Category: Corporate Finance


You Would’ve Thought They Worked for Moo-dy’s

If you were deciding whether to loan someone money, it would be very useful to know the chances that the person would pay you back.  (For example, the higher the chance they would default, the more you would charge them to borrow the money.)  Rating agencies–two dominant agencies are Moody’s and Standard and Poor’s (or “S&P”)–are supposed to provide lenders with that information.  The less the risk of default on a particular financial instrument, the higher the rating.   The rating agencies predict (or model) the risk, and if the rating agencies don’t do a good job, financial instruments’ market prices don’t reflect their actual value.

As others have discussed in a much more nuanced fashion, rating agencies may be partly to blame for the recent financial crisis.  The agencies appear to have been more concerned about keeping their clients (those who issued the financial instruments) happy than rating financial instruments accurately.  The ratings were too high, prices were too high, lenders and other purchasers of financial instruments didn’t anticipate default…and (to oversimplify) there’s your financial crisis.

But there appears to have been another market failure associated with rating agencies–a totally unexploited chance for profit.

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“We Own GM” and Other Rhetorical Illusions

illusion-spinning-circlesMisleading talk continues to plague discussions of government’s financial intervention into private enterprise, including automotive, insurance and banking companies. Latest talk, centered at General Motors but applicable to AIG, Citigroup and others, is misuse of three abstract notions: taxpayer, ownership and investment.

Standard talk sees US government’s capital transfers from the federal purse to private corporations as resulting in “taxpayers owning investments” in these companies. The upshot of this speech is the illusion that (a) people who pay US federal income tax (b) now own a bit of these corporations and (c) are entitled to enjoy investment return from that. All these conceptions are misleading. Clinging to them will complicate the process of government rescue and revival at the heart of this effort.  Read More

Brooksley Born: Profile in Financial Courage

borngreenspanWhile public intellectuals like Richard Posner assure us that “no one could have foreseen” today’s financial crisis, many voices called for the types of sensible regulation that may well have prevented it. Today one of them, Brooksley Born, is being honored at the John F. Kennedy Presidential Library with a Profile in Courage Award. It is given to “to one or more public officials who took a stand that took a lot of integrity and nerve.” Here is Born’s citation:

In 1998, as chair of the Commodity Futures Trading Commission (CFTC), Brooksley Born unsuccessfully tried to bring over-the-counter financial derivatives under the regulatory control of the CFTC. The government’s failure to regulate such financial deals has been widely criticized as one of the causes of the current financial crisis. In the booming economic climate of the 1990’s, Born battled other regulators in the Clinton Administration, skeptical members of Congress and lobbyists over the regulation of derivatives, warning that unregulated financial contracts such as credit default swaps could pose grave dangers to the economy.

Her efforts brought fierce opposition from Wall Street and from Administration officials who believed deregulation was essential to the extraordinary economic growth that was then in full bloom. Her adversaries eventually passed legislation prohibiting the CFTC from any oversight of financial derivatives during her term. She stepped down from the CFTC in 1999 and returned to a distinguished career in public interest law.

The silencing of Born was just one more sad consequence of the Clinton administration–whose tilt to Wall Street lobbies was almost indistinguishable from that of Reagan and the Bushes. As Frank Partnoy has said,

History already has shown that [Alan] Greenspan was wrong about virtually everything, and Brooksley was right . . . I think she has been entirely vindicated. . . . If there is one person we should have listened to, it was Brooksley.

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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


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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