Category: Corporate Finance

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Goldman’s $550 Million SEC Settlement

The SEC announced this afternoon that Goldman Sachs agreed to settle, for $550 million, the civil lawsuit against it alleging materially misleading disclosures in circulars for some mortgage-backed securities it hawked.  As I wrote on this blog, in a post of April 19 called SEC v. Goldman as a Simple Case, the case was simple. 

In a bruising Consent to a Final Judgment in the federal case against it, Goldman acknowledges the point I made that makes the case simple.  Its marketing circular said the reference portfolio was “selected by” the independent firm, ACA Management LLC, when in fact Paulson & Co. Inc., an interested party, played a role in that selection. 

Within 30 days, Goldman must pay investors it misled by the marketing materials: $150 million to Deutsche Bank and $100 million to the Royal Bank of Scotland (known as ABN AMRO Bank when it bought Goldman’s securities).  It must pay another $300 million to the SEC.  

The SEC’s press release headlined that this amount set a “record” for the agency and is non-trivial even for a firm of Goldman’s size.   Its enforcement chief, Bob Khuzami, boasted that “half a billion dollars is the largest penalty ever assessed against a financial services firm in the history of the SEC.”

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Here Comes FinReg

Via Ezra Klein’s Wonkbook (definitely one of my favorite morning emails), a variety of takes on what’s in the financial reform bill:

1. From Deloitte’s 12-page summary:

Because the new U.S. law is complex, it can be helpful to remind ourselves that its underlying purpose is relatively simple and has two powerful strands: 1. ‘De-risk’ the financial system by constraining individual organizations’ risk-taking activities and capturing a broader set of organizations’, including the so-called “shadow” banking system, in the regulatory net 2. Enhance consumer protections. . . .For example, the need for “arm’s-length” swap desk affiliates combined with the move from over- the-counter to exchange trading for derivatives, tighter constraints on leverage and risk-taking, and higher liquidity requirements imply lower profit margins in future from those activities.

Some estimates I’ve seen have estimated the profit margins might be around 15% lower.

2. Simon Johnson on the Kanjorski Amendment as a “new kind of antitrust:”

Effective size caps on banks were imposed by the banking reforms of the 1930’s, and there was an effort to maintain such restrictions in the Riegle-Neal Act of 1994. But all of these limitations fell by the wayside during the wholesale deregulation of the past 15 years. Now, however, a new form of antitrust arrives – in the form of the Kanjorski Amendment, whose language was embedded in the Dodd-Frank bill. Once the bill becomes law, federal regulators will have the right and the responsibility to limit the scope of big banks and, as necessary, break them up when they pose a “grave risk” to financial stability.

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Tricks of the Traders

Loans and securities are not merely products. While progressive forces can win some political battles by deploying the product metaphor, it obscures more than it illuminates. Consider the practice of “high-frequency trading.”

Matt Krantz discusses the ways in which automation in the finance sector can leave ordinary investors high and dry:

Not only are the markets completely computerized, more than half of the market’s volume is churned by computers programmed to spot certain patterns in trading. These machines see stocks not as securities used by companies to raise money, but rather, symbols, numbers and bits that are traded, swapped and exchanged.

And now, traders say, humans are responding to machines rather than the other way around. Increasingly, too, the machines are reacting to each other, trying to second-guess what their next moves might be on how to take advantage of an edge that might be gone in milliseconds.

As Keynes might have predicted, we have “reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” The machines are perhaps devoted to “practice the fourth, fifth and higher degrees.” But there’s a twist: part of the investment game now appears to be a falsification of (or at least fake-outs via) data on such opinions:
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The Value of Finance

Brad Delong and Stephen Cohen’s work The End of Influence illuminates the role of law & policy in shaping the US economy. They calculate that, over the past 15 years,

the United States has half-consciously re-shaped its economy. The country shifted some 7 percent of its GDP out of manufacturing and added some 7 percent of GDP in the expansion of finance, insurance, and real estate transactions. . . . The communities of engineering practice and innovative technological development do move and emerge elsewhere as you shift labor from real engineering, which calculates stresses in materials and quantum tunneling in doped semiconductors, into financial engineering, which calculated delta-hedge decay and vega convexity for synthetic securities. It also means that you must create more and more debt so that other nations have the dollars to accumulate and not balance their trade—and yours.

So what was the end result of that big shift of resources into the finance sector? Some might argue we were on our way to becoming a “virtual state,” the highest link in the financial food chain. Clive Dilnot offers an alternative perspective:

For the banks and financial houses of Wall St. and the City what mattered was not the creation of wealth . . . but the extraction of realizable value from capital that could be made to flow through the institution. This explains the ‘relentless’ drive for expanded balance sheets ‘at all costs’—and for expansion on both sides of the balance sheet, assets and liabilities alike. Value is here a cull. Innovation is creating the conditions under which, and from which, immediate surplus can be won from flows of capital.

However the financial reform legislation turns out, it is unlikely to do much to stop that dynamic.

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Are We There Yet? Driving The Financial Reform Bill Home

This morning, at 5:39am, a conference committee comprised of 43 lawmakers from the House and the Senate agreed upon a final version of the financial reform bill. The bill is expected to pass in both chambers of Congress and to be signed into law on July 4th by President Obama. As anticipated, the final version reflects critical compromises that may alter the bill’s ability to mitigate the systemic risk in the financial system that inspired  the bill’s creation.

Earlier versions of the bill included provisions proposed by former Federal Reserve Chairman Paul Volcker and Senator Blanche Lincoln. These provisions aimed to prohibit federally insured banks from engaging in riskier investment activities, such as investments in hedge funds or private equity funds, and required banks to limit and isolate their proprietary trading activities and to discontinue their origination and trading of nontraditional or exotic investment products, such as derivatives contracts. In the face of strong and well-financed opposition, the conference committee has adopted a less restrictive version of the proposed regulation.

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Recommended Reading: The Buyout of America

As lawmakers squabble over the “carried interest” tax rate, it’s nice to find a big picture overview of some of the economic activity they’re discussing. I recently read Josh Kosman’s book The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis, and I highly recommend it to our readers. Kosman painstakingly describes the byzantine financial maneuvers behind marquee private equity firms which bought “more than three thousand American companies from 2000-2008.” He describes in detail how they resist transparency (164) and “hurt their businesses competitively, limit their growth, cut jobs without reinvesting the savings, and generate mediocre returns” (195). The recipe for high earnings is simple: the firms “get large fees up front and are largely divorced from their results if their transactions fail” (195).

Like Kwak and Johnson’s account in 13 Bankers, Kosman offers a political economy account of private equity’s favored treatment by government. As he notes,

[F]our of the past eight Treasury Secretaries joined the PE industry . . . . and they have significant influence in Washington. President Bill Clinton, and both President Bushes, have also advised PE firms or worked for their companies. . . . KKR retained former Democratic House majority leader Richard Gephardt as a lobbyist and hired former RNC chairman Kenneth Mehlman as head of global public affairs. (196)

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Volcker on the Crisis

One of the quiet heroes of current debates on financial reform is Paul Volcker, a veritable Cincinnatus who has been asking the right questions throughout. Here are a few of his queries from a recent NYRB essay:

Has the contribution of the modern world of finance to economic growth become so critical as to support remuneration to its participants beyond any earlier experience and expectations? Does the past profitability of and the value added by the financial industry really now justify profits amounting to as much as 35 to 40 percent of all profits by all US corporations? Can the truly enormous rise in the use of derivatives, complicated options, and highly structured financial instruments really have made a parallel contribution to economic efficiency? If so, does analysis of economic growth and productivity over the past decade or so indicate visible acceleration of growth or benefits flowing down to the average American worker who even before the crisis had enjoyed no increase in real income?

I highly recommend the rest of the essay. Volcker subtly works in some of the substantive dimensions of economic reform that are necessary to a sustainable economic recovery. If advice like his is not taken, it becomes all the more likely that more radical alternatives will gain traction.

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GW’s Junior Scholar Workshop and Prizes

As anticipated, the Center for Law, Economics and Finance at George Washington University Law School (C-LEAF)  has formally announced its first annual Junior Faculty Business and Financial Law Workshop and Junior Faculty Scholarship Prizes.    The Inaugural Workshop will be held and Prizes awarded on April 1-2, 2011, at GW Law School in Washington, DC.

Up to ten papers will be chosen from those submitted for presentation at the Workshop. At the Workshop, one or more senior scholars will comment on each paper, followed by general discussion of each paper among all participants. The Workshop audience will include invited junior scholars, faculty from GW’s Law School and Business School, faculty from other institutions, and invited guests.

At the conclusion of the Workshop, up to three papers will be awarded Junior Faculty Scholarship Prizes, of $3,000, $2,000, and $1,000, respectively. Chosen papers will be featured on C-LEAF’s website as part of its Working Paper Series. In addition to participating in the Workshop, all scholars selected to present at the  Workshop will be invited to become Fellows of C-LEAF. Read More

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Nonlinear Theory Explains May 6 Market Break

One week after stock markets dropped 10% in half an hour, regulators still confess bewilderment yet equally resolve never to let it happen again.  No one at the SEC or CFTC or any of the exchanges has been able to identify a particular cause of the flash crash.  They do say the precipitous decline was magnified by how some trading platforms, like the old-fashioned New York Stock Exchange, halted trading when the downward spiral began while electronic trading platforms did not.

A consensus appears to believe that this worsened the spiral because trades could still be made elsewhere but with fewer participants, in a thinner market. Adherents think the cure is obvious: such trading breaks should be adopted across all trading platforms so if there is ever any significant decline in price, all trading would halt.  I respectfully dissent.

This is a replay of the 1987 stock market crash: no one could figure out why it happened so everyone decided such circuit breakers were the thing to do about it.   The consensus is likely to be just as wrong today as it was wrong then, based on an alternative view, which I laid out in my 1994 GW Law Review article, From Random Walks to Chaotic Crashes: The Linear Genealogy of the Efficient Capital Market Hypothesis. Those seeking an explanation for the 1987 crash and last week’s flash crash presuppose things about stock markets and pricing that may simply be false. Read More

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Breaking Up Behemoth Banks

Thanks to banking industry mistakes and government’s orchestration of its rescue, the country now has ten banks that together command some $10 trillion in assets, roughly equal to nearly 70% of the country’s gross domestic product. Pending legislation would break those up into a total of about 36, each still commanding about $285 billion in assets apiece—larger than the next largest bank is now.

That break up would eliminate the continuing threat to the US economic and political system posed by banks deemed so big that government lavishes trillions in aid to avoid letting them fail—at enormous cost to ordinary citizens and the real economy. It is by far the cleanest and most reliable solution to the manifest havoc massive banks wreak, not addressable by any pending technocratic tinkering like better regulation or capital requirements.

The break-up idea is not as radical as it is controversial, due to foes of ex ante legal constraints on private power.  All passage of the legislation would mean is substantially a return to the scale and distribution of the US banking system as of the mid-1990s, when no bank commanded assets exceeding more than a few percent of GDP. In important part, as the lists below suggest, the conglomerate mergers of the past two decades that caused this massive concentration of economic and political power would be reversed. Read More