Archive for the ‘Securities’ Category
Wheel of Fortune? Not Your Family Board Game
posted by Kristin Johnson
Wheel of Fortune: Not Your Typical Board Game
In the wake of the recent financial crisis, many now ask whether we should blame the Board of Directors of investment banks, commercial banks and other financial services firms for failing to manage the economic risks associated with their market activities. (See here , here, and here. In teaching the Business Associations course, I find that we have the most interesting discussions when we cover the role of the Board of Directors and Management. The conflicts among the cast of corporate characters – the board, managers, employees, creditors and shareholders (to name a few)- intrigue students. In assessing risk management, we typically do not expect the Board to have a direct role in monitoring risk on a transaction-by-transaction basis or determining the day-to-day operating procedures that reduce risk. We do, however, expect the Board to have a role in establishing policies that address enterprise risk management. When we juxtapose the danger of risks of loss related to certain market activities (think AIG’s financial products group) with our traditional expectations of the Board’s role in firm oversight, we find ourselves asking if it may be prudent to require that the Board be more informed and active in monitoring enterprise risk management.
February 25, 2010 at 2:29 pm
Posted in: Corporate Law, Securities, Teaching
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A Greek Tragedy
posted by Kristin Johnson
A Greek Tragedy
Finance markets defend derivative contracts by pointing to their long history. One of the oldest recorded references to a derivative contract appears in ancient Greek literature. In Chapter 9 of Aristotle’s Politics, a philosopher gains a handsome profit by agreeing to place a deposit on olive presses one year in advance of the next olive harvest. In securing rights to the presses prior to the harvest, the buyer, Thalus ensures that if the harvest is bountiful, he will have access to the presses at the lower negotiated rate that press operators are grateful to receive in advance of the harvest.
Investigations reveal that derivatives played a critical role in Greece’s recent credit woes, threatening to collapse the country’s economy and de-stabilize neighbors. (See here.) Financial markets use the term derivative to describe a transaction that derives its value from an independent reference asset. Finance literature identifies four basic types of derivatives contracts –futures, forwards, options and swaps. Futures and forwards involve agreements to deliver goods at a stated contract price on a specified future date. Thalus’s right (assuming he has no obligation to exercise the right but may suffer the loss of the deposit if he does not exercise the right) to elect to access the olive presses at a price negotiated in advance, illustrates features of a classic option contract. Swap agreements allow counterparties to exchange a series of cash flows over time. The market classifies derivatives based on the reference asset used to determine the value of the agreement. For example, we refer to a swap agreement for which the reference asset is an agricultural product (corn, soybeans, cotton, grain) or a raw material (copper, crude oil, natural gas) as a commodity swap. The reference asset for a financial swap likely involves one of the following: foreign currencies, bonds, stocks, and other financial assets and liabilities. Thus, the jargon evolves and we have foreign currency swaps, interest rate swaps and equity swaps among the many varietals.
While commodity derivatives may date back to Mesopotamia (see here), the Dojima rice futures exchange in shogunate Japan (see here), or the tulip bubble in Holland, financial derivatives are the product of financial innovation. In the 1980’s, derivatives traders at Salomon Brothers engineered a foreign currency swap. The transaction allowed the World Bank and IBM to swap risk exposure to foreign currency exchange rates; the two entities exchanged bond payment obligations and bond earnings denominated in Swiss Francs and German Deutsche marks, respectively, in a $210 million transaction. Parties using derivatives attempt to limit their exposure to or predict future movements in the price of the reference asset.
Futures and options trade on registered exchanges. Other derivatives are privately negotiated, bi-lateral agreements that trade over-the-counter among dealers and financial intermediaries. There is often little or no record of the parties originating the instruments. The ability to originate and trade these instruments in the shadows may have motivated some actors to make bad bets.
Greece’s concerns stem from the use of interest-rate and foreign currency swaps. These instruments serve useful and important functions in allowing parties to manage their exposure to volatile interest rate and foreign currency markets. The complexity of pricing the instruments and the opacity of the market, however, engendered grave concerns. According to reports, Greece used derivative transactions that involved securitized rights to cash flows from national projects to conceal mounting debt. Greece’s current troubles exemplify the need for greater transparency and accountability in derivative markets.
The Greek debacle with swaps illuminates the need to address oversight of derivatives from a global perspective. The markets for derivatives involve financial services firms that may be domiciled in the United States or Europe but whose influence and relationships are undeniably international. The financial instability of systemically significant private institutions (investment banks or international insurance firms or sovereign debtors) threatens global market disruptions. We are left pondering the effectiveness of any domestic derivative market reform that lacks international collaboration. (See here.)
February 14, 2010 at 11:24 am
Tags: derivatives
Posted in: Corporate Finance, Corporate Law, International & Comparative Law, Securities, Securities Regulation
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Asking new questions or at least hoping for more useful answers
posted by Kristin Johnson
From 1933 to 1934, Senator Ferdinand Pecora, the senior lawyer for the Senate Banking Committee, led an examination into securities market abuses that inspired the regulatory framework set out in the Securities Act of 1933 and the Securities Exchange Act of 1934. The legislation noted the predatory practices that motivated its consideration and adoption:
“Alluring promises of easy wealth…freely made with little or no attempt to bring to investor’s attention those facts essential to estimating the worth of any security. High pressure salesmanship rather than careful counsel was the rule in this most dangerous enterprise.” H.R. Rep. No. 85, 73d Cong., 1st Sess. 2 (1933).
More than seventy years later, as the Financial Crisis Inquiry Commission begins to hold hearings to unravel the causes of the recent financial crisis, Congress again takes up the task of addressing the accuracy of disclosure regarding valuation of complex financial instruments sold to the public (pension funds and other institutional investors). Throughout the hearings, we can anticipate accusations of greed and retorts equating greater federal government intervention with paternalism. As regulators, independent experts and senior management of the largest financial services firms arrive in Washington DC, however, we should take this opportunity to consider carefully the broader weaknesses in the structure and substance of federal securities market regulation.
The testimony solicited publicly and privately prior to the commission’s inaugural meeting suggests that disclosure will present a critical point of departure for inquiries about the recent crisis. For example, Congress is likely to challenge the practices of banks that sold clients financially engineered products like collateralized debt obligations which involve the sale of interests in bundles of residential and commercial mortgages. While the same banks encouraged credit rating agencies to assign strong, positive ratings to these products to increase revenues, they contemporaneously entered into short position contracts on these investments which rewarded the banks when the CDOs declined in value.
While important, questions or legislation focused exclusively on increasing the quality and quantity of disclosure are myopic and solutions arising out of this approach will prove insufficient to address broader market concerns. Questions or legislation should also address financial innovation or the development of new financial products or uses of products or processes not previously available and the ethical obligations of the firms that develop and distribute these products, the fragmentation among securities market regulators and the absence of consistent, effective inter-agency collaboration and the influence of international economic interdependence and regulatory competition on the development of U.S. regulation and the regulation in foreign jurisdictions. As often is the case in the securities regulation debates, there are many challenging questions and far too few effective answers.
January 12, 2010 at 10:24 am
Posted in: Consumer Protection Law, Corporate Finance, Corporate Law, History of Law, International & Comparative Law, Securities, Securities Regulation
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Junior Faculty Workshops: GW in Business Law
posted by Lawrence Cunningham
For ages, academic institutions have promoted scholarly inquiry by younger faculty members, especially through the junior faculty workshop. Scores of US law schools host these regularly during terms; both the AALS and Law & Society run programs at their annual meetings; the Yale/Stanford junior faculty forum boasts wonderful annual draws; and now regional junior faculty workshops are rising, like that in the southwest next term, hosted by Arizona State.
Though these ventures focus on career stage, not field, more recent, school-sponsored forums add substantive focus. Junior faculty workshops appeared recently in environmental law (arranged jointly by Harvard, Berkeley and UCLA); family law (at Washington & Lee); national security law (at Texas); and federal courts (hosted alternately by American University and Michigan State).
You can soon add to that list business/financial law (including corporate, securities and banking) at George Washington. Next year, GW will inaugurate a series of Junior Faculty Workshops and Junior Faculty Prizes, seeking submission of papers in Fall 2010, for a celebratory academic event to be held in Spring 2011. This is one part of GW’s forthcoming Center for Law, Economics and Finance (C-LEAF), which also includes GWNY (posted about here).
While further details about these C-LEAF programs and descriptions of others must await a formal grand announcement, these Junior Scholar endeavors are ripe and time-sensitive enough to warrant advance notice.
December 18, 2009 at 11:12 am
Posted in: Corporate Finance, Corporate Law, Law School, Law School (Scholarship), Securities, Securities Regulation
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House Financial Committee Busy
posted by Lawrence Cunningham
The Staff of the House Financial Services Committee is extremely busy and doing a very good job of keeping its role in the legislative process transparent. A reasonable run down of current activity in financial regulation reform appears here. (You can even sign up to get email alerts.)
These bills are elaborate, complex and defy tidy characterization. All are likely to change, some significantly, as the legislative process grinds along. The Senate Banking Committee is unlikely to produce anything equivalent until well into November.
In general, however, together the House FSC’s work would make for sweeping change. The bills would:
(1) create three new federal agencies: a Federal Oversight Council, a Consumer Financial Protection Agency and an Office of Federal Insurance;
(2) considerably expand powers of the Securities Exchange Commission, including by subjecting rating agencies to considerable regulation and oversight by the SEC plus eliminate an exemption to the Investment Company Act of 1940 for private financial advisors.; and
(3) expand the mandate and powers of the Commodity Futures Trading Commission concerning regulation of derivative securities.
These pending Committee steps, of course, are in addition to bills the House passed earlier this year, including the summer’s Corporate and Financial Institution Compensation Fairness Act of 2009, embracing shareholder say on executive compensation to a certain extent.
At this link, you can access pending bills totaling just about 1,000 pages. Following is an additional breakdown: Read the rest of this post »
October 28, 2009 at 2:22 pm
Posted in: Consumer Protection Law, Corporate Finance, Current Events, Securities, Securities Regulation
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Smart or Not So Smart Money; The Limits on Derivatives and Regulating Them
posted by Deven Desai
The New York Times op-ed by Calvin Trillin, Wall Street Smarts, has a parable-like quality with the two characters meeting and exchanging wisdom. The lesson offered by the wiseman: “The financial system nearly collapsed,” he said, “because smart guys had started working on Wall Street.” The piece goes on to explain why that is a good explanation. It seems that the not-so-smart sat at the top of the heap and ran the companies: “Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.” There is also an claim about what is enough and what is greed in this tale. I leave it to others to debate or verify these ideas (our own Mr. Cunningham has been a favorite for me on these issues). Now, a paper by some folks at Princeton may show that not even the smart guys knew what they were doing.
As Andrew Appel explores in his post Intractability of Financial Derivatives, the computer science world’s Intractability Theory may better explain the derivative world than other theories. (the theory is used for DRM, cryptography, and more). The paper is Computational Complexity and Information Asymmetry in Financial Products (pdf) by Sanjeev Arora, Boaz Barak, Markus Brunnermeier, and Rong Ge.
For those who are interested in the topic and/or understand the math and theory behind the risk shifting involved in this area, check out Andrew’s post. He does a great job explaining how the paper applies to a CDO (collateralized debt obligation). If you need a little more to understand why this paper and its ideas are important, consider Andrew’s take away
In principle, an alert buyer can detect tampering even if he doesn’t know which asset classes are the lemons: he simply examines all 1000 CDOs and looks for a suspicious overrepresentation of some of the asset classes in some of the CDOs. What Arora et al. show is that is an NP-complete problem (“densest subgraph”). This problem is believed to be computationally intractable; thus, even the most alert buyer can’t have enough computational power to do the analysis.
Arora et al. show it’s even worse than that: even after the buyer has lost a lot of money (because enough mortgages defaulted to devalue his “senior tranche”), he can’t prove that that tampering occurred: he can’t prove that the distribution of lemons wasn’t random. This makes it hard to get recourse in court; it also makes it hard to regulate CDOs.
UPDATE: It appears from the comments to Andrew’s post that CDO and derivatives are not precisely the same thing. In addition, the comments explore the limits of the study. It is a good discussion.
ALSO check out the FAQ for the paper. It addresses many issues that the initiated may want to probe.
October 18, 2009 at 9:17 am
Tags: computer science, derivatives, securities law
Posted in: Corporate Finance, Corporate Law, Securities, Securities Regulation
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Fraud on a Crazy Market
posted by Kaimipono D. Wenger
Basic v. Levinson clearly sets out the theoretical justification for the fraud on the market theory:
The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business. . . .
Of late, it’s not so easy to tell this to my law students with a straight face. Read the rest of this post »
July 6, 2009 at 11:56 pm
Tags: financial crisis, fraud on the market, securities law
Posted in: Securities
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“A great vampire squid wrapped around the face of humanity”
posted by Kaimipono D. Wenger
That’s how Matt Taibbi describes Goldman Sachs in the opening paragraph of his 12-page Rolling Stone article (which, as far as I can tell, is available online only here, in moderately annoying scanned form). From there, Taibbi picks up steam. For instance, we learn that:
The bank’s unprecedented reach and power have enabled it to turn all of America into one giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumer credit rates, half-eaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you’re losing, it’s going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where its going.
Yikes!
Is this just another crackpot conspiracy theory? (Paging Mr. Stein, Mr. Ben Stein.) Nay — Taibbi has give us proof of Goldman’s nefari-iety. It goes more or less along these lines: 1. Goldman survived the Great Depression. 2. Goldman made some savvy bets in the past ten years. 3. Goldman pays really big bonuses. Read the rest of this post »
June 26, 2009 at 11:51 am
Tags: financial crisis, goldman sachs, market, money, securities law
Posted in: Corporate Finance, Corporate Law, Current Events, Securities, Securities Regulation
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Forms May Fail Big Four Auditing Firms
posted by Lawrence Cunningham
A common form of business organization designed to limit liability of participants may have failed the four largest auditing firms, according to a judicial opinion last week refusing a motion for summary judgment based on the design. The case, involving claims by defrauded investors in the Italian company, Parmalat, seeks to hold liable affiliates of the Italian accounting firm found culpable in the fraud, Deloitte S.p.A. The court refused to dismiss the latter’s US affiliate, Deloitte Touche LLP, and the Swiss entity that unites them, Deloitte Touche Tohmatsu.
If sustained after further fact resolution, the result would expose Deloitte US to crushing legal liability—and likewise expand the liability exposure of the other three large auditing firms that use similar structures (Ernst & Young; KPMG; and PriceWaterhouseCoopers). That, in turn, could increase the risks that one of those four firms may soon fail, which would make it difficult or impossible for many large publicly-listed companies to find outside auditors as required by federal securities laws. Ultimately, this could mean US federal governmental takeover of the traditional process of private audits of listed companies.
At issue in the Parmalat securities case against Deloitte is the standard structure that the four large auditing firms use. They operate as networks of scores of member firms organized as separate legal entities in jurisdictions where they practice. They enter into agreements that enable identifying members with the global brand name and practice of a global firm. These structures are designed to promote a recognizable professional identity while insulating each member from the others’ liabilities. The delicacy of the balance appears in how the court last week questioned its liability limiting efficacy.
February 3, 2009 at 7:27 am
Posted in: Accounting, Corporate Law, Securities
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The Hidden Wisdom of Merely Shaming Wall Street
posted by Frank Pasquale
President Obama has just called Wall Street’s billions of 2008 bonus dollars “the height of irresponsibility.” He has stated “It is shameful, and part of what we’re going to need is for folks on Wall Street who are asking for help to show some restraint and show some discipline and show some sense of responsibility.”
Recently both Dan Markel and co-blogger Danielle Citron have commented on the new trend of shaming these high-flying executives. I want to add one sincere argument against shaming, and one cynical one for it.
First, if Obama only wants to exhort Wall Street “to show some restraint and show some discipline”–well, that horse has left the barn. Even after the federal government has become part owner of their establishments, they reward themselves for behavior that brought their firms to near-ruin and the larger economy to the brink of depression. There is but one ethic operative here: get while the getting is good. Why should it stop now? As Robert Reich patiently explains, “You and I are paying Wall Street to lobby Congress to go easy on Wall Street:”
[W]hat’s happened to the Wall Street campaign contributions and to the lobbyists? They’re still going strong. We now know that many of the financial giants that have been bailed out by taxpayers continue to finance a platoon of Washington lobbyists, who are at this moment trying to influence TARP II and the next attempt to regulate Wall Street. In effect, your money and mine, and that of all other taxpayers, is paying these lobbyists to push Congress in a direction we have every reason to believe is not in our interests but in the continued interests of Wall Street. [emphasis added]
Citigroup, the recipient of $45 billion of taxpayer money so far, is still fielding “an army” of Washington lobbyists, according to the New York Times. Its lobbyists are working on a host of issues, including the bailout. In the fourth quarter of 2008, when it got its first infusion of bailout money, Citi spent $1.77million on lobbying fees. During the last three months of 2008, at least seven other firms receiving bailout funds (American Express, Capital One, Goldman Sachs, KeyCorp, Morgan Stanley, PNC and Bank of New York Mellon) lobbied the government about the bailout.
Which leads me to the hidden wisdom of the mere shaming sanction.
January 29, 2009 at 8:30 pm
Posted in: Corporate Law, Economic Analysis of Law, Politics, Securities
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What Did Steve Jobs Know, and When Did He Know It?
posted by Dave Hoffman
Joan Heminway has a great blog post on securities law aspects of the Steve Jobs health story. In part she argues:
At any rate, assuming the existence of a duty to disclose, both the general standard for materiality and the specialized probability/magnitude balancing under Basic v. Levinson, 485 U.S. 224, 232 (1988), for analyses of contingent or speculative information, may be applicable here. Is there a substantial likelihood that information about Jobs’ health is important to the reasonable investor in the market? Is there a substantial likelihood that disclosure of Steve Jobs’ health would be viewed by the reasonable investor as having significantly altered the total mix of information available to public investors? Finally, viewing information about Steve Jobs’ health as contingent or speculative information about his continued tenure as the CEO of Apple, does a balancing of the probability that he will not be able to continue to lead Apple against the magnitude of his departure from Apple (as an iconic founder/CEO) counsel disclosure? Yes, yes, and yes.
To read more of Joan’s views, check out her article on the materiality aspects of Personal Facts About Executive Officers.
January 15, 2009 at 8:11 pm
Posted in: Securities
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The Failing TARP
posted by Frank Pasquale
The more one reads about basic problems in the handling of $700 billion in emergency economic stabilization funds–and the Treasury’s stonewalling response to even the most basic questions about their disbursement–the more worries pile up. Congressional Oversight Panel chair Elizabeth Warren suggests that some basic tools designed to prevent corruption in the administration of the program are not yet apparent. That’s particularly shocking given Michael Lewis & David Einhorn’s smart commentary on the problems that sunk us into this crisis:
At every turn we keep coming back to an enormous barrier to reform: Wall Street’s political influence. [Even the Securities and Exchange Commission is] compromised by [Wall Street's] ability to enrich the people who work for it. Realistically, there is only so much that can be done to fix the problem, but one measure is obvious: forbid regulators, for some meaningful amount of time after they have left the S.E.C., from accepting high-paying jobs with Wall Street firms.
Lewis & Einhorn suggest several other solutions that I’ll quote below:
January 6, 2009 at 8:15 am
Posted in: Economic Analysis of Law, Securities
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Jonathan Lipson’s Auto Immune: The Detroit Bailout and the Shadow Bankruptcy System
posted by Dave Hoffman
[Jonathan Lipson has been a terrific, episodic, contributor to CoOp on the bankruptcy aspects of the financial crisis and the bailout. He approached me about posting the following very useful set of thoughts about the auto-mess, which I'm happy to now share with you.]
Today’s New York Times reports that President Bush now recognizes that the auto industry’s disease may be worse than the bankruptcy “cure.”
Despite ominous threats that the administration would leave the industry to an “orderly reorganization”, the President is now apparently willing to release about $17 billion in TARP funds, to save the auto industry (at least for a while) from Chapter 11.
According to the Times, the President now believes that:
bankruptcy was not a workable alternative. “Chapter 11 is unlikely to work for the American automakers at this time,” Mr. Bush said, noting that consumers would be unlikely to purchase cars from a bankrupt manufacturer.
While I am ordinarily a cautious supporter of the Chapter 11 reorganization system — and suspect much of today’s trouble could have been averted (or at least minimized) if Bear Stearns had been permitted to go through Chapter 11 — I think this is probably the right move, albeit for the wrong (stated) reasons.
December 19, 2008 at 3:03 pm
Posted in: Bankruptcy, Corporate Finance, Corporate Law, Securities
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IBG: Foundation of American Finance Capitalism?
posted by Frank Pasquale
Thomas Friedman delivers today with a column that makes me proud he’s a fellow Marshall Scholar. My favorite paragraphs:
I have no sympathy for Madoff. But the fact is, his alleged Ponzi scheme was only slightly more outrageous than the “legal” scheme that Wall Street was running, fueled by cheap credit, low standards and high greed. What do you call giving a worker who makes only $14,000 a year a nothing-down and nothing-to-pay-for-two-years mortgage to buy a $750,000 home, and then bundling that mortgage with 100 others into bonds — which Moody’s or Standard & Poors rate AAA — and then selling them to banks and pension funds the world over? That is what our financial industry was doing. If that isn’t a pyramid scheme, what is?
[T]his legal Ponzi scheme was built on the mortgage brokers, bond bundlers, rating agencies, bond sellers and homeowners all working on the I.B.G. principle: “I’ll be gone” when the payments come due or the mortgage has to be renegotiated. . . . The Madoff affair is the cherry on top of a national breakdown in financial propriety, regulations and common sense.
Thank you, Mr. Friedman. Finally, respectable opinion is coming around to a view that the “man on the street” has intuited for some time: the recklessness of contemporary finance capitalism is systemic, not merely the product of a few bad apples. A passion for deregulation and budget cuts left an administration unable to detect even the grossest frauds. In that culture, virtually anything went. And as the Bush years come to a close, I expect many inspector generals across the administrative state will be detecting ever more wrongdoing.
December 17, 2008 at 9:20 pm
Posted in: Current Events, Economic Analysis of Law, Law and Inequality, Securities
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Plutocrat Putsch
posted by Frank Pasquale
The IMF’s quarterly magazine Finance and Development has a number of good articles on the financial crisis, with Noel Sacasa’s Preventing Future Crises leading the pack. He identifies “four sets of innovations and structural changes” that rendered the system unstable:
[P]rocyclical capital and accounting practices and regulations; excessive reliance on backward-looking, market-based risk management models and systems; and a more complex and opaque configuration of players; [and] the originate-to-distribute business model and reliance on wholesale funding markets.
Each of these is worth unpacking in a little more detail before discussing his solutions.
December 15, 2008 at 8:18 am
Posted in: Economic Analysis of Law, Securities
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A Total Breakdown in Trust
posted by Frank Pasquale
The recent Madoff scandal, along with the ongoing Blagojevich farce, are almost too repulsive to blog about. The sheer chutzpah of the banker and stupidity of the politician are breathtaking. The Panglosses among us would like to believe that a “few good men” could have averted something like the banking crisis–a Bullworth-meets-Carlyle theory of history. But it’s increasingly apparent that our Darwinianly structured markets and politics have made fitness synonymous with greed and self-dealing in far too many settings.
That’s one reason why this Speaking of Faith interview with moralist Parker Palmer is so refreshing. It is rich with ideas and insights, and at the core are Palmer’s ideas about the necessity of trust and community. Here is a brief glimpse of the ideas discussed:
Alexis de Tocqueville [essentially argued] that the French Revolution happened long before it happened. The eruption that shattered French society at the end of the eighteenth century was the result of small seismic shifts that had been accumulating for decades deep underground. If people had paid attention to the tectonic instabilities caused by greed and injustice, and had responded wisely to the nervous needles on their inner seismographs, the “Reign of Terror” might have been avoided.
A parallel point can be made about the economic terrors that now engulf America: at some level, most of us knew they were coming. Who doesn’t know that a society in which the rich get richer while the poor get poorer is a society that will someday have to pay the piper? Who doesn’t know that when a relatively small fraction of the world’s population uses its power to command and consume a disproportionately large fraction of the world’s resources, the chickens will come home to roost? Who doesn’t know that an economic system that encourages us to live beyond our means and refuses to regulate greed is one in which our avarice will come back to bite us? Who doesn’t know that at every level of life, from personal to global to cosmic, what goes around comes around?
[Unfortunately, while r]eclaiming identity and integrity in personal and public life may make you a person who evokes the better angels of our nature . . . it will not improve your “bottom line” — at least not in the understanding of that phrase that has landed us in so much trouble. Take, for example, the companies that banks hire to identify people on the verge of foreclosure, people so desperate to salvage their homes that they can be conned into signing up for yet another mortgage scam. Who cares about destroying these families’ finances, along with the credit market itself, as long as the scammers’ bottom lines improve?
Palmer has great wisdom to offer in the face of the terrible incentives we all face in a “devil take the hindmost” society. And his book The Courage to Teach is a great guide for educators as we try to take stock of the moral challenges of our own institutions and profession.
December 13, 2008 at 3:40 pm
Posted in: Economic Analysis of Law, Securities
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Fraud, Everywhere
posted by Danielle Citron
Recent investor pressure to liquidate investments has exposed fraud of massive proportions. On Thursday, federal investigators arrested trader and hedge fund manager Bernard L. Madoff, a former chairman of the Nasdaq Stock Market, for allegedly defrauding investors of $50 billion. According to the accompanying civil complaint filed by the SEC in federal district court, Madoff ran Bernard Madoff Investment Securities (BMIS), a broker dealer and investment firm, where he also maintained a lucrative investment adviser business. Madoff apparently kept that business on a separate floor of the firm under “lock and key” from BMIS employees. There, Madoff managed money for hight net-worth individuals, hedge funds, and other institutions, a business whose steady returns had long provoked skepticism from traders. Early this month, investors sought $7 billion in redemptions from the business. Unable to pay these returns, Madoff allegedly confessed to two senior employees (his sons, according to the Wall Street Journal’s sources) that his investment advisory business was a fraud. Madoff allegedly admitted: “it’s all just one big lie,” a “giant Ponzi scheme” that for years had paid returns to investors out of the principal received from other investors and had nothing left. Madoff apparently told those employees that the business had been insolvent for years and the fraud was worth billions.
This recalls 1987, the “Den of Thieves” period of insider trading, risky takeover stocks, and manipulations of the junk-bond market. As Time reported that year, maintaining integrity was a “difficult challenge in the deregulated, hurly-burly Wall Street of the 1980s, where traders have been tempted to use insider tips to maintain their competitive edge.” Now, as then, fraud has blossomed in the face of loose regulatory controls and oversight as well as a lack of transparency in a complex financial market. One might suppose that our current task is to figure out how to strike the balance between tougher regulation and a productive and unencumbered market. But there are no doubt other important questions, and hopefully our insightful corporate/law and economics gurus Dave, Frank, Lawrence, and Nate will help us explore them.
December 13, 2008 at 9:44 am
Posted in: Criminal Law, Culture, Current Events, Securities
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Our Wonderful Financial Sector: Alchemy + Gotcha Capitalism
posted by Frank Pasquale
The PBS program NOW features an excellent discussion of the crucial role of the ratings agencies in the current financial meltdown–and a good page of background materials. Professors Frank Partnoy and Joseph Stiglitz discuss how “top PhD’s” and “math geniuses” seduced investors into accepting assumption-ridden models. Maria Hinojosa asks one of the rocket scientists: “You just said you didn’t have sufficient data to make [these] huge assumption[s]. This is astounding. If you didn’t have the data, and you’re a data-based credit rating agency, why not walk away?” The only answer: incredible revenue potential for rubber-stamping the bad paper. Hinojosa grills many players at the heart of the industry, and tells the full story behind the brazen email messages and IMs:
“it could be structured by cows and we would rate it”
“model definitely does not capture half the risk”
“let’s hope we are all wealthy and retired by the time this house of cards falters 
)”
That’s the essence of the Wall Street we are now spending untold (and apparently unknowable) billions to bail out–gloating emoticons over opportunistic profiteering. The three CEOs of the ratings agencies earned $80 million themselves over the past 6 years. As Nobelist Stiglitz has stated, we have a “peculiar form of capitalism” in America–”wizards of Wall Street walk away with the profits, and taxpayers are stuck with the losses.” CDOs were the new fool’s gold for Wall Street’s alchemists.
December 2, 2008 at 6:42 pm
Posted in: Corporate Finance, Securities
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The Continuing Triumph of Trickledown
posted by Frank Pasquale
No comment needed here:
U.S. banks getting more than $163 billion from the Treasury Department for new lending are on pace to pay more than half of that sum to their shareholders, with government permission, over the next three years. . . . Critics, including economists and members of Congress, question why banks should get government money if they already have enough money to pay dividends — or conversely, why banks that need government money are still spending so much on dividends. . . .
“The whole purpose of the program is to increase lending and inject capital into Main Street. If the money is used for dividends, it defeats the purpose of the program,” said Sen. Charles E. Schumer (D-N.Y.). . . [But] Ed Yingling, chief executive of the American Bankers Association, said he was increasingly hearing from banking executives who feel they should not be forced to accept money with so many strings attached.
Indeed–how dare we even ask what the money is being used for? Mightn’t that destroy valuable trade secrets of these dynamic innovators?
October 30, 2008 at 10:22 am
Posted in: Securities
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Parasitism, Inc.: A Deficient Markets Hypothesis
posted by Frank Pasquale
Accoring to an article by Jonathan Ford of Prospect, the finance sector gobbled up nearly 35% of total corporate profits in the US and Britain in 2005. As financier-turned-academic Paul Woolley observes in the piece, “There is no economic merit in a sector that makes exceptional profits and devours capital and labour, and then justifies it on the grounds that you can get some ‘cash back.’”
Woolley’s analysis animates the article and should wake up anyone still complacent about the validity of the “efficient markets hypothesis.” Ford points out a cozy revolving door relationship between academics, regulators, and tycoons in high finance. All were complicit in a parasitic reallocation of money from the real economy to speculative games designed to enhance cream-skimming at the top:
While the efficient market idea held sway, academics viewed the expansion of finance with equanimity. . . . Financial instruments always existed for a purpose—such as to pass on risk cheaply and efficiently to the investor best placed or most willing to bear it. If that were not the case these products simply would not exist. More trading was beneficial because it enhanced liquidity, and liquidity lowers costs and promotes efficient pricing.
But, according to Woolley, the scale of derivatives trading should be seen as symptomatic of distorted markets. . . . [M]omentum causes mispricing which in turn creates an insatiable demand for active management. This then spills into the derivatives markets in various ways. For instance, the investor responds to the volatility of the equity market by hedging his risk and buying a put option (giving the right to sell shares at a pre-determined price). The seller of the put protects his own exposure by selling equities. The investor has thus brought about, at a cost, the very event he was seeking to insure against.
Both Ford and Woolley still endorse “market solutions” to the crisis, such as “lengthening the period over which performance is assessed,” so that bonuses depend less on quarterly and annual results. Dilip Abreu has proposed similar realignment of incentives for ratings agencies. But I’d like to see more public involvement in investment decisions generally–a move featured in the stimulus plan Timothy Canova has suggested.
October 28, 2008 at 10:39 pm
Posted in: Corporate Finance, Economic Analysis of Law, Law and Inequality, Securities
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