An Emerging Financial Crisis In 2023? A Primer on Old Metrics
Potential weaknesses in the financial system are augmented by social media and the gamification of financial markets.
With the failures of Silicon Valley Bank, Signature Bank, and First Republic Bank; the wipeout of $17 billion in Credit Suisse additional tier 1 bonds; and the liability-driven investing crisis in the UK—all within the first half of 2023—U.S. Treasury officials and banking regulators have assured Americans that the financial system remains sound. But one seasoned investor who predicted the 2007-2008 credit and financial crisis believes that more instability is ahead.
“Other things will break, and who knows what they will be,” Jeremy Grantham, the co-founder and chief investment strategist at asset management firm GMO, told CNN in April 2023. “We’re by no means finished with the stress to the financial system.”
Other market observers are starting to pinpoint financial risk to certain market sectors. In mid-May, Moody’s Analytics reported the first quarterly drop in commercial real estate prices in more than a decade.
Shedding more light on the potential depth of this risk, one chief strategist at a prominent U.S. investment bank forecast a 25 percent year-over-year drop in office property values and a 21 percent drop in apartment property values. This forecast coincides with U.S. banks tightening lending conditions and a sharp, sector-wide decrease in commercial real estate transactions.
Market observers also are watching for signs of illiquidity in overnight reverse repo markets due to the effects of the Federal Reserve’s quantitative tightening, in a potential repeat of market dynamics in 2019 (the “repo ruckus”).
The potential weaknesses in the financial system are augmented by a post-modern quickener: the gamification of financial markets. An academic paper published in April 2023 (“Social Media as a Bank Run Catalyst”) investigated social media’s role in the bank run that led to the failure of Silicon Valley Bank. The authors concluded that Silicon Valley Bank depositors who were active on social media played a central role in the bank run. They observed: “These depositors were concentrated and highly networked through the venture capital industry and founder networks on Twitter, amplifying other bank run risks.”
The point here is not to promote potential conditions that might combine to cause a financial crisis. But with storm clouds looming, and with new social media accelerants of instability, companies might be prudent to open the old tool box and refresh strategies of mitigating exposure to regulatory enforcement actions and shareholder litigation.
Known Trend Disclosure Risk
Item 303 of Regulation S-K, “Management’s discussion and analysis of financial condition and results of operations,” generally requires a registrant to describe any known trends or uncertainties that have had, or that the registrant reasonably expects will have, a material impact on net sales or revenues, income from continuing operations, and liquidity.
In one of its seminal management discussion and analysis (MD&A) interpretative releases in 1989, the U.S. Securities and Exchange Commission (SEC) set forth a test concerning the Item 303 disclosure requirements. If a trend, demand, commitment, event, or uncertainty is known, management must make two assessments:
1. Is the known trend, demand, commitment, event, or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.
2. If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event, or uncertainty on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.
An important example of the failure to make disclosures of Item 303 requirements is found in the 2008 credit-crisis–era SEC enforcement action against Bank of America. In August 2014, the SEC secured a $20 million civil settlement against Bank of America for failing to inform investors about its exposure to repurchase claims on mortgage loans. In particular, Bank of America admitted that it failed to disclose, under Item 303 known uncertainties, potential increased costs related to mortgage loan repurchase claims stemming from more than $2 trillion in residential mortgage sales by the bank and certain companies it acquired.
Known trend disclosure obligations continue to be reaffirmed by U.S. courts. In a December 2022 decision, Moab Partners v. Macquarie Infrastructure Corp., the Second Circuit Court of Appeals vacated a district court’s dismissal of claims under Section 10(b) of the Securities Exchange Act of 1934 based on an issuer’s alleged failure to disclose the threat to its business posed by a regulation to reduce sulfur oxide emissions from ships. The regulation—International Maritime Organization (IMO) regulation 2020—cut the permissible upper limit on the sulphur content of ships’ fuel oil from 3.5 percent to 0.5 percent. This change harmed the core business of one of the issuer’s subsidiaries—storing No. 6 fuel oil, which has sulfur content of 3 percent.
The Second Circuit held that the plaintiff adequately alleged that the business threat was a known trend or uncertainty which the issuer had a duty to disclose under Item 303. The court reasoned that, even if the defendants were not certain of the regulation’s impact, “it would not have been ‘objectively reasonable’ for defendants to determine that IMO 2020 would not likely have a material effect on [Macquarie’s] financial condition or operations.”
Liquidity Risk
Liquidity risk generally is defined as the risk of incurring losses resulting from the inability to meet payment obligations in a timely manner when they become due or from being unable to do so at a sustainable cost. The Lehman Brothers Securities & ERISA Litigation involved a set of consolidated civil actions following Lehman Brothers’ filing for bankruptcy protection in September 2008. There, a putative class of bond and equity purchasers alleged that statements claiming Lehman’s liquidity pool was sufficient to meet its expected needs over the next 12 months and that its liquidity position was “strong” were misleading.
But the district court held that those statements were non-actionable statements of opinion, for which there were insufficient facts alleged that the Lehman executives did not truly believe them when made. The statement about liquidity was based on models and assumptions, some of which were disclosed in Lehman’s various securities offering materials, about what would happen in the future.
A different result was reached in In re MF Global Holdings Limited Securities Litigation, which involved a commodities futures broker that failed in October 2011. In that case, the operative complaint alleged misstatements about MF Global’s capital and liquidity management based on representations by the company and its officers about its “strong” liquidity position. The district court ruled such statements were actionable under the federal securities laws, in light of allegations that MF Global faced substantial strain on its capital and liquidity and met its regulatory requirements only through “daily intracompany transfers” and collapsed when “RTM [repurchase-to-maturity] counterparties demanded additional margins.”
Concentration Risk
A risk concentration is any exposure with the potential to produce losses large enough (relative to a bank’s capital, total assets, or overall risk level) to threaten the institution’s health or ability to maintain its core operations. The early 2008 financial crisis case SEC v. Mozilo examined the characterization of concentration risk exposures. There, the SEC alleged that three senior Countrywide executives made a series of misleading statements aimed at reassuring investors that the company was mainly an originator of prime-quality mortgages, qualitatively different from competitors that engaged in less-sound lending practices.
As one of its core holdings, the district court concluded that the SEC had adequately pleaded that Countrywide’s description of its loan categories—“prime non-conforming” and “subprime”—constituted misleading statements. The court observed that, “because the banking industry and regulators viewed 660 or 620 as the dividing line between prime and subprime loans, by using the word ‘prime,’ Countrywide affirmatively created the impression that it used the same dividing line and only included loans with a credit score of 660 or above, or, at the very least, 620 or above, within that category.”
In another 2008 financial crisis case, In re Citigroup Inc. Securities Litigation, class plaintiffs alleged that Citigroup and its executives misled investors about, among other things, the bank’s collateralized debt obligation (CDO) exposure. In particular, the plaintiffs had alleged that Citigroup’s November 2007 disclosure that it held $43 billion of super senior CDO tranches and expected a writedown of $8 billion to $11 billion was materially misleading. The district court sustained the falsity of those allegations because Citigroup allegedly had omitted from its disclosure the existence of $10.5 billion in hedged CDOs (and thus $43 billion was not the full extent of exposure), and the announced writedown was inadequate because it overstated the value of the CDO positions.
Considerations as Uncertainty Reigns
Continuing economic volatility will present risk management challenges to financial services firms of all types, including traditional consumer and investment banks, fintech companies, and digital asset platforms. With obligations to monitor available information available and to identify categories of risk exposure, corporate leaders face the difficult task of making precise disclosure determinations in the midst of quickly changing market conditions. Analysis of known risk categories may provide some protection against future exposure.
Todd Fishman is a partner at Allen & Overy. His practice primarily focuses on the defense of antitrust, commodities markets and securities investigations, and complex class actions.
From: New York Law Journal