We had a job candidate come through at some point this Fall who generally is interested in the field of commercial law.  That person mentioned in passing that although they were more than willing to teach the traditional secured transactions course, in their opinion it wasn’t well structured.  Why? Not, as the navel-gazer might imagine, because the field of commercial law is supposedly intellectually dead.  Rather because the traditional secured transaction course is too narrowly conceived — it usually is limited in coverage to personal property security interests under Article 9.  But many security interests that matter to lawyers aren’t held on movable property.  Since secured [...]]]> I’ve never taught Secured Transactions, so I’ll start by saying that the following is purely speculative and subject to correction.

We had a job candidate come through at some point this Fall who generally is interested in the field of commercial law.  That person mentioned in passing that although they were more than willing to teach the traditional secured transactions course, in their opinion it wasn’t well structured.  Why? Not, as the navel-gazer might imagine, because the field of commercial law is supposedly intellectually dead.  Rather because the traditional secured transaction course is too narrowly conceived — it usually is limited in coverage to personal property security interests under Article 9.  But many security interests that matter to lawyers aren’t held on movable property.  Since secured is ordinarily the foundational course for the commercial curriculum, students are left starting on too narrow a footing in understanding bankruptcy and bank regulation.  It’s even worse than having a corporations course that excludes LLCs.  Because of its technicality, ST is traditionally so difficult to teach that many students are turned off to the idea of commercial law practice at all.

Again, I don’t know much about this area of law.  I never took ST in law school, I haven’t taught it, and (worse) I haven’t even read a ST syllabus at my current institution.  But it struck me as an interesting thought, at least worth airing.  It’s related to concerns I have about the general corporate curriculum — is “corporations” really a subject that ought to be taught in a single course, or is it really a merger of too many (or too few) legal principles that have glommed together over time.  It’s also related to concerns that one might have about continuing to use the increasingly outdated, purportedly uniform, UCC to teach when States’ adopted versions are moving ever-further-away from that ideal.

But please note that it is not altruism or patriotism that induces the rescues.  Instead, Buffett’s value investing philosophy leads him to show up when the chips are down.  Value investing means to commit private capital only when the price you may is substantially below [...]]]> In today’s Financial Times, Dan McCrum cites one of my books and quotes me when portraying Warren Buffett as the investor of last resort in the US.  Inspired by Buffett’s investment in preferred stock and warrants of Bank of America (in which I have owned stock for 20 years, through predecessors), it is interesting to think of Buffett as rescuer of troubled American financial institutions: from Salomon Brothers in the late 1980s through Goldman Sachs in the 2008 crisis and B of A today. 

But please note that it is not altruism or patriotism that induces the rescues.  Instead, Buffett’s value investing philosophy leads him to show up when the chips are down.  Value investing means to commit private capital only when the price you may is substantially below the value you get.  “Be greedy when others are fearful and fearful when others are greedy,” Buffett has written.

In the depths of the 2008 crisis, Buffett shrewdly negotiated great investment deals at Goldman Sachs, with a 10% dividend rate, and at General Electric. He made a calculation that what he paid was way less than what he got. (And he was correct.)

Buffett, a friend of mine for 15 years whom I admire greatly,  also turned down other opportunities presented to him during the crisis, including at AIG. He found the price insufficiently below the value.

He also proposed an investment opportunity in 1997 in Long Term Capital Management, giving the firm an hour to accept, but they balked. He offered a steep discount, which he insisted on and they could not accept.

The Bank of America position today is likewise a shrewd value proposition: preferred stock with a hefty 6% dividend, along with warrants (options) to buy common shares at the bargain basement price of $7.14.  Notably, that price was above the trading price when the deal was inked but, foreseeably, the market shot up on news of Buffett’s investment and is now in the money—an instant profit.

So Berkshire is certainly a fortress (a kind of Fort Knox in American folklore) and Buffett, a patriot and altruist, is as beloved as Will Rogers for all his folksy home-spun wisdom and “tax me and other billionaires” populism. But Buffett is an investor first and foremost and you see him stepping up in these big ways in times of stress because that’s where value investing takes him.

Photo Credit: Cardozo Law School (Buffett guest teaching my class in 1998).

Since AIG executives are afraid to speak out, disclosure of this un-American provision was left to Maurice (“Hank”) Greenberg, former chair and until 2008 the largest shareholder of AIG. He disclosed it yesterday on CNBC.

This is yet another example of the dubious tactics used in Sept. 2008 by Hank Paulson and Tim Geithner when they wrested control of AIG for the U.S. government. Besides having scant legal authority for [...]]]> Top business executives in the United States regularly contact Members of Congress to lobby on legislation and other matters of public policy. But since the September 2008 government takeover of AIG, executives of that company have been forbidden to do so, unless they first get the Treasury Department’s permission, and the Treasury Department refuses to grant it.

Since AIG executives are afraid to speak out, disclosure of this un-American provision was left to Maurice (“Hank”) Greenberg, former chair and until 2008 the largest shareholder of AIG. He disclosed it yesterday on CNBC.

This is yet another example of the dubious tactics used in Sept. 2008 by Hank Paulson and Tim Geithner when they wrested control of AIG for the U.S. government. Besides having scant legal authority for their takeover actions, the successive Treasury Secretaries tried to keep from the public how the government funds injected into AIG did not support it or its shareholders or employees but were funneled as a backdoor bailout of Goldman Sachs and other Wall Street firms.

It is thus par for the course—but equally outrageous—that we now learn that when Paulson and Geithner imposed this straightjacket on AIG, they also made the company (a) adopt a policy suspending all lobbying and then (b) sign a loan agreement prohibiting it from changing that policy without Treasury’s consent—which apparently may be withheld for any reason or no reason.

Mr. Greenberg, who had run AIG for 40 years and lost his personal fortune of $2 billion to the government takeover by Paulson and Geithner, said of this gag order on MNBC yesterday: “It’s incredible. It’s hard for me to believe it happens in America, where you first impose terms on the company by making them a bridge loan, at usurious rates, and then say to the company you can’t lobby any member of Congress to bring about any kind of change whatsoever.”  (MNBC Interview, at about 3:50 / 8:26.)

The audacity of Treasury’s original inclusion of these provisions may only be outmatched by its current strict interpretation and stubborn stance. I understand that the Treasury has told AIG’s management that the lobbying policy (excerpted below) prohibits AIG from talking to Members of Congress regarding the terms of the government’s AIG  bailout. Apparently the Treasury contends that any such discussions would be lobbying for legislation!

Heated discussions between AIG management and Treasury are ongoing. If this upsets you, call your Member of Congress!

__________

AIG Lobbying Policy: ”All federal lobbying activities by AIG or its representatives related to advocacy on legislation, as well as political contributions on behalf of AIG, and including the operation of AIG’s political action committee, are suspended.”

 Section 6.04(e) of the Treasury-AIG Recapitalization Agreement: ”Restrictions on Lobbying.  AIG shall continue to maintain and implement its comprehensive written policy on lobbying, governmental ethics and political activity and distribute such policy to all AIG employees and lobbying firms involved in any such activity. Any material amendments to such policy shall require the prior written consent of the UST and any material deviations from such policy, whether in contravention thereof or pursuant to waivers provided for thereunder, shall promptly be reported to the UST. . . .”

Financial Institutions and Consumer Financial Services Section

AALS Annual Meeting – January 2012

Rubber Hits Road: Implementing Dodd-Frank amid Reform Fatigue

This program will take place one and a half years after the Dodd-Frank Act was signed into law. The law left many of the details of financial reform to be filled in by regulators, raising the risk of capture. Some of the most important rule makings have begun in earnest; others have stalled as reform fatigue sets in. Meanwhile, reform efforts in Europe and international regulatory initiatives remain works-in-progress.

What lessons can we draw from the implementation of Dodd-Frank so far? What have been the greatest achievements and the greatest disappointments as the legislative process has given way to the administrative? What devils have lain hidden [...]]]> Call for Papers:

Financial Institutions and Consumer Financial Services Section

AALS Annual Meeting – January 2012

Rubber Hits Road: Implementing Dodd-Frank amid Reform Fatigue

This program will take place one and a half years after the Dodd-Frank Act was signed into law. The law left many of the details of financial reform to be filled in by regulators, raising the risk of capture. Some of the most important rule makings have begun in earnest; others have stalled as reform fatigue sets in. Meanwhile, reform efforts in Europe and international regulatory initiatives remain works-in-progress.

What lessons can we draw from the implementation of Dodd-Frank so far? What have been the greatest achievements and the greatest disappointments as the legislative process has given way to the administrative? What devils have lain hidden in the details of the Federal Register? What aspects of reform have been largely forgotten? What does the path of financial reform say about legislative and regulatory process? What lessons can be drawn from the reform efforts in Europe and elsewhere? Does the focus on regulating institutions detract from a focus on regulating financial instruments, markets or economic functions and risks?

More ominously, is the crisis truly over? Are we at grave risk of fighting the last war? Has reform missed the mark altogether? This meeting is part of a project to engage the legal academy in sustained theoretical and policy contributions to financial regulation. It also presents an opportunity to look at specific rulemakings in detail, as well as to address larger questions about the course of reform after laws are made.

Call for papers:

Law teachers and other scholars are invited to submit manuscripts or abstracts dealing with any aspect of the foregoing topics. Junior faculty members are particularly encouraged to submit manuscripts or abstracts. A review committee consisting of Section officers will select one or more papers or proposals and will invite the author(s) of each selected submission to present their work at the program session in Washington, D.C. in January 2012.

Abstracts should be comprehensive enough to allow the review committee to meaningfully evaluate the aims and likely content of papers they propose. Please send manuscripts or abstracts to the Program Chair (Erik Gerding, University of Colorado) at profgerding@gmail.com no later than August 30, 2010. Please place the name and contact information of authors only on the cover page of submissions.

Please forward this Call for Papers to anyone who might be interested.

Simkovic argues that 80 years of erosion of classic commercial law doctrine ensured that “complex [...]]]> Secretive practices and institutions are common in contemporary finance. For those who’ve ceased the search for long-term value creation, temporary information advantage is key. Even commonplace practices can be reinterpreted as havens of hiddenness. My colleague Michael Simkovic’s article “Secret Liens and the Financial Crisis of 2008” exposes the role of derivatives and securitization as secretive borrowing strategies, designed to keep the naive or trusting from discovering the fragility of the institutions they loan funds to. His work has been presented to the World Bank Task Force on the Bankruptcy Treatment of Financial Contracts, and is relevant to both private and sovereign debt risks.

Simkovic argues that 80 years of erosion of classic commercial law doctrine ensured that “complex and opaque financial products received the highest priority in bankruptcy.” Products like swaps and over-the-counter derivatives were not adequately disclosed (either by banks in their consolidated financial statements or by their counterparties in publicly accessible transaction registries). By concealing those debts, these already overleveraged financial institutions were able to attract ever more credit and investment, at better rates than those who reported their overall financial health more accurately. (All other things being equal, it’s safer to lend to an entity that owes 10 billion rather than 100 billion dollars.) The genius of Simkovic’s article is to show how “fundamental causes of the financial crisis are relatively old and simple,” even as an alphabet soup of instrument acronyms (CDO, CDS, MBS, ad nauseam) and government programs (TARP, TALF, PPIP, et al.) makes our time seem unique.

As Simkovic explains:

Losses act as a spark; widespread leverage is the powder keg. Leverage can be “regulated” privately by creditors or regulated by government, but only if the extent of leverage is known [emphasis added]. Hidden leverage is a perennial problem because debtors rationally wish to borrow at the lowest price possible. Debtors can borrow at more attractive rates by hiding their existing debts and creating an exaggerated appearance of creditworthiness. [emphasis added]

Debtors who wish to hide their debts can exploit competition between potential creditors to gain active cooperation from some creditors. These cooperative creditors will work with debtors to hide loans either through simple non-disclosure or through complex structures. Debtors may compensate these cooperative creditors for their assistance with higher fees, a deeper business relationship with the creditors, or liens on the debtors’ property. The result of this subterfuge is lower financing costs for the debtor and lower profits—or steeper losses—for unsophisticated unsecured creditors.

Note that Simkovic’s work is more incrementalist than that of Stephen Lubben (another colleague of mine) or Mark Roe, who question the wisdom of safe harbors for derivatives in bankruptcy. Whatever you feel about that position—and however you feel about the relative advantages of regulation or market forces in deterring systemic risk—Simkovic’s work points to a fundamental problem that all sides in these debates must grapple with. Neither market forces nor regulators can deter systemic risk if there’s not fair warning that an interaction between secrecy and priority in bankruptcy can suddenly create disastrous runs on financial institutions. It’s one thing to create priorities (or supersecured creditors) that everyone knows about. It’s quite another to allow sophisticated debtors to promise the moon and stars to entities that have no idea what rival claimants are going to demand.

Pushing for Priority

For “financial innovators” in the years leading up to 2008, the game was straightforward: sophisticated lenders wanted to obtain first priority in bankruptcy (and/or the right to make collateral calls quickly), while borrowers wanted to hide how much they’d borrowed (and how encumbered their assets were). Like the fraudulent subprime broker who added a few zero’s to the end of his client’s W-2 form, leading bankers exaggerated the well-being of the desks and divisions they fronted for by obscuring certain obligations on their books.

How did they do it? Simkovic explains how the bankruptcy code now favors “securitized” over “secured” debt. The code forces secured creditors to try to keep their bankrupt debtor afloat during reorganization. For example, an “automatic stay[] prevents a secured creditor from seizing and liquidating the underlying collateral to recoup its investment.” A securitization can stave off such obligations by “distancing” certain obligations from bankruptcy. Simkovic explains these steps:

In an asset securitization, the debtor (or “Originator,” the term typically used in documentation) transfers financial assets such as credit card receivables or mortgage receivables to a special purpose entity, or SPE, typically a wholly-owned subsidiary of the debtor. The SPE (or another transferee) issues debt to investors. Investors pay the SPE which then pays the debtor.

For the securitization to isolate the underlying assets from the debtor’s bankruptcy, the transfer of assets from the debtor to the SPE must qualify as a “true sale.” Most securitizations do not economically resemble “true sales” because the debtor retains the risk of default or non-performance of the underlying assets. The debtor retains risk because the debtor owns the equity (or “first loss tranche”) in the SPE, and because the debtor may be required to repurchase assets from the SPE if losses reach a level exceeding . . . [a] pre-set trigger.

However, just as clever legislators let AIGFP characterize its disastrous CDS business as “protection-selling” (rather than insurance), Delaware’s Asset-Backed Securities Facilitation Act let securitizers safely call the SPE fancy footwork a “true sale” to avoid the responsibilities associated with secured debt. The debtor’s obligation to its SPE’s is kept “off balance sheet,” hidden from many creditors. Limited disclosure of asset securitizations (and their terms) means that “even professionals can underestimate the extent of debtors’ exposure to losses from securitized assets.”

Rating agencies have given very high ratings to securitized debt, reasoning that the originating “‘companies retain the subordinated interest in the transaction known as the equity tranche or ‘first-loss’ piece.’” But they ignored the underlying economic motivations behind the transaction: those who brokered the deals would walk away with huge fees regardless of how well it did overall. Aside from sacrificial wolf Fabrice Tourre, virtually everyone involved in the securitization machine has done fine financially. And as the WSJ noted in 2008, the SEC failed to require rating agencies to “disclose to the public all underlying information about any debt they are rating.”

Financial Innovation as Epiphenomen of Legislation: The Case of Credit Default Swaps and BAPCPA

Simkovic also highlights how another aspect of the CDO doomsday machine thrived on secrecy. Just as a firm could both stand behind a securitization (to assure buyers of the securitized assets) and not stand behind it (for accounting purposes, so it looked like it had less exposure than it actually did), so too could the buyers of securitized assets have their cake and eat it too. The securitized asset promised a steady income stream, and a transaction called a “credit default swap” allowed its beneficiary to offload the risk that the income would not materialize onto another entity, in exchange for steady payments of its own. So even when outside observers might bridle at the amount of leverage an entity took on to buy securitized assets (often from another entity that was heavily leveraged to create and support the same assets), the buyer could outwardly appear to be placing one bet with its publicly disclosed balance sheet, while secretly hedging its bets by buying a credit default swap from a well-capitalized firm that promised to pay in case the SPE and originator could not. Its purchase of the assets, a “vote of confidence” in public, might even be swamped by skepticism about the viability of the assets, if the CDS paid off far more than the expected value of the CDO it insured.

By September, 2008, AIG had sold $440 billion of CDS protection. It had no way of paying out anywhere near that amount, and had not reinsured itself, or offloaded some of the risk onto someone with deeper pockets. Where were the regulators? Stupefyingly uninformed, as the FCIC Report shows:

The Office of Thrift Supervision has acknowledged failures in its oversight of AIG. . . . [S]upervisors failed to recognize the extent of liquidity risk of the Financial Products subsidiary’s credit default swap portfolio. John Reich, a former OTS director, told the FCIC that as late as September 2008, he had “no clue—no idea—what [AIG’s] CDS liability was.” [emphasis added].

According to Mike Finn, the director for the OTS’s northeast region, the OTS’s authority to regulate holding companies was intended to ensure the safety and soundness of the FDIC-insured subsidiary of AIG and not to focus on the potential impact on AIG of an uninsured subsidiary like AIG Financial Products. Finn ignored the OTS’s responsibilities under the European Union’s Financial Conglomerates Directive (FCD)—responsibilities the OTS had actively sought. (350) [emphasis added]

Throughout late 2007 and 2008, the company’s accountant tried repeatedly to discover the true amount of risk involved in its transactions. As Simkovic shows, this was exceedingly difficult to do:

Credit default swaps, like most OTC derivatives, are an ideal vehicle for hidden leverage and secret liens because of their inherent complexity, limited disclosure, and superior treatment in bankruptcy. . . .Unlike exchange traded derivatives, which are standardized, simplified, and priced by the market through frequent trading, OTC derivatives are custom, bilaterally negotiated, relatively illiquid contracts and therefore difficult to price. The value of the derivative depends on three things: (i) the value of the underlying asset; (ii) the contractually negotiated formula that determines the counterparties’ obligations to each other based on that value; and (iii) the creditworthiness of the counterparty to the derivative, which determines the likelihood that the obligation will actually be paid. . . .

In the case of credit default swaps written on CDO tranches held by financial institutions: (i) the value of the underlying assets is difficult to determine because of the mathematically complex structuring that governs loss allocation among tranches and because of limited information about the credit quality of the underlying loans; (ii) the extent of counterparties’ obligations to each other is difficult to determine because of the subjective nature of determining when a “credit event” has occurred and the risk that disagreement will result in litigation; and (iii) the creditworthiness of counterparties is difficult to determine because they too have extensive and hard-to-measure exposures to derivatives such as credit default swaps.

Simkovic discusses how it may be impossible, even in principle, for large players to figure out the true extent of their exposure. CDS counterparties thought they were safe once they bought protection from AIG, and didn’t realize that AIG might go under. The banks didn’t accurately gauge the risk posed by AIG.

Willful Blindness

Simkovic’s position has been amply confirmed by other critics’ work. Consider, for instance, the cutting analysis from Eric Banks’s prescient The Failure of Wall Street (2004), which describes “financial controllers and auditors who don’t understand the nature of the business they are meant to be ‘independently monitoring,’” and trading desks which have little sense of “what kind of credit risks they are exposed to.” Combine these internal weaknesses with the regulatory arbitrage that allowed institutions to seek the most pliant “watchdogs,” and disaster was inevitable.

Of course, there were some forward-thinking participants in the financial markets who saw the risks, and ran away from them. As one report noted about Warren Buffett:

When Berkshire bought General Re in 1998, the reinsurance company had 23,000 derivative contracts. “I could have hired 15 of the smartest people, you know, math majors, Ph.D.’s. I could have given them carte blanche to devise any reporting system that would enable me to get my mind around what exposure that I had, and it wouldn’t have worked,” [Buffett] said to [a] government panel. “Can you imagine 23,000 contracts with 900 institutions all over the world with probably 200 of them names I can’t pronounce?” Berkshire decided to unwind the derivative deals, incurring some $400 million in losses.”

As one commentator observed, this type of complexity leads to a number of other problems:

Derivatives, because they are so hard to value, make it easier for traders and chief executives to inflate earnings. They exacerbate problems if a company, for unrelated reasons, suffers a credit downgrade that requires it to post collateral with counterparties – “a spiral that can lead to a corporate meltdown,” [Buffett] wrote. They create a “daisy chain” of risk as the troubles of one company infect another.

That “daisy chain” of risk echoes the diagnoses of Yale economist John Geanakoplos (whose work has indicated the instability caused by high leverage and “tight chains of financial interdependence”), Rick Bookstaber (who chronicles the instability inherent in “tightly coupled” systems), and Lawrence Baxter (who brings attention to recent network science on the “cascading failure” that is “common to many complex systems”). An interdependent system as complex as the OTC derivatives market can crumble at any moment. If key participants are too highly leveraged and one or more of them experience a shock, disaster is inevitable. The problem is not a “black swan;” it’s the black box dealmaking that make it impossible for markets or regulators to grasp how leveraged and fragile institutions really are.

Secrecy vs. Resilience

So how resilient should these systems be? That is a matter due much more political and regulatory attention than it is currently getting. Regardless of one’s views on leverage, one thing is clear: the types of opacity described in Simkovic’s article prevent us from getting any handle on the scope and severity of the problem. As he notes,

[E]ven basic information about OTC derivatives transactions can be extremely hard to come by. Market participants themselves are often unaware of the extent of their net exposures or the identity of counterparties to their transactions. Mandatory disclosures to third parties are even more limited, and the industry group, the International Swaps and Derivatives Association, has resisted voluntary disclosure.

Why the lack of clarity? There’s a fundamental contradiction in finance. Financial managers need to compete by keeping what they know secret so they can place big bets at “wrong” prices and make money when the prices eventually correct. At the same time, the policy justification for financial markets is that markets get the pricing right. As Simkovic has argued, “Allowing greater secrecy is essentially a decision to allow financiers greater private profits and to reduce the public benefit from quick ‘price discovery’ by markets.”

Accounting rules compound the difficulties, allowing certain deals to be quarantined from the rest of the bank’s financial status. For example, since a “simple fixed/ floating interest-rate swap contract . . . has zero value at the start,” it “is considered neither an asset nor a liability, but is an ‘off-balance-sheet’ item.” Lehman Brothers had $738bn in derivative contracts labeled as “off balance sheet arrangements” in its 2007 accounts, it’s now hard to accept uncritically its estimate of their ultimate “netted” value at the time. Carol Loomis did a post-mortem on the situation:

Lehman had a derivatives book of only $730 billion as it neared bankruptcy. Even so, when Lehman’s U.S. entities filed for Chapter 11 in September, this not-so-big figure translated into about 900,000 derivatives contracts. The great bulk of them have been “terminated” by derivatives counterparties which under industry protocols had the right to immediately “net” their accounts with Lehman in the event it declared bankruptcy. A handful – the last reported number was 18,000 – are still open.

Each of these contracts has a “fair value” – an amount that one side owes the other. Lehman, in fact, has a lot of open contracts that have been going its way. In a droll sign of how derivatives have come to be viewed as indispensable, Lehman has received permission from the court to buy them to hedge some of its open contracts, so that it can lock in the profits it has made since filing for bankruptcy.

Move now to the accounting problem. While sometimes the fair value of a derivative can be precisely determined, at other times it must be derived from murky markets and models that leave considerable room for interpretation. That gives the holders of derivatives a lot of bookkeeping discretion, which is troubling because changes in fair value flow through earnings — every day, every quarter, every year — and alter the carrying amounts of receivables and payables on the balance sheet.

The subjectivity involved in derivatives accounting also means that the counterparties in a contract may come up with very different values for it. Indeed, you will be forgiven if you immediately suspect that each party to a derivatives contract could simultaneously claim a gain on it — which should be a mathematical impossibility. In fact, we have a weird tale, gleaned from court documents, supporting that suspicion. It involves Lehman, Bank of America, and J.P. Morgan, and suggests how far some of those “terminated” contracts are from being truly settled.

That last point—that both parties could “simultaneously claim a gain” on what had to be zero-sum arrangements—is critical to understanding the risks posed by black box finance. It explains why deal complexity is often pursued for its own sake, and not for a genuine economic or investment purpose. Webs of debt become a smokescreen for what is really going on: institutions are rendered more and more vulnerable (both individually and collectively) so that privileged parties within them can reap enormous incomes from fees and bonuses. Formalities didn’t matter: as Stephen Lubben notes, “many credit default swaps were assigned to new protection buyers without the prior consent of the seller,” even though the ISDA Master Agreement governing such deals forbids this. Murky accounting kept Chuck Prince’s famous “music” playing ever longer, as a mountain of leverage and misallocated capital accumulated.

It Gets Worse: BAPCA’s Ugly Legacy

According to Simkovic, 2005 amendments to the Bankruptcy Code under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) have exacerbated the problem. This law assured that “derivatives counterparties effectively bear no risk of loss to the extent that the debtor posts collateral to cover its obligations.” Simkovic describes the rush of creditors to take advantage of its provisions, a stampede that made it “harder for those creditors to communicate with one another and monitor debtors’ leverage.” AIG was the poster child for overleveraged indebtedness, selling $440 billion in “protection” on CDOs. According to Lynn Turner, “In one year, the disclosures from the company had gone from not losing a dollar to over $26 billion in valuation losses and counter parties that to this day have not been disclosed demanding over $16 billion in collateral.” Since the Treasury Department believed that “the global economy was on the brink of collapse” when the the magnitude of the problem became clear, the government stepped in to bail out AIG (and, thus, its counterparties).

(Turner, former chief SEC accountant, describes how opaque AIG’s procedures were. The recent book Fatal Risk gives the “tick tock” details, chronicling the deepening unease of AIG’s auditors as the mark-to-fantasy approach of its subsidiary AIGFP became clear.)

From 2000-2008, AIG made $66 billion in profit, but in 2008, it had a $99.3 billion loss. The employees and execs who benefited in the boom years have kept nearly all their cashed out compensation. By January, 2011, according to the FCIC report, AIG had cost US taxpayers $152 billion (FCIC Report, 350). It’s an incredible sum for a process whose only social contribution, so far as I can see, was a marginal (and likely temporary) bump upwards in the rate of homeownership.

Simkovic describes financial sector creditors consumed by a desire for positional advantage, ignoring the slow erosion of the viability of the system as a whole. It’s an “I’ll be gone, you’ll be gone” culture, where accountability has largely vanished. If we really want to understand the recent investor rush to gold and commodities, it’s better to look beyond the central banks’ “printing money” and to think hard about why they’ve had to do so. Do you really want to park much money—be it in stocks, bonds, or some other instrument—at institutions staffed and run by people who bear virtually no pain in case of their collapse?

Picking Up Pennies in Front of a Bulldozer

Asymmetric compensation schemes are common in finance: managers enjoy substantial upside (perhaps even a life of leisure) if things go well; there is very limited downside if things go badly. Simkovic analyzes how opacity, corporate law, and bankruptcy code provisions help preserve this lack of accountability at the core of finance. The usual Wall Street metaphor for behavior like AIG’s is “picking up pennies in front of a bulldozer.” But the agency problems (and amounts involved) flesh out the metaphor: financial institutions are like wheezing couch potatoes, suddenly running to pick up suitcases of cash in front of a bulldozer of risk, and delivering most of the proceeds to high-flying managers lounging on settees by the side of the road. When the financial institution finally ends up getting a hand or arm caught under the bulldozer, it faces the horror of an impromptu amputation or annihilation. The managers will surely rue the untimely death or disability of their “runner,” but they’ll walk away with cash they’ve “earned,” and almost certainly find some other institutional form to renew the game another day. Even if some don’t, they may have made enough while the getting was good to fund an early retirement to the Caribbean.

At a recent event on the LSE report on the Future of Finance, panelists and audience members suggested that rent-seeking, as well as tax, accounting, legal, and agency distortions, are driving finance sector transactions more than the real economic substance of deals. Simkovic helps us understand the full extent of the problem. The bankruptcy code is becoming the tail that is wagging the dog of investment decisions. He argues that we need to “revive recordation,” as Hernando de Soto and other luminaries have urged. Perhaps real financial reform will ultimately depend on more radical approaches. But I see no way of significantly improving the situation without regulators taking seriously the problems Simkovic has described. In my next post on the issue, I will look at Michael Greenberger’s relatively optimistic take, and Arthur Wilmarth’s pessimistic view, on whether aspects of Dodd-Frank can address Simkovic’s concerns. Early developments have not been promising.

X-Posted: The Pareto Commons.

Whatever the merits of that view, the GFC did highlight debilitating trends in US finance infrastructure that have been intensifying for years. In this week’s Businessweek, Hernando de Soto (with Karen Weise) highlights one of the most important: the opacity of key markets and relationships. With scant exaggeration, de Soto warns that the US is on its way to levels of uncertainty more common in developing and communist countries:

During the second half of the 19th century, the world’s [...]]]> In his press conference last week, Ben Bernanke concluded on an upbeat note. He had high hopes for a US recovery, since he believed that the Great Financial Crisis (GFC) of 2008 hadn’t taken from the US any of its basic productive capacity.

Whatever the merits of that view, the GFC did highlight debilitating trends in US finance infrastructure that have been intensifying for years. In this week’s Businessweek, Hernando de Soto (with Karen Weise) highlights one of the most important: the opacity of key markets and relationships. With scant exaggeration, de Soto warns that the US is on its way to levels of uncertainty more common in developing and communist countries:

During the second half of the 19th century, the world’s biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial, and tribal relationships. . . . The result was a huge rift between the old, fragmented social order and the needs of a rising, globalizing market economy.

To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. . . . The result was the invention of the first massive “public memory systems” to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, [etc]), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: “economic facts.”

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. . . . In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

de Soto gives a number of concrete examples of how we are kept in the dark about the “thousands of filaments that businesses are creating between themselves,” including:

1) Mortgage Bundling: Law professor Christopher L. Peterson observes that, “For the first time in the nation’s history, there is no longer an authoritative, public record of who owns land in each county.”

2) Default Swaps: “these risks have slipped outside the public memory systems, making it very difficult to know who ultimately bears the risk and where it is.” And you can count on Tim Geithner to exacerbate the problem. McClatchy’s Greg Gordon identified the problem in 2009:

Cayman Islands deals . . . . became key links in a chain of exotic insurance-like bets called credit-default swaps that worsened the global economic collapse by enabling major financial institutions to take bigger and bigger risks without counting them on their balance sheets. The full cost of the deals, some of which could still blow up on investors, may never be known.

3) Exemptions: “Businesses are left to figure out [accounting realities] on the basis of connections, influence, and private information. Just like we do in developing and former communist countries.”

4) Off-Balance-Sheet Accounting: “In the 1990s governments began . . . allowing companies in financial difficulty to pass facts concerning debts from their public balance sheet to a less visible memory system called a special purpose entity (SPE) (or to sweep debt information into the balance sheet’s footnotes in words so obtuse that the statements cease being factual).”

5) Government Use of Swaps and Repo Markets: “Gary Norton at the Brookings Institution has argued that we still do not have the vaguest idea of the size of the repo market.”

6) Rating Agencies: We need “to consider whether overreliance on ratings based on co-variance formulas is a trustworthy substitute for facts. Any reform effort must keep in mind the difference between facts, which can be tested for truth, and opinions, such as ratings, which can’t. Facts are not simply about transparency; facts are about empirical truth.”

de Soto has long been a hero of conservative property rights groups. Unfortunately, the official Republican position on finance reform appears not merely to tolerate, but to affirmatively encourage the “destruction of economic facts” that de Soto laments. Leaders like Spencer Bachus want to reduce funding for the SEC, the Office for Financial Research and the Office of Credit Ratings (or kill the latter offices outright).

Some might be astonished that a political movement based on the rhetoric of “property rights” sees fit to undermine the very institutions necessary for us to understand who owns (and owes) what. But perhaps we shouldn’t be surprised, since rapidly increasing opacity in political donations makes it very difficult to understand what dominant donor classes are demanding. Just as the Koch-allied groups have largely drown out other libertarian voices on monetary policy, so too can veiled money flows trump the doux commerce ideal of an invisible hand. Who wants to be on the wrong side of Rove’s Crossroads group? There is a much broader “process of social control” at work here.

Ideas for Reform

de Soto gives several brief suggestions for reform; more are developed in detail in the Roosevelt Institute report “Make Markets Be Markets.” For example, Joshua Rosner elaborates on worries about bundled mortgages, and proposes a solution:

[K]ey terms that define contractual obligations are not standardized across the industry, across issuers of securities with the same type of collateral (e.g. RMBS, CMBS or RMBS based CDOs) or even by issuer (each issuer often had several different Pooling and Servicing Agreements and Representation and Warranty Agreements).

The lack of standardization and the length of the documentation effectively created opacity, which contributed to the problems in the securitization market. When panic set in and investors began to question the value of their securities, they knew that they did not have the time to read all of the different several- hundred page deal agreements. This reinforced the rush to liquidate positions. . . .

In order to accurately price securities, investors need timely loan-level performance data on the assets backing each deal. We need loan-level data on a daily, or at least monthly, basis in both the primary and secondary markets. Without frequently updated and standardized disclosure of loan-level data, market participants can’t independently analyze and credibly value asset-backed securities based on full information.

I think these are very good points, but reformers will need to overcome much entrenched dogma about the sanctity of trade secrets and proprietary information. In coming weeks, I’ll be focusing on other solutions, suggested in sources ranging from the de Larosiere report to Eric J. Weiner’s book The Shadow Market. I’ll also look at journalists’ ideas of their role, ranging from Gillian Tett’s pre-crisis “Iceberg Memos” (which warned FT managers that they were only covering the tip of an increasingly murky financial world) to Joe Nocera’s recent declaration that journalists have a fundamentally different role than, say, law enforcement, because they lack surveillance tools.

Consumer Combat: Crouching Exceptions, Hidden Fees

I have one more big picture point to make: “gotcha capitalism” extends from the highest levels of finance down to the consumer end of the economy. As Nathalie Martin recently noted:

I heard a humorous radio program this morning in which Europeans were complaining about how you never know the real price of anything in America. Things seem cheap, but once you consider the taxes, the tipping, the hidden ad-ons, the price is so much more. There is no transparency. Boy, they don’t know the half of it. At times it seems everywhere you turn, you find a scam or an unauthorized fee.

I have been following efforts to improve transparency in health insurance contracts, especially those sponsored by the Center for Consumer Information & Insurance Oversight. Recently, Daniel Schwarcz has demonstrated the need for more clarity in homeowners’ insurance policies, too:

The current personal lines insurance marketplace is largely organized around a myth. That myth is that personal lines insurance policies are completely uniform. This myth explains regulatory rules that do nothing to promote insurance contract transparency. It explains the ignorance of most information intermediaries about the details of contract terms. And, to a substantial degree, it explains the willingness of courts to treat insurance policies as ordinary contracts. . . .

[The situation] reflects the efforts of carriers to limit coverage relative to the presumptive industry baseline. These insurers have actively hidden and obscured this trend, in notable contrast to the comparatively transparent marketing of the few carriers who have departed from standardized policies to improve coverage. If regulators do not act to substantially improve consumer protection in this domain, then it can be expected that coverage will continue to degrade for most carriers, in a modern day reenactment of the race to the bottom in fire insurance that triggered the first‐wave of standardized insurance policies.

Many commentators have worried that consumer protection has been a neglected goal of bank and insurance regulators, whose primary goal was promoting credit and industry. Consumer protections in the financial world have too often been treated as a distraction from the primary goals of regulators, rather than as a critical part of their mission. As work from de Soto’s to Schwarcz’s shows, that attitude is impossible to sustain. Practices that harmed borrowers contributed to a larger crisis of confidence that threatened to initiate a chain reaction of catastrophic consequences for the finance system. In 2010, legislators realized that the regulatory arbitrage persistent in the financial sector—where the Office of Thrift Supervision, Office of the Comptroller of the Currency, and other regulators competed to offer the most lax regulatory regime—served neither consumers nor the larger economy. The Dodd-Frank Act addresses both concerns by establishing a Financial Stability Oversight Council, the Consumer Financial Protection Bureau, and the Office of Financial Research. Each could help rebuild institutions devoted to the “economic fact-finding” that de Soto recommends.

Photo Credit: Autovac.

Executive pay has skyrocketed in recent decades, in absolute terms and compared to average wages. The area of largest growth has been in stock-based components, including stock options, often tending to focus on the short-term, with associated risks we’ve seen. A vigorous academic debate has run for more than a decade, becoming a popular political discussion amid the financial crisis exposing arcane debate to public scrutiny.

Growth could be laudable, explained as creating proper incentives to align manager interests with shareholder interests and to promote optimal risk taking. In this view, if there is a problem, it is narrow and [...]]]> Cross-posted at Harvard Law School’s Corporate Governance blog, this summarizes in some detail my new paper on applying simple contract principles to police odioius executive pay contracts:

Executive pay has skyrocketed in recent decades, in absolute terms and compared to average wages. The area of largest growth has been in stock-based components, including stock options, often tending to focus on the short-term, with associated risks we’ve seen. A vigorous academic debate has run for more than a decade, becoming a popular political discussion amid the financial crisis exposing arcane debate to public scrutiny.

Growth could be laudable, explained as creating proper incentives to align manager interests with shareholder interests and to promote optimal risk taking. In this view, if there is a problem, it is narrow and limited. Critics are skeptical whether this story holds up. They worry that managerial power has strengthened to enable top executives to control setting their own compensation. In this view, the problem is pervasive and warrants a comprehensive response—and proposals abound.

I come down in the middle. There are problems in at least an important number of cases, and current proposals to redress them are unlikely to work. So I seek a new approach—contract unconscionability—to police extreme cases. The proposal must surmount some hurdles but isn’t as radical as it sounds.

A good way to summarize the debate highlights a three-pronged theory that promotes much of prevailing executive compensation, especially stock-based components, and contrasts it with limits on each prong.

First: in optimal contracting theory, boards design manager contracts to minimize agency costs. But when managers dominate the process, the managerial power thesis suggests this ideal may not be met.

Second: with efficient stock markets, stock price is a good proxy for the shareholder interest and a mirror of managerial performance. But stock price can differ from business value for sustained periods, fogging both.

Third: stock-based pay could align managerial incentives with shareholder interests if designed right and markets work well. But otherwise they create perverse effects.

From the viewpoint of critics, one problem with corporate pay is relatively little legal oversight. Even well-intended boards can fail, yet corporate law defers to them; federal securities and tax law encourage stock-based pay, without regard to perverse effects.

Reforms debate expanding shareholder power to motivate boards, led by Lucian Bebchuk and Jesse Fried. Others, like David Walker, prescribe tax changes or better disclosure. Still others, others, like Randall Thomas and Harwell Wells, look to enhanced corporate law oversight, invoking officer fiduciary duties, recently explicated in Gantler v. Stephens, to police renewals of employment contracts.

Throughout debate, and most of the reforms, there is much talk of redesigning pay contracts to focus managers on long term value, not short term price, by scholars as diverse as Bebchuk/Fried to Roberta Romano. Many of these are careful and useful. What’s still missing is a way to implement them, and I suggest using private litigation and contract law.

So I invent a new way to provide legal oversight to regulate associated risk: a contract law doctrine that has much in common with corporate waste, but is slightly more capacious. Pay has been evaluated under corporate law. But its business judgment rule and deference to independent committees and process means the only possible way to prevail is under corporate law’s waste doctrine. It bans only gifts, or dumping cash into the river, so massive salaries and stock-based pay with perverse incentives are outside it.

Unconscionability has some kinship to waste. It is used sparingly, reflecting freedom of contract. It looks at procedural aspects of a transaction. But unlike waste, which varies little with context, contract law’s propensity to use unconscionability intensifies according to a coherent logic. It becomes increasingly skeptical of lop-sided bargains as it goes beyond arm’s-length deals, into those plagued by procedural irregularities, heard by courts in equity, and involving fiduciaries.

So my basic theory is simple. These are contracts and when unconscionable should be rescinded—whether or not they amount to corporate waste, or are approved by boards or shareholders. Several hurdles appear, meaning few cases succeed, catching only the most odious.

First Hurdle: The first is the internal affairs doctrine that could make pay contracts governed by the corporate law of the state of incorporation, not the contract law of another. This doctrine protects corporate participants in relations with each other against inconsistent laws. Compared to the home state, others have weak interests in internal affairs, like shareholder voting, director elections, and mergers.

Employment agreements could be internal affairs. They are authorized by the board with officers as the counter-party. They regulate the corporation-officer relation. The internal affairs case is strengthened by seeing stock-based pay as a way to align manager-shareholder interests. But they are not inevitably internal affairs. That is clearest when formed with a newly-recruited manager—an outsider. Their primary function is to get labor in exchange for pay. They are increasingly justified as recruiting and retention tools, not alignment devices. From these viewpoints, they are merely contracts.

Second Hurdle.  Another hurdle could arise if managers put favorable choice of law clauses in their contracts. That’s a nice gambit but faces three limits.  First, choice-of-law clauses are not dispositive. Standard conflicts of law principles apply, asking what state has greatest interest. Second, an unconscionability claim can render the entire contract unenforceable, determined before applying any contract terms, including a choice of law. Third, even a Delaware choice of law clause would mean Delaware contract law not corporate law applies, which is a bit tougher.

Third Hurdle. The next hurdle involves whether a claim is direct or derivative. If derivative, shareholders face corporate law hurdles. Most seriously, shareholders must demand that boards act or show why that’s futile and special board committees can take control of the case and even decide to dismiss it. The line between the two can be blurry. The issue is whether a harm to be remedied is better conceived as individual to a shareholder or runs to the corporation as a whole.

The conceptual difficulty makes classification turn on factors, not bright line rules. These include the theory of liability and remedy. Cases tend to classify as derivative—claims for breach of duty and seeking money damages. Cases and statutes tend to classify as direct, claims asserting lack of corporate authority (called ultra vires), and/or seeking equitable relief.  Shareholder challenges to pay contracts will more likely be seen as direct by asserting that their unconscionable character puts them beyond the corporation’s authority, and the primary remedy is rescission.  

Fourth/Final Hurdle. Finally, judges may exercise comity and refuse to confront these hurdles or refrain because contracts may be so complex that judges hesitate to assume competency to evaluate them. Enforcement incentives are another practical issue. It is certainly beyond the SEC’s power and probably beyond that of many states or the interests of their attorney’s general. That leaves the private bar, whose incentives may be limited. A pure case of rescission would produce no payment and even a claim accompanied by a judgment in restitution may be comparatively small. But there may be sufficient incentives for the most high-profile case that could yield instrumental and reputational value.

Still, the hurdles are formidable, though incrementally lower than under corporate law. On balance, that is desirable. There is no risk of any floodgate effect. And a few egregious cases would be enough to deter excesses.

Turning to the merits, contract analysis is slightly broader than corporate law’s. Procedural aspects are not confined to corporate law’s focus on board independence or information. Courts consider the bargaining process, probing whether it was more consistent with optimal contracting or managerial power. Substantive unconscionability analysis is contextual, so stating broad principles difficult. But some tests can be suggested. One would compare the contract’s terms with academic models appearing in the literature (whether by Bebchuk/Fried or by Romano). Conforming contracts would be presumptively valid, but those wildly out of line suspect.

Another would compare dollar amounts, though that often will be difficult, and doubts resolved in favor of upholding the agreement. But when that ratio can be measured with reasonable certainty, and does shock the judicial conscience, the contract can be declared unconscionable and rescinded. 

In short, while not a slam dunk, this approach would be considerably stronger under contract law than corporate law. And that offers a new legal theory to test executive pay.  Not as radical as you thought, and not merely theoretical either, as readers who specialize in lawsuits targeting corporate abuses indicate that they are prepared to apply the proposal when the right factual case comes along.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.”  You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, [...]]]> The hottest book of the century, on corporate law, is in production, thanks to editors Brett McDonnell and Claire Hill, both of Minnesota. As part of a series investigating the economics of particular legal subjects, overseen by Richard Posner and Francesco Perisi, this Research Handbook on the Economics of Corporate Law, promises a comprehensive canvass of the broadest definition of this field of law as it has been structured by economic theories over the past forty years.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.”  You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, some intended and desirable, others unintended and undesirable. That’s the story of the influence the field of law and economics has had on the domain of law and accounting. That influence comes primarily from agency theory and modern finance theory, specifically through the efficient capital market hypothesis and capital asset pricing model. Those theories have forged considerable change in federal securities regulation, accounting standard setting, state corporation law, and financial auditing. Affected areas include the nature of disclosure, the measure of financial concepts, the limits of shareholder protection, and the scope of auditor duty.

Analysis reveals how agency theory and finance theory often but not always point to the same policy implications; it reveals how finance theory’s assumptions and limitations are often but not always respected in policy development. As a result, while these theories sometimes produced policy changes that were both intended and desirable, some policy changes were both unintended and undesirable while others were intended but undesirable.  Examination stresses the power of ideas and how they are used and cautions creators and users of ideas to take care to appreciate the limits of theory when shaping practice. That’s vital since the effects of law and economics on law and accounting remain debated in many contexts.

Other contributions to the book similarly available in draft form are by Matt Bodie (St. Louis), David Walker (BU) and Charles Whitehead (Cornell).  The following scholars are also contributing chapters: Bobby Ahdieh (Emory), Steve Bainbridge (UCLA), Margaret Blair (Vandy), Rob Daines (Stanford), Steve Davidoff (Ohio State), Jill Fisch (Penn), Tamar Frankel (BU), Ron Gilson (Stanford/Columbia), Jeff Gordon (Columbia), Sean Griffith (Fordham), Don Langevoort (GT), Ian Lee (Toronto), Richard Painter (Minnesota), Frank Partnoy (SD), Gordon Smith (BYU), Randall Thomas (Vandy), and Bob Thompson (GT).

 The workshop will take place at GW on April 1 and 2, 2011.  We are delighted by the submissions, congratulate those chosen, and stress that making the selections was difficult because of the volume of amazing papers.  We encourage everyone interested to attend and look forward to the weekend.

Adam Leviton (Georgetown), In Defense of Bailouts [George Geis (Virginia) & Art Wilmarth (GW)]

Jodie Kirshner (Cambridge), A Transatlantic Perspective on Regional Dynamics and Societa Eurpoea [Francesca Bignami (GW) & Theresa Gabaldon (GW)]

Alan [...]]]> Thanks to my colleague, Lisa Fairfax, GW has finalized the program for this year’s Junior Faculty Business and Financial Law Workshop and Prize (detailed here).   Of the more than 100 papers submitted, the following dozen presenters were chosen.  [Commentators appear in brackets; I've shortened some paper titles.]  

 The workshop will take place at GW on April 1 and 2, 2011.  We are delighted by the submissions, congratulate those chosen, and stress that making the selections was difficult because of the volume of amazing papers.  We encourage everyone interested to attend and look forward to the weekend.

Adam Leviton (Georgetown), In Defense of Bailouts [George Geis (Virginia) & Art Wilmarth (GW)]

Jodie Kirshner (Cambridge), A Transatlantic Perspective on Regional Dynamics and Societa Eurpoea [Francesca Bignami (GW) & Theresa Gabaldon (GW)]

Alan White (Valparaiso), Welfare Economics and Regulation of Small-Loan Credit: Lessons from Microlending in Developing Nations [Michael Pagano (Villanova) & Lawrence Mitchell (GW)]

Nicola Sharpe (Illinois), Corporate Board Performance and Organizational Strategy [Deborah Demott (Duke) & Michael Abramowicz (GW)]

Julie Hill (Houston), The Rise of Ad Hoc Bank Capital Requirements [Anna Gelpern (American) & John Buchman (E*Trade Bank & GW Adjunct)]

Michael Simkovic (Seton Hall), The Effects of Ownership and Stock Liquidity on the Timing of Repurchase Transactions [Richard Booth (Villanova) & Henry Butler (Mason)]

Michelle Harner (Maryland), Activist Distressed Debtors [Donna Nagy (Indiana Bloomington) & Lisa Fairfax (GW)]

Saule Omarova (UNC), The Federal Reserve Board’s Use of Exemptive Power [Patricia McCoy (Connecticut) & Arthur Wilmarth (GW)]

Heather Hughes (American), Suburban Sprawl, Finance Law and Environmental Harm [Scott Kieff (GW) & Lawrence Cunningham (GW)]

Robert Jackson (Columbia), Private Equity and Executive Compensation [Norman Veasey (Weil Gotshal) & William Bratton (Penn)]

Brian Quinn (BC), Putting Your Money Where Your Mouth Is: Post Closing Price Adjustments in Merger Agreements? [Gordon Smith (BYU) & John Pollack (Schulte Roth)]

Mehrsa Baradaran (BYU), Reconsidering Wal-Mart’s Bank [Heidi Schooner (Catholic) & Renee Jones (BC)]

This is one of many events sponsored by GW’s Center for Law, Economics and Finance.

Two former executives of Sadia SA, the foodmaker that BRF Brasil Foods SA bought to form the world’s biggest poultry exporter, were sentenced and fined in the country’s first insider trading court ruling.

Former Chief Financial Officer Luiz Gonzaga Murat Jr. was sentenced to 21 months in prison and fined 349,712 reais ($210,100), Brazil’s securities regulator said today in an e- mailed statement. Romano Ancelmo Fontana Filho, a former board member, was sentenced to 17 months and fined 374,941 reais. Both can serve community service in lieu of prison.

Murat, who was Sadia’s CFO for 12 years until resigning in 2006, and Fontana were charged with illegally purchasing American depositary receipts of Perdigao SA before Sadia made a hostile bid to buy [...]]]> I find it hard to believe, but apparently so:

Two former executives of Sadia SA, the foodmaker that BRF Brasil Foods SA bought to form the world’s biggest poultry exporter, were sentenced and fined in the country’s first insider trading court ruling.

Former Chief Financial Officer Luiz Gonzaga Murat Jr. was sentenced to 21 months in prison and fined 349,712 reais ($210,100), Brazil’s securities regulator said today in an e- mailed statement. Romano Ancelmo Fontana Filho, a former board member, was sentenced to 17 months and fined 374,941 reais. Both can serve community service in lieu of prison.

Murat, who was Sadia’s CFO for 12 years until resigning in 2006, and Fontana were charged with illegally purchasing American depositary receipts of Perdigao SA before Sadia made a hostile bid to buy the rival in 2006. Murat and Fontana settled similar allegations of insider trading with the U.S. Securities and Exchange Commission in 2007.

The student who passed this along to me seemed relatively confident that the ruling would be overturned on appeal. If anyone out there knows something about Brazilian securities law, sufficient to explain how the market there functioned without a rigorous enforcement regime, please drop on by and comment.  Otherwise, lots of L&E folks will be made very, very happy.

On the other hand, financial innovation has done wonders to extract purchasing power from the broad middle into the closed circuit at the top. Here, for example, is how one of our leading firms created enormous value in 2006:

Consider the tale of Travelport, a Web-based reservations company. [A] private equity [...]]]> I’ve talked in previous posts about a “closed circuit” economy among the wealthy. A plutonomy at the top increasingly circulates buying power (be it luxury goods, real estate, gold, or securities) among itself. The middle class used to dream that a rising Wall Street tide would lift all boats; as Felix Salmon shows, that hope is fading. Whatever innovations arise out of these companies aren’t doing much for average incomes.

On the other hand, financial innovation has done wonders to extract purchasing power from the broad middle into the closed circuit at the top. Here, for example, is how one of our leading firms created enormous value in 2006:

Consider the tale of Travelport, a Web-based reservations company. [A] private equity firm and a smaller partner bought Travelport in August 2006. They paid $1 billion of their own money and used Travelport’s balance sheet to borrow an additional $3.3 billion to complete the purchase. They doubtless paid themselves hefty investment banking fees, which would also have been billed to Travelport.

After seven months, they laid off 841 workers, which at a reasonable guess of $125,000 all-in cost per employee (salaries, benefits, space, phone, etc.) would represent annual savings of more than $100 million. And then the two partners borrowed $1.1 billion more on Travelport’s balance sheet and paid that money to themselves, presumably as a reward for their hard work. In just seven months, that is, they got their $1 billion fund investment back, plus a markup, plus all those banking fees and annual management fees, and they still owned the company. And note that the annual $100 million in layoff savings would almost exactly cover the debt service on the $1.1 billion. That’s elegant—what the financial press calls “creating value.”

The corporate geniuses at Boeing offer another display of modern-day business acumen.

The more stories like this you read, the more you realize that massive unemployment isn’t a bug in our economic system; it’s a feature. A country can’t have legal rules that permit these moves without expecting to hemorrhage jobs. All the Michael Porter homilies in the world can’t put this Humpty Dumpty back together again.

Ibanez held that, according to well-established Massachusetts precedent, a mortgagee cannot foreclose unless — surprise, surprise — it actually isthe mortgagee, or a legitimate assignee thereof.  In Ibanez,  lenders or servicers had foreclosed mortgages prior to completing (or commencing) the process of taking assignment of the note and  mortgage  on which they foreclosed.  When they later sought to clear title, Massachusetts courts balked.   “Utter carelessness,” Justice Cordy scolded the plaintiffs.

mistakes were made

This is potentially a huge [...]]]> The Massachusetts Supreme Judicial Court’s recent ruling in U.S. Bank v. Ibanez  is the latest and loudest salvo in what may be the most engaging and gruesome legal aspect of the credit crisis yet:  The day of reckoning for the staggering sloppiness that infected virtually every step of the mortgage-securitization process.

Ibanez held that, according to well-established Massachusetts precedent, a mortgagee cannot foreclose unless — surprise, surprise — it actually isthe mortgagee, or a legitimate assignee thereof.  In Ibanez,  lenders or servicers had foreclosed mortgages prior to completing (or commencing) the process of taking assignment of the note and  mortgage  on which they foreclosed.  When they later sought to clear title, Massachusetts courts balked.   “Utter carelessness,” Justice Cordy scolded the plaintiffs.

mistakes were made

This is potentially a huge problem for mortgage servicers (among others), given the long and convoluted chains of title through which mortgages may have passed in order to create mortgage-backed securities (MBS).   Not surprisingly, many observers are apoplectic, warning that this will lead to the end of the financial markets as we know them. 

How did this happen? 

There are probably several answers, but I think one is that the elite financial services sector (EFSS) that created the MBS is (or believes itself to be) a unique institutional force, unchallengeable by the ordinary legal or political mechanisms that keep institutions in check.  It is immune from the rules and norms  that apply to the rest of us.  But we know that spoilt children often lack discipline, so persistent failures of scrutiny have led inevitably to failures of competence. The drip, drip, drip of deregulation left us with firms that are not only too big to fail: they’re also too big to succeed. 

What will happen next? 

We can expect that the EFSS will respond to Ibanez as it always has after suffering any set-back: It will run to Congress for help. With a newly purchased Republican majority in the House, it will likely get it. 

The important questions for those concerned about the power of the EFSS should therefore be: 

1.  What power does Congress have to remedy these mistakes—especially in a world where, Republicans would tell us, we are bound to a Constitution whose “original” understanding would probably not tolerate federal intrusion into state power over real property conveyancing? and

2.  What will we get in exchange for fixing yet another mess created by the EFSS?

Others have already begun to address the former question, and the latter will play out in the media if (when) Congress takes up the question in the future.  I think many (not all) would agree that we should not permit portfolios of MBS to collapse further, or void (technically flawed) foreclosure sales to bona fide purchasers.  But simply sweeping aside state foreclosure law (as Congress nearly did last term) is probably not the answer, either.

In the meantime, what no one seems to have noticed is the larger point here:  We have, for many years, made “the rule of law” a core objective at home and abroad.    What this means generally — and whether it is sound policy — are debates above my pay grade.  Yet, whatever else it may mean, it would appear that from bailout to whiteout, when it comes to the EFSS, it is the rule of flaw — not the rule of law — that counts.

Perhaps this is attributable to analytical factors, such as observed user growth rates, potential market and revenue sources, perceived capacity to convert the revenue into earnings, competitive threats—or negotiating skill in trading of privately-held shares. But given the wildly varying pricing traders give enterprises like this in recent years, it could be a sign of a bubble.

Financial bubbles recur as a natural, inherent product of human behavior in capitalist economies—from the recent real estate bubble, [...]]]> The mysterious ways of financial valuation manifest daily. One mystery: Facebook, the social network business, and Groupon, the buying network company, both generate annual revenues of about $1 billion. Yet reported private stock trading indicates that traders are pricing Facebook at about 50 times that while pricing Groupon at about 5 times that.

Perhaps this is attributable to analytical factors, such as observed user growth rates, potential market and revenue sources, perceived capacity to convert the revenue into earnings, competitive threats—or negotiating skill in trading of privately-held shares. But given the wildly varying pricing traders give enterprises like this in recent years, it could be a sign of a bubble.

Financial bubbles recur as a natural, inherent product of human behavior in capitalist economies—from the recent real estate bubble, to the dot-com bubble a decade earlier, and stretching back to the tronics bubble of the 70s and back to Amsterdam tulip bulbs centuries ago.  (I wrote a trade book about this after last decade’s bubble burst.)  By definition, a critical mass cannot recognize the bubble as it is in inflating, though invariably some pessimists detect something.

Internet and other tech companies are notoriously difficult to value, especially in early years before earnings, and the best value clues are calculated as a multiple of recent revenue. With standard value measures and recognized business types, reliable rules of thumb apply, putting limits on a fair price to pay expressed in ratios of price to basics like earnings or tangible assets.

But with businesses in unchartered territory, the tendency is to measure price in relation to annual revenue—and there is essentially no standard yardstick. Of late, the range has extended from 6x revenue to nearly 400x revenue.

At the extremes in recent years: Microsoft bid 6x revenue for Yahoo, which declined the offer as insulting; eBay bought Skype for 370x revenue, which it later acknowledged as a massive overpayment that it had to write down.  More moderately but not much more succesffully, News Corp bought MySpace for 12x revenue, also later written down.  More wildly, Google bought YouTube at 113x revenue and Microsoft’s initial small investment in Facebook was bought at 100x revenue—neither yet seen to be profitable.  This month, Google bid 6x revenue for Groupon, which declined the offer as too low.

At todays’s ratios (Facebook 50x revenue, Gropuon 5x revenue), Facebook looks overpriced and Groupon on sale.  On the other hand, laying down cash for shares in either is akin to gambling in Atlantic City or Las Vegas. You can make a bundle or lose all you commit, with odds favoring losing.  But if you work for an institution, playing with other people’s money, you can hedge your bets—brag if returns turn out big and simply not speak about the deal otherwise.   That may explain some of the wild valuations, driven by institutional buyers, the “smart money.”

Having authored the perceptive book How Markets Fail, Cassidy looks behind the liquidity talisman and finds it tends to melt into cliche:

“Liquidity” refers to how easy or difficult [...]]]> Argue against a complex financial practice, and you’ll hear it sooner or later: the liquidity trump card. Promoters of virtually every form of securitization, leverage, collateralized debt obligations, credit default swaps, swaptions, you name it—will insist that, if their activity is regulated or limited, the markets will lose liquidity. For example, as John Cassidy quotes John Mack, ‘subprime-mortgage bonds . . . “give[] tremendous liquidity to the markets.’” Another private equity executive tells Cassidy, ““Part of the value in a stock is the knowledge that you can sell it this afternoon. Banks provide liquidity.’”

Having authored the perceptive book How Markets Fail, Cassidy looks behind the liquidity talisman and finds it tends to melt into cliche:

“Liquidity” refers to how easy or difficult it is to buy and sell. A share of stock in a company on the Nasdaq is a very liquid asset: using a discount brokerage such as Fidelity, you can sell it in seconds for less than ten dollars. A chocolate factory is an illiquid asset: disposing of it is time-consuming and costly. The classic justification for market-making and other types of trading is that they endow the market with liquidity. . . .

But liquidity, or at least the perception of it, has a downside. The liquidity of Internet stocks persuaded investors to buy them in the belief they would be able to sell out in time. The liquidity of subprime-mortgage securities was at the heart of the credit crisis. Home lenders, thinking they would always be able to sell the loans they made to Wall Street firms for bundling together into mortgage bonds, extended credit to just about anybody. But liquidity is quick to disappear when you need it most. Everybody tries to sell at the same time, and the market seizes up. The problem with modern finance “isn’t just about excessive rents and a misallocation of capital,” Paul Woolley said. “It is also crashes and bad macroeconomic outcomes. The recent crisis cost about ten per cent of G.D.P. It made tackling climate change look cheap.”

Just like the portmanteau terms “growth” or “innovation,” liquidity is the start of an argument, not the end of it. We need to ask why it is socially valuable that certain forms of investment can be quickly bought and sold.

The liquidity fetish is part of a larger project in finance—what Manhattan Institute Scholar Nicole Gelinas characterizes as a quixotic (and dangerous) quest for a “risk-free world.” Her book After the Fall: Saving Capitalism from Wall Street—and Washington is well worth reading. Both Cassidy and Gelinas challenge the finance world’s soundbite selling points for endless “hedging” and “risk management.”

First off, he lamented the fact that we have been holding hearings like this since 2007. “Every year we have another set of hearings, and you can add 2 million foreclosures” to the bottom line. Nothing gets fixed, despite all kinds of documented evidence that the banks and servicers have committed fraud. Levitin’s position is that the servicers should be banned from the loan modification business entirely, because they don’t have any interest in it except as a profit-maximization scheme, and they have massive conflicts of interest that cut [...]]]> Adam Levitin has been one of the most courageous and compelling commentators on the financial crisis. So it’s not much of a surprise to see this report on his latest testimony before the Senate Banking Committee:

First off, he lamented the fact that we have been holding hearings like this since 2007. “Every year we have another set of hearings, and you can add 2 million foreclosures” to the bottom line. Nothing gets fixed, despite all kinds of documented evidence that the banks and servicers have committed fraud. Levitin’s position is that the servicers should be banned from the loan modification business entirely, because they don’t have any interest in it except as a profit-maximization scheme, and they have massive conflicts of interest that cut against doing right by the borrowers (and even the investors for whom they work).

Levitin said that we don’t have the full data sets from the servicers, or any comprehensive data to see whether there is a full-on crisis of unclear title and improper mortgage assignment. In other words, we don’t quite know the full extent of the problem. Levitin said, essentially, “The federal regulators don’t want to get info from servicers, because then they’d have to do something about it.” They don’t want to recognize the scope of the problem because it would require them to act. And Levitin in particular singled out the Treasury Department. “The prime directive coming out of Treasury is ‘protect the banks’ and don’t force them to recognize their losses.”

While I’m sure the FCIC will issue a nuanced report on the web of causes behind the foreclosure crisis, Levitin sees the spider. It looks like courts are beginning to identify it, too. As Kate Berry reported in the American Banker,

Countrywide, the mortgage giant that’s now part of Bank of America Corp., routinely didn’t bother to transfer essential documents for loans sold to investors, an employee testified. The testimony — which a New Jersey bankruptcy judge cited in dismissing a B of A claim against a debtor — could complicate attempts by the company to foreclose on soured loans that Countrywide originated and sold in better times.

The B of A employee’s admission that the lender customarily held on to promissory notes could also undermine the industry’s position that document transfers to securitization trusts are fundamentally sound. O. Max Gardner, a North Carolina consumer bankruptcy lawyer who was not involved in the case, called the testimony “a major problem” for B of A, which acquired Countrywide, the country’s largest servicer of residential mortgages, in 2008. “These original notes were supposed to be transferred and delivered all the way up the line and for this witness to admit they were never transferred is pretty amazing,” Gardner said. “I’ve never see this admitted anywhere.”

I guess there’s a reason why so much financial activity nowadays goes on in the “shadow banking system.” And as Gillian Tett notes, what’s more worrisome is the role of the “shadow, shadow banking” system propping it up:

[M]any things about the modern financial system remain mysterious – even today. On the edges of [their diagram of the extant shadow banking system], NY Fed economists list all the government programmes that have supported the system since 2007 (and, in effect, replaced shadow banks when they suffered runs). This “shadow, shadow bank system” – as it might be called – looks complex and baffling too. And in practical terms, the sheer breadth and complexity of that box makes it hard to know what will happen if – or when – government aid disappears.

Commentators on the left and the right realize the magnitude of the problem. Perhaps Levitin will help the “sensible middle” connect foreclosure fraud, systemic risk, and a struthious Treasury Department.

Where's the goo?

They are, in short, evidence of the virtues of extreme recycling.

Just imagine the pitch meeting for Galactica:  We’ll take what has to have been one of the dumbest pop-culture packing peanuts ever and make it stronger, faster, better:  How about an allegory about civil liberties and faith after 9/11 using Cylons and vats of [...]]]> I don’t watch much TV.  So, I am hardly the person to make strong claims about its quality or trends.  That said, I find it fascinating that three of the best shows of the past few years—Battlestar Galactica, Madmen, and Glee—share a really odd structural feature:  They have all taken ridiculously bad ideas from cringe-able eras and turned them around completely, made them not only fresh, but evocative, disturbing, intriguing.

Where's the goo?

They are, in short, evidence of the virtues of extreme recycling.

Just imagine the pitch meeting for Galactica:  We’ll take what has to have been one of the dumbest pop-culture packing peanuts ever and make it stronger, faster, better:  How about an allegory about civil liberties and faith after 9/11 using Cylons and vats of goo?

Or what about Madmen:  Let’s explore the most virulent cancers on our culture with lovingly pornographic attention to detail, to demonstrate the complex symbiosis among banality, beauty, evil and exculpation.  Madmen is the money shot of commodity fetishism, proving once again the truth of Chomsky’s admonition that if you want to learn what’s wrong with capitalism, don’t read The Nation, read the Wall Street Journal.

And Glee?  Well, all I can say is:  Don’t Stop Believing.

Which may lead you to this question:  No one really takes the “and everything else” part of CoOps’s desktop mantra seriously, so what the frak does this have to do with law?

Two things.  First, it is a way to understand what’s wrong with the system-salvation provisions of Dodd-Frank.  Second, it describes what (imho) courts will have to do with the likely coming wave of lender liability (and similar) claims falling out from the credit crisis.

Dodd-Frank has already seen more than its fair share of attention, much of it centered on the instability built into the resolution powers given to the executive branch for systemically important (TBTF) firms.  No doubt, these powers might be threatening to capital market participants long accustomed to profound (and in some cases profoundly expensive) government obeisance.  Not only do we now know that the federal government, through the Financial Stability Oversight Council, really has the power to do what it said it couldn’t do (but sort of did anyway with Bear Stearns, AIG, GM, and, depending on your version of the story, Washington Mutual): we also know that the scope and use of these powers is almost entirely unpredictable ex ante.

What is extreme here is the failure to recycle, the failure to learn from history that lasting, effective regulatory restructuring requires years of investigation, analysis and horse-trading.  The Dodd-Frank Congress has tried to do in about a year what it took Roosevelt and his Congresses nearly a decade to do.  We may be faster, but I am not sure that we are that much smarter.  (I note, here, the one important exception to this criticism:  the creation of the Consumer Financial Protection Bureau.  While it was not based on massive, multi-year studies of the sort William O Douglas developed to support securities and bankruptcy reform, it nevertheless was backed by outstanding empirical and normative legal scholarship from two people (Warren and Bar Gill) who—while they may have an axe to grind—understand how properly to hone blades).

A form of extreme legal recycling I think we may see will involve the rebirth of the lender liability lawsuit.  During the 1970s and ‘80s—you know, when we had proto-Galactica and Journey—courts occasionally held lenders liable to borrowers or their creditors for enforcing their rights too aggressively (e.g., foreclosing for mere technical defaults), actions that may have been within the four walls of the contract, but nevertheless lacked “good faith.”

These cases largely collapsed under the convulsive contractarian logic of Frank Easterbrook in Kham & Nate’s No. 2:  Lender liability, Easterbrook told us, is an oxymoron, and courts have no business policing aggressive, but contractually contemplated, collection practices.

This may have made sense in the early 1990s, when lenders were banks trying to collect loans from borrowers whose technical defaults may (or may not) have signaled serious risk of payment default.  Today, I have argued to anyone who will listen, the world is fundamentally different:   We have a Shadow Bankruptcy System, which means, in part, that we have sophisticated, aggressive (largely) unregulated investors (hedge funds, etc) trading in a (largely) unregulated secondary market for distressed debt.  With credit derivatives, equity short sales, and a variety of important gaps in securities, bankruptcy and commercial law, opportunities for opportunistic behavior, I have argued here, appear to be rich and alluring.

Since Dodd-Frank won’t deal with this–Too Small To Matter?–the solution, I have also argued, is another kind of recycling:  build a newer, faster, better form of good faith review of distress investor behavior.  I don’t need to get into the details here.  Suffice to say, if you didn’t like “good faith” in the lender liability cases of the 1970s and 1980s, I’ve got something else you might want to think about.

To paraphrase Faulkner:  The past isn’t prologue—it isn’t even past.

Extremely Recycled Cylon courtesy of Wikimedia

Browder soared to fame and fortune investing in Russian equities amid the chaos and corruption of the post-Soviet economy. His hallmark: finding hidden values in Russian companies and driving up their share prices by exposing corporate malfeasance and mismanagement. His widely publicized campaigns for shareholder rights and corporate governance helped propel the Hermitage Fund from $25 million in 1996 to [...]]]> This presentation by Bill Browder at the Stanford Graduate School of Business is a pretty astonishing account of the Russian economy over the past two decades. I am familiar with the usual story of oligarch profiteering, but Browder’s experience shows how even the ostensibly sound legal arrangements of today can quickly unfold into a nightmare for investors. As the Stanford GSB news puts it,

Browder soared to fame and fortune investing in Russian equities amid the chaos and corruption of the post-Soviet economy. His hallmark: finding hidden values in Russian companies and driving up their share prices by exposing corporate malfeasance and mismanagement. His widely publicized campaigns for shareholder rights and corporate governance helped propel the Hermitage Fund from $25 million in 1996 to $4 billion a decade later. But eventually the U.S.-born financier ran afoul of the Russian government, which banned him from the country in 2005 as a threat to national security.

According to Browder, “Anyone who would make a long-term investment in Russia right now, almost at any valuation, is completely out of their mind. . . .My situation is not unusual. For every me, there are 100 others suffering in silence.” And for a “bigger picture” presentation about the “disembedded markets” and the types of forces Browder was a victim of, Nancy Fraser’s Storrs Lecture podcast on “Predatory Protections, Tragic Tradeoffs, and Dangerous Liaisons: Dilemmas of Justice in the Context of Capitalist Crisis” is also well worth listening to.

It’s a tragic situation, especially because there are some real truth tellers out there—Yves Smith, Mike Konczal, Michael Greenberger, and many affiliates of the Roosevelt Institute come to mind. The difference between Pecora’s time and ours is a fragmented and manipulated media that a) can barely follow a complex financial story for more than a few hours, and b) fastidiously counterbalances every account of a Wall Street misdeed with some “expert” assuring us that it’s just business as usual in an industry that’s way too [...]]]> In his post on Michael Perino’s book Hellhound of Wall Street, Lawrence Cunningham observes that “Our predecessors were fortunate to have someone like Ferdinand Pecora to uncover top-secret financial shenanigans. No such person appears in our midst.”

It’s a tragic situation, especially because there are some real truth tellers out there—Yves Smith, Mike Konczal, Michael Greenberger, and many affiliates of the Roosevelt Institute come to mind. The difference between Pecora’s time and ours is a fragmented and manipulated media that a) can barely follow a complex financial story for more than a few hours, and b) fastidiously counterbalances every account of a Wall Street misdeed with some “expert” assuring us that it’s just business as usual in an industry that’s way too complicated for ordinary people to understand.

Charles Ferguson’s compelling film Inside Job steps in for a phantom mass media. Every citizen should be conversant with the basic narrative Ferguson puts together. Andrew Sheng, Chief Advisor to the China Banking Regulatory Commission, puts it in a nutshell: there was massive private gain in the US financial sector leading to massive public loss. Looking back, we might have all been better off if the finance tycoons profiled in the film had simply demanded hundreds of millions of dollars directly from the government back in 2000, and retired to Capri.

Instead, these deci- and centimillionaires helped build up the Rube Goldberg contraption of derivative deregulation, CDO’s, and CDS’s Ferguson describes. Fortunately, the film concisely explains that farrago in a way that will both educate the uninitiated and intrigue those who’ve read some books on the crisis. The film’s real contribution lies in four arguments it makes.

First, Ferguson shows just how loopy Wall Street pay has become. If you ever doubted that the compensation cart is in front of the capital allocation horse, you won’t any more. In the film, Raghuran Rajan describes Larry Summers’s infamous dismissal of Rajan’s prescient description of perverse compensation incentives in the financial sector. We then hear how AIGFP’s 400 employees earned $3.5 billion between 2000 and 2007, stonewalling accountants like Joseph St. Denis who could have blown the whistle on their casino. As one consumer advocate notes, for top bankers, any given compensation level was “never enough.” Given that the Wall Street Journal recently reported that financiers now call $100 million a “unit,” $1 million a “stick,” and $1 billion a “yard,” that mentality persists.

Second, Inside Job dissects the Obama Administration’s string of failures in dealing with Wall Street. When other world leaders organized to demand compensation reform fundamental to real change (including Christine Lagard and five other European finance ministers), our Treasury Department and Fed did nothing. In Ferguson’s telling, Summers, Geithner, and Bernanke either overtly cheerled (or politely tolerated) the excesses that led up to the crisis. Ferguson traces an unbroken line of Wall Street solicitude from Reagan to Clinton to Bush to the current administration. I’m hoping that the Dodd-Frank Act will be energetically enforced, but optimism is not an easy option after Ferguson’s film, which describes in detail Wall Street’s lobbying clout.

Third, the film explains why a President as visionary and smart as Obama could not think beyond the incrementalism of an economic team rife with Goldman Sachs alums and fail-upward regulators. It portrays an academic environment festering with direct and indirect conflicts of interests. Economists and B-school professors appear content to churn out papers and reports without revealing the full web of financial ties affecting their thinking. Cognitive capture has rarely been conveyed so concisely.

When Ferguson grills Harvard Econ Dep’t chair John Campbell on the cozy relationship between academe and the finance sector, Campbell shrugs it off. Ferguson then asks Campbell what the difference is between an economist who, say, champions a deregulatory policy while failing to disclose payments from a party interested in the policy, and a doctor who promotes a drug while failing to disclose he is paid for doing so. The response (or lack thereof) is priceless. Harvard luminary Martin Feldstein also proudly claims to have “no regrets” for his long time service on the AIG board. And Columbia Business School Dean Glenn Hubbard imperiously declaims “this is not a deposition” when asked to reveal the companies he consults for which are not listed on his resume. Ferguson goes on to describe a multi-billion dollar industry of “academics for hire.” In his review of the film, Dean Baker concludes that “the economics profession . . .richly deserves the abuse” Ferguson delivers.

Finally, Ferguson connects the reckless growth of the finance sector to its actual consequences for the real economy. He quotes a Chinese official wondering how on earth, in the US, “financial engineers” are regularly paid 4 to a hundred times as much as real engineers. The latter build bridges, the official notes, while the former build mere dreams—or nightmares, as the case may be. It was no surprise to me to hear recently that one of our leading manufacturers of rare earth magnets has shipped production off to China, as our miraculous market delivered a factory up to its highest and best use:

Just how far U.S. manufacturing has waned is apparent at a factory in Valparaiso, Indiana, where dogs skitter across a bare concrete shop floor, their nails clicking. This brick plant on Elm Street once made 80 percent of the rare-earth magnets in laser-guided U.S. smart bombs, according to U.S. Senator Evan Bayh, a Democrat from Indiana. In 2003, the plant’s owner shifted work to China, costing 230 jobs.

Now the plant houses Coco’s Canine Cabana, a doggy day care the current tenants started to supplement sagging income from their machine shop.

Ferguson states that US wealth inequality is higher than in any other industrialized country, and he describes how the struggling middle class has had to work and borrow ever more to get by as productivity gains are monopolized by an ever-narrower elite. For the first time in history, he states, average Americans are less wealthy, and have less education, than their parents. He leaves little doubt that we can expect further decline for a country whose economic future is largely determined by a finance sector with no vision beyond enriching itself.

Ferguson does not give any easy “answers,” and his closing shot of the Statue of Liberty feels more elegiac than hopeful. Nevertheless, at the end of this documentary, we have a much better sense of where the answers to our economic problems will not be found. I won’t be eager to hear any more editorializing from hedge fund managers who worry about a looming, Medicare-driven sovereign debt crisis while failing to even entertain the thought of a Tobin tax or higher taxes for the top 0.1% of earners. I’ll be looking beyond the core of the economics profession for a compelling account of a fair and just society. When it comes to finance, progressives should also realize they have few friends in the current administration. They should treat whatever rulemakings it proposes with the same level of scrutiny as they would have given Bush, Clinton, or Reagan-era regulation.

Ferguson may not make up for the deficiencies of our FCIC, CNN, and Fox. But I have little doubt that Ferdinand Pecora would approve of the film he has crafted.

This summer started off with a three part series from Professor Olufunmilayo B. Arewa looking at the credit crisis and possible changes that would focus on averting future market failures, rather than continuing to create regulations that only address past ones.  Part I of Prof. Arewa’s looks at the failure of risk management within the financial industry.  Part II analyzes the regulatory failures that contributed to the credit crisis as well as potential reforms.  Part III concludes by addressing recent legislation and whether it will actually help solve these very real problems.

Next, Professors Alan Devlin and Michael Jacobs take on an issue at the “heart of a highly divisive, international debate over the proper application of antitrust laws” – what should be done when [...]]]>

This summer started off with a three part series from Professor Olufunmilayo B. Arewa looking at the credit crisis and possible changes that would focus on averting future market failures, rather than continuing to create regulations that only address past ones.  Part I of Prof. Arewa’s looks at the failure of risk management within the financial industry.  Part II analyzes the regulatory failures that contributed to the credit crisis as well as potential reforms.  Part III concludes by addressing recent legislation and whether it will actually help solve these very real problems.

Next, Professors Alan Devlin and Michael Jacobs take on an issue at the “heart of a highly divisive, international debate over the proper application of antitrust laws” – what should be done when a dominant firm refuses to share its intellectual property, even at monopoly prices.

Professor Carter Dillard then discussed the circumstances in which it may be morally permissible, and possibly even legally permissible, for a state to intervene and prohibit procreation.

Rounding out the summer was Professor Clay Calvert’s article looking at journalists’ use of open record laws and death-related privacy rights.  Calvert questions whether journalists have a responsibility beyond simply reporting dying words and graphic images.  He concludes that, at the very least, journalists should listen to the impact their reporting has on surviving family members.