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Category: Financial Institutions

Watch the Banks First

I have not been a big fan of Wikileaks. I believe in diplomacy and the rule of law as cornerstones of a civilized society. But the recent revelations about a clandestine campaign to discredit Wikileaks supporters forces reconsideration of a pro-state, anti-Wikileaks position.

According to numerous press accounts, the DOJ advised Bank of America (BofA) to consult with a law firm that, in turn, consulted with “security firms” about how to address possible revelations from Wikileaks about BofA. A leaked report “suggested numerous ways to destroy WikiLeaks . . . including planting fake documents with the group and then attacking them when published; ‘creat[ing] concern over the security’ of the site; ‘cyber attacks against the infrastructure to get data on document submitters.’”
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A2K Symposium: Owning the Stars

I heard Lawrence Liang give a terrific talk at the Open Video conference in New York last Fall. His contributions to the A2K volume are also thought-provoking. Here is the conclusion from one of them:

I end this piece with a small parable that many of us will have read while we were children. The story is from Antoine de Saint Exupéry’s tale The Little Prince. The Little Prince visits a number of planets and encounters a range of different characters. On the fourth planet, he meets a businessman who owns millions of stars, and the reason why he owns them is because he was the first one to think of owning the stars.

The Little Prince is perplexed, because he can’t seem to find a reason for owning the stars beyond the fact that they can be put in a bank to enable the businessman to buy more stars. The Little Prince tells the businessman that “I own a flower myself, which I water every day. I own three volcanoes, which I rake out every week. I even rake out the extinct one. You never know. So it’s of some use to my volcanoes, and it’s useful to my flower, that I own them. But you’re not useful to the stars.”

Liang’s parable in turn made me think of ownership as an obligation, not (just) an opportunity for exploitation.

A2K As a a Statement of Progressive Intellectual Property?

In a special issue of the Cornell Law Review, four noted professors of property law wrote a brief series of propositions they identified as “A Statement of Progressive Property.” I found the following propositions particularly compelling:
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“Ten Times More Productive”

I respect Tom Friedman’s Cassandran efforts to curb American dependence on foreign oil. One can occasionally snicker at his exuberant style, but not the environmentalist substance. America needs more green hawks like him.

But I was taken aback by his casual comment on a radio show that American workers need to be “ten times as productive” as Indian or Chinese workers to maintain current earning levels. Over the past fifty years, we’ve seen CEO salaries go from about 50 times employee average pay to a 500-fold multiple. If anyone needs to become “ten times more productive,” it’s those at the top of the “value chain.”

But the myth of the coddled everyman persists, spreading to a “new global elite,” as Chrystia Freedland reports:

The U.S.-based CEO of one of the world’s largest hedge funds told me that his firm’s investment committee often discusses the question of who wins and who loses in today’s economy. In a recent internal debate, he said, one of his senior colleagues had argued that the hollowing-out of the American middle class didn’t really matter. . . . (emphasis added)

I heard a similar sentiment from the Taiwanese-born, 30-something CFO of a U.S. Internet company. A gentle, unpretentious man who went from public school to Harvard, he’s nonetheless not terribly sympathetic to the complaints of the American middle class. “We demand a higher paycheck than the rest of the world,” he told me. “So if you’re going to demand 10 times the paycheck, you need to deliver 10 times the value. It sounds harsh, but maybe people in the middle class need to decide to take a pay cut.”

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Surveillance of the War Games of Finance

Some of America’s greatest economists spent World War II devising formulas for optimal bombing. Milton Friedman, for instance, had to determine whether an anti-aircraft shell should burst into 600 small pieces or 20 big pieces in order to best accomplish a mission. Many translated their work into finance’s portfolio selection theory, which was “all about balancing risk and return.”* As Friedman said, “The logical character of the problem was the same. . . . How much power do you want to sacrifice in order to have a greater probability of hitting? [Finance theory involves] exactly the same thing: How much return do you want to sacrifice in order to increase the probability that you will get what you planned for?”

Today’s finance theorists probably have not spent much time on the battlefield. But they can still have fun with ballistics trajectories, in touchscreen video games like Angry Birds. To play, you use a virtual slingshot to launch squawking birds at pigs holed up in encampments made of glass, wood, and stone. The virtual materials in the game don’t act much like real structures; that’s not the point (who really cares whether a real vaulted bluebird would displace a girder)? Rather, you gradually learn from the game itself the strategies that cause optimal destruction, blissfully unmoored from the messiness of actual materials science.

From Wars to Games to High Finance

Stock trading now appears to be similarly deracinated, concerned less with actual fundamentals than with windows of opportunity for sudden arbitrage. In “Algorithms Take Control of Wall Street,” the indispensable econoblogger Felix Salmon (and Jon Stokes) extend a line of recent articles on high frequency trading. (I collect some earlier contributions here; this piece on news-reading technology also gives the flavor of the innovations they’re describing.) They define prop trading, algorithmic trading, and predatory trading, and tell the story of a former head of American Century Ventures who built a “neural network” to optimize his picks. They also discuss the unanticipated consequences of runaway algorithmic interactions.
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Hockett on the Financial Crisis

There is a growing consensus that our mortgage markets are fundamentally broken. In a recent article in The American Prospect, Robert Kuttner surveys a number of leading legal academics’ prescriptions for the foreclosure crisis:

Katherine Porter, a law professor at the University of Iowa and an expert in mortgage servicing, recently testified to the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP) that according to lawyers for both home-owners and banks, “a very large number (perhaps virtually all) securitized loans made in the boom period in the mid-2000s contain serious paperwork flaws, did not meet underwriting or other requirements of the trust, and have not been serviced properly as to default and foreclosure.” . . . .

One remedy, proposed by professor Adam Levitin of the Georgetown Law Center, would create a new chapter of the bankruptcy code and allow a home-owner to come before a bankruptcy judge and get the mortgage reduced to the present value of the home. The process would also clear the title. Another proposal, by professor Howell Jackson of Harvard Law School, would use government’s power of eminent domain to take securitized mortgages, compensate the holder at the securities’ (much reduced) fair market value, and use the savings to turn the paper back into whole mortgages with steep reductions in interest and principal. This would also allow millions of people to keep their home and help stem the broad decline in housing values.

I think each of these ideas is valuable. I’d also like to see them complement a broad set of proposals articulated by Robert Hockett in a recent piece in the Washington University Law Review. Hockett’s proposals are worth quoting at length, since he keenly grasps the historical dimensions of this crisis:
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Why Big Banks Fail to Act in Their Own Self Interest

In an earlier post, I characterized some financial institutions as “shadowy and unstable ensembles of desks and divisions whose main goal is slipping by whatever bonus-maximizing scheme won’t set off alarms among risk managers and regulators.” Too harsh? Well, today ProPublica’s Jake Bernstein and Jesse Eisinger offer offer yet another confirmation of value-destroying skulduggery at the core of contemporary finance. They explain how payments of a few million in “bonuses” to employees running one division of Merrill Lynch helped those running another division “offload” billions of dollars in toxic assets to their own firm:

Two years before the financial crisis hit . . . [n]o one, not even the bank’s own traders, wanted to buy the supposedly safe portions of the mortgage-backed securities Merrill was creating. Bank executives came up with a fix . . . .They formed a new group within Merrill, which took on the bank’s money-losing securities. But how to get the group to accept deals that were otherwise unprofitable? They paid them. The division creating the securities passed portions of their bonuses to the new group, according to two former Merrill executives with detailed knowledge of the arrangement.

The executives said this group, which earned millions in bonuses, played a crucial role in keeping the money machine moving long after it should have ground to a halt. “It was uneconomic for the traders” — that is, buyers at Merrill — “to take these things,” says one former Merrill executive with knowledge of how it worked. Within Merrill Lynch, some traders called it a “million for a billion” — meaning a million dollars in bonus money for every billion taken on in Merrill mortgage securities. Others referred to it as “the subsidy.” One former executive called it bribery. The group was being compensated for how much it took, not whether it made money.

The three men at the top of the scheme made about $6 million each that year, and there were probably some handsomely paid lieutenants beneath them. Surely, there must have been someone who objected to such deals? There was: “a Merrill trader [who refused to go along] . . . was sidelined and eventually fired.” The power in the firm was held by those who could make quick money in big deals. Has anything changed about the structure of these firms since the crisis to alter that dynamic?
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The Persistence of Perverse Incentives

There is news today that “regulators are considering whether to require large financial firms to hold onto a chunk of executive pay to discourage the excessive risk-taking that contributed to the financial crisis.” Europe is way out ahead on the issue; “Starting next year, [its] rules limit the amount of certain bonuses that can be paid immediately in cash to 20% of the overall payout, meaning the rest must be a mix of upfront shares and deferred pay.” I would like to be encouraged by the news that the US is seeking to crack down on what can amount to a form of looting. But after reading Richard Freeman’s reflections on the financial crisis, recently published as the Kenneth M. Piper Lecture, it is daunting to consider just how much of an uphill battle pay reformers face:

For the most part, as Harvard’s Rakesh Kurana and Andy Zelleke have stated, during the 1990s–2000s management seemed to operate corporations “for the purpose of creating vast wealth for senior executives.” Just as Bernard Madoff knew he was running a Ponzi scheme, the big Wall Street firms knew what they were doing when they packaged sub-prime mortgages and earned their fees by selling them quickly to others; as one portfolio manager put it, “a lot of people knew this was bogus, but the money was too good.” . . .

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Finance Sector as Ultimate Risk Manager?

David A. Moss’s When All Else Fails: Government as the Ultimate Risk Manager should be a vital guide to our future. Moss describes programs ranging from social security to bankruptcy as backstops of support for all classes. As volatility in prices, employment levels, and wages climbs, we should be exploring new “automatic stabilizers” to guarantee every family a “social minimum.” Instead, we appear to be privatizing and financializing risk via opaque institutions whose only mandate is to increase their own profits.

Consider, for instance, this vignette from Louise Story’s excellent reporting on derivatives trading:
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Gambling? In Casablanca?

With each passing week, there are more embarrassing revelations about foreclosure practices. Here’s a mind-boggling chart, limning failures to follow “obligations . . . from secured credit and trust law.” Adam Levitin argues that most legal observers are slow to recognize how bad things have gotten, because they believe “there’s no way there were massive screw-ups because thousands of top Wall Street legal minds were working on securitization deals.” Levitin responds: “the best legal minds in the country weren’t doing diligence on endorsements on securitization deals.”

After reading Levitin’s testimony, and much of Michael Hudson’s book The Monster, I was reminded of a Global Witness report called Undue Diligence: How Banks Do Business with Corrupt Regimes. The report shows how major financial institutions have enhanced their profits by not looking too carefully into the details of transactions they engage in. As Global Witness concludes:
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