October 17, 2012
June 17, 2012
May 18, 2012
John Geanakoplos, the James Tobin Professor of Economics at Yale University, discusses the perils of leverage in regard to the current global economic situation.
May 14, 2012
January 20, 2012
November 9, 2011
September 5, 2011
If you don't read anything else this Labor Day weekend, check out this Nassim Taleb/Mark Spitznagel op-ed on the impact of dubious government bailout of Wall Street and big banks over the past several years:
For the American economy - and for many other developed economies - the elephant in the room is the amount of money paid to bankers over the last five years. In the United States, the sum stands at an astounding $2.2 trillion. Extrapolating over the coming decade, the numbers would approach $5 trillion, . . . That $5 trillion dollars is not money invested in building roads, schools and other long-term projects, but is directly transferred from the American economy to the personal accounts of bank executives and employees.
Such transfers represent as cunning a tax on everyone else as one can imagine. It feels quite iniquitous that bankers, having helped cause today's financial and economic troubles, are the only class that is not suffering from them - and in many cases are actually benefiting.
As I've been saying for years, it's not rocket science.
August 23, 2011
First, the Wall Street Journal's Holman Jenkins, Jr. notes that Bank of America's declining value reflects that the federal government's bailout of Wall Street during the financial crisis of 2008 has been of dubious merit:
Let's revisit the theory of the bailout. The government holds a safety net under the financial system, preventing a worse panic, with consumers and business cutting back spending more radically, with more people losing jobs, with more houses going into foreclosure.
It made sense on paper and underlies claims today that the government has been a net profiter from its bailout activities.
But it becomes apparent that the 2008 crisis isn't over. And our bailout strategy?
In one presumed lesson of the Great Depression, a splurge of deficit-financed spending is supposed to support the economy while consumers and businesses get over their shellshock. But as George Soros noted to Der Spiegel, the U.S. government in the 1930s wasn't saddled with huge debt. Unless today's deficit spending is visibly directed at projects with a positive return, he says, it just frightens the public that the government itself is going bankrupt.
Meanwhile, this Bradley Keoun and Phil Kuntz/Bloomberg article reports that the Federal Reserve loaned an astonishing $1.2 trillion to Wall Street during the 2008 crisis. Interestingly, that amount is roughly equal to the amount that U.S. homeowners currently own on 6.5 million delinquent and foreclosed mortgages.
The foregoing does not surprise regular readers of this blog. Efficient operation of markets depend in large part on the allocation of losses based on who took the risk of loss. Remove the consequences of that risk and the result is that the politically well-connected profit, not necessarily those who carefully assessed and hedged risk.
Remember, it's not rocket science.
August 19, 2011
August 9, 2011
In early 2005, back when Eliot Spitzer was taking his first pot-shots at American International Group, Inc., I wrote this blog post explaining how even mighty AIG could suffer a fate similar to that of Enron Corporation.
Inasmuch as AIG had a net worth of about $80 billion at the time coming off a previous year of $11 billion in net income on almost $100 billion in revenues, no one (including me) thought there was much of a chance that what I was suggesting could happen to AIG would actually happen to the firm.
Less than four years later, AIG would have suffered the same fate as Enron but for a massive federal government bailout.
The lesson here is that if creditors trust the federal government, then the government's credit standing will remain high regardless of what the New York analysts say. In reality, the market rates the government's credit continuously each moment of every day. Just look at fluctuations in interest rates on government debt.
Quite simply, it's mostly about trust.
July 26, 2011
As Washington dithers over whether the federal government should default on its debt obligations, it is helpful to remember that New York City faced the same problem a generation ago.
This Financial Times video provides an excellent overview of the background and implications of that financial crisis.
June 1, 2011
March 2, 2011
Meanwhile, Charles Gasparino explains why those who made faulty business decisions that led to a major U.S. banking crisis really shouldn't be prosecuted for crimes.
Yet, Skilling continues to serve a 24-year prison sentence and endure the immense collateral damage of his fate.
On the other hand, Mozilo and Fuld deal with civil litigation and move on with life.
Neither Mozilo nor Fuld should be prosecuted for trying to save their companies. Any responsibility that they have for the demise of their companies can be allocated in the civil justice system among all the responsible parties.
But that Jeff Skilling remains in prison - particularly given the despicable way in which he was put there - remains a serious blot on the American criminal justice system.
A truly civil society would find a better way.
December 13, 2010
Larry Ribstein -- the law professor who has done more than anyone in the blogosphere to decry the enormous financial and human cost of the federal government's criminalization of business lottery over the past decade - highlights in this blog post Ninth Circuit Judge Alex Kozinski's lucid concurrence in the Ninth Circuit's reversal of the business fraud conviction of former Network Associates CFO, Prabhat Goyal:
This case has consumed an inordinate amount of taxpayer resources, and has no doubt devastated the defendant's personal and professional life. The defendant's former employer also paid a price, footing a multimillion dollar bill for the defense. And, in the end, the government couldn't prove that the defendant engaged in any criminal conduct. This is just one of a string of recent cases in which courts have found that federal prosecutors overreached by trying to stretch criminal law beyond its proper bounds. See Arthur Andersen LLP v.United States, 544 U.S. 696, 705-08 (2005); United States v. Reyes, 577 F.3d 1069, 1078 (9th Cir. 2009); United States v. Brown, 459 F.3d 509, 523-25 (5th Cir. 2006); cf. United States v. Moore, 612 F.3d 698, 703 (D.C. Cir. 2010) (Kavanaugh, J., concurring) (breadth of 18 U.S.C. Â§ 1001 creates risk of prosecutorial abuse).
This is not the way criminal law is supposed to work. Civil law often covers conduct that falls in a gray area of arguable legality. But criminal law should clearly separate conduct that is criminal from conduct that is legal. This is not only because of the dire consequences of a conviction-including disenfranchisement, incarceration and even deportation-but also because criminal law represents the community's sense of the type of behavior that merits the moral condemnation of society. See United States v. Bass, 404 U.S. 336, 348 (1971) ("[C]riminal punishment usually represents the moral condemnation of the community . . . ."); see also Wade v. United States, 426 F.2d 64, 69 (9th Cir. 1970) ("[T]he declaration that a person is criminally responsible for his actions is a moral judgment of the community . . . ."). When prosecutors have to stretch the law or the evidence to secure a conviction, as they did here, it can hardly be said that such moral judgment is warranted.
Mr. Goyal had the benefit of exceptionally fine advocacy on appeal, so he is spared the punishment for a crime he didn't commit. But not everyone is so lucky. The government shouldn't have brought charges unless it had clear evidence of wrongdoing, and the trial judge should have dismissed the case when the prosecution rested and it was clear the evidence could not support a conviction. Although we now vindicate Mr. Goyal, much damage has been done. One can only hope that he and his family will recover from the ordeal. And, perhaps, that the government will be more cautious in the future.
As Professor Ribstein has been saying for years, the problem with this policy is that the government is prosecuting agency costs, such as KPMG pushing the edge of the envelope on tax shelters or Andersen not using very good sense in carrying out its document retention policy.
There is a big difference between prosecuting agency costs and prosecuting clear-cut crimes, such as embezzlement. The difference relates primarily to the nature of the evidence involved, the relevance of contracts, and the subtleties of dividing responsibility between corporate actors.
Professor Ribstein has put it this way. Suppose somebody mugs you on the street. There is no question that is a crime.
However, what if the mugger asks you first if he can borrow your wallet, you loan it to him, and then he doesn't give it back in time? What if the mugger asks your employee who's running the store for you whether he can borrow some money, the employee allows it and then the mugger doesn't pay it back? What if the "thief" is another employee who says the manager gave him the money as bonus compensation?
Who is liable in these situations turns on the contracts among the various parties. Proof depends on who said what to whom. Can we rely on what the witnesses say about this? What if the prosecutor tells the employee who's minding the store that he'll not face prosecution for conspiracy if he spills the beans on the other employee who says that the manager gave him bonus compensation?
Society needs to have appropriate punishment and accounting for clear-cut crimes. But in cases such as Enron or Lehman Brothers, the civil lawsuits -- unlike the criminal prosecution - included all the people involved, including the directors who approved wrongful corporate conduct and accountants and lawyers who may have facilitated it. That is a much more rational and effective way in which to deal with agency costs than attempting to make them appear to be clear-cut crimes, which they simply are not.
Finally, criminal prosecutions over merely questionable business judgment obscure the true nature of risk and fuel the myth that investment loss results primarily from criminal misconduct. Taking business risk is what leads to valuable innovation and wealth creation. Throwing creative and productive business executives such as Michael Milken and Jeff Skilling in prison does nothing to educate investors about the true nature of risk and the importance of diversification.
The supposed payoff to criminal prosecutions of agency costs is deterrence. But some businesspeople will keep on pulling these shenanigans regardless of the prosecutions, while the legitimate risk-takers who create jobs and wealth for the community sorts will be the ones who are deterred.
I'm not suggesting that the Bernie Madoffs of the world should be encouraged. But the cases against businesspeople such as Milken, Skilling, Hank Greenberg, Jamie Olis, the NatWest Three and the Merrill Lynch bankers are fundamentally different than Madoff's scam, and I am not comfortable that politically ambitious prosecutors can tell the difference. As Professor Ribstein notes in another article, "prosecutors turn up the fire [in mounting dubious business prosecutions] and then sell extinguishers."
September 9, 2010
No, really. Get a load of this:
The unexpectedly deep plunge in home sales this summer is likely to force the Obama administration to choose between future homeowners and current ones, a predicament officials had been eager to avoid.
Over the last 18 months, the administration has rolled out just about every program it could think of to prop up the ailing housing market, using tax credits, mortgage modification programs, low interest rates, government-backed loans and other assistance intended to keep values up and delinquent borrowers out of foreclosure. The goal was to stabilize the market until a resurgent economy created new households that demanded places to live.
As the economy again sputters and potential buyers flee - July housing sales sank 26 percent from July 2009 - there is a growing sense of exhaustion with government intervention. Some economists and analysts are now urging a dose of shock therapy that would greatly shift the benefits to future homeowners: Let the housing market crash.
When prices are lower, these experts argue, buyers will pour in, creating the elusive stability the government has spent billions upon billions trying to achieve.
As regular readers of this blog know, the notion that housing markets need to allocate risk of loss before those markets can stabilize and recover is not rocket science.
In fact, the government's dithering over the past two years in propping up these inflated housing markets has actually made the situation worse because it has postponed the transfer of misallocated resources in the housing markets to other markets.
Another day, another failed bailout. So it goes.
August 26, 2010
August 23, 2010
Regular readers know that I'm not a big fan of Treasury Secretary Geithner.
But after poorly-conceived governmental programs subsidizing mortgage loans played a not insubstantial part in the worst financial crisis in a generation, this NY Times article left me speechless for a few days:
Treasury Secretary Timothy F. Geithner, speaking Tuesday at a conference to discuss the possibilities [of reforming the government's role in housing finance], made clear that the administration was not pondering such radical kinds of surgery as it develops a proposal it hopes to unveil in January.
Rather, Mr. Geithner and the conference after his remarks focused largely on drafting a new and improved version of the current system, in which the government subsidizes mortgage loans made by private companies.
Mr. Geithner said continued government support was important to make sure that Americans can borrow at reasonable interest rates to buy a house even in a downturn. The absence of such support, Mr. Geithner said, would deepen future recessions because unsubsidized private companies would curtail lending.
I mean really. After what we've been through, why on earth should the government be involved in mortgage markets in any respect?
Government intervention in mortgage markets is simply a thinly-disguised redistribution of income. But even if you think government should be doing such things, creating moral hazard in mortgage markets is a very costly way to accomplish that goal.
Stated simply, the social benefits of home ownership result from homeowners building equity in their homes through saving and enhancing neighborhoods. Those social benefits are not generated from homeowners who borrow excessively to speculate on housing in which they have no equity.
As with proponents of publicly-financed sports stadiums, proponents of such redistribution policies should simply make their case that redistribution is sound public policy and not disguise it in expensive mortgage subsidies. They don't because of fear that voters would reject such a redistribution policy if they came to understand the true cost of these subsidies. Truth in advertising in politics is rare, indeed.
August 7, 2010
Could it be that folks are finally realizing that old-fashioned greediness really should not be a crime?
Of course, the rationalization for the lack of villains now as compared to earlier crises has never been particularly compelling.
Business prosecutions over merely questionable business judgment obscure the true nature of risk and fuel the myth that investment loss results primarily from criminal misconduct. Taking business risk is what leads to valuable innovation and wealth creation. Throwing creative and productive business executives such as Michael Milken and Jeff Skilling in prison does nothing to educate investors about the true nature of risk and the importance of diversification.
Ignorance about business risk has led in part to the criminalization of business lottery. Such a lottery breeds cynicism and disrespect for the rule of law. Isn't it about time that dubious policy be put to permanent rest?
July 28, 2010
Yesterday's post touches on the enormous direct costs attributable to the federal government's questionable policy of regulating business through criminalization of bad or simply incorrect business judgments.
However, as enormous as those direct costs are, the indirect costs of criminalizing bad business judgments dwarfs the direct ones.
Whether management makes such judgments correctly is a fundamental risk of business ownership. Criminalizing that risk -- through the prism of hindsight bias -- will simply make executives in the future less likely to take the risks necessary to build wealth and create jobs while not deterring in the slightest the Bernie Madoffs of the world from embezzling money.
Business owners deserve protection from theft, but not from risk taking, and it's not clear that government prosecutors know -- or even care about -- the difference.
Those indirect costs came to mind again as I read this Wall Street Journal article (H/T Russ Roberts) on the unintended consequences arising from the government?s new regulations concerning rating agencies:
Ford Motor Co.'s financing arm pulled plans to issue new debt, the first casualty of a bond market thrown into turmoil by the financial overhaul signed into law Wednesday.
Market participants said the auto maker pulled a recent deal, backed by packages of auto loans, because it was unable to use credit ratings in its offering documents, a legal requirement for such sales. The company declined to comment.
The nation's dominant ratings firms have in recent days refused to allow their ratings to be used in bond registration statements. The firms, including Moody's Investors Service, Standard & Poor's and Fitch Ratings, fear they will be exposed to new liability created by the Dodd-Frank law.
The law says that the ratings firms can be held legally liable for the quality of their ratings. In response, the firms yanked their consent to use the ratings, hoping for a reprieve from the Securities and Exchange Commission or Congress. The trouble is that asset-backed bonds are required by law to include ratings in official documents.
The result has been a shutdown of the market for asset-backed securities, a $1.4 trillion market that only recently clawed its way back to health after being nearly shuttered by the financial crisis.
Professor Roberts sums it up in his post by quoting Hayek:
"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."
July 27, 2010
Take Enron, for example. The anti-business myth contended that that Enron ? at one time one of the largest publicly-owned companies in the U.S. -- was really just an elaborate financial house of cards that a massive conspiracy hid from innocent and unsuspecting investors and employees.
The Enron Myth is so widely accepted that otherwise intelligent people reject any notion of ambiguity or fair-minded analysis in addressing facts and issues that call the morality play into question. The primary dynamics by which the myth is perpetuated are scapegoating and resentment, which are common themes of almost every mainstream media report on Enron.
The mainstream media -- always quick to embrace a simple morality play with innocent victims and dastardly villains -- was not about to complicate the story by pointing out that the investors in Enron could have hedged their risk of loss by buying insurance quite similar to that which Enron developed in creating their wealth in the first place.
Instead of attempting to examine and tell the nuanced story about what really happened at Enron, much of the mainstream media simply became a part of the mob that ultimately contributed to the death of Ken Lay and hailed the barbaric 24 year sentence of Jeff Skilling. Ambitious prosecutors, given wide latitude to obtain convictions of key Enron executives regardless of the evidence, gladly took advantage of the firestorm of anti-Enron public opinion to lead the mob.
As noted originally here and in many subsequent posts over the years, it is far more likely that the truth about Enron is that no massive conspiracy existed, that Skilling and Lay were not intending to mislead anyone and that the company was simply a highly-leveraged, trust-based business with a relatively low credit rating and a booming trading operation.
Although there is nothing inherently wrong with such a business model, it turned out it to be the wrong one to survive amidst choppy post-bubble, post-9/11 market conditions when the markets were spooked by revelations of the embezzlement of millions of dollars by Enron CFO Andy Fastow and a relative few of his minions.
The carnage of the Enron Myth is now piled high -- the destruction of Arthur Andersen, the death of Lay, the outrageous prosecutorial misconduct involved in the case against Lay and Skilling, the senseless prosecution and imprisonment of the four Merrill Lynch executives in the Nigerian Barge case, Richard Causey, Chris Calger, Kevin Howard, Joe Hirko and the other Enron Broadband defendants -- the list goes on and on.
In the wake of such destruction of careers and lives, the public is even less willing to confront the vacuity of the myth and the destructive dynamics by which it is perpetrated. indeed, even though what happened to Enron has now happened to Bear Stearns, Freddie and Fannie, Merrill Lynch, Lehman Brothers, AIG and any number of other trust-based businesses over the past two years, much of the public and the mainstream media still cling to the Enron Myth.
Attempting to challenge this enduring myth is a wonderful new resource -- Ungagged.net: The Other Side of the Enron Story.
Created, funded and filmed by Beth Stier -- who was the subject of prosecutorial misconduct as a non-party witness in the trial of the Enron Broadband case -- Ungagged.net is a "webumentary." That is, a website comprised of short modules of documentary-style content, organized into two main categories: "What It Was Like to Be on The Other Side of the Enron Story," and "Behind the Scenes of The Other Side of the Enron Story."
Ungagged.net currently features over a dozen relatives of defendants, attorneys, former Enron executives and employees telling their stories about what they experienced personally in dealing with the overwhelming governmental power and societal forces at work in the Enron saga. Moreover, six experts in economics, political science, finance, UK law and civil liberties -- including Clear Thinkers favorites William Anderson and Harvey Silverglate -- provide their views on the ominous implications that the government's handling of the Enron case have on us all.
Ms. Stier continues to add new information to the site, the latest of which are dozens of snippets from fascinating interviews of David Bermingham and Gary Mulgrew, two of the NatWest Three bankers from England who were caught up in an international firestorm in connection with the Enron Task Force's effort to turn Fastow and his right-hand man, Michael Kopper, into witnesses for the Task Force against Skilling and Lay. This series of interview modules paints an absolutely fascinating tale of three regular fellows from the U.K. having their lives, families and careers turned utterly upside down by governmental forces that viewed them as mere pawns in a much larger game.
Apart from the its egregious human toll and the serious abuse of state power that its promoters ignore, the Enron Myth?s devastating impact is that it obscures the true nature of investment risk and fuels the notion that investment loss results primarily from someone else's misconduct. As Larry Ribstein has been asking for years, do we really want to be sending a message to investors that risk is bad when it often leads to valuable innovation and wealth creation?
For example, self-settled derivative prepay transactions are not particularly intuitive (no product actually changes hands) and are not well-understood outside the trading business. Nevertheless, such transactions provide the valuable benefit of hedging risk for companies, who pass along that benefit to consumers in the form of lower prices for their products and services.
Do we really want to allow prosecutors and regulators to paint such beneficial transactions as frauds and then manipulate the public's ignorance to demonize innovative risk-takers who are attempting to create wealth? How does throwing creative and productive business executives such as Michael Milken and Jeff Skilling in prison do anything to educate investors about the true nature of risk and the importance of diversification and hedging?
Ungagged.net is currently a voice in the wilderness advocating against such governmental overreach. Here?s hoping that voice grows louder as those of us who are concerned by the pernicious growth of abusive governmental power listen to the stories and observations contained in this valuable resource.
The trailer for the webumentary is below.
July 19, 2010
As noted in April when the Securities and Exchange Commission brought its lawsuit against Goldman Sachs, the case was destined to settle with Goldman paying a hefty settlement, which the SEC announced last week. But Larry Ribstein expands on that thought in this timely post on what the proposed settlement means to the folly of the current reform movement regarding governmental regulation of financial firms:
The SEC is heralding the $550 million settlement in its suit against Goldman as “the largest penalty ever assessed against a financial services firm in the history of the SEC,” and “a stark lesson to Wall Street firms that no product is too complex, and no investor too sophisticated, to avoid a heavy price if a firm violates the fundamental principles of honest treatment and fair dealing.” Surely the agency had a strong incentive to try to use the Goldman settlement to obscure the memory of Madoff, Stanford and the Bank of America settlement. Meanwhile,today’s NYT concludes its Goldman story with a quote suggesting Goldman got off lightly.
The truth is far more disturbing: the SEC got a big payday in what would have been seen as a strike suit had it been a private securities class action lawyer. [. . .]
What clues on all this can be gleaned from a settlement that involves a huge amount of money but only an admission of a “mistake”?
The bottom line is that this suit has proved to be no more than a common “strike” suit, no better than the sort of private securities class actions that triggered Congressional reform 15 years ago. Instead of attorneys’ fees, the SEC’s objective appears to have been purely political. In the end it extracted a ransom payment from Goldman so the firm could reclaim its reputation and get back to business.
The court must now review the settlement. It should take a cue from the dissenting Commissioners and reject it because of the puzzling and troubling inconsistency between the amount of the settlement and Goldman’s meaningless admissions. The SEC should have to prove exactly what Goldman did wrong. This will force Goldman to either litigate or make a meaningful settlement. Goldman is hardly an object of pity at this point. In any event, the issues here go far beyond Goldman to, among other things, the proper role and function of the SEC.
It is sad that the SEC not only cannot be trusted to find fraud, but that it can no longer be trusted to litigate and settle cases involving the supposed frauds that it finds. But this is where we find ourselves in the days following “financial reform.”
Expecting the SEC to regulate a firm as sophisticated as Goldman Sachs effectively is about as rational as investing one’s entire nest egg with Bernie Madoff or Allen Stanford.
June 30, 2010
It’s good to see that James Surowiecki has come around to my way of thinking that better investor education is far more likely to hedge the risk of future financial scandals than throwing a few business executives in prison:
The government’s new consumer-protection agency has the authority to “review and streamline” financial literacy programs, but that’s not enough. We really need something more like a financial equivalent of drivers’ ed. There’s evidence that just improving basic calculation skills and inculcating a few key concepts could make a significant difference. One study of the few states that have mandated financial education in schools found that it had a surprisingly large impact on savings rates. . . .The point isn’t to turn the average American into Warren Buffett but to help people avoid disasters and day-to-day choices that eat away at their bank accounts. The difference between knowing a little about your finances and knowing nothing can amount to hundreds of thousands of dollars over a lifetime. And, as the past ten years have shown us, the cost to society can be far greater than that.
Surowiecki is spot-on with his observation (as is this TGR post on Surowiecki's article), but the promoters of the Greed Narrative continue to protest -- what about the innocent victims who lost their nest eggs as a result of the collapse of a company such as Enron?
Well, one of the main reasons that those victims' nest eggs ever had value in the first place was because innovative executives such as Jeff Skilling and Ken Lay transformed Enron into the world's leading energy risk management company through the creative use of futures and options contracts to hedge price risk for natural gas producers and industrial consumers.
Although it’s fine to feel sorry for someone who loses money on an investment, the Greed Narrative ignores the fact that most of those "victims" who lost their nest eggs were imprudent in their investment strategy. Taking Enron as an example, those investors should have diversified their Enron holdings or bought a put on their Enron shares that would have allowed them to enjoy the rise in Enron's stock price while being protected by a floor in that share price if it fell below a certain value. Those are the type of precautions that a prudent – and well-educated – investor would take in regard investing in a trust-based business.
Incongruously, while virtually all of those Enron "victims" hedged the risk of their investment in their homes by purchasing homeowner's insurance, few of them hedged the risk of their investment in Enron stock. Most of them simply did not understand how Enron's risk management services created their nest egg in the first place. Thus, when those nest eggs evaporated during the bank run on Enron, those investors didn't even try to understand what truly had occurred. They simply embraced the easy-to-understand Greed Narrative.
The Greed Narrative's devastating impact is that it obscures the true nature of investment risk and fuels the myth that investment loss results primarily from someone else's misconduct. As Larry Ribstein has been asking for years, do we really want to be sending a message to investors that risk is bad when it often leads to valuable innovation and wealth creation?
Do we really want to allow prosecutors and regulators to paint such beneficial transactions as frauds and then manipulate the public's ignorance to demonize innovative risk-takers?
At a time when America desperately needs innovators and entrepreneurs to create jobs and wealth, better education for investors makes much more sense than the paths we have been taking.
June 14, 2010
In this NY Times op-ed, Richard Thaler picks up on a theme that Ken Rogoff and James Hamilton raised last week – the similarity between the miscalculation of risks relating to the Gulf of Mexico oil spill and the Wall Street financial crisis:
AS the oil spill in the Gulf of Mexico follows on the heels of the financial crisis, we can discern a toxic recipe for catastrophe. The ingredients include risks that are erroneously thought to be vanishingly small, complex technology that isn’t fully grasped by either top management or regulators, and tricky relationships among companies that are not sure how much they can count on their partners.
For the financial crisis, it has become clear that many chief executives and corporate directors were not aware of the risks taken by their trading desks and partners. Recent accusations against Goldman Sachs suggest the potential for conflicts of interest among banks, investors, hedge funds and rating agencies. And it is clear that regulators like the Securities and Exchange Commission, an agency staffed primarily with lawyers, are not well positioned to monitor the arcane trading strategies that helped produce the crisis.
The story of the oil crisis is still being written, but it seems clear that BP underestimated the risk of an accident. Tony Hayward, its C.E.O., called this kind of event a “one-in-a-million chance.” And while there is no way to know for sure, of course, whether BP was just extraordinarily unlucky, there is much evidence that people in general are not good at estimating the true chances of rare events, especially when human error may be involved. [. . .]
How can government reduce the frequency and the severity of future catastrophes? Companies that have the potential to create significant harm must be required to pay for the costs they inflict, either before or after the fact. Economists agree on this general approach. The problem is in putting such a policy into effect.
Suppose we try to tax companies in advance for activities that have the potential to harm society. First, we have to have some basis for estimating the costs they may inflict. But before the recent disasters, companies in both the financial and oil drilling sectors would have claimed that the events we are now trying to clean up were, well, one-in-a-million risks, suggesting a very low tax.
Alternatively, an offending party could be made to pay after the fact, by holding it responsible for the costs it imposes. BP has volunteered that it will pay for all damages it considers “legitimate,” but we can expect a fight over how to define that word.
. . . Suppose a company worth only $1 billion was responsible for this accident. It would go bankrupt and we would be unable to collect. And if we aren’t careful, we will encourage companies that have enough money for collection to leave the drilling to those that don’t. [. . .]
We are left in a difficult place. Neither the private nor the public sector seems up to handling these kinds of problems. And we can’t simply wait for the next disaster, because, as people might say if they had to use G-rated language, stuff happens.
Professor Hamilton zeros in on the group dynamic that leads to the underestimation of risk:
I think part of the answer, for both toxic assets and toxic oil, has to do with a kind of groupthink that can take over among the smart folks who are supposed to be evaluating these risks.
It's so hard to be the one raising the possibility that real estate prices could decline nationally by 25% when it's never happened before and all the guys who say it won't are making money hand over fist.
And this interacts with the forces mentioned above. When the probability of spectacular failure appears remote, and moreover it hasn't happened yet, it's hard to set up incentives, whether you're talking about a corporation or a regulatory body, in which the person who makes sure that the risks stay contained is the person who gets rewarded. When everyone around you starts thinking that nothing can go wrong, it's hard for you not to do the same. It can become awfully lonely in those environments to try to be the voice of prudence.
Finally, Cato's Gerald O'Driscoll, Jr. notes the futility of reacting to the oil spill by implementing even more regulation:
What is the missed lesson from all this? When President George W. Bush had his Katrina moment, the federal government's bumbling response was blamed on him, on the Republicans, and on conservatives. Now it is President Obama's turn. His administration's faltering response to the disaster in the Gulf is attributed to his personal failings, staff ineptitude, communication failures, etc. And, of course, the two administrations have shared responsibility for the poor handling of the financial crisis.
A big-government conservative administration failed in crisis, as has a big-government liberal administration. The regulatory state did not prevent excessive risk taking whether in financial services, nor perhaps in offshore oil drilling. Government response to crises once they occur is slow and inept. All this is not because either Republicans or Democrats are in power, but because big government doesn't work. It can't deliver on its promises. Big government overpromises and underdelivers. In reaching to do more, big government accomplishes less. That is not an ideological statement, but an empirical observation.
In the case of financial services, virtually all the proposed regulatory reform offers more of the same. Additional regulations will be added to existing ones without addressing why existing ones failed to prevent the crisis. The same process will likely happen with respect to offshore drilling.
The oil spill has triggered an important debate about the value of off-shore drilling, and that debate might conclude that off-shore drilling generates more harm than benefit.
But despite the nightly photos and videos of the oil spill on television, it’s important to remember that drilling produces benefits in addition to its costs. Deep-sea drilling has been ongoing for decades with relatively few incidents that even come close to the current spill.
So, while this spill may reveal that deep-sea drilling is too risky, it’s also quite possible that this incident was simply the result of poor decision-making combined with bad luck, and that there is a nominal chance that it will reoccur.
And it is very difficult to regulate bad decision-making and bad luck.
Stuff happens, indeed.
May 5, 2010
Mostly, the politicos contend that financial derivatives are dangerous instruments that are contrary to sound public policy. We have to protect those poor souls who bet against John Paulson, don't you see?
But the proponents of this view simply do not want to understand the nature of derivatives, just as most of the same ones didn't want to understand the valuable nature of the risk management of natural gas prices that Ken Lay and Jeff Skilling contributed to markets 20 years ago.
Derivatives are simply a way for an investor to warn by trading - that is, by putting his money where his mouth is - that he has information about an upcoming shift in the markets. That facilitates a transparent and well-informed marketplace.
However, heavily regulating traders from taking advantage of that valuable source of information only makes it more difficult for valuable information about market shifts to reach the marketplace. How is that good for investors seeking as transparent and well-informed marketplace as possible?
An underappreciated cause of the Wall Street crisis was the underlying information failure. As opposed to restricting trading, we ought to be finding ways to bring more information to the market faster so that prices can be adjusted promptly. Rather than demonizing folks who bet their money in bringing information to the marketplace, we ought to be encouraging them.
I won't hold my breath waiting for that to happen.
May 3, 2010
Although it really shouldn't have surprised anyone, the big business news at the end of last week was the the Department of Justice had opened up a criminal probe of Goldman Sachs well before the filing of the SEC's lawsuit a couple of weeks ago.
Craig Pirrong provides his typically lucid perspective toward the news, while the Epicurean Dealmaker insightfully notes a dynamic involved in the growing cascade against Goldman Sachs that should concern us all. Interestingly, that dynamic is the same one that was involved in the prosecution to death of former Enron chairman, Ken Lay.
Frankly, after almost a decade of misdirected prosecutions of businesspeople, it's confounding that many citizens believe that a prosecution of Goldman Sachs would serve any useful public interest.
It is indisputable that government cannot possibly discover or prosecute all business fraud. But government policies that purport to prevent fraud by prosecuting simply prompt private parties to be less careful in detecting or avoiding fraud in the first place.
Moreover, the utter randomness of the criminalization-of-business policy undermines the public's respect for the rule of law. For example, who can possibly keep up with all the rules that government has invoked in determining whether an important businessperson gets prosecuted for a supposed business crime?
And who could forget the Geithner Rule?
Frankly, the rule of law has been replaced by what Larry Ribstein has coined the criminalization-of-business lottery where winning or losing becomes random.
And no one lost bigger than Jeff Skilling.
Finally, who possibly can justify what Bill Furst has been through?
Just as with a gambling lottery, there is no rhyme or reason as to who wins or loses in the criminalization-of-business lottery. But in this lottery -- which does little or nothing to deter the true business criminals of the world -- the losers and their families give up much more than merely money.
A truly civil society would find a better way.
April 19, 2010
The inevitable SEC action against Goldman Sachs took the financial system by storm on Friday, so the weekend has been a feast of blogosphere analysis on the implications of the lawsuit. The best way to follow daily developments in the case is over at Clusterstock where Joe Weisenthal and Henry Blodget have their fingers on the blogosphere’s pulse in regard to the SEC lawsuit.
The best analysis of the lawsuit that I’ve read in the blogosphere to date comes from Larry Ribstein, Erik Gerding and UH’s Craig Pirrong. Read their posts and you will have a good understanding of the issues involved in the case.
Frankly, the SEC action against Goldman looks a lot more about public relations than effective regulation. As Blodget pointed out on Friday morning, the timing of the filing pushed the highly embarrassing SEC Inspector’s report on the SEC’s bungling of the investigation into Stanford Financial off the public’s radar screen. One would hope that the SEC’s due diligence in regard to its action against Goldman is better than its research into Stanford Financial, which was widely known in Houston financial and legal circles to be a sketchy outfit for over a decade before it blew up last year.
The key to the SEC's case is that Goldman apparently did not disclose to ACA nor IKB and ABN knew that uber-mortgage short specialist John Paulson was placing bets against the underlying securities upon which the synthetic CDO was based at the same time as Paulson was helping Goldman and ACA choose the underlying securities.
Thus, the theory goes, Paulson presumably had an incentive to enhance the failure of the securities. Accordingly, the SEC contends that Goldman and Paulson structured the deal to lose, that Goldman knew the investors wouldn't buy if they knew that, and that Goldman didn't disclose those details because it was making fees all over the place.
My sense is that the case is far from a slam dunk (see also here and here) for the SEC, but it probably doesn't make any difference. If Goldman defends itself and loses, then the trial penalty is that private civil lawsuits by other investors will use the judgment in favor of the SEC to establish liability against Goldman (interestingly, Goldman elected not to disclose its receipt of the Wells Notices related to the SEC lawsuit). Although Goldman could manage the payment of an SEC fine, damages in those civil lawsuits could seriously harm the firm.
Thus, my sense is that Goldman has to settle with the SEC, and probably for a good chunk of change to make the SEC look good. That will likely suit Goldman just fine because it would continue to distract the public from the far larger travesty, which was the way in which the federal government bailed Goldman out from its massive risk of loss in regard to AIG.
From a policy standpoint, the SEC action is a part of the Obama Administration's public relations campaign to promote federal regulation of the derivatives markets, a point that Professor Ribstein makes in this post:
In other words, the SEC, under pressure to come up with something on the eve of Congress's final push toward financial regulation comes with a case that the complaint makes clear is much more about the creation of systemic risk than about securities fraud.
This reflects, in part, the new Wall Street, more than three quarters of a century after the securities laws were enacted. Financial regulation is now much more about sophisticated market intermediaries than about individual investors who need somebody to ensure they have the truth about securities.
This is not to say that securities fraud is irrelevant. However, the SEC has struggled on that front – the Bank of America settlement, Madoff, Stanford.
And so now we are left with . . . Goldman.
Inasmuch as such regulation will allow federal regulators to exercise the same judgment in regard to derivatives regulation that it applied to regulating the likes of Stanford Financial and Bernie Madoff, count me as decidedly unconvinced that this development constitutes progress.
However, one positive aspect about the SEC’s complaint is that it provides a stark reminder to investors of the risk of doing business with the likes of Goldman. As Arnold Kling has been saying for years, perhaps it wouldn’t be such a bad thing if investors didn’t rely so much on the chauffered investment bankers of Wall Street and their friends in government.
March 16, 2010
Well, I’m as full of bullshit as anyone, but my sense is that Mike’s analysis is flawed. That’s not to say that the folks involved in reporting Lehman’s earnings to the marketplace after those repo 105 transactions didn’t commit fraud. I don’t know enough about the facts to know one way or the other.
The main point of my post is that a whole bunch of of executives, accountants, auditors, counterparties and governmental officials were swirling around Lehman at the time of these repo 105 transactions. As a result, the responsibility for any fraud is better allocated among the responsible parties in the civil justice system than in the criminal justice system, where guilt is adjudicated with a sledgehammer when a scalpel is more appropriate.
But one of the interesting aspects about Mike’s post is that he is very sure that he understands that Lehman committed fraud. So, let’s take a look at his example of what he thinks happened with regard to Lehman and the repo 105 transactions (my observations are in italics below each of his statements):
I ask you to invest $100,000 in my new business. You ask me how much money I have in my business account. I only have $5,000, but do not tell you this.
Okay, as my prior post noted, I concede that Lehman may have misrepresented its true liquidity position through the repo 105 deals.
I can sell everything the business owns (including all of our inventory) to a pawn shop for $100,000.
If Mike can sell all the assets of the business to a pawn shop for $100,000, then the business owns much more than $100,000 in assets. Pawn shops - much like the financial institutions with whom Lehman was dealing – do not engage in repo 105 transactions unless they are darn sure that they can liquidate the assets that they purchase for more than they paid if the seller breaches his obligation to repurchase the assets.
The pawn shop will sell me everything back for $105,000 if I come up with the money within 48 hours. They won't even take possession of the property if I pay them within 48 hours.
I do not know of any pawn shop – or financial institution for that matter – that would be willing to leave property that they purchased in the hands of a financially-troubled seller, even for just 48 hours. Moreover, my understanding of the repo 105 transactions is that Lehman was not obligated to repurchase the asset for the sale price plus 5%. My understanding is that the “105” in repo 105 relates to the fact that financial institutions require property at least worth 105% of the purchase price that the financial institution pays the seller for the asset. I’m sure that Lehman’s counterparties required a steep fee for engaging in the repo 105 sales, but not 5% of the purchase price.
I make the "sale" to the pawn shop. I show you a copy of my bank statement. You can see that I have $105,000 cash in my bank account. I'm, in other words, liquid 100 grand. You loan me $100,000.
Here is where Mike is confused. Prior to taking the $100,000 loan, his company’s balance sheet actually looks a bit worse because of his sale to the pawn shop. The company has sold assets worth more than $100,000 in order to increase its liquidity to $105,000. No rational investor would make a $100,000 unsecured loan to a company with assets of only $105,000 cash that the investor would not have been willing to make when the company had $5,000 cash and over a $100,000 in non-liquid assets. But , let’s play along with Mike to get to his main point. After the loan, his company now has $205,000 in cash with a $100,000 liability.
I buy my stuff back for $105,000. I now have, thanks to you and some quick accounting fraud, $95,000.
No, that’s only part of it. The company now has repurchased its assets that are worth over $100,000, it has cash of $100,000 and a $100,000 liability. So, the company’s balance sheet is pretty much the same had the investor made his loan when the company only had $5,000 cash and over $100,000 of non-liquid assets. The only difference is that the investor feels deceived because he would not have made the loan under those circumstances.
So, maybe Mike’s investor in the example above has a good fraud case against the company (I’m not sure that’s the best way for the investor to recover his loan, but that’s another issue). But maybe not, too. And the situation that Lehman faced was far more complex than Mike’s hypothetical and involved a large number of well-intentioned people who were attempting to find any loophole available to save Lehman.
And that’s no bullshit.
March 15, 2010
The big news in the business world at the end of last week and over the weekend was the publication of the examiner's report in the Lehman Brothers bankruptcy case.
The mainstream media jumped all over the report as a precursor to criminal indictments of former Lehman executives because of allegations in the report (that's all they are at this point) that Lehman used repo 105 transactions at the end of several quarters to make its balance sheet look more attractive than it really was. Fancy that, executives trying to stem a run on a trust-based business!
Despite the gathering MSM lynch mob, the truth is that the examiner's report is shaky grounds, at best, for criminal indictments against former Lehman executives. As folks who are experienced in bankruptcy realize -- but those who aren't don't -- an examiner's report is hardly an objective analysis of a debtor's affairs. Bankruptcy examiners are highly incentivized to recommend as many legal actions against the debtor's insiders and counterparties as possible. The fruits of those legal actions inure to the benefit of the bankruptcy debtor's creditors, which is really the only constituency in most bankruptcy cases that really can effectively challenge an examiner's compensation. As a result, feather nesting is not an unusual tactic of bankruptcy examiners.
Moreover, examiner's reports in bankruptcy cases are far from dispositive. I haven't read the Lehman examiner's report yet, but I'm skeptical of the MSM's initial rave reviews. The Enron examiner's report met with similar early favorable reaction, but it turned out to be chock full of plain factual errors and dubious conclusions based on those errors.
For example, the MSM's reporting of the examiner's conclusions regarding the timing of the repo 105 transactions doesn't make sense to me. As I understand those transactions, they improved Lehman's balance sheet by increasing its liquidity position at the end of several quarters through converting non-liquid assets to cash. When Lehman repurchased the assets after the date of the financial statement, the balance sheet didn't change much except for showing less liquidity because the repurchased asset - which went back on the balance sheet after the repurchase - was probably worth more than the liquidity used to repurchase it (I seriously doubt that the sharpies who were dealing with Lehman as it was going down in flames were consenting to using Lehman's trash assets in the repo deals).
At any rate, Peter Henning and Larry Ribstein have both done a good job of analyzing the main problem facing the Lehman insiders from a criminal standpoint. It is different and potentially more troublesome than the honest services wire fraud theory that was the basis of most Enron-related prosecutions. That is, the Lehman executives are subject to the provisions in the Sarbanes-Oxley legislation enacted after Enron's bankruptcy that impose criminal liability on executives who falsely certify the (i) accuracy of the financial statements and (ii) absence of deficiencies in internal controls regarding the preparation of the financial statements.
By the way, although Henning's analysis is quite good, his analogy of the repo 105 transactions to the Nigerian Barge transaction in the Enron-related criminal prosecutions is a stretch. The Nigerian Barge transaction was a relatively small deal in which Enron -- about an $80 billion market cap company at the time -- sold its interest in the Nigerian barges to Merrill Lynch to make a $12 million profit at the end of the particular quarter. On the other hand, the examiner alleges that Lehman was using repo 105 transactions to raise $35 - $50 billion of liquidity at the end of several quarters. Big difference.
Also, flying beneath the radar (as usual) is current Treasury Secretary Timothy Geithner and former Treasury Secretary Hank Paulson's role in all of this. As closely as Geithner (as head of the New York Federal Reserve) and Paulson (as Treasury Secretary) were monitoring Lehman during much of this time, it strains credulity that Geithner and Paulson didn't have at least some idea of what Lehman was doing to make its balance sheet as attractive as possible. Both Geithner and Paulson were intimately involved in attempting to broker a Bear Stearns-type bailout of Lehman.
So, if Geithner and Paulson knew what was going on, then how on earth is the federal government going to single out Richard Fuld and other former Lehman executives for criminal conduct?
Which brings us to the real lesson of all this -- that is, the inherently fragile nature of a trust-based business (related posts here) and the misguided nature of the notion that more governmental regulation will somehow protect investors from the next bust of such a business.
Larry Ribstein has been insightfully pointing out for years that more regulation of those businesses will not prevent the next meltdown, just as the more stringent regulations added under Sarbanes-Oxley after Enron's collapse did not prevent Lehman Brothers from failing. More responsive forms of business ownership certainly are a hedge to the inherent risk of investment in a trust-based business. But also helpful would be better investor understanding of the wisdom of hedging that risk and the importance of short sellers in providing information on troubled companies to the marketplace.
And as for criminal prosecutions? Unless there is evidence beyond a reasonable doubt of a crime, far better to allow the civil justice system allocate responsibility for Lehman's failure among the multitude of potentially responsible parties. Professor Ribstein nails this point in the final paragraph of his post:
The lesson here is that pursuing high-profile criminal prosecutions in Lehman after the problems with such prosecutions in these situations proved so manifest in Enron would prove that after a decade of hugely costly trials and a massive new law that was supposed to change everything, we still haven't learned a thing about the unsuitability of criminal liability for these kinds of cases.
Finally, Lawrence Kudlow and John Carney have an excellent seven-minute discussion below of the failure of governmental regulation in regard to Lehman:
February 17, 2010
This time, Norris applies the Enron narrative to Greece, which supposedly hid its true financial condition from honest investors through engaging in complex derivative transactions with the ever-present and greedy investment bankers.
There is only big problem with Norris’ morality tale. It’s not true.
As University of Houston finance professor Craig Pirrong points out in this blog post that runs rings around Norris and the Times’ dubious analysis, what Greece was doing in using swaps engineered by the investment banks to finance its way into the European Monetary Union has been well known since the early part of this decade. Thus, as Professor Pirrong points out, “nobody . . . has any more reason to be shocked about these transactions than Captain Reynaud had to be shocked about gambling going on at Rick’s.”
That includes Floyd Norris and the New York Times.
February 13, 2010
Don't miss George Mason University economic professor Russ Roberts' lucid, four minute statement to a House Committee condemning the federal government's bailout of large financial institutions. The written statement is here. As I've been saying all along, it's not rocket science.
February 2, 2010
Neil Barofsky, the Special Inspector General for the Troubled Asset Relief Program, observed something similar in his quarterly report regarding the troubled TARP program:
The government's bailout of financial institutions deemed "too big to fail" has created a risk that the United States could face a worse fiscal meltdown in the future, an independent watchdog assigned to review the program told Congress on Sunday.
The Troubled Assets Relief Program, known as TARP, has not addressed the problems that led to the last crisis and in some case those problems have festered and are a bigger threat than before, warned Neil Barofsky, the special inspector general at the Treasury Department.
"Even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car," Barofsky wrote.
Barofsky wrote the $700 billion financial bailout has encouraged more risk-taking because bank executives, who are still receiving massive bonuses, figure the government will come to the rescue the next time they steer their ships nearly aground. . . .
None of what Barofsky reports is a surprise to regular readers of this blog. It was not rocket science.
January 29, 2010
Geithner has made his share of dubious decisions over the past several years. I think he was wrong not to allow the markets to allocate the risk that many financial institutions took, particularly in regard to American Insurance Group. As a result of these decisions, I don’t think he should be the Secretary of the Treasury.
But I do not think it is fair to question that Geithner honestly believed that the actions he took were necessary to save the U.S. and world financial systems from chaos. You, like me, may not believe he was right about that, but there is little question that he honestly believed that he was mitigating the risk of a financial tsunami.
Turning to Skilling, the DOJ’s case against Skilling now boils down to several alleged misrepresentations that Skilling approved regarding a couple of financially-troubled divisions of Enron. But the overwhelming evidence at trial was that Skilling truly believed that the statements he approved regarding those divisions were accurate.
For example, one of those divisions – Enron Broadband – was attempting to develop and deliver the video-on-demand service that is now a popular and profitable product of digital television and such gadgets as Apple's iPod. These systems are a creative accommodation to copyrighted music and video programming that has generated enormous wealth for artists and shareholders of companies in the business.
Skilling testified at trial about his optimism regarding Broadband:
“And one last thing -- I'll make the last one argument for Broadband because people criticize me about Broadband, and I will take the criticism. We -- certainly, we made a mistake. But it wasn't big. I mean, it was a billion dollars. We invested a billion dollars in the Broadband business. If it had worked, it could have been worth $30 billion. It didn't work. We lost a billion dollars, but if you can make those kinds of bets, that's the kind of the risk you [should be taking] as a corporation. And if you do a lot of [deals with a] downside of a billion and upside of 30 [billion], you're doing a good job for your shareholders in the long run, in my opinion. This one didn't work.”
Given the current value of video-on-demand technology, Skilling's valuation of Enron's Broadband business opportunity was probably low. But regardless of the wisdom of Enron’s timing in investing in that technology, there is little question that Skilling honestly believed that Enron Broadband could generate enormous wealth for Enron’s shareholders.
Geithner will probably leave the Treasury soon and return to a Wall Street firm to make his fortune. Skilling lost his fortune and remains in a Colorado prison, where he is enduring a 24-year prison sentence.
I submit that no rational basis exists for the radically different futures of these two men.
December 26, 2009
But doesn't the U.S. Constitution -- not to speak of simple human decency -- provide him with the opportunity to contest the government's charges against him fairly?
These earlier posts (here, too) touched on the indefensible prison conditions that the federal government has imposed on R. Allen Stanford as he awaits trial on criminal fraud charges arising from the demise of Stanford Financial Group.
Last week, Stanford's lawyers filed the motion below requesting that U.S. District Judge David Hittner release Stanford on strict conditions pending his trial that would make it virtually impossible for him to go to the corner drug store without the U.S. Marshals being notified immediately.
Judge Hittner promptly denied the motion without comment, which is next to inexplicable given what is contained in the motion. Here is a mere sampling:
Mr. Stanford has been incarcerated since June 18, 2009 and was moved to the [Federal Detention Center] on September 29, 2009. Immediately upon his arrival at the FDC, he underwent general anesthesia surgery due to injuries that were inflicted upon him at the Joe Corley Detention Facility. He was then immediately taken from surgery and placed in the Maximum Security Section — known as the “Special Housing Unit” (SHU) — in a 7' x 6 1/2' solitary cell. He was kept there, 24 hours a day, unless visited by his lawyers. No other visitors were permitted, nor was he permitted to make or receive telephone calls. He had virtually no contact with other human beings, except for guards or his lawyers.
When he was taken from his cell, even for legal visits, he was forced to put his hands behind his back and place them through a small opening in the door. He then was handcuffed, with his arms behind his back, and removed from his cell. After being searched, he was escorted to the attorney visiting room down the hall from his cell; he was placed in the room and then the guards locked the heavy steel door. He was required, again, to back up to the door and place his shackled hands through the opening, so that the handcuffs could be removed. At the conclusion of his legal visits, he was handcuffed through the steel door, again, and then taken to a different cell where he was once again required to back up to the cell door to have his handcuffs removed and then forced to remove all of his clothing. Once he was nude, the guards then conducted a complete, external and internal search of his body, including his anus and genitalia. He was then shackled and returned to his cell. In his cell there was neither a television nor a radio and only minimal reading material was made available to him. He remained there in complete solitude and isolation until the next time his lawyers returned for a visit.
In short, Mr. Stanford was confined under the same maximum security conditions as a convicted death row prisoner, even though the allegations against him are for white collar, non-violent offenses. He is certainly not viewed as someone who poses a threat to other persons or the community, nevertheless, he has been deprived of human contact, communication with family and friends, and was incarcerated under conditions reserved for the most violent of convicted criminals. Officials at the FDC informed counsel that this was for Mr. Stanford’s “own protection” and to minimize their liability. . . .
The U.S. criminal justice system used to be an institution that distinguished a free society from those that endured under oppressive regimes.
But with cases such as Stanford's, it's sure getting hard to tell the difference between the U.S. system and the supposedly more oppressive ones.
November 28, 2009
Following on a point made in these earlier posts, the Chron's Mary Flood reports on the indefensible conditions that the federal government has imposed on R. Allen Stanford as he awaits trial on criminal fraud charges arising from the demise of Stanford Financial Group.
Sort of reminds you of the way in which certain other countries handle the prosecution of business executives, doesn't it?
Ironically, while rightfully questioning whether Stanford is being given a fair shake, the Chron continues to avoid examining its equally dubious record in creating a presumption of community prejudice against Jeff Skilling.
Witch hunts do not reflect well on the participants.
November 18, 2009
What caused the financial crisis?
The widely accepted narrative, prominent in the media and pressed by the Obama administration, is that the crisis was caused by deregulation--the "repeal" of the Glass-Steagall Act and the failure to regulate both derivatives and mortgage brokers--which allowed excessive financial innovation, risk taking, and greed among financial players from mortgage brokers to Wall Street bankers.
With this diagnosis, the proposed remedy is more regulation and government control of the financial system, from the over-the-counter derivative markets to mortgage brokers and the compensation of CEOs.
The alternative explanation is that the crisis was caused by the government's own housing policies, which fostered the creation of 25 million subprime and other low-quality mortgages--almost 50 percent of all mortgages in the United States--that are now defaulting at unprecedented rates.
In this narrative, the fact that two-thirds of all these weak mortgages are now held by government agencies, or were produced by government requirements, shows that the demand for these mortgages--and the financial crisis itself--originated in Washington.
The problem for the administration's narrative is that its principal examples do not stand up to analysis: the repeal of a portion of the Glass-Steagall Act did not eliminate the restrictions on banks' securities activities (they were left unchanged), the mortgage brokers were responding to demand created by the government, and, there is no evidence that the failure to regulate credit default swaps (CDS) had any effect in causing or enhancing the financial crisis.
Without a persuasive explanation for the cause of the financial crisis, the administration's regulatory proposals rest on a mythic foundation.
An enduring truth about financial regulation is this: Given the discretion to do so, financial regulators will always do the wrong thing.
Remember -- it's the incentives, folks.
November 11, 2009
Despite the government's sordid expansion of crimes against business people over the past decade, at least it's not a crime to decline to throw in the towel on a business venture simply because there are signs that it might fail. As John Carney eloquently points out, that's in all of our best interests.
Sort of makes one wonder what would have happened if Jeff Skilling had been tried in even a reasonably fair environment?
And the government's response of putting Messrs. Cioffi and Tannin through hell over the past year?:
"Of course, we are disappointed by the outcome in this case, but the jurors have spoken, and we accept their verdict," said Benton Campbell, the U.S. Attorney for the Eastern District of New York, in a written statement.
Of course, the off-the-record response was a tad less diplomatic toward the jury. But at least Campbell should know about failed prosecutions. Is a result such as this the reason why he insists on continuing to bring them?
Update: Frostburg State Economics Professor William Anderson, who has written extensively on the adverse economic impact of the government's criminalization of business policy, followed the trial closely and provides this insightful postscript, which includes the following insightful observation about the obstacles that defendants face even in the face of a weak prosecution:
If anything, the slanderous and dishonest post-acquittal remarks by prosecutors drive home just how contemptuous federal prosecutors are of everyone else. The jury did not acquit because they were too stupid and vapid to understand the clarity of the prosecution’s case; they acquitted because they did understand that the government’s simple, clear presentation was not true, or, at very best, did not do a good job of meeting the "reasonable doubt" standards.
I was not surprised at the acquittal, given what I knew was presented in court and given what my sources had been telling me. My only fear was a federal jury being, well, a federal jury that throws sops to those poor, underpaid prosecutors who claim they only are trying to do justice.
In the end, however, the jury did its job, and judge did his job, the defendants were innocent, and the prosecution continued to lie. Oh, and the media will continue to be the media. Like the Bourbons, they "learn nothing and they forget nothing."
November 10, 2009
As with many folks in the financial and legal world, I'm finishing up Andrew Ross Sorkin's entertaining new best-seller, Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System---and Themselves (Viking 2009). Clear Thinkers favorite Arnold Kling has the best analysis of the book that I've read to date:
Reading the book leads me to ponder the differences between Chauffered America--Hollywood, investment bankers, and high government officials--and Strip Mall America--people who launch businesses like restaurants, hair salons, and other small enterprises. [. . .]
The obvious sociological point is that the top finance people live in a bubble, with secret entrances, isolated offices, chauffered automobiles, and private jets. Even the top government officials inhabit this world. Sorkin describes Geithner arriving at the airport in DC and losing it over not being met by a driver. Forced to take a taxi, Geithner turns to his colleague and says that he has no cash. Perhaps this would have been a moment to teach the head of the New York Fed how to use an ATM. [. . .]
I do not see how reading this book can help but reinforce a Simon Johnson/James Kwak view of Washington captured by Wall Street. Paulson seems to have no use for anyone who is not a Goldman Sachs alumnus. Geithner seems to have no use for anyone who is not a CEO of a large financial institution. Both of them view the collapse of major Wall Street firms as Armageddon.
The "regulatory overhaul" promised by the Obama Administration is still the same-old, same-old. Chauffered America will be restored to its exalted status, with a few new rules and regulations thrown in.
Instead, somebody should be asking the deeper question about Chauffered America. If Chauffered America were to disappear, would the rest of us miss it? Or could Strip Mall America get along just fine without the big-time bankers and their friends in government?
One comes away from the book with the conclusion that the primary purpose of the government and corporate leaders involved in resolving the crisis was to maintain the elitist culture of Wall Street with regard to financial matters, while at all times making sure that the government protected the maximum number of the folks making the bad bets from ever having to endure the true extent of the risk that they took in placing those bets. That's why things like this happened.
As I noted after the demise of Lehman Brothers last fall, resolving the crisis was not rocket science. Sorkin's book establishes that the leaders who were calling the shots were never going to let on that such was the case.
November 3, 2009
Last week, we learned that Timothy Geithner, while the head of the New York Fed, let Goldman Sachs and several other large investment banks fleece the Fed in connection with the AIG bailout.
Then, over the weekend, we learn that the Geithner-orchestrated $2.3 billion federal government investment in C.I.T. Group last fall without requiring debtor-in-possession financing protections under chapter 11 of the Bankruptcy Code is going to result in a total loss of that investment. Why? Because C.I.T. has decided to file bankruptcy now.
Now, in the big scheme of things, $2.3 billion is not all that much money when placed in the context of the federal budget and the American economy. Heck, it's not even close to as much as Geithner left on the table for the investment banks in regard to the AIG bailout.
But Geithner has proven beyond a reasonable doubt that he is in over his head. This bailout stuff is not rocket science.
Why is Geithner still Treasury Secretary?
October 29, 2009
Timothy Geithner -- while heading up the New York Fed in 2008 -- left upwards of $13 billion of taxpayer money on the table to the likes of Goldman Sachs, Merrill Lynch and Deutsche Bank during negotiations over payment of AIG's credit default swaps because "some counterparties insisted on being paid in full" and Geithner "did not want to negotiate separate deals."
As regular readers of this blog know, I thought the federal bailout of AIG and various other Wall Street firms was a bad idea from the start because it prevented our insolvency and reorganization system from allocating the risk of loss among the creditors of the financially-troubled firms.
Nevertheless, after various political forces stoked a climate of fear, Congress approved broad bailout legislation even though it was clear at the time that few of the legislators understood what they were approving.
Not surprisingly, various large creditors of the financially-troubled firms did very well for themselves under the bailout legislation. Can't blame them for protecting their shareholders' interests, now can you?
But really. Geithner got fleeced for billions in regard to AIG's bailout by investment banks that had no negotiating leverage whatsoever. What were the banks going to do if Geithner had demanded that they take a discounted amount? Risk a global financial meltdown by demanding that the Fed pay AIG's CDS's at par?
Geithner let them get away with it. And now he is out Treasury Secretary.
September 16, 2009
The legal and business communities are still buzzing over U.S. District Judge Jed Rakoff's scathing refusal earlier in the week to approve the proposed $33 million "settlement" (i.e., sweep under the rug) between the SEC and Bank of America over that the Bank's failure (at least transparently) to disclose to its shareholders the billions in bonuses that the Bank agreed that an insolvent Merrill Lynch was allowed to pay to its employees.
The 12-page decision is certainly worth a read. Judge Rakoff tears into into the SEC for contradicting its own guidelines in penalizing BofA shareholders rather than the executives and lawyers who supposedly approved the lack of disclosure. The settlement "does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank's alleged misconduct now pay the penalty for that misconduct." The Judge didn't buy the SEC's contention that this punishment will result in better management, characterizing it as "absurd." Sort of like the notion that the SEC can really police this type of thing in the first place.
Judge Rakoff goes on in his opinion to raise at least another half-dozen or so good questions about the proposed settlement. But there's a couple more that I wish he'd asked.
A few years ago, former Enron chairman Ken Lay was prosecuted to death for promoting Enron to its shareholders even though he had a reasonable basis for believing that what he was saying about his company was true.
In contrast, the BofA executives and lawyers could not even offer the defense in a criminal fraud trial that the bad things they intentionally failed to tell BofA shareholders about the Merrill Lynch deal were immaterial.
So, isn't it about time that somebody in the federal government acknowledge that it was a mistake to prosecute Ken Lay to death? And isn't it about time that the government do something about this barbaric injustice?
August 7, 2009
Frank Quattrone, the former CSFB investment banker who has an interesting perspective, notes a dynamic of the now almost decade-long criminalization of business that I have been warning business owners and lawyers about for quite some time now -- the increasing cost of public equity:
[W]hy did [public offerings] disappear in the first place?
One reason is the heightened bar for small companies to go public, Mr. Quattrone said. Throughout his career, he said, some of the greatest companies he was associated with had $30 million to $50 million in revenue when they went public. Today, he said, bankers require companies to have $100 million or even $200 million in revenue.
Part of the underappreciated societal impact of prosecutors such as those on the Enron Task Force implementing the criminalization of business lottery is that the days of small companies tapping public equity for relatively cheap venture capital are gone. Moreover, the supply of executives who are willing to work for public companies is smaller because many of the best and the brightest simply do not consider the risk of operating in the public domain worth the draconian downside. The result is that investment alternatives for investors in public markets are declining.
Not exactly a policy to encourage economic revival, now is it?
Update: Along the same lines, Larry Ribstein reviews the destruction of public equity wealth in regard to AIG that resulted in no small part from Eliot Spitzer's machinations. It's a risk that I first noted in regard to AIG way back in early 2005. When will we learn?
July 31, 2009
Has there ever been a Treasury Secretary who has been an easier target than Timothy Geithner?
|The Daily Show With Jon Stewart||Mon - Thurs 11p / 10c|
|Home Crisis Investigation|
July 15, 2009
Casey Mulligan's clever post below reminded me of the classic Onion News segment that follows:
In 2008, we were told that each American taxpayer had to spend thousands on bank bailouts in order to avoid utter disaster. We were not supposed to object, because a few thousand is a cheap price to pay for disaster avoidance.
In early 2009, we were told that each American taxpayer had to spend thousands on fiscal stimulus in order to avoid utter disaster. We were not supposed to object, because a few thousand is a cheap price to pay for disaster avoidance.
Now we are told that each American taxpayer has to spend thousands (? amount to be unveiled later) on government health care in order to avoid utter disaster. We were not supposed to object, because a few thousand is a cheap price to pay for disaster avoidance.
We are lucky to have the White House to save us from so many disasters!
July 9, 2009
I recognize that he is not the most popular fellow in Houston investment circles these days, but is anyone else but me a tad uncomfotable that the federal government is running roughshod over R. Allen Stanford?
As everyone following the Stanford Financial Group scandal knows by now, at the request of the Department of Justice, U.S. District Judge David Hittner overruled a federal magistrate's order last week that would have allowed Stanford to remain free on bond pending his trial on business fraud charges. As a result, Stanford is imprisoned in Houston's Federal Detention Center pending his trial, which will probably not occur until sometime next year.
Meanwhile, the DOJ, the SEC, a federal court-appointed receiver and a British receiver operating in Antigua have frozen all of Stanford's personal assets, as well as the assets of the Stanford Financial empire. Consequently, Stanford has no funds with which to retain counsel.
And now he doesn't even have the freedom to help his attorneys prepare his defense.
However, it's now become reasonably clear that the DOJ and the SEC's repeated public allegations that Stanford was running a Ponzi Scheme through Stanford Financial are, if not outright false, at least misleading and irresponsible.
Stanford Financial clearly owned substantial assets, including the Antiguan Bank that also owned substantial assets itself. Perhaps those assets were over-valued and perhaps Stanford and his associates misled investors on the bank's capability of repaying the certificates of deposit that the company promoted and sold. But that's a far cry from running a Ponzi Scheme.
Moreover, the government's efforts to prevent Stanford from paying for defense counsel are downright scary.
The fact that Stanford Financial is not in a position to pay them is not particularly surprising. The company would probably be in bankruptcy if it were not already in receivership, and it's unlikely that either a bankruptcy judge or a U.S. district judge would allow the company to pay for Stanford's criminal defense.
But putting aside for the moment the issue of Stanford not being allowed to use his personal assets to defend himself, Stanford Financial has a Director's & Officer's insurance policy that provides for payment of at least a portion of Stanford's defense However, the Stanford Financial receiver has threatened to seek contempt charges against the insurer (Lloyds) if it pays Stanford's defense costs as it is contractually obligated to do under the policy. At the same time, the receiver, the DOJ, and the receiver are spending millions in preparing the case against Stanford. My conservative estimate is that the government's tab is more than $25 million already (the receiver alone has a pending request for $20 million in fees).
Finally, Stanford has exhibited absolutely no inclination to flee from the charges against him. He has numerous family ties to Texas and the Houston area, and he has no prior criminal record. And it's not as if Stanford can just walk away from the charges if he is allowed out on bond. He has no passport and, with the GPS tracking device that the U.S. Marshal's Office requires criminal defendants to wear these days, the U.S. Marshals know immediately when a defendant is going somewhere that he is not supposed to be.
It's easy to look the other way when this type of concerted effort by the federal government essentially strips an unpopular businessman of the capacity to defend himself against charges that could imprison him for the rest of his life.
But remember -- if it can happen to R. Allen Stanford, then it can certainly happen to you and me.
A copy of Stanford's motions seeking release of funds for his defense and for reconsideration of his detention order are below.
July 2, 2009
Being generally an optimistic sort, I keep thinking that the financial crisis of the past year or so will eventually prompt the Houston Chronicle to reconsider its generally biased coverage of the demise of Enron over the past seven years. After all, it's not every day that the Fifth Circuit Court of Appeals concludes that a newspaper's coverage of a particular event was a major factor in the creation of a presumption of community prejudice.
Nevertheless, the local paper's recent coverage of disgraced financiers R. Allen Stanford and Bernard Madoff reflects that no such soul-searching is likely to emerge anytime soon down on Texas Avenue.
Take this recent Loren Steffy column in which he asks the following: "Why, then, does Madoff get a sentence six times that of [former WorldCom CEO Bernie] Ebbers or Enron’s Jeff Skilling?"
I mean, really. Is the answer to that question all that difficult?
Madoff turns himself in and admits from the outset that he was stealing money from investors for years by running a Ponzi scheme. Any wonder why he was hammered by the sentencing judge?
Ebbers was essentially convicted of covering up accounting fraud at WorldCom, but he at least put up a colorable defense that he was not responsible for such matters and had no knowledge of the fraud.
Moreover, Skilling wasn't even accused of accounting fraud. He was convicted essentially of making too many rose-colored statements about Enron, notwithstanding that his belief in the truth of those statements was never seriously challenged.
Finally, neither Ebbers nor Skilling stole a dime from the investors of their respective companies. Yet, Steffy insists upon comparing them with the larcenous Madoff. who essentially stole tens of millions. The Greed Narrative prevails again.
But here's my main point. Now that what happened to Enron has happened to numerous other trust-based Wall Street firms, shouldn't the Chronicle be advocating that similarly aggressive criminal prosecutions be mounted against numerous executives of the Wall Street firms who made the same type of rosy statements about their wobbling companies as Skilling made about Enron?
Now, I don't believe that there was widespread criminal fraud at Enron. The only true criminal fraud there was relatively small and isolated in Andrew Fastow's Global Finance unit. Similarly, I don't believe that there was widespread criminal fraud at the Wall Street firms that endured the same downward spiral that engulfed Enron.
But inasmuch as the Chronicle fanned the flames of criminal prosecutions against dozens of Enron executives and others involved in transactions with them, shouldn't the Chronicle be taking the same position with regard to executives at the similarly-situated Wall Street firms? Or at least shouldn't the Chronicle be explaining why it threw dozens of Enron executives under the bus even though it now fails to advocate similar treatment for executives of the failed Wall Street firms?
It seems like the least that the local newspaper can do.
June 16, 2009
Tongues were wagging in financial circles around the world last week regarding this Wall Street Journal article about Austin-based Amherst Holdings' amazing play in which they sold credit default swaps on mortgage bonds to a number of Wall Street and London's biggest banks. Amherst then turned around and bought the mortgages underlying the bonds upon which the CDS were written to prevent a default that would have triggered Amherst's obligation to pay on the CDS.
Thus, in short, Amherst sold CDS on bonds and then bought the security for the bonds, thereby rendering the CDS worthless. Although the amount of profit is somewhat unclear, Amherst reportedly pocketed tens of millions of dollars on the deal.
The Financial Times' economist Willem Buiter does an entertaining job of explaining Amherst's transactional plan in the context of gambling and the difficulties involved in regulating such transactions. In so doing, he makes the following observation:
"The scheme is beautiful in its simplicity, absolutely outrageous, quite unethical, deeply deceptive and duplicitous, indeed quite immoral, but apparently legal."
Geez, maybe these Amherst sharpies could have saved AIG?
June 13, 2009
June 6, 2009
May 18, 2009
Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Yes, it was all the fault of deregulation.
There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we’re in now. Third, the continental Europeans — who supposedly have much better-regulated financial sectors than the United States — have even worse problems in their banking sector than we do. The German government likes to wag its finger disapprovingly at the “Anglo Saxon” financial model, but last year average bank leverage was four times higher in Germany than in the United States. Schadenfreude will be in order when the German banking crisis strikes.
We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street. New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers. And the globalization of finance played a crucial role in raising growth rates in emerging markets, particularly in Asia, propelling hundreds of millions of people out of poverty.
The reality is that crises are more often caused by bad regulation than by deregulation. [. . .]
. . . Taxpayers, therefore, should beware. It is more than a little convenient for America’s political class to blame deregulation for this financial crisis and the resulting excesses of the free market. Not only does that neatly pass the buck, but it also creates a justification for . . . more regulation. The old Latin question is highly apposite here: Quis custodiet ipsos custodes? — Who regulates the regulators? Until that question is answered, calls for more regulation are symptoms of the very disease they purport to cure.
Stated another way, it's not that rules are unnecessary for markets to perform efficiently. But what type of rules are better?
Rules that politicians enact and government bureaucrats enforce generally are far less efficient than rules that emerge as a result of the voluntary interactions of millions of individuals and companies. The successes and mistakes of those individuals and companies pursuing their own interests create rules that are the product of competition and personal responsibility. When those rules become sufficiently important in the fabric of a market economy, they become formalized as common law and precedent by courts. The distinction between inefficient government-imposed rules and the decentralized rules that facilitate productive market economies is an important one to understand as we wade through this current financial crisis.
The rules that the government is currently making up on the fly in connection with the Chrysler bankruptcy are a good example of rules that are destined to allocate resources inefficiently.
April 24, 2009
Joe Weisenthal and Henry Blodget over at Clusterstock have been all over the breaking story yesterday that, as many of us suspected, former Treasury Secretary Henry Paulson and perhaps other governmental officials threatened Bank of America CEO Ken Lewis and the BofA board if the bank exercised its right to terminate the Merrill Lynch acquisition based on a material change in Merrill Lynch's financial condition.
Of course, this is not the story that Lewis and Paulson were telling to BofA shareholders. They were assuring the shareholders that the Merrill Lynch acquisition was a great deal for BofA.
A few years ago, former Enron chairman Ken Lay was prosecuted to death for promoting Enron even though he had a reasonable basis for believing that what he was saying about his company was true. In contrast, neither Lewis nor Paulson could even offer the defense in a criminal fraud trial that they thought that the good things that they were telling BofA shareholders about the Merrill Lynch deal were true. We now know that they knew that the assurances were false.
This is not to suggest that Paulson or Lewis should be prosecuted for criminal fraud. They were in an extremely difficult situation -- they and others were concerned that the U.S. and world financial system might collapse if the markets became spooked by BofA backing out of the Merrill Lynch deal. I didn't agree with that concern, but I understood the position of those that did. They may have been correct. At this point, we'll never know for sure.
However, regardless of whether that view was correct, neither Paulson nor Lewis should be prosecuted for a violation of criminal law for their actions. Although they made intentionally false statements to the markets regarding BofA's acquisition of Merrill Lynch, there is no question that they thought what they were doing was essential to saving the financial system and firms such as BofA. If their actions make them responsible for damages to BofA shareholders, then let that liability be sorted out in civil court where liability can be allocated fairly to everyone who had a hand in causing those damages. What's to be gained by throwing them in prison? They simply were not operating on the same fraud plane as Bernie Madoff.
But here is my other point -- Ken Lay was prosecuted to death for conduct that was not even intentional. Now that what happened to Enron has happened to many of the biggest and most prestigious Wall Street firms, isn't it about time that somebody in the federal government acknowledges that what was done to Ken Lay was a massive injustice?
And in the meantime, isn't it about time that this barbaric injustice be rectified, too?
April 10, 2009
From Bill Flanagan's recent interview with Bob Dylan:
What's your take on politics?
Politics is entertainment. It's a sport. It's for the well groomed and well heeled. The impeccably dressed. Party animals. Politicians are interchangeable.
Don't you believe in the democratic process?
Yeah, but what's that got to do with politics? Politics creates more problems than it solves. It can be counter-productive. The real power is in the hands of small groups of people and I don't think they have titles.
March 30, 2009
David Henderson makes an insightful point about the Ryan Moats/Robert Powell run-in in Dallas last week in which Powell (the policeman) exhibited an utter lack of common sense, much less prosecutorial discretion (and this incident is apparently not the first time that Powell has exhibited this type of behavior):
So what is the essence? The issue of control. Read the abridged transcript of the interaction or, better yet, watch the whole 20-minute video. What comes out loud and clear is that the policeman was upset because the driver, Ryan Moats, tried passionately to tell him the nature of the emergency, whereas what Robert Powell saw as being primary was that Moats wait patiently while Powell wrote him a ticket. Even once a nurse came out from the hospital and assured the policeman that Moats's mother-in-law was dying, Powell, writing the ticket, said, "I'm almost done." Must get that ticket written no matter why Moats jumped a red light. [. . .]
This is the nature of government whether the government employees are policemen with guns on their sides or sometimes in their hands or are teachers in government-financed schools. The whole Powell-Moats incident reminds me of a passage from Steven E. Landsburg's book, Fair Play: What Your Child Can Teach You About Economics, Values, and the Meaning of Life. Landsburg tells of the propaganda his daughter Cayley's teachers subjected her to about the importance of not letting the water run when she brushed her teeth. Landsburg writes:
[. . .]
Where is the pattern, then? What general rule compels us to conserve water but not to conserve on resources devoted to education? The blunt truth is that there is no pattern, and the general rule is simply this: Only the teacher can tell you which resources should be conserved. The whole exercise is not about toothbrushing; it is about authority.
The Moats-Powell incident is a micro example of the government's proclivity to exert power arbitrarily. That essential nature is being largely ignored as the Obama Administration runs headlong into seeking even greater governmental regulation over broad sectors of the economy.
Given that one of the clearest lessons of the 20th century is the capacity of large government to cause unspeakable evil, any effort to centralize more power in the federal government should be subject to the most careful scrutiny and not the type of superficial posturing that Congress has exhibited to date.
Count me as not confident that Congress will oblige.
March 28, 2009
As regular readers of this blog know, I thought the federal bailout of AIG and various other Wall Street firms was a bad idea from the start because it prevented our bankruptcy system from allocating the risk of loss among the creditors of the financially-troubled firms.
Nevertheless, after various forces stoked a climate of fear, Congress approved broad bailout legislation even though it was clear at the time that few of the legislators understood what they were approving.
Not surprisingly, various large creditors of the financially-troubled firms did very well for themselves under the bailout legislation. Can't blame them for protecting their shareholders' interests, now can you?
So now, confronted with the fact that the bailout primarily benefited these large institutional creditors, various members of Congress and New York AG ("Attorney General" or "Aspiring Governor," take your pick) Andrew Cuomo are starting investigations into why AIG did precisely what it was supposed to do -- i.e., pay its bills -- with the bailout funds.
A little late, don't you think?
March 26, 2009
The business blogosphere was abuzz yesterday over publication of AIG executive Jake DeSantis' remarkable resignation letter to AIG CEO, Ed Liddy.
But what was even more remarkable was the reaction of some commentators that makes abundantly clear that common sense often evaporates in the face of big money.
DeSantis is a longtime AIG executive who worked for one of AIG's profitable units. When AIG was going down the tubes last year because of losses incurred in the company's untethered CDS trading unit, DeSantis agreed to stay on at a nominal salary and continue making profits in his unit in return for a substantial, but not over-market, bonus.
Such arrangements are not unusual for financially-troubled companies and might very well have been arranged even had AIG gone into a chapter 11 reorganization rather than become the subject of an ill-advised government bailout. In short, it's a good thing for creditors of AIG -- including now U.S. taxpayers -- that the company retain people such as DeSantis who might make the company profitable and valuable again.
Or course, we all know what happened when AIG disclosed publicly that it had made the bonus payments to DeSantis and other AIG executives. They were demonized in a manner that has not been seen since Enron.
DeSantis' resignation letter lays this all out and notes the indisputable hypocrisy of AIG executives and government officials who knew about these compensation arrangements, but who flamed the public uproar rather than provide the quite simple and reasonable explanation for the bonuses.
I mean really. Who could argue that DeSantis and the other similarly-situated AIG executives were treated in an abominable manner?
Well, up to the plate steps one Brian Montopoli, a CBSNews.com political reporter, who establishes beyond any doubt that he needs to remain a political, rather than business, reporter:
Mr. DeSantis is not a plumber. He is a Wall Street executive who has made millions of dollars. And it’s safe to assume that most plumbers don’t believe he has gotten a bad deal, AIG scandal notwithstanding.
In essence, Montopoli reasons that other people are working just as hard as DeSantis and they would gladly trade places with him if they could have made as much scratch as he has earned over the years. Given that DeSantis made a lot of money while he was at AIG, Montopoli thinks he is "tone deaf" for pointing out the injustice of being unfairly demonized and cheated out of the compensation that was promised to him in return for staying on at AIG under extremely difficult circumstances.
In short, those evil capitalist roaders deserve most of our scorn and they should just shut the hell up.
In the face of such addled reasoning, it's hard to know where to begin. But let's start by pointing out that Montopoli ignores the rather important fact that no one has stopped him or anyone else from attempting to compete with DeSantis in his area of business and make just as much money as he has over the years. The reality is that there are relatively few people who do what DeSantis does well. That's why he commands a larger salary than most of us.
The fact that DeSantis makes more money than we do doesn't mean that it's OK to screw him out of his compensation or that he shouldn't be heard to set the record straight when such an injustice takes place.
March 23, 2009
Geez. I leave the country for ten days on a European trip and, upon my return, the entire U.S. body politic appears to be going batshit over a couple hundred million dollars of performance bonuses that the now-thoroughly Enronized American International Group paid to its employees.
What on earth is going on here?
Well, Michael Lewis pretty well nails the dynamic in this Bloomberg.com article:
To the political process, all big numbers look alike; above a certain number the money becomes purely symbolic. The general public has no ability to feel the relative weight of 173 billion and 165 million. You can generate as much political action and public anger over millions as you can over billions. Maybe more: the larger the number the more abstract it becomes and, therefore, the easier to ignore. . . .
Of course, the 173 billion that Lewis refers to in the foregoing passage is the amount that the federal government funneled through AIG to Goldman Sachs and various other big AIG creditors.
Meanwhile, Goldman is feeling some of the shrapnel from the AIG-bonus explosion and has disclosed publicly for the first time the details of why it would not have really been damaged all that much by an AIG bankruptcy.
When the U.S. Treasury started throwing money at AIG in September, Goldman had already gathered from AIG $7.5 billion of collateral against insurance that AIG had written on a $20 billion portfolio of debt securities. Moreover, Goldman arranged $2.5 billion in primarily credit derivative hedges on AIG because Goldman was betting that the value of the securities portfolio was substantially lower than AIG's was betting. Finally, Goldman received another $2.5 billion of collateral from AIG between September and the end of last year and the Fed transferred another $5.6 billion to Goldman to purchase the AIG-insured securities for the Maiden Lane III bail-out entity. Meanwhile, Goldman continues to extract additional collateral on about $6 billion of securities that did not qualify for Maiden Lane III.
None of the foregoing is particularly surprising. Goldman is one of the world's largest trading entitles and AIG is one of the world's largest insurers, so it is inevitable that their affairs are going to be intertwined. When the federal government caved to fears of a global financial calamity and bailed AIG out, Goldman secured its position in regard to AIG in a manner that was consistent with Goldman's best interests. As Joe Weisenthal points out, it really doesn't make any sense to get angry at Goldman for taking advantage of the federal government's bad financial decisions.
So, let's lay off the AIG bonuses -- in the big scheme of things, they are innocuous. Similarly, let's not hyperventilate over Goldman and various other AIG creditors taking advantage of the federal government's dubious investment in AIG. If we are honest, then most of us would admit that we would have done the same thing had we been in the creditors' position.
But let's do start insisting that our representatives get out of the way and allow the market to force these creditors to endure the true cost of the risk that they took in entering into contractual relationships with AIG. Until that risk of loss is properly allocated, investment capital is going to remain on the sidelines, particularly while the government continues to make ill-advised investments that postpones and distorts such allocation.
It's already been an expensive lesson, but one that might well be worth the cost if the counterproductive nature of the governmental actions in regard to AIG comes to be better understood.
March 10, 2009
As this WSJ weekend article and this subsequent Bloomberg article note, the funds that the Fed and the Treasury have loaned to AIG really bailout out Goldman Sachs and a number of other prominent banks, including some Europe's largest.
Thus, shouldn't we be calling this the "Goldman Sachs bailout?"
By now, we all know what happened. AIG sold credit default swaps that provided the buyer of the CDS with insurance against default on bonds and other credit instruments that the buyers held.
However, insurance is only as good as the financial capacity of the insurer to pay claims on that insurance. So, when it became apparent last summer that AIG had seriously blown the assessment of its risk in issuing CDS, the level of the credit risk that AIG had insured was well beyond its ability to pay potential claims on the CDS. That's not good news for a trust-based business.
Consequently, when bond defaults started hemorrhaging through the mortgage markets, the buyers of AIG's CDS -- namely Goldman and the Euro banks -- had a similar problem to AIG's. They had failed to assess the risk of doing business with their insurer accurately and they were facing huge losses on their CDS claims.
Well, under normal circumstances, that shouldn't have been any big deal to anyone other than parties involved. AIG would have been floundered into chapter 11, Goldman and the other big creditors would have assessed whether it made sense to reorganize the company or simply liquidate its constituent parts, the creditors would have converted their debt to equity in a new AIG or taken a haircut on their claims in return for receiving a portion of AIG's liquidation proceeds, everyone would have licked their wounds and the profitable parts of AIG's business would have emerged from bankruptcy with new owners highly incentivized to generate value for their ownership interest. That's the way markets have sorted out such errors in judgment for generations.
However, as we all know, that's not what has happened this time. Instead, after stirring up a climate of fear, the federal government -- led by supposedly free-market oriented Republicans -- paid Goldman and the Euro banks full price for the unsecured claims that they would otherwise be asserting against AIG in a chapter 11 case. The new Democratic administration doesn't appear to have any better understanding of what to do now that it is clear that the prior Administration's gambit has failed miserably.
The Financial Times' William Buiter summarizes the lesson that we all should learn from this:
The logic of collective action teaches us that a small group of interested parties, each with much at stake, will run rings around large numbers of interested parties each one of which has much less at stake individually, even though their aggregate stake may well be larger. The organized lobbying bulldozer of Wall Street sweeps the floor with the US tax payer anytime.
The modalities of the bailout by the Fed of the AIG counterparties is a textbook example of the logic of collective action at work. It is scandalous: unfair, inefficient, expensive and unnecessary.
March 6, 2009
Writing in 1951 about popular attitudes toward income inequality in "The Ethics of Redistribution," Bertrand de Jouvenel observed the following (H/T WSJ):
The film-star or the crooner is not grudged the income that is grudged to the oil magnate, because the people appreciate the entertainer's accomplishment and not the entrepreneur's, and because the former's personality is liked and the latter's is not. They feel that consumption of the entertainer's income is itself an entertainment, while the capitalist's is not, and somehow think that what the entertainer enjoys is deliberately given by them while the capitalist's income is somehow filched from them.
In arguably the best financial blog post to date in 2009, the Epicurean Dealmaker analyzes the skewed dynamics that led to the Merrill Lynch high-level executive bonus pool and observes, among other things:
It would not be outlandish to consider the Merrill executives' bonus pool as the latest and largest campaign gift toward Mr. [Andrew] Cuomo's 2010 gubernatorial run.
Meanwhile, Andrew Morris wrote the following in a letter to the WSJ editor (H/T Don Boudreaux):
At first, when I read your headline “States give gambling a closer look” (Mar. 3) I thought you were reporting on yet another “stimulus” or “bailout” bill in which politicians played games of chance with taxpayers’ money. Hardly news -- just another “dog bites man” story.
Then I realized it was just a story about allowing ordinary people to risk their own money -- now that’s a “man bites dog” story!
Along the same lines, the WSJ's Notable and Quotable series provided the following excerpt from Friedrich A. Hayek's "The Constitution of Liberty" (1960) on the illusory nature of progressive taxation and large increases in governmental spending:
Not only is the revenue derived from the high rates levied on large incomes, particularly in the highest brackets, so small compared with the total revenue as to make hardly any difference to the burden borne by the rest; but for a long time . . . it was not the poorest who benefited from it but entirely the better-off working class and the lower strata of the middle class who provided the largest number of voters.
It would probably be true, on the other hand, to say that the illusion that by means of progressive taxation the burden can be shifted substantially onto the shoulders of the wealthy has been the chief reason why taxation has increased as fast as it has done and that, under the influence of this illusion, the masses have come to accept a much heavier load than they would have done otherwise. The only major result of the policy has been the severe limitation of the incomes that could be earned by the most successful and thereby gratification of the envy of the less-well-off.
And Jason Kottke noted the technological irony of the week:
Finally, legendary Houston trial lawyer Joe Jamail passes along this anecdote about the late, great Houston criminal defense lawyer, Percy Foreman:
In the early 1980s, Jamail represented his courtroom idol, Houston criminal defense attorney Percy Foreman, whose neck was injured when his car was rear-ended by a commercial truck. On direct examination, Foreman testified that he had not experienced any neck problems before the accident, and that he was entitled to $75,000 for lost income due to the injury.
But on cross-examination, the defense revealed that Foreman had been hospitalized nine times for neck problems prior to this accident.
“The jury looked at me, expecting me to give them an answer,” says Jamail. “So I told them that Percy had been a great lawyer throughout his life, but that he was now just an old man and was growing senile.”
At that moment, Foreman jumped up and yelled out across the courtroom, “You goddamned son of a bitch!”
“See what I mean,” Jamail immediately told jurors. “He doesn’t even know where he is right now.”
The jury awarded Foreman the sum of $75,004. Jamail says he never figured out why the extra $4.
February 28, 2009
As noted here last fall, one of the key dynamics that is delaying the recovery of financial markets is the resistance of many societal forces to allow the markets to allocate the risk of loss among the various investors in failed businesses.
Inasmuch as private capital will not invest in even a potentially viable business until that company's financial condition is likely to reward such an investment, the liquidation of unviable companies is an essential part of the process that has allowed market-based economies to generate the most wealth and jobs throughout modern history.
Despite the foregoing, the beneficial aspects of liquidating unprofitable businesses remains often unappreciated. A scene from the 1991 Norman Jewison film "Other's People Money" illustrates this truth wonderfully, first as Gregory Peck's character demonizes the forces of liquidation and then as Danny DeVito's "Larry the Liquidator" shatters the myths upon which such demonizing rests. Enjoy.
February 25, 2009
In market economies, people who create jobs and wealth often generate great wealth personally. During periods of market unrest, those wealthy folks are often demonized as being greedy.
During a period of economic malaise in1979, the late Milton Friedman counsels Phil Donahue on the vacuity of demonizing greed. Enjoy.
February 18, 2009
Well, that certainly didn't take long, now did it?
As noted here this past Sunday, R. Allen Stanford's Stanford Financial Group has been well-known around Houston as a smoke-and-mirrors investment outfit for quite awhile. Joe Weisenthal over at Clusterstock has the best overview of Stanford's collapse, while Felix Salmon does a good job of summarizing the SEC complaint and asking the right questions about the principals of the firm. The Chron's Kristen Hays and Tom Fowler provide the local angle here.
Meanwhile, the Chronicle's business columnist Loren Steffy bemoans the fact that government regulators -- who have been investigating Stanford for at least the past four years -- were again behind the knowledge curve in protecting investors from Stanford's apparent investment fraud.
However, Steffy's expectations are simply misplaced. A government regulatory body will rarely be as effective or efficient as the information marketplace in preventing or mitigating investment fraud loss. Had the investors in Stanford relied on Houston's information market in deciding on whether to invest in the company, they wouldn't have needed the "protection" of government regulation.
February 15, 2009
The mainstream media has finally begun to notice the unusual circumstances surrounding R. Allen Stanford and his Houston-based investment firm, Stanford Financial Group (the latest Chronicle story is here).
Although the firm characterized the various investigations as "routine" in news reports, believe me -- it's never "routine" when the FBI starts nosing around. This is doubtful to end well for Stanford and its investors.
But what's most remarkable about all this is how long it has taken for the media and regulators to catch on to Stanford. It took blogger Alex Dalmody less than 30 minutes to size up the situation, and it didn't take Felix Salmon (update here) much longer.
Meanwhile, this Business Week article reports that the SEC has been investigating Stanford for the past three years!
Interestingly, I've asked dozens of folks in Houston investment community about Stanford over the years and have never once heard one vouch that an investment in the firm would be a good idea except as an absolute flyer. Nevertheless, I cannot recall even one media article over the years examining how Stanford was supposedly paying its lucrative returns to investors. Sure, the firm advertised well and contributed money to a number of powerful politicians. But I kept hearing from competent investment folks -- exactly how is the firm paying those kinds of returns on CD's again? And then there was that whole false association thing with the late Leland Stanford of Stanford University. How could anyone really take this outfit seriously?
Well, as recent news reports indicate, apparently about 30,000 investors did just that.
Now, it appears that many of these investors are from Central and South America, so maybe those investors didn't have ready access to the information about Stanford that was available in Houston. But the important point here is that -- as with Bernard Madoff -- no regulatory agency is ever going to do a better job than the information market in preventing or mitigating fraud loss. I mean really, can you imagine how an investor who bought a Stanford CD during the past three years is feeling toward the SEC right now?
Thinking that the government can prevent a slick con man from fleecing investors is about as rational as investing one's life savings with Stanford Financial Group.
February 11, 2009
Cato Unbound points us to a couple of articles that provide insightful observations on two of the crises that are swirling around us these days.
First, William Niskanen cautions us regarding the fear-mongering that supporters of the Obama Administration's fiscal stimulus plan are using to justify emergency passage of the plan:
This is the fifth time in my adult life that the president has asked for or asserted unprecedented authority on an expedited basis with little or no congressional review. Each of the prior occasions turned out to be a disaster. [. . .]
The only coherence in this plan is political, not whether it is an effective or efficient method to stimulate the economy. . . . Again, as in the four prior episodes, there is every reason not to rush to approve a program of such magnitude.
The primary reason for the current financial crisis is that many banks cannot evaluate their own solvency or that of their current or potential counter-parties, primarily because of the difficulty of valuing mortgage-backed securities and other complex derivatives, and neither TARP nor the fiscal stimulus plan addresses this problem.
Our political system, unfortunately, is strongly biased to try to protect people against the effects of a crisis without addressing the causes of the crisis. To Congress: Slow down. Make sure you understand the causes of the financial crisis and the potential solutions before you burden your children and your grandchildren with another trillion dollars of federal debt.
Your present course is best described as fiscal child abuse.
Meanwhile, as Texans continue to watch nervously to the south as the Mexican government teeters on the brink of losing control of large sectors of the country to drug kingpins, Dale Gieringer reminds us that the main cause of this crisis -- U.S. drug prohibition -- is the result of dubious public policy:
This week marks the centennial of a fateful landmark in U.S. history, the nation's first drug prohibition law. On February 9, 1909, Congress passed the Opium Exclusion Act, barring the importation of opium for smoking as of April 1. Thus began a hundred-year crusade that has unleashed unprecedented crime, violence and corruption around the world —a war with no victory in sight.
Long accustomed to federal drug control, most Americans are unaware that there was once a time when people were free to buy any drug, including opium, cocaine, and cannabis, at the pharmacy. In that bygone era, drug-related crime and violence were largely unknown, and drug use was not a major public concern. [. . .]
Early 20th-century Americans would be astounded to see what a problem drugs have become since the establishment of drug prohibition. Every year, two million Americans are arrested and 400,000 imprisoned for drug offenses that did not exist in their time. Drug laws are now the number-one source of crime in the U.S., with one-half of the entire adult population having violated them.
Long gone are the days when Americans were free to keep opium in their closet; today, even gravely suffering patients are denied pain-killing narcotics by their doctors out of fear of federal prosecution. While smoking opium has faded from the scene, the country is now rife with more potent and lethal narcotics, which are widely sold on the illegal market.
Seen in retrospect, drug prohibition ranks as one of the great man-made disasters of the 20th century. . . .
February 2, 2009
It may or may not be true that we would have avoided much of this crisis had credit default swaps never been invented. I suspect it's not true, and that the CDS market, in allowing people to short the credit market, actually helped at the margin to stop the credit bubble from expanding. But even if it is true, that doesn't mean that the solution is to ban or unwind the CDS market which now exists. It was foolish to sell protection too cheaply on risky debt; it was sensible to buy that protection when it was cheap. So let's not punish the sensible people and bail out the foolish ones by abrogating those contracts.
"Animal spirits", Keynes' view of capitalists, reeks of detachment and some condescension. Trouble is no one really knows how to incite the barnyard or rattle the cage. The past six months of ad hoccery have not helped and I am pessimistic about the next chapter, guessing that whatever comes out of the Washington sausage factory will do more harm than good. Bad times do breed bad policy. And there is now very little sympathy for getting the taxman (and the politician) out of the way.
There are some very smart people who claim that desperate measures are called for. But desperate measures can also make matters worse. Printing money to finance questionable projects that enrich lobbyists, empower bureaucrats and entrench politicians is surely not a promising signal to investors here or abroad.
January 30, 2009
Over the years, I've written quite a bit (for example, here, here and here) on the questionable nature of the prosecutions of the executives who were involved in the AIG/General Re finite risk transaction that prompted Eliot Spitzer to demonize Hank Greenberg.
However, I've never written as eloquently about the injustice of those prosecutions as Anthony O'Donnell does in this I&T post about the sentencing of former AIG vice-president of reinsurance, Christian Milton.
A truly civil society would find a better way.
January 27, 2009
It's rarely pleasant for a businessman to have his personal affairs splashed across the front page of the New York Times business section.
But it has to be particularly unsettling for the businessman when he is already the target of numerous civil lawsuits and, quite possibly, a criminal prosecution.
Frankly, I've never understood the reasoning of lawyers who advise their clients at the center of such a litigation firestorm to transfer assets to their family members. Fuld and his wife are reportedly quite wealthy, so maybe they have legitimate estate planning reasons for Fuld to transfer his interest in a multi-million dollar home to his wife for nominal consideration.
But Fuld is also subject to numerous civil lawsuits in connection with the Lehman Brothers meltdown. Those lawsuits seek hundreds of millions in damages, and the company's officers and directors' insurance likely will not come close to covering those damages. Thus, the fact that Fuld is transferring a valuable interest in an asset to his wife for nominal consideration at this particular time will be of more than passing interest to the plaintiffs in those lawsuits.
Inasmuch as Fuld is the only person in his family who has any civil liability in those lawsuits, why subject other family members to possible fraudulent transfer liability?
Similarly, in the unlikely -- but certainly possible -- event that Fuld's litigation problems force him into a personal bankruptcy case, why take the risk that his legal right to a discharge of personal liability for claims against him would be denied because of the transfer to his wife?
However, beyond the civil liability concerns, the main reason that Fuld should not have engaged in this type of transfer under his particular circumstances is simply that it looks bad. Real bad. Not only to potential creditors, but more importantly, to prosecutors who will make the decision on whether to indict Fuld. And, most importantly, to jurors who will decide Fuld's fate.
For example, remember the criminal case against former Enron chairman, Ken Lay? The prosecutors conceded (bragged?) afterward that it was a very weak case. So, rather than focus on the supposed criminal conduct, the prosecutors hammered away on Lay's indiscrete use of his personal line of credit with the company. As noted in my concluding post on the seventeen-week trial:
[I]f there was a defining moment in the trial that sealed the defendants' fate, then it likely came in Week Fourteen during Task Force prosecutor John Hueston's cross-examination of Lay over the use of his company line of credit.
Although Lay's line of credit was legal and the company disclosed his use of it in accordance with applicable law, Lay's repayment of the large draws on the line with Enron stock at a time when he was encouraging employees and the market to buy company stock was an apparent contradiction that the jurors could easily grasp.
Similarly, Lay's decision to draw down $1 million on the line five days before Enron's bankruptcy [to help pay off the mortgage on Lay's condominium] was a disastrous decision for the defense. Although done on advice of counsel, Lay's last-minute draw as the company was sinking into insolvency looked so bad that reference to that testimony by leaders of the jury during deliberations was probably enough to seal any wavering non-leader juror's view on whether to convict.
If Fuld is indicted, then you can rest assured that prosecutors will bring his recent transfer to his wife to the attention of the judge during proceedings over the amount of his bond pending trial. And although the transfer has nothing to do with the probable criminal charges against Fuld (i.e., violating the obligation to throw in the towel), prosecutors will try to use it anyway to make him look tricky in the eyes of jurors.
You see, such a transfer plays right into the real presumption these days in business crime prosecutions -- Fuld is wealthy and his company collapsed, so he must be guilty of some crime in connection with his company's demise.
Sadly, being proven greedy is often enough to be convicted of a crime.
January 26, 2009
Next, there was the Buffett Rule.
And then we had the GM Rule.
Now, Larry Ribstein reports that we have the Geithner Rule.
Does anyone really believe that all these rules and the criminalization-of-business lottery constitutes a coherent policy for regulating questionable business deals?
January 20, 2009
This earlier post made the following point about folks who lost their entire nest egg by investing it with Bernard Madoff:
Although nothing is wrong with compassion for folks who lose money in an investment fraud, it's important to remember that those investors who lost their nest egg in the Madoff implosion were imprudent in their investment strategy. They should have diversified their Madoff holdings or done some real due diligence into his operation if they were going to bet the farm on it. Even though every one of Madoff investors carry insurance on their homes and cars, one can only speculate why they didn't attempt to understand the risk of their investment in Madoff's company better than most did. Most likely, many of the investors simply did not care to truly understand how Madoff claimed to create wealth for them in the first place. . . .
It's easy to throw Madoff in prison for the rest of his life, simply attribute the investment loss to him and pledge to do a better job of policing the crooks next time. It's a lot harder to understand how Madoff's investors could have hedged their risk of Madoff's fraud. As this WSJ editorial concludes, "expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff."
Professor Antony Davies of Duquesne University in Pittsburgh makes an analogous point in this W$J letter-to-the-editor (H/T Don Boudreaux) about folks who are calling for increased regulation because of losses incurred in their 401(k) retirement accounts:
In the article "Big Slide in 401(k)s Spurs Calls for Change" (page one, Jan. 8), 35-year-old project manager Kristine Gardner says in response to the 44% drop in her 401(k) last year: "There's just no guarantee that when you're ready to retire you're going to have the money."
Newsflash: Higher returns are the compensation for incurring risk, and lower returns are the price of safety. Ms. Gardner's 401(k) would have been completely safe had she shifted her investment allocations into money markets. As money markets yield a paltry 1%, Ms. Gardner's real complaint isn't that 401(k)s are unsafe, but rather that financial markets require her to incur risk in exchange for being compensated for incurring risk.
Retirement consultant Robyn Credico claims that "This is the biggest test that the 401(k) plan has seen . . . and it has failed." Au contraire, 401(k) plans have worked exactly as designed. It is the workers (and their retirement consultants) who have failed.
There is only one reason why the average person close to retirement should have lost 50% of his 401(k): incompetence. Most workers at that age should have long since shifted the bulk of their 401(k)s into bonds and money markets. The 401(k) is a powerful investment tool but can be dangerous when abused.
If you aren't willing to put forth the effort to learn the principles of investing, that's your choice. But don't hobble the rest of us by asking for government regulation of a tool that works perfectly well just so that you can be spared the effort of figuring out how to use it.
As with the security theater in our nation's airports, increased regulatory control over retirement investment is a fake safety net. It will not protect retirement savings (check out the solvency of the Social Security system if you don't believe that), and the "protection" of increased regulation will lead many investors to believe that they still do not need to understand the best ways to create wealth and hedge risk in their retirement accounts.
Indulging ignorance is generally not a good reason for increasing governmental power.
January 13, 2009
On the other hand, Jamie Olis may have been the earliest big loser.
Just as with a gambling lottery, there is no rhyme or reason as to who wins or loses in the criminalization-of-business lottery. But in this lottery -- which does little or nothing to deter the true business criminals of the world -- the losers and their families give up much more than merely money.
A truly civil society would find a better way.
January 8, 2009
Now, as this timely Roger Parloff/Fortune article notes, an even larger mob is gathering to lynch the businesspeople who were attempting to save their companies in the wake of last year's financial meltdown on Wall Street:
The level of fury surrounding these inquiries is of a different order from what we saw with, say, the backdating scandals or the Enron and WorldCom failures. Today's credit collapse has already vaporized about $9 trillion in investment capital, while ripping another trillion in assorted bailout money from the pockets of enraged taxpayers - also sometimes known as "jurors."
Based on the Fifth Circuit's Skilling decision, those targeted businesspeople would be wise not to rely on the courts for protection from the mob.
December 30, 2008
On the heels of this post from a couple of days ago that addressed Tyler Cowen's recent NY Times op-ed that speculated that expectations generated from the 1998 government bailout of Long Term Capital Management hedge fund were not such a good thing, this W$J article on the Lehman Brothers bankruptcy case bemoans the enormous cost attributable to lack of reorganization planning in connection with the Lehman Brothers case:
As much as $75 billion of Lehman Brothers Holdings Inc. value was destroyed by the unplanned and chaotic form of the firm's bankruptcy filing in September, according to an internal analysis by the company's restructuring advisers.
A less-hurried Chapter 11 bankruptcy filing likely would have preserved tens of billions of dollars of value, according to a three-month study by the advisory firm, Alvarez & Marsal. An orderly filing would have enabled Lehman to sell some assets outside of federal bankruptcy-court protection, and would have given it time to try to unwind its derivatives portfolio in a way that might have preserved value, the study says. [. . .]
"While I have no position on whether or not the federal government should have provided further assistance to Lehman, once the decision was made not to provide further assistance, an orderly wind-down plan should have been pursued. It was an unconscionable waste of value," said Bryan Marsal, co-chief executive of the advisory firm who now serves as Lehman's chief restructuring officer.
Mr. Marsal estimates that the total value destruction at Lehman will reach between $50 billion and $75 billion, once losses from derivatives trades and asset impairment are combined.
Losses are a natural part of the risk allocation that occurs in big reorganization cases. But anyone who has been involved in such cases knows that it takes at least a couple of months to prepare a big reorganization case properly.
Friends who are closely involved in the Lehman Brothers case have confided to me that Lehman CEO Richard Fuld never in his wildest imagination thought, after the precedent of Bear Stearns, that the Fed and the U.S. Treasury would fail to bail out Lehman Brothers. When that proved wrong, Lehman Brothers had to file its chapter 11 case on a relatively unplanned, emergency basis. That miscalculation cost creditors even more than they would have lost had Lehman's management taken the normal step of planning the case when they saw the writing on the wall. I've got my doubts that the additional losses are $50-75 billion as suggested by the consultant's report (could the Lehman-related parties be using that report as a liability shield?), but there is little question that an emergency bankruptcy filing generally costs creditors more than a properly planned one.
As John Carney notes, maybe the conventional wisdom is wrong that the Fed made matters worse by failing to bailout Lehman Brothers.
It's hard enough to evaluate the risk of insolvency in regard to a trust-based business under normal circumstances. It becomes a real crapshoot when there exists an expectation that the federal government will provide stop-gap financing for a big trust-based company's losses. And crapshoots generate some pretty bad risk-taking.
December 28, 2008
Marginal Revolution's Tyler Cowen makes a similar point in this NY Times op-ed about the 1998 federal bailout of the Long-Term Capital Management hedge fund that this earlier post made about Enron and the current Treasury bailout:
At the time, it may have seemed that regulators did the right thing [in bailing out LTM]. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed. [ . . .}
The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.
Absent allocation of risk consequences to the parties who entered into transactions with financially-troubled companies, markets have a difficult time accurately pricing risk in regard to future investment and transactions. Such indecision plays a big part in delaying recovery in financial markets.
Similarly, without cleaning up the balance sheets of troubled companies (and putting the hopelessly insolvent ones out of their misery), extending additional credit to financially-strapped companies only makes them an even poorer risk for investment. That doesn't facilitate recovery in the financial markets, either.
Amidst many blunders, the Bush Administration's failure to tap corporate reorganization experts in connection with its policy-making regarding the financial crisis was one of the worst. Hopefully, Obama's advisors note the mistake and correct it in the next Administration.
Update: Barry Ritholtz agrees with Tyler and me.
December 19, 2008
Posted by Tom at 12:01 AM
December 18, 2008
You will recall that Steffy was one of the leaders of the mainstream media lynch mob that embraced the myth of the Greed Narrative in calling for harsh criminal prosecutions of former Enron executives, particularly the late Ken Lay and Jeff Skilling.
However, now that pretty much the same thing that happened to Enron has happened to Bear Stearns, Freddie and Fannie, Merrill Lynch, Lehman Brothers, AIG and any number of other trust-based businesses during the current financial crisis, Steffy has had difficulty making sense of it all. We can't just throw all of those executives in prison, can we?
Now to make things even more confusing for Steffy, Bernard Madoff's alleged Ponzi scheme has unraveled. Steffy's column from yesterday bemoans that Madoff, as with Enron, was at least in large part the result of lax regulation:
And so the era of lax regulation that began with Enron ends with the Madoff madness looming as a monument to the SEC’s ineptitude. Already under fire for smelling the flowers while Bear Stearns — to cite one example — charged toward collapse, the SEC’s days may be numbered. Treasury Secretary Henry Paulson introduced a sweeping reform plan earlier this year that would relieve it of much of its oversight role.
But wait a minute. The SEC had been continually warned about Madoff's company (see Henry Markopolos' 2005 notice to the SEC here). Moreover, the "lax regulation" that Steffy complains about came at a time of unparalleled growth in the SEC during the supposedly pro-business Bush Administration:
Since 2000 and especially after the fall of Enron, the SEC's annual budget has ballooned to more than $900 million from $377 million. . . . Its full-time examination and enforcement staff has increased by more than a third, or nearly 500 people. The percentage of full-time staff devoted to enforcement -- 33.5% -- appears to be a modern record, and it is certainly the SEC's highest tooth-to-tail ratio since the 1980s. The press corps and Congress both were making stars of enforcers like Eliot Spitzer, so the SEC's watchdogs had every incentive to ferret out fraud.
Yet, the regulators couldn't put the pieces of the puzzle together (even Spitzer's family was a victim of Madoff!). So, Steffy's solution is the SEC "needs to be put out to pasture." In other words, rearrange the deck chairs on the Titanic.
Look, as J. Robert Brown and Larry Ribstein point out, there are understandable systemic reasons why Madoff was able to slip through the regulatory cracks for decades. Most of those flaws are not going to be fixed by simply creating a Super-SEC. Indeed, the suggestion that such regulatory remedies are the best protection against the next Madoff (and, rest assured, there will be many) actually is counter-productive to understanding the truly best protection from such schemes.
The primary justification for this regulatory retrofitting is the plight of the innocent investors (and it sure is an interesting bunch) who lost millions when Madoff's company went bust. Although nothing is wrong with compassion for folks who lose money in an investment fraud, it's important to remember that those investors who lost their nest egg in the Madoff implosion were imprudent in their investment strategy. They should have diversified their Madoff holdings or done some real due diligence into his operation if they were going to bet the farm on it. Even though every one of Madoff investors carry insurance on their homes and cars, one can only speculate why they didn't attempt to understand the risk of their investment in Madoff's company better than most did. Most likely, many of the investors simply did not care to truly understand how Madoff claimed to create wealth for them in the first place. Chidem Kurdas' speaks to this dynamic in his timely study on the demise of the Manhattan Capital hedge fund:
As the failure of the hedge-fund firm Manhattan Capital demonstrates, both government regulators and market players can make mistakes resulting from cognitive biases. Responding to such mistakes by strengthening government watchdogs, although often recommended, reduces both the watchdogs’ and the public’s incentive to learn, thereby creating a vicious spiral of regulation, regulatory failure, and even more regulation.
Thus, as Larry Ribstein has been advocating for years, no amount of increased regulation is likely ever to do a better job than the market in mitigating fraud loss. It's easy to throw Madoff in prison for the rest of his life, simply attribute the investment loss to him and pledge to do a better job of policing the crooks next time. It's a lot harder to understand how Madoff's investors could have hedged their risk of Madoff's fraud. As this WSJ editorial concludes, "expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff."
December 17, 2008
As a result of the Buffet Rule, the federal government decided to land a bunch of tuna rather than the barracuda in regard to an AIG-General Re finite risk insurance transaction that was not clearly illegal, much less criminal.
Subsequently, after convicting the business executives (sort of like shooting tuna in a barrel these days), the federal prosecutors proposed that the tuna get effective life sentences. For what?
Thankfully, a federal judge in Connecticut showed unusual restraint on Tuesday in rejecting the government's brutal behavior. He handed the first of the tuna to face sentencing a two-year prison term.
Meanwhile, former Enron executive Jeff Skilling continues serving an effective life prison sentence in Colorado pending his appeal after being convicted (although not fairly) for pretty much the same thing as the tuna above.
So, during a financial downturn when we need to be promoting our best and brightest to be engaging in the business risks that generate jobs and wealth, our federal government continues promoting its corporate criminal lottery.
Why would the best and brightest risk that? Do any investors really feel safer now that Skilling is off the streets? And does anyone really think that keeping Skilling locked up for most of the rest of his life will deter the next Bernie Madoff?
A truly civil and wise society would find a better way.
December 13, 2008
As Congress and the mainstream media continue their muddle over the current downturn in financial markets, one of the ubiquitous "solutions" that Washington and the MSM have already decided is needed to prevent another such disruption is more and better governmental regulation of those markets.
Thus, it was with great interest that I read this W$J article today about the meltdown of Bernard Madoff's apparent Ponzi scheme:
Bernard Madoff is alleged to have pulled off one of the biggest frauds in Wall Street history. But there were multiple red flags along the way, including a series of accusations leveled against Mr. Madoff's operation. Now some are asking why regulators and investors didn't pick up on the alleged scheme long ago.
"There were multiple smoking guns of various calibers," says Harry Markopolos, an industry executive who in 1999 first contacted the Securities and Exchange Commission with his suspicions. "People were willfully blinded to the problems, because they wanted to believe in his returns." [. . .]
Mr. Markopolos, who years ago worked for a rival firm, researched the strategy and was convinced the results likely weren't real. "Madoff Securities is the world's largest Ponzi scheme," Mr. Markopolos wrote in a letter to the SEC. Mr. Markopolos pursued his accusations over the past nine years, dealing with both the New York and Boston bureaus of the agency, according to documents he sent to the SEC that were reviewed by The Wall Street Journal. An SEC spokesman declined to comment.
In short, the regulatory agency that is supposed to protect investors has been warned about Madoff's fund since 1999 and has done nothing.
Meanwhile, Marcia Vickers and Roddy Boyd write in this Fortune article about the troubles of Citadel Investment Group, the Chicago-based hedge fund that manages $15 billion and has 1,300 employees worldwide, which announced yesterday that it has frozen withdrawals through March:
The panic that swept through the capital markets after Lehman declared bankruptcy was one form of human frailty that Citadel’s sophisticated mathematical models could never have anticipated. The second and perhaps more devastating one occurred on Wednesday, Sept. 17, when news broke that the Securities and Exchange Commission was considering a temporary ban on short-selling 900 stocks - 799 of them financial stocks.
The proposed ban was good news for the banks and brokers. It meant that Morgan Stanley (MS, Fortune 500), Citigroup (C, Fortune 500), and others didn’t need to worry that hedge funds could drive them to the brink.
Yet the news was horrifying for hedge funds like Citadel. Scores of Citadel’s positions - particularly in convertible arbitrage, which requires shorting - would simply blow up if the ban went into effect.
According to sources, Griffin phoned Christopher Cox, the SEC’s chairman. Griffin pleaded with Cox, telling him the ban could mean certain death to many hedge funds - including Citadel. Cox, according to these sources, was unmoved and merely responded with the party line about how the country was going through a national financial crisis and the SEC needed to do what it had to.
There was nothing Griffin could do or say to sway him, and on Friday, Sept. 19, the ban was made official. (The SEC declined to comment for this story.)
Citadel was now hemorrhaging money. Over the weekend and throughout the following week, Griffin talked with his portfolio managers and told them to dump the dogs and keep the racehorses, meaning preserve the positions that they believed had long-term upside as they engaged in a selloff.
By the end of September, Citadel’s funds were down 20%. In early October, Griffin sent a letter to investors stating that September had been the “single worst month, by far, in the firm’s history. Our performance reflected extraordinary market conditions that I did not fully anticipate, combined with regulatory changes driven more by populism than policy.”
So, let me get this straight. The CEO of a huge hedge fund calls the SEC chairman to protest that responsible businesses that have hedged risk properly are going to suffer huge, unfair financial losses as a result of the SEC's dubious, knee-jerk temporary ban on short-selling. And the best that the SEC chairman can come up with is that "the SEC needed to do what it had to"?
Go ahead and toss Chairman Cox in with this group.
Finally, almost unnoticed amidst all this turmoil is this piece of news that the Federal Trade Commission is inexplicably continuing to fight Whole Foods' merger with natural food competitor, Wild Oats, despite the fact that it is now pretty darn clear that Whole Foods overpaid for Wild Oats, that Whole Foods isn't doing all that well right now, and that the grocery business generally continues to be brutally competitive.
So, in light of all this, even more regulation is the solution?
As Larry Ribstein points out, that "solution" could well make things worse.
December 11, 2008
The W$J's Holman Jenkins continues what should be Pulitzer Prize-winning commentary on the problems of the U.S. auto industry:
None of [Congress' complicity in the auto industry's problem] was mentioned at four days of congressional bailout hearings, because Detroit knows better than to suggest Congress has a role in the industry's problem. . .
. . . The tragedy of GM and Ford is that, inside each, are perfectly viable businesses, albeit that have been slowly murdered over 30 years by CAFE. Both have decent global operations. At home, both have successful, profitable businesses selling pickups, SUVs and other larger vehicles to willing consumers, despite having to pay high UAW wages.
All this is dragged down by federal fuel-economy mandates that require them to lose tens of billions making small cars Americans don't want in high-cost UAW factories. Understand something: Ford and GM in Europe successfully sell cars that are small but not cheap. Europeans are willing to pay top dollar for a refined small car that gets excellent mileage, because they face gasoline prices as high as $9. Americans are not Europeans. In the U.S., except during bouts of high gas prices or in the grip of a Prius fad, the small cars that American consumers buy aren't bought for high mileage, but for low sticker prices. And the Big Three, with their high labor costs, cannot deliver as much value in a cheap car as the transplants can.
Under a law of politics, such truths were unmentionable in last week's televised circus because legislators are unwilling to do anything about them. They won't repeal CAFE because they fear the greens. They won't repeal CAFE's "two fleets" rule (which effectively requires the Big Three to make small cars in domestic factories) because they fear the UAW. They won't hike gas prices because they fear voters. [. . .]
We hate to admit it, but the only good idea from the bailout debate is the proposal for a new "auto czar." Along with disposing of Chrysler and downsizing Ford and GM, his job should be to confront Congress with its own policy cowardice and failure. If saving gasoline and Detroit are both worthy goals, let's ditch CAFE and institute a gasoline tax to make consumers value the cars government is forcing auto makers to build. If Congress doesn't have the tummy for that, at least ditch the "two fleets" rule so Detroit can import small cars to meet the mandate.
Alas, Barack Obama's vaunted "change" apparently doesn't include spending the political capital to make Congress acknowledge the failure of CAFE. If he can't do better than throw taxpayer money at a dismal policy disaster like our fuel-economy regulations (and so far he seems to be joining Congress in pretending it's all Detroit's fault), we might as well give up on his presidency along with any hope of progress on the nation's other unresolved dilemmas.
His campaign never really answered the question of whether he was Chance the Gardener or Abraham Lincoln. We might as well find out now.
December 3, 2008
While General Motors is making its case in Congress for an $18 billion bailout (didn't GM need "just" $12 billion last week?), it's trying to cut corners in other areas, such as its endorsement deal with Tiger Woods that paid Woods $7 million annually over the past nine years.
As one sage headline writer put it -- "GM lays off Tiger Woods."
But Conan O'Brien had an even better crack about GM's termination of its relationship with Woods during one of his monologues last week:
"General Motors announced that they are ending their endorsement deal with Tiger Woods. When asked why, a spokesperson for General Motors said: 'Tiger Woods is successful, competitive, and popular. And that’s just not us.'”
November 21, 2008
November 19, 2008
So, less than two months after this previous post noted that chapter 11 reorganizations with possible government financing of reorganization plans were the best tools to shake out the current financial crisis, even the NY Times (here and here) is promoting that approach for restructuring the Big Three automobile companies.
I guess that's a sign of real progress.
Funny how the way we typically handle such things in the civil justice system usually is the most efficient solution to the problems.
It sure beats having this bunch fumble around looking for an alternative solution.
By the way, I've mentioned this before, but it merits passing along again. One of the best ways to keep up on developments in regard to the current financial crisis is to check in frequently on the following sites: Clusterstock, Dealbreaker, and Felix Salmon.
The blogosphere rules!
November 18, 2008
Now that folks have had at least a bit of time to reflect on the financial crisis on Wall Street, some good historical perspectives are starting to pop up, such as this Niall Ferguson Vanity Fair piece (previous posts on other Ferguson works are here). Toward the end, Ferguson makes an excellent point about market economies that is not widely understood:
The modern financial system is the product of centuries of economic evolution. Banks transformed money from metal coins into accounts, allowing ever larger aggregations of borrowing and lending. From the Renaissance on, government bonds introduced the securitization of streams of interest payments. From the 17th century on, equity in corporations could be bought and sold in public stock markets. From the 18th century on, central banks slowly learned how to moderate or exacerbate the business cycle. From the 19th century on, insurance was supplemented by futures, the first derivatives. And from the 20th century on, households were encouraged by government to skew their portfolios in favor of real estate.
Economies that combined all these institutional innovations performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning. For this reason, it is not wholly surprising that the Western financial model tended to spread around the world, first in the guise of imperialism, then in the guise of globalization.
Yet money’s ascent has not been, and can never be, a smooth one. On the contrary, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes. The excesses of the Age of Leverage—the deluge of paper money, the asset-price inflation, the explosion of consumer and bank debt, and the hypertrophic growth of derivatives—were bound sooner or later to produce a really big crisis.
In short, markets are imperfect and sometimes quite messy. But they have stood the test of time in proving more efficient than the alternatives. Don't give up on them just yet.
November 14, 2008
Fast forward a couple of years. Yesterday, the W$J reported (NYTimes here) that General Motors may not be able to avoid bankruptcy because of political problems involved in obtaining a bailout loan package from the federal government. GM is "rapidly burning through cash reserves as car sales plummet and their access to credit tightens. GM has warned it may run out of money within months without outside help."
From what I can tell, no one is calling for the scalp of GM CEO Rick Wagoner because of confident public statements that he made just a few months ago about his company.
So, the corporate crime lottery continues. A truly civilized society would find a better way.
November 13, 2008
And you think the Texans' season is going badly?
The Dallas Cowboys are seeking to borrow $350 million by Dec. 1, according to numerous finance sources, in one of the worst credit environments in the nation’s history.
The club’s proposed deal would refinance $126 million the team borrowed last year through the now-imploded auction-rate securities market, as well as add new debt to cover cost overruns at the team’s $1.2 billion stadium that is set to open next year, the sources said. [. . .]
For the Cowboys, getting out from underneath the auction-rate debt is a pressing concern. They are one of four NFL teams to have borrowed from the auction-rate securities (ARS) market, a market that allowed companies to borrow cheaply and continue to reset the interest rate with auctions of the debt weekly and monthly.
In February, the ARS market seized up, and debt auctions failed, which automatically triggered significant interest rate hikes. [. . .]
The Cowboys estimated the stadium would cost $650 million when they announced the project in 2004. With $350 million of public funding and $76 million from the NFL, it looked like a choice deal for the team.
The club arranged to borrow at least $450 million through Banc of America Securities for its portion, with the first $126 million through the ARS market. But Jones agreed to cover cost overruns as part of the team’s share, and like many stadiums in this period, the price has spiraled.
H'mm. I wonder whether the Cowboys will apply for a portion of the TARP fund, too?
November 1, 2008
Comedian Louis CK sums it pretty well:
October 31, 2008
We believe that the Board of Directors is most appropriately positioned to respond to our requests as the firm's top management likely has a significant interest in the size of the bonus pools. In this new era of corporate responsibility we are entering, boards of directors must step up to the plate and prevent wasteful expenditures of corporate funds on outsized executive bonuses and other unjustified compensation.
As my Office has told AIG, now that the American taxpayer has provided substantial funds to your firm, the preservation of those funds is a vital obligation of your company. Taxpayers are, in many ways, now like shareholders of your company, and your firm has a responsibility to them.
Accordingly, we also ask that the Board inform us of the policies, procedures, and protections the Board has instituted that will ensure Board review of all such company expenditures going forward. Please provide this Office with an accounting of the actions the Board plans to take that will protect taxpayer funds.
So, Cuomo charts the same political course as Eliot Spitzer before him and Rudy Giuliani before Spitzer. Embrace the Greed Narrative and then sit back and let the mainstream media do the rest. Before you know it, even both major presidential candidates tout the myth that business failure is always about dastardly villains and innocent victims.
My question for Cuomo and his mainstream media minions is quite simple: What is the likely quality of the management and board members who are willing to stick around and put up with Cuomo's grandstanding?
My bet is that you won't see many Hank Greenbergs.
Meanwhile, those less-than-stellar management teams all have tickets to feed at the Fed's money trough.
Ah, the webs we weave.
October 25, 2008
Newspapers are under siege. This Henry Blodget post reports on the continuing financial deterioration of the New York Times, which looks to be in real trouble.
Meanwhile, the blogosphere continues to thrive. For example, this Stephanie Stradley post about the chronically under-performing Houston Texans defense is far more insightful than anything that I've read in years from the cheerleaders, er, I mean, reporters who cover the Texans for the Houston Chronicle, which continues to layoff employees by the droves.
And to think that one of those Chronicle cheerleaders -- whose most recent piece is this fawning salute to the manager who was mainly responsible for blowing the 2003 NL Central pennant for the Stros -- had the audacity to defame Stradley recently.
Any wonder why newspapers and the blogosphere are going in different directions?
October 23, 2008
If you didn't have the opportunity to watch or record it last Friday, then watch the following six YouTube segments of John Stossel's Politically Incorrect Guide to Politics when you have the time (the other five segments are below the break). The program is television at its best presenting and analyzing key issues involving government regulation of business and the impact of that regulation on the creation of jobs and wealth. Enjoy:
October 18, 2008
"At a dinner party last Saturday I was asked by a fellow guest what I did and I said I was an investment banker. I might as well have said I was a paedophile. Suddenly the whole table – all friends of my wife from the art world – turned on me with such venom I was really taken aback. I tried to defend myself by saying that I had nothing to be ashamed of in the work that I do in M&A, but the more I argued the more hostile the other guests became."
"Next time this happens – and I fear there will be a next time – should I accept guilt for what isn’t my fault, or should I lie and say I’m a librarian?"
Investment banker, male, 42
Among the many entertaining reader comments to the letter were the following:
"Bit surprised you were invited to dinner in the first place."
"Confess and beg for another glass of wine."
"A sensitive investment banker……….. whatever next?"
October 14, 2008
One of the more entertaining aspects of the current Wall Street financial crisis has been reading how some of the business columnists have been interpreting it.
Take, for example, Houston Chronicle business columnist, Loren Steffy. You may remember him from his acerbic coverage of the trial of former Enron executives, Jeff Skilling and the late Ken Lay, or his perpetuation of the Enron Myth regardless of the circumstances.
Apparently confused by the fact that what happened to Enron has now happened to Bear Stearns, Freddie and Fannie, Merrill Lynch, Lehman Brothers, AIG and any number of other trust-based businesses impacted by the current credit crunch, Steffy reaches for insight from one of the fellows who set the stage for this mess:
Investigators are poring over the failed firms, looking for signs that executives misled shareholders. Some evidence may be found, but Sam Buell, the former prosecutor who led the effort to indict Enron's Jeff Skilling, doesn't think we'll see widespread prosecutions.
"It's not a conspiracy if everybody's in on it," said Buell, who's now a law professor at Washington University in St. Louis. "In order to have a fraud conspiracy, you've got to have some effort by one group to deceive another group."
In this case, individual investors may not have understood what Wall Street bankers were doing with complex debt securities, but those charged with safeguarding the marketplace were certainly aware.
Regulators knew and approved. So did credit rating agencies. And auditors, both internal and external. With a mouse click, investors could find public documents that described the debt instruments with hundreds of pages of detail. [. . .]
"If everybody's in a bubble mentality, if they're betting the price of real estate will keep going up, disclosure doesn't address the problem of what happens when all those assumptions turn out to be wrong," Buell said. "Everybody knows what they're doing. They're just making bad decisions."
Yes, you read that correctly. Buell implies that Skilling was guilty of criminal conspiracy because not "everybody" was "in on it" at the time Enron was making its supposedly opaque disclosures. However, since "everybody's in on it" now, Buell doesn't think there will be widespread prosecutions because "[i]t's not a conspiracy if everybody's in on it."
With such reasoning, is there any doubt now why this outfit generated this record?
For the record, I actually hope Buell is right this time that few businesspeople are prosecuted for misjudging business risk. But for a more rational explanation of how financial regulation fits into the current crisis, check out these Larry Ribstein posts here, here and here and this masterful one by Arnold Kling.
October 12, 2008
Don't miss Larry Ribstein's post on Oliver Stone's financing philosophy in regard to his new movie about George W. Bush -- W -- the trailer of which is below:
October 11, 2008
So, the Justice Department is seeking a sentence of 230 years for former General Re senior counsel Robert Graham, a 60-year old man who has never been involved in any wrongdoing in his life.
Mercifully, the pre-sentencing report recommends a sentence of "only" 12-17 years.
Graham was convicted earlier this year of securities fraud in connection with his involvement in a finite risk transaction between General Re and AIG that was one of the transactions that led to the downfall of former AIG CEO, Hank Greenberg (prior posts here).
Ironically, AIG is now fighting for its life -- even after receiving loans from the Fed in amounts approaching $150 billion -- as a result of thousands of transaction decisions that were far more questionable than the one Graham made.
230 years. For involvement in a transaction that was not even clearly improper, much less criminal in nature.
230 years. As a result of a prosecution that required application of the Buffett rule.
230 years. What does that portend for the AIG executives who engaged in this bit of bad judgment? Or those who were involved in this? Did they commit a crime because they breached an obligation to throw in the towel?
This is our government doing such things, folks. It is a reflection of us. And that reflection is not particularly attractive these days.
October 9, 2008
October 2, 2008
Take the chronically dysfunctional American health care finance system. This Boston Globe article reports that Massachusetts' supposedly innovative 2006 health insurance mandate has caused such a shortage of primary care physicians in the state that the wait to see such a doctor has grown to as long as 100 days. In addition, almost half a million citizens are having a difficult time finding a doctor at all:
"There were so many people waiting to get in, it was like opening the floodgates," [Dr. Kate] Atkinson said. "Most of these patients hadn't seen the doctor in a long time so they had a lot of complicated problems." She closed her practice to new patients again six weeks later. "We literally have 10 calls a day from patients crying and begging," she said.
On the other hand, maybe its better that Congress is distracted from such problems. As a friend of Don Broudreaux observes:
"The one good thing that came out of this whole credit debacle, I now have the perfect pithy response to all the lefties who tell me that the government should take over health care and make it affordable to everyone. You mean the way they made home ownership affordable to all through Fannie and Freddie? How did that work out for you?"
October 1, 2008
The proposed Treasury bailout leads to an awkward loan interview:
September 30, 2008
I've already said my piece on the proposed Treasury Bailout of Wall Street, so I won't belabor that view.
In the meantime, there are much better places to keep up with the minute-by-minute political developments on the proposed bailout -- for example, check out Clusterstock, DealBreaker and Felix Salmon for astute and up-to-the-minute analysis.
However, one point from my previous post deserves further review -- that is, circumstances such as this provide us with a revealing view of our political leaders. Do they inspire positive and collaborative action in difficult times for the better good of society? Or do they attempt to generate support for their political position through fear-mongering and demagoguery?
In my view, President Bush's handling of the negotiations over the proposed bailout has been abysmal. As Jeff Matthews points out:
The President’s unfortunate choice of words—"this sucker could go down"—carry the same deer-in-headlights quality as his televised speech to the American people last week, in which he used the word “panic,” as we recall. At a minimum, it makes you nervous; at a maximum, it makes you want to throw up first and sell everything second.
What happened to the heroic, forward-looking rhetoric great leaders are supposed to provide in times of crisis?
FDR gave us “We have nothing to fear but fear itself.”
Churchill gave us “We shall fight on the beaches.”
George Bush cruises in with “This sucker could go down.”
We wonder: has a more irresponsible sentence been uttered, by anyone, during this entire crisis?
John Carney reports that President Bush wasn't any better today in responding to the House's rejection of the proposed bailout:
"We put forth a plan that was big because we got a big problem," Bush just said, sitting in a chair placed before a fireplace in the White House. He's meeting with advisers, he said. "I'm disappointed with the vote in Congress," the president said.
Was that his version of FDR's famous fireside chats? Bush looked annoyed he was being bothered with this stuff.
This from a President who failed to persuade more than a third of his own party members in the House for his position in response to a financial emergency?
Meanwhile, proving that dubious leadership is bipartisan, Democratic House Speaker Nancy Pelosi provided us with a lesson on how not to win support for a position:
Finally, Tina Fey didn't even need to change any of Sarah Palin's words to drive home the point that John McCain certainly didn't bolster his lack of financial and economic acumen with his running mate selection:
Update: More "leadership."
September 24, 2008
The debate over the proposed Treasury bailout of Wall Street firms is coming at a fortuitous time -- the election season. Be wary of any candidates who, after looking appropriately concerned about the dire predictions of the plan's promoters, throw up their hands and vote in favor of the bailout because "we just have to do something" even if they don't understand what they are doing.
The fear mongering that the promoters are using to sell the bailout is laughable. This is not rocket science.
For example, when Enron tanked in late 2001, it was the seventh largest public company in the U.S. Enron traded derivatives and other financial instruments with counterparties that were among Wall Street's biggest commercial and investment banks, which were heavily exposed to its losses. To make matters worse, these investments were concentrated in the energy sector, which is at least as important to the nation's economy as the housing sector that is at the center of the current crisis.
In short, at the time of its bankruptcy, Enron was one of the nation's largest publicly-owned companies, a vitally-important market-maker in the natural gas trading industry and a leader in hedging corporate risk through structured finance transactions.
Despite the huge wealth destruction that would result from Enron's insolvency, not one government or Wall Street leader proposed a bailout of Enron in order to preserve the huge value to the public of the natural gas trading industry and the market for structured finance transactions.
Enron's bankruptcy proceeded to cause enormous tremors through various industries -- particularly the energy industry -- because valuable resources for hedging risk of loss had evaporated seemingly overnight. The natural gas trading industry nearly fell apart completely, costing companies and their customers untold billions of dollars that they otherwise could have saved through hedging risk of loss. Similarly, the market for many structured finance transactions dried up, also costing companies another valuable avenue for hedging risk.
However, the nation's financial system did not break down. Companies adjusted to the changed circumstances and endured their additional costs as best they could. Markets also adjusted. Slowly but surely, both the natural gas trading industry and the market for structured finance transactions rebounded so that both are again providing companies with valuable alternatives for hedging risk and saving money.
Now, the tables are turned on Wall Street. Rather than facing the consequences of their risk-taking decisions in chapter 11, Wall Street's politically well-connected leaders are weaving their tales of doom for the overall economy to compliant governmental leaders who are only too willing to do their bidding.
In reality, each of these Wall Street firms should be required to endure the same thing that Enron and its creditors did -- a chapter 11 reorganization where equity gets wiped out and creditors either take a haircut on payment of their debts or convert their debt to equity in a reorganized firm that emerges from bankruptcy with a cleaned-up balance sheet.
That process ensures that investors and creditors who undertook the risk of investing or dealing with the bankrupt firms share the losses of their risk-taking. Moreover, it allows the firms that really are worth saving (as opposed to simply liquidating) to emerge from bankruptcy with an improved financial condition that should provide the firm with an enhanced opportunity to create wealth again.
What the bailout plan proposes to do is insulate investors and creditors from risk of loss by having the government -- funded by taxpayers such as you and me -- undertake that risk. There is simply no moral justification for foisting that risk on taxpayers and the only possible practical justification is that sorting all of these firms' problems out in chapter 11 might take awhile.
But even if the government saw fit to accelerate the Wall Street reorganizations to hedge the risk of a prolonged economic downturn, there is simply no reason for the government to overpay for assets from financially-troubled firms. Rather, the government should simply propose a plan that implements the going-concern liquidation and debt-for-equity reorganization features of chapter 11 on an accelerated basis in return for some reasonable financial contribution to the process. And you can bet that contribution doesn't need to be close to $700 billion.
Luigi Zingales, the Robert C. Mc Cormack Professor of Entrepreneurship and Finance at the University of Chicago, has written the most cogent piece I've seen to date on why the bailout is a bad idea. Even though it was wrong for the government to contribute to the massive amounts of wealth destruction that resulted from the demonization of Enron, the government was right not to bail out Enron. The circumstances are different now, so perhaps a different approach is more prudent than simply allowing all of these Wall Street companies to be sorted out in chapter 11.
But throwing $700 billion at investors and creditors who should be sharing the losses of their risk-taking is not even close to the best way of doing it.
Update: I couldn't help but laugh out loud this morning as Warren Buffett and the promoters of the Treasury bailout plan point to Buffett's sweet $5 billion investment in Goldman Sachs as an endorsement of the plan.
I prefer to look at what Buffett is doing rather than what he is saying.
What he is not doing is what Paulson and Bernanke want the U.S. Treasury to do -- buy investment banks' toxic assets. Rather, Buffett is buying preferred shares in Goldman with a big yield and warrants to buy Goldman stock at $115 (its trading at over $130) so that he can recover the profit his investment helps foster while Goldman transitions from an investment bank to a bank holding company over the next couple of years.
Meanwhile, Paulson and Bernanke keep promoting their plan to throw $700 billion at whatever trashy assets that Wall Street serves up to them.
It does not engender much confidence that Buffett can cut a far better deal with Wall Street's best-run investment bank than Paulson and Bernanke propose to cut with the worst-run ones.
September 18, 2008
Do you recall what we were thinking about three and a half years ago?
September 16, 2008
So, while the Houston area was enduring a hurricane, the financial markets were enduring one, too.
Larry Ribstein has been insightfully pointing out for years that more regulation of those businesses will not prevent the next meltdown, just as the more stringent regulations added after Enron's collapse did not prevent Bear Stearns or Lehman Brothers from failing. More responsive forms of business ownership certainly are a hedge to the inherent risk of investment in a trust-based business. Better investor understanding of the wisdom of hedging that risk would help, too.
But as Warren Meyer eloquently wonders, what must Jeff Skilling be thinking about all this? Is Skilling's inhumane sentence -- as well as the barbaric handling of the criminal case against him and other Enron executives -- the sacrifice that American society needs to quench its blood thirst to do the same to the leaders of trust-based businesses that suffer the same fate as Enron? I hope not, but . . .
The truth is that Enron -- as with Bear and Lehman Brothers -- was simply a highly-leveraged, trust-based business with a relatively low credit rating and a booming trading operation that got caught in a liquidity crunch when the markets became spooked by revelations about Andrew Fastow embezzling millions in the volatile months after September 11, 2001.
Fastow's embezzlement is a crime, but Enron's demise is not, nor should it be. Beyond the shattered lives and families, the real tragedy here is that an angry mob convicted Skilling, trumping the rule of law and the dispassionate administration of justice along the way. None of us would be able to survive "in the winds that blow" from the exercise of the government's overwhelming prosecutorial power in response to the demands of the mob.
I continue to hope that Skilling's unjust conviction and sentence are reversed on appeal. Not only for his benefit, but for ours.
September 11, 2008
Mr. Juggles over at Long or Short Capital passes along this fictional thank-you note from Treasury Secretary Hank Paulson to American taxpayers after this week's seemingly inevitable federal bailout of Freddie Mac and Fannie Mae (prior posts here):
Dear US Taxpayer,
I would like to congratulate you on your recent purchase. I am glad I was able to convince you that now is the ideal time to offer an uncapped backstop on a $5.2 trillion book of mortgages. We here at the Treasury Dept (along with our sisters over at the Fed), appreciate your repeat business. I am confident that this acquisition will be a profitable one; perhaps even more profitable than your recent purchase of JPMorgan’s Bear Stearns’ liabilities!
Please know that we are actively seeking more deals on which we can work together. I am confident we will find more interesting opportunities before the end of the year.
"The ultimate effect of shielding men from the effects of folly, is to fill the world with fools."
August 27, 2008
Dealbreaker's essential Opening Bell yesterday included the following note about the connection between the state of Florida and mortgage fraud:
This is not surprising... Florida is already a key location of the housing bubble. What's more, Florida tops every fraud list. Hello, Boca Raton? Clearwater? These cities are to fraud what Hungary is to Paprika. It's an industry. Plus, doesn't Florida have really lax mortgage/bankruptcy laws as it is?
However, what's most interesting about Florida is how relatively well the state has turned out given its checkered history. In his fine Throes of Democracy: The American Civil War Era 1829-1877 (HarperCollins 2008) (earlier blog post here), Walter A. McDougall provides the following colorful overview of Florida's evolution from the epitome of a backwater port:
From the day of the of the pirates to our day of offshore bank accounts, hedonistic resorts, and drug smuggling, Americans have found in the Caribbean an escape from their own laws and morals. The sand spit that Juan Ponce de Leon baptized La Florida was no exception.
In 1595, the Spaniards garrisoned Saint Augustine, the oldest European settlement on what became U.S. soil; and over a century Franciscans founded thirty-two missions to proselytize the Indians. But the province, which was 300 miles wide at the Panhandle and 400 miles long on the Atlantic coast, remained a derelict.
The whole Spanish navy could not have policed its 8,246 miles of tidal coastline, nor could the army police its 54,000 square miles of jungle and swamp. Nor could either defend the Indians from European infectious diseases or from the renegade Creeks they called cimarrones (whence “Seminoles”).
By the nineteenth century, the Native American Floridians were dead, the European population was measured in hundreds, and the whole peninsula from the Apalachicola River to Key West served as a refuge for Tampa Bay buccaneers, mutineers, deserters, fugitive slaves, Seminoles, and plunderers of shipwrecks (a frequent occurrence, especially during the hurricane season).
John Quincy Adams cited the anarchy as justification for the treaty of 1819 ceding Florida to the United States. But he was pretentious to think Americanization would ensure law and order. The mostly poor, mostly Scots-Irish “crackers” who spilled into the Panhandle had no patience for government. Hot blood, hot sunshine, laws so variable that even judges could not parse them, no jails, no constables, and plenty of places to hide encouraged “ingenious rascality.” Florida was “a rogue’s paradise.” [ . . .]
. . . [V]irtue was in short supply, not only among the murderers, gamblers, slavers, squatters, and drunks who poured over the border from Georgia, but among the erstwhile elite. One feud over banking provoked two duels, a murder and a lynching that left all parties dead. In 1827, Ralph Waldo Emerson found Tallahassee “a grotesque place . . . settled by public officers, land speculators, and desperadoes.” . . . [. . .]
The Jacksonian hatred of banks likewise prevailed. So stringent were the state’s restrictions that no state banks were chartered until the legislature itself chartered one in 1855. Education? The same story. In 1851, the state founded “seminaries” to train teachers at Ocala (parent of the University of Florida) and Tallahassee (the future Florida State University), but as late as 1860 the state counted just ninety-seven schools with 8,494 pupils.
The government showed vigor only in the enforcement of slave codes and the repression of free Negroes. As the state’s population rose from 87,445 in 1850 to 140,424 by 1860, the percentage of slaves remained above 40 percent. Disciplining that underclass was everyone’s business. Policing white people’s behavior was pretty much left up to the women and the Baptist and Methodist clergy. [. . .]
. . . Today [Florida] is home to Disney World, the space program, South Beach and golf and retirement complexes. But the original Florida will never die out so long as "darkies" gather in jook joints to dance the jubilee (jitterbug), bumper stickers proclaim "Redneck and Proud of it," policeman cruise with alcoholic "roaders" in hand, and transplanted Yankees are taught that "blacks is blacks, but there ain't nothin' sorrier than po' white trash."
Mortgage fraud doesn't sound all that out of place there, now does it? ;^)
August 20, 2008
The new Creative Capitalism blog created by Bill Gates, Michael Kinsley and Conor Clarke is quickly making an interesting corner of the blogosphere. Today, Martin Wolf, the associate editor and chief economics commentator at the Financial Times, pens this remarkable blog post about what a company is, and what it is not, under different political systems. In so doing, Wolf provides a an engaging overview of the underlying forces that drive market economies. Read the entire post, but here here is a taste:
First, one has to distinguish the goal of the firm from its role. The role of companies is to provide valuable goods and services – that is to say, outputs worth more than their inputs. The great insight of market economics is that they will do this job best if they are subject to competition. Profit-maximization (or shareholder value maximization, its more sophisticated modern equivalent) is NOT the role of the firm. It is its goal. The goal of profit-maximization drives the firm to fulfill its role.
Second, by creating a competitive market for corporate control, we more or less force companies to maximize shareholder value, or at least behave in ways that the market believes will lead them to do so. . .
Third, a company is viewed in the Anglo-American world as a bundle of contracts. But companies are also social organisms created by a highly gregarious mammalian species with a unique capacity for large-scale co-operation over time and space. Companies have cultures and histories. For many of those most closely associated with them, they also have (and offer) a certain meaning. Committed workers in successful companies do not work in order to maximize shareholder value or even to earn the largest possible living. Indeed, it is impossible to direct most companies solely by the goal of profit-maximization. (Goldman Sachs may be an exception.) They have to be aimed at the intermediate goal of producing and developing goods and services that people want to buy and are worth more in the market than they cost to produce.
Fourth, the idea that a company is an entity that can be freely bought and sold is culturally specific. It is the view, above all, of Anglo-Americans. It is not shared in most of the rest of the world. . .
Fifth, in this perspective, shareholders are not genuine owners. They contribute nothing of value to the competitive strengths of the firm, enjoy the benefits of limited liability and are well able to diversify the risks they run. They are merely an (ever-shifting) group of people with a claim to the residual incomes. Those with the biggest (undiversifiable) investment in the firm -- and thus the greatest exposure to firm-specific risks -- are not shareholders, but core workers. The interests of the latter are, therefore, paramount.
And as if the foregoing wasn't enough, Wolf follows that one up with this post on the issues involved in a company embracing social responsibility as a part of its role:
This is a point of considerable and, indeed, general importance. We live in a world of two fundamentally conflicting tendencies: between ever greater competition, as markets are liberalised and opened to the world, and greater demands on companies to bear social burdens of many kinds. But the latter is incompatible with the former. Extractive industries are in a relatively good position to meet such burdens, because they enjoy rent. In general, however, companies will be increasingly unable to bear them except to the extent that social obligations help them, rather than are costly to them.
That has an important consequence – positive and negative. The positive consequence is that many social goals can only be met through political action. That is also where they ought to be met. The negative consequences are two: first, where political systems are weak or defective, social goals will not be met; second, where companies feel forced by popular pressure to accept costly burdens – to pay higher than market wages, for example – they will feel obliged to lobby to spread those burdens onto all their competitors. The result could, at worst, be less efficiency and less economic growth than otherwise. In that case, therefore, social responsibility will become a machine for spreading anti-social outcomes. That is an end nobody should desire.
If you are involved or simply interested in business, my sense is that you should bookmark Creative Capitalism and check in often.
August 9, 2008
The always-insightful Larry Ribstein points out that Jamie Olis would have been better off providing material support for Osama Bin Laden than working on the beneficial structured finance transaction that ultimately led to his criminal conviction.
The sad case of Jamie Olis remains one of the most egregious abuses of the government's prosecutorial power during the post-Enron criminalization of business. The relative lack of outrage over it reflects poorly on all freedom-loving Americans.
August 8, 2008
One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on "too much risk" in recent years. I think it is equally accurate to suggest that the financial system took on too little risk. [. . .]
The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up "super-senior AAA" tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed 'em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was "safe", so who cared what it was funding? [. . .]
. . . We've trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I've nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.
Investors' childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.
Read the entire piece here. As noted many times on this blog (most recently here), many powerful forces in our society -- the government and the mainstream media to name just two -- continue to embrace myths that distract from a mature understanding of the nature of risk.
August 3, 2008
July 23, 2008
Gosh, I thought the political coalition that supports inefficient light rail systems was formidable. But that coalition can't hold a candle to the one that the W$J's Paul Gigot says (non-gated version here) protected the dubious quasi-public structure of Freddie Mac and Fannie Mae:
The abiding lesson here is what happens when you combine private profit with government power. You create political monsters that are protected both by journalists on the left and pseudo-capitalists on Wall Street, by liberal Democrats and country-club Republicans. Even now, after all of their dishonesty and failure, Fannie and Freddie could emerge from this taxpayer rescue more powerful than ever. Campaigning to spare taxpayers from that result would represent genuine "change," not that either presidential candidate seems interested.
Meanwhile, Cato's Gerald O'Donnell points out that the proposed bailout represents "casino capitalism" for taxpayers:
Treasury Secretary Henry Paulson's bailout plan for mortgage giants Fannie Mae and Freddie Mac . . . prompted Sen. Jim Bunning (R-Ky.) to remark that he thought he'd woken up in France. Yes, socialism is alive and well in America - thanks to a Republican Treasury secretary.
Absent from Paulson's plan is any protection for taxpayers. They'll fund the downside if losses mount at the two mortgage giants. But if Fannie and Freddie recover, stockholders and management gain. Call it "casino capitalism" - taxpayers bankrolling management high rollers.
The plan doesn't ask stockholders or management to suffer for their financial indiscretions. The players who put their companies in jeopardy get to stay in charge - Paulson says he isn't looking for "scapegoats." Someone should remind him that capitalism without failure is like religion without sin.
July 18, 2008
Then, over the past several weeks, speculators who facilitate markets to hedge energy costs became targets of the demagogues.
And now this week, with the demise of Fannie Mae and Freddie Mac, SEC Chairman Christopher Cox issued an emergency order attempting to curtail naked short-sellers of the stock of the embattled government sponsored entities and also the stocks of Lehman Brothers, Goldman Sachs, Merrill Lynch and Morgan Stanley.
What on earth is Christopher Cox, a supposedly sophisticated securities lawyer, doing issuing orders that hinder the efficient functioning of markets?
Folks, the problem is not that stock prices of the GSE's and the investment banks are low because some nasty market manipulators have been targeting them. Larry Summers has a much more rational explanation for the GSE's demise. Instead of rethinking those misguided policies that led to the bubble in the GSE's stock price, Cox is engaging in a classic case of shooting the messenger by attempting to limit a price-setting mechanism for shares of stock.
Short selling -- the act of betting against a stock by borrowing it, selling it and then purchasing the stock later at a lower price to repay the loan -- plays an important role in well-functioning markets. If short selling is repressed, then optimists will dominate in the marketplace, which generally results in stocks becoming overpriced. Stated simply, persecuting the short-sellers contributes to stock bubbles. Larry Ribstein summed up the absurdity of the Cox's action well:
“[I]n our wacky world of regulation, as we step up liability to get out the truth about securities, we stomp down an important mechanism for getting the truth out about securities.”
And in addressing the above question about Cox, Craig Pirrong had an interesting 1993 encounter with the SEC chaiman regarding short-selling (and with Hillary and Bill Clinton, too, but that's a sideshow) that prompts him to make the following observation about Cox:
Given my 1993 experience with Chris Cox, I have my suspicions that the new short selling restrictions aren’t based on any empirical evidence or deep economic reasoning -– instead they are a reflection of Cox’s anti-shorting prejudices (and the prejudices of like-minded folks at the SEC) -– prejudices that he displayed in 1993.
When are we going to learn that knee-jerk regulatory responses such as Cox's latest often do more economic harm than good, not the least of which is the perpetuation of myths that distract investors from prudent risk allocation?
We humans have a long and embarrassing history of blaming devils for distressing aspects of reality that we don't understand. Droughts, floods, plagues, and erupting volcanoes have all been ascribed to the machinations of unseen super-powerful entities – as ill-defined as they are ill-intentioned – who manipulate a reality to which they are immune but to which we mortals must inevitably bend.
Today's witch hunt for speculators who allegedly are driving oil prices to heights unconnected with the realities of supply and demand is just the latest entry in this pageant of ignorance.
This post from two years ago addressed the same dynamic in connection with the death of Ken Lay. And Arnold Kling chimes in with an absolutely spot-on analysis about the folly of attempting to limit the pricing mechanism of markets:
In the mortgage market, people saw risk-takers outperforming prudent lenders. So they took more risks. There is no simple fix for that. For the foreseeable future, we can count on investors sticking to prudence when it comes to mortgage lending. We don't need any regulations to close that barn door.
But somewhere, some time, in some other market, there will be another outbreak of excessive risk-taking. You can't make the system idiot-proof. They'll just build a better idiot.
July 14, 2008
General Motors CEO Rick Wagoner made some interesting public comments this past week in Dallas regarding the besieged automaker's bankruptcy prospects:
"Under any scenario we can imagine, our financial position, or cash position, will remain robust through the rest of this year," Mr. Wagoner said Thursday while in Dallas to speak to a business organization. He said the company has plenty of options to shore up its finances beyond 2008, although he declined to outline them.
The comments failed to boost investor sentiment as GM shares fell 6.2% to $9.69 in 4 p.m. New York Stock Exchange composite trading Thursday. The stock has been trading at its lowest levels in more than 50 years as concerns mount about the company's financial position amid a steep decline in U.S. sales.
GM and other U.S. auto makers are reeling as the slow U.S. economy depresses sales and as high gasoline prices push many would-be buyers to small, more-fuel-efficient vehicles and away from the higher-margin SUVs and trucks. Through June, for instance, GM's U.S. sales slipped 16%, more than offsetting strength in overseas markets.
GM has about $24 billion in cash but is burning an estimated $3 billion a quarter, prompting talk that it will need a significant cash influx to get to 2010.
"We have no thought of [bankruptcy] whatsoever," Mr. Wagoner said in response to an audience question during the Dallas event.
Now, I am not involved with GM, but I have been involved over the past 30 years in my share of big company reorganizations. Contrary to Wagoner's statements, GM has almost certainly "thought" of bankruptcy and GM management probably continues to examine whether a reorganization under chapter 11 of the Bankruptcy Code makes sense for the company, which it just might. Frankly, not to examine such alternatives would be egregious mismanagement. Any seasoned investor knows this and the market is clearly pricing that risk by lowering the company's stock price.
So, despite all that, if GM ends up in bankruptcy, is Wagoner at risk of being indicted for misleading investors regarding the company's ongoing bankruptcy analysis? Stated another way, will Wagoner be indicted for breaching the obligation to throw in the towel?
July 3, 2008
The WSJ's Holman Jenkins splashes some cold water on the suggestion that General Motors' Volt automobile will have much of a positive impact either environmentally or on GM's bottom line:
At best, the Volt will be an affluent family's third car. It will have to be plugged in for six hours a day – i.e., it will be a car for a suburbanite with a sizeable garage wired for power. It won't be a car for a city dweller who parks on the street or in a public lot. It will travel 40 miles on a six-hour charge. After that, a small gas motor will kick in to recharge the battery while you drive. Some reports claim the Volt will get 50 mpg in this mode, but that's hallucinatory: If using a gasoline engine to power an electric motor were so efficient, the streets would be full of such vehicles. (Our guess: The car will be lucky to get 15 mpg under gasoline power.)
Notice that, even today, some people continue to buy SUVs capable of hauling eight passengers, the dog and groceries, though they spend most of their time in the car driving alone. Customers value flexibility in their vehicles. For a car with the Volt's narrow usability to sell would require an unlikely revolution in consumer behavior, especially if gasoline prices aren't going to $10 a gallon.
So why is GM placing so much emphasis on development of an auto that is not particularly competitive in the marketplace? The answer: government financing:
GM executives are not nuts. They justify the costs and risks of the Volt as a way of changing GM's image in the minds of consumers and politicians. To commit a pun, the Volt is GM's vehicle for making a bailout of GM politically acceptable.
The company has already started signaling it expects Washington to provide a whopping $7,000 tax credit to Volt purchasers. In Europe and the U.S., under whatever fuel economy and emissions regulations prevail, GM also expects special favoritism for the Volt. The goal is to re-enact the flex-fuel hoax, in which GM receives extra credit for making cars that can burn 85% ethanol, even if they never see a drop of such fuel.
CEO Rick Wagoner last week laid out the case to Barack Obama personally for turning GM into a ward of the state, by way of direct and indirect subsidies to support a transition to "alternative" fuel vehicles. GM has done yeoman's work getting its structural costs (i.e., labor) in line, but shareholders should note that a big part of the company's turnaround gamble consists also of eliciting favor once again from Washington after a period in which the domestic auto makers were nothing but whipping boys on Capitol Hill.
. . . [GM is] betting the Volt will trigger a change in Washington's taste for bailing out a domestic car maker.
Finally, Jeff Matthews channels Hamlet in expressing his skepticism about GM's strategy:
The least helpful call you will get today is so unhelpful that, young as the day might be, we think there is no chance it will be superseded by anything even less helpful as the morning wears on.
This particularly unhelpful call comes from the alma mater of the proprietor of this blog, Merrill Lynch, and it is a downgrade of General Motors stock, from “Buy” to “Underperform.”
The analyst has also lowered his price target on the stock from, and we are not making this up, $28 to $7. Last trade: $11.75.
The reasoning behind the change is not particularly important. Like Hamlet’s recounting of Claudius’ commission for the killing of Hamlet, these things are always “larded with many several sorts of reasons” which all avoid the essential issue: the analyst has been wrong; his clients and his sales force all know he’s been wrong; he can’t take it anymore; and he’s throwing in the towel.
We know: been there, done that.
June 20, 2008
As I read the indictment, the government is contending that Messrs. Cioffi and Tannin were required to disclose to investors immediately in February and March, 2007 that the two of them feared that the two funds might be "toast" even as Cioffi and other Bear executives were fighting market pessimism toward the funds and urging investors to maintain trust in their ultimate financial merit. So, with their careers riding on whether the funds would survive, Cioffi and Tannin were supposed to throw in the towel and light a match to the funds by disclosing to the market their concerns about the heightened risk of a meltdown.
Stated simply, according to the Feds, about the time you think your trust-based business might be toast, it's already too late. Inasmuch as you are required to disclose to the markets that you think the business might be toast, that disclosure will understandably prompt the market to lose trust in your business, which means that your company is kaput. So, the smart thing to do is never to voice (and sure as heck don't write any emails!) your concern to anyone regarding the downside risk of your business. That lack of communication might dampen internal company analysis regarding risk of loss, but what the hell -- at least you won't get indicted for misleading investors when your company fails.
Just another chapter in the twisted policy implications that result from regulating business through criminalizing businesspeople's risk-taking. Larry Ribstein has typically insightful observations along the same lines, while Bess Levin muses over the Feds' suggestion that investors didn't know exactly what they were buying when investing in Bear's funds.
June 17, 2008
Meanwhile, John Carney wonders whether any investors really feel safer as a result of these criminal probes?
And although Bear struck out, do we really want to deter potentially beneficial risk-taking by criminalizing it when it fails?
June 16, 2008
As Republican presidential nominee John McCain is doing his best to stoke public prejudice against job-creators and wealth builders, longtime Houston lawyer and businessman Bill King is promoting his new book, Saving Face (Somerset 2008), which is King's personal history of the savings & loan crisis of the late 1980's and early 1990's. Ironically, McCain knows quite a bit about the back story to King's book. McCain was one of the Keating Five, the Congressional supporters of former Lincoln Savings & Loan chairman and CEO Charles Keating, who was convicted of various corporate fraud crimes and served four years in prison as a result of highly-stoked but substantively-thin prosecutions that were ultimately overturned on appeal. Keating eventually pled guilty to a single count of bankruptcy fraud to limit further prison time and insulate a family member from prosecution. For a thorough review of the mendacity of the Keating prosecutions, pick up a copy of Dan Fischel's book, Payback: The Conspiracy to Destroy Michael Milken and his Financial Revolution (HarperCollins 1995).
King's story is the Houston version of Keating's and a precursor of the prosecutorial abuse that the post-Enron criminal prosecutions in Houston generated a decade later. Not only does King do an excellent job of explaining the financial, economic, regulatory and political underpinnings of the S&L crisis, he explores how the government wielded its prosecutorial power indiscriminately to serve up scapegoats to a salivating mainstream media and an ill-informed public. King is thinking about running for Houston mayor in 2009 and, based on the depth and perspective that he exhibits in Saving Face, King would probably be a fine mayor. The following is King's overview of Saving Face, which I recommend highly:
These days I find myself cringing when I hear media accounts that fraudulent and greedy mortgage brokers are responsible for all of the woes of the current housing bubble and the sub-prime defaults. I do so because the recriminations are an all too familiar echo of an earlier debacle. One to which I had a ring-side seat.
Many of you who have known me for some years know that shortly after law school I made the somewhat less-than-fortuitous career decision of joining a law firm that specialized in representing savings and loans. At the time it did not seem like a bad decision. The Houston real estate market was enjoying an unprecedented boom and the savings and loan industry had just been deregulated. Investors were clamoring to get into the business.
Within a few years of joining the law firm, I began investing in savings and loans and related businesses. By 1986, notwithstanding that I had started with barely two nickels to rub together after working my way through law school, I had built a small, but respectable, business empire consisting of savings and loan holdings, title companies, and real estate investments. However, within a couple of years, everything I had built evaporated into thin air.
The Houston market collapsed when the price of oil fell from over $34 per barrel in 1984 to $9 the next year. It did not recover to above $20 until 2002. Manufacturing jobs in the region fell by nearly 50% and for the first time in history Texans' personal income declined.
Bankruptcies in Houston tripled between 1983 and 1987. All but one of Texas' major banking holding companies failed. Harris County's population actually declined from 1985 to 1989. It was the first and only time in Houston's history that it has lost population. If you did not live through these times, the magnitude of melt down is hard to imagine.
It is certainly difficult to lose everything that you have worked for, but the environment that existed in the late 1980s and early 1990s had an even more ominous aspect. As the public became increasingly aware that the savings and loan crisis was going to take a major taxpayer bailout, there were ever more strident cries to hold someone responsible.
The complexity of confluence of interest rates, regulatory policy, oil prices, the Tax Reform Act of 1986, and the collapse of large portions of the real estate market that actually explained the collapse was too great to be reduced to sound bites. Politicians and bureaucrats began pointing the finger at those in the industry, and soon, the "S&L crook" was born. And there were enough egregious cases for the politicians and bureaucrats to hold up as "proof" of their argument that the "S&L crooks" caused the crisis.
The proposition that fraud and insider abuse had sunk the savings and loan industry was eventually discredited. In 1993, a National Commission concluded that fraud had caused less than 15% of the total problem. But in the heat of the moment, there was little interest in cool, scholarly reflection on the problems of the industry.
As the 1980s came to a close I watched as many friends, associates and former clients in the S&L industry were swept up in a maelstrom of civil and criminal litigation. Naively, it never occurred to me that I might be caught up in such a dispute as well. But I was.
Eventually, I prevailed in my battle with the regulators, but as you might imagine, it was an experience that left an indelible mark and from which it took me many years to recover. For some time I have been jotting down notes for a book about these experiences. For a couple of reasons, I recently decided to finalize such a book.
First, as many of you know, I am considering a candidacy for mayor of Houston in 2009. We all know too well that "negative campaigning" has become the standard today. Certainly going bankrupt in the savings and loan business will provide potential opponents ready ammunition. So first and foremost, I want to put the issue squarely on the table. If I decide to become a candidate, there will undoubtedly be some voters who will be troubled by these experiences. Some will believe difficult times such as the ones I went through are a crucible that better prepares a person for leadership. Most, I expect, will simply want to be advised of the facts so that they can be weighed with other issues bearing on their decision.
But beyond the potential political implications, the troubling similarities between what I saw in the S&L collapse of the 1980s and the sub-prime crisis playing out before us now demands some consideration. It is a well worn adage, but nonetheless true, that if we do not learn from our history, we are doomed to repeat our mistakes. Perhaps relating what I saw during the saving and loan industry collapse will provide some perspective on the current financial crises.
So for these reasons I have written Saving Face: An Alternative and Personal Account of the Savings and Loan Debacle. I have attempted in the book to tell the story of what I experienced during these times, but at the same time, to place my experiences in a larger, national context. I believe my story has some relevance to anyone experiencing trying times generally, and certainly to those in the Houston real estate industry, many of whom lived through these times as I did.
May 30, 2008
Yesterday brought the final installment of Kate Kelly's extraordinary three-part W$J series on the fall of Bear Stearns (Kelly also contributed to today's story on Bear's final shareholders meeting). My goodness, was Kelly a fly on the wall over at Bear's office during all of this? Dear John Thain has an interesting critical analysis of the series here, here and here, while Larry Ribstein and John Carney point out that Kelly apparently fell for what has become known as "the loophole legend" in regard to JP Morgan's buyout of Bear.
Although all the articles in the series are fun reading, Kelly's most insightful observation comes from the second installment:
It was the beginning of a frantic 72 hours that would bring the Wall Street firm to its knees and threaten the stability of the global financial system. . . . The brokerage's sudden fall was a stark reminder of the fragility and ferocity of a financial system built to a remarkable degree on trust. Billions of dollars in securities are traded each day with nothing more than an implicit agreement that trading partners will pay up when asked. When investors became concerned that Bear Stearns wouldn't be able to settle its trades with clients, that confidence evaporated in a flash. Trading partners, eager to avoid losses, began to disappear almost as quickly. That further fueled rumors of trouble. Some partners, spotting a chance to profit, made bets against Bear Stearns, helping accelerate its demise. . . .
Even after the Bear Stearns lesson, our understanding of the pesky trust-based business model is still not what it should be. Improving the investing public's understanding of how best to hedge the risk of investing in trust-based businesses is a far more productive response to Bear Stearns-type business failures than this.
May 29, 2008
As Larry Ribstein cogently explains, Southwest Airlines has taken advantage of futures markets over the past several years to hedge its fuel costs (previous posts on Southwest's hedging program are here). That hedging program has been one of the major factors in allowing Southwest to remain one of the only profitable U.S. airlines. Along the same lines, Bloomberg's Matthew Lynn explains how such markets provide an essential function in re-directing resources in the overall economy.
Meanwhile, Congress is trying to hamstring the very markets (see also here) that provided Southwest and many other businesses with the platform on which they hedged fuel-cost and other business risk. The wealth and lower prices generated from those hedges is not inconsequential.
Finally, the Justice Department continues its advocacy of an effective life sentence for one of the men primarily responsible for developing the robust markets that facilitate Southwest and others' wealth creation for shareholders and lower costs for customers.
And these folks in Congress and the Justice Department are supposed to be representing our interests?
May 19, 2008
James Freeman of the Wall $treet Journal, one of the only mainstream media outlets to expose Spitzer's extortion of AIG for what it truly was, reports here on the massive reduction of wealth to which Spitzer's unbridled regulation of AIG contributed greatly. Larry Ribstein, who was one of the first bloggers to shed light on this injustice, surveys the economic carnage here.
My question: Where is the rest of the mainstream media in reporting on this enormous destruction of wealth to AIG shareholders?
May 6, 2008
Well, well, well. Look who is resurfacing in connection with the creation of the Justice Department's latest criminal Task Force to investigate whether crimes were committed when the subprime-mortgage market collapsed (just what we need -- another corporate crime lottery):
Federal prosecutors are stepping up their scrutiny of players in the subprime-mortgage crisis, with a focus on Wall Street firms and mortgage lenders.
Prosecutors in the Eastern District of New York in Brooklyn have formed a task force of federal, state and local agencies that will involve as many as 15 law-enforcement agents and investigators.
The U.S. attorney for the office, Benton J. Campbell, who supervises about 150 prosecutors, said the group will look into potential crimes ranging from mortgage fraud by brokers to securities fraud, insider trading and accounting fraud.
You may remember Campbell. He was the lead prosecutor on the Enron-related criminal trial known in these parts as the first Enron Broadband trial, which ended in an embarrassing loss for Enron Task Force after the prosecution was caught threatening defense witnesses (see also here) and propounding false testimony from one of its key witnesses during the trial. Sort of what you would expect from a trial in which the Task Force advocated an unwarranted expansion of a criminal law intended to punish kickbacks and bribes against business executives who did no such thing.
Interestingly, in the Wall Street investigation, Campbell thinks there actually may be a non-criminal explanation about the meltdown in the sub-prime market:
Mr. Campbell said the "jury is still out" on just how much criminal activity the office might find, particularly on Wall Street, which saw a sudden decline in the value of securities backed by pools of mortgages last year. "There are market forces in play in that area, and that doesn't necessarily mean there is fraud," said Mr. Campbell, 41 years old.
March 27, 2008
Michael Lewis -- author of Moneyball and The Blind Side: Evolution of a Game (previous post here) provides this particularly lucid Bloomberg.com op-ed regarding the implications of the Bear Stearns affair to investors generally:
All of this raises an obvious question: If the market got the value of Bear Stearns so wrong, how can it possibly believe it knows even the approximate value of any Wall Street firm? And if it doesn't, how can any responsible investor buy shares in a big Wall Street firm?
At what point does the purchase of such shares cease to be intelligent investing, and become the crudest sort of gambling? [. . .]
To both their investors and their bosses, Wall Street firms have become shockingly opaque. But the problem isn't new. It dates back at least to the early 1980s when one firm, Salomon Brothers, suddenly began to make more money than all the other firms combined. (Go look at the numbers: They're incredible.)
The profits came from financial innovation -- mainly in mortgage securities and interest-rate arbitrage. But its CEO, John Gutfreund, had only a vague idea what the bright young things dreaming up clever new securities were doing. Some of it was very smart, some of it was not so smart, but all of it was beyond his capacity to understand.
Ever since then, when extremely smart people have found extremely complicated ways to make huge sums of money, the typical Wall Street boss has seldom bothered to fully understand the matter, to challenge and question and argue.
This isn't because Wall Street CEOs are lazy, or stupid. It's because they are trapped. The Wall Street CEO can't interfere with the new new thing on Wall Street because the new new thing is the profit center, and the people who create it are mobile.
Anything he does to slow them down increases the risk that his most lucrative employees will quit and join another big firm, or start their own hedge fund. He isn't a boss in the conventional sense. He's a hostage of his cleverest employees.
As noted in this earlier post, nothing is wrong with having compassion for Bear Stearns employees who lost much of their net worth as a result of the firm's demise. But the reality is that the ones who suffered large losses in their nest egg when Bear Stearns failed were imprudent in their investment strategy. They should have diversified their holdings or bought a put on their shares that would have allowed them to enjoy the rise in the company's stock price while being protected by a floor in that share price if things did not go as planned. Even though most of those Bear Stearns investors carry insurance on their homes and cars, relatively few of them elected to hedge the risk of their more speculative Bear Stearns investment. Most likely, many of these investors simply did not understand how Bear Stearns created their wealth in the first place. Absent a better understanding of investment risk and how to hedge it, such investment losses will continue in the future, regardless of whatever ill-advised regulations are devised in an attempt to prevent them.
March 18, 2008
Following on recent posts here and here, The Economist produces the best mainstream media article that I've seen to date placing the prosecutorial misconduct of the Enron Task Force toward former Enron executives Jeff Skilling and Ken Lay in the context of the most recent demise of a trust-based business, Bear Stearns:
For many people, the mere fact of Enron’s collapse is evidence that Mr Skilling and his old mentor and boss, Ken Lay, who died between his conviction and sentencing, presided over a fraudulent house of cards. Yet Mr Skilling has always argued that Enron’s collapse largely resulted from a loss of trust in the firm by its financial-market counterparties, who engaged in the equivalent of a bank run. Certainly, the amounts of money involved in the specific frauds identified at Enron were small compared to the amount of shareholder value that was ultimately destroyed when it plunged into bankruptcy.
Yet recent events in the financial markets add some weight to Mr Skilling’s story—though nobody is (yet) alleging the sort of fraudulent behaviour on Wall Street that apparently took place at Enron. The hastily arranged purchase of Bear Stearns by JP Morgan Chase is the result of exactly such a bank run on the bank, as Bear’s counterparties lost faith in it. This has seen the destruction of most of its roughly $20-billion market capitalisation since January 2007. By comparison, $65 billion was wiped out at Enron, and $190 billion at Citigroup since May 2007, as the credit crunch turned into a crisis in capitalism.
The Economist article goes on to compare the similarity of certain of Ken Lay's public comments regarding Enron's liquidity in the turbulent post 9/11 markets (for which he was eventually prosecuted) with those of Bear Stearns and Lehman Brothers executives during the current turmoil in the financial markets. As this post from almost two years ago notes, the source of the information upon which Lay based his positive statements is the same fellow (former Enron CFO Andrew Fastow) whose exculpatory statements regarding Skilling and Lay the Enron Task Force improperly withheld in connection with their criminal trial. And the revelations of this latest round of prosecutorial misconduct with regard to Fastow comes on top of the Task Force's blatant misrepresentation (see also here) of Fastow's plea deal to the Lay-Skilling jury during the trial.
As usual, Larry Ribstein places all of this in context:
I'm constructing a "narrative" for the prosecutorial misconduct case: Prosecutors desperate for a conviction, their careers turning on the outcome, have a key witness, Andy Fastow. The problem is, the guy has, in [Enron Task Force prosecutor John] Hueston's words, a "heartstopping history of self-dealing." Obviously the government couldn't afford any additional shadow on Fastow's credibility. Yet in the government interviews it seems his story got more negative on the defendants over time. Could be a big problem for Fastow on the witness stand, as the defense sought on cross to show he was changing his story to suit his jailers. Could the prosecutors afford to give these notes to the defense? Why not just turn over a summary? By the time the truth came out (if it ever did) they could do a dance about how the differences were inconsequential.
The government is saying the differences are inconsequential. So why, then, didn't they produce the notes as repeatedly requested, rather than summarizing them? I think those prosecutors have some explaining to do.
Update: Warren Meyer also notes the similarities between Bear Stearns' demise and that of Enron.
March 16, 2008
Over the weekend, we learned that the Fed had bailed out New York-based investment bank Bear Stearns during this unsettled time in the financial markets.
Almost seven years ago, a much larger company that shared many characteristics with Bear Stearns -- Houston-based Enron -- did not even generate serious consideration for a Fed bailout before it went under in the turbulent post-9/11 financial markets.
In between those two events, one of the world's wealthiest insurers and another company that is similar in many respects to Bear Stearns and Enron -- American Insurance Group -- barely escaped a similar fate by cutting a deal with the now-disgraced former Governor and Attorney General of New York to cut loose the executive primarily responsible for creating AIG's vast wealth.
The fact of the matter is that Enron was -- and Bear Stearns and AIG are -- trust-based businesses that fundamentally depend on the trust of the markets to sustain their value. Once that trust is lost, such companies lose value quickly and dramatically (a case in point -- JP Morgan Chase's proposed $236 million purchase price for Bear Stearns comes just hours after Bear's market cap was $3.5 billion this past Friday and $20 billion as of January, 2007). Although unfortunate for the owners of such companies, such a dramatic loss of wealth does not necessarily mean that any criminal conduct caused or was even involved in the loss. Rather, such loss is simply one of the risks of investing in a company based on a trust-based business model. The sooner we all recognize and understand this risk -- and avoid the mainstream media's promotion of myths about them -- the quicker we can put a stop to injustices such as this while advancing the discussion of how best to hedge the risk of such potential losses.
March 11, 2008
The mainstream media and the blogosphere have been buzzing over the past 24 hours regarding the fall from grace of New York's governor and former Lord of Regulation, Eliot Spitzer. As noted in this previous post, there is an under-appreciated human element in such dubious criminal problems as Spitzer fell into. So, I have a great deal of compassion for the members of Spitzer's family, although Spitzer's many victims would certainly attest that he showed none for them. Larry Ribstein has related and typically insightful thoughts regarding why the revelers in Spitzer's fate should be concerned about the way in which he was brought down.
But I hope that the most important lesson that Spitzer's political career teaches us is not lost amidst the glare of a tawdry sex scandal. As with Rudy Giuliani before him, Spitzer rose to political power through the misuse of the state's overwhelming prosecutorial power to regulate business interests. In so doing, Spitzer manipulated an all-too-accommodating mainstream media, which never misses an opportunity to take down an easy target such as a wealthy businessperson. Spitzer is now learning that the same media dynamic applies to powerful politicians, as well.
However, as noted earlier here, where was the mainstream media's scrutiny when Spitzer was destroying wealth, jobs and careers while threatening to go Arthur Andersen on American Insurance Group and other companies? Where was the healthy skepticism of the unrestrained use of the state's prosecutorial power to regulate business where business had no available regulatory procedure with which to contest Spitzer's actions? As Dealbreaker's John Carney noted at the time of that earlier post:
Why didn’t [the mainstream media covering Spitzer's investigation of Grasso] reveal the slimy tactics of the Spitzer squad? We suspect part of the problem was the fear of being “cut off” of access. Reporters compete for scoops, and often those scoops depend on sources who will leak information to them. In the NYSE case, reporters assigned to the story were largely at the mercy of the investigators, who could cut-off uncooperative reporters, leaving them without copy to bring to their editors while their competitors filed stories with the newest dirt. They probably felt—not unrealistically—that their very jobs were on the line.
This reveals an unfortunate state of affairs. Playing bugle boy while government officials call the tunes from behind a veil of anonymity is not investigative journalism—it’s hardly journalism at all. It’s closer to propaganda. It would have been far better had the journalists turned their backs on the Spitzer squad, or even revealed these tactics to the public. Sure they may have lost some “good” stories but they could have painted a truer picture of what was going on. But that’s probably too much to hope for.
Alas, change does not come easily to the mainstream media. Late last week, this post reported on developments that could well expose an egregious abuse of prosecutorial power in connection with the prosecution for former Enron CEO, Jeff Skilling. Why has no mainstream media outlet intervened in that case and demanded that the information about potentially serious governmental misconduct be made public?
The Spitzer lesson is not easily embraced.
Update: Following on the theme of this post, the W$J's Kimberly Strassel reviews the mainstream media's complicity in portraying Spitzer as something that he is not, and Charlie Gasporino -- who wrote the book about Spitzer that foreshadowed these issues -- comments along the same lines here.
February 13, 2008
[I]n the end, Sarbanes-Oxley has just made it easier for ambitious government attorneys to criminalize bad business judgment and complex accounting in hindsight. Further, in their focus on strengthening legal enforcement, the feds have passed up opportunities to create commonsense protections for investors. Worse still, the government has instilled investors with false confidence by implying that they can rely on prosecutors, not prudence, to protect their market holdings. Now the housing and mortgage meltdown—which could hurt the economy far more than Enron did—is reminding investors that no law or regulation can protect them from economic disruption. [. . .]
As the economy heads into a possible downturn, calls will grow for someone to pay for the pain of another burst bubble—and for yet more onerous rules, regulations, and prosecutions of businesses to prevent future crises. But no government mandate or punishment, however harsh, will stop companies and markets from being imperfect collections of fallible human beings. At the end of a decade of financial surprises, that may be the most enduring lesson of all.
As I noted here almost three years ago and have reiterated many times, the truth about Enron is that no massive conspiracy existed, that Jeff Skilling and Ken Lay were not intending to mislead anyone and that the company was simply a highly-leveraged, trust-based business with a relatively low credit rating and a booming commodities trading operation. Although there is nothing inherently wrong with such a business model, it turned out it to be the wrong one to survive amidst the perilous post-tech bubble, post-9/11 market conditions. Thus, when the markets were spooked by revelations of the embezzlement of several millions by Enron's CFO and his relative few minions, the company failed.
However, Gelinas is spot on in observing that Enron's failure was not a market failure. That Jeff Skilling failed to predict that Enron would fail is not a crime. Unlike his main accusers Andy Fastow and Ben Glisan, Skilling didn't embezzle a dime from Enron. Did he tirelessly advocate on behalf of this innovative company? Sure, but since when is it a crime for a CEO to be optimistic -- even overly-optimistic -- about his company?
The primary justification for the absurdly-long sentence handed to Skilling is the plight of the innocent employees and investors who lost their nest eggs when Enron went bankrupt. But the main reason that those nest eggs ever had value in the first place was because Skilling had transformed Enron into the world's leading energy risk management company through the creative use of futures and options contracts to hedge price risk for natural gas producers and industrial consumers.
Although nothing is wrong with compassion for folks who lose money on an investment, rarely is it mentioned in the Enron morality play that many of those investors who lost their nest egg when Enron failed were imprudent in their investment strategy. They should have diversified their Enron holdings or bought a put on their Enron shares that would have allowed them to enjoy the rise in Enron's stock price while being protected by a floor in that share price if things did not go as planned. Even though virtually all of those innocent Enron investors carry insurance on their homes and cars, one can only speculate why they didn't attempt to hedge the risk of their investment in Enron stock. Most likely, many of the investors simply did not understand how Enron's risk management services created their wealth in the first place.
Beyond the shattered lives, families and careers, the real tragedy of the post-Enron demonization of business is that it has distracted us from examining the tougher issues of what really causes the demise of a company such as Enron and understanding how such a company can be structured to survive in even the worst market conditions. It's easy to throw a good and decent man such as Jeff Skilling in prison for most of the rest of his life, throw away the keys and simply attribute Enron's failure to him. It's a lot harder to try and understand what really happened.
January 28, 2008
A common topic on this blog has been the power of anti-business myths within American society. Take Enron, for example. We all know how the myth played out. Enron, which was one of the largest publicly-owned companies in the U.S., was really just an elaborate financial house of cards that a massive conspiracy hid from innocent and unsuspecting investors and employees. The Enron Myth is so widely accepted that otherwise intelligent people reject any notion of ambiguity or fair-minded analysis in addressing facts and issues that call the morality play into question. The primary dynamics by which the myth is perpetuated are scapegoating and resentment, which are common themes of almost every mainstream media report on Enron.
The mainstream media -- always quick to embrace a simple morality play with innocent victims and dastardly villains -- was not about to complicate the story by pointing out that the investors in Enron could have hedged their risk of loss by buying insurance quite similar to that which Enron developed in creating their wealth in the first place. Instead of attempting to examine and tell the nuanced story about what really happened at Enron, much of the mainstream media simply became a part of the mob that ultimately contributed to death of Ken Lay and hailed the barbaric 24 year sentence of Jeff Skilling. Ambitious prosecutors, given wide latitude to obtain convictions of key Enron executives regardless of the evidence, gladly took advantage of the firestorm of anti-Enron public opinion to lead the mob.
Consequently, as Wall Street continues to endure massive equity write-downs that dwarf the $1.1 billion non-recurring charge against earnings that triggered Enron's demise after the 3rd quarter of 2001, I was somewhat surprised to read this common sense analysis from NY Times columnist, David Brooks:
There is roughly a 100 percent chance that we’re going to spend much of this year talking about the subprime mortgage crisis, the financial markets and the worsening economy. The only question is which narrative is going to prevail, the Greed Narrative or the Ecology Narrative.
The Greed Narrative goes something like this: The financial markets are dominated by absurdly overpaid zillionaires. They invent complex financial instruments, like globally securitized subprime mortgages that few really understand. They dump these things onto the unsuspecting, sending destabilizing waves of money sloshing around the globe. Economies melt down. Regular people lose jobs and savings. Meanwhile, the financial insiders still get their obscene bonuses, rain or shine.
The morality of the Greed Narrative is straightforward. A small number of predators destabilize the economy and reap big bonuses. The financial system is fundamentally broken. Government should step in and control the malefactors of great wealth.
The Ecology Narrative is different. It starts with the premise that investors and borrowers cooperate and compete in a complex ecosystem. Everyone seeks wealth while minimizing risk. As Jim Manzi, a software entrepreneur who specializes in applied artificial intelligence, has noted, the chief tension in this ecosystem is between innovation and uncertainty. We could live in a safer world, but we’d have to forswear creativity. [. . .]
The Ecology Narrative is not morally satisfying. I wouldn’t bet on its popularity as a backlash against Wall Street and finance sweeps across a recession-haunted country. But the Ecology Narrative has one thing going for it. It happens to be true.
Along those same lines, this Landon Thomas/NY times story reports on how two Wall Street executives who were intimately involved in $34 billion in write-downs remain reasonably hot properties on the Wall Street employment market. The Greed Narrative apparently hasn't caught up with those two yet, either.
But not so fast. This NY Times article reports that New York attorney general Andrew Cuomo, who replaced Eliot Spitzer as the Lord of Regulation, is currently putting the squeeze on a company that analyzed the quality of home loans for investment banks to provide evidence to prosecutors that the banks had detailed information that they did not reveal to investors about subprime mortgage risk. So, maybe that Greed Narrative still has legs after all.
But for the final word, don't miss this Larry Ribstein post in which he exposes NY Times columnist Gretchen Morgenson's stubborn adherence to the Greed Narrative even when it is clear from the subject of the story (in this case, the troubles of retailer Sears) that the narrative doesn't fit. In short, Morgenson is not one to allow the facts to get in the way of spinning a Greed Narrative morality play.
January 3, 2008
As noted here last month, Berkshire Hathaway chairman and mainstream media folk hero Warren Buffett is a key player and, as these NY Times and W$J articles report, perhaps even a key witness in the upcoming criminal trial of a former AIG executive and four former executives of Berkshire's General Reinsurance Corp, including former General Re CEO, Ronald E. Ferguson.
Although Buffett knew about the finite risk transactions that are at the heart of the prosecution, he is exempt from prosecution under the Buffett Rule. Previous posts on this case are here, here, here, here and here.
What's particularly interesting about all this is that the prosecution is attempting to prevent the defense from even mentioning Buffett, whose knowledge of the transactions (and the government's election not even to include Buffett as an unindicted co-conspirator, much less a defendant) is at least some evidence of the defendants' lack of criminal intent (Warren Buffett would not engage in any criminal conduct, now would he?). The prosecution is contending that any evidence relating to Buffett's knowledge of the transactions is hearsay and, thus, inadmissible. But until the testimony regarding Buffett's knowledge is propounded in court, who knows whether it is hearsay?
Of course, the prosecution is not shy about using hearsay testimony when it comes from someone who is not an avuncular media darling such as Buffett. The prosecution has fingered former AIG chairman Maurice "Hank" Greenberg as an unindicted co-conspirator in the trial, which -- based on previous experience -- means that the prosecution will use testimony about Greenberg's statements that would otherwise be hearsay.
As usual, Larry Ribstein sums up the vagaries of the government's policy of selectively criminalizing merely questionable business transactions:
One might think that the government would have been trying to ensnare Buffett, who would be a high-profile trophy. The problem is that trying a cultural icon like Buffett would raise public doubt about the legitimacy of the government's corporate crime enterprise. So Buffett gets the benefit of a version of the Apple rule -- . . . the Buffett rule. In this case, unlike Enron, it's better for the government to land the tuna than the barracuda.
According to the WSJ, the prosecution is arguing that "[t]he defendants want to deflect the issue of their involvement, knowledge and the intent relating to ... the fraudulent transaction at the heart of this case by creating a trial-within-a-trial about Warren Buffett." Deflect? Yes, I guess, for the government, a defendant's insistence on defending himself is a pesky nuisance.
The bottom line is that issues of defendants' guilt, including critical evidence of whether they knew they were engaging in wrongdoing, may not be available because, ultimately, the government decides who testifies by deciding whom to prosecute. All part of the costs of the extensive criminalization of accounting and other conduct of corporate agents.