The Volokh Conspiracy

In the terrific conference on the Constitution in the Financial Crisis that Co-Conspirator Todd and I were privileged to attend last week at Stanford Law School, one of the panelists (this was a panel looking at the peculiar incentives and disincentives created for corporate governance by having government as a controlling shareholder, as in GM) pointed out something I had completely missed and apparently a number of other people in that highly expert audience, too.  A WSJ article of November 3, 2010, by Randall Smith and Sharon Terlep, points to a little-noticed IRS ruling on GM’s tax-loss carryforwards from years prior to the bailout.  The amount at issue is potentially $45 billion.   (Thanks to commenters for links to ruling.)

Although ordinarily a company in the midst of major restructuring would have limits on its ability to use the carryforwards – and ordinarily the Treasury’s 61% stake would trigger such limitations – the IRS has ruled that companies receiving TARP bailout funds will not be subject to the restructuring limits.  (Someone can correct me, since is from memory (one of my first assignments in practice back when I started as a tax lawyer was on this very question, but I have long since dropped out of corporate tax), but I believe this is a classic section 382 problem (corrected per comment).)  The WSJ story puts the argument and counter-argument over the ruling this way:

But the federal government, in a little-noticed ruling last year, decided that companies that received U.S. bailout money under the Troubled Asset Relief Program won’t fall under that rule.

“The Internal Revenue Service has decided that the government’s involvement with these companies, both its acquisitions plus its disposals of their stock, means they should be exempt” from the rule, said Robert Willens, a New York tax consultant who advises investment banks and hedge funds.

The government’s rationale, said people familiar with the situation, is that the profit-shielding tax credit makes the bailed-out companies more attractive to investors, and that the value of the benefit is greater than the lost tax payments, especially since the tax payments would not exist if the companies fail.

In terms of the “internal” question as between GM and taxpayers, one takes the point that this can be seen as saving money for the taxpayer, or at least simply moving the losses from one pocket to another.   But even granting that, in another way it’s part of the problem.  The tax losses were generated under circumstances in which the losses and associated tax attributes, good and bad and with the tax code limitations as understood then, were about a company in which it was on one side and the Treasury as a revenue collection machine on the other.  All of a sudden, the US government has a very different interest in the company, no longer at arms length, and so now we simply see it as a shift from the taxpayer’s right to left pockets, net position unchanged.  That is true at this moment; it is not true of the situation seen over time.

But probably the biggest question the ruling raises is not about the “internal” question for GM and its USG owner, it is about its relative position to its competitors.  Even if this is just shifting from one pocket to another now that the owner is the USG, it is not merely that for GM’s competitors, who have to cope with a company that, relative to them, now has in effect “found” money.  Which, as the panelists at Stanford pointed out last week, is a real issue for the government as privileged competitor in the marketplace.  Just saying that it doesn’t matter as between government and company is not the whole story; it is also how a change in otherwise long-standing rules changes the relative positions of competitors in the marketplace.

In the past few days there has been speculation that President Obama would name Harvard law professor Elizabeth Warren to be the interim head of the new Consumer Financial Protection Agency (CFPA) created by the Dodd-Frank financial reform legislation.  What did Senator Chris Dodd think of this? TPMDC reports:

In dismissing the rumor last night, though, Senate Banking Committee Chair Chris Dodd — who authored the law — claimed he’d never heard of the interim appointment power.

“I don’t know what it is. I never heard of it before,” said a flabbergasted Dodd to TPMDC. “It’s kind of unique isn’t it?”

Yes it is somewhat unique — the interim appointment would be different than, say, a recess appointment — but the Dodd-Frank legislation provides for interim stewardship of the agency. From TPMDC:

The authority for the Treasury Department to grant an interim appointment — distinct from a “recess appointment” — comes from the financial reform law itself.

To be fair to Senator Dodd, the law does not use the phrase “interim appointment,” but it expressly authorizes the Treasury Secretary to “perform the functions of the Bureau . . . until the Director of the Bureau is confirmed by the Senate.”  This authority would entail naming someone to head the agency until an official director could be confirmed by the Senate.  Presumably this provision was included for a reason, such as to ensure that the new agency could begin work even if either the President or the Senate drags their feet in naming or confirming a new agency head.  But don’t ask Senator Dodd about it.  Even though he was lead sponsor on the bill, he can’t be expected to know everything that’s in it.

(Hat tip: Daniel Foster at NRO)

With an eye to Ben Bernanke’s upcoming testimony to the Financial Crisis Inquiry Commission during the two days of hearings on “too big to fail” – in other words, systemic risk – the WSJ has an editorial in today’s paper raising various questions about the basis on which the Fed, the FDIC, and other agencies concluded that AIG, Bear Stearns, Wachovia, and others qualified as “systemic risk” exceptions allowing for extraordinary actions – i.e., bailouts.

I follow the systemic risk discussions pretty closely, as part of a current writing project, but I realized that I had not been tracking the FOIA requests surrounding some of the US government actions – in part because the government doesn’t seem to be much interested in responding to them.  The general point of the FOIAs is to try and get an understanding of what particular government agencies, and the Fed and FDIC in particular, believed constituted systemic risk, along with an account of how the concept was applied in practice in 2007-2009.  The conclusion of the editorial is, I think, right in the question it poses:

Two years after the bailouts and more than a month after President Obama signed into law new authority for the government to prevent “systemic risk,” Washington still won’t tell us what this term means. Releasing the history of 2008 would at least allow us to know what regulators thought it meant at the time, with lessons for the future.

I agree that the question takes on more importance given the new legislation that confers even more discretionary authority on the Fed to address questions of systemic risk.  What the Fed understands by that term as applied in particular circumstances – which is to say, as a concrete regulatory term, and not just as a matter of a conceptual economic term – is far from irrelevant.  Call it (maybe!) the ‘regulatory casuistry’ of systemic risk, how it gets worked out as a practical term in a run of particular circumstances.

(A useful discussion of the term as a regulatory concept is in Steve Schwarcz’s Georgetown law journal article from midway through the financial crisis, “Systemic Risk,” parts of which are being incorporated into a book Steve and I are doing on financial regulatory reform; the FOIA requests remind me that the concrete ways in which agencies interpret an abstract term that grants them a great deal of discretionary authority matters a lot, and not just the abstract concept denoted by the term.)

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.

The Atlantic is running an excerpt from Sebastian Mallaby’s new book, More Money Than God: Hedge Funds and the Making of  New Elite, which is out on June 14.  The excerpt covers the famous moment when George Soros broke the pound in 1992.  (It was then that I went to work for him, as general counsel to his charities, but mostly I remember people running in and out of rooms bringing him faxes while he was holding simultaneous meetings on assisting Eastern Europe.)  Mallaby is a terrific writer, and if you have any interest at all in the topic – and Mallaby is outstanding at bringing together the matters of finance and money with politics and power – you are likely to be interested in this book.  It is definitely on my summer reading list, although I am desperately hoping for a Kindle version, as I will be traveling and can’t haul around a lot of stuff.

On hedge funds and private equity in a different direction, I received an examination copy of a new textbook, An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm, by David P. Stowell.  It is excellent – clear, informative, well-written.  It is aimed at an undergraduate course audience, perhaps in the upper classes, but would also be perfectly useable in business school as an intro text, as well as in law school as an introductory class in these topics, if the professor were able to supplement it with legal materials.  (In fact, that might make an easy way to create something that does not now seem to exist for law school – a private equity-hedge fund text that covers both the business and legal aspects.  A fix for that might be to use this book, with a detailed supplement with examples and legal documents to illustrate the business descriptions in the text.)

I decided to stop teaching my introductory law school course on venture capital, private equity, and hedge funds, and instead return to the basic Business Associations class in the fall, after 7 or 8 years away from it.  I did so for two reasons – one, I find the whole private equity-hedge funds field too unsettled at the moment to teach with a lot of confidence that what I say now will reflect the industry in even just a couple of years, and I also think that at this moment, it has become so much just part of the deal industry that I can safely leave most of it to the M&A class, at least for now.  Second, though, I also wanted to return to BA, because my interests in business and finance law are shifting back towards the deeply embedded concepts of trust, agency, fiduciary duty, duty of care and duty of loyalty, and away from my long time focus on financial instruments and derivatives.

The latter goes to my scholarly interest in what I have called the “moral psychology of finance,” and somtimes called “virtue economics” – not in the sense of distributional justice in the economy, but instead the Aristotlean sense of “virtue ethics” and its intersection among practical reason, attitudes and rationality, and affective behavior and rational choice.  I am slowly re-reading Theory of Moral Sentiments, alongside Ian Simpson Ross’s exemplary Life of Adam Smith, a book I read with insufficient attention when it first appeared, but which I am re-reading with a great deal of care.

And finally, in this same broad area, I am also re-reading with intense care and considerable respect the papers in Ruth Chang’s 1997 volume, Incommensurability, Incomparability, and Practical Reason – with particular attention to Chang’s excellent introductory paper, and then Elizabeth Anderson’s contribution on practical reason (I’ll let the library locate me her later 2001 book, Making Comparisons Count, at over $100).  Partly this has to do with how this notion of virtue ethics intersects with practical reason – with every passing week, especially as I acquire and mostly skim an ever growing pile of books on the roots and solutions to the financial crisis and regulation, I am convinced that there is a lot more work to be done on the philosophy of economics, the philosophy of value and even the philosophy of valuation.  If I were advising a young person where to make a mark today, that would be a good starting point – where philosophy, economics, and intellectual history come together on these topics.

But, interestingly, the whole question of incommensurability and incomparability is at the center of a new paper I am completing on the vexed issue of proportionality in the laws of war.  Reading the examples in Chang’s book, I am much struck that the question of incommensurability and proportionality are far more real and unavoidable, as far as I can tell, in the ethics of war, and the classic calculation in the ethics of war between the demands of military necessity, on the one hand, and civilian harm, on the other.

From the beginning of the financial reg reform debate I’ve supported the idea of a more coherent and integrated institutional approach to consumer financial protection.  I’ve also consistently argued that a failure of consumer protection was not a major cause of the financial crisis, misaligned incentives were the problem.  In my view the two questions are distinct–I think we need streamlining of the system of consumer protection regardless of whether it caused the crisis, in order to make it more responsive to market dynamics and consumer choice.

And, in fact, there are a few things in the legislation that do that–for example, there is a requirement that the new agency create a new, single form for mortgage disclosures that should help consumers.

So what’s my gripe?  Mainly that the philosophy of the CFPB is predicated on bad economics and a faulty understanding of consumer behavior and that the overall effect of the agency will be negative for consumers–higher prices, less innovation, less competition, less access to mainstream credit and greater use of “fringe” lending products, and ironically, increased threats to the safety and soundness of the banking system.  The fact that the House and Senate appear to be headed for the enactment of some sort of legislation is pretty strong evidence that the Democratic majority in Congress disagrees with me.

I’ve not heard any supporters of the CFPB credibly argue that the overall effect of the new bureaucracy will be to make credit cheaper or more widely available.  Some have argued about the size of the effect–whether it will make consumer credit a lot more expensive or just a little bit more expensive.  But I don’t know of anyone who has contested the sign of the effect–that it will make credit more expensive.

So with that in mind, here’s three things that I’d like to see the conference committee do to further the Bureau’s consumer protection mission while protecting consumers and small business from the unintended consequences of higher credit costs and regulatory overreach.

Better Supervision and Accountability: First, although the current version of the consumer protection regulator has been moved from an independent stand-alone agency into the Federal Reserve, it remains largely unaccountable to oversight by the Federal Reserve Board or any other entity except through a cumbersome and limited oversight process by a council of regulators.  Moreover, it is headed by a single head appointed by the President rather than a commission, leaving the agency’s actions subject to the whims of a single individual.

As an unaccountable bureaucracy with single head, the Bureau will be susceptible to bureaucracy’s worst pathologies: a tunnel vision focus on the agency’s regulatory mission, undue risk aversion, and agency overreach.  While a more coherent consumer protection regime is needed, consumer protection goals can often conflict with other goals such as the promotion of competition, lower prices and expanded choice for consumers, and ensuring safety and soundness.

For example, the law gives the Bureau new authority to regulate slippery mortgage brokers.  But brokers can also provide a salutary competitive check on traditional bank lenders.  Research by economists Morris Kleiner and Richard Todd finds that overly restrictive regulation that reduces the number of mortgage brokers results not only in higher prices for consumers but also lower quality service and higher foreclosure rates.  Thus, while stricter regulations on mortgage brokers could theoretically reduce fraud by brokers (although there is no evidence that is the case), this greater security could come at the expense of higher prices and reduced consumer choice.  An effective consumer protection regulator must be able to balance consumer protection against other benefits to consumers and the economy of greater competition, lower prices, and enhanced safety and soundness.  Even leaving aside bureaucratic pathologies, the current CFPB is not structured to weigh those broader trade-offs between the benefits to consumers of greater competition and consumer protection.

A better model is the Federal Trade Commission, the primary consumer protection regulator for most of the American.  At the FTC (where I was the Director of the Office of Policy Planning from 2003-04), the mission of the Bureau of Consumer Protection is virtually identical to that of the CFPB, focusing particularly on unfair and deceptive marketing.  But the final decision whether to act rests not with the director of the consumer protection bureau but with the five member bipartisan Commission to which the bureau reports.  Moreover, by combining under its roof the Bureau of Competition and the Bureau of Economics, the FTC has a broader scope to weigh the consumer protection bureau’s narrow focus on consumer protection against the larger impacts on competition and economic efficiency (and vice-versa).  Yet no one contends that this larger focus, greater accountability, and internal checks and balances weakens the FTC’s effectiveness as a consumer protection watchdog.

More fundamentally, no FTC veteran believes that consumers would be made better off if the Director of the Bureau of Consumer Protection were unleashed with unilateral authority litigate and regulate without accountability to the Commissioners.  Having located the new bureau inside the Fed, I think that Congress’s conferees would do well to model the relationship between the Federal Reserve Board on the FTC’s structure.

Eliminate the “abusive” standard. Second, the CFPB would have the power to regulate and punish not only “unfair” and “deceptive” lending practices (the FTC’s standard) but also the apparently novel authority to punish “abusive” acts.  The contours of this new basis for liability are vague, but it seems to make lenders responsible for a subjective standard of understanding and competency by the borrower in at least some circumstances.  The House version provides no definition at all, but leaves it solely up to the head of the agency to define.

Here’s the definition of “abusive” in the Senate bill:

The Bureau shall have no authority under this section to declare an act or practice abusive in conneciton with the provision of a consumer financial product or servvice, unless the act or practice:

(1) materially interferes with the ability of a consuemr to understand a term or condition of a consumer financial product or serive;

(2) takes unreasonable advantage of–

(A) a lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service:

(B) the inability of the consumer to protect the intersts of the consumer in selecting or using a consumer financial product or service; or

(C) the reasonable reliance by the consumer on a covered person to act in the interests of the consumer.

What does this mean?  Under the “abusive” standard. the new super-regulator would seem to have power to ban loan terms and products if the Bureau chief considers certain products to be simply too risky or too complicated for some or all consumers, even if (by definition) they are not unfair or deceptive.  Since the definition of “unfairness” tracks the FTC’s definition, it permits the regulator to declare a product to be unfair only if it “causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers” and that “such substantial injury is not outweighed by countervailing benefits to consumers or to competition.”  (The House version of the legislation resuscitates an older, broader FTC standard that was abandoned 30 years ago because of its problems.  I assume that the Senate version that adopts the new FTC standard will be the one that prevails in conference).  As I read the juxtaposition between abusive and unfair, this suggests that under the “abusive” standard certain products could be illegal even if they would be otherwise justified under a cost-benefit analysis of unfairness.  In particular, what this seems like it could reach would be terms that would be justified under an efficient risk-based pricing rationale, but which consumers find too confusing (in the view of the regulator).  How this tradeoff would be determined without the type of analysis contemplated by the unfairness standard is not clear.

If that’s not what “abusive” means, I’d be interested in hearing alternative interpretations.  It is a novel term and I’ve not read any good explanations as to the limits of the term.

The second possible interpretation is potentially more pernicious–it could be read to create certain classes of consumers who are believed to be systematically less able to protect themselves than others.  This is one reading of (2)(B) above.  If so, and its not clear to me that is the case, it raises a whole host of other issues.  But I’ll assume this is not what is meant.

What might this mean?  It seems like the “abusive” standard could give the Bureau chief the authority to ban many non-traditional lending products such as payday lending.  The statute itself provides that the Bureau head is not permitted to impose usury ceilings.  That’s good.  But consider a product like payday lending, where borrowers often roll over their loans from one period to the next.  Empirical research indicates that payday loan customers value highly the option of rolling over their loans.  But so-called consumer advocates are often critical of the rollover option, saying that it creates a “cycle of debt.”  Well, the rollover option is plainly not deceptive (all payday loan customers know about it and is almost certainly not unfair (most borrowers prefer the option).  But could the new super-regulator say that many payday loan customers tend to systematically overestimate their belief that they will pay off the loan at the end of the period and thus underestimate the likelihood that they might end up rolling over their loan?  It seems like it.  Would this qualify as taking “unreasonable advantage of a lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service”?  I think so.

One could extend this logic to almost any non-traditional lending product.  Auto title loans, for example, have an obvious risk that the borrower will lose his car.  Does the borrower fully understand and appreciate his potential that he will fail to pay the loan or the hardship of losing his car?  Virtually every product has this sort of inquiry attached to it.

This suggests that even though the CFPB couldn’t regulate interest rates, it could regulate through the abusive standard virtually every other provision of consumer credit contracts and essentially abolish many of these alternative products.

The big picture here to me is that deceptive and unfair are well-defined and well-understood words from the FTC.  I don’t see what “abusive” adds that is going to be beneficial to consumers.  Instead, it seems to be a largely empty term that empowers the super-regulator to make purely subjective evaluations of certain products and terms.  If we want to have a super-regulator enacting purely paternalistic regulations, as opposed to regulating objectively unfair and deceptive practices, then I think Congress should be more clear that is what it is voting for.

Preemption. Third, the conference committee should reject the legislation’s plan to make it more difficult for federal regulators to preempt state regulatory and enforcement authority over federally chartered banks.  The problem addressed by preemption is longstanding—the effort of populist state legislatures and politically-ambitious Eliot Spitzers to score political points by attacking out-of-state federally chartered banks.  But the consequences are heightened by the national character of the modern banking system which has grown in large part because of the power of federal regulators to preempt parochial state laws.  Moreover, to the extent that the financial crisis supports redundant state authority, the creation of the Bureau seemingly eliminates the primary justification for additional state authority.  Instead, it threatens a nightmare regulatory scenario: a new federal regulator that reaches down to the level of local payday lenders and small merchants while simultaneously empowering state regulators to attack national banks.

This is a very fluid part of the legislation and I expect movement on this issue in conference.

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.

Nobody likes bailouts, but what’s the alternative?  Stanford economist John Taylor has an interesting op-ed in today’s WSJ suggesting that proper reforms of the bankruptcy code could reduce the need for the federal government to retain legal authority to bail out ailing financial firms.  Here is the core of his proposal:

During the past year since the administration proposed its financial reforms, bankruptcy experts have been working on a reform to the bankruptcy law designed especially for nonbank financial institutions. Sometimes called Chapter 11F, the goal is to let a failing financial firm go into bankruptcy in a predictable, rules-based way without causing spillovers to the economy and permitting, if possible, people to continue to use its financial services—just as people flew on United Airlines planes, bought Kmart sundries and tried on Hartmax suits when those firms were in bankruptcy.What would a Chapter 11F amendment look like? It would create a special financial bankruptcy court, or at least a group of “special masters” consisting of judges knowledgeable about financial markets and institutions, which would be responsible for handling the case of a financial firm.

In addition to the normal commencement of bankruptcy petitions by creditors or debtors, an involuntary proceeding could be initiated by a government regulatory agency as prescribed by the new bankruptcy law, and the government would be able to propose a reorganization plan—not simply a liquidation. Defining and defending the circumstances for such an initiation—including demonstrating systemic risk using quantitative measures such as interbank credit exposures—is essential.

Third, Chapter 11F would handle the complexities of repurchase agreements and derivatives by enabling close-out netting of contracts in which offsetting credit exposures are combined into a single net amount, which would reduce likelihood of runs.

Fourth, a wind-down plan, filed in advance by each financial firm with its regulator, would serve as a blueprint for the bankruptcy proceedings.

According to Taylor, such reforms of Chapter 11F are preferable to the proposed “orderly liquidiation” authority, though this sort of reform would face political obstacles.  I would be curious to see what VC readers think of this approach.

According to The Hill, Goldman Sachs CEO Lloyd Blankfein endorsed the financial regulation reform legislation during his Senate testimony today.

“I’m generally supportive,” Blankfein told the Senate Permanent Subcommittee on Investigations.

Wall Street will benefit from the bill because it will make the market safer, Blankfein said.

“The biggest beneficiary of reform is Wall Street itself,” he said. “The biggest risk is risk financial institutions have with each other.”

I don’t think this says much about the merits of the legislation, particularly because Blankfein also confessed not to know all of the bill’s details, but I suspect it could affect the politics.

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!

The Washington Post has an interesting story on the 3-2 split on the Securities and Exchange Commission over whether to file charges against Goldman Sachs.  According to the story, Republican appointees Kathleen Casey (a former Hill aide) and Washington Univeristy law professor Troy Paredes, “were skeptical that the evidence showed that Goldman had misled its clients because the investors were big, sophisticated firms who should have known what they were doing.”  They also raised concerns that filing a flawed case could hurt the agency’s reputation, which is already smarting from its failures to uncover the Madoff ad Stanford fraud schemes.

The dissenting commissioners are not the only ones to raise questions about the SEC’s case.  Sebastian Mallaby and David Zaring also have questions.  Professor Bainbridge also looks at the suit’s timing.

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.