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Category: Corporate Finance

5

Barney Frank’s Bad Idea

Last month Barney Frank unveiled the House plans to fix the financial services industry. One of the provisions (section 1501) will require that any creditor who originates a loan to retain some of the ultimate risk of non-repayment of the loan. The provision is an apparently sensible response to the pathologies in the originate-to-distribute (OTD) model of mortgage lending that we saw at the height of the subprime boom. The basic idea is that originators were insufficiently incentivized to monitor the credit worthiness of applicants, and therefore manufactured a huge volume of ultimately toxic financial assets. The idea is to fix the problem of agency costs by aligning the incentives of loan originators with loan holders. Despite the plausibility of the proposal, I think that it is ultimately a bad idea.

First, it is a bad idea because it addresses a symptom rather than a cause of financial rot. The problem with the mortgage-brokers-as-villains narrative is that it fails to explain why the brokers could do a land office business selling toxic junk to a voracious secondary market. One explanation – the one implicit in section 1501 – is that brokers were taking advantage of purchasers, selling them supposedly sound financial assets that the purchasers were too unsophisticated or blinded by greed to realize were junk. To state this assumption explicitly is to see its limitations. The purchasers of mortgages were not unsophisticated consumers or little old ladies entrusting their savings to fast talking swindlers. These were a bunch of extremely wealthy, extremely sophisticated, extremely large financial institutions. It is rather unlikely that these guys were “fooled” by the mortgage brokers.

A more plausible story, in my opinion, looks at the underlying supply and demand for credit. First, why did the mortgage brokers go into the subprime market? At least in part the answer is that they could afford to do so. With the short term wholesale funding on which they relied to originate loans costing them essentially nothing, it was extremely inexpensive to originate loans. At the same time, the massive subsidization of the subprime market through implicit guarantees to the Fannie and Freddie, the so-called “Greenspan Put” on which Wall Street relied, and various (admittedly much smaller) direct subsidies created a massive demand for the assets churned out by the mortgage brokers. Add to this the impact of monetary and Chinese balance of payments factors on asset prices, and the notion that the subprime crisis was really the result of agency costs in the OTD model looks implausible. Absent macro-economic and regulatory distortions, I suspect that market competition and reputational sanctions are sufficient to keep the OTD brokers honest. Given those distortions, we have seen spectacular examples of those who did have skin in the game responding perversely to the perverse incentives with which they were presented. Read More

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House Financial Committee Busy

Alphabet SoupThe Staff of the House Financial Services Committee is extremely busy and doing a very good job of keeping its role in the legislative process transparent. A reasonable run down of current activity in financial regulation reform appears here. (You can even sign up to get email alerts.) 

These bills are elaborate, complex and defy tidy characterization.  All are likely to change, some significantly, as the legislative process grinds along. The Senate Banking Committee is unlikely to produce anything equivalent until well into November.

In general, however, together the House FSC’s work would make for sweeping change.  The bills would:

(1) create three new federal agencies: a Federal Oversight Council, a Consumer Financial Protection Agency and an Office of Federal Insurance;

(2) considerably expand powers of the Securities Exchange Commission, including by subjecting rating agencies to considerable regulation and oversight by the SEC plus eliminate an exemption to the Investment Company Act of 1940 for private financial advisors.; and

(3) expand the mandate and powers of the Commodity Futures Trading Commission concerning regulation of derivative securities.

These pending Committee steps, of course, are in addition to bills the House passed earlier this year, including the summer’s Corporate and Financial Institution Compensation Fairness Act of 2009, embracing shareholder say on executive compensation to a certain extent.

At this link, you can access pending bills totaling just about 1,000 pages.   Following is an additional breakdown: Read More

4

Smart or Not So Smart Money; The Limits on Derivatives and Regulating Them

The New York Times op-ed by Calvin Trillin, Wall Street Smarts, has a parable-like quality with the two characters meeting and exchanging wisdom. The lesson offered by the wiseman: “The financial system nearly collapsed,” he said, “because smart guys had started working on Wall Street.” The piece goes on to explain why that is a good explanation. It seems that the not-so-smart sat at the top of the heap and ran the companies: “Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.” There is also an claim about what is enough and what is greed in this tale. I leave it to others to debate or verify these ideas (our own Mr. Cunningham has been a favorite for me on these issues). Now, a paper by some folks at Princeton may show that not even the smart guys knew what they were doing.

As Andrew Appel explores in his post Intractability of Financial Derivatives, the computer science world’s Intractability Theory may better explain the derivative world than other theories. (the theory is used for DRM, cryptography, and more). The paper is Computational Complexity and Information Asymmetry in Financial Products (pdf) by Sanjeev Arora, Boaz Barak, Markus Brunnermeier, and Rong Ge.

For those who are interested in the topic and/or understand the math and theory behind the risk shifting involved in this area, check out Andrew’s post. He does a great job explaining how the paper applies to a CDO (collateralized debt obligation). If you need a little more to understand why this paper and its ideas are important, consider Andrew’s take away

In principle, an alert buyer can detect tampering even if he doesn’t know which asset classes are the lemons: he simply examines all 1000 CDOs and looks for a suspicious overrepresentation of some of the asset classes in some of the CDOs. What Arora et al. show is that is an NP-complete problem (“densest subgraph”). This problem is believed to be computationally intractable; thus, even the most alert buyer can’t have enough computational power to do the analysis.

Arora et al. show it’s even worse than that: even after the buyer has lost a lot of money (because enough mortgages defaulted to devalue his “senior tranche”), he can’t prove that that tampering occurred: he can’t prove that the distribution of lemons wasn’t random. This makes it hard to get recourse in court; it also makes it hard to regulate CDOs.

UPDATE: It appears from the comments to Andrew’s post that CDO and derivatives are not precisely the same thing. In addition, the comments explore the limits of the study. It is a good discussion.

ALSO check out the FAQ for the paper. It addresses many issues that the initiated may want to probe.

1

Lipson on Bankruptcy, the Inky and Irony

Our Roving Bankruptcy Correspondent

Our Roving Bankruptcy Correspondent

I asked Jonathan Lipson, who previously owned the credit crisis for us, for his thoughts on a really interesting story involving the Philadelphia Inquirer’s bankruptcy process.  His (pretty cool, even for non-bankruptcy geeks) thoughts follow:

Like other markets for company control, the one created by Chapter 11 of the Bankruptcy Code is largely about information:  If you control the story, there’s a good chance you will control the outcome.

So it’s not surprising that The Philadelphia Inquirer has used its own storied assets—the paper and website–to try to sell readers on management’s plan to save the company from rapacious hedge funds and, in their words, “keep it local.”

As you may recall, Brian Tierney, who owns an advertising firm in the Philadelphia suburbs, acquired The Inquirer and its related properties (The Daily News and Philly.com, their collective website), from the McClatchy papers in 2006 for about half a billion dollars.

Like several other newspapers, including The Chicago Tribune, The Inquirer could not service its massive acquisition debt.  Thus, in February 2009, the paper (and its affiliates) filed a Chapter 11 case in Philadelphia.  In August, management filed a proposed reorganization plan where Tierney (who manages the papers and owns some equity) and some of his supporters would buy the papers out of bankruptcy, for about $90 million, leaving most large creditors—i.e., the ones holding the acquisition debt–with a very small recovery.  The management buyout would be subject to higher and better offers.

According to the official Creditors’ Committee in the case, the Inquirer’s “keep it local” campaign is designed to make sure there are no better offers.  Management’s ad campaign warns of dire consequences “[i]f out-of-towners were to seize control.”  Allegedly hailing from such illiterate venues as New York, Beverly Hills “and even Lausanne, Switzerland, these out of towners would feel little commitment to, or understanding of, [Philadelphia’s] local non-profit needs.”

Read More

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Negligent Misrepresentation and Rating Agencies

One of the leading cases in the Unfair Competition course that I’m teaching this semester is Cardozo’s opinion in 85px-Benjamin_CardozoUltramares Corp. v. Touche.  Ultramares rejected the creation of a negligent misrepresentation action (akin to fraud).  The case involved an accounting firm that negligently audited the books of a company.  That negligent “clean bill of health” led another firm to extend a loan that went bad.  The lender then sued the accountants for damages.  Cardozo reasoned that this theory would “expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class. The hazards of a business conducted on these terms are so extreme as to enkindle doubt whether a flaw ma not exist in the implication of a duty that exposes to these consequences.”

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From Antitrust to Anti-Systemic Risk

The “optimal size and complexity of developing countries’ financial systems” has been hotly debated in the economics community. Writing for the Harvard Business Review & Boston Globe, Duncan Watts focuses on our own dilemmas in a provocative account of complex systems:

[G]lobally interconnected and integrated financial networks just may be too complex to prevent crises like the current one from reoccurring. . . . A 2006 report co-sponsored by the Federal Reserve Bank of New York and the National Academy of Sciences concluded that even defining systemic risk was beyond the scope of any existing economic theory. Actually managing such a thing would be harder still, if only because the number of contingencies that a systemic risk model must anticipate grows exponentially with the connectivity of the system.

So if the complexity of our financial systems exceeds that of even the most sophisticated risk models, how can government regulators hope to manage the problem? There is no simple solution, but one approach is close to what the government already does when it decides that some institutions are “too big to fail,” and therefore must be saved – a strategy that, as we have seen recently, can cost hundreds of billions of taxpayer dollars. . . .

An alternate approach is to deal with the problem before crises emerge. On a routine basis, regulators could review the largest and most connected firms in each industry, and ask themselves essentially the same question that crisis situations already force them to answer: “Would the sudden failure of this company generate intolerable knock-on effects for the wider economy?” If the answer is “yes,” the firm could be required to downsize, or shed business lines in an orderly manner until regulators are satisfied that it no longer poses a serious systemic risk. Correspondingly, proposed mergers and acquisitions could be reviewed for their potential to create an entity that could not then be permitted to fail.

Of course, our system has been headed in precisely the opposite direction, largely thanks to the “best and brightest” now at Treasury and the Fed. As Simon Johnson puts it, we “pay too much deference to the expertise and presumed wisdom of a sector that screwed up massively.”

Rating Agencies: Privilege Without Responsibility

First Amendment fundamentalist Floyd Abrams is back on the attack, now in the service of the credit rating agency S&P. He says that their ratings are essentially the same as an editorial — a position I looked at with some skepticism here. Editorials fail to receive the regulatory subsidy routinely channeled to raters, via acts like the Secondary Mortgage Market Enhancement Act of 1984 and the Investment Company Act of 1940, and agencies like the National Credit Union Administration (all of which mandate the use of raters’ products). Abrams appears to want to let the raters get all the benefits of such government subvention, without the liability or extensive regulation it should naturally lead to.

On the Media has a great interview with Abrams, who vigorously defends the agencies’ actions:

[Interviewer] BROOKE GLADSTONE: Okay, so first of all, explain to me why this is more like an editorial. To me it seems more like a clothing inspector, the people who leave the little number inside the clothing you buy. They leave their number so that if the zipper was put in backwards, for instance, they could theoretically take responsibility. Why are the ratings companies different from that?

FLOYD ABRAMS: Well, because the rating agencies use their models, use their heads, use their common sense, have ratings committees. They sit down and they come out with their best judgment as to what is likely to happen in the future about repayment of debt. And that is not subject to mathematical yes/no answers. It’s not the same as saying, my zipper is no good or a couch is no good. It’s not being an inspector. It’s not.

BROOKE GLADSTONE: Fair enough. Let’s move away from that analogy and let’s go to one that attorney David Grais, who we just spoke to, came up with, that in many cases rating agencies want their ratings to be protected as opinion, like, say, a restaurant critic’s. But more often, he notes, they’re like critics who go into the kitchen, make the food and then come out and write about it. They help create these deals. And they have a financial stake in their own ratings ‘cause they’re paid by the very companies they rate, a seemingly obvious conflict of interest.

FLOYD ABRAMS: Rating agencies have analytic standards. They apply those standards. And, yes, they discuss with the entities that they’re rating why they’re doing what they’re doing. And if the entity asks them, well, you know, how come you’re giving us a triple BBB instead of a double AA, they tell them why. And if the entity wants to do things to get a higher rating, they can do them.

And it is not inappropriate, in my view, so long as they take good steps to deal with the potential for conflict of interest. It is not inappropriate that they get paid by the entities they rate. I mean, it is not conceptually that distinguishable from, you know, a large entity which puts big ads in – what, a motorcycle magazine and then they write about the motorcycles. Do they have to be careful? Yeah.

BROOKE GLADSTONE: The fact of the matter here is that the ratings agencies, in this case, were so widely off the mark, ultimately, that it doesn’t seem to have been just a series of mistakes of judgment.

I really look forward to seeing how Abrams would deal with facts like these if similar revelations emerge about his own client:

[In the package of loans it was to rate,] Moody’s learned that [over 38 percent of the borrowers] did not provide written verification of their incomes. . . . On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” [one analyst] said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”

Borrowers have no chance of repaying via income and assets? Assume a ski chalet! (Much like the classic economic approach of assuming a can opener.) As the Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies (by the Office of Compliance Inspections and Examinations of the SEC) noted in July 2008, none of the rating agencies had specific procedures for collateralized debt obligations–even though 17 CFR 240.17g-2 required them to make certain internal documents public, including procedures and methodologies they use to determine credit ratings.

Sadly, I think that, given the current state of the law, Abrams’s First Amendment arguments will do well in front of many courts. But as David Segal states in the NYT article, “The First Amendment is no defense against fraud, and that is what is alleged by many of the plaintiffs.” Segal notes that, “Against them, Mr. Abrams will argue that S.& P. was every bit as blindsided as nearly everyone else in the private sector and in the regulatory sphere.”

Here are a few quotes that appear to be from S&P:

1. Internal Email: “rating agencies continue to create [an] even bigger monster – the CDO [collateralized debt obligation] market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”

2. Instant Message: “It could be structured by cows and we would rate it.”

These people don’t sound blindsided to me. Rather, they, like the three ratings agency CEOs who together earned $80 million themselves over the past 6 years, sound like people who knew exactly what they were doing: getting while the getting was good. If Abrams succeeds, he’ll be making that particular Wall Street strategy all the more foundational for America’s brave financial innovators.

But would a loss for S&P change anything? I really don’t know. What I do believe is that the US discourse on rating agencies would probably benefit from some input by scholars like John Quiggin, who argue that “Among the many challenges in reconstructing a sustainable system of global finance, the replacement of ratings issued by for-profit agencies with an alternative system, in which AAA ratings actually mean something, is among the most important.” Quiggin notes that the rating agencies are biased in many important ways:

[T]hey have a long-standing ideological bias against the public sector. This is reflected in the fact that state and local governments, which rarely default on their debt, are assessed far more stringently than corporate issuers. In the last year, thousands of private-sector securities issued with AAA ratings have been downgraded to junk, and many have subsequently gone into default.

By contrast, defaults on government debt have remained rare. One effect of the differential ratings practices of the agencies is that government borrowers have been forced to seek insurance from bond insurance companies such as AMBAC that are, in reality, less sound than the governments they are insuring.

Unfortunately, the 2006 Credit Rating Agency Reform Act specifically prohibited the SEC from regulating the “substance of the credit rating or the procedures and methodologies” used to calculate it. Reform measures proposed by the Obama administration have barely addressed the CRA’s. At the very least the government ought to be able to use FAIR v. Rumsfeld to insist on more responsible behavior (as Jennifer Chandler has argued, in another context, here). CRA’s should take the bitterness of regulation with the sweetness of regulatory subsidies.

I believe that as long as the US government provides a de facto regulatory subsidy to CRA’s, it should require them to factor into at least some of their ratings the full social value of the rated entity—not simply its likelihood to default. Ratings are often a self-fulfilling prophecy, and the state should harness their value to promote projects that improve the health, safety, security, and well-being of citizens. At the very least, the government should set up a “public option” in credit rating (akin to the proposed public option in health insurance) that is more transparent and accountable than extant credit raters. If the finance sector is going to grow as dependent on government help as the health care sector has, it should learn to accept the same web of standards and regulation that guarantee some minimal accountability for providers who accept government funds. Looking at the AHRQ and comparative effectiveness research could be a good place to start.

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What Evil Lurks in the Hearts of Men?

When students, friends and family have asked me what I think “happened” to cause our current financial crisis, my response has been an embarrassed shrug.  Embarrassed because (as a corporate law teacher) I’m expected to have clear answers.  A shrug because the crisis doesn’t have a obvious anecdote or story that explains it, and lacks a clearly defined evil doer who might be plausibly blamed.  The best candidate – who I’ve thrown out there to quiet persistent friends – is Joe Cassano, formerly head of AIG’s Financial Product’s Division, and the so-called “patient zero” in the crisis.

Now comes the myth-killer, Michael Lewis, with a must-read article in Vanity Fair.  He starts by reminding us that “nearly a year after perhaps the most sensational corporate collapse in the history of finance, a collapse that, without the intervention of the government, would have led to the bankruptcy of every major American financial institution, plus a lot of foreign ones, too, A.I.G.’s losses and the trades that led to them still haven’t been properly explained.”  And he then takes a crack at that problem, suggesting that AIG’s traders (i) made a bad (negligent?) bet on the likely course of the housing market, (ii) didn’t unwind their positions fast enough; (iii) fell victim to a liquidity crunch caused by covenants tied to their AAA rating; (iv) were made into a convenient villain by the media; and (v) like everyone else, were outsmarted by Goldman.

And how about Cassano?  Here’s the key – and dispiriting – paragraph:

[T]he A.I.G. F.P. traders left behind, much as they despise him personally, refuse to believe Cassano was engaged in any kind of fraud. The problem is that they knew him. And they believe that his crime was not mere legal fraudulence but the deeper kind: a need for subservience in others and an unwillingness to acknowledge his own weaknesses. “When he said that he could not envision losses, that we wouldn’t lose a dime, I am positive that he believed that,” says one of the traders. The problem with Joe Cassano wasn’t that he knew he was wrong. It was that it was too important to him that he be right. More than anything, Joe Cassano wanted to be one of Wall Street’s big shots. He wound up being its perfect customer.

“A need for subservience in others and an unwillingness to acknowledge his own weaknesses.” The flip side of authority and confidence, and the hallmarks of an executive who has passed many gates in the corporate advancement tournament.  The law lacks purchase on this kind of evil – if that is what it is.

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“A great vampire squid wrapped around the face of humanity”

That’s how Matt Taibbi describes Goldman Sachs in the opening paragraph of his 12-page Rolling Stone article (which, as far as I can tell, is available online only here, in moderately annoying scanned form). From there, Taibbi picks up steam. For instance, we learn that:

The bank’s unprecedented reach and power have enabled it to turn all of America into one giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumer credit rates, half-eaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you’re losing, it’s going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where its going.

Yikes!

Is this just another crackpot conspiracy theory? (Paging Mr. Stein, Mr. Ben Stein.) Nay — Taibbi has give us proof of Goldman’s nefari-iety. It goes more or less along these lines: 1. Goldman survived the Great Depression. 2. Goldman made some savvy bets in the past ten years. 3. Goldman pays really big bonuses. Read More

Where are the Rating Agencies in the Financial Regulatory Overhaul?

Jonathan Stempel of Reuters notes that “rating agencies [were] largely spared” in the financial industry regulatory overhaul proposed by the Obama administration. Jonathan Macey of Yale critiques the oversight:

“The overall impact of existing and proposed regulatory changes on rating agencies is extraordinarily easy to summarize: They reward abject failure,” said Jonathan Macey, deputy dean of Yale Law School.

“Any credit rating agency that relies on an NRSRO rating [nationally recognized statistical rating organization pursuant to the Securities and Exchange Act of 1934], which is effectively a government subsidy, should be subject to lawsuits by investors,” he went on. “It should also be made clear to professional investors that it is not a defense or a sufficient discharge of their fiduciary duties to rely on credit ratings when assembling portfolios.”

Given my recent series of posts on the “public/private” divide, I was heartened to see Macey characterize the government licensure of rating agencies as a “subsidy.” As I noted in my 2007 post “From First Amendment Absolutism to Financial Meltdown?,” the agencies have used a “free expression” shield to protect against legal consequences for their incompetence, malfeasance, and conflicts of interests. Following the reasoning of FAIR v. Rumsfeld, Congress may be able to condition the “subsidy” of requiring investor reliance on ratings agencies’ work on ratings agencies’ willingness to give up First Amendment immunity from lawsuits.

Admittedly, Congress has gone in precisely the opposite direction in the recent past. In 2006, the Rating Agency Reform Act specifically prohibited the SEC from regulating the “substance of the credit rating or the procedures and methodologies.” We can only hope that current Congress is more serious about either really regulating this field, or getting out of the “implicit subsidy” business altogether.