Category: Corporate Finance

The Question Concerning Finance: Party Like It’s 1929? Or Prepare Like It’s 1957?

Another day, another story of Wall Street’s failure to allocate capital responsibly. Today’s installment appears on ProPublica, and describes how “Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history:”

Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses: They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged. The products they were buying and selling were at the heart of the 2008 meltdown — collections of mortgage bonds known as collateralized debt obligations, or CDOs.

As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created — and ultimately provided most of the money for — new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those. . . .Because of Wall Street’s machinations, more mortgages had been granted to ever-shakier borrowers.

The article explains the details of the deals, whose byzantine structures should be numbingly familiar to anyone who’s read ProPublica’s earlier work on Magnetar, or chapter 9 of Yves Smith’s book Econned. Smith calculated that, “if you look at the non-synthetic component, every dollar in mezz ABS CDO equity that funded cash bonds created $533 in subprime demand” (Econned, 261). (If mezz ABS CDO means nothing to you, I highly recommend Smith’s blog, or John Lanchester’s I.O.U., the most stylishly written of the “crisis” books.)

Behind all the reticulated swaps of risk and reward, in article after article, the crash of 2008 is boiling down to a familiar story: endless leverage designed to support ever more fee-generating deals. Read More

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Book Review: Bank’s From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present

Steven A. Bank, From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present (Oxford University Press, 2010)

The U.S. corporate income tax is under attack. The right calls it “the most growth-inhibiting, antitcompetitive tax of all.” Some on the left argue that “canceling the corporate income tax” and replacing it with a value-added tax would “reduce[] the cost [of corporate goods] to all consumers.

But at the same time the corporate income tax is being excoriated in some circles, it is unlikely to be repealed.  Although it only accounts for approximately 12 percent of the government’s tax revenue, Americans say that increasing the corporate income tax is one of their preferred methods of fixing the fiscal straits in which the United States finds itself.

Absent from the arguments over the proper role of the corporate income tax is any consideration of its provenance. If the corporate income tax is such an anticompetitive, expensive, and insignificant source of government revenue, why was it enacted in the first place?  And why did it evolve into the form in which it exists today?

Steven A. Bank’s excellent From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present provides answers to these questions. Ultimately, Professor Bank paints a picture of an undeliberate, though not-quite-accidental, tax, the design and underlying purpose of which changed regularly, and the consequences of which were poorly understood, even by the business interests that lobbied for legislation that would ultimately prove problematic for corporations and their shareholders. Read More

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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