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Category: Corporate Finance

Banks, Bankers, and the New Political Economy

As post-mortems of the financial crisis proliferate, it’s helpful to keep an eye on some foundational causes. Michael Lewis recently commented that “the people who squandered the most money paid themselves the most”—and continue to do so. We’ve all heard about agency problems, but rarely are they as crisply illustrated as in this post by James Kwak:

[The hedge fund] Magnetar made the Wall Street banks look like chumps. [In] one deal . . . Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.

But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan’s bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet. Here’s the second lesson: the idea that bankers’ pay is based on their performance is also hogwash. (The idea that their pay is based on their net contribution to society is even more absurd.)

I was recently at a conference on “Too Big to Fail” banks organized by Zephyr Teachout, and several experts explained how the tail of massive compensation was wagging the dog of societal capital allocation. William K. Black‘s theory of “control fraud” is one of many efforts to illuminate the persistent conflicts of interest between banks, bankers, and investors, but one needn’t designate any of these conflicts “fraudulent” in order to see how socially destructive they have become. Rather, pulling back to see the big picture—from the lens of political economy—illuminates the key drivers of the crisis. As Kwak notes, “the crisis was no accident: it was the result of the financial sector’s ability to use its political power to engineer a favorable regulatory environment for itself.” Thinkers across the political spectrum—from Kling to Kuttner—can recognize the critical role of political connectedness in driving bankers’ compensation.
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SCOTUS Chides Posner/Easterbrook in Jones v. Harris

In a gentle rebuke to two famous academic judges, Richard Posner and Frank Easterbrook, today the US Supreme Court told them a debate they were airing in a recent case was not for federal judges but for Congress.

The Court, in Jones v. Harris, unanimously vacated as erroneous Easterbrook’s opinion that went out of its way to disagree with well-settled judicial interpretations of a relatively simple federal statute. Posner’s contending opinion engaged directly with the economic and market theories on which Easterbrook drew, both judges wrongly making debate out of the wisdom rather than the meaning of the statute.

The statute says an adviser to mutual funds is “deemed to be a fiduciary with respect to the receipt of compensation for services.”   For thirty years, virtually all federal courts take that to mean adviser fees cannot be so disproportionate to services rendered as to indicate lack of an arms-length sort of bargain.    Testing that requires considering all relevant factors.

The Court affirmed that interpretation and test as correct, in an opinion written by Justice Samuel Alito. Easterbrook erred when instead saying the fiduciary duty language required only that advisers disclose fees and that no other factor is relevant. The Court indicates that his dissertation on competition in the mutual fund industry and theories of market behavior is irrelevant to federal court business in the case.

Posner’s opinion, in the form of a dissent from the Circuit’s refusal to rehear the case en banc, engaged Easterbrook directly on economic theories and views of market efficacy, including debating empirical academic studies reaching opposite conclusions. The Supreme Court rebuked both, saying their job was to apply the statute not debate its wisdom. Read More

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You, Lehman’s Re-Po Magic, and Ernst & Young

Ernst & Young, one of four remaining large auditing firms, allegedly botched its financial audits of Lehman Brothers, the bankrupt investment banking firm. E&Y responds that its audits met legal and professional requirements.

My view, reported in today’s New York Times, wonders, suggesting E&Y offers a “technical compliance defense,” when what’s needed is an objective judgment, based on professional skepticism, of whether financials provide a fair presentation.

Though the allegations sound esoteric, it is easy to translate them into simple terms.  When considering the following analogue between Lehman’s deals and your personal finance, think about how an independent accountant would assess what I suppose you are doing.

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SEC Should Calm Markets, Ahead of Possible Audit Crisis

If you thought the 2008 credit crisis that temporarily froze global debt markets wrought havoc, watch out for the next shoe to drop.  At stake is the viability of global equity and other financial markets that could freeze if one of the four large auditing firms goes extinct.

And the existence of one of them, Ernst & Young, is threatened, as it faces the prospect of billion dollar liability for botched audits of Lehman Brothers, the defunct investment bank struggling in bankruptcy. It is an eerie echo of the fate of erstwhile big auditing firm Arthur Andersen, which dissolved after its culpability in 2001’s Enron fraud emerged.

Today, only four auditing firms have the resources and expertise to audit the vast majority of thousands of large public corporations. If one of those dissolved, its clients would have to scramble to find a replacement. Some of the remaining three lack requisite expertise for some of those corporations and others would be disqualified from auditing due to consulting work they do for them.

The result would be hundreds, possibly thousands, of large corporations who could not get their financial statements audited as required by US federal securities law. Stock markets could go berserk, along with other financial markets. The costs now, of moving from four firms to three, would dwarf those incurred when Andersen’s dissolution moved the total from five to four.

It does not appear that the US government, specifically its Securities and Exchange Commission, has any plans to deal with this prospect. It should. And it should announce them promptly to get ahead of any market crisis the failure of E&Y, or of the other three, would wreak. 

If not, the credit crisis of 2008 will look mild in comparison. After all, the credit crisis was readily addressed by government pumping enormous amounts of capital to rejuvenate liquidity; an auditing crisis cannot by solved by throwing money at it. Read More

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A Greek Tragedy

A Greek Tragedy

Finance markets defend derivative contracts by pointing to their long history. One of the oldest recorded references to a derivative contract appears in ancient Greek literature. In Chapter 9 of Aristotle’s Politics, a philosopher gains a handsome profit by agreeing to place a deposit on olive presses one year in advance of the next olive harvest. In securing rights to the presses prior to the harvest, the buyer, Thalus ensures that if the harvest is bountiful, he will have access to the presses at the lower negotiated rate that press operators are grateful to receive in advance of the harvest.

Investigations reveal that derivatives played a critical role in Greece’s recent credit woes, threatening to collapse the country’s economy and de-stabilize neighbors. (See here.) Financial markets use the term derivative to describe a transaction that derives its value from an independent reference asset. Finance literature identifies four basic types of derivatives contracts –futures,  forwards, options  and swaps. Futures and forwards involve agreements to deliver goods at a stated contract price on a specified future date. Thalus’s right (assuming he has no obligation to exercise the right but may suffer the loss of the deposit if he does not exercise the right) to elect to access the olive presses at a price negotiated in advance, illustrates features of a classic option contract. Swap agreements allow counterparties to exchange a series of cash flows over time. The market classifies derivatives based on the reference asset used to determine the value of the agreement. For example, we refer to a swap agreement for which the reference asset is an agricultural product (corn, soybeans, cotton, grain) or a raw material (copper, crude oil, natural gas) as a commodity swap. The reference asset for a financial swap likely involves one of the following: foreign currencies, bonds, stocks, and other financial assets and liabilities. Thus, the jargon evolves and we have foreign currency swaps, interest rate swaps and equity swaps among the many varietals.

While commodity derivatives may date back to Mesopotamia (see here), the Dojima rice futures exchange in shogunate Japan (see here), or the tulip bubble in Holland, financial derivatives are the product of financial innovation. In the 1980’s, derivatives traders at Salomon Brothers engineered a foreign currency swap.  The transaction allowed the World Bank and IBM to swap risk exposure to foreign currency exchange rates; the two entities exchanged bond payment obligations and bond earnings denominated in Swiss Francs and German Deutsche marks, respectively, in a $210 million transaction.  Parties using derivatives attempt to limit their exposure to or predict future movements in the price of the reference asset.

Futures and options trade on registered exchanges. Other derivatives are privately negotiated, bi-lateral agreements that trade over-the-counter among dealers and financial intermediaries. There is often little or no record of the parties originating the instruments. The ability to originate and trade these instruments in the shadows may have motivated some actors to make bad bets.

Greece’s concerns stem from the use of interest-rate and foreign currency swaps. These instruments serve useful and important functions in allowing parties to manage their exposure to volatile interest rate and foreign currency markets. The complexity of pricing the instruments and the opacity of the market, however, engendered grave concerns. According to reports, Greece used derivative transactions that involved securitized rights to cash flows from national projects to conceal mounting debt. Greece’s current troubles exemplify the need for greater transparency and accountability in derivative markets.

The Greek debacle with swaps illuminates the need to address oversight of derivatives from a global perspective. The markets for derivatives involve financial services firms that may be domiciled in the United States or Europe but whose influence and relationships are undeniably international. The financial instability of systemically significant private institutions (investment banks or international insurance firms or sovereign debtors) threatens global market disruptions. We are left pondering the effectiveness of any domestic derivative market reform that lacks international collaboration. (See here.)

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Asking new questions or at least hoping for more useful answers

From 1933 to 1934, Senator Ferdinand Pecora, the senior lawyer for the Senate Banking Committee, led an examination into securities market abuses that inspired the regulatory framework set out in the Securities Act of 1933 and the Securities Exchange Act of 1934.  The legislation noted the predatory practices that motivated its consideration and adoption:

“Alluring promises of easy wealth…freely made with little or no attempt to bring to investor’s attention those facts essential to estimating the worth of any security. High pressure salesmanship rather than careful counsel was the rule in this most dangerous enterprise.” H.R. Rep. No. 85, 73d Cong., 1st Sess. 2 (1933).

More than seventy years later, as the Financial Crisis Inquiry Commission begins to hold hearings to unravel the causes of the recent financial crisis, Congress again takes up the task of addressing the accuracy of disclosure regarding valuation of complex financial instruments sold to the public (pension funds and other institutional investors). Throughout the hearings, we can anticipate accusations of greed and retorts equating greater federal government intervention with paternalism. As regulators, independent experts and senior management of the largest financial services firms arrive in Washington DC, however, we should take this opportunity to consider carefully the broader weaknesses in the structure and substance of federal securities market regulation.

The testimony solicited publicly and privately prior to the commission’s inaugural meeting suggests that disclosure will present a critical point of departure for inquiries about the recent crisis. For example, Congress is likely to challenge the practices of banks that sold clients financially engineered products like collateralized debt obligations which involve the sale of interests in bundles of residential and commercial mortgages. While the same banks encouraged credit rating agencies to assign strong, positive ratings to these products to increase revenues, they contemporaneously entered into short position contracts on these investments which rewarded the banks when the CDOs declined in value.

While important, questions or legislation focused exclusively on increasing the quality and quantity of disclosure are myopic and solutions arising out of this approach will prove insufficient to address broader market concerns. Questions or legislation should also address financial innovation or the development of new financial products or uses of products or processes not previously available and the ethical obligations of the firms that develop and distribute these products, the fragmentation among securities market regulators and the absence of consistent, effective inter-agency collaboration and the influence of international economic interdependence and regulatory competition on the development of U.S. regulation and the regulation in foreign jurisdictions. As often is the case in the securities regulation debates, there are many challenging questions and far too few effective answers.

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Junior Faculty Workshops: GW in Business Law

academic doorwayFor ages, academic institutions have promoted scholarly inquiry by younger faculty members, especially through the junior faculty workshop. Scores of US law schools host these regularly during terms; both the AALS and Law & Society run programs at their annual meetings; the Yale/Stanford junior faculty forum boasts wonderful annual draws; and now regional junior faculty workshops are rising, like that in the southwest next term, hosted by Arizona State.

Though these ventures focus on career stage, not field, more recent, school-sponsored forums add substantive focus.  Junior faculty workshops appeared recently in environmental law (arranged jointly by Harvard, Berkeley and UCLA); family law (at Washington & Lee); national security law (at Texas); and federal courts (hosted alternately by American University and Michigan State).

You can soon add to that list business/financial law (including corporate, securities and banking) at George Washington.  Next year, GW will inaugurate a series of Junior Faculty Workshops and Junior Faculty Prizes, seeking submission of papers in Fall 2010, for a celebratory academic event to be held in Spring 2011. This is one part of GW’s forthcoming Center for Law, Economics and Finance (C-LEAF), which also includes GWNY (posted about here).

While further details about these C-LEAF programs and descriptions of others must await a formal grand announcement, these Junior Scholar endeavors are ripe and time-sensitive enough to warrant advance notice.   

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Book Review: Justin Fox, The Myth of the Rational Market

Fox Myth Rational MarketThose interested in the intellectual history of modern finance theory will find Justin Fox’s The Myth of the Rational Market riveting. It is familiar territory to anyone who has written on the subect; Fox, a writer at Time, uses the pop style of financial journalism. Even so, many useful insights appear and the arrangement suggests relationships among ideas worth exploring.  

Notably, this book, which Fox began writing in 2002, is not about the current financial crisis.   But of the dozen about the current crisis I’ve read so far (several reviewed on this blog) it is far more illuminating in relation to it.   Fox demonstrates how the ideas hatched by academic financial economists during the past 45 years, and adopted with alacrity by nearly everyone else, from bankers to law professors to regulators, contributed significantly, though unwittingly, to prevailing woes.  

Fox’s story, using lucid and engaging prose, based on well-documented research and interviews, concentrates on how academic finance departments reshaped our world, not always for the better.  Beyond the book’s scope is a parallel story, yet to be written, about how law professors, applying the finance work, wrought similar change.  Read More

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Against Politics and Finance in Accounting

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An old joke says every financial crisis needs an accounting culprit to blame. The current crisis may be attributable instead to the dominance of modern finance theory and subordination of traditional accounting principles. Two generations of finance theorists—in business and law schools—developed elaborate models to measure and manage risk in a theoretical world of efficient markets where accounting is not relevant.

Yet two strange twists have arisen—one showing the intellectual limits of the finance story and the other the dark art of making accounting into a political issue. Both concern debate over how to measure financial assets on a balance sheet—the so-called fair value debate.

First, for decades, proponents of modern finance theory urged standard setters to direct asset measurements using fair value rather than applying traditional accounting conventions. The prescription was based on assertions that emphasized the reliability of efficient markets to reveal relevant values. Proponents said traditional accounting conventions, using acquisition cost adjusted over time, were comparatively impoverished.

Amid the crisis, those same people shift their stance, now saying fair value measures in stressful markets are either misleading or put downward pressure on values that could render owners of impaired assets, especially banks, insolvent. On its face, this is an admission about the limits of markets to reveal reliable asset values, that modern finance theory is impoverished.

Second, without opining on the merits of measuring assets at fair value or using historical cost accounting conventions, this issue, once again, is turning accounting standard setting into a political expression rather than a professional one. Politicians in Congress, under heavy bank lobbying, pressured the US standard setter [the Financial Accounting Standards Board] to adopt bank-friendly approaches to asset measurement.   Now, Congressional bills  (here, for example, and noted here) contemplate empowering politicians and/or a new federal agency to oversee US accounting standard setting, equipping them with veto rights over any accounting standards the political power consensus disfavors.

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