Category: Corporate Finance

Toward Transparent Derivatives Trading

Could you describe the financial crisis in a sentence? Margaret Atwood’s description (in Payback: Debt and the Shadow Side of Wealth) appears to me as good as any:

[This] scheme. . . boils down to the fact that some large financial institutions peddled mortgages to people who could not possibly pay the monthly rates and then put this snake-oil debt into cardboard boxes with impressive labels on them and sold them to institutions and hedge funds that thought they were worth something.

I’d only add one amendment, to recognize the last step in the agency problem: the products were sold by and to institutions whose managers believed that they could still pocket fees and bonuses without being liable to principals for gross malfeasance. As the former head of AIGFP enjoys his fortune, the joy in passing on the proverbial hot potato must daily bring a smile to his face.

As these black boxes continue to blow up, the WSJ Opinion page recently featured a proposal to open up some of them. Professors Viral Acharya and Robert Engle argue that “derivative trades should all be transparent,” in refreshingly plain English:

Most financial contracts are arrangements between two parties to deliver goods or cash in amounts and at times that depend upon uncertain future events. By their nature, they entail risk, but one kind of risk — “counterparty risk” — can be difficult to evaluate, because the information needed to evaluate it is generally not public. Put simply, a party to a financial contract might sign a second, similar financial contract with someone else — increasing the risk that it may be unable to meet its obligations on the first contract. So the actual risk on one deal depends on what other deals are being done. But in over-the-counter (OTC) markets — in which parties trade privately with each other rather than through a centralized exchange — it is not at all transparent what other deals are being done.

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Deconstructing the Put-Option State

Larry and David Zaring have a thoughtful piece making the case against an overly exhuberent regulatory response to the financial crisis.  There is a lot of wisdom to what they say.  At its bottom, however, it seems to me that the keygovernment failure lay not in our regulations but in our political culture.  As Simon Johnson (of the must-read Baseline Scenario blog) observes in the most recent issue of The Atlantic, our current debacle looks less like Wall Street circa 1930 than Indonesia circa 1997.  The problem is not that we are reaping the whirl-wind of unregulated markets run amok, but rather that we are reaping the whirl-wind of a system where politically powerful business actors get the up-side of huge risks, while they can push the downside on to the public.  We are living in the put-option state.

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Hayek, the True Sale Doctrine, and the Origins of the Financial Crisis

Hayek.jpgHere is my theory du jour about the origins of the financial crisis, suggested by one of my students*: blame it all on the true sale doctrine or rather on its evisceration. Stick with me to the end, and I have some overly broad generalizations about expertise, property rights, and Hayek.

The “true sale doctrine” is not a staple of the law school curriculum. At best it makes a brief cameo in secured transactions and bankruptcy courses. Notwithstanding this academic obscurity, however, its failure may have had a big role in the current melt-down of the banking sector and with it the world economy. Here is the gist of the issue:

Securitization is the process by which financial assets (essentially promises to pay money in the future) are transferred from their original holder to a special purpose vehicle such as an LLC or business trust, which then issues securities entitling the holder to some fractional right to the income from the transferred assets. Hence, for example, a bank might transfer mortgage loans to an SPV, the SPV would then issue securities to investors, and the cash from the sale of these securities would flow back to the bank. The investors in the securities have two ultimately inconsistent goals.

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How is Tom Barr Like Shane Battier: Or, Measuring Individuals’ Roles in Group Success

hls faculty.jpgMichael Lewis recently published a Times Magazine story on NBA player Shane Battier. The article is largely an anecdotally driven portrait of Battier, a player who supposedly makes his teammates better and opposing players worse, while engrossing few individual gains. But the Houston Rockets, who employ Battier, recognize his value, because they’ve finally cracked the nut of regressing success in group sports. According to Lewis, the Rockets use a sophisticated plus-minus measure:

One well-known statistic the Rockets’ front office pays attention to is plus-minus, which simply measures what happens to the score when any given player is on the court. In its crude form, plus-minus is hardly perfect: a player who finds himself on the same team with the world’s four best basketball players, and who plays only when they do, will have a plus-minus that looks pretty good, even if it says little about his play. Morey says that he and his staff can adjust for these potential distortions — though he is coy about how they do it — and render plus-minus a useful measure of a player’s effect on a basketball game. A good player might be a plus 3 — that is, his team averages 3 points more per game than its opponent when he is on the floor. In his best season, the superstar point guard Steve Nash was a plus 14.5. At the time of the Lakers game, Battier was a plus 10, which put him in the company of Dwight Howard and Kevin Garnett, both perennial All-Stars. For his career he’s a plus 6. “Plus 6 is enormous,” Morey says. “It’s the difference between 41 wins and 60 wins.”

The problem with the article is that it offers no perspective at all on how the Rockets tweak the statistic to make it useful and a competitive advantage. In that sense, the piece could be thought of as Moneyball III: This Time With No Data and No Human Interest. (Moneyball Had Data; Blind Side had a compelling story; this piece is unripe on both fronts.)

Nevertheless, in some quarters Lewis’s work has again caught the attention of legal innovators. Jim Chen, who has already opined that Deans should use a version of plus-minus to evaluate faculty performance, suggests that Battier is a promising case study: “the single factor that makes a great team player is the mirror image of the single factor that turns even the most productive scholar into a toxic Arschloch: selfishness.” To which an astute commentator responded: “If anything, a stats-driven evaluation process will almost certainly lead to the Battiers of academia being under-rewarded, rather than the reverse. Wouldn’t it be enough to reward those who just seem to distinguish themselves by their selflessness? . . . Note that, even within the NBA — in which it is much easier to do a plus/minus assessment — Battier gets undervalued by most teams, and if he weren’t still riding a six year contract would probably get paid a lot less even by the Rockets.”

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President Obama Outlines Fin Reg Reform

White House Photo 2 25 09.jpg

Yesterday afternoon President Obama outlined his approach to financial regulation reform that is undoubtedly coming our way. He named the following seven goals

1. Enforce strict oversight of financial institutions that pose systemic risks

2. Strengthen markets so they can withstand both system-wide stress and failure of large firms

3. Encourage a financial system that is open and transparent.

4. Supervise financial products based on “actual data on how actual people make financial decisions”

5. Hold participants accountable for their actions, “starting at the top”

6. Overhaul regulations so they are comprehensive and free of gaps and do not result in regulatory competition

7. Recognize that the challenges are global

The President said: “Iif we all do our jobs, if we once again guide the market’s invisible hand with a higher principle, our markets will recover. . . . Our economy will once again thrive, and America will once again lead the world in this new century as it did in the last.”

The President also emphasized the following:

“The choice we face is not between some oppressive government-run economy or a chaotic and unforgiving capitalism. Rather, strong financial markets require clear rules of the road, not to hinder financial institutions, but to protect consumers and investors, and ultimately to keep those financial institutions strong. Not to stifle, but to advance competition, growth and prosperity. And not just to manage crises, but to prevent crises from happening in the first place, by restoring accountability, transparency and trust in our financial markets.”

Hat Tip: Don Marlais

Photo: Official White House Photo taken during the President’s remarks

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State Law Guidance for Treasury Investment Program

Del State Seal.gifAs the US Treasury Department continues to lend to or make senior equity investments in corporate America, especially its financial institutions, people debate whether those taxpayer investments should be accompanied by limits on investees’ right to pay cash dividends to common stockholders.

This is a fundamental issue in corporate finance, requiring mediation of a tension between senior investors, who want security of repayment, and common (junior) stockholders, who want periodic returns on their investment.

The balance and how to resolve it is reflected in state corporation law regulating dividends. In general, those laws provide a minimum level of protection to senior lenders and equity holders, restricting distributions to common stockholders to minimize bankruptcy risk, and assuring that a corporation has flexibility to make such distributions.

A review of state corporation law approaches may be useful to assess what policies Treasury should consider when investing taxpayer funds in senior loans or equity in corporate America. The review suggests that: (1) Treasury may go too far if it prohibits cash dividends altogether; and (2) tools it is developing to assess investee’s positions, called stress tests, routinely used under some state statutes to determine the legality of distributions to common stockholders, should be applied to determine, on a case by case basis, to what extent, if any, government investment of taxpayer funds should be conditioned on investees’ restricting dividends on common stock.

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New Treasury’s Shackled Dividend Policy

shackles.jpgGovernment is treating the country to a national conversation on corporate finance, focusing on a tension between common stockholders of corporations and those who lend or buy preferred stock. The government is deep into the business of lending or buying preferred stock with taxpayer money; the public is interested to know how secure those positions are and how likely they are to reinvigorate private investment in public companies.

While the Bush Administration made loans and bought preferred stock without insisting on many restrictions, the Obama Administration proposes a more restrictive posture. Both struggle with the inherent tension in corporate finance between protecting creditor and senior equity interests, on the one hand, and providing common (junior) stockholders with periodic returns on investment through dividends on the other.

Creditors and senior equity holders want assurance of repayment, so the temptation may be to prohibit common stock dividends entirely. This temptation explains why many populist critics rebuked Bush Treasury Secretary, Henry Paulson, for lending or investing in corporations without restricting their right to pay cash dividends to common stockholders. The rebuke may also explain Obama Treasury Secretary Timothy Geithner’s opposite proposal to prohibit such dividends, although this populist stance may prolong rather than shorten the current capital crisis.

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Two Ways to do Government Corp Fin

Money Bags.jpgThe United States government is one of the largest, and few, investors in corporate finance deals these days. Congress authorized Treasury to use up to $350 billion in government funds to invest in corporate America (with a contingent increase of another $350 billion). Its authorization to Treasury is very broad, and has allowed it to make any form of investment (mostly but not exclusively in financial institutions), on such terms as the Treasury Secretary deems advisable.

The approach to investing these funds appears strikingly different between Bush Administration Treasury Secretary Hank Paulson and Obama Treasury Secretary Tim Geithner.

Paulson took a tailored, deal by deal approach. He never published clear guidelines concerning in which companies he would invest. Sometimes he invested by lending and sometimes in preferred stock. Sometimes he’d negotiate for covenants from the other side and sometimes he would not. He did not publicize resulting investment contracts. In general, he did not impose covenants on investees, such as restrictions on making asset distributions to common stockholders, although in some cases he did extract those concessions (e.g., with General Motors Acceptance Corporation).

Geithner on Tuesday issued a general template for his investment program. He has published guidelines for what investees must do to earn his investments. They have to explain how they will use funds, requiring that they be used to run the business, not hoarded, meaning, for banks, lending money to customers. Investees have to make monthly reports to Treasury showing how they used the funds to make loans or support loans made by other institutions. Investees must undergo a threshold financial stress test, assessing their financial position, and capital needs.

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Jonathan Lipson’s Auto Immune: The Detroit Bailout and the Shadow Bankruptcy System

lipson.JPG[Jonathan Lipson has been a terrific, episodic, contributor to CoOp on the bankruptcy aspects of the financial crisis and the bailout. He approached me about posting the following very useful set of thoughts about the auto-mess, which I’m happy to now share with you.]

Today’s New York Times reports that President Bush now recognizes that the auto industry’s disease may be worse than the bankruptcy “cure.”

Despite ominous threats that the administration would leave the industry to an “orderly reorganization”, the President is now apparently willing to release about $17 billion in TARP funds, to save the auto industry (at least for a while) from Chapter 11.

According to the Times, the President now believes that:

bankruptcy was not a workable alternative. “Chapter 11 is unlikely to work for the American automakers at this time,” Mr. Bush said, noting that consumers would be unlikely to purchase cars from a bankrupt manufacturer.

While I am ordinarily a cautious supporter of the Chapter 11 reorganization system — and suspect much of today’s trouble could have been averted (or at least minimized) if Bear Stearns had been permitted to go through Chapter 11 — I think this is probably the right move, albeit for the wrong (stated) reasons.

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Rational Actors and the Economic Crisis

I missed this when it originally happened, but you should read Richard Posner’s take on the financial crisis, as delivered to Columbia law students.

Posner devoted the bulk of his presentation to outlining the myriad motivations behind the excessive risks. What disturbs him most, he said, is that all of the risk-takers – from CEOs to the day traders to home buyers – were behaving rationally, which free-marketers such as Posner generally believe should act as a bulwark to protect against such catastrophes.

The bankers, for example, were rational in betting on mortgage-backed securities and other housing-related investments, even long after they recognized that their entire industry was, in fact, standing deeply inside an enormous, overstretched bubble. “Even if you know you’re in a bubble, it’s extremely difficult to get out,” said Posner. Pulling up stakes before the bubble explodes means telling investors to expect smaller short-terms rewards. “I think that is a very hard sell,” he said.

Besides, Posner added, when investors want to balance their portfolios, they will do it themselves with, say, bonds or treasuries. The purpose of the high-risk funds is to take the high risks necessary to generate the outsized profits.

Posner also cited the win-win structure of most top executives’ contracts: If their high-risk decisions result in big gains they receive huge bonuses, and if the gambles fail they result in huge severance packages. He noted the $161.5 million awarded last year to outgoing Merrill Lynch chief Stanley O’Neil. “Very, very generous compensation incentivizes executives to maximize their short-term profits,” he added.

Boards of directors, Posner lamented, are hardly “reliable agents of shareholders.” With compensation in the high six-figures for positions that require them to attend only a few meetings per year, board members would need to act against their own self-interest to contest a CEO’s plus-size salary – which wouldn’t exactly be rational.

“This is rational behavior. This is troublesome for economists,” Posner said. “You can have rationality and you can have competition, and you can still have disasters.”

Though he said he wanted to end the presentation on a high note, Posner seemed to have trouble finding one.

There is much here to agree with, particular Judge Posner’s skepticism about the efficacy of regulation. But I’m not as convinced (as he is) that this story is best explained as a failure of perfectly maximizing actors. Indeed, as the story describes his position, it sounds like many of the agents were not maximizing at all. Why, for instance, could bankers not convince (purported) rational investors that we were in a bubble? The best reason, which Posner hints at, is overoptimism bias. Why aren’t executives’ contracts structured for long-term return instead of short-term profit taking? Wouldn’t rational boards and rational executives prefer a smooth future income stream? I’ve got to think that a rich account of compensation behavior would take into account both the tournament effect and risk aversion. And why isn’t there a better market for board members? Could it be some kind of bias against out-groups?