Henry T.C. Hu, the Allan Shivers Chair in the Law of Banking and Finance at the Law School, recently helped organize the Texas Law Review symposium that convened in Austin in February 2012, “Reshaping Capital Markets & Institutions: Twenty Years On.” The exceptional group of speakers—the authors, paper commentators, and panelists—were wonderfully eclectic: top academics, both financial and legal; senior regulators, past and present; and real world heavyweights in law and in business. The associated symposium issue was published in June 2012, two decades after the pioneering TLR symposium issue, “New Financial Products, the Modern Process of Financial Innovation, and the Law,” which he also helped organize. Hu’s own article in the June 2012 symposium issue offers a fundamental rethinking of the Securities and Exchange Commission’s disclosure system—in place since the 1930s—and of the very nature of “information” in an age characterized by unprecedented innovations in finance and in computer-related technologies. The article also analyzes the question of whether JPMorgan Chase and certain other “too big to fail” banks may be too complex to depict and also raises the further, more difficult, question of whether they are thus perhaps too complex to exist.
The article, “Too Complex to Depict? Innovation, ‘Pure Information,’ and the SEC Disclosure Paradigm,” received immediate worldwide attention, including a June 8 Financial Times column by Gillian Tett, then U.S. Managing Editor. Calling the article a “fascinating piece,” she stated that Hu “reached some unorthodox, if not radical conclusions about the nature of ‘transparency,’ whether at JPMorgan or anywhere else,” urged wide consideration of Hu’s thesis, and expressed agreement both with Hu’s analysis of the obsolescence of the SEC’s disclosure paradigm and of banks that are too complex to depict.
Over a six-week period this fall, Hu presented the article at a Public Company Accounting Oversight Board (PCAOB) hearing; an invitation-only “Chief Risk Officers’ Summit” in New York; a securities regulation seminar in Los Angeles, at which the article’s commentators were Mark Cahn, the SEC’s General Counsel, and Simon Lorne, the Vice Chairman of Millennium Management; and a research meeting at M.I.T. of the Consortium for Systemic Risk Analytics.
Hu sat down with the editor of UT Law magazine to discuss his work on the disclosure paradigm.
UT Law: What is your article’s primary thesis?
Henry Hu: Since the Depression, the SEC’s totemic philosophy has been to promote a robust informational foundation for private decision makers. The article starts with a fresh conceptualization of how the disclosure philosophy has been substantially implemented: what I call an “intermediary depiction” model. An intermediary—such as a corporation issuing shares—stands between the investor and an objective reality. The intermediary observes that reality, crafts a depiction of the reality’s pertinent aspects, and transmits that depiction to investors. Securities rules direct that depictions are to be accurate and complete, and private lawsuits and public enforcement efforts seek to ensure compliance with the rules. “Information” is thought of as, if not equated to, such depictions.
The article’s second step—one aspect of its primary thesis—is that the longstanding “intermediary depiction” model is increasingly undermined by innovations in financial theory and practice, and that this disclosure paradigm must change to comprehend what can be referred to as “pure information” models—as well as the full spectrum of possibilities between these polar extremes.
I show this largely by using two important contexts. First, I focus on “asset-backed securities” (ABS). Informational problems associated with ABS played major roles in causing the global financial crisis that began around 2007. Second, I focus on “too big to fail” banks deeply involved in swaps and other over-thecounter (OTC) derivatives. The Dodd-Frank Act enacted in 2010 was the most sweeping capital markets–related statute since the banking and securities statutes enacted under President Franklin Roosevelt, and it was largely motivated by concerns over such banks and such derivatives.
UT: In general terms, how does financial innovation pose roadblocks to good intermediary depictions?
HH: Financial innovation poses two basic roadblocks to good depictions. The first roadblock is that financial innovation has resulted in objective realities that are far more complex than in the past, often beyond the capacity of the English language, accounting terminology, visual display, risk measurement, and other tools on which all depictions must primarily rely. Given such rudimentary tools and such complex realities, the depictions may offer little more than shadowy outlines of the objective reality.
The second roadblock is more fundamental: even a completely well-intentioned intermediary sometimes either may not truly understand or may not function as if he understands the reality he is charged with depicting. The second roadblock can flow both from the complexities of the financial innovation—what can be called “true misunderstanding”—and organizational complexities associated with the intermediary itself—what can be called “functional misunderstanding.” Irrespective of the reason, if the intermediary fails to understand the objective reality, how can it possibly provide a good depiction of reality?
UT: Can you offer one illustration of the limitations of the intermediary depiction model within the ABS context?
HH: At the PCAOB hearing at which I was invited to present “Too Complex to Depict?” Chairman James Doty stated that he found the article “absolutely terrifying,” pointing to, among other things, the article’s thesis that even “objective reality” can sometimes be subject to multiple meanings.
With ABS transactions, the tranching, or prioritization of claims, with respect to the cash flow from the pooled assets is the animating force that allowed for “AAA” credit rating designations. The so-called “waterfalls” are supposed to define the cash-flow rights of each of the tranches. So, for an investor in an ABS, having a good depiction of the pertinent waterfall is essential to evaluating the ABS.
Crafting depictions of waterfalls faces really fundamental challenges. Before one even gets to problems in the depiction of reality, there are foundational difficulties as to what “reality” even means. That is, I show that as to waterfalls, even the “objective reality” is subject to multiple meanings. Among other things, the “true reality” of the contractual provisions may, in fact, be less pertinent than the actual cash flows generated by the “effective reality” of the issuer’s waterfall computer program. Also, the contractual provisions may well be so ambiguous or badly drafted as to preclude reverse engineering.
Moreover, irrespective of the particular conception of reality implicitly used in the issuer’s depiction, as a practical matter, it can be extremely difficult for the investor to map the intermediary’s depiction to the actual cash flows he would encounter over the life of his investment.
UT: What about the bank context? How does the article relate to JPMorgan Chase’s credit derivatives–related problems with its Chief Investment Office that garnered so many front-page headlines this year?
HH: The article shows that depictions of major banks involved in financial innovation activities can suffer from both roadblocks, helping explain the severity of the bank disclosure problems that helped cause the financial crisis. That is, such a bank’s activities may be too complex relative to existing depiction tools, and the activities and the organization of the bank itself may be so complex that the bank sometimes may suffer from both true misunderstanding and functional misunderstandings of the objective reality that the bank is in. This analysis relies in part on “Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism,” a 1993 Yale Law Journal article in which I showed how compensation structure issues, the peculiarities of financial “science,” cognitive biases, and other factors were likely to cause major financial institutions to make mistakes in the area of complex financial products.
As “Too Complex to Depict?” was in the final stages of editing in early May, the JPMorgan Chase Chief Investment Office credit derivatives situation started unfolding. Because the situation so well illustrated the article’s main themes, I added an eleven-page afterword on JPM. I based this analysis on information that was publicly available in May and, for the purposes of the article, assumed absolutely no intentional misconduct on the part of either JPM or anyone at JPM.
UT: Does the article propose any solutions?
HH: Yes. The solutions constitute a key component of my primary thesis. If the modern’s era’s revolution in financial innovation is creating problems for the SEC’s disclosure paradigm, I think that the modern era’s revolution in computer-related innovation offers a partial solution. With advances in computer and Internet technologies, it is no longer essential to rely exclusively on intermediary depictions of reality. The intermediary need not always stand between the investor and an objective reality, recounting to the investor what the intermediary sees.
Figuratively, if the intermediary steps out of the way, the investor may now be able to see for himself, to download the objective reality in its full, gigabyte richness. Such “pure information” can be more granular and accurate than the intermediary’s depiction. Moreover, with such “disintermediation,” investors will have information freed from possible intermediary biases and misunderstandings embodied in the depictions.
However, at the same time, disintermediation will also leave investors bereft of the benefits of an intermediary’s efforts to analyze and distill objective reality and incorporate the resulting insights in the intermediary’s depiction.
The article thus suggests that a disclosure paradigm that relies on both the intermediary depiction model and the pure information model— and the full spectrum of disclosure models between these opposite extremes—can help investors triangulate the truth. The article outlines some possible models along the spectrum, including strategies that would generate “moderately pure” information as well as strategies involving the “simplification of reality” itself.
UT: So how does this relate to JPMorgan and other “too big to fail” banks that are heavily involved in complex financial products and strategies?
HH: Some such banks’ public reports are now some three hundred pages long, in fontsizes that only the carrot-eating Bugs Bunny can read. Yet some prominent investment managers refuse to invest in such banks on the grounds that they do not understand what’s in the black box. I do not want to add needless bulk to reports that must already be reaching some kind of obesity limit.
For JPMorgan and other such banks, I offer some possible solutions involving the provision of “moderately pure” information, solutions that could actually be useful to investors and yet not be burdensome to the banks, or cause banks to lose proprietary information. In this respect, I propose what I refer to as a “common bank models” approach and a “common bank assets” approach.
UT: Some observers believe that the banks that are too big to fail are also too big to exist—that is, they should be broken up.
HH: There are substantive implications of this article for the “too big to fail” issue, broadly defined. Consider the essential problem with using the intermediary depiction model: it can be insufficient when the reality is too complex.
The article focuses primarily on how to supplement depictions with requirements that the intermediary, in effect, provide access to the reality itself. But another alternative would be the “simplification” of reality. If reality itself is simpler, it would generally be easier to depict. In a physical sense, Kazimir Malevich’s painting, White on White, would be far easier to describe accurately, fully, and succinctly than Hieronymus Bosch’s triptych, The Garden of Earthly Delights.
If, for instance, a major bank is too complex to depict, and pure- or moderately-pure information models are insufficient, the article argues that we should at least ask the question whether it may also be too complex to exist.
The article also suggests, as the 1993 Yale Law Journal article did before it, that organizational complexities and other factors can contribute to misunderstandings of the financial innovations it is involved in.
Framing the associated issue as merely a “too big to fail” one misses the complexity elements of depiction and understanding.
UT: You referred to the foregoing intermediary depiction/pure information analysis as being the primary thesis of the article. Are there others?
HH: As a necessary corollary to the SEC’s totemic philosophy of promoting a robust informational foundation, the SEC’s approach has been “incremental” in the sense of not venturing beyond the realm of information to that of substantive decision making, as to stock prices or otherwise.
The article suggests, as a secondary thesis, that challenges to the SEC disclosure regime extend even to the philosophy’s incrementalist component. Recent departures from incrementalism have been extraordinary in number and nature, even leaving aside the departures arising from the Troubled Asset Relief Program and the derivatives-related provisions of the Dodd-Frank Act. Here I discuss such matters as the 2008 SEC short-selling ban and interventions to address the 2010 high frequency trading–related “flash crash.”
UT: Why should the public care about the issues addressed in the article?
HH: A well-functioning capital market is essential to everyone’s well-being. Informational failures can not only contribute to financial crises and affect our retirement savings, as we have so painfully seen, but cause misallocations of real economic resources. The SEC disclosure paradigm emerged in a simpler time, relied on a simple conception of information and implementation strategy, and was directed at simple goals. The modern process of financial innovation has resulted in financial strategies and other products, as well as major financial institutions, that are far more complex than in the past.
It is in everyone’s interest to ensure that the SEC disclosure paradigm be able to encompass in a meaningful and systematic way the vast complexities of modern markets and institutions. I am extraordinarily grateful to the Law School for having welcomed me to its community of alumni, faculty, and students—among whom were exceptional research assistants— and to SEC Chairman Mary Schapiro for having invited me into the candy store as I try to think about, and try to influence the resolution of, these and many related types of issues. [Editor’s note: Hu served as the inaugural Director of the SEC’s Division of Risk, Strategy, and Financial Innovation from 2009 to 2011.]
Hu’s symposium article and Foreword to the symposium issue are downloadable at, respectively, http://ssrn.com/abstract=2083708 and http://www.texaslrev.com/wp-content/uploads/Hu-90-TLR-1597.pdf?9d7bd4
Sidebar: SEC establishes Division of Risk, Strategy, and Financial Innovation
Appointed by SEC Chairman Mary Schapiro, Henry Hu was the inaugural Director of the SEC’s Division of Risk, Strategy, and Financial Innovation from 2009 to 2011. The first new Division in thirty-seven years, “Risk Fin” was created to provide sophisticated, interdisciplinary analysis across the entire spectrum of SEC activities, including policymaking, rulemaking, enforcement, and examinations in an increasingly complex financial world. All members of the Office of Economic Analysis (including the SEC’s Chief Economist) and the Office of Risk Assessment became members of Hu’s staff at Risk Fin’s creation. In addition, he quickly recruited renowned experts in the most complex aspects of modern capital markets, including derivatives and hedge funds. The Economist noticed, declaring in its February 13, 2010, issue that Risk Fin “was packed with heavyweight thinkers” and proceeding to name Hu and two of his recruits. Not coincidentally, the most important matter faced by the SEC during the pertinent period was especially complex and interdisciplinary in nature. Thus, this SEC “think tank,” as with each of the other four Divisions, was deeply involved in the lead-up to and implementation of the Dodd-Frank Act enacted in 2010, the sweeping statute which, among other things, finally brought the $600 trillion dollar over-the-counter derivatives market into the regulatory fold. In Schapiro’s words, Hu had “set the SEC on a new path. Interdisciplinary thinking is no longer a novelty at the SEC, thanks to Henry.”