SEC Panel: Beware of Invisible Financial Time Bombs

Last Updated Oct 8, 2008 7:08 PM EDT

explosion.JPGPeople who have been in war often say that you never hear the shot that hits you.

For CEOs and other top executives, that has become very apparent in the past month that plenty of things out in the financial market can roar up and bite unforeseen.

Christopher Cox, chairman of the Securities and Exchange Commission, made that point today as he opened a panel roundtable discussion on improving SEC disclosure requirements.

Participating were a wide variety of knowledgeable people including the director of accounting policy at Xerox, law professors from Harvard, the University of Iowa and Stanford, and an expert from the American Association of Individual Investors.
"Above all in the current turmoil," Cox said, "the markets and investors need transparency. From the moment that the collapse of lending standards created billions in worthless mortgage paper -- and billions more in hidden risk -- market participants have had enormous difficulty in discovering and pricing that risk. Illiquid instruments that were not long ago rated AAA for credit quality were hidden in off-balance sheet vehicles and elaborately structured securities."

Indeed, as participants noted, there was plenty of unknown stuff that contributed mightily to the current financial mess. Derivatives, off-the-book accounting and other schemes created a murk so dense that it was impossible to see the precise state of financial affairs in a company. It could be the reason that Richard Fuld of Lehman Brothers says he thought his investment bank was liquid just days before it declared bankruptcy.

Cox singled out credit default swaps as being in a "regulatory black hole." These complex bets that someone will default on a loan gained currency over the past decade. Congress decided not to regulate them in 2000. Cox notes that the market for them doubled to $58 trillion in just two years.

CEOs apparently weren't aware that their companies were so beholden to these swaps. When mortgage-backed securities started to go sour and credit ratings agencies downgraded, the terms of the swamps kicked in. It is something like a damaged airplane suddenly going into a fatal tailspin for no clear reason.

Cox insists that Congress started regulating swaps. Another idea, underway in Chicago, is to create trading systems for them so they can be clearly identified and valued.

The SEC has a new electronic documentation system coming along that should make retrieving required documents much faster and easier. It would replace the clunky and venerable EDGAR system that's been around since the 1980s.

Problem is, the system won't be of much use if off-the-books deals aren't reported on them. And, it seems a little late for Cox to start getting regulatory religion on credit default swaps.

Meanwhile, executives need to root out the risks their firms face because of these hidden time bombs.

(Image by veo via Flickr, CC 2.0)