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Category: Securities

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

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

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

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

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

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

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

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

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Fraud on a Crazy Market

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 More

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

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

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

Yikes!

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

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Forms May Fail Big Four Auditing Firms

org chart.jpgA 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.

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The Hidden Wisdom of Merely Shaming Wall Street

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.

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What Did Steve Jobs Know, and When Did He Know It?

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.

The Failing TARP

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:

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Jonathan Lipson’s Auto Immune: The Detroit Bailout and the Shadow Bankruptcy System

lipson.JPG[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.

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IBG: Foundation of American Finance Capitalism?

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.

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Plutocrat Putsch

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.

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