The Manicures Don't Matter; the Campaign Contributions Do

There are going to be more shocking revelations of Wall Street decadence in coming weeks; AIG's managers' manicures are just the beginning. While not yet demagogic, this focus obscures the real story of our ongoing economic collapse: the self-reinforcing cycle of money and favors that led to disastrous policy choices not to regulate the finance industry more. Ellen Miller of the Sunlight Foundation has summarized the process: "the finance, insurance and real estate (FIRE) industries that collectively are at the center of the current crisis are the single largest sector–by far–of all the major economic and interest groupings that give campaign contributions to federal politicians." Here is Larry Makinson's visualization (if you like Edward Tufte, you'll love this):

In media prone to parrot compartmentalized "experts," these relationships between economics and politics are rarely in the foreground. It was refreshing to hear Danny Schechter make the connection on the Tom Ashbrook show when an apologist for laissez-faire started talking about how important a government policy of increasing homeownership was to the current crisis. Schechter simply asked: who lobbied for that policy? or for no regulation of derivatives? or for the SEC's oxymoronic "self-regulation?"

Anyone with a nodding acquaintance with Charles Lindblom's Politics and Markets (or Owen Fiss's Why the State) understands the problem of circularity--the intimate interconnection of political and economic elites. Real campaign finance reform would help break down those ties. As it stands, Wall Street titans can use the tens of millions of dollars they earned in the "boom" to influence policy during the bust--and can count on the Supreme Court to slap down any "millionaire's amendments" that could retard that process.

As we reap the whirlwind of years of conspicuous consumption and positional competition, we may want to consult the thought of Thorstein Veblen, who never cordoned off economic thought from the types of political and psychological analyses necessary to understand flows of money and power:

[A] prime theme (or principle) of Veblen’s is that of institutional holism, which is advanced in various ways in all his works, but . . . especially in The Theory of the Leisure Class (1899). Central to holism is the need to study the interplay of social, political, and psychological factors in the determination of economic processes. Economics is part of an open system, with determination including values, beliefs, individuals, institutions, social behaviours and human-centred aspects of the provisioning process. Every aspect of economics, in this view, needs to be situated within a broad framework of reference in order to comprehend adequately the nature of the processes in motion and to recognise the element of novelty and creativity that are prime factors in change (along with blind drift).

At least we can now recognize where the "blind drift" of a politics mastered by market forces has led us.

Posted by Frank Pasquale at 06:00 PM | Comments (2) | TrackBack

Looting, Wall Street Style

A House Committee is uncovering machinations of Lehman execs before the firm's collapse:

One Lehman document among thousands reviewed by the House committee showed that four days before the bank filed for bankruptcy protection, Lehman’s compensation committee was asked to grant $20 million in “special payments” for three executives who were leaving, Mr. Waxman said. An e-mail exchange recommending a delay in bonus payments was apparently brushed aside.

Another document showed that executives were warned in a January 2008 meeting that the company was facing liquidity problems. Yet the firm moved forward with capital outlays, including $5 billion in bonuses, $4 billion in shares and $750,000 in dividend payments between 2007 and the firm’s bankruptcy filing on Sept. 15.

Do they teach this in business school? I hope at some point all the deans of major B-schools read Rakesh Khurana's From Higher Aims to Hired Hands: The Social Transformation of American Business Schools and the Unfulfilled Promise of Management as a Profession. As Tom Ashbrook noted in a great podcast on the topic, Khurana describes how "business schools have failed in their promise; . . . they are turning out hedge fund hotshots who don’t build companies but tear them down." And i-bankers who might be hard to distinguish from looters.

Posted by Frank Pasquale at 02:06 PM | Comments (0) | TrackBack

Where's the SEC?

Credit market dramas have put the Securities and Exchange Commission in the background, where Chairman Chris Cox is being stung by rebuke for his neglect of investor interests and capital market safety, while fiddling away with luxury items few care about like high-tech financial reporting called XBRL. Now stalled yet again, despite earlier exuberance, is the SEC’s proposal to switch the US from its own accounting standards (GAAP) to new international financial reporting standards (IFRS).

Mr. Cox formally began to back this initiative aggressively early last year. He staked much of his legacy on it. Auditors and managers favor it and benefit from it. Investors and auditing standard setters express serious reservations about the plan, which many say has been rushed. Even the SEC seemed to accept this criticism, most recently saying it would propose a longer timetable for the shift than Mr. Cox and the SEC initially imagined.

Still, the SEC promised a month ago, on August 27, that a Release outlining milestones on this road would be forthcoming shortly. As of today, the SEC has issued no such Release, despite the SEC Chief Accountant, Conrad Hewitt, and Corporate Finance Chief, John White, describing its contents and assuring the public one would be forthcoming “this summer.”

Why not?

It is hard to believe that it’s because the SEC is too busy with pressing matters concerning the credit crunch. After all, its campaign to curb short selling has largely been functionally outsourced to the New York Stock Exchange. Investment banking firms previously subject to its jurisdiction are no longer: Bear Stearns and Lehman Brothers are bankrupt; Merrill Lynch is to become part of Bank of America; and Goldman Sachs and Morgan Stanley are reregistering as banks under supervision of the Federal Reserve rather than the SEC.

On the other hand, the SEC is busy fielding campaigns by lobbyists, especially the American Bankers Association, which is meeting with the SEC tomorrow, to eliminate accounting rules requiring reporting certain investments, including those at the heart of the credit crunch, at fair value (“marking them to market”). That requirement of GAAP also appears, in slightly different form, in IFRS. For an SEC sympathetic to friends like the ABA, it is easier to change GAAP (simply passing regulations overruling our domestic accounting standard setter) than to change IFRS (requiring the US to opt out of an international protocol that would risk embarrassing the US as antagonistic to the international standard setter).

Two other speculative explanations for the SEC’s delay appear. First, Mr. Cox may have decided now is not the best time for the SEC to issue a Release that would be largely deregulatory and elevate managerial and auditor interests over those of investors and other users of financial reports. Second, Mr. Cox may believe that he should have unanimous Commission support for such a controversial Release. This may be more difficult now that he must work with a full slate of Commissioners, compared to earlier this year when vacancies existed. Some current Commissioners may side with investors and oppose the Release.

Despite the SEC’s earlier exuberance, there no longer appear to be reasons for Mr. Cox to continue a quixotic campaign to move the US from its own to international accounting standards. For Mr. Cox, the consequence is being deprived of a legacy he sought. For investors, that would be a good thing too.

Posted by Lawrence Cunningham at 07:24 PM | Comments (3) | TrackBack

Marcy Kaptur Lays Down the Law

This is an outstanding commentary on the bailout:

Are other politicians going to recognize the deeper structural roots of the present problems in financial markets? Simply printing more money is not an option:

The size of the bailout, analysts said, has focused attention on just how much debt the United States can handle without being forced to raise taxes or make sharp cutbacks in government spending. Peter Schiff, [commented on] the fear of inflation provoked by the $700 billion plan . . . . "Where's the tax increase to fund this bailout? Where is the cut in programs? The government's not doing either -- they're just going to print money," he said. "And if you think inflation is the answer, take a trip to Zimbabwe and see how it's working for them."

And yet it looks as if we are about to be stampeded again.

UPDATE: David Bernstein has interesting insights on the homebuilding industry's plea for a bailout--including CEO compensation figures at some leading firms in 2005. Does anyone have leads on estimates of the average level of compensation (for the past three to five years) among the top 100 earners at the large financial institutions about to be bailed out?

Posted by Frank Pasquale at 08:29 PM | Comments (8) | TrackBack

Chapter 11 as Metaphor: The Financial Systems Restructuring Act of 2008?

Last week, when all that was on the table was the mere collapse of a few investment banks and one large insurance holding company, I posted Jonathan Lipson's lucid analysis, identifying the "selective socialism" of A.I.G.'s bailout as a consequence of the Bankruptcy Amendments of 2005.

Now that we're frying bigger fish, I wondered what Lipson would say. His comments follow:

There are many options for a bailout. One that has received surprisingly little (if any) attention in Washington is reorganization under Chapter 11 of the United States Bankruptcy Code.
Strictly speaking, Chapter 11—which governs business reorganizations—would not apply in any meaningful way to many of the entities that are concerned here. Nor should it. But its general approach may, by analogy, be instructive.

Chapter 11 is a response to the collective action problem presented by a company’s general default. It is designed to enable parties to work out—restructure—legal and economic relationships with a mix of market incentives and government oversight. Some features of that system might, by analogy, help to avoid the growing stalemate in Washington while also creating mechanisms that actually resolve the underlying financial problems.

What, then, might a Financial Systems Restructuring Act of 2008 modeled on Chapter 11 do?

Stay

The Bankruptcy Code provides that the commencement of a case creates a stay of collection actions. This is vital, since it enables a troubled business to focus on correcting underlying problems rather than responding in ad hoc fashion to large numbers of collection suits.

Here, a stay might temporarily halt foreclosures on homes and enforcement of the various instruments currently in private hands that are apparently in default (or about to default). It could temporarily stay collection on credit default swaps. It would only be temporary, while a more fulsome plan is developed (see below).

Financing

Simply freezing the market, without more, would be the disaster Paulson legitimately seeks to avert. So, the government must inject capital and acquire some distressed assets to revive the capital markets.

Bankruptcy reorganization contemplates this through what is known as “debtor in possession financing,” where banks or other financial institutions make short term (usually) high interest loans to finance the process of a company’s reorganization.

Here, the Fed may lead a syndicate of lenders to provide short term financing to keep capital markets functioning, with the understanding that this financing would have to be repaid. It might be repaid in whole or in part by the Federal government, but that would depend on the development of a more fulsome plan (see below).

Today, of course, we do not know how much is really needed to stabilize markets in the short term. Paulson wants $700 Bn. But, like the claim that Iraq had weapons of mass destruction, I have seen no credible evidence supporting this number. Paulson and Bernanke admit that it may be too much or too little.

There is likely to be some smaller number that would stabilize the markets until, say, after the election. I don’t know what that is. But I would certainly hope that it was something far south of $700 Bn.

Market Testing—Treasury as Stalking Horse

The reason Paulson and Bernanke can’t tell us the right number is because there has been a market failure. No one, apparently, wants to purchase the toxic paper. If the market is what a willing buyer would pay a willing seller then, strictly speaking, the paper has a value of $0.

But in the long run, that seems unrealistic. I am sure that many CDOs were issued with nothing but smoke and mirrors behind them. They probably are worthless. But I am equally sure that many MBS are backed by real mortgages that really are worth something. We need to develop some mechanism for assessing the value of these securities, for many reasons.

Reorganization under Chapter 11 offers a helpful analogy. It contemplates fairly quick sales with auction mechanisms designed, at least in theory, to maximize asset values.

Here, rather than simply buying securities wholesale in the opaque and unaccountable way proposed by Paulson, perhaps the Treasury should be the statutory stalking horse in a series of controlled auctions, buying only where no one else will. I don’t know what formula should be used to set the initial price, but suspect that if this is done in some reasonably transparent way, it would produce better values and help to revive the market.

Reorganization Plan

There has to be some larger plan about how to address the underlying problems. In Chapter 11, this is called a plan of reorganization, and becomes the contract between the debtor and its stakeholders if enough of them support it.

A reorganization plan takes time to develop, but is essentially a set of rules that define how the affected parties will behave going forward. I am of the (admittedly under informed) view that much of the trouble here was driven by investment bankers’ and hedge fund managers’ fee incentives to issue and buy as much paper as possible, and the credit rating agencies’ incentives to provide unrealistic ratings of that paper because they were paid by the sellers, not the buyers. If these were the problems, a plan should include rules that address these problems going forward.

It should also contain a funding mechanism. Here, the initial funding might come from Treasury. But it seems possible to establish various mechanisms for recouping or minimizing some of the costs, whether through the auctions described above or in the form of fees paid by the largest beneficiaries of the bailout, or equity in those entities, or new debt issued by them, and so on. Some of these proposals are already on the table.

One of the problems with the Paulson proposal—which the Senate response does not really address—is how to value whatever it is the government gets in the bargain. Everyone now agrees that the government should get something--an “equity interest” or maybe debt of firms whose toxic paper the government acquires. But how much equity? At what valuation? With what rights?

These questions are usually at the heart of the negotiations over a Chapter 11 reorganization plan. We can’t really answer these questions now, however, because we don’t know enough about the underlying values.

I suspect part of what concerns Congress and the taxpaying public is that Paulson’s proposal simply sounded like more “planning by opportunity,” which is really no plan at all. Congress has legitimate concerns, many of which could be addressed in an intelligent plan. But that takes time. Using a stay, short term financing and controlled auctions may buy the time and gain the information we need to better understand the real problem and develop a more lasting and effective response to it.

Governance

A central feature of Paulson’s plan was that it made no real effort to change the governance of financial institutions. Executives would keep their jobs. The Treasury would acquire bad assets, not bad firms (although one could argue that enough bad assets make for a bad firm). Congress has responded with a much more rigorous oversight program, which might help.

Part of the logic of Chapter 11—and what distinguishes it from many other bankruptcy systems—is that management gets to remain in possession and control of the troubled company. But, there is considerably more oversight, both by the government (in the form of a bankruptcy judge and the office of the United States Trustee) and stakeholders (in the form of committees of creditors and equity holders) than in the marketplace generally.

Here, governance would remain with companies that participate in the program. But, picking up on the Senate bill, oversight would be provided by an Emergency Oversight Board, or similar entity. It would review not simply the decisions of the Treasury Secretary but consider how those decisions affect all stakeholders, including taxpayers and financial institutions. It might function like a combination of a bankruptcy judge and creditors’ committee. And, its decisions, like the decisions of the Treasury Secretary under the Senate bill, would be subject to some administrative and judicial review.

Recoveries

There’s a great deal of discussion about how much Wall Street executives should be “punished” for this. That’s an understandable sentiment.

But this sort of talk is not likely to get executives excited about any plan. Among other problems, merely capping future compensation simply gives executives an incentive to do nothing. If they are terminated by a board that wants them to compromise and work with Treasury, they may well sue on their employment agreements and hope for the best.

I am frankly less concerned about executive compensation going forward than I am about recovering from those who caused the problems. It seems to me unlikely that capping John Thain’s future salary (were Merrill independent and seeking a bailout) is likely to do much good. But getting back the $57 million Stan O’Neill took away might be a good (if small) start.

How would that be possible? Bankruptcy incorporates a number of traditional legal mechanisms for avoiding transfers of property, or remedying other conduct, that might have harmed a debtor.

Here, this would mean that someone like the special inspector general (SIG) contemplated under the Senate proposal might be empowered to investigate the banks and hedge funds that played a major role in this crisis and to sue under recognized (albeit perhaps strengthened) principles of fraudulent conveyance, breach of fiduciary duty, professional negligence, etc, with the recoveries going to the Treasury, subject to appropriate oversight.

The SIG would have to be given explicit standing to sue on behalf of these entities. This won’t sit well with everyone, but those who have little to fear should have little to lose.

Questions

Using reorganization as a metaphor would obviously leave many questions. After all, the whole point of Paulson’s initial proposal was to avoid the equivalent of bankruptcy—taking banks over.

The political standoff at this point seems to reflect competing ideologies. The administration says “trust us” and the market will heal itself. The Democrats seem to want something much closer to the Resolution Trust Corporation which really did take over failed banks. Republicans don’t seem to know what they want—other than to be (re-)elected.

None of this seems promising.

Restructuring as contemplated by Chapter 11 of the Bankruptcy Code can be seen as a third way, a hybrid, that might give us time and information that would permit cooler heads to really figure out what’s going on without an unchecked giveaway or total system meltdown.

Posted by Dave Hoffman at 05:57 PM | Comments (2) | TrackBack

A Defense of the Bailout, and a New Divide

My colleague Stephen Lubben has written a brief defense of the bailout, available here. He asks: "Foregoing the bailout likely means freezing up the financial system for a good, long time -- are we really ready to say no home or car loans until 2010?" But it's unclear whether, in the game of chicken now going on at Capitol Hill, there will be enough transparency in the final bill to make it plausible. We can hope for some Doddian tweaks, but perhaps most interesting here is the new political divide the bailout is uncovering.

The people who are most dismissive about this plan are on opposite sides of the political spectrum. Todd Zywicki calls it a "blunderbuss bailout" that recalls the worst aspects of the New Deal; Nation blogger Christopher Hayes analogizes it to a Nigerian spam scam. Greenwald articulates a realist/populist case against trusting the experts here:

Economic policy in this country has been dictated by Wall Street for the past two decades because . . . [it] funds both political parties. The face of Clinton's economic policy of the 1990s, Robert Rubin, had exactly the same background as Hank Paulson, the Treasury Secretary who presided over the current crisis -- former Chairmen of Goldman Sachs. These aren't Sober Traditionalists who shunned the complex derivatives [often blamed] for this crisis. . . . They're people who became wildly rich as Goldman Sachs led the way in staking the nation's economic health on those reckless instruments.

One can look at these economic disputes in terms of "Republican v. Democrat" but, when it comes to economic policy, that is often unhelpful because the core leadership factions of both parties are funded and controlled by the same corporate interests. . . . [W]hile cultural wedge issues have divided ordinary American on the Left and Right, there is a growing, angry populism among both factions against the dominant Washington establishment elite that is so transparently running the Federal Government on behalf of the tiny group of corporate elite which funds and owns them. The backlash against the Paulson plan on both the Left and Right is a function of that same anger and resentment.

Populism has become something of a dirty word in contemporary American political discourse. But when John McCain proposes that "bank executives who take the mortgage bailout should have an annual salary limit of $400,000," a serious re-think of current priorities may be in the air. Here's the background:

McCain . . . blasted a plan by Lehman Brothers, which filed for bankruptcy last week, to set aside $2.5 billion in bonuses for its executives. The bonus pool was first reported by The (London) Sunday Times, and was on the front page of Sunday's New York Post as "GALL STREET." "I notice at Lehman ... some $2.5 billion in compensation," McCain said. "If they're bankrupt, where did they get that? But the major point is that no CEO of any corporation or business that is bailed out by us, that is rescued by American tax dollars, should receive any more than the highest paid person in the federal government."

I'd propose some similar rules for, say, Blackwater or other wartime contractors--to the extent they receive government funding, there ought to be some caps on compensation keyed to some reasonable multiple of what regulators make. (I'm eyeing the "single digit ratio" on punitives presently.) How else can we assure that regulators are competent enough to catch the crooks? Capping compensation is also an important part of the way Medicare and the VA hold down costs. If the government is to get as involved in the finance sector as it has been in the health care sector, we should consult the massive literature on health care finance in order to get the balance right.

What Robert Kuttner has written about the health care sector may apply a fortiori to efforts to preserve "private initiative" in a now massively subsidized financial sector:

Ironically, by maintaining a largely private health insurance system aimed at limiting the reach of government regulation, we reap ever more complex regulation to compensate for the inadequacies of that very system. . . . In a universal system . . . there is no regulatory need to resolve issues of continuity and eligibility, let alone interminable certifications, appeals, and adjudications. . . .There are no questions of rate-banding, cross-subsidies, guranteed issues, or permissible exclusions for various categories of applicants and conditions. . . .

My sense is that all those types of issues will come up for the "quasi-nationalized" companies slated to benefit from Treasury's plan. We need to assure that the bailout does not become a shell game of hidden subsidies to inefficient and venal private actors.

Perhaps it's impossible for the government to step in and become a direct lender instead of banks. But it would be so dispiriting to see this crisis's authors walking away with massive handouts because of the very problems they created. We cannot underestimate the size of the spend we are being asked to authorize:

$700 billion . . . is roughly what the U.S. has spent to prosecute the war in Iraq to date, and nearly $2,300 for every man, woman, and child in the country. Added to the $200 billion that could go toward shoring up Fannie Mae (FNM) and Freddie Mac (FRE), and the $85 billion the government has pledged to acquire most of insurance giant American International Group (AIG), the potential price tag for taxpayers soars to near $1 trillion. That's just under half what the country spends annually on health care.

Though some of that health care spending is wasteful, most goes to hardworking doctors, nurses, researchers, and other vital service providers who actually improve people's health. Have the bailout beneficiaries produced goods or services even a fraction as valuable?

Posted by Frank Pasquale at 01:42 PM | Comments (4) | TrackBack

Some Skeptical Questions About the Bailout

A group of my colleagues and I have been discussing the bailout in email. One of them, impeccably centrist, has raised some fundamental objections to the plan that I wanted to share with a wider audience. With his permission, I reprint them below.

1) The Treasury is proposing to buy assets that no one knows how to value. Perhaps it is a deal like Alaska [aka Seward's Folly], where the government can pick up assets at bargain basement prices from distressed sellers. On this theory, the derivatives (and presumably the underlying mortgages and houses) are worth more than the irrationally fearful market realizes.

But why do we have any reason to believe that the market isn't valuing these assets correctly? In fact, given the absence of a market for these assets, isn't their fair market value effectively zero, so that paying anything is overpaying? To my mind, housing is still overpriced, and it sounds to me like the Treasury is planning to pay more for the derivative assets than they are worth.

2) I understand the concern that simply allowing those who hold the derivatives to take their lumps would mean that credit would freeze up (and had frozen up) because of the interlocking credit swaps and other agreements that would trigger the obligation to post additional collateral. But if the problem is credit drying up even for good loans, why wouldn't it make more sense for the government to make those good loans? Surely it would cost less for the government to make good loans (if they are good loans, the government should make money on them) than to buy apparently worthless assets, no? And if the problem is a cascade of margin calls, why not abrogate (or put a moratorium on) the enforcement of those margin calls?

3) If the real concern is that we need to reassure foreign lenders so that we can keep borrowing from them, it seems to me that we need to stop such borrowing and stop living beyond our means. The Treasury's plan seems a junkie manuevering for another fix, when what he needs is drug rehab, if not cold turkey. (And what would happen -- really -- if we simply repudiated foreign debt? Isn't that where we are headed in the long run if we continue down our current path?)

4) If the Paulson plan is the best we can do, we can at least attempt to privatize the loss as much as possible by imposing retroactive taxes on those who made money getting us into this mess in the first place. Why shouldn't the money for the bailout come from those who profited from it?

5) Whenever I hear someone talking about the need to restore confidence to the market, I worry that the market needs -- not so much more confidence -- but rather more reality. And I recall that we have a name for people who seek to build confidence where it is unwarranted: con men.

I used to think that people running these institutions knew far more about what they were doing than I did. But I am increasingly thinking that they don't really know what they are doing. . . .

I think these are all fair questions. I'm going to try to discuss more of the distributional implications of the US's 2 billion dollar a day current account deficit in a future post. For now, we need to realize (as a Nobelist reminds us) that an ungodly amount of American "financial innovation" was little more than a Ponzi Scheme:

America's financial system failed in its two crucial responsibilities: managing risk and allocating capital. The industry as a whole has not been doing what it should be doing - for instance creating products that help Americans manage critical risks, such as staying in their homes when interest rates rise or house prices fall - and it must now face change in its regulatory structures. Regrettably, many of the worst elements of the US financial system - toxic mortgages and the practices that led to them - were exported to the rest of the world.

It was all done in the name of innovation, and any regulatory initiative was fought away with claims that it would suppress that innovation. They were innovating, all right, but not in ways that made the economy stronger. Some of America's best and brightest were devoting their talents to getting around standards and regulations designed to ensure the efficiency of the economy and the safety of the banking system. Unfortunately, they were far too successful, and we are all - homeowners, workers, investors, taxpayers - paying the price.

Posted by Frank Pasquale at 10:47 PM | Comments (4) | TrackBack

The Greed Rolls On

One of the sticking points in the uberbailout negotiations is whether there will be "limits on executive compensation at firms taking advantage of" the government's largesse. Treasury Secretary Hank Paulson is apparently battling against such intrusive government intervention. I wonder why? Maybe his personal fortune of $500 million is having some influence. I mean, isn't that the purpose of the financial system: to create centimillionaires?

Some allege that Paulson didn't deign to worry about subprime until his pals started hurting. He's apparently now on the frontlines battling for their right to keep amassing vast fortunes. Luigi Zingales calls out the audacity here:

The Paulson RTC will buy toxic assets at inflated prices, thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses.

Compare Paulson's overweening solicitude for the fortunes of the wealthiest with this proposal from Chuck Collins of The Nation:

The corporations that rigged the casino economy and the wealthy CEOs and investors that profited at everyone else's expense should bear the recovery costs, not our kids and grandchildren. . . . Lehman CEO Richard Fuld is sitting pretty, with his $354 million compensation from the last five years and a mega-mansion in Greenwich, Connecticut. . . .

When a CEO or employee improperly takes money from a company and is forced to pay it back, it is colorfully referred to as "disgorgement." In 1999, managers of Compaq Computer cooked the books and gorged on bonuses based on misrepresented profits. The government forced them to pay it back.

Collins proposes "six actions that will fairly generate over $400 billion a year to pay for a broad-based economic recovery and reduce the extreme inequalities that fueled speculation at the outset."

Collins links to reports from the Institute for Policy Studies and United for a Fair Economy on ways of raising the revenue necessary for getting us out of the mess we're in now. Eisenhower-style 91% marginal rates are looking mighty appropriate now for all those "financial innovators" who pioneer "investment strategies" (i.e., frauds) too complex for regulators to understand.

UPDATE: Here's Bill Kristol:

[I]s the administration’s proposal the right way to do this? It would enable the Treasury, without Congressionally approved guidelines as to pricing or procedure, to purchase hundreds of billions of dollars of financial assets, and hire private firms to manage and sell them, presumably at their discretion There are no provisions for — or even promises of — disclosure, accountability or transparency. Surely Congress can at least ask some hard questions about such an open-ended commitment.

Only a fantastically bad plan could unite Kristol, Paul, Krugman, and The Nation on a given day.

Posted by Frank Pasquale at 10:02 PM | Comments (0) | TrackBack

Should the Uber-Bailout be Unreviewable?

Both Jack Balkin and Glenn Greenwald point out a disturbing aspect of the draft bailout plan: its provision that "Decisions by the Secretary pursuant to the authority of this Act are . . . committed to agency discretion, and may not be reviewed by any court of law or any administrative agency." Balkin raises many troubling possibilities:

Oversight and regulations of public contracts are designed to prevent malfeasance, corruption, self-dealing and conflicts of interest in the distribution of federal monies. The Administration wishes to dispense with all of these restraints and precautions, just as it sought to run the Iraq war on no-bid contracts. That was bad enough, but here the dangers of bad deals and conflicts of interest are staggering. The Secretary is asking for authority to bail out Wall Street and enter into negotiations with financiers who include important parts of the political and financial base of the Republican Party. . . .

Put differently, the Administration wants the Secretary to take over a sizable chunk of the nation's capital and insurance markets, and run them as a firm. It is a merger of public power and private capital that would have made a 1930s advocate of state corporatism proud. And because the Secretary's power is effectively unreviewable, he can make sweetheart deals with any or all of the firms and financiers that got us into this mess, providing handsome compensation packages to outgoing executives or, in the alternative, bring these failures into the government to run the new grand public/private business enterprise.

Admittedly, financial reporting has encouraged us to see the policy here as essentially being made on the fly by a group of three, including the Federal Reserve Chairman (Ben Bernanke) and the President of the New York Fed. I will leave it to scholars of Roman history to explain how much better a triumvirate functioned than consuls or emperors. . . .

Greenwald is shocked, and notes that "all of this was both foreseeable as well as foreseen . . . and it's also happened before, when the Federal Government bailed out the S&L industry that (with John McCain's help [to friends like Charles Keating]) was able to gamble recklessly and then force the country to protect them from their losses." Perhaps we are to believe that the new uber-agency will have on hand a stable of honest brokers and technical economists capable of better handling contingencies they overlooked in the past. However, Nassim Nicholas Taleb raises some doubts by analogizing "experts'" misuse of statistics to a homelier anecdote:

[Example 1:] A Turkey is fed for a 1000 days—every days confirms to its statistical department that the human race cares about its welfare "with increased statistical significance". On the 1001st day, the turkey has a surprise.

[Example 2:] The banking system (betting AGAINST rare events [by observing ever-rising profits at firms that peddled CDO's, derivatives, and other exotic financial instruments]) just lost > 1 Trillion dollars (so far) on a single error, more than was ever earned in the history of banking. Yet bankers kept their previous bonuses and it looks like citizens have to foot the bills. And one Professor Ben Bernanke pronounced right before the blowup that we live in an era of stability and "great moderation" (he is now piloting a plane and we all are passengers on it).

I am not an expert on these markets, and I can't say with any certainty whether this plan will work. However, one thing that is very clear to me is that leading news outlets (asleep at the wheel for so long, and apparently even now likely to hire those bored by the whole affair) need to start focusing on the distributional consequences of whatever bailout occurs. Greenwald's perspective here is invaluable:

The headline in the largest Brazilian newspaper this week was: "Capitalist Socialism??" and articles all week have questioned. . . whether [the US just] . . . ushered in some perverse form of "socialism" where industries are nationalized and massive debt imposed on workers in order to protect the wealthiest. . . .

Can anyone point to any discussion of what the implications are for having the Federal Government seize control of the largest and most powerful insurance company in the country, as well as virtually the entire mortgage industry and other key swaths of financial services? Haven't we heard all these years that national health care was an extremely risky and dangerous undertaking because of what happens when the Federal Government gets too involved in an industry?

Apparently bailouts for well-heeled brokers are quite attractive to this administration. . . .help to kids without health care, not so much. As I noted after the Bear Sterns bailout, the $30 billion spent on that firm alone would have covered 4 million more children with heatlh insurance.

Greenwald asks "How can these bailouts not at least be categorically conditioned on the disgorgement of ill-gotten gains from those who are responsible?" Unfortunately, for the Grover Norquists of the world, the bailouts may actually be functional--they drain billions of dollars out of the treasury that might have once gone to intrusive, socialistic programs like Medicare or SCHIP expansions. . . .or truly dreadful ideas like adequately paying the ever-shrinking number of dentists who take Medicaid.

Given the three trillion dollars dedicated to Iraq, and the new trillion now reserved for this bailout, it appears that executive branch policymakers have moved from a "starve the beast" strategy to an "exhaust the beast" reality. I had once thought that using "beast" as a metaphor for the state was a diabolical rhetorical device for reifying the old bromide "government is not the solution, government is the problem." But the more one considers the distributional consequences of the "predator state's" interventions in the financial markets, the more appropriate that figure of speech may be. In other words, Norquist's characterization of the state as a beast was a self-fulfilling prophecy--fulfilled by his own disciples.

UPDATE: Given the relevance of L. Randall Wray's review of Galbraith's The Predator State (in the Journal of Economic Issues) to the current situation, it makes sense to quote it:

[Galbraith] provides a careful analysis of the frontline battles on many of the most important issues--Social Security, health care, inequality, immigration, security after 9-11, trade and outsourcing, and global warming—showing how “market solutions” are designed to enrich a favored oligarchy through a spoils system administered through the state’s structure. The policy “mistakes” in Iraq or New Orleans or at Bear-Stearns do not result from incompetence—indeed they only appear to be failures because we apply inappropriate measures of success. There is no common good, no public purpose, no shareholder’s interest; we are the prey and governments as well as corporations are run by and for predators. . . .

There is a way out, but it is not easy. Historically, regulation and standards have required acceptance by progressive business—those firms that recognized they would lose in races to the bottom.

Let's hope that some responsible companies in the financial world can play the same advocacy role that Safeway has been playing in health policy. As G. Richard Shell has noted, progressive businesses need to learn to make the rules--or their rivals will.

Posted by Frank Pasquale at 10:59 AM | Comments (3) | TrackBack

The Loophole that Became a Wormhole: Why the Fed Had to Bail out AIG

Many explanations have been offered for the "why" of the Fed found it necessary to bail-out AIG, mostly centering around uncertainty and risk. It's not exactly that AIG was "too big to fail," but rather that no one could say, with any certainty, that its failure wouldn't lead to a real market crash of enormous scope. That is, AIG is a good example of the precautionary principle in action. Maybe so. But I still am a little unclear why AIG is so exceptional in that regard.

Back in the Spring, when Bear failed, I asked my colleague Jonathan Lipson to offer a set of observations about Bear's bailout. (Check out also Ribstein's response to Lipson here.) Based on a recent correspondence with him about AIG, I thought it would make sense to share with you his unique & very interesting perspective on the problem.

Why did the Fed bail out AIG but not Lehman?

The conventional answer—which is true but incomplete—is that AIG was too big to fail. But that begs two questions: Too big how? And why?

In part, AIG was too big to fail because it could owe an astronomical amount—allegedly about $300 BN—on credit default swaps issued to support mortgage-backed securities.

The problem, however, is not just the amount AIG owes, but the fact that these obligations are not like other obligations. They occupy a series of loopholes that make them unusually dangerous. Perhaps the greatest loophole of all came in the 2005 amendments to the Bankruptcy Code. Although designed ostensibly to “get tough” on profligate debtors, those amendments also made certain that CDS holders would get special treatment in bankruptcy—special treatment that may have made the Fed bailout inevitable.

Credit Default Swaps and AIG

Credit default swaps (CDS) function much like insurance on another party’s debt. So, for example, investors that purchased a mortgage-backed security issued by, say, Lehman Brothers may also have purchased a credit default swap issued by AIG that would pay if Lehman defaulted on its bonds (e.g., by going into bankruptcy).

Credit default swaps are essentially unregulated insurance contracts. Not technically securities, they do not have to be registered with the SEC. Not technically insurance, their issuance by AIG was not overseen by state regulators.

Among other things, this meant that AIG was apparently not required to disclose the full extent of its liability, or to hold reserves against these contingent liabilities, as they would for the life insurance policies their (currently) healthy subsidiaries write. So, when the rating agencies threatened to downgrade AIG, it is not surprising that the counterparties to these contracts would have required AIG to pony up more collateral.

This, AIG could not do.

Thus, a liquidity crisis.

Chapter 11

Ordinarily, when an ostensibly healthy company (e.g., AIG) faces a liquidity crisis, it seeks protection under chapter 11 of the U.S. Bankruptcy Code. In chapter 11, the company benefits from, among other things, a temporary stay of collection actions, the exclusive opportunity to propose a reorganization plan, and the power to discharge debts.

So, if AIG merely had $300 BN in bonds that it could not pay because it found itself in a cash crunch, bankruptcy might be a sensible strategy. Bondholder collection actions would halt, and the company would be able to catch its breath and right the listing ship, or at least sell its parts for more than scrap value. Imagine Lehman Brothers, but to a higher order of magnitude.

Credit Default Swaps in Bankruptcy

That logic fails in the strange world of credit default swaps. Swaps are not like other debts. The 2005 amendments to the Bankruptcy Code were the culmination of a series of amendments which began in the 1980s, and which assure that CDS will essentially be untouched by the bankruptcy of any party to the swap.
Most important, the bankruptcy stay will not halt collection efforts by swap counterparties. Unlike other creditors, CDS counterparties may “net” their “positions”—claims—against the company. This simply means that if you were lucky enough to hold a swap issued by AIG, you would be able to enforce it even if AIG went into bankruptcy. If you were a bondholder, you wouldn’t.

For AIG, this presented a serious problem, because it meant bankruptcy could not realistically protect the company. Given the way the Bankruptcy Code treats CDS, an AIG bankruptcy would (likely) create a cascade of defaults, with all of AIG’s counterparties “running” the company to collect. Because the bankruptcy stay would not protect AIG, the CDS counterparties would simply be able to take their collateral and leave. With private lenders unwilling to lend, and bankruptcy off the table, this left only a Fed bailout as a viable alternative.

Is AIG a Disguised Lehman Bailout After All?

Last March, I put up some paranoid posts about the Fed’s bailout of Bear Stearns. I argued that chapter 11 of the Bankruptcy Code could solve problems like those presented by Bear’s failure.

I was suspicious of the motives to keep Bear out of bankruptcy. Who was being protected? The executives? The hedge fund managers? The folks on Wall Street and the Fed, however, believed that a Bear bankruptcy would have catastrophic results. It, too, was too big to fail.

The Fed’s resistance to a Lehman bailout was thus curious. Wouldn’t a Lehman bankruptcy be even more catastrophic than a Bear bankruptcy?

So far, the answer would seem to be: No. The stock market rose the day after Lehman’s bankruptcy. If the reaction to Lehman is any indication (and of course it may not be), in hindsight, a Bear bankruptcy may not have been so bad either.

Not so for AIG. After the AIG bailout was announced, the market plunged.

Why? One possibility is that the AIG bailout really isa disguised Lehman bailout. If Lehman’s bondholders purchased, say, $85 BN of AIG-issued CDS insuring against a Lehman bankruptcy, perhaps they are the ultimate beneficiaries of the Fed’s largesse. Perhaps no one cared when Lehman itself filed because insiders knew (or hoped) that the real money was coming from AIG. Then the only question was: Where would AIG get it?
This is rank speculation, of course. We may never know the relationship between the AIG bailout and the Lehman bankruptcy because—being unregulated—the general public has no idea who issues or holds CDS, in what amounts, or against whom.

The Real Problems—Selective Socialism and Deregulation

Ultimately, there are two problems here, one of regulation, the other of policy.

The regulatory problem is that once the Fed bailed out Bear, it created a new grade (tranche?) of moral hazard. Why wouldn’t every anxious Wall Street executive plead for a meeting with the Fed? If they did it for Bear, they might do it for Merrill, or Lehman, or Wachovia, or WaMu, or AIG.

But this was the worst of all possible regulatory strategies (and I use that word generously), because it is opaque, unpredictable and unfair. It’s selective socialism. It gave Wall Street nothing but an incentive to keep begging rather than doing the hard work of deleveraging.

If Bear had gone into bankruptcy, it may have caused some pain. But perhaps that pain would have prevented the much larger pain we see today. Bailing out Bear may simply have forestalled the day of reckoning.
Which, by the way, may still have yet to come.

The policy problem involves the choice in the 1970s to embark on a massive program to deregulate many industries. It is difficult to point to many success stories here. With the possible exception of certain telecom sectors (i.e., cell phones), few of the promised benefits of deregulation materialized. Electricity is more expensive, cable television is (generally) pretty lame, and transportation hasn’t exactly improved. And, while lightened regulation has been good for executives and hedge fund managers, average investors aren’t doing nearly so well. And they’re likely to do a lot worse in the near term.

The CDS Loophole: The Wormhole Cometh

The story of the CDS exemption under the Bankruptcy Code is part of this deregulatory story, which has seen Bankruptcy Code loopholes for all sorts of special interests. Swaps are not the only specialized financial contracts that are immune from bankruptcy. Among others, repurchase agreements and commodity contracts also get special treatment.

The difference is that those are generally regulated in other ways, whether by federal securities laws, by the Commodities Futures Trading Commission, under Federal Reserve Bank regulation, or state securities or insurance law. The decision to exempt those contracts from bankruptcy may not be ideal policy, but may also not be so harmful because those contracts get some regulatory reality check at some point. Not so for credit default swaps.

No one stops to think about the role that obscure and technical amendments to the Bankruptcy Code play in larger debates about regulatory policy. But here, the decision to exempt swaps from the ordinary operation of the Bankruptcy Code may have been the greatest deregulatory mistake of all. It may have helped AIG to become too big to fail in any way short of a massive Fed bailout. It may be the loophole that became a wormhole, sucking all value out of the financial space-time continuum.

Posted by Dave Hoffman at 09:48 AM | Comments (3) | TrackBack

The Black Box Blows Up

Apropos of Danielle's post on transparency: kudos to journalist Stephen Mihm for his prescient Jan. 27, 2008 article on "The Black Box Economy." Here's a taste:

[W]hen the mortgage crisis broke last summer, it opened a window on [a frightening situation]: . . . A staggeringly complex financial instrument that most Americans had never heard of, and which many financial writers still don't fully understand, [had become] in a matter of months the most important influence on home values in America. That's not how the economy is supposed to work - or at least that's not what they teach students in Economics 101.

The reason this had been happening totally out of sight is not difficult to understand. Banks of all stripes chafe against the restraints that federal and state regulators place on their ability to make money. By cleverly exploiting regulatory loopholes, investment banks created new types of high-risk investments that did not appear on their balance sheets. Safe from the prying eyes of regulators, they allowed banks to dodge the requirement that they keep a certain amount of money in reserve. These reserves are a crucial safety net, but also began to seem like a drag to financiers, money that was just sitting on the sidelines.

"A lot of financial innovation is designed to get around regulation," says Richard Sylla, professor of economics and financial history at NYU's Stern School of Business. "The goal is to make more money, and you can make more money if you don't have to keep capital to back up your investments."

I find Sylla's comment particularly interesting in light of the famous business method patents case State Street Bank. Is there any way to quantify the degree to which once-celebrated "financial innovation" was merely avoidance or evasion of regulation?

Posted by Frank Pasquale at 10:37 PM | Comments (0) | TrackBack

Kuttner on the Meltdown

What's the bottom line from today's crisis? A lot of people once written off as Cassandras are looking quite prophetic. And the stock of laissez-faire Pollyannas is dropping faster than the Dow.

Robert Kuttner was one of the first public intellectuals to systematically indict the failures of our financial system. He has just posted a brilliant article on The American Prospect explaining "Seven Deadly Sins of Deregulation -- and Three Necessary Reforms." Here's some basic historical context from his piece:

In the 1930s, the Roosevelt administration acted to prevent a repetition of the ruinous 1920s. Commercial banks were separated from investment banks, so that bankers could not prosper by underwriting bogus securities and foisting them on retail customers. Leverage was limited in order to rein in speculation with borrowed money. Investment banks, stock exchanges, and companies that publicly traded stocks were required to disclose more information to investors. Pyramid schemes and conflicts of interest were limited. The system worked very nicely until the 1970s -- when financial innovators devised end-runs around the regulated system, and regulators stopped keeping up with them.

This process accelerated over the past 15 years or so, as people like Frank Partnoy and Timothy Canova have noted. Enormous campaign contributions from the financial services industry helped assure regulatory lethargy. And now we face an epochal change in our financial landscape:

The world of banking was divided for decades largely into two kinds of businesses. Commercial banks took deposits and made loans, making a decent return under the burden of heavy regulations designed to protect depositors [emphasis added]. Securities firms took no deposits and were lightly regulated, which let them take big risks and rake in big profits - and occasional losses. More recently, some of the biggest institutions, such as Citigroup and UBS AG, combined both businesses.

Now, as many securities firms are falling following 'financial wizardry', the balance of power is shifting. 'There is a recognition that when the dust settles. . . the construct of the industry will be different,' [one expert said].

The fact that pejorative characterizations like "burden[some]" and "heavy" are used to describe the very framework that saved the commercial banks from the fate of the securities firms shows just how far from reality much contemporary discourse on finance has become. It's almost like saying "laboring under the heavy burden of vaccination, he avoided typhoid fever." I've come to expect bias from Murdoch's WSJ, but this is a bit rich.

Ezra Klein suggests one indisputably necessary step to implement in the wake of this disaster:

I'd start with an immediate push to equalize the tax treatment of incomes derived from private investment. It's an odd quirk of the tax system that simply treating income as income will be judged a punishment, but so be it. These guys have lost any public sympathy they ever had and sacrificed their ability to claim that they're taking advantage of lenient tax treatment to create value for the rest of us. Close the loophole.

Or, as Peter Wilby puts it:

Many of the super-rich specialise in shifting money around, allegedly so it can be used most productively. This . . . may be described as a service: wealth management for the world. Now the credit crunch has revealed that financiers, to put it mildly, did a less than brilliant job and that large sums ended up in their own pockets. Indeed, the high earnings in the finance industry came mostly from the speculative activity that got us into the present mess. One must wonder how long the world will continue paying for this kind of service.

Here is Kuttner's bottom line on what to do about the crisis. Combine it with Shiller's program, and I think we may begin mapping a way out of this nadir.

Reform One: If it Quacks Like a Bank, Regulate it Like a Bank. Barack Obama said it well in his historic speech on the financial emergency last March 27 in New York. "We need to regulate financial institutions for what they do, not what they are." Increasingly, different kinds of financial firms do the same kinds of things, and they are all capable of infusing toxic products into the nation's financial bloodstream. That's why Treasury Secretary Hank Paulson has had to extend the government's financial safety net to all kinds of large financial firms like A.I.G. that have no technical right to the aid and no regulation to keep them from taking outlandish risks. Going forward, all financial firms that buy and sell products in money markets need the same regulation and examination. That will be the essence of the 2009 version of the Glass-Steagall Act.

Reform Two: Limit Leverage. At the very heart of the financial meltdown was extreme speculation with esoteric financial securities, using astronomical rates of leverage. Commercial banks are limited to something like 10 to one, or less, depending on their conditions. These leverage limits need to be extended to all financial players, as part of the same 2009 banking reform.

Reform Three: Police Conflicts of Interest. The conflicts of interest at the core of bond-raising agencies are only one of the conflicts that have been permitted to pervade financial markets. Bond-rating agencies should probably become public institutions. Other conflicts of interest should be made explicitly illegal. Yes, financial markets keep "innovating." But some innovations are good, and some are abusive subterfuges. And if regulators who actually believe in regulation are empowered to examine all financial institutions, they can issue cease-and-desist orders when they encounter dangerous conflicts.

It's interesting to compare this to pages 396-402 of Partnoy's Infectious Greed....and to the worries expressed in John Brenner's The Boom and the Bubble. Both these books were written years before the current crisis.

UPDATE: Here's useful perspective from the increasingly indispensable Thomas Friedman:

We are at the end of an era — the end of ‘leave it to the markets’ and of the great cop-out that less government is always better government,” argues David Rothkopf, a former Commerce Department official in the Clinton administration and author of a book about the world’s financial leaders who brought about this crisis: “Superclass: The Global Power Elite and the World They Are Making.”. . .

In sum, government’s job is to police that fine line between the necessary risk-taking that drives an innovation economy and crazy gambling with other people’s savings in ways that threaten us all. We need to make sure that what happens in Vegas stays in Vegas — and doesn’t come to Main Street. We need to get back to investing in our future and not just betting on it.

Posted by Frank Pasquale at 08:14 PM | Comments (2) | TrackBack

List of Differences Between US GAAP and IFRS

Is anyone aware of the existence of a simple list of differences between the requirements of traditional US accounting (GAAP) and international financial reporting standards (IFRS)? A simple listing of the top 25 or so differences between these two systems could be a handy tool for many purposes, including for reference, research, and instruction. But I and colleagues interested in finding such a list have not been able to locate one.

This is somewhat surprising to us. After all, pending debate over moving the US from GAAP to IFRS involves a fundamental question: how convergent or divergent are the two systems? There is no question that the two differ on numerous topics in important ways. Examples include inventory, research & development costs, and leases. Extensive research explores the effects of such differences on resulting reports of net income and shareholders’ equity. But there does not appear to be a simple list of the major differences by topic.

If anyone is aware of one, I’d be grateful to know about it. Alternatively, I may create one and share it on the SSRN as a “working paper.” I would invite others to comment on it to improve its accuracy and also update it as the two sets of standards continue to change.

Posted by Lawrence Cunningham at 07:31 AM | Comments (2) | TrackBack

SEC's Global Views

The SEC made two important announcements this week concerning its current interest in promoting global capitalism. Both were somewhat surprising. One, concerning accounting standards, is surprising for its cautiousness; the other, concerning mutual recognition of foreign regulatory systems, is surprising for a potential lack of caution.

The surprising cautiousness appeared in the SEC’s announcement yesterday concerning its interest in switching the US from traditional US accounting standards to new international standards. Earlier Commissioner speeches and Commission releases suggested strong interest in a rapid short-term switch to the new standards. But the SEC now says it will soon release a discussion document contemplating the possibility of such a switch in 2014. Formal SEC consideration would occur in 2011, assuming designated milestones are reached by then.

The costs, uncertainties, and complexities associated with the imagined switch from US to international standards justify this long lead time. Stakeholders will eagerly await the SEC’s discussion document. One hopes for a thoughtful, analytical framework to evaluate such a revolutionary move, analysis that the SEC has to date not supplied.

The surprising potential lack of cautiousness appeared in the SEC’s announcement on Monday of a mutual recognition agreement with its Australian counterparts. Short term, this agreement contemplates allowing brokers regulated in one country to offer services to investors in the other without the broker being subject to the other’s laws, supervision or enforcement mechanisms.

The Australian agreement also contemplates expanding such mutual recognition to include other subjects within securities regulation. It is a first step along a more ambitious road that envisions similar agreements with more countries or blocs. For instance, the SEC has previously announced that it is pursuing similar discussions with the EU and with Canada.

The SEC states several justifications for pursuing such mutual recognition programs generally. Goals include increasing global capital market efficiency and liquidity; facilitating access by US investors to global markets; expanding information about foreign investment opportunities to US investors; promoting diversification of securities portfolios; reducing costs; and increasing regulatory coordination.

Earlier this year, the SEC said that achieving these goals would involve the following steps towards establishing a process leading to mutual recognition programs: (1) an initial agreement with foreign counterparts based on mutual comparability assessments; (2) a formal process to pursue substantive discussions with qualifying countries; and (3) a framework to define the scope of discussions for possible agreement.

The initial agreement with Australia is presumably based on such a comparability assessment that the SEC mentions. But it does not appear that the SEC has published the framework it uses to assess comparability or how any such framework applied to Australia. It may be more prudent to publish such a framework first before entering into agreements based on it.

Among vital purposes of such a framework, it would specify what comparability means and how it should be assessed. As extreme examples, comparability can focus on shared general principles (such as an emphasis on investor interests and disclosure supported by active oversight and enforcement by non-bribable authorities) or existence of specific kinds of laws (such as those protecting customer funds in brokerage accounts or restricting insider trading or short-selling).

In addition, the integrity of any mutual recognition program should consider the difference between the comparability of foreign regulation on the one hand and the domestic regulator’s capacity to inspect and enforce those regulations on the other. For example, suppose Australian brokers now may operate in the US without local registration because they are supervised by Australian authorities. How can the SEC know whether particular brokers satisfy requirements?

For US brokers, the SEC has power and authority to make direct inquiries and require satisfactory responses. The SEC has no such power over foreign firms, relying instead on assurances or cooperation by its counterpart. It may be difficult to imagine any mutual recognition program that enables the SEC to provide investor protection prevalent in the US. In the Australian agreement, the SEC addresses the investor protection point by requiring that Australian brokers disclose to US investors that US investor protection laws do not apply.

The SEC may not be unwise to enter into this particular agreement with Australian regulators. But it may be incautious to do so without publishing a thought out framework for further efforts, with Australia or other countries. It may be particularly important to do so in order to address the wide range of participants other than brokers and subjects other than brokerage services. Other participants include accountants, clearing agents, dealers, exchanges, investment advisors, lawyers and settlement operations; other subjects range from issuer disclosure to corporate governance requirements and to timing and other standards applicable to clearing and settlement organizations.

The SEC’s cautiousness revealed yesterday concerning international accounting standards appears attributable to criticism asking the SEC to publicize a more complete analysis of the subject and to proceed more thoughtfully. [My own detailed analysis appears here.] Similar expressions may lead the SEC to publish a thoughtful framework for mutual recognition and to use a more measured pace in pursuing these arrangements.

Posted by Lawrence Cunningham at 03:46 PM | Comments (0) | TrackBack

Are You Disposed Toward Corruption?

A reader passes along an interesting white collar crime story. In the latest development of an (apparently) long-running federal investigation,

Scott Salyer, president and chief executive officer of SK Foods, Monterey, Calif., a food processor and the parent company of Salyer American Fresh Foods Inc., is accused of allegedly encouraging New Jersey-based broker Randall Rahal to offer bribes to its customers’ buyers over a four-year period.

Federal Bureau of Investigation special agent Paul Artley filed an affidavit Aug. 14 in U.S. District Court in Sacramento, Calif., supporting the government’s April 16 seizure of nearly $600,000 held in the name of Rahal’s company, Intramark USA Inc., from two of his accounts in the Vineland, N.J. branch of Sun National Bank. The document alleges he used the accounts to bribe buyers from a number of food companies.

I tracked down that affidavit. A highlight, from my perspective, comes in paragraph 23:

"Witness #1 stated RAHAL told Witness #1 and others that he identifies the customers that he can get to take bribes by dropping a $100 bill and picking it up and saying, 'You must have dropped this, is it yours?; If the individual says 'yes,' RAHAL knows that they are open to a 'business offer.' Witness #1 understood 'business offer' to mean bribe."

There are other juicy bits, as this storynotes, including this one:

In one phone conversation between Salyer and Rahal, the broker tells the SK chief a buyer is "gonna need a retirement program. So, it's a perfect fit for me."

Salyer asks, "How fast are you going to reel in that fish?"

Rahal, referring to a dinner meeting he has set up with the buyer, says, "Probably by the time the coffee comes."

An enthusiastic Salyer replies, "I want that sucker on speed reel."

Apart from the local color, the story is interesting because it goes to the heart of the situationalist v. dispositionalist explanation of criminality so often discussed over at The Situationalist. Were the folks who accepted Rahal's bribes disposed toward corruption, or did his temptation make them act in ways they never otherwise would have? It's a question that bears on our attributional assumptions and the ways we punish. For what it's worth, I suspect that Rahal's test is one that many, many of us would fail.

(Image Source: Wikicommons)

Posted by Dave Hoffman at 06:11 PM | Comments (1) | TrackBack

The Big Picture on Financial Deregulation

Chapman law prof Timothy Canova has a superb article on the follies of Clinton-era financial deregulation, and their exacerbation under the current administration.

The Clinton administration’s free-market program culminated in two momentous deregulatory acts. Near the end of his eight years in office, Clinton signed into law the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, one of the most far-reaching banking reforms since the Great Depression. It swept aside parts of the Glass-Steagall Act of 1933 that had provided significant regulatory firewalls between commercial banks, insurance companies, securities firms, and investment banks. . . .

Deregulation and lax lending practices were part and parcel of the bubble economy. Clinton often boasted of the rise in homeownership during his presidency, foreshadowing the Bush-Cheney “ownership society.” But for too many, homeownership became something more speculative, a wager that interest rates would not rise in the future, and that if rates did rise, mortgage lenders would allow them to refinance at fixed interest rates based on constantly rising housing prices. . . .

During Clinton years, command-and-control regulation was largely replaced by a risk-based approach that was based on inherently flawed estimates of value and risk. According to risk-based capital requirements, the greater the risk of a loan, the greater amount of capital a bank would be required to raise. But this risk-based approach made little sense when regulators were using inflated market prices to build their defenses. . . .

Free-market fundamentalists will argue that . . . command-and-control regulations would prevent some borrowers from purchasing their first homes, thereby impeding their ability to build up equity capital. This may be, but other incentives could always be offered to help low- and middle-income families save money for future homeownership, such as a tax deduction for rental payments to match the current mortgage interest rate deduction for homeowners. . . .

I would push this analysis further and ask why the "ownership society" has become such a political desideratum in the first place? One key reason is the shredding of the social safety net in so many areas. When deregulated, private insurance markets leave one constantly worrying if the next illness will be covered, it can be quite comforting to think about one's home equity as a down payment for chemo. As Jacob Hacker has discussed in the Great Risk Shift, social policies that shift the burden of economic volatility from government and business to individuals can only be justified if those individuals think they've got some economic reserve capable of cushioning the blow.

In this as in many other areas, debt has been used to hide the real chasms in buying power opened up by growing inequality. Now we're paying the price for following laissez-faire advice:

Since the early 1980s, the value of home equity loans outstanding has ballooned to more than $1 trillion from $1 billion, and nearly a quarter of Americans with first mortgages have them. That explosive growth has been a boon for banks. Banks’ returns on fixed-rate home equity loans and