Category Archives: Business – 2008-10 Financial Crisis

Thinking about financial regulation

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Peter Wallison and Steve Randy Waldman have each written a thought-provoking and important analysis of the effect of regulation on the recent financial crisis.

First Wallison:

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.

And Waldman:

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.

Refusing to throw in the towel is not a crime

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Cioffi and Tannin Thank goodness.

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 prosecutionís case; they acquitted because they did understand that the governmentís 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.”

Too Big Even to Consider Failing

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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.

Why is Timothy Geithner Still Employed?

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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?

Bluffing Geithner is Profitable

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Say what?

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.

So it goes.

While you’re at it, Judge Rakoff

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jedrakoff 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?

The increasing cost of public equity

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frank quattrone google 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?

“Is it not like hiring a personal trainer who is morbidly obese?”

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Has there ever been a Treasury Secretary who has been an easier target than Timothy Geithner?

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The Money Pit

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Money%20Pit.jpg 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!


In The Know: Should The Government Stop Dumping Money Into A Giant Hole?

 

A daunting jury verdict for deal lawyers

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Collins Flying a bit under the radar this past weekend was the dreaded "we’re sure as hell not coming back on Monday" verdict that the jury returned on Friday afternoon in the Refco, Inc-related criminal case against Mayer Brown partner, Joseph P. Collins.

Collins was Refco’s outside corporate counsel for ten years or so before Refco disintegrated into bankruptcy in October, 2005. A New York city federal jury found Collins guilty on five of 14 criminal counts, including two counts of wire fraud, two counts of securities fraud and conspiracy, and a mistrial was declared on the other nine counts. Sentencing is scheduled for November 3rd. A previous post on the indictment is here and a copy of the original indictment against Collins is here and previous posts about the Refco case are here.

The jury verdict against Collins crosses the Rubicon in terms of the federal government’s willingness to prosecute an outside deal lawyer for merely advising a client in regard to structuring transactions that are not intrinsically illegal. As is typical of most business prosecutions over the past several years that criminalize questionable business judgment rather than clear white collar criminal acts such as embezzlement, the case against Collins was a jumble of conclusory allegations of fraud without any specific allegations of what Collins did that was criminal.

Heck, it was undisputed at trial that Collins barely worked on the transactions on which the prosecutors based their case against him. Essentially, the prosecution alleged that Collins assisted former Refco CEO and controlling shareholder Phillip Bennett in using Refco’s credit to reduce indebtedness to Refco of an affiliate controlled by Bennett. That’s not a crime, but the government asserted that Collins committed a crime by aiding Bennett in misleading Refco auditors and investors by not telling them about the use of Refco’s credit to reduce the affiliate’s debt to Refco.

It didn’t help Colling that a couple of other former Refco officers who copped pleas testified for the prosecution, although Bennett was not one of them. And the fact that a couple of partners from Weil Gotshal — which replaced Mayer Brown as Refco’s corporate counsel after Thomas H. Lee Partners bought a majority stake in the firm a few months before Refco’s public offering — also testified against Collins. I’d bet that testimony didn’t help relations between the two firms.

What’s curious about all of this is that numerous lawyers, accountants and investment bankers scrutinized and presumably profited from Refco over the past several years in connection with various investments in the firm, including its well-publicized public offering that valued the company at $4 billion five months before it disintegrated into bankruptcy. Not only did those professionals fail to uncover the alleged fraud, but none of them other than Collins was targeted as a criminal. See why these matters are better suited for civil cases in which responsibility for wrongdoing can be allocated among all the responsible parties?

Moreover, as this earlier post notes, if Collins knew about a massive fraud at Refco, then why on earth did he allow the company to be bought by Thomas H. Lee Partners and then go public where discovery of the fraud would likely lead to far more draconian consequences than if Refco had remained private?

Collins testified in his own defense and rightfully contended that it was never the job of Collins — or generally any outside corporate counsel, for that matter — to monitor the company’s transactions, which would be an impossible task for outside counsel. Collins went on to testify that was never informed of the hidden debt and that Refco’s top executives lied to him from the beginning.

At any rate, at the end of the trial, the prosecution contended that none of the specifics really meant much. Collins and Mayer Brown made millions off of Refco, which ultimately tanked. Thus, Collins must have done something wrong, right? Even this apparently divided jury agreed with that twisted logic.

Here’s hoping that the trial judge will set aside the verdict against Collins, but that’s probably wishful thinking in these anti-business times. The problem with this emerging governmental policy of prosecuting transactional lawyers is similar to the policy of criminalizing agency costs against corporate officers. 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.

Larry Ribstein has put it this way. Suppose somebody mugs you on the street. There is no question that is a crime. However, what if they ask you first if they can borrow your wallet, you loan it to them, and then they don’t give it back in time? What if they ask your employee who’s running the store for you whether they can borrow some money, the employee loans it to them and then they don’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 and the legal relationships 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 guy who’s minding the store that he’ll not face a prosecution for conspiracy if he spills the beans on the employee?

In the meantime, the Collins verdict sends an ominous message to transactional lawyers everywhere. Rest assured that American business — and ultimately all of us — will endure the additional costs that deal lawyers will charge to endure the risk that the government will prosecute them for a crime that they do not know about.