal Reserve Banking System, 87–89 composition, 87–88 federal funds transactions, 89–90 purpose, 88 responsibilities, 88–89 Federal Reserve Bank of New York, 131 Federal Reserve banks, 79 Federal Reserve board, 101–2 Federal Reserve System, 79, 100 communication strategy, 106–7 defined, 79 origins, 79 Federal securities laws Exchange Act, 241 prohibition against insider trading, 136 rule 10b-5, 241 Securities Act, 241 Securities Exchange Act of 1934, 241 Federal system of securities regulation, 269 FHLMC, 152 Fiduciary obligation to manage risk controlling risk, 221 directors and officers’ duty to manage risk, 222–26 Financial crisis origins, 2, 263–64 Financial engineering, banks and, xvii Financial futures, 275–78 Financial Industry Regulatory Authority (FINRA) defined, 268 rulebook, 268–69 rules, 269 Financial innovation, 2–3, 13, 23–24, 68, 194, 232, 236 Financial instruments, xxvii ability to shift risk throughout the capital markets, 190 defined, 83 directors’ and officers’ understanding of, 230 economic purpose, 84 importance of, 190 mortgage-backed securities as, shortest-term interest bearing, 84 short term, 86 used as a means to enhance yield, 83 used for hedging, 171 used to access capital from investors, 83 used to make money, 83 used to manage risk, 83 valuation, 123 yields on fixed income, 138 index 345 Financial market(s) regulators, xxviii, 13–14, 29–30 stability of, 10, 24 Financial Regulatory Reform: A New Foundation, xx, 41 Financial risk calculating, 226 curve risk, 226 defined, 226 delivery risk, 226 methods of calculating, 226 quantifying, 226 stress testing, 227 swing risk, 226 types, 226 value at risk, 226 VAR formulas, 227 volatility risk, 227 FINRA, 268, 270 Fixed income securities, 138, 154 indenture, 147 regulatory framework, 147 special types of, 149–52 types of, 147 Fixed-rate-financing, 177 Fixed versus floating rate securities, 138 Flat yield curve, 126f Floating rate note, 138 Floating rate securities, 138 FNMA, 152 FOMC, 83, 105–106 FOMC minutes, 109–119 Foreign Boards of Trade, 214–15 Foreign currency swap, 178 Foreign exchange contracts, 206 Foreign Exchange forwards, 169–70 Foreign exchange futures, 169–70 Foreign exchange instruments, 205 Foreign exchange products, 205 Foreign exchanged swap, 177–78 Forward contracts See also Forwards categorized as futures agreements, 258 excluded from regulatory jurisdiction of the CFTC, 257 exempt from CFTC regulation, 258 litigation, 258 Forwards counterparties, amount of financial leverage of, 169–70 defined, 166–167, 197–98 and futures, 200 primary purpose, 166 spots transactions, 169–70 typical, 166 Forwards and futures, 200 Fraud, 204 Freddie Mac, 4, 152 FTPA, 253, 276 Future agreements, 258 Futures counterparties, amount of financial leverage of, 169–70 characteristics, 177 defined, 177, 198 narrow-based securities indexes, 199 nonsynthetic security, 199 reduction of counterparty risk in, 177 security, 199 spot transactions, 169–70 suitability as hedging instruments, 177 synthetic security, 199 trading of, 199 Futures commission merchants (FCMs), 276, 278 Futures contracts See also Futures defined, 258–259 subject to CFTC regulation, 258 Futures Trading Act of 1986, 253 G Geithner, Timothy, on current regulatory framework, xxi General Accounting Office, 160–62 Generally Accepted Accounting Principles (GAAP), 239 Gibson Greeting Cards, 245–46 Ginnie Mae, 152 Global capital marketplace, 2, 23 Global economy disruptions in, xxvii, financial crisis and the, xxvii financial institutions in, 1–2 mortgage backed securities, the subprime credit crisis and, 2–3, 279–80 GNMA, 152 Government agency securities, 155–56 346 index Government IOU’s, 84 Government securities, 155 Government sponsored entities See GSEs Greenspan, Alan, xxvii, 1, 102 GSEs (government-sponsored entities), 3–5, 39, 85, 86, 307–9, 307 debt, 86 guaranteed mortgages, 86 oversight of, H Hawaii Market test, 61–62 Hedge, 30 Hedge funds, 31, 67 Holistic risk management, 229 Housing market, 11–12, 81–86, 97, 103, 106, 115–19 Housing And Urban Delvelopment, U.S Department of Howey test, 51–56, 59–60 Hybrid instruments defined, 205 nature of, 205 I Increase in market demand for long-term securities, 127 Indenture, 147 Inflation indexed treasury securities See Treasury inflation-indexed securities Inflation targeting, 107–8 approach, 107 communication strategy, 108 ideas, 107 policy framework, 107 Insider trading, 136, 204 Intercontinental Exchange (ICE), 212 Interest rate yield curve, 124–28 Interest rates, 79, 138 Interest rate swap defined, 175 plain vanilla, 175–77 International economies, 2–3 International Swaps and Derivatives Association See ISDA In re Kidder Peabody Securities Litigation See Kidder Peabody Securities Litigation In the matter of Orlando Joseph Jett See Joseph Jett Inverse interest only See I/O Inverse I/O floating-rate note, 308f Inverted yield curve, 126f Investment Advisers Act, 70 Investment banks, 6, 14, 140, 245 Investment Company Act of 1940, 69 Investment grade securities, 280 ISDA, 170, 172–73, 179–80 ISDA Master Agreement, 183 defined, 172–73 negotiated “schedules,” 180 most important function, 173 provisions, 172–73 standard, 180 terms, 180 J Joseph Jett, 142 Jurisdiction, 41, 192 K Kevin Warsh, xxiii, 13 Key economic statistics, 93–96 balance of trade, 94–95 business inventories, 95 capacity utilization, 96 consumer price index (CPI), 95 industrial production, 96 initial jobless claims, 95 import price indexes, 94 New York Empire State index, 96 producer price index, See PPI, 95–96 retail sales, 95 treasury monthly budget, 95 University of Michigan’s Consumer Survey, 96 Kidder Peabody Securities Litigation, 142 Kwiatkowski, Henryk de, 249, 266 L Labor market, 12, 105, 116–17 Lehman Brothers, Leverage, 164 Levy v Bessemer Trust, 290–92 Liability, common law theories, 245 LIBOR, 175, 304, 312 index 347 Liquidity crisis, xxvii–xxviii, 1, 5–8, 16, 80 Litigation, 240–253 Long Term Capital Management (LTCM) bail out of, 160–62 counterparties, 161–62 default, 160–62 Long-term rates, 124, 127 Longer-term interest rates See Long-term rates M Madoff, Bernard L., 32 Market failures, xxvii–xxviii Market manipulation, 204 Market turmoil, 123 MBS purchase program FAQ, 120–22 originator, 153 MBSs, 280–81 MD&A public companies, 238 MD&A rules, 238, 239 Monetary Control Act of 1980, 101 Monetary policy decisions, 98–99 Monetary policy implementing, 102–3 Moral hazard, Mortgage-backed and asset-backed securities, 147 Mortgage-backed bonds, 2, 33, 263, 281 Mortgage-backed securities, 152–154, 279, 280–81 backing by government sponsored agencies, 152 defined, 152 prepayment risk and, 152–53, 179, 182 residential, 4–5 risks associated with, 282 structuring, 153–54 types of, 153 Mortgage-backed securities market, 279 Mortgage derived securities, Mortgage loan, 281 Mortgage meltdown, xxvii–xxviii, Mortgages, pools of, Mortgage rates, 2, 124 MSRB, 278 disclosure requirements, 156 disclosure rule of the, 156 Municipal bonds, 19, 146 Municipal securities regulated by MSRB, 156 Municipal Securities Rulemaking Board See MSRB N Nagel v ADM Investor Services, Inc., 201 NASD rules, 271 suitability rule, 270 NASD rule 2110, 271 NASD rule 2310 recommendations to customers, 282 NASD rule 2860, 271 NASD rule 2860(19) options, 283 NASD rule 2865(19) securities futures, 283 National Association of Securities Dealers (NASD), 268, 271 National Futures Association, (NFA) authority, 209–10 defined, 277 disciplinary actions, 209–10 governance, 210 know-your-customer rule, 277 mandatory registration, 210 membership, 210 registration functions, 210 regulatory activities, 209 National Securities Exchanges rules governing transactions, 268 New York Commodities Exchange, 212 See also COMEX New York Mercantile Exchange, 211–12 See also NYMEX Nonprime borrowers, 81 Normal sloping yield curve, 125 NYSE, 267–68, 284 express suitability rule, 272 rules governing transactions executed on exchanges, 268 NYSE know-your-customer rule See NYSE Rule 405 NYSE Rule 405 diligence as to accounts, 284 violations, 272 NYSE Rule 723, 272, 284 348 index O Obama, President Barack encouraging revision of financial regulation, xx on financial innovators, xix–xx new financial agency proposal, xxi OCC, 280, 310 Off-balance sheet transactions, 240 Office of the Comptroller of the Currency See OCC Open market desk, 104 Open market operations defined, 104 performing, 103–104 Operational risk, 229–237 Operational risk management, 229, 238 Operational risk management standards, 223 Options, 170–71, 275–278 Black-Scholes model, 294 call, 171, 289 categorized as, 287 characteristics of, 287–88 contracts that are economically options, 297–99 covered call, 300 defined, 170, 198, 287–88 delta, 171 example, 288 jurisdiction, 253 measures of volatility in, 294–95 premium, 170–171, 289 price using the Black-Scholes formula, 171 pricing, 292 put, 171, 290 regulation of, 300 strategies, 300 trading, 253 types of volatility in, 293–94 used to enhance yield, 303 Options agreements, 256 Option contract See Options Option pricing, 292, 294 Option strategies collar, 301 covered call, 300 synthetic call, 300 Orange County Case Study, 150–51 OTC See Over The Counter OTC derivatives, 162–63 OTC derivatives contract, 172 OTC foreign exchange (FX) forward agreement defined, 169–70 trading at a premium, 179 OTC market, 253, 265 OTC trades, 212 OTC transactions, 212 OTC vs Exchange-traded options, 299 Over-The-Counter, 162–63 P Pass-through participation certificate, 153 Pass-through securities, 281 Paulson, Secretary of the Treasury Hank, xx Phillips, Susan M., xvii Plain Vanilla Swap basic structure of the, 176 contracts, 176 examples, 176 Policy stimulus, 101–2, 124 Premium, 289 Prepayment risk, 282 Price/yield relationship, 134 Pricing of assets See Asset valuation Primary Dealer Credit Facility, 8, 104 Primary Dealers compliance with Tier I and Tier II capital standards, 131 defined, 131 trading relationship with, 132 Primary Government Security Dealers See Primary Dealers Primary market, 131 Put options, 171, 290 R Range notes defined, 312 options built into, 313 risk, 312–313 Real Estate Mortgage Investment Conduits, 282 index 349 Real estate prices, 2, 279–280 Reference entity, 183 Regulation standards and, xvii proposals for new, xxi Regulation D, 100, 100–102 Regulatory agencies, 207 Regulatory distinctions between forwards and futures, 200 Regulatory Reform, 40–41 REMICs See Real Estate Mortgage Investment Conduits Repos See Maturing repurchase agreements defined, 149–150, 307 described, 307 description, 149–150 maturing, transactions, 307 Repurchase agreement See Repos Residential mortgage backed securities, 4–5, 281, 331 Reves test, 47–50 Risk and Derivatives Consulting Board, Inc., 222 Risk categories, 231 credit risk, 2–3, 6, 38, 81, 84, 89, 160–62, 304 delivery risk, 226, 231 financial risk, 226–27, 231 legal risk, 180, 231, 256 liquidity risk, 231 operational risk, 222–24, 226, 229–34, 236–38 Risk disclosure, 254–256 Risk management assessment, 223 business judgment rule, 238 capital markets and, xix code of conduct, 236 control, 223 daily exception report, 234 derivatives and, xvii empowering board members for 232–33 ethical concerns, 235–236 executive protection and, 237–40 financial and nonfinancial institutions, 224 firm-wide compensation, 235 flexibility, 237 free flow of information, 236–37 holistic, 229 identification, 223 information flow, 234 mitigation, 223 monitoring, 223 operational, 229–37 portfolio dynamics, 229 qualitatively, effective operational, 232 reporting lines and audit techniques in, 232 reporting structures, 233–34 responsibility for, 237–38 Risk Management Committee and, 232 red flags, 235 risk policy, 230 role of, 224 rule of disclosure in, 224 Risk management tools, 165 Risk policy, 230, 237, 282–83 Rule I0b-5, Claim, 271, 273 investor partially at fault, 244 suitability claim, 264 Rule I0b-5 employment of manipulative and deceptive devices, 285 Rule 405, 272 Rule 2310, 271 Rule of 72, 141 S Sarbanes-Oxley Act disclosure under, 238–40 disclosures in, 238 off-balance sheet transaction under the, 240 SCAP templates, 315, 337–38 Scholes, Myron, 292 SEC, 135, 154, 188, 275 authority, 204 disclosure requirements, 156 hybrid instruments and, 205 jurisdiction, 204 options trading, 253 rules, 156, 238, 240 Self Regulated Organizations and the, 269 350 index SEC v Davis et al., 135 Secondary market, 131 Section 4B of the Commodity Exchange Act (as amended), 285–86 Section 10 of the Securities Exchange Act 1934, 284 Securities fixed income, 138 floating rate, 138 Securities Act of 1933 claim under rule10b-5, 244 section12(2) of the Federal Securities Act of 1933, Claim, 244 Securities Act Registration, 154–58 Securities and Exchange Act of 1934 See Exchange Act Securities and Exchange Commission See SEC Securities markets, 269 Security, 41–42 Securitization, 4, 23, 153 Self-Regulated Organizations, 265, 268, 278 authority, 269 enforcement and disciplinary proceedings, 269 governance standards, 269 rulemakings, 269 rules, 269 suitability requirements, 270 Salomon Brothers 136 Separate Trading of Registered Interest and Principal Securities abuses, 142–144 current value of, 143 dealers, 142 defined, 140 description, 140 exchange of, 143 as a means of restructuring an income security, 141 prices of, 141 purchasers and dealers of, 142 quotes for, 141 “rule of 72,” 141 sale of, 143 uses, 141–142 valuation, 140–41 Short term interest rates, 97 Synthetic call, 300 Special circumstances rule, 266–68 Special purpose entity, 174 SRO, 268 SRO rules, 269 See Self-Regulated Organizations, rules State blue sky laws, 252–53 State regulation, 269 Stocks, 43, 73 Stress testing as a means of determining the viability of financial institutions, 227 comprehensive, 227 forms, 227 Obama administration and, 227 Pricing models incorporated into, 227–228 Supervisory Capital Assessment Program (SCAP), 228 Strike price, 289 STRIPS See Separate Trading of Registered Interest and Principal Securities Structured investment vehicles, Structured notes embedding of a derivative into a, 304 interest rate risk, 309–10 hedging or speculating with, 304 historical example: Erlanger “Cotton” Bonds, 304–9 liquidity risk, 310 OCC warning, 310–11 pricing, 304 reinvestment risk, 310 risk involved, 309–12 shifting risk, 304 transactions, 310 unique market risk, 304 Structuring securities, 313 Structures, 303–304 Subprime, 154 Subprime ARM market, 81 Subprime ARMs, 81 Subprime credit crisis, 279 Subprime crisis, 81 Subprime lending, 2–3 index 351 Subprime mortgage crisis, 154 Subprime mortgages, 81 adjustable interest rates, 81 availability of, 154 crisis, 81 defined, 154 increased risk associated with, 154 Suitability affirmative misrepresentation of, 277 analysis, 277 doctrine, 263–67 express, 272 FINRA, 270 obligation, 265 rule, 270, 276 sources, 265 special circumstances rule and, 266–68 Suitability doctrine basis of the, 264–66 defined, 263 origins, 263 Suitability rule, 270, 276 Supervisory capital assessment program, 315 Swap agreements See Swaps Swap contracts See Swaps Swaps characteristic, 172 credit default, 178 currency, 177 defined, 172, 203 equity, 177 exempted transactions, 203–4 legal risk from, 256 litigation issues associated with, 256 OTC, 278 plain vanilla interest rate, 175–77 regulations, 204 regulatory relief for transactions, 278 types of, 175–90 Synthetic call, 300 Synthetic trading, 297 Systemic failure, xxvii–xxviii, 13–14, 29, 80 Systemic risk, 190 T TARP See Troubled Asset Relief Program Term Asset Relief Program, 14 Term Auction Facility (TAF), 7, 80, 91 Term Securities Lending Facility, 7–8 TIIS See TIPS TIPS See Treasury inflated-indexed securities (TIPS) based on consumer price index, 139 defined, 138 example, 139 hedge against inflation, 138 maturity, 138 use, 139 Trading and capital markets activities manual, 307 Treasuries appeal of, 130 credit risk, 130 long-term rates, 134 primary dealers of, 131 risk-free nature of, 130 short-term interest rates, 134 ten-year yield, 134 use, 130 Treasury, U.S Department of the, 4–5, 23–24, 39–41, 137, 197, 214, 269 Treasury bills auctioned, 132 defined, 132 discounts and premiums, 133 face value of the, 132 factors affecting yield, 133–34 issued, 132 pricing, 133 purchase price, 132 Treasury Inflation-Indexed Securities (TIIS), 138–9 See also TIPS Treasury Inflation-Protected Securities (TIPS), 138 Treasury inflated-indexed securities Treasury notes, 138 Treasury notes and bonds defined, 132–3 face amount, 133 issued, 133 “par-value” of a, 133 pricing, 133–5 trading price, 133 Treasury obligations, 84 352 index Treasury securities as credit risk-free investment vehicle, 145 description of, 132–35 types of, 132–33 Troubled Asset Relief Program (TARP), 11 Troubled asset See Asset, troubled Trust indentures See Indenture Trust indenture Act, 155 Trust indenture Act of 1939, 155 Turner, Adair, 1–2 U United States Constitution, 87 United States economy, 84 United States Treasury, 135 United States Treasury Bill, 138 United States Treasury Securities defined, 129 purpose and goals, 129–30 United States v Salomon Brothers See Salomon Brothers Unsecured obligations, V Volatility measures of, 294 types of, 293 W World economy See Global economy Y Yield curve defined, 125 flat, 125 flat or inverted, 127 interpretations of the shape of the, 126 inverted, 125 normal sloping, 125 types, 125 Yield/Price relationship, 134 Z Zelener, CFTC versus 201, 218–19 .. .capital markets, derivatives and the law This page intentionally left blank capital markets, derivatives and the law alan n rechtschaffen 1 Oxford University... Ensuring the stability of the capital markets, therefore, is of paramount concern for the Federal Reserve and other financial market regulators in order to prevent systemic failure By shoring up the capital. .. participant in the capital markets should have of the complexity of the role of the Federal Reserve in domestic capital markets, the use of financial instruments to manage risk and to enhance yield, the