Category: Corporate Finance


What Evil Lurks in the Hearts of Men?

When students, friends and family have asked me what I think “happened” to cause our current financial crisis, my response has been an embarrassed shrug.  Embarrassed because (as a corporate law teacher) I’m expected to have clear answers.  A shrug because the crisis doesn’t have a obvious anecdote or story that explains it, and lacks a clearly defined evil doer who might be plausibly blamed.  The best candidate – who I’ve thrown out there to quiet persistent friends – is Joe Cassano, formerly head of AIG’s Financial Product’s Division, and the so-called “patient zero” in the crisis.

Now comes the myth-killer, Michael Lewis, with a must-read article in Vanity Fair.  He starts by reminding us that “nearly a year after perhaps the most sensational corporate collapse in the history of finance, a collapse that, without the intervention of the government, would have led to the bankruptcy of every major American financial institution, plus a lot of foreign ones, too, A.I.G.’s losses and the trades that led to them still haven’t been properly explained.”  And he then takes a crack at that problem, suggesting that AIG’s traders (i) made a bad (negligent?) bet on the likely course of the housing market, (ii) didn’t unwind their positions fast enough; (iii) fell victim to a liquidity crunch caused by covenants tied to their AAA rating; (iv) were made into a convenient villain by the media; and (v) like everyone else, were outsmarted by Goldman.

And how about Cassano?  Here’s the key – and dispiriting – paragraph:

[T]he A.I.G. F.P. traders left behind, much as they despise him personally, refuse to believe Cassano was engaged in any kind of fraud. The problem is that they knew him. And they believe that his crime was not mere legal fraudulence but the deeper kind: a need for subservience in others and an unwillingness to acknowledge his own weaknesses. “When he said that he could not envision losses, that we wouldn’t lose a dime, I am positive that he believed that,” says one of the traders. The problem with Joe Cassano wasn’t that he knew he was wrong. It was that it was too important to him that he be right. More than anything, Joe Cassano wanted to be one of Wall Street’s big shots. He wound up being its perfect customer.

“A need for subservience in others and an unwillingness to acknowledge his own weaknesses.” The flip side of authority and confidence, and the hallmarks of an executive who has passed many gates in the corporate advancement tournament.  The law lacks purchase on this kind of evil – if that is what it is.


“A great vampire squid wrapped around the face of humanity”

That’s how Matt Taibbi describes Goldman Sachs in the opening paragraph of his 12-page Rolling Stone article (which, as far as I can tell, is available online only here, in moderately annoying scanned form). From there, Taibbi picks up steam. For instance, we learn that:

The bank’s unprecedented reach and power have enabled it to turn all of America into one giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumer credit rates, half-eaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you’re losing, it’s going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where its going.


Is this just another crackpot conspiracy theory? (Paging Mr. Stein, Mr. Ben Stein.) Nay — Taibbi has give us proof of Goldman’s nefari-iety. It goes more or less along these lines: 1. Goldman survived the Great Depression. 2. Goldman made some savvy bets in the past ten years. 3. Goldman pays really big bonuses. Read More

Where are the Rating Agencies in the Financial Regulatory Overhaul?

Jonathan Stempel of Reuters notes that “rating agencies [were] largely spared” in the financial industry regulatory overhaul proposed by the Obama administration. Jonathan Macey of Yale critiques the oversight:

“The overall impact of existing and proposed regulatory changes on rating agencies is extraordinarily easy to summarize: They reward abject failure,” said Jonathan Macey, deputy dean of Yale Law School.

“Any credit rating agency that relies on an NRSRO rating [nationally recognized statistical rating organization pursuant to the Securities and Exchange Act of 1934], which is effectively a government subsidy, should be subject to lawsuits by investors,” he went on. “It should also be made clear to professional investors that it is not a defense or a sufficient discharge of their fiduciary duties to rely on credit ratings when assembling portfolios.”

Given my recent series of posts on the “public/private” divide, I was heartened to see Macey characterize the government licensure of rating agencies as a “subsidy.” As I noted in my 2007 post “From First Amendment Absolutism to Financial Meltdown?,” the agencies have used a “free expression” shield to protect against legal consequences for their incompetence, malfeasance, and conflicts of interests. Following the reasoning of FAIR v. Rumsfeld, Congress may be able to condition the “subsidy” of requiring investor reliance on ratings agencies’ work on ratings agencies’ willingness to give up First Amendment immunity from lawsuits.

Admittedly, Congress has gone in precisely the opposite direction in the recent past. In 2006, the Rating Agency Reform Act specifically prohibited the SEC from regulating the “substance of the credit rating or the procedures and methodologies.” We can only hope that current Congress is more serious about either really regulating this field, or getting out of the “implicit subsidy” business altogether.


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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