A Capital Markets Safety Board

After every major transportation disaster, we Americans have become accustomed to a review of what went wrong by the National Transportation Safety Board (NTSB). Why not something similar for when trouble befalls the capital markets?

That’s an idea put forward by a trio of academics back in 2004, and reiterated in the Atlanta Federal Reserve’s Q4 ’06 Economic Review. Mila Getmansky (UMass), Andrew Lo (MIT) and Shauna Mei (MIT) are not advocating for a regulatory body, but rather one to do post mortems. Their argument follows verbatim, and is compelling:

One possibility… is to create an independent organization along the lines of the National Transportation Safety Board (NTSB) to sift through the wreckage of all major hedge fund collapses, ultimately producing a publicly available report that documents the specific causes of the collapse, along with recommendations on how to avoid similar disasters in the future.

Although there may be common themes in the demise of many hedge funds—too much leverage, too concentrated a portfolio, operational failures, securities fraud, or insufficient AUM—each liquidation has its own unique circumstances and is an opportunity for hedge fund managers and investors to learn and improve.

In the event of an airplane crash, the NTSB assembles a team of engineers and flight-safety experts who are immediately dispatched to the crash site to conduct a thorough investigation, including interviewing witnesses, poring over historical flight logs and maintenance records, and sifting through the wreckage to recover the flight recorder or “black box” and, if necessary, reassembling the aircraft from its parts to determine the ultimate cause of the crash. Once its work is completed, the NTSB publishes a report summarizing the team’s investigation, concluding with specific recommendations for avoiding future occurrences of this type of accident. The report is entered into a searchable database that is available to the general public (see:www.ntsb.gov/ntsb/query.asp), and this kind of information has been one of the major factors underlying the remarkable safety record of commercial air travel.

For example, it is now current practice to spray airplanes with deicing fluid just prior to takeoff when the temperature is near freezing and it is raining or snowing.

This procedure was instituted in the aftermath of USAir Flight 405’s crash on March 22, 1992. Flight 405 stalled just after becoming airborne because of ice on its wings, despite the fact that deicing fluid was applied before it left its gate.

Apparently, Flight 405’s takeoff was delayed because of air traffic, and ice reaccumulated on its wings while it waited for a departure slot on the runway in the freezing rain. The NTSB Aircraft Accident Report AAR-93/02—published February 17, 1993, and available through several Internet sites—contains a sobering summary of the NTSB’s findings:

The National Transportation Safety Board determines that the probable causes of this accident were the failure of the airline industry and the Federal Aviation Administration to provide flightcrews with procedures, requirements, and criteria compatible with departure delays in conditions conducive to airframe icing and the decision by the flightcrew to take off without positive assurance that the airplane’s wings were free of ice accumulation after 35 minutes of exposure to precipitation following deicing. The ice contamination on the wings resulted in an aerodynamic stall and loss of control after liftoff. Contributing to the cause of the accident were the inappropriate procedures used by, and inadequate coordination between, the flightcrew that led to a takeoff rotation at a lower than prescribed air speed. (Report AAR-93/02, page vi)

Current deicing procedures have no doubt saved many lives thanks to NTSB Report AAR-93/02, but this particular innovation was paid for by the lives of the twenty-seven individuals who did not survive the crash of Flight 405. Imagine the waste if the NTSB did not investigate this tragedy and produce concrete recommendations to prevent
such situations from happening again.

Hedge fund liquidations are, of course, considerably less dire, generally involving no loss of life. However, as more pension funds make allocations to hedge funds, and as the “retailization” of hedge funds continues, losses in the hedge fund industry may have more significant implications for individual investors, in some cases threatening retirement wealth and basic living standards.

Moreover, the spillover effects of an industrywide shock to hedge funds should not be underestimated, as the events surrounding LTCM in the fall of 1998 illustrated. For these reasons, a “Capital Markets Safety Board” (CMSB) dedicated to investigating, reporting, and archiving the “accidents” of the hedge fund industry—and the financial services sector more generally—may yield significant social benefits in much the same way that the NTSB has improved transportation safety enormously for all air travelers. By maintaining teams of experienced professionals—forensic accountants, financial engineers from industry and academia, and securities and tax attorneys—who work together on a regular basis to investigate a number of hedge fund liquidations, this investigative body would be able to determine quickly and accurately how each liquidation came about, and the resulting reports would be an invaluable source of ideas for improving financial markets and avoiding future liquidations of a similar nature.

Of course, formal government investigations of major financial events do occur from time to time, as in the April 1999 report of the President’s Working Group on Financial Markets. However, this interagency report was put together on an ad hoc basis with committee members that had not worked together previously and regularly on forensic investigations of this kind. With multiple agencies involved, and none in charge of the investigation, the administrative overhead becomes more significant.

Although any thorough investigation of the financial services sector is likely to involve the SEC, the Commodity Futures Trading Commission, the U.S. Treasury, and the Federal Reserve—and interagency cooperation should be promoted—there are important operational advantages in tasking a single independent office with the responsibility for coordinating all such investigations and serving as a repository for the expertise in conducting forensic examinations of financial incidents.

The establishment of the CMSB will not be inexpensive. Currently, regulatory agencies like the SEC are understaffed and overburdened, and this condition is likely to worsen as financial markets grow in size and complexity.

In addition, the lure of the private sector makes it challenging for government agencies to attract and retain individuals with expertise in these highly employable fields. Individuals trained in forensic accounting, financial engineering, and securities law now command substantial premiums on Wall Street over government pay scales.

Although the typical public sector employee is likely to be motivated more by civic duty than financial gain, it would be unrealistic to build an organization on altruism alone.
However, the cost of an independent CMSB is more than justified by the valuable lessons that would be garnered from a systematic analysis of financial incidents and the public dissemination of recommendations by seasoned professionals that review multiple cases each year. The benefits would accrue not only to the wealthy—which is currently how the hedge fund industry is tilted—but would also flow to retail investors in the form of more stable financial markets, greater liquidity, reduced borrowing and lending costs as a result of decreased systemic risk exposures, and a wider variety of investment choices available to a larger segment of the population because of increased transparency, oversight, and ultimately, financial security.

It is unrealistic to expect that market crashes, panics, collapses, and fraud will ever be completely eliminated from our capital markets, but we should avoid compounding our mistakes by failing to learn from them.