Category: Securities

Recommended Reading: The Buyout of America

As lawmakers squabble over the “carried interest” tax rate, it’s nice to find a big picture overview of some of the economic activity they’re discussing. I recently read Josh Kosman’s book The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis, and I highly recommend it to our readers. Kosman painstakingly describes the byzantine financial maneuvers behind marquee private equity firms which bought “more than three thousand American companies from 2000-2008.” He describes in detail how they resist transparency (164) and “hurt their businesses competitively, limit their growth, cut jobs without reinvesting the savings, and generate mediocre returns” (195). The recipe for high earnings is simple: the firms “get large fees up front and are largely divorced from their results if their transactions fail” (195).

Like Kwak and Johnson’s account in 13 Bankers, Kosman offers a political economy account of private equity’s favored treatment by government. As he notes,

[F]our of the past eight Treasury Secretaries joined the PE industry . . . . and they have significant influence in Washington. President Bill Clinton, and both President Bushes, have also advised PE firms or worked for their companies. . . . KKR retained former Democratic House majority leader Richard Gephardt as a lobbyist and hired former RNC chairman Kenneth Mehlman as head of global public affairs. (196)

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GW’s Junior Scholar Workshop and Prizes

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. Read More

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Nonlinear Theory Explains May 6 Market Break

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. Read More

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The Center on New Fin Reg Duties

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.  

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SCOTUS Chides Posner/Easterbrook in Jones v. Harris

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

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

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

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

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

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Wheel of Fortune? Not Your Family Board Game

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.

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A Greek Tragedy

A Greek Tragedy

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

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

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

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

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

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

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Asking new questions or at least hoping for more useful answers

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

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

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

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

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

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Junior Faculty Workshops: GW in Business Law

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

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

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

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

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House Financial Committee Busy

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

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

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

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

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

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

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

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