Category: Corporate Finance


A Greek Tragedy

A Greek Tragedy

Finance markets defend derivative contracts by pointing to their long history. One of the oldest recorded references to a derivative contract appears in ancient Greek literature. In Chapter 9 of Aristotle’s Politics, a philosopher gains a handsome profit by agreeing to place a deposit on olive presses one year in advance of the next olive harvest. In securing rights to the presses prior to the harvest, the buyer, Thalus ensures that if the harvest is bountiful, he will have access to the presses at the lower negotiated rate that press operators are grateful to receive in advance of the harvest.

Investigations reveal that derivatives played a critical role in Greece’s recent credit woes, threatening to collapse the country’s economy and de-stabilize neighbors. (See here.) Financial markets use the term derivative to describe a transaction that derives its value from an independent reference asset. Finance literature identifies four basic types of derivatives contracts –futures,  forwards, options  and swaps. Futures and forwards involve agreements to deliver goods at a stated contract price on a specified future date. Thalus’s right (assuming he has no obligation to exercise the right but may suffer the loss of the deposit if he does not exercise the right) to elect to access the olive presses at a price negotiated in advance, illustrates features of a classic option contract. Swap agreements allow counterparties to exchange a series of cash flows over time. The market classifies derivatives based on the reference asset used to determine the value of the agreement. For example, we refer to a swap agreement for which the reference asset is an agricultural product (corn, soybeans, cotton, grain) or a raw material (copper, crude oil, natural gas) as a commodity swap. The reference asset for a financial swap likely involves one of the following: foreign currencies, bonds, stocks, and other financial assets and liabilities. Thus, the jargon evolves and we have foreign currency swaps, interest rate swaps and equity swaps among the many varietals.

While commodity derivatives may date back to Mesopotamia (see here), the Dojima rice futures exchange in shogunate Japan (see here), or the tulip bubble in Holland, financial derivatives are the product of financial innovation. In the 1980’s, derivatives traders at Salomon Brothers engineered a foreign currency swap.  The transaction allowed the World Bank and IBM to swap risk exposure to foreign currency exchange rates; the two entities exchanged bond payment obligations and bond earnings denominated in Swiss Francs and German Deutsche marks, respectively, in a $210 million transaction.  Parties using derivatives attempt to limit their exposure to or predict future movements in the price of the reference asset.

Futures and options trade on registered exchanges. Other derivatives are privately negotiated, bi-lateral agreements that trade over-the-counter among dealers and financial intermediaries. There is often little or no record of the parties originating the instruments. The ability to originate and trade these instruments in the shadows may have motivated some actors to make bad bets.

Greece’s concerns stem from the use of interest-rate and foreign currency swaps. These instruments serve useful and important functions in allowing parties to manage their exposure to volatile interest rate and foreign currency markets. The complexity of pricing the instruments and the opacity of the market, however, engendered grave concerns. According to reports, Greece used derivative transactions that involved securitized rights to cash flows from national projects to conceal mounting debt. Greece’s current troubles exemplify the need for greater transparency and accountability in derivative markets.

The Greek debacle with swaps illuminates the need to address oversight of derivatives from a global perspective. The markets for derivatives involve financial services firms that may be domiciled in the United States or Europe but whose influence and relationships are undeniably international. The financial instability of systemically significant private institutions (investment banks or international insurance firms or sovereign debtors) threatens global market disruptions. We are left pondering the effectiveness of any domestic derivative market reform that lacks international collaboration. (See here.)


Asking new questions or at least hoping for more useful answers

From 1933 to 1934, Senator Ferdinand Pecora, the senior lawyer for the Senate Banking Committee, led an examination into securities market abuses that inspired the regulatory framework set out in the Securities Act of 1933 and the Securities Exchange Act of 1934.  The legislation noted the predatory practices that motivated its consideration and adoption:

“Alluring promises of easy wealth…freely made with little or no attempt to bring to investor’s attention those facts essential to estimating the worth of any security. High pressure salesmanship rather than careful counsel was the rule in this most dangerous enterprise.” H.R. Rep. No. 85, 73d Cong., 1st Sess. 2 (1933).

More than seventy years later, as the Financial Crisis Inquiry Commission begins to hold hearings to unravel the causes of the recent financial crisis, Congress again takes up the task of addressing the accuracy of disclosure regarding valuation of complex financial instruments sold to the public (pension funds and other institutional investors). Throughout the hearings, we can anticipate accusations of greed and retorts equating greater federal government intervention with paternalism. As regulators, independent experts and senior management of the largest financial services firms arrive in Washington DC, however, we should take this opportunity to consider carefully the broader weaknesses in the structure and substance of federal securities market regulation.

The testimony solicited publicly and privately prior to the commission’s inaugural meeting suggests that disclosure will present a critical point of departure for inquiries about the recent crisis. For example, Congress is likely to challenge the practices of banks that sold clients financially engineered products like collateralized debt obligations which involve the sale of interests in bundles of residential and commercial mortgages. While the same banks encouraged credit rating agencies to assign strong, positive ratings to these products to increase revenues, they contemporaneously entered into short position contracts on these investments which rewarded the banks when the CDOs declined in value.

While important, questions or legislation focused exclusively on increasing the quality and quantity of disclosure are myopic and solutions arising out of this approach will prove insufficient to address broader market concerns. Questions or legislation should also address financial innovation or the development of new financial products or uses of products or processes not previously available and the ethical obligations of the firms that develop and distribute these products, the fragmentation among securities market regulators and the absence of consistent, effective inter-agency collaboration and the influence of international economic interdependence and regulatory competition on the development of U.S. regulation and the regulation in foreign jurisdictions. As often is the case in the securities regulation debates, there are many challenging questions and far too few effective answers.


Junior Faculty Workshops: GW in Business Law

academic doorwayFor ages, academic institutions have promoted scholarly inquiry by younger faculty members, especially through the junior faculty workshop. Scores of US law schools host these regularly during terms; both the AALS and Law & Society run programs at their annual meetings; the Yale/Stanford junior faculty forum boasts wonderful annual draws; and now regional junior faculty workshops are rising, like that in the southwest next term, hosted by Arizona State.

Though these ventures focus on career stage, not field, more recent, school-sponsored forums add substantive focus.  Junior faculty workshops appeared recently in environmental law (arranged jointly by Harvard, Berkeley and UCLA); family law (at Washington & Lee); national security law (at Texas); and federal courts (hosted alternately by American University and Michigan State).

You can soon add to that list business/financial law (including corporate, securities and banking) at George Washington.  Next year, GW will inaugurate a series of Junior Faculty Workshops and Junior Faculty Prizes, seeking submission of papers in Fall 2010, for a celebratory academic event to be held in Spring 2011. This is one part of GW’s forthcoming Center for Law, Economics and Finance (C-LEAF), which also includes GWNY (posted about here).

While further details about these C-LEAF programs and descriptions of others must await a formal grand announcement, these Junior Scholar endeavors are ripe and time-sensitive enough to warrant advance notice.   

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Book Review: Justin Fox, The Myth of the Rational Market

Fox Myth Rational MarketThose interested in the intellectual history of modern finance theory will find Justin Fox’s The Myth of the Rational Market riveting. It is familiar territory to anyone who has written on the subect; Fox, a writer at Time, uses the pop style of financial journalism. Even so, many useful insights appear and the arrangement suggests relationships among ideas worth exploring.  

Notably, this book, which Fox began writing in 2002, is not about the current financial crisis.   But of the dozen about the current crisis I’ve read so far (several reviewed on this blog) it is far more illuminating in relation to it.   Fox demonstrates how the ideas hatched by academic financial economists during the past 45 years, and adopted with alacrity by nearly everyone else, from bankers to law professors to regulators, contributed significantly, though unwittingly, to prevailing woes.  

Fox’s story, using lucid and engaging prose, based on well-documented research and interviews, concentrates on how academic finance departments reshaped our world, not always for the better.  Beyond the book’s scope is a parallel story, yet to be written, about how law professors, applying the finance work, wrought similar change.  Read More


Against Politics and Finance in Accounting




An old joke says every financial crisis needs an accounting culprit to blame. The current crisis may be attributable instead to the dominance of modern finance theory and subordination of traditional accounting principles. Two generations of finance theorists—in business and law schools—developed elaborate models to measure and manage risk in a theoretical world of efficient markets where accounting is not relevant.

Yet two strange twists have arisen—one showing the intellectual limits of the finance story and the other the dark art of making accounting into a political issue. Both concern debate over how to measure financial assets on a balance sheet—the so-called fair value debate.

First, for decades, proponents of modern finance theory urged standard setters to direct asset measurements using fair value rather than applying traditional accounting conventions. The prescription was based on assertions that emphasized the reliability of efficient markets to reveal relevant values. Proponents said traditional accounting conventions, using acquisition cost adjusted over time, were comparatively impoverished.

Amid the crisis, those same people shift their stance, now saying fair value measures in stressful markets are either misleading or put downward pressure on values that could render owners of impaired assets, especially banks, insolvent. On its face, this is an admission about the limits of markets to reveal reliable asset values, that modern finance theory is impoverished.

Second, without opining on the merits of measuring assets at fair value or using historical cost accounting conventions, this issue, once again, is turning accounting standard setting into a political expression rather than a professional one. Politicians in Congress, under heavy bank lobbying, pressured the US standard setter [the Financial Accounting Standards Board] to adopt bank-friendly approaches to asset measurement.   Now, Congressional bills  (here, for example, and noted here) contemplate empowering politicians and/or a new federal agency to oversee US accounting standard setting, equipping them with veto rights over any accounting standards the political power consensus disfavors.

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Barney Frank’s Bad Idea

Last month Barney Frank unveiled the House plans to fix the financial services industry. One of the provisions (section 1501) will require that any creditor who originates a loan to retain some of the ultimate risk of non-repayment of the loan. The provision is an apparently sensible response to the pathologies in the originate-to-distribute (OTD) model of mortgage lending that we saw at the height of the subprime boom. The basic idea is that originators were insufficiently incentivized to monitor the credit worthiness of applicants, and therefore manufactured a huge volume of ultimately toxic financial assets. The idea is to fix the problem of agency costs by aligning the incentives of loan originators with loan holders. Despite the plausibility of the proposal, I think that it is ultimately a bad idea.

First, it is a bad idea because it addresses a symptom rather than a cause of financial rot. The problem with the mortgage-brokers-as-villains narrative is that it fails to explain why the brokers could do a land office business selling toxic junk to a voracious secondary market. One explanation – the one implicit in section 1501 – is that brokers were taking advantage of purchasers, selling them supposedly sound financial assets that the purchasers were too unsophisticated or blinded by greed to realize were junk. To state this assumption explicitly is to see its limitations. The purchasers of mortgages were not unsophisticated consumers or little old ladies entrusting their savings to fast talking swindlers. These were a bunch of extremely wealthy, extremely sophisticated, extremely large financial institutions. It is rather unlikely that these guys were “fooled” by the mortgage brokers.

A more plausible story, in my opinion, looks at the underlying supply and demand for credit. First, why did the mortgage brokers go into the subprime market? At least in part the answer is that they could afford to do so. With the short term wholesale funding on which they relied to originate loans costing them essentially nothing, it was extremely inexpensive to originate loans. At the same time, the massive subsidization of the subprime market through implicit guarantees to the Fannie and Freddie, the so-called “Greenspan Put” on which Wall Street relied, and various (admittedly much smaller) direct subsidies created a massive demand for the assets churned out by the mortgage brokers. Add to this the impact of monetary and Chinese balance of payments factors on asset prices, and the notion that the subprime crisis was really the result of agency costs in the OTD model looks implausible. Absent macro-economic and regulatory distortions, I suspect that market competition and reputational sanctions are sufficient to keep the OTD brokers honest. Given those distortions, we have seen spectacular examples of those who did have skin in the game responding perversely to the perverse incentives with which they were presented. Read More


House Financial Committee Busy

Alphabet SoupThe Staff of the House Financial Services Committee is extremely busy and doing a very good job of keeping its role in the legislative process transparent. A reasonable run down of current activity in financial regulation reform appears here. (You can even sign up to get email alerts.) 

These bills are elaborate, complex and defy tidy characterization.  All are likely to change, some significantly, as the legislative process grinds along. The Senate Banking Committee is unlikely to produce anything equivalent until well into November.

In general, however, together the House FSC’s work would make for sweeping change.  The bills would:

(1) create three new federal agencies: a Federal Oversight Council, a Consumer Financial Protection Agency and an Office of Federal Insurance;

(2) considerably expand powers of the Securities Exchange Commission, including by subjecting rating agencies to considerable regulation and oversight by the SEC plus eliminate an exemption to the Investment Company Act of 1940 for private financial advisors.; and

(3) expand the mandate and powers of the Commodity Futures Trading Commission concerning regulation of derivative securities.

These pending Committee steps, of course, are in addition to bills the House passed earlier this year, including the summer’s Corporate and Financial Institution Compensation Fairness Act of 2009, embracing shareholder say on executive compensation to a certain extent.

At this link, you can access pending bills totaling just about 1,000 pages.   Following is an additional breakdown: Read More


Smart or Not So Smart Money; The Limits on Derivatives and Regulating Them

The New York Times op-ed by Calvin Trillin, Wall Street Smarts, has a parable-like quality with the two characters meeting and exchanging wisdom. The lesson offered by the wiseman: “The financial system nearly collapsed,” he said, “because smart guys had started working on Wall Street.” The piece goes on to explain why that is a good explanation. It seems that the not-so-smart sat at the top of the heap and ran the companies: “Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.” There is also an claim about what is enough and what is greed in this tale. I leave it to others to debate or verify these ideas (our own Mr. Cunningham has been a favorite for me on these issues). Now, a paper by some folks at Princeton may show that not even the smart guys knew what they were doing.

As Andrew Appel explores in his post Intractability of Financial Derivatives, the computer science world’s Intractability Theory may better explain the derivative world than other theories. (the theory is used for DRM, cryptography, and more). The paper is Computational Complexity and Information Asymmetry in Financial Products (pdf) by Sanjeev Arora, Boaz Barak, Markus Brunnermeier, and Rong Ge.

For those who are interested in the topic and/or understand the math and theory behind the risk shifting involved in this area, check out Andrew’s post. He does a great job explaining how the paper applies to a CDO (collateralized debt obligation). If you need a little more to understand why this paper and its ideas are important, consider Andrew’s take away

In principle, an alert buyer can detect tampering even if he doesn’t know which asset classes are the lemons: he simply examines all 1000 CDOs and looks for a suspicious overrepresentation of some of the asset classes in some of the CDOs. What Arora et al. show is that is an NP-complete problem (“densest subgraph”). This problem is believed to be computationally intractable; thus, even the most alert buyer can’t have enough computational power to do the analysis.

Arora et al. show it’s even worse than that: even after the buyer has lost a lot of money (because enough mortgages defaulted to devalue his “senior tranche”), he can’t prove that that tampering occurred: he can’t prove that the distribution of lemons wasn’t random. This makes it hard to get recourse in court; it also makes it hard to regulate CDOs.

UPDATE: It appears from the comments to Andrew’s post that CDO and derivatives are not precisely the same thing. In addition, the comments explore the limits of the study. It is a good discussion.

ALSO check out the FAQ for the paper. It addresses many issues that the initiated may want to probe.


Lipson on Bankruptcy, the Inky and Irony

Our Roving Bankruptcy Correspondent

Our Roving Bankruptcy Correspondent

I asked Jonathan Lipson, who previously owned the credit crisis for us, for his thoughts on a really interesting story involving the Philadelphia Inquirer’s bankruptcy process.  His (pretty cool, even for non-bankruptcy geeks) thoughts follow:

Like other markets for company control, the one created by Chapter 11 of the Bankruptcy Code is largely about information:  If you control the story, there’s a good chance you will control the outcome.

So it’s not surprising that The Philadelphia Inquirer has used its own storied assets—the paper and website–to try to sell readers on management’s plan to save the company from rapacious hedge funds and, in their words, “keep it local.”

As you may recall, Brian Tierney, who owns an advertising firm in the Philadelphia suburbs, acquired The Inquirer and its related properties (The Daily News and, their collective website), from the McClatchy papers in 2006 for about half a billion dollars.

Like several other newspapers, including The Chicago Tribune, The Inquirer could not service its massive acquisition debt.  Thus, in February 2009, the paper (and its affiliates) filed a Chapter 11 case in Philadelphia.  In August, management filed a proposed reorganization plan where Tierney (who manages the papers and owns some equity) and some of his supporters would buy the papers out of bankruptcy, for about $90 million, leaving most large creditors—i.e., the ones holding the acquisition debt–with a very small recovery.  The management buyout would be subject to higher and better offers.

According to the official Creditors’ Committee in the case, the Inquirer’s “keep it local” campaign is designed to make sure there are no better offers.  Management’s ad campaign warns of dire consequences “[i]f out-of-towners were to seize control.”  Allegedly hailing from such illiterate venues as New York, Beverly Hills “and even Lausanne, Switzerland, these out of towners would feel little commitment to, or understanding of, [Philadelphia’s] local non-profit needs.”

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