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Category Archives: Business – 2008-10 Financial Crisis
Again, Why is Timothy Geithner Still Treasury Secretary?
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 recent 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.
Where Are All the Villains?
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?
Those darn unintended consequences
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.”
Ungagged.net: The Other Side of the Enron Story
A common topic on this blog has been the power of anti-business myths within American society.
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 in many subsequent posts here 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 lonely 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.
The SEC’s strike suit against Goldman
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 ìthe largest penalty ever assessed against a financial services firm in the history of the SEC,î and ìa 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.î 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,todayís 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 ìmistakeî?
The bottom line is that this suit has proved to be no more than a common ìstrikeî suit, no better than the sort of private securities class actions that triggered Congressional reform 15 years ago. Instead of attorneysí fees, the SECís 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 Goldmanís 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 ìfinancial reform.î
Expecting the SEC to regulate a firm as sophisticated as Goldman Sachs effectively is about as rational as investing oneís entire nest egg with Bernie Madoff or Allen Stanford.
Financial Ed 101
Itís 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 governmentís new consumer-protection agency has the authority to ìreview and streamlineî financial literacy programs, but thatís not enough. We really need something more like a financial equivalent of driversí ed. Thereís 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 isnít 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 itís 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 ñ and well-educated ñ 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.
Stuff happens
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In this NY Times op-ed, Richard Thaler picks up on a theme that Ken Rogoff and James Hamilton raised last week ñ 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 isnít 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 ìone-in-a-million chance.î 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 ìlegitimate,î 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 arenít careful, we will encourage companies that have enough money for collection to leave the drilling to those that donít. [. . .]
We are left in a difficult place. Neither the private nor the public sector seems up to handling these kinds of problems. And we canít 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, itís 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, itís 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.
Stu
ff happens, indeed.
The Beneficial Nature of Derivatives
I don’t watch much television news. But when I catch a glimpse these days, it always seems as if some politician is loudly declaring the need for more governmental financial regulation.
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.
Next Victim of the Criminalization-of-Business Lottery?
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?
First, there was the Apple Rule, which was quickly followed by the Dell Rule.
Then there was the Buffett Rule, closely followed by the GM Rule.
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.
For instance, the owners of Long Term Capital Management may have been the earliest winners in the most recent era. On the other hand, Jamie Olis may have been the earliest big loser.
Martha Stewart lost, but at least never lost her business enterprise. Frank Quattrone also lost, but then he won, although I suspect that he believes that he lost overall.
Subsequently, Theodore Sihpol won while Bill Fuhs and his family lost a year of his life before he won, too. But he and his family will never get that year back.
And no one lost bigger than Jeff Skilling.
Meanwhile, although mainstream media darlings Steve Jobs and Warren Buffett won, several of Buffett’s associates did not fare as well. Neither did Greg Reyes.
And who knows about those Lehman Brothers executives — they may be winners, after all? I mean, everyone was doing it, right? But you never know for sure.
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.