The Volokh Conspiracy

The American Association of Law Schools section on financial regulation is seeking paper proposals for the January meeting on all topics of financial regulation and regulatory reform.  The deadline for proposal submissions is August 1, fast approaching; I have posted details below the fold, and you can also contact my colleague Anna Gelpern with any questions ... agelpern at wcl dot american dot edu.  I encourage to take advantage of this opportunity for exploring these issues; as I suggested in a recent talk to a student group that was later published as an informal essay, lawyers and law professors do have certain comparative advantages in relation to economists and others in addressing financial regulatory reform.   Continue reading ‘Financial Regulation Reform – AALS Call for Papers’ »

In my earlier post from last night on the Dodd-Frank financial reform bill, I asked whether the highly discretionary provisions in the legislation addressing aspects of systemic risk have the effect of “returning” us to the 2008 crisis policy of “regulation by deal.”  That term comes from a paper by Steven M. Davidoff and David Zaring that was posted to SSRN in November 2008; I realize looking at some of the comments that many readers were not familiar with the term, so here is an approximate definition from the abstract to the 2008 paper (Professor Davidoff also discusses the idea in his excellent and highly readable book Gods at War, in chapter 10, beginning particularly at p. 269):

The government’s team, largely staffed by investment bankers, pushed the limits of its statutory authority to authorize an ad hoc series of deals designed to mitigate that crisis. It then decided to seek comprehensive legislation that, as it turned out, paved the way for more deals. The result has not been particularly coherent, but it has married transactional practice to administrative law. In fact, we think that regulation by deal provides an organizing principle, albeit a loose one, to the government’s response to the financial crisis. Dealmakers use contract to avoid some legal constraints, and often prefer to focus on arms-length negotiation, rather than regulatory authorization, as the source of legitimacy for their actions, though the law does provide a structure to their deals. They also do not always take the long view or place value on consistency, instead preferring to complete the latest deal at hand and move to the next transaction.

The marriage of “transactional practice” to “administrative law” – yes; Davidoff and Zaring’s description of it was shrewd in 2008 and it remains a shrewd way to characterize it now.  My question today was whether the embrace of discretionary authority in the Dodd-Frank bill effectively enshrined this statutory authority, with further questions about the effects on future moral hazard.  Professor Zaring has been kind enough to email me something to post.  David’s comment emphasizes not so much the question of a return to regulation by deal as the question of whether anything in the financial reform bill replaces it, e.g., through the new resolution authority.  To which his comment is (and my thanks to David for weighing in with this; you can read more of David’s comments at The Conglomerate, where he is much more sanguine that I about the overall bill):

Have we replaced regulation by deal?  The answer is probably not – because governments have been bailing out banks, often by deal, so many times over the course of the twentieth century that one would have to conclude that it is a very hard habit to break.  And I think that is an implicit part of the message of Kenneth Rogoff’s and Carmen Reinhardt’s This Time Is Different, which goes even deeper into that not-so-enviable history.

The way that Congress hopes to end the emergency dealmaking lies in the new grant of resolution authority, summarized here, which would continue to try to force the government to swing into action before desperation sets in, and extend the ability to seize and bankrupt insolvent institutions to financial holding companies, as well as to banks and thrifts (thereby reaching the Lehmans – an investment, rather than FDIC insured bank – and AIGs – an insurer – of the future).  The superquick bankruptcies would be paid for by an assessment on large banks.  It’s an important grant of authority, but will it be exercised in a pinch?  The banking regulators have had a hard time pulling the trigger on resolution authority – hence the dealmaking that ensues when times get really bad.  And, of course, the fact that the government had the power to “resolve” Fannie Mae and Freddie Mac (which it did) has not prevented either precipitous action or a big bailout.

So I’m not sure that the bill ends regulation by deal, but that is very hard to do.  And the bill will probably change the way that big banks operate, depending on the way it is enforced by the regulators, and not in altogether bad ways.

The reference to This Time Is Different is apt – it makes for (what would be the right adjective?) rueful reading late at night.  As I say, I am much less sanguine that David about this bill (see his Conglomerate post linked above); my view is approximately that of Nicole “After the Fall” Gelinas, in a quick summary for a popular audience in the New York Post today.  But I also think David is quite right about resolution authority and regulation by deal, whether before this bill or after it.  And thanks to him for the comment.

Update:  I’m happy to see that the WSJ today has more or less the same view that I’ve put out here:

The Treasury, which bailed out institutions willy-nilly without consistent rules, will now lead the Financial Stability Oversight Council that will have the arbitrary power to define which financial companies pose a “systemic risk” and which can be shut down without recourse to bankruptcy. Willy-nilly will now be the law.

(Update:  Thanks, Glenn, for the Instalanche!  If readers want a further discussion of this, including a short response from one of the co-authors of the “Regulation by Deal” paper, David Zaring, go here.  One reason to look at that further comment is that it gives an approximate definition of “regulation by deal” from the paper.)

I have spent a lot of the weekend reading summaries – I grant, I have not yet read the text of more than a couple of bits and pieces in the derivatives materials – of the financial regulation reform bill.  (Here is a pretty good summary from the front page of the New York Times, Saturday, June 26, 2010, by Edward Wyatt and David M. Herszenhorn.  But if you are looking for a good graphic summary of the highlights, see this graphic, “The Hope and the Worry,” that accompanies the article at page A12.)

With regard to the bill overall, well, I share the concerns raised by the editors of the Wall Street Journal and many others.  Far from eliminating too big to fail, or too systemically connected to fail, etc., the bill instead enshrines it and all the moral hazard accompanying it.  Much of the important systemic risk stuff is left in the discretionary authority of the Fed, however.  This leads me to a particular question about it.

In a certain way, this seems like a return to the phenomenon that Steven Davidoff and David Zaring identified in an article early on in the crisis – the so-called crisis response of “regulation by deal.”  Meaning by that, regulatory actions taken on a deal by deal, firm by firm basis, running through, of course, Bear, Fannie-Freddie, and so on.  Does this new discretionary authority amount to a return to the policy of regulation by deal?  A certain amount of ‘regulation by deal’ seemed justified at the moment of crisis.  But very soon into the process of regulation by deal, everyone had to consider its limitations.

What was it, from a downside view?  There was already a toxic combination of liabilities in existence – triple whammy, simultaneously massive; yet widely diffused throughout the financial system; and yet also interconnected with one another so that one failure might trigger another in unforeseen directions – based around the assumption that in any moment of crisis, they would be put to the Fed. That is, lingering moral hazard and its mis-leveraged fruits, on the one hand.  And yet completely discretionary behavior by governmental authorities as to how they would respond to crisis in any particular firm  at that particular moment, on the other.  Presumably the freedom to respond to Bear but not to Lehman would choke off the moral hazard.  The problem was, given that the liabilities and the leverage that the moral hazard had permitted had already created rafts of really-existing securities with really-existing obligations, things could not be stuffed back into Pandora’s box simply by a policy that eliminated (supposedly) the moral hazard.

Even if the regulation by deal policy was the right way to re-center the market players around risk, that policy would have to act into the future, not the past.  The result was that, at least for purposes of addressing the crisis as it was then unfolding, it merely increased uncertainties without addressing the already-ripened fruits of moral hazard.  (I’m sure if I worked at it, I could come up with a One Ring LOTR metaphor here.  But I will refrain.)  Regulation by deal could not address the moral hazard, because the externalities comprising it had been created by a vast number of deals over years; suddenly putting back in the “threat” of not getting bailed out did not make any of that go away.  At the moment of crisis, it merely increased the uncertainty.  If you were a firm, you didn’t know whether or not you would get bailed out – but since you could not really unwind all the moral hazard assuming risks all at once, in the moment of crisis, there was no “compliance” behavior that could respond to the supposed incentive.  The only result would be the same risk as before since the relevant securities had already been created – and a new dollop of uncertainty.

My question is, does the discretion now handed off to the Fed return us to “regulation by deal”?  And is this a good idea or a bad idea?  After all, in favor of it is that if it truly resolved the moral hazard problem by introducing genuine strategic uncertainty as to the Fed’s actions for any particular firm, then if this is supposed to be regulation for the future, maybe it is a good idea.    Against it?  Well, to start with, the markets would have to believe it – and believe it in the context of everything else that is in the bill.  I don’t believe it.  In fact, I think the bill should have been titled, The Dodd-Frank Put.  I think it’s a bad idea.  But do you?

(I leave aside, for now, certain public choice consequences that seem to me highly problematic with regard to the Fed role.  I also leave aside the topic in this that I follow most closely, the details of derivatives.)

If David Zaring (David blogs at The Conglomerate, but I don’t see anything from him on the new bill as yet) has any views on this, I would be delighted to post them here as a guest post.

This week’s The New Republic features a cover story by Harvard Law School’s Jack Goldsmith on cyberwar.  (June 24, 2010.)  It’s a long, serious review essay, using Richard A. Clarke and Robert K. Knake’s new book, Cyber War, as the hook.  But Jack goes well beyond a book review into the rapidly expanding literature on the subject – expanding across technical computer science and engineering, software, security, strategic, and legal lines.  Terrifically well written and intelligent, I strongly recommend it (full disclosure: I haven’t read the book under review) – whether you know the field or are looking to get an overview of it.  One thing is clear, it is not going away.

Years ago I decided my inner geek comparative advantage was in robotics, but I read this essay with particular attention to its discussion of complexity of systems, and just how hard it is to get a handle on cyber systems, and their diffuse, distributed natures:

Many factors make computer systems vulnerable, but the most fundamental factor is their extraordinary complexity. Most computers connected to the Internet are general-purpose machines designed to perform multiple tasks. The operating-system software that manages these tasks–as well as the computer’s relationship to the user–typically has tens of millions, and sometimes more than one hundred million, lines of operating instructions, or code. It is practically impossible to identify and to analyze all the different ways these lines of code can interact or might fail to operate as expected. And when the operating-system software interfaces with computer processors, various software applications, Web browsers, and the endless and endlessly complex pieces of hardware and software that constitute the computer and telecommunications networks that make up the Internet, the potential for unforeseen mistakes or failures becomes unfathomably large.

The complexity of computer systems often leads to accidental mistakes or failures. We have all suffered computer crashes, and sometimes these crashes cause serious problems. Last year the Internet in Germany and Sweden went down for several hours due to errors in the domain name system that identifies computers on the Internet. In January of this year, a software problem in the Pentagon’s global positioning system network prevented the Air Force from locking onto satellite signals on which they depend for many tasks. The accident on the Washington Metro last summer, which killed nine people and injured dozens, was probably caused by a malfunction in the computer system that controls train movements. Three years ago, six stealth F-22 Raptor jets on their maiden flights were barely able to return to base when their onboard computers crashed.

The same complexity that leads to such malfunctions also creates vulnerabilities that human agents can use to make computer systems operate in unintended ways. Such cyber threats come in two forms. A cyber attack is an act that alters, degrades, or destroys adversary computer systems or the information in or transiting through those systems. Cyber attacks are disruptive activities. Examples include the manipulation of a computer system to take over an electricity grid, or to block military communications, or to scramble or erase banking data. Cyber exploitations, by contrast, involve no disruption, but merely monitoring and related espionage on computer systems, as well as the copying of data that is on those systems. Examples include the theft of credit card information, trade secrets, health records, or weapons software, and the interception of vital business, military, and intelligence communications.

This drew my attention in part because of my interest in complexity and complex systems interacting one another in another part of my work – finance and financial regulation.  Duke’s Steve Schwarcz and I are doing a book on financial regulation reform, and our approach – in a field currently getting saturated with books on this very topic – is to offer pragmatic, basic heuristics, rules of thumb, really, for how financial regulation needs to be designed.  Not some super deep conceptualization, but something much more practical.

The same pragmatic assessment applies to diagnosing What Went Wrong, so to speak, in financial regulation.  We have settled on the three homely, but still useful, categories of complexity, complacence, and conflicts (cupidity we take for granted).  They’re useful because they’re homely.  Complexity hides conflicts that undermine basic duties of loyalty, and breeds complacency that undermines basic duties of care, and they feed back into the development of more complexity.  They stoke each other.

Professor Schwarcz has a Washington University Law Review paper on the issue of regulating complexity in finance and financial regulation, from which we are drawing for the book.  I recommend it, partly for those interested in financial regulation issues and complexity – but I also recommend it as a way of thinking comparatively about complexity in other settings that cross-weave technological and legal-regulatory divides.

I want to return again briefly to how the traditional distinction of liquidity and insolvency in a crisis applies to sovereign states such as Greece.  Liquidity is usually thought of as a gap in information that causes investors, creditors, depositors or others to suddenly question an institution’s financial position. In the classic bank run, the information gap becomes a self-fulfilling prophecy of insolvency; in other cases, insolvency is discovered, not made, as information becomes available and indicates that the institution is genuinely not solvent. But in either case, insolvency is a condition of an institution, such as a bank or financial institution, discovered or made in the present.

In the case of sovereign states, the analogy is apt, but not entirely so. Sovereign states, even when they default on their obligations, do not simply disappear “into” (much less “in”) bankruptcy the way a private firm would, unless the firm had the deus ex machina of a government bailout.  States don’t just go away, their assets sold off and distributed out to the creditors.  The question of solvency or insolvency – the urgent information gap that has driven much of the recent Greek debt crisis – is not so much a question of solvency today, as whether a state can muster the political will to be solvent into the future.

Questions of political will across a long time horizon are by their nature deeply uncertain, not least from an investor’s point of view.  So it seems likely that in the absence of a flat out guarantee from a trusted party – the EU or its leading members – liquidity issues (including not just risk premiums, but much volatility in debt pricing, reflecting genuine uncertainties) will trouble Greece, and other shaky euro economies.  The special sovereign uncertainties arise as investors seek to bridge an information gap that is fundamentally about the special solvency issue for a sovereign state – long term political will.  Can a trillion-dollar euro fund allay the uncertainties, not just today, but over the required time horizon?

(Whatever the answer to that question, it seems to me that Professor Anna Gelpern, whose Roubini blog post I earlier referenced, is right in saying that Greece does not have much reason to seek a restructuring at this point in time.)

Anna Gelpern’s post on the Roubini blog (that I posted on earlier) had an interesting point I wanted to follow up.   She remarks in passing, “apropos commitment, isn’t it interesting that the European Commission will issue collateralized debt (secured by its €141bn budget)?”  Indeed, and even more interesting that the bulk of the bailout fund will come via a vast intergovernmental SPV.  If you follow her link, it takes you to a Financial Times article discussing the legal-financial structure of the EU bailout, which describes the bailout fund:

The so-called European stabilisation mechanism will consist of two parts with separate legal bases.

The €60bn extension of the EU’s existing balance of payments facility – used to help Hungary, Latvia and Romania – to members of the eurozone will be based on Article 122.2 of the EU treaty which allows for support for governments during “exceptional circumstances”. It thus circumvents the eurozone’s no-bailout principle.

The €440bn loan guarantee mechanism will be organised on an intergovernmental basis between the 16 eurozone member states.

Why the intergovernmental structure for the overwhelming bulk of it?  For political and legal reasons – first, to deal with German constitutional legal concerns and, second, to deal with British political concerns that it could be dragged into indirect liability if the fund were handled through Brussels institutions.  The governments will provide credit guarantees; the intergovernmental SPV will use the guarantees to raise money on the capital markets.  The 60 bn euro piece from the EU directly will come in the form of debt collateralized by the EU’s own budget.

My colleague and a rising star in sovereign debt studies, Anna Gelpern, has a new and important post at the Roubini blog, on the question of where Greece goes with the new announcement of a trillion-dollar fund.    The opening:

Leading economists and editorialists say Greece will restructure its debt (here, here, here, here and here are just a few examples).  Many say so because they see so much in common between the spiraling European crisis and past crises in the emerging markets.  The analogy has merit, and until recently, I too subscribed to it.  Now I am not so sure.  This is because the benefits of restructuring now are oddly remote, because Greece has the legal leverage to extract a deep debt haircut if and when it can maximize its benefits, because the EU needs time to get its act together and seems willing to pay for it—and because, as a descriptive matter, the global political commitment behind the no-restructuring option is without precedent.  And sovereign debt is nothing but political commitment.

The post goes on to offer six reasons why restructuring is not likely for now.  Trenchant analysis, highly recommended.

Many commentators have raised the idea of requiring banks and financial institutions to issue contingent convertible debt that can be converted to equity as a sort of pre-set form of re-capitalization in case of trouble.  Greg Mankiw has said that it is his favorite idea in financial regulation reform.  He has pointed to reports that Swiss authorities are going forward with a version of it for large Swiss institutions.  Here is how Mankiw described the idea in a recent NYT column:

MY favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

Bankers may balk at this proposal, because it would raise the cost of doing business. The buyers of these bonds would need to be compensated for providing this insurance.

But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.

I agree it is a good idea.  But I’d like to ask what this would look like from the finance lawyer’s drafting point of view.  Suppose you proposed to do what Professor Mankiw says above.  First off, can anyone point me in the direction of any actual examples of what this is – any examples of convertible bond documents online designed to do this?  Any bond documents for this exist in real life?

Second, what would be the basic functional terms of the bond that would make this happen – what would the triggers be?  And finally, what would be the covenants and protections for, e.g., the regulator, the financial institution, and the bondholder?  What would they want to be protected against, respectively?

For that matter, is there any reason to think that while aligning some interests in controlling leverage, this proposal either creates other unintended perverse incentives, or perhaps creates other kinds of possibly unresolvable conflicts of interest between these three parties (and potentially the existing shareholders as well).  Put on your bond lawyer hats!

Update:  The Lincoln version of the derivatives legislation clears the Senate Agriculture Committee today (which raises another set of issues, different from the ones under discussion below):

Democrats won the support of a senior Republican who voted in a Senate committee Wednesday for a sweeping overhaul of the market for derivatives, the complex financial instruments at the heart of the financial crisis.  The backing from Sen. Charles Grassley (R., Iowa) is the first sign of what Democrats hope will be an eventual wave of Republican support ...  The move was also significant because Mr. Grassley said he favored one of the bill’s most controversial elements, a provision that could force Wall Street banks to spin off their derivatives trading desks.   The 13-8 vote in the Senate Agriculture Committee came as Senate lawmakers appeared to be inching closer to a deal on a broader remake of market rules.

The New York Times reported yesterday on negotiations over financial regulation legislation, and included this comment on derivatives regulation and Wall Street:

The derivatives bill, which is expected to be folded into the sweeping overhaul of the nation’s banking system, would also require most derivatives trades to be routed through a third party, known as a clearing agent. That would provide each of the parties a guarantee that they would be paid if the other party defaulted or went out of business. The bill would also require most derivatives to be traded on an open exchange.

Currently, the only way to trade many derivatives is to call up various dealers and ask for the price at which they are willing to buy or sell. The securities dealer profits from the difference between the prices at which it buys from one party and sells to another. Investors rarely, if ever, see details on the other side of the trade. Wall Street has signaled that it can live with a clearinghouse approach, but it is strongly opposed to exchange trading of derivatives, which would introduce price competition and lower the profits.

I think it’s fair to quote those two grafs from the lengthy article, which covers many aspects of the bill negotiations.  Here is my question – and it’s a genuine question, I’m not sure exactly what to think.

I had more or less assumed that Wall Street would be bothered more by a clearinghouse than an exchange, if it were one or the other and not both.  Why?  I assumed Wall Street would be concerned that a clearinghouse serving as a centralized counterparty would be motivated to contain its risk, by limiting margin and generally limiting leverage on the contracts for which it ultimately was responsible to clear.  The exchange seemed much weaker as a regulatory device because it would not have the ability, or at least the same incentives, to limit margin.  The exchange would help matters by making public the prices and counterparties, but not act to clear and, so, have to think about its own risk.  (If you had both, however, you would have the advantages of an entity motivated to limit risk and with public information on prices by which to help the determination of regulatory margin.  But we’re assuming here it is one or the other, although I myself strongly would like to see both.)

So I was surprised to read this passage and see my assumptions turned on their head.  And maybe I should never have been surprised, and this ordering preference should have been obvious.  But it did surprise me.  Which then leads me to the further thought, what is Wall Street’s assumption on the NYT’s description of its ordering preferences?  Wall Street prefers a clearinghouse that takes central counterparty risk but which should then address attendant risks?  Why?  Is it because of an assumption that – in a market that does not publicly post prices for everyone to see – if leverage gets out of control, the central clearinghouse will serve as the clearer of last resort?

In other words, does a clearinghouse without a public posting of exchange prices increase or decrease the likelihood that the central clearinghouse (in practical effect backed by the Federal government, which blessed the system through legislation after all) run the serious risk of serving as the next Wall Street bailout mechanism?  The New Fed-Market Put Option?

I don’t know the answer to this; this reporting surprised me, so I put the proposition to you.  Or have I misconceived Wall Street’s motivations or misunderstood what this ordering preference is all about?  Please stay on topic here and directly address these issues.

(Update 2.  Also see Gary Gensler urging a clearinghouse in the Wall Street Journal today, and Thomas Jackson and David Skeel, also in today’s WSJ, urging that derivatives be treated like other contracts in bankruptcy as a mechanism by which failed parties could have the regular bankruptcy protection against contract enforcement and so avoid cascading risk – and financial firms would not have to put (or give up) their customized derivatives onto exchanges (i.e., make everything into a uniform plain vanilla derivative).)

I’m sure many VC readers have been looking at the papers today, trying to sort out facts versus allegations, in the SEC suit against Goldman Sachs for fraud involving CDOs.  The Wall Street Journal, New York Times, Washington Post, and Financial Times all have good stories, to take the papers from my front lawn.

One of those stories (they have all, ahem, melded together in my mind) remarked that if sustained in court, and quite possibly even if not, the fraud suit and the narrative it tells, has the possibility of significantly altering the perception of the financial crisis, or at least its relationship to complex derivatives.  Away from a (possible, anyway one I share) perception of banks that didn’t much care about the down-stream performance of their products because they would get paid up-stream anyway – a perception of a systemically driven indifference, but not necessarily fraudulent, toward knowing, deliberately constructed malfeasance, understanding pretty well that these CDOs were headed to the dust-bin of history.

Such a shift in perception might come about regardless of whether this narrative is established as factually correct or not.  Another version might be that most of Wall Street was complacent and badly incentivized, so as to not care about credit quality – whereas Goldman Sachs, being the Masters of the Universe and Smarter Than the Average Bear (Stearns -ed.), uniquely saw it coming  and, in this case at least, protected itself and even figured out how to profit, but alas through fraud.

One of the problems with trying to say much at this stage about the legal analysis is that it is so factually driven.  If the facts are as the SEC alleges, well, then, bad, bad Goldman!!  But  on these allegations, there’s not a lot of room for legal nuance, although I am happy to be corrected on that in the comments, not being a securities litigator.  So, here’s my question for the comments.  Assume that the facts are as alleged.  In that case, is there an important legal issue, or is it the application of straight securities fraud principles?  Is there an alternative, plausible reading of the facts?  And is there an alternative, plausible factual reading that creates an important legal question?

That’s with respect to the fraud case on its own.  Assume the facts as alleged by the SEC.  What would that argue as a matter of long term regulatory reform in financial markets and institutions and regulation?  Although, frankly, at this stage, I’m more interested in the comments in trying to see whether there’s an important legal issue in the case at hand, as a legal issue.  As the New York Times Room for Debate blog exchange seemed to show, at this stage the systemic lessons people seem to be drawing out of the suit against Goldman are pretty much whatever they thought before the suit against Goldman.

I just finished reading Alan Greenspan’s paper for the spring Brookings economics confab, The Crisis, and then a bunch of reactions around the econo-blogosphere.  The paper is well worth reading – it’s time to get beyond the blame game and the mea culpas and mea non-culpas, in order to get to longer term regulatory reform.  Of the blog reactions, the most interesting, I thought, was Greg Mankiw, who was a respondent on the paper at Brookings:

Alan proposes raising capital requirements and reducing leverage, but he suggests that there are limits to how much we can do so. If we reduce leverage too much, he argues, financial intermediaries will be not be sufficiently profitable to remain viable. He offers some back-of-the-envelope calculations that purport to show how much leverage the financial system needs to stay afloat.

When I read this part of the paper, my first thought was: What about the Modigliani-Miller Theorem? Recall that this famous theorem says that a firm’s value as a business enterprise is independent of how it is financed. The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners. But it does not affect whether the firm is fundamentally viable as an on-going concern. It seems to me that, as least as first approximation, the logic of this theorem should apply to financial intermediaries as well as other types of business. If not, we need some explanation as to why.

Note that this is a different objection to imposing higher/firmer/objective/fixed minimum/what have you capital versus leverage requirements than is sometimes made – viz., that no one, least of all regulators, is in any good position to be able to determine the proper level, and that, therefore, the problem ought to be to ensure that risk falls so as to ensure that those that should care, do care.  Greenspan is suggesting, rather, that without some minimum level of leverage that might well turn out to be crisis-inducing risky, financial firms will not have a sufficient level of profitability to remain in business.  I might have misunderstood that reading the paper, so if (and only if) you have read the paper, feel free to correct me in the comments.

If my understanding of the paper is correct, I think my reaction would be ... as compared to what alternative on a risk adjusted basis?  It seems to me that the problem identified here is a “gotta get up and dance” issue – if on a short term basis, all your competitors are engaged in a certain level of leverage, and are hitting certain rates of return while, in fact, taking inefficiently high risks considered over a longer run, then, sure, you might not remain in business.  If, on the other hand, leverage for all market players (at least in the taxpayer guaranteed sector) is constrained, sure, rates of return will be lower.  But if the effect, on a long term basis, is to force return to take into account risk, and properly price it for all players, then capital will flee the sector and threaten, perhaps, to put financial firms out of business only insofar as capital wants to take greater risks for greater returns in other asset classes and investment opportunities.

But of course I might have misunderstood something fundamental, particularly since Greg Mankiw zooms in on something quite different, Miller and Modigliani.  He asks what M&M would have to say about Greenspan’s argument – and maybe he is saying something similar to what I suggest above, although I have focused on short term versus longer term risk versus return:

I have a hunch as to where, from the Modigliani-Miller perspective, Alan’s calculations go awry. Alan assumes that the rate of return on equity must be at least 5 percent. But this number should be endogenous to the degree of leverage. If a bank is less levered, its equity will be safer. (It will be like a combination of today’s equity and bonds.) As a result, the required rate of return should fall.

Thus, Mankiw goes on, a less levered – indeed, wholly unlevered – bank should do just fine with a rate of return that reflects the decreased risk.  Investors who want that kind of safety as part of their portfolio will gravitate to that bank.  The problem, as I suggest above, is when risk and return in the capital market for all firms is skewed so as to favor getting up to dance in the short term.  But then Mankiw raises the general question of the applicability of M&M to this case:

To put the point most broadly: The Modigliani-Miller theorem says leverage and capital structure are irrelevant, while undoubtedly many bankers would claim they are central to the process of financial intermediation. A compelling question on the research agenda is to figure out who is right, and why.

Actually, this seems to me to put M&M in a highly specific context – rather than being the classic question, does capital structure matter to the value of the firm? – this question is quite exact – do leverage and capital structure matter to the process of financial intermediation?  If the question is financial intermediation alone – so-called narrow banking – I’d hazard that it still matters.  Mankiw proposes a thought experiment with a wholly unleveraged bank – could it supply financial intermediation?  Answer, presumably yes, at least if the playing field for capital is level, so that return reflects risk.

But isn’t the more difficult question, if one is following the symmetry of M&M, to ask, can a bank perform the functions of financial intermediation with something close to total leverage?  Wouldn’t M&M suggest it should be able to do that as well?  And hasn’t the meltdown suggested that, for some reason, it doesn’t work that way – rather than being symmetric as pure M&M in a pure world would suggest, in our world, firms, leverage and assets are asymmetric?  To be sure, the financial intermediation part might have worked just fine, which, true, confirms Mankiw’s point.  But the firm itself seems not to have worked – meaning, those arguing that in our world, capital structure and degree of leverage matter, and even matter with respect to a firm conducting financial intermediation, given that if the firm goes kaput on account of overleverage, the intermediation collapses with it?  Which is another way to say, Mankiw suggests through the unlevered thought experiment that financial intermediation can be “unbundled” from the rest of a financial services conglomerate, and that seems right.  But it seems equally right – and not consistent with “pure” M&M in a “pure” world – that you can’t successfully “bundle” them, at least not to the leveraged limit. Continue reading ‘Greenspan’s ‘The Crisis’ and Modigliani and Miller’ »

Two items in today’s Wall Street Journal (Tuesday, March 9, 2010) capture two different views of regulatory reform of credit default swaps.  The first is the emerging European view:

European leaders pushed for a ban on speculative bets against government debt following recent financial turmoil in Greece ...  German Chancellor Angela Merkel said Tuesday that her government is backing an initiative to curb the credit-default swaps market, together with France, Greece and Luxembourg, and she suggested Europe would forge ahead on its own even if the U.S. didn’t go along.

José Manuel Barroso, president of the European Commission, the European Union’s executive arm, said the commission would examine closely the possibility of banning outright “purely speculative” trading of the swaps ...

The ban now being discussed in Europe would allow investors to use the contracts to hedge against possible defaults by government borrowers, but prevent them from taking purely speculative positions. “It’s hard to justify why market players should purchase insurance against risks to which they are not themselves exposed,” Mr. Barroso said.

There are a number of responses one could make to the EU’s Barroso (below the fold, I put what appears to be the implied Obama administration view).  Contrast this, however, with the March 9, 2010 speech by CFTC Chair Gary Gensler on CDS regulatory reform. Gensler did not suggest attempting to ban “speculative” trading in CDS, but did endorse three general reforms to the CDS (and more generally the OTC derivatives) market:

The 2008 financial crisis demonstrated how over-the-counter derivatives – initially developed to help manage and lower risk – can actually concentrate and heighten risk in the economy.

A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, no matter where traded or marketed. It should include interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future. Effective reform of the marketplace requires three critical components:

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, Wall Street and the Federal Government had no price reference for particular assets – assets that we began to call “toxic.” Financial reform will be incomplete if we do not achieve public market transparency.

Third, to lower risk further, standard OTC derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. With their use, transactions with counterparties can be moved off the books of financial institutions that may have become both “too big to fail” and “too interconnected to fail.” Centralized clearing has helped to lower risk in futures markets for more than a century.

Gensler’s speech is serious, plain-spoken and, even if one disagrees with particular policy prescriptions, a useful, well-organized walk through the issues.  I think that most participants in the regulatory reform process would accept these proposals as commonsense, at least in the US; going beyond them to the kinds of proposals being made in Europe currently is a different matter.  (There has been a lively debate going on in the Financial Times in the past few days over CDS and liquidity.)  (My own view is close to Gensler’s, FWIW, and where it differs, it certainly does not head down the EU path outlined above.) Continue reading ‘Two Views of Credit Default Swaps’ »

Not everyone is quite so fascinated as I with CDS spreads on Greek sovereign debt.  However, the issues raised by the Greek debt difficulties and the urgent discussions in the Eurozone over a possible bailout, attendant moral hazard, and the like are far more than merely fiscal or monetary questions.  Rather, this crisis is one of those instances in which the deep economic and financial problems directly reflect the questions of founding political design.  Political economy in its purest sense.  Regardless of what one thinks the right policy for the EU, Germany, Greece, and others, is at this moment, economist Otmar Issing’s Financial Times comment today (Tuesday, February 16, 2010) lays out a lucid statement of the foundational political issue of monetary union without political (or fiscal) union:

It seems that quite a number of observers have forgotten what Emu is, and what it is not. The monetary union is based on two pillars. One is the stability of the euro, guaranteed by an independent central bank with a clear mandate to maintain price stability. The other is fiscal solidity, which has to be delivered by individual member states. Member countries are still sovereign. Emu does not represent a state; it is an institutional arrangement unique in history.

In the 1990s, many economists – I was among them – warned that starting monetary union without having established a political union was putting the cart before the horse. Now the question is whether monetary union can survive without such a political union. The current crisis must be handled in such a way as to produce a positive answer. The viability of the whole framework – nothing less – is at stake.

By joining Emu, a country accepts its rules. Greece, moreover, also knew that adopting a stable currency that was not controlled by its own central bank implied a total break with the past. Devaluation of the national currency and an inflationary monetary policy were no longer options. A single monetary policy is implemented by the European Central Bank and it is the responsibility of each country to adjust its economic policies so that this one size fits all.

The fundamental political problem is a collective action problem – the “responsibility of each country” to adjust its fiscal policies to comport with a single monetary policy.  The collective benefits, including those enjoyed by Greece, of a single monetary union with a currency widely trusted are enormous, starting with a lowering of borrowing costs – lower costs of which, however, could have been used either to lower public debts to put/keep Greece in line with the levels of fiscal policy of the monetary union, or leverage the savings to borrow ever more.  Greece promised the former and went for the latter:

The benefits of joining a stable economic area are greatest for countries that were unable to deliver such conditions before. Thanks to the euro, Greece has enjoyed long-term interest rates at a record low. But instead of delivering on its commitment at the time of entry to reduce public debt levels, the country has wasted potential savings in a spending frenzy. The crisis with which it is now confronted is not the result of an “external shock” such as an earthquake, but the result of bad policies pursued over many years.

I myself believe that the sanitized language of economists on display here tends to hide, below a veneer of ‘sense’, a much more palpable ‘sensibility’ of “spend” that went with joining the monetary union.  It isn’t just that Greece and its public saw an opportunity to free-ride on the euro.  I’d say (from experience living in Spain and other poorer countries of the “old” EU) that joining monetary union was seen as joining the lifestyle of the richest countries in the EU.  It was a powerful behavioral signal toward living like northern Europe, not toward seeing virtues in lowering the borrowing costs of the public fisc.  My strong impression of what many Spaniards in traditionally poorer parts of Spain thought the EU meant, when I lived there on sabbatical in the mid 2000s was that to “be European” mean to have a “European” lifestyle, based on a Euro income.  And, moreover, that the reason why the EU showered particular regions of Spain with money for so many years was not simply in order to promote economic development or political stability – both of which it did – or to purchase regional loyalty to the EU even over national solidarity – it did that, too – but, from the inhabitants’ view, tomake them “European,” which meant, ultimately, to consume like Europeans were supposed to, and did, even if it was financed on debt-fuel.  This is another of those instances in which the sensibility – even though hard to document and measure – is hugely important and perhaps as important as the economic sense.

The EU is, from the standpoint of this sensibility, about equality, and it is unjust that there should be rich regions and poor regions.  Again, from the standpoint of this essentially EU citizenship=consumer sensibility, if you didn’t intend that the EU should be gradually moving not so much closer to political union as egalite, then why on earth did you create a euro, the point of which, from a consumer standpoint, is to put everyone on an equalized playing field?  I realize this sounds strange from the standpoint of economic sense, but that’s not what I’m talking about.  The great sociologist Zygmunt Bauman once remarked, in an essay in Telos in the late 1980s, that the fundamental condition of poverty in our age is not that it is a class as such.  It is that to be poor is to be a “flawed consumer.”

The euro, understood from this sensibility, took poor people who were poor because their countries were poor – a status that described whole national societies – and made them poor people within a unified social environment in which their poverty was no longer the condition of the country, but rather them as individuals who, within Europe, were now “flawed consumers.”  Small wonder, as a matter of sensibility if not sense, that they concluded that the point of the euro was to make them ... not poor.  Small wonder that their governments responded in kind.  Which is why the conclusion of this FT article, so economically sensible, lucid and compelling – it gets my complete agreement as a matter of policy – misses the fundamental point from the standpoint of euro-sensibility.

This moment is a turning point for Emu, and for the future of Europe. Most observers point to the high risks – which cannot be denied. However, any crisis also presents an opportunity. This is a big chance – probably the last for Greece, and others – to adapt fully to a regime of stable money and solid public finances.

For Emu, the crisis represents a final test of whether such an institutional arrangement – a monetary union without a political union – is viable for an extended period of time. Lax monitoring and compromises when it comes to observing implementation of rules have to stop. Emu is a club of states with firm rules accepted by entrants. These rules must not be changed ex-post. Governments should not forget what they promised their citizens when they gave up their national currencies.

From the point of view of the sensibility of citizens who define themselves as citizens of the EU – at the Union’s own urging – as consumers, identifying “with” the European Union on the basis of the solidarity of consumption, Greece has not forgotten in the least what it promised its citizens in joining the euro.  It promised to deliver them from the condition of merely “flawed consumers” among the wealthy of northern Europe.

The former General Counsel of Long Term Capital Management – it of the late 1990s near global financial meltdown – James Rickards, had a comment in the Financial Times a few days ago (Feb 11, 2010) on the credit default swap market and Greek sovereign debt.  Key section:

Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?

When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.

Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.

Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata. What does any of this have to do with Greece? Very little. It is not much more than a floating craps game in an alley off Wall Street.

This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.

When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.

I have general doubts about this being a complete, or accurate description, of the incentives in the CDS market.  In particular, I have two questions about this description of CDSs:

• First, is this a genuinely accurate description of the CDS market?  This presents it as being unmoored from the fundamentals, partly on account of the lack of an insurable interest (e.g., Goldman Sachs as an empty creditor at the time of the AIG meltdown) – but also because the parties have a massive agency failure problem in which the costs fall upon the hedge fund investors getting charged fees.  But is this really the case?  Are the parties on both sides, and the middle, in the CDS market really not checking against each other, quite apart from whether there is an insurable interest or not?
• Second, what is the argument for not requiring an insurable interest in the creation of an insurance market?  Liquidity and depth in the market?

Political scientist Jeffrey Friedman has an excellent article arguing that political ignorance by both regulators and voters played a key role in causing the financial crisis:

You are familiar by now with the role of the Federal Reserve in stimulating the housing boom; the role of Fannie Mae and Freddie Mac in encouraging low-equity mortgages; and the role of the Community Reinvestment Act in mandating loans to “subprime” borrowers, meaning those who were poor credit risks. So you may think that the government caused the financial crisis. But you don’t know the half of it. And neither does the government....

Given the large number of contributory factors — the Fed’s low interest rates, the Community Reinvestment Act, Fannie and Freddie’s actions, Basel I, the Recourse Rule, and Basel II — it has been said that the financial crisis was a perfect storm of regulatory error. But the factors I have just named do not even begin to complete the list. First, Peter Wallison has noted the prevalence of “no-recourse” laws in many states, which relieved mortgagors of financial liability if they simply walked away from a house on which they defaulted. This reassured people in financial straits that they could take on a possibly unaffordable mortgage with virtually no risk. Second, Richard Rahn has pointed out that the tax code discourages partnerships in banking (and other industries). Partnerships encourage prudence because each partner has a lot at stake if the firm goes under. Rahn’s point has wider implications, for scholars such as Amar Bhidé and Jonathan Macey have underscored aspects of tax and securities law that encourage publicly held corporations such as commercial banks — as opposed to partnerships or other privately held companies — to encourage their employees to generate the short-term profits adored by equities investors.....

This litany is not exhaustive. It is meant only to convey the welter of regulations that have grown up across different parts of the economy in such immense profusion that nobody can possibly predict how they will interact with each other. We are, all of us, ignorant of the vast bulk of what the government is doing for us, and what those actions might be doing to us. That is the best explanation for how this perfect regulatory storm happened, and for why it might well happen again.

For more of Jeff’s analysis of the ways in which ignorance contributed to the crisis, see here, and his much longer academic article on the subject in a special symposium issue of Critical Review (which also includes important contributions by many other scholars).

I don’t know enough about financial regulation to have any strong opinion on whether Jeff’s arguments are correct (though many of them strike me as persuasive). However, his analysis does overlap with my own work suggesting that the size and complexity of modern government greatly exacerbates the dangers of political ignorance (e.g. here and here). It is definitely a good and thought-provoking piece, even if there are parts that are hard for me to judge.

CONFLICT OF INTEREST WATCH: Jeff was one of the people who played a key role in getting me interested in the issue of political ignorance back in the 1990s. As editor of Critical Review, he published my very first article on the subject back in 1998. So I owe Jeff a great debt for, among other things, pointing me towards a subject that is one of the main parts of my research agenda, and promoting my work at a time when I wasn’t well-known at all. At the same time, we have disagreed in print over several major issues relating to political ignorance. So I’m hardly an uncritical cheerleader for Jeff’s arguments, or he for mine. In this series of articles, I think he makes a valuable contribution to the debate, even if we ultimately conclude that some other explanation of the crisis is more compelling. My guess is that the ignorance Jeff points to was at least an important contributing factor, even if other causes also played a major role.

UPDATE: Jeff has another interesting article about the causes of the financial crisis here (coauthored with Wladimir Kraus).