Author: Lawrence Cunningham

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The Fancy Dining Barometer

During the early 2000s, capital flourished, Wall Street prospered and it was hard to get reservations at top New York restaurants, except months in advance; today, as capital flows contract, and finance is paralyzed, you can get reservations at some of the best New York restaurants with a mere one week’s notice—or less.

In that earlier period, you could get reservations at any restaurant in Washington DC less than a month in advance, and at many on shorter notice. Today, top DC restaurants are booked solid, no tables available—at least not until late January, after President-elect Obama is inaugurated.

What gives? Probably some version of C + I + G, part of the famous Keynes/Samuelson formula defining aggregate economic demand as the sum of consumption, investment, and government spending. In a simplified picture of the US today, I happens in New York; G happens in Washington; and C happens nationwide.

Earlier this decade, I was the biggest factor in the formula and you had to wait months for a reservation at Manhattan’s revered Gramercy Tavern. Now, with the New York Stock Exchange reeling while Congress lets the US Treasury dole out nearly a trillion dollars—and Congress discusses handing out more—G is the big factor in the formula, and you have to call months in advance for a table at West End’s Blue Duck Tavern.

Between Wall Street’s I and K Street’s G, of course, is C, the consumption component of the formula, the ultimate reality measure, capturing what’s going on in America, beyond New York and Washington. Today, the answer is not much. In all but a few big cities, Americans can get a reservation anywhere, today for tonight. But, alas, outside the Beltway and the Apple, many are eating tuna fish sandwiches at home.

An old quip says a recession occurs when your neighbor is out of work; a depression occurs when you are out of work. Hundreds of millions of people—including those in Manhattan—know that the United States is in a serious economic vise. But you would never know that here in Washington DC (at least not in the northwest quadrant of this city), where restaurants catering to the lobbying crowd are packed, and money flows freely.

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The Coming Capital Flood

dollar sign.jpgExcesses in the financial sector have spilled into all sectors of the economy and are spelling global recession. The worst, most say, is yet to come, as the manufacturing, retail, housing and other sectors reel from the fallout, with more layoffs, generally rising unemployment, curtailed consumer and business spending, slashing asset values and so on—all on a global scale.

Nor have the financial sector causes of these real economy consequences ended: there remain trillions of dollars of financial instruments, created in the period 2004-06, outstanding, whose settlement upon maturity or other triggering events will have additional consequences.

Those consequences may either continue to add to the economic crisis or just possibly resolve it, not only by providing capital to the financial sector but possibly by reversing the consequences infecting the real economy.

This is the interesting analysis offered by Australian financial columnist, Alan Kohler, in Business Spectator, entitled A Tsunami of Hope or Terror?

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SEC Schizophrenic on Global Accounting

SEC Seal.gifWith surprising absence of fanfare, the Securities and Exchange Commission released over the weekend a 165-page document outlining its delayed and long-awaited proposals for how the US might switch from using its own generally accepted accounting principles to new international financial reporting standards. The release bears a schizophrenic quality. It offers one unsurprising and one surprising proposal.

The unsurprising portion reflects what the Commission reluctantly came to accept last summer: the US is not ready for such a switch and is not likely to be until 2014 at the earliest. Accordingly, the release principally outlines the many obstacles to such a switch and lays out milestones that would have to be met before considering such a radical move.

The surprising portion contemplates allowing selected US issuers voluntarily to make the switch as early as the year after next—2010. This radical proposal would be limited to US issuers whose industry uses IFRS as the basis of financial reporting more than any other set of standards. The release struggles to explain why this special approach for such issuers overcomes the many obstacles facing other US issuers.

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Explanation Option on Multiple Choice Exams

Teaching Hours Burden Post.jpgLaw professors may struggle to determine optimal exam format, especially between essays and multiple-choice questions or a combination. Student appetite varies. But many students prefer essay exams. They may express concern that multiple choice questions limit ability to identify and explain ambiguities.

Teachers may find a multiple-choice format optimal for many reasons, including psychometric evaluation, the nature of substantive material to test (e.g., statutory versus common law), or simple time budgeting to grade exams (e.g., a professor teaching both Contracts and Corporations in a single term to large enrollments simply cannot grade 200+ written exams within deadline).

One way to offer multiple-choice exams while meeting that student concern is to give students a limited option to address perceived ambiguities. This can be done for a limited number of questions on a separate attachment to the multiple choice exam. I’ve done this for years, using an approach passed on to me by Bernie Black years ago when he was at Columbia and I taught a course there.

The mechanism is easiest to explain by excerpting below the related instruction that appears on the general instructions page to my exam; it is followed by the form of explanations page I attach to the exam booklet. I always circulate the instruction and sample form of explanations page in the weeks before the end of the term and explain the method in the beginning of the term when summarizing the course evaluation method.

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Crisis Yields Turnabout by SEC Chair

SEC Seal.gifIn a speech Wednesday

at the Practising Law Institute’s program on securities regulation, the historically arch-conservative, deregulatory Chair of the Securities and Exchange Commission, Christopher Cox, offered very surprising recommendations for financial regulation reform based on lessons taught by the current economic meltdown. Highlights include:

1. Establishing a Congressional Select Committee on Financial Services Regulatory Reform.

2. Merging the SEC and the Commodity Futures Trading Commission “with a clear mandate to protect investors by regulating the markets in all financial investments, including securities, futures, and derivatives.” Many such calls have been made, dating to the 1987 market crash to the Treasury Department’s March 2008 blueprint for financial regulation reform. Most propose diluting the resulting agency by having the merged agency adopt the lax approach to regulation used by the CFTC rather than the relatively tight approach of the SEC. Mr. Cox’s statement emphatically prescribes sticking with traditional SEC approaches in the resulting merged agency. He says the crises “highlight the need for a strong SEC.”

3. Merging all existing bank regulators, of which there are six at the federal level and scores at state levels. Again, this proposal has been often made, including by Treasury, although Mr. Cox again signals an urgency and muscularity that differs from the looser supervisory approach Treasury contemplated. Mr. Cox says: “the lessons of the credit crisis all point to the need for strong and effective regulation.” He contrasts the traditionally “strong SEC” with the comparatively lax banking regulatory structure: the SEC is independent of those it regulates. In contrast: “banks regulated by the Federal Reserve Bank of New York elect six of the nine seats on the board of the New York Fed. Both the CEOs of J.P. Morgan Chase and Lehman Brothers served on the New York Fed board at the beginning of the credit crisis.”

4. Mr. Cox also takes the lessons from the crisis to reject proposals, made as recently as a year ago, to weaken US regulations on the grounds such regulation results in the US losing financial business to less-regulated markets. The “mortgage meltdown” and “credit crisis” show that what is needed is strong regulation backed by statute, not mere supervision, voluntary compliance, weaker regulation or limited enforcement, Mr. Cox said.

The speech overall is an impassioned defense of a strong SEC, and strong regulation. Numerous SEC observers over Mr. Cox’s tenure may recognize this as a bit of a turnabout for him.

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Capitalism and Regulation

dollar sign.jpgThis weekend’s talk among world leaders will be accompanied by opposing diagnoses of economic failure and prescriptions for correction and prevention. The outgoing President of the United States sought to frame discussion in a speech yesterday extolling the virtues of unbridled free-market capitalism, warning that government regulation is a danger not a solution. In contrast, the continuing President of France and Prime Minister of Great Britain signal interest in devising an elaborate international, government-sponsored regulatory structure at global levels, to modulate capitalism’s most acute downsides.

Neither of these extremes is likely to hold. All modern capitalistic economies involve considerable government regulation and no advanced modern government is likely to cede sufficient national sovereignty to international regulatory authorities to forge a single global financial regulator. Reality suggests a combination of continued or enhanced national regulatory oversight with perhaps greater international coordination among senior national regulators.

Deeper policy talk may turn to the form regulations should assume within nations to enhance oversight and facilitate coordination. This may refashion discussion about whether rules or standards are superior. No slogan has been more popular in financial regulatory circles in the past few years than “principles-based systems” as contrasted to “rules-based systems.” Conservative reformers in the US, including current Treasury Department leadership, had been condemning the US system as “rules-based” and celebrating the “principles-based systems” they assert exist in the UK and Europe.

Regulation in general, and rules in particular, are a problem not a solution, in this view. If any regulation is politically necessary or economically justified, it would assume the form of broad general expressions of expected conduct, as standards or principles, not rules. This approach enables reposing maximal discretion in targeted actors, letting them exploit opportunities and take risks sans regulatory shackles. Opponents, skeptical of such discretion, contend that, at least for some purposes, strict rules are required to restrain excesses to which such actions can lead. When taking stances on the form of national and international financial regulation in coming discussions, participants may need to confront several fundamental questions.

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Michael Lewis on Causes of Financial Crisis

Michael Lewis, author of the long-selling book, Liar’s Poker, offers a magazine-style account of some of the factors provoking the current financial crisis. It is a delightfully literary contribution that will likely appeal to those captivated by best-selling narrative (complete with protagonists and famous characters plus expletives and references to football, sex and gambling).

Mr. Lewis’s 9000-word piece does not purport to provide a full picture, of course, because many factors conspired to generate the disaster. Extensive research and diagnosis must be undertaken to form a useful understanding. But the piece is enjoying attention and may be of some interest.

In general, Mr. Lewis blames the crisis on a “Wall Street machine” incubated by stupid investment bankers who lacked training to understand the risks they were creating. He ties the current crisis back 20 years to his period on Wall Street, as a 20-something, know-nothing paid a huge salary and bonuses. It was in that period that devices like mortgage-backed derivative securities were invented—the devices that proliferated geometrically in the past five years and form the catalyst of crisis.

In particular, the “Wall Street machine” consists of two parts: (1) real pools of subprime mortgage loans packaged into bonds presenting meaningful default risk and (2) a synthetic market of side bets that those bonds would indeed default packaged into bonds backed by bettors’ wagers. Mr. Lewis reports a story based on interviews with several people who participated in this casino. Its substantive elements can be summarized as follows.

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Saving Sallie Mae?

Salle Mae Logo.gifSallie Mae continues to weather the widening financial havoc that began by throttling the financial sector and now spreads to manufacturing, retail and even university sectors. SLM Corporation, its formal name, is a private corporation that in 2004 shed its government sponsored roots that dated to 1972. It provides student loans for education that are financed, in turn, by extensive use of asset-backed securitizations. In its quarterly report issued last week, Sallie Mae reported significant losses ($158 million) but far less than in the same quarter the previous year ($343 million). Institutional investors have been seen increasing their stake in Sallie Mae’s equity. Its stock closed in New York today at $8.26 per share (compared to a 52-week trading range of $4.19 to $42.00).

If Sallie Mae is a bright spot in an otherwise dismal economy, it may be vital to provide hope for a timely economic recovery from the brewing recession. Many universities, including Brown, Cornell and Harvard, faced with shrinking endowments, are reporting hiring freezes and budget cuts. Conventionally, these and other universities could count on economic recessions to increase demand measured by rising applications, especially for graduate programs in business and law. In general, applications to those programs rise as employment opportunities for college graduates shrink. When the economy expands, employment opportunities rise and applications flatten out.

Recently, unemployment rates are rising sharply and are expected to continue rising. Law school applications are predictably up. Past patterns, however, are likely to recur only if students are both able to secure requisite funding and ultimately land jobs that facilitate loan repayment. So far, Sallie Mae’s relatively respectable performance bodes well, as it has avoided the fate ensnaring its former cousins, Freddie Mac and Fannie Mae. And also so far, despite some contrary rumors, there does not appear to be any student loan crisis.

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Rating Agencies: Disease and Cure

Today Congress put credit rating agencies on the hot seat during intense hearings. Rating agencies, including Moody’s and Standard & Poor’s, gave top grades to debt the credit crisis is now showing everyone was junky. Scholars have long berated the rating agencies, especially Frank Partnoy. The fundamental problem is that securities issuers pay the rating agencies their fees. The proverbial result: whose bread I eat, his song I sing. Also, law requires very little of rating agencies and essentially insulates them from liability to investors harmed by irresponsible ratings.

As Congress turns hearings into policymaking, Members should consider new scholarship from Jeffrey Manns forthcoming in North Carolina Law Review. He proposes that investors, not issuers, pay rating agencies. The so-called user fee system is coordinated mainly by investors, those owning rated bonds, with a government agency coordinating the system in the pre-issuance stages of a rated debt offering. In addition, rating agencies would have to certify their ratings much as auditors certify their audits. Also like auditors, agencies would be required by law to disclose discovered fraud or illegal acts at issuers whose securities they rate.

The proposal is timely and sensible. Inevitably, it contains elements worthy of debate as well. In particular, the proposal contemplates applying a standard of gross negligence for investor recovery for rating agency violations. The standard for auditors generally is the tougher one of recklessness. In addition, the proposal caps rating agency damages measured in relation to earnings from the botched rating. Despite decades of campaigning by auditor lobbyists for such a cap on their damages, they have not been able to win this victory. Also, alas, auditors continue to be paid by the clients whose financial statements they audit (which I’ve proposed addressing by using financial statement insurance or capital market funding to prevent destroying the auditing industry).

Those interested in preliminary diagnosis of causes and cures for the current crisis should read Manns’ new article. My guess is that everyone who has written or thought about the rating agency’s role in our corporate finance system will consider the piece must reading.

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Rescue Plan Relies on Accounting Finesse

Green Eyeshade.jpg Treasury’s latest plan to address the credit crisis by direct investment of $250 billion in US banks has politicians telling Americans one thing and firms telling investors another. Politicians tell Americans the investments are temporary, no threat to private market capitalism in a democracy; thanks to deals brokered by Treasury and the Securities and Exchange Commission this weekend, firms will tell investors the investments are permanent, necessary to account for them as increasing firms’ permanent capital and minimizing dilution of common stockholders.

The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area in accounting dividing debt from equity. Borrowed funds a firm must repay are debt (liability); permanent funds a firm need not repay are equity (capital). Preferred stock is a liability if the firm must repay it and equity otherwise.

Critical to the Treasury’s plan is boosting firms’ equity capital, which means making the securities look as permanent as possible. But if they look too permanent, that would impeach the political story. The result is a term sheet negotiated this weekend calling the preferred perpetual while incentivizing firms to repay it within five years, without an explicit obligation to do so. Examples include a spike in the dividend rate at year five from 5% to 9%, forbidding firms to pay dividends on common stock unless dividends are first paid on preferred and limiting firms’ right to repurchase common stock while the preferred is outstanding.

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