Concurring Opinions » Securities

Call for Papers: Dodd-Frank

Lawrence Cunningham — Wed, 15 Jun 2011 11:54:01 +0000

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.

Making fair funds fairer

Kaimipono D. Wenger — Wed, 25 May 2011 21:17:15 +0000

The PENNumbra website (online companion to the Pennsylvania Law Review) is spotlighting a recent article by Adam Zimmerman and David Jaros which proposes building class-action-like protection into the high-profile criminal restitution actions that have dominated the news in recent years. In The Criminal Class Action, Zimmerman and Jaros examine cases such as Bernie Madoff, noting that,

The past decade has witnessed the rise of new, massive settlements forged not out of civil litigation but on the periphery of the criminal justice system. Since 2003, prosecutors have demanded that defendants in a variety of high-profile corporate scandals set up multimillion-dollar restitution funds for victims to settle criminal charges. Yet few rules exist for the prosecutors who create and distribute these complex settlements.

After setting out the concept of the criminal class action, the authors argue that “when prosecutors compensate multiple victims in a criminal class action, prosecutors should adopt rules similar to those that exist in private litigation to ensure that the victims receive fair and efficient compensation,” and they set out some specific proposals including coordination rules, stakeholder representation, a court review of settlements. It’s an excellent article, pointing out an important and undertheorized topic, and proposing sensible fixes. (Available online via SSRN or the Penn. L. Rev. website.)

This dovetails with Adam Zimmerman’s other recent article, Distributing Justice (SSRN link), which discusses how to build better safeguards into the distribution of “fair fund” assets recovered by agencies. As in his other article, Adam highlights an important issue — statutes such as Sarbanes-Oxley have resulted in vastly increased agency power to use fair funds to distribute money to victims, but these funds lack oversight and consistency — and once again, he proposes a set of pragmatic solutions:

“I propose three solutions to give victims more voice in their own redress, while preserving an agency’s flexibility to enforce the law: (1) that agencies involve representative stakeholders in settlement discussions through negotiated rulemaking; (2) that courts subject agency decisions to hard look review; and (3) that courts and agencies coordinate overlapping settlements before a single federal judge.”

Adam has been a friend since our clerkships with Judge Weinstein which briefly overlapped. He’s a perceptive and creative scholar with a real knack for noticing gaps in the law, and his recent work is really good — his articles tend to point out important gaps and suggest sensible and pragmatic ways to address them. If you haven’t yet taken a look at Adam’s scholarship, you are missing out.

Targeting Odious Top Pay Contracts

Lawrence Cunningham — Wed, 13 Apr 2011 16:09:51 +0000

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.

GW’s Junior Scholars Finalists

Lawrence Cunningham — Tue, 01 Mar 2011 01:53:47 +0000

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.

Hockett on the Financial Crisis

Frank Pasquale — Thu, 23 Dec 2010 16:22:47 +0000

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:

1. Regulation as Modulation: The Fed and Bubble Preemption
Easily the most important lesson to be drawn from the model of asset price bubbles and bursts schematized [earlier in the article], I think, is the critical role that the Fed must play in preventing bubbles from emerging and inflating in the first instance. . . . While, of course, it is not easy to separate out “fundamental” value and “merely speculative” value with scalpel-like precision or an entirely bright line, it is often quite easy to find reasonable proxies for fundamental value and then to compare prevailing market prices to them. When home prices depart as significantly from counterpart rental prices and from building costs . . . there simply cannot be serious doubt that a bubble is afoot. . . .

Second, and relatedly, any inadequacy in private rates of betting against bubbles could readily be supplemented by regulatory action. For one thing, of course, the Fed now would have means of better timing their boosting of the market rate of interest, the credit-dampening margin requirements imposed upon financial institutions, or both. For another thing—and here we would be speaking not simply of the Fed, but the IRS working in cooperation with the Fed—we could readily impose a form of “Tobin taxation” on the capital gains realized by those who “flip” assets like houses during times of speculative excess, as now would be newly determinable by the Fed.

2. Portfolio Regulation by Reference to Underlying Assets
Asset markets’ overvaluation of assets during times of speculative excess, and their undervaluation of such assets during times of symmetrical “depressive” excess, are problem enough in themselves. But their harmful effects are transmitted more widely when assets are valued by regulators–not just the Fed, but other financial regulators as well—and private institutions by reference to market value. So-called “market value” and “mark-to-market” accounting—employed by our financial regulators, our rating agencies, and many other institutions alike . . . played a critical role in enabling our stock and real estate bubbles to inflate. . . .I]t has never been obvious why such measures should altogether supplant, rather than simply complement, measures-by-proxy of more lasting, “fundamental” value. . . .

3. Derivative and Hedge Fund Disclosure
[T]he multitude of derivative financial arrangements pursuant to which asset price risk was transmitted worldwide have been occluded. . . . [which] is surely one of the most remarkable and surprising features of our current finance-regulatory environment. As any student of securities regulation knows, the leading strategy adopted by Congress in the 1930s for purposes of securities regulation was that of disclosure. . . . Up through the mid-1990s, there might arguably have been reason for this. Derivative transactions were, well, derivative—they were, at most, the tail on the dog of securities. . . . But that growth has long since occurred, and the once-tail now very much wags the dog.

4. A Glass-Steagall for Auditors, Rating Agencies, and Regulators
Banks now are able to affiliate with securities firms, as well as insurance companies, with abandon. A single financial holding company may hold multiple such firms. . . . [T]here are two conspicuous conflicts of interest that proliferate right now and are clearly germane to the integrity of our financial system. One is the case of auditors and rating agencies. These reputational intermediaries are retained and paid by the very financial firms that they audit and rate. And significant evidence already is emerging that some of these intermediaries have been lax in rating many of our recently worst-hit financial institutions. A related conflict is that raised by the practice of many financial regulators–not to say Members of Congress–who pursue careers with financial institutions after brief careers regulating them. . . .

[S]omething in the way of imposition of walls of separation here could be managed at little public cost. It would not be at all difficult, for example, simply to prohibit former regulators from taking positions with financial firms for some lengthy period–say five years or more–following their stints in office. By the same token, it would not be that difficult to impose upon financial firms, as a sort of licensing cost, fees of the sort that they pay auditors and raters, with a view then to publicly paying those intermediaries. . . .

5. Originator Liability
We do not, after all, permit manicurists and pizza delivery companies to underwrite or sell securities. Why, then, did we permit them to originate mortgages–a form of asset at least as critical to wealth and the health of the macroeconomy? The final reform that I take our present troubles to show critical, then, is just this: Recognize once and for all that real estate finance is as critical as is corporate finance, and regulate markets in these assets accordingly.

These are all excellent ideas, and illuminate a holistic response to the crisis. Hockett’s article is well worth reading in toto. He notes that “among the many accomplishments of the first Roosevelt Administration touted on campaign flyers during the 1936 reelection campaign now on display at [the Roosevelt Library in Hyde Park, New York], upwards of half are finance-regulatory in nature.” A party that took Wall Street reform seriously could expect similar electoral dividends.

Cuomo Sues E&Y: Auditing Profession At Risk

Lawrence Cunningham — Tue, 21 Dec 2010 19:57:09 +0000

Ernst & Young, one of the Big-4 auditing firms left in the world, faces a grave lawsuit filed a couple of hours ago by New York’s Andrew Cuomo, the incoming governor’s last major act as state attorney general. The lawsuit is based on fraudulent accounting committed by Lehman Brothers, the failed investment bank, that E&Y either overlooked or condoned, as I explained last March.

The AG seeks unspecified damages the audit failure caused, certainly running to the hundreds of millions and easily reaching into the billions. Given that E&Y does not have external insurance to cover such losses, but self-insures, the lawsuit could put the firm’s survival at risk. Even so, settlement talks, going off-and-on since March, failed, suggesting that the firm is banking on being exonerated. That is quite a gamble.

As I told the New York Times and readers of this blog in March, if the case impairs E&Y’s viability as a going concern, a corporate financial reporting crisis should be expected. It would be acute compared to the modest scramble that corporate America faced after government prosecutors a decade ago drove from the profession the Big-5 firm, Arthur Andersen, auditor of Enron Corp. Then, 1/5 of companies needed to find a new auditor and most were able to count on one of the remaining four with little trouble.

Today, 1/4 of public companies would be obliged to find a replacement auditor; thanks to rules stated in the federal response to Enron, the Sarbanes-Oxley Act of 2002, about 1/3 of those would be unable to engage any of the 3 remaining firms because of conflicts of interest (those other firms provide internal control or tax advisory services making them ineligible to render financial audits). Amid such a crisis, and with only 3 available firms, the existing structure of the auditing profession would be unsustainable.

It would be reassuring if the Securities and Exchange Commission could tell the nation that is has foreseen this contingency and developed plans for addressing it, as urged last March and in 2006. Alas, I am not sure that it is prepared to do either.

Finance Sector as Ultimate Risk Manager?

Frank Pasquale — Thu, 16 Dec 2010 16:03:55 +0000

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:

[B]anks in an elite group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market. . . Banks’ influence over this market, and over clearinghouses like the one this select group advises, has costly implications for businesses large and small, like Dan Singer’s home heating-oil company in Westchester County, north of New York City.

This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.

But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives. “At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.

As Story explains, if this arrangement prevailed in the housing market, “It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it.” Whatever Wall Street’s apologists say, the secrecy is indefensible. But perhaps the reliance of people like Mr. Singer on derivatives themselves is more troubling still.

Let’s step back a bit and think about what a derivative is. There is a dazzling world of financial transactions that come under that heading, but when we think of deals like Robson Oil’s, the following reflections from Brian Holmes are clarifying:

[A derivative] is a fungible contract, created by applying a mathematical formula to an underlying asset or commodity whose price is susceptible to fluctuation . . . . By assembling constellations of values that statistically tend to fluctuate in opposite directions, derivatives were supposed to mitigate the risks of globalization with the highest degree of efficiency. The idea was that that all risks, including collective ones, should be made into salable products, formatted for the market by private actors in search of a profit. . . .

Derivatives . . . have nothing directly to do with production; instead they are conceived to manage the environmental risks that weigh on the future of speculative activity. In this sense they are meta-commodities that govern the unfolding of the contemporary economic model. Their fascinating appearance acts to conceal the private deliberations that effectively shape the environment in which any productive or consumptive activity can take place.

Derivatives thus offer a tempting alternative to the messiness of politics. Rather than investing in sustainable energy, the US can allow everyone to hedge their own bets. Worry about peak oil? Buy some derivative that pays off big when it hits $200 a barrel. Think it’s all a big hoax? Then you can short the same instrument, or come up with some exotic variation on the short. Everyone gets to vote with dollars on some future. Worried about your home price? Robert Shiller seems to think that a “thick housing futures market” would help you diversify away that risk.

There are a few problems with such a future. Let’s forget, for now, the unfortunate fact that so many Americans are broke. Let’s not trouble with the divide between the median household (which has has net worth of under $100,000) and the top 1 percent of households’ mean wealth of over $15 million.* Let’s heroically assume that individuals can make all kinds of bets, er, investments, based on what they think the future holds. Could derivatives still serve as our ultimate risk manager?

Not really. Consider Mike Konczal’s fanciful take on the problem:

[W]hat do we call a product that pays out in times of high volatility, in times when an event out of the ordinary happens? One thing to call it is “insurance.” . . . There’s good reason we regulate insurance – it needs to pay out exactly at the moment when it is the least likely to get paid.

[There are limits to what insurers can promise. What] would you price a contract that paid $100 if the world turned into The Walking Dead, where cities were overrun with armies of zombies? The short answer is that you wouldn’t pay anything, since when you need to collect it the person on the other end is probably a zombie. This “who can credibly commit to backstopping bad events” goes towards a notion of the role the government can play in financial markets.

Of course, we did see a version of that disaster in 2008. Zombie banks walk among us to this day, propped up by lenient regulators, low interest rates, and dead ideas. Their employees will get about $143 billion in bonuses this year–more than the “$130 billion total budget gap for all 50 states,” according to SEIU. Perhaps in gratitude for the state’s generous subvention, Josef Ackermann (head of Deutsche Bank) said “I no longer believe in the market’s self-healing power” in 2008, admitting a role for government.

Yet this is the same Josef Ackermann who “pledged to seek 25 percent returns on capital before tax” after the crisis. As Simon Johnson argues, “In a world where safe assets barely earn a few percent, he can only achieve such returns through significant risk-taking.” Competitors will do the same, dancing while the music is playing. It’s hard to credibly promise protection to all the Robson Oils of the world, and to support seven to nine figure incomes. Risks have to be taken.

So we are in a curious situation: the very instruments designed to diversify away risk in one field end up exacerbating it in others. Back in November, 2007, one of the world’s best economic sociologists (Donald Mackenzie) was thinking about what he called the “end-of-the-world trade:”

The trade is the purchase of insurance against what would in effect be the failure of the modern capitalist system. It would take a cataclysm – around a third of the leading investment-grade corporations in Europe or half those in North America going bankrupt and defaulting on their debt – for the insurance to be paid out.

I asked one investment banker what might cause half of North America’s top corporations to default. No ordinary economic recession or natural disaster short of an asteroid strike could do it: no hurricane, for example, and not even “the big one,” a catastrophic earthquake devastating California. All he could think of was “a revolutionary Marxist government in Washington.”

The exchange both reveals a mindset common in New York and London, and confirms Mackenzie’s larger thesis about “performative theories” in finance. MacKenzie’s book An Engine, Not A Camera: How Financial Models Shape Markets describes how both finance theorists and traders’ views on “how the world works” end up promoting the very conditions they claim to merely reflect. The trader here locates the source of risk in the only institution that could credibly get the economy out of a severe rut, or (more importantly) avoid the rut in the first place.

MacKenzie’s trader’s nightmare scenario of a Marxist government is not nearly as plausible as the doomsday on the horizon of leading novelists, historians, environmentalists, and geologists. To take but the latest example of a flourishing genre, consider these ideas from Alfred McCoy:

Other developed nations are meeting [the threat of declining oil supply] aggressively by plunging into experimental programs to develop alternative energy sources. The United States has taken a different path, doing far too little to develop alternative sources while, in the last three decades, doubling its dependence on foreign oil imports. Between 1973 and 2007, oil imports have risen from 36 percent of energy consumed in the U.S. to 66 percent. . . .

[Given current trends in the dollar's value, one can imagine] OPEC oil ministers, meeting in Riyadh, demand[ing] future energy payments in a “basket” of Yen, Yuan, and Euros. That only hikes the cost of U.S. oil imports further. At the same moment, while signing a new series of long-term delivery contracts with China, the Saudis stabilize their own foreign exchange reserves by switching to the Yuan. . . .

The oil shock that follows hits the country like a hurricane, sending prices to startling heights, making travel a staggeringly expensive proposition, putting real wages (which had long been declining) into freefall, and rendering non-competitive whatever American exports remained.

Rather than engineering alternative sources of energy, we have focused on “financial engineering” of distributed risk management. But who really thinks we can arrange an “end of the oil era” trade to hedge against the situation McCoy is describing?

The ultimate irony is that ostensibly distributed risk management really isn’t that diversified at all. As Amar Bhide has demonstrated, the modern financial system is Hayek’s nightmare:

The financial system has been giving up . . . on the decentralization of judgment and responsibility. Case-by-case judgments by many, widely dispersed financiers with the necessary ‘local knowledge’ have been banished to the edges. . . . The core is now dominated by a small number of very large firms that have little direct contact with the ultimate real users or providers of finance. . . . [E]mployees of the organizations that produce research and ratings–and the traders whose aggregated opinions constitute the wisdom of crowds–usually don’t have much case-by-case local knowledge. They, too, often rely on [standard] statistical models, or just take cues from each other. (A Call for Judgment, 12)

Conservative thinkers like Russ Roberts and Nicole Gelinas have also observed just how far modern finance is from anything resembling a decentralized, “free market.” Louise Story’s “secetive banking elite” is not merely affecting derivatives trading, but core operations across the sector.

The finance industry’s long term efforts to take over government’s role in major risk management fail even on their own, free market terms. It’s time for radical rethink of the role of finance in the economy. The right is already well on its way toward “tight money” or even a gold standard as an answer to our current economic crisis. Progressives must realize how much is at stake if they fail to deliver an alternative narrative. Matt Stoller gets this, and offers the following insights:

Liberals should stop their love affair with conservative technocratic myths of monetary independence[,] move beyond [a] consumer-driven approach[,] and think about reform of the credit system, of the monetary order, as Elizabeth Warren [and Jane D'Arista have]. The link between the Federal Reserve and the ‘real economy’ is broken. When banks were the main conduit between the financial world and economic activity, translating savings into investment, the Fed could manipulate the economy by manipulating the banking sector. But now that shadow banks dominate our credit markets, and the Fed has allowed hot money to take over monetary policy, the Fed’s tools just don’t work. That’s why quantitative easing is foolish. We must dispatch with the ridiculous notion that pushing hundreds of billions of dollars into a broken banking system will have useful consequences.

Instead, let’s recognize that the Fed doesn’t fulfill either part of its mandate, and work towards a better and more plausible system of monetary stability. That’s not a longterm process, it’s a constant process. D’Arista argues that the Fed must connect itself to the shadow banking system and force credit to flow. This necessarily implies important changes in how the Fed interacts with financial services firms and entities. To give some idea of what this might look like, at least conceptually, Timothy Canova paints the portrait of a more democratic Federal Reserve financing the government debt during World War II. Cooperating with a phalanx of institutions, such as the Reconstruction Finance Corporation, and government boards that directed wartime rationing, the Fed was able to . . . dramatically equalize economic opportunity and wealth-building for the middle class.

Whatever one thinks of Stoller’s, Canova’s, and D’Arista’s views, we should be able to agree that high finance’s theories of risk management have led it to usurp roles that only government can play. We continue to bet on the privatization of risk at our peril.

*I derive that figure from Wolff’s update on trends in household wealth and Domhoff’s observation that “there has been an ‘astounding’ 36.1% drop in the wealth (marketable assets) of the median household since the peak of the housing bubble in 2007. By contrast, the wealth of the top 1% of households dropped by far less: just 11.1%.”

Closed-Circuit Economics

Frank Pasquale — Fri, 26 Nov 2010 16:26:42 +0000

The economy has now reached a “new normal” of soaring profits and stalled employment. Why aren’t stock market gains, bank bonuses, and rising CEO pay translating into more jobs for American workers?

Firms could be buying more labor-saving technology or speeding up production. They may also be investing overseas. Brazil, India, and China have more growth potential than the US. As Keynes stated, “Owing to [a developed economy's] accumulation of capital already being larger . . . the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate.” While American securities markets have long been reputed to be far more transparent and law-governed than “developing” markets, the gap may not seem so great nowadays. This will be a painful transition for the U.S., all the more so due to our repeated failure to follow stabilizing models of industrial policy. But it is an overdue “rebalancing” of global economic flows.

More troubling is the possibility that buying power is being segregated by the very wealthy into closed circuits of spending and investment (among themselves). Inequality has now become so extreme that it’s difficult to imagine how, say, America’s Fortunate 400 could spend their money. Consider this analysis of Sandy Weill’s recent purchase of a $31 million estate:

Although the value of most housing in Sonoma County, in the heart of the wine country, is down 30 to 50 percent, Weill was willing to pay close to the asking price for his new property. And why not? As the San Francisco Chronicle quoted one Coldwell Banker real estate agent, the sale “is not an indicator of an emerging real estate recovery, but rather the ability of the world’s wealthiest individuals to buy what they desire.”

In a transaction like Weill’s, some real estate agent(s) probably made a good commission. But the home’s former owner may just use that $31 million to buy a Damien Hirst work. Or stocks. Or gold. The possibilities are limitless, of course, but as the top 5% of earners now account for 35% of consumer spending (and a far higher proportion of investing), we might learn something from modeling ideal-typical economic decisions of the very wealthy.

In the case of the art splurge, a gallery may have a big payday, and spend some of that money in the less rarefied economy. In the case of stocks, the public often thinks of such funds as inevitably invested in more or better equipment and staff, to enable the growth of a company. But maybe the firm just piles up cash.

Already-mined gold appears to be the ultimate sink of value. Of course, the seller of the gold has the cash, which she or he might spend. But a long term appreciation of the price of gold could signal the hope of the rich to opt out of currencies altogether, and to develop their own private circuit of “hard” value.

Luxury goods of enduring value might fill a similar role; as Swiss watchmaker Patek Philippe puts it: “You never actually own a Patek Philippe. You merely look after it for the next generation.” The FT’s weekly guide “How to Spend It” may actually instruct “How to Save It,” assuming some connoisseur will eventually want whatever “eclectible” (definition: a “desirable acquirable”) one happens to purchase. (Admittedly, the “Bespokesperson” on the site advises the ultimate indulgence of customization.) Finally, exotic financial instruments offer another venue for speculation for those rich enough to take a gamble.

When Finance Mostly Finances Finance

But is this process sustainable? A Green Tory might advocate for more money circulating in the economy’s stratosphere: a luxury handbag costing $80,000 may have less of a carbon footprint than, say, 32 Tata Nanos. I am uncomfortable with that justification. For anyone concerned about the environment, it would be far better to see the handbag consumption turned to sustainable energy investment, rather than continuing as a diversion of spending power away from the poor. Moreover, if domestic and international inequality continues at current levels, it will reinforce the US recession. Even for those who think the average US citizen is too rich anyway, the probable political consequences of perpetual stagnation are frightening.* Money is being drained away from an ordinary economy into an economic stratosphere with a logic of value all its own.

In an extended essay on financialization (first delivered as the keynote address at the Fifteenth National Conference on Economics of the Brazilian Political Economy Society (SEP)), John Bellamy Foster responds to Keynes and observes how increasingly segregated circuits of consumption and production affect the economy:

In the 1970s total outstanding debt in the United States was about one and one-half the size of GDP. By 2005 it was almost three and a half times GDP and not far from the $44 trillion world GDP. Speculative finance increasingly took on a life of its own. Although in the prior history of the system financial bubbles had come at the end of a cyclical boom, and were short-term events, financialization now seemed, paradoxically, to feed not on prosperity but on stagnation, and to be long lasting. Crucial in keeping this process going were . . . central banks . . . assigned the role of “lenders of last resort,” with the task of bolstering and ultimately bailing out the major financial institutions whenever necessary (based on the “too big to fail” principle). . . .

[As] Jan Toporowski (professor of economics at the University of London) observed in The End of Finance, ‘[We] have seen the emergence of an era of finance that is the greatest since the 1890s and 1900s. . . . In an era of finance, finance mostly finances finance.’ . . . We can picture this dialectic of production and finance, following Hyman Minsky, in terms of the existence of two different pricing structures in the modern economy: (1) the pricing of current real output, and (2) the pricing of financial (and real estate) assets. More and more, the speculative asset-pricing structure, related to the inflation (or deflation) of paper titles to wealth, has come to hold sway over the “real” pricing structure associated with output (GDP). Hence, money capital that could be used . . . within the economic base is frequently diverted into . . . speculation in asset prices.

To put it more concretely: if a very wealthy person wants to maintain his spending power today, he may be far more interested in buying gold, collectible handbags, or commodities futures, than investing in a green energy company or even, say, Ikeas in China. A cautious investment manager following the herd may want, above all else, to deal with a counterparty who is “too big to fail,” guaranteed by the coercive power of the state and backing of the Fed or Treasury to deliver whatever payments it commits to. Such counterparties are most often found on Wall Street. As Robert Kuttner of The American Prospect reports, “Fitch Ratings gives Bank of America and Citigroup ‘stand alone’ ratings of C/D when external government support is not included but actual ratings of A-plus when it is.”

This month, Kuttner’s magazine focused on phantom green jobs, noting that the US has done little to guarantee a market for renewable energy sources. I am under no illusions that current politicians will change this; even the President has failed to take many important steps to change government procurement policies in a green direction. It also appears that some degree of TBTF backing is inevitable. As its price, the government should insist that TBTF firms take measurable steps toward rebuilding America’s real economy—rather than endlessly siphoning more of our human and financial capital into complex games of speculation.

*Though perhaps not as frightening as Benjamin Friedman thinks.

Image Credit: Lucas Jennis’ engraving of an Ouroboros, published on alchemical emblem-book De Lapide Philisophico (1625).

Treasury’s Prime Directive: Protect the Banks

Frank Pasquale — Sat, 20 Nov 2010 18:50:59 +0000

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.

Flaming the Victims

Jonathan Lipson — Sun, 07 Nov 2010 16:18:25 +0000

Two recent items have me wondering about overinvesting in victim claims: (1) Christine Hurt’s new article on the implications of the Madoff scandal, Evil has a new name, and (2) Janet Tavakoli’s claim (if the link doesn’t work, this is also squibbed in the margin) that financial institutions caused the mortgage mess, the “biggest fraud in history.” Both tell important—and perhaps accurate—stories about massive frauds that certainly produced victims. But both overlook an obvious point: Not all victims are created equal. As Pogo said, “we’ve seen the enemy, and he is us.”

Pogo victim dance

When Madoff first hit, I heard two interesting things from (reasonably) reliable sources which complicate the victim calculus. First, one person who claimed to know a number of Madoff investors, said that many believed that Madoff was able to guarantee outsized returns because of his access to inside information. This, of course, is a kind of securities fraud. So, my friend said, “everyone knew Madoff was committing fraud—they just thought it was a different fraud.” You have to wonder how innocent investors were if, as Hurt reports, they were sworn to secrecy when they gave him their money.

I realize I will likely be flamed by holocaust survivors for insensitivity to their losses. To the extent they were innocent, of course, I have nothing but sympathy for them. The point, however, is that, as Madoff’s bankruptcy trustee is learning, there is little moral clarity in some of these claims.

Second, we should not overstate the severity of Madoff’s punishment. A lingering question I had about the case was why he turned himself in at all. Given the cash to which he had access, it seems implausible that he could not have fled to some remote, pleasant place without an extradition treaty. Why didn’t he?

The answer other friends on Wall Street gave was this: He hadn’t simply screwed the Jews–he also screwed the Russian Mafia/Mossad/Name your other secret, powerful organization. In other words, he believed—perhaps quite rationally—that spending the rest of his life in a federal prison—and taking the fall for his family—were vastly preferable to being murdered by victims who were most likely to take matters into their own hands.

As for Tavakoli’s claims about the mortgage mess: It is alluring to say that the entire real estate bubble was the fault of the investment banks. While they were clearly major malefactors, there were failures at every point, as I argued briefly here, from origination to foreclosure. Tavakoli speaks as if the banks were the sole source of the problem.

But this massive failure cannot really be called a fraud in a conventional sense, and certainly not attributable to the banks alone. It is something else—I am not sure what—because too many people had the wrong (or right) state of mind. For example, fraud generally requires some kind of intent to mislead by act or omission. But, so far as we can tell, many of the serious risks associated with mortgages being sold into securitizations were disclosed. Even the Magnetar Trade—surely the most brazen manipulation we know of so far—was effectively revealed to investors, who all knew from the selling documents that it was possible that the sponsor was going to short the mortgage-backed securities it was selling.

I think all of this reflects a culture of denial and entitlement with which we have yet to come to grips. Republicans genuinely believe, after having nearly destroyed the economy, that they are entitled to reclaim the wreck. GM’s bondholders—professional investors who for years have used bankruptcy to force others to absorb losses—don’t like it when the same is done to them.

This may simply reflect the inevitable costs of a society that lives in the illusion that it is governed by the “rule of law.” The rule of law requires rights, and we all think we have lots of them—including the rights both to attempt to screw each other and to compensation if we are unsuccessful in that attempt.

Where Have You Gone, Hernando de Soto?

Frank Pasquale — Sun, 03 Oct 2010 21:56:52 +0000

Remember Randy “Duke” Cunningham’s “bribe list” pricing—”$50,000 for every $1 million in appropriated funds he would obtain?” There are now allegations that certain firms offered to “fabricat[e] documents out of whole cloth” to lubricate the foreclosure machine. For a mere $95, one could “recreate entire collateral file,” which is all “the documents the trustee (or the custodian as an agent of the trustee) needs to have pursuant to its obligations under the pooling and servicing agreement on behalf of the mortgage backed security holder [including] the original of the note (the borrower IOU), copies of the mortgage (the lien on the property), the securitization agreement, and title insurance.” Yves Smith draws some interesting implications:

Amar Bhide, in a 1994 Harvard Business Review article, said the US capital markets were the deepest and most liquid in major part because they were recognized around the world as being the fairest and best policed. As remarkable as it may seem now, his statement was seem as an obvious truth back then. In a mere decade, we managed to allow a “free markets” ideology on steroids to gut investor and borrower protection. The result is a train wreck in US residential mortgage securities, the biggest asset class in the world. The problems are too widespread for the authorities to pretend they don’t exist, and there is no obvious way to put this Humpty Dumpty back together.

Smith’s global perspective reminds me of two items. I once heard that, in the wake of Bush v. Gore, a representative of the OAS began a meeting by saying something along the lines of: “We are now to hear from a fragile democracy, one that has suffered severe strains but which looks capable of attaining legitimate procedures for governance. Would the United States representative please come to the dais?” And policymakers who prescribe the titling work of Hernando de Soto for Latin America might want to apply it a bit more carefully at home.

On the Colloquy: The Credit Crisis, Refusal-to-Deal, Procreation & the Constitution, and Open Records vs. Death-Related Privacy Rights

Northwestern University Law Review — Sun, 05 Sep 2010 17:15:08 +0000

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.

Goldman’s $550 Million SEC Settlement

Lawrence Cunningham — Thu, 15 Jul 2010 21:59:42 +0000

The SEC announced this afternoon that Goldman Sachs agreed to settle, for $550 million, the civil lawsuit against it alleging materially misleading disclosures in circulars for some mortgage-backed securities it hawked. As I wrote on this blog, in a post of April 19 called SEC v. Goldman as a Simple Case, the case was simple.

In a bruising Consent to a Final Judgment in the federal case against it, Goldman acknowledges the point I made that makes the case simple. Its marketing circular said the reference portfolio was “selected by” the independent firm, ACA Management LLC, when in fact Paulson & Co. Inc., an interested party, played a role in that selection.

Within 30 days, Goldman must pay investors it misled by the marketing materials: $150 million to Deutsche Bank and $100 million to the Royal Bank of Scotland (known as ABN AMRO Bank when it bought Goldman’s securities). It must pay another $300 million to the SEC.

The SEC’s press release headlined that this amount set a ”record” for the agency and is non-trivial even for a firm of Goldman’s size. Its enforcement chief, Bob Khuzami, boasted that “half a billion dollars is the largest penalty ever assessed against a financial services firm in the history of the SEC.”

In addition to the cash outflow, Goldman agrees to extensive business practice and internal governance reforms. These include specific requirements for expanded oversight of internal product review; legal oversight of marketing materials, by internal and outside counsel; internal auditing; and education and training. It must file with the SEC special certifications of compliance with these requirements, which Goldman must maintain for three years.

Goldman also agrees to cooperate fully with the SEC in other ongoing investigations and litigation, including putting Goldman employees at the SEC’s disposal. That’s important because, though this settles the case for the firm, the SEC’s litigation against the Goldman man behind the misleading securities sale, wisecracking Fabrice Tourre, continues.

It was a simple case and this is a simple way to end it, especially with Goldman’s express acknowledgement of its misleading materials. As the Wall Street saying goes, though, there’s rarely only one cockroach in the kitchen. The SEC enforcement team is on the beat under Chair Mary Schapiro, a big improvement over her predecessor Chris Cox, whom I criticized repeatedly on this blog for regulatory laxity. Hats off to the diligent SEC team.

Here Comes FinReg

Frank Pasquale — Thu, 15 Jul 2010 13:42:17 +0000

Via Ezra Klein’s Wonkbook (definitely one of my favorite morning emails), a variety of takes on what’s in the financial reform bill:

1. From Deloitte’s 12-page summary:

Because the new U.S. law is complex, it can be helpful to remind ourselves that its underlying purpose is relatively simple and has two powerful strands: 1. ‘De-risk’ the financial system by constraining individual organizations’ risk-taking activities and capturing a broader set of organizations’, including the so-called “shadow” banking system, in the regulatory net 2. Enhance consumer protections. . . .For example, the need for “arm’s-length” swap desk affiliates combined with the move from over- the-counter to exchange trading for derivatives, tighter constraints on leverage and risk-taking, and higher liquidity requirements imply lower profit margins in future from those activities.

Some estimates I’ve seen have estimated the profit margins might be around 15% lower.

2. Simon Johnson on the Kanjorski Amendment as a “new kind of antitrust:”

Effective size caps on banks were imposed by the banking reforms of the 1930’s, and there was an effort to maintain such restrictions in the Riegle-Neal Act of 1994. But all of these limitations fell by the wayside during the wholesale deregulation of the past 15 years. Now, however, a new form of antitrust arrives – in the form of the Kanjorski Amendment, whose language was embedded in the Dodd-Frank bill. Once the bill becomes law, federal regulators will have the right and the responsibility to limit the scope of big banks and, as necessary, break them up when they pose a “grave risk” to financial stability.

I wish I could say I was as optimistic as Johnson about the prospects for effective enforcement here, but he certainly knows the lay of the land far better than I do. As Barry Lynn shows, in a variety of industries, we need a new form of antitrust, or at least better competition advocacy.

3. The Roosevelt Institute publishes a variety of takes; William K. Black is the most pessimistic:

The fundamental problem with the financial reform bill is that it would not have prevented the current crisis and it will not prevent future crises because it does not address the reason the world is suffering recurrent, intensifying crises. A witches’ brew of deregulation, desupervision, regulatory black holes and perverse executive and professional compensation has created an intensely criminogenic environment that produces epidemics of accounting control fraud that hyper-inflate financial bubbles and cause economic crises. . . .

The financial industry, with Bernanke’s support, already got Congress to extort FASB to gimmick the accounting rules so that insolvent banks could hide their losses and continue to pay the executives (already made rich by destroying “their” firms — that’s the meaning of Akerlof & Romer’s classic article: “Looting: Bankruptcy for Profit”) massive bonuses. All of this is made possible by huge, off budget subsidies to [systemically dangerous institutions] via the Fed and Fannie and Freddie.

4. Daniel Indiviglio on the uncertainty at the heart of the legislation (does it end or encourage TBTF?):

The prevailing debate between Republicans and Democrats on financial reform is whether the new bill institutionalizes the too big to fail problem. Democrats swear it doesn’t, since the legislation also includes a new non-bank resolution authority which will make quite certain that all firms can, and will, fail if they run into trouble. Republicans haven’t developed a very sensible criticism to this, but they could. While the resolution authority ensures that big firms fail, it would also almost certainly provide them some advantage.

A lot will depend on regulators’ interpretation and enforcement here.

5. James K. Galbraith provides some background:

The financial crisis in America isn’t over. It’s ongoing, it remains unresolved, and it stands in the way of full economic recovery. The cause, at the deepest level, was a breakdown in the rule of law. And it follows that the first step toward prosperity is to restore the rule of law in the financial sector.

[What went wrong?] First, there was a stand-down of the financial police. The legal framework for this was laid with the repeal of Glass-Steagall in 1999 and the Commodities Futures Modernization Act of 2000. Meanwhile the Basel II process relaxed international bank supervision, especially permitting the use of proprietary models to value complex assets—an open invitation to biased valuations and accounting frauds.

Key acts of de-supervision came under Bush. After 9/11 500 FBI agents assigned to financial fraud were reassigned to counter–terrorism and (what is not understandable) they were never replaced. The Director of the Office of Thrift Supervision appeared at a press conference with a stack of copies of the Code of Federal Regulations and a chainsaw—the message was not subtle. The SEC relaxed limits on leverage for investment banks and abolished the uptick rule limiting short sales to moments following a rise in price. The new order was clear: anything goes.

Second, the response to desupervision was a criminal takeover of the home mortgage industry. Millions of subprime mortgages were made to borrowers with undocumented incomes and bad or non-existent credit records. Appraisers were selected who were willing to inflate the value of the home being sold. This last element was not incidental: surveys showed that practically all appraisers came under pressure to inflate valuations in order to make deals happen. There is no honest reason why a lender would deliberately seek to make an inflated loan. . . . Third, the counterfeit mortgages were laundered so they would look to investors like the real thing. . . .Fourth, the laundered goods were taken to market. . . . Upon taking office, President Obama had a chance to change course and didn’t take it.

The question now is whether FinReg will provide a “second chance” for an Administration that so far has not distinguished itself on the financial reform front.

Image Credit: 1901 image of J.P. Morgan.

Tricks of the Traders

Frank Pasquale — Sun, 11 Jul 2010 23:22:04 +0000

Loans and securities are not merely products. While progressive forces can win some political battles by deploying the product metaphor, it obscures more than it illuminates. Consider the practice of “high-frequency trading.”

Matt Krantz discusses the ways in which automation in the finance sector can leave ordinary investors high and dry:

Not only are the markets completely computerized, more than half of the market’s volume is churned by computers programmed to spot certain patterns in trading. These machines see stocks not as securities used by companies to raise money, but rather, symbols, numbers and bits that are traded, swapped and exchanged.

And now, traders say, humans are responding to machines rather than the other way around. Increasingly, too, the machines are reacting to each other, trying to second-guess what their next moves might be on how to take advantage of an edge that might be gone in milliseconds.

As Keynes might have predicted, we have “reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” The machines are perhaps devoted to “practice the fourth, fifth and higher degrees.” But there’s a twist: part of the investment game now appears to be a falsification of (or at least fake-outs via) data on such opinions:

Rapid-fire computer systems allow sophisticated traders, including the giant Wall Street firms, to post bid (buy) and offer (sell) prices they have no intention of actually following through on . . . . For instance, a firm might post a bid for a stock showing they want to buy at a certain price. But by the time investors interested in selling at that price get their order to the market, the false buyer yanks the electronic bid literally faster than a blink of the eye . . . This interplay happens in milliseconds, making it difficult to detect. . . . [T]he firms that are physically located nearest the market centers in New York and pay market-access fees get a leg up.

One physical barrier to equality here is mere location: “Each 186 miles a trader is physically located away from the New York trading center, about a millisecond is added to the time to execute a trade.” There’s no way to discern “honest signals” in such an accelerated environment. Other tricks include effectively spamming the market:

Thanks to low-cost and automated trading, trading firms can swamp markets with a deluge of buy and sell orders in a way that gives them an advantage . . . As other firms must parse through the extraneous trades, slowing them down, the firms behind the pseudo bids and offers can ignore them, saving them milliseconds of analysis time. This gives their computers valuable extra milliseconds to parse true trends in the market and gain an advantage, [Eric Hunsader, founder of market data feed provider Nanex] says . . . [A]nyone who knows some of those trades can be ignored gets a huge advantage.

The destructive potential of these dynamics is clear. John Jacobs, the COO of LimeBrokerage, told the SEC in 2009 that “unrestrained computer-generated trading has the potential to create catastrophic economic damage to the U.S. national market system.”

Rather than reflecting or reporting or trading on changes in the value of a given security, the HFTers appear to be creating such changes. On the most charitable reading, they are “engines, not cameras,” like the now-discredited theories of finance that led to their rise. On a less-charitable view, they should be the subject of agnotology, the science of “how and why various forms of knowing do not come to be.” Doubt is their product, or at the very least the condition under which they thrive. As Senator Kaufman said in a hearing:

No one at the SEC as far as I know, or anyone else really, knows what actually goes in the market centers that are engaged in high-frequency trading. And now with high-frequency tradings at between 60 percent and 70 percent of all market transactions, sometimes things get too big to fail, sometimes things get too big to even look into.

Some hope that “radical transparency” and better reporting standards will improve matters. I’m beginning to think we have little to rely on other than a cultural turn toward investing in projects with real social value. Rather than viewing investment as a zero-sum game of predicting the valuation of securities as products, we might begin to think of it as a process of supporting certain futures over others. Flash trading and other forms of short-termism merely abdicate that responsibility. They promise fast profits for those with the best computers, quants, and communications, but little hope for efficient, just, or rational capital allocation.

GW’s Junior Scholar Workshop and Prizes

Lawrence Cunningham — Tue, 08 Jun 2010 17:00:29 +0000

As anticipated, the Center for Law, Economics and Finance at George Washington University Law School (C-LEAF) has formally announced its first annual Junior Faculty Business and Financial Law Workshop and Junior Faculty Scholarship Prizes. The Inaugural Workshop will be held and Prizes awarded on April 1-2, 2011, at GW Law School in Washington, DC.

Up to ten papers will be chosen from those submitted for presentation at the Workshop. At the Workshop, one or more senior scholars will comment on each paper, followed by general discussion of each paper among all participants. The Workshop audience will include invited junior scholars, faculty from GW’s Law School and Business School, faculty from other institutions, and invited guests.

At the conclusion of the Workshop, up to three papers will be awarded Junior Faculty Scholarship Prizes, of $3,000, $2,000, and $1,000, respectively. Chosen papers will be featured on C-LEAF’s website as part of its Working Paper Series. In addition to participating in the Workshop, all scholars selected to present at the Workshop will be invited to become Fellows of C-LEAF.

Scholars who have held a full-time academic appointment for less than seven years as of the submission date are eligible. Subject matters encompass accounting, banking, bankruptcy, corporations, economics, finance, and securities.

Interested scholars should submit a summary or draft, preferably by e-mail, before October 15, 2010. Submissions, along with any inquiries related to the Workshop, should be directed to: Professor Lisa M. Fairfax, Leroy Sorenson Merrifield Research Professor of Law, George Washington University Law School, Washington, DC 20052. Email: lfairfax@law.gwu.edu

Papers and Junior Faculty Scholarship Prizes will be selected after a blind review by a committee of C-LEAF’s Executive Board. Authors of accepted papers will be notified by November 19, 2010.

The Workshops and Prizes are made possible by generous sponsorship of Schulte Roth & Zabel LLP, one of the leading law firms serving the financial services industry and known for its premier practice in the area of private investment funds and private equity M&A.

Nonlinear Theory Explains May 6 Market Break

Lawrence Cunningham — Thu, 13 May 2010 18:30:41 +0000

One week after stock markets dropped 10% in half an hour, regulators still confess bewilderment yet equally resolve never to let it happen again. No one at the SEC or CFTC or any of the exchanges has been able to identify a particular cause of the flash crash. They do say the precipitous decline was magnified by how some trading platforms, like the old-fashioned New York Stock Exchange, halted trading when the downward spiral began while electronic trading platforms did not.

A consensus appears to believe that this worsened the spiral because trades could still be made elsewhere but with fewer participants, in a thinner market. Adherents think the cure is obvious: such trading breaks should be adopted across all trading platforms so if there is ever any significant decline in price, all trading would halt. I respectfully dissent.

This is a replay of the 1987 stock market crash: no one could figure out why it happened so everyone decided such circuit breakers were the thing to do about it. The consensus is likely to be just as wrong today as it was wrong then, based on an alternative view, which I laid out in my 1994 GW Law Review article, From Random Walks to Chaotic Crashes: The Linear Genealogy of the Efficient Capital Market Hypothesis. Those seeking an explanation for the 1987 crash and last week’s flash crash presuppose things about stock markets and pricing that may simply be false.

They suppose prices accurately reflect collectively-rational behavior among informed traders whose spontaneously-coordinated actions invariably result in stock prices, and stock price changes, that linearly give up-to-the-minute best estimates of underlying business value. That is a delineated version of the popular efficient market hypothesis. Things like the 1987 crash and last week’s flash crash are inconsistent with that, so stand out as anomalies needing an explanation outside the popular hypothesis.

But that isn’t how prices actually work and episodes like the 1987 crash and last week’s flash crash merely put the recurring reality in sharp relief. Stock price adjustments are not always elegantly fluid, linear, and endlessly up-to-date. They are nonlinear and often chaotic. Price changes do not move in increments of pennies and dollars but alter abruptly, non-linearly, skipping from $10 to $14 to $8, not moving between those figures from $10.01, $10.02, $10.03 . . . $14. . . .

The same is true of the aggregate Dow index: when it drops from 10,600 to 9,870 — whether in 20 minutes or 20 days — that doesn’t mean anyone could have traded at incremental levels in between during that time. Stock prices are driven by the volume of buy-sell orders and the relative imbalance. Stock prices rise rapidly when buyers outbid sellers and vice versa.

Sometimes that means a massive rally in prices and sometimes it means a sharp plunge. Why is a combination of fundamental analysis and behavioral dispositions unrelated to that. So what, therefore, if stock prices rise 1000 points or fall 1000 points in a few minutes or a day or a month? Let the market rise; let the market fall!

If you still believe, as regulators insist, that we simply cannot have 1000 point drops in half an hour, one prescription seems obvious to them: if markets start to fall like that, shut them down—don’t let them fall. That is the logic behind the consensus that last week’s fall was magnified by trading halts (called circuit breakers) only applying at some, but not all, trading platforms. But at least two issues arise from this digagnosis of circuit breakers that were too limited and cure that circuit breakers should be universal.

One: if you are going to interfere and shut down a market because price levels are rapidly falling, why are you not going to interfere and shut down a market because price levels are rapidly rising? Proponents of circuit breakers think they know it is a potentially bad thing when prices plummet, bad enough to shut down the market. But sometimes prices get so high that they should plummet. (The reason circuit breaker proponents do not propose to shut markets down when prices are rising is not about policy logic but because that is party time and no one wants to take away the punch bowl!)

Two: if you think you are good at knowing that a market should shut down when prices have fallen by a certain amount within a certain time, how do you know ahead of time that your solution of automatically shutting them down will not exacerbate the problem you seek to correct? It is at least equally likely that, as a price change trigger is approached, the mere proximity to it induces panic selling by those fearful that the market soon will shut down and prevent them from getting out.

So far, officials officially are saying they don’t really know what happened last Thursday but they think whatever happened is a problem to which they need to find a solution. But it is possible that it was simply normal market behavior, in its chaotic non-linear beauty, merely magnified in its visibility, yet still quotidian. There is good news in this mix of professed regulatory ignorance about cause coupled with regulatory confidence about the cure: the SEC-CFTC are setting up a special committee to have a closer look. I hope they consider nonlinear market realities.

The Center on New Fin Reg Duties

Lawrence Cunningham — Wed, 28 Apr 2010 20:00:34 +0000

Talk on financial regulation reform debates the wisdom of new federal legislation that may impose new duties on financial professionals. This appears to have gained momentum in light of Congressional hearings yesterday probing whether top players at Goldman Sachs thought they owed any special duties to their customers.

Focusing on the possibility of imposing fiduciary duties on securities brokers, Erik Gerding rightly notes how this would be a “sea change” on Wall Street. Firms like Goldman Sachs make markets in securities and generally do not owe such duties to the respective buyers and sellers. Larry Ribstein worries that imposing fiduciary duties on securities brokers would entail high costs for little gain.

There are at least two other ideas that could be considered as an alternative to imposing fiduciary duties on brokers: heightened disclosure and business conduct standards.

Disclosure is the more standard federal response in securities regulation. New federal legislation could require securities brokers and dealers to disclose information about: (A) material risks and characteristics of a security; (B) the source and amount of the broker/dealer’s fee or incentives in the deal; and (C) any conflicts of interest the broker/dealer faces.

Another alternative to fiduciary duties or disclosure would impose business conduct standards on securities broker/dealers. These could be established by the Securities and Exchange Commission in rules or regulations relating to: (A) fraud, manipulation and other abusive practices and (B) diligent supervision of the broker/dealer’s business.

Securities broker-dealers are not alone in facing this kind of new duties in financial regulation reform. A similar set of alternative new standards will be proposed to apply to swap dealers and major swap market participants.

In the political process, one suspects that proponents of serious reform will urge adoption of all three of these ideas–fiduciary duties, business conduct standards, and heightened disclosure obligations–on both categories of participants. Opponents will resist all three.

The likely middle ground will almost certainly include disclosure. The concept of a fiduciary duty may be both too vague and scary to carry the day. Business conduct standards would become the fighting issue. As long as they are tied to the specific contexts suggested–fraud and diligent supervision–they could help provide the centrist compromise too.

Hat Tip: Lynn Turner

SCOTUS Chides Posner/Easterbrook in Jones v. Harris

Lawrence Cunningham — Tue, 30 Mar 2010 21:53:11 +0000

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.

On the merits, the Court recognized that fiduciary duty is not so crimped as Easterbrook thinks, in general or in the statute. Quoting its famous 1939 Pepper v. Litton opinion (by Justice William O. Douglas), fiduciary duty means requiring inherent fairness, under a test asking whether “under all the circumstances the transaction carries the earmarks of an arm’s length bargain. If it does not, equity will set it aside.”

The district court in Jones applied exactly that standard and upheld the fee contract challenged. Easterbrook’s opinion affirmed that , but on the detoured grounds of an anemic notion of fiduciary duty lacking legal support in a curious assertion of judicial competence. Posner’s engagement was proportional to that fault.

The issue of judicial competence is germane because statutory challenges to mutual fund fee contracts like that in Jones require courts to assess whether a deal resembles an arm’s-length transaction. The Supreme Court directs judicial modesty in doing so, that lower courts give weight to the process followed to approve contracts and to be cautious against excessive second-guessing of fee decisions. The Court emphasizes limited judicial competence to make such judgments.

Easterbrook likely would amplify the Court’s caution that judges beware of their limited competence to second-guess the relationship between a fee contract and an adviser’s services. Yet he had no trouble asserting judicial competence to second-guess a legislative determination on how to resolve related disputes. This gets things exactly backwards. In Jones, the Supreme Court emphasizes that federal judges do have a role reviewing mutual fund pay decisions by virtue of a statute whose wisdom federal judges do not have a role in reviewing.