Ideoblog

The Oracle talks about mortgages and the financial crisis

From Warren Buffett's Letter to Shareholders (HT CR):

I will write here at some length about the mortgage operation of Clayton Homes and skip any financial commentary, which is summarized in the table at the end of this section. I do this because Clayton’s recent experience may be useful in the public-policy debate about housing and mortgages.* * *

The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified. Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition. * * *

Clayton’s lending operation, though not damaged by the performance of its borrowers, is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire. Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

Today’s extreme conditions may soon end. At worst, we believe we will find at least a partial solution that will allow us to continue much of Clayton’s lending. Clayton’s earnings, however, will surely suffer if we are forced to compete for long against government-favored lenders.

So, to summarize: 

1. Making loans to borrowers that they couldn't and didn't want to repay was bad business.
2. The poorly managed lenders that did that are now being rewarded with government guarantees.
3. The well-managed lenders that did not do that are being punished because they can't compete with the guarantees.

Buffett is often referred to as a genius.  But maybe the secret of success, and good public policy, is just not being stupid.

Citigroup, AIG and the uncorporation

The Delaware chancery court has decided two very important cases arising out notorious cases of managerial malfeasance or neglect – In re Citigroup Inc Shareholder Derivative Litigation, decided last Tuesday, and American International Group, Inc. Consolidated Derivative Litigation, decided February 10. '

The bottom line is that Chancellor Chandler dismissed a Caremark bad faith monitoring claim in Citigroup, but VC Strine let the Caremark claim proceed in AIG. Chancellor Chandler let a waste claim proceed in Citigroup based on approval of excessive compensation for Prince. Note that both cases came up on demand excuse/refusal issues, so there may be a lot more litigation to come.

I don’t need to exhaustively analyze the cases here, because they’ve been well discussed elsewhere, notably including Francis Pileggi’s discussions of Citigroup (with links to other discussions) and AIG. But I will emphasize a couple of points relating to this blog’s themes.

First, critics of Delaware indeterminacy will have a field day. Yes, one can distinguish the two Caremark claims on the ground that AIG involved claims of criminality and insider trading. But one can also ask lots of questions about how much redder the flags have to be without those elements. Also, as to the Prince compensation claim in Citigroup, there wasn’t much discussion of the Supreme Court’s Disney decision dismissing a claim for excessive compensation.

Anyway, I’ve argued that indeterminacy is more the corporation’s fault than the court’s, which brings in my next couple of points.

Second, let’s think about the Caremark claims rejected in Citigroup. Plaintiff alleged that the board (a majority of whom had also been on the Enron board) ignored problems “brewing in the real estate and credit markets” starting in 2005.

And, indeed, that’s probably true. Recall that the financial community as a whole basically bet their companies on the dubious proposition that real estate prices would keep going up, and kept the bet going amid signs that the vast Ponzi scheme that was the real estate market was starting to unravel.

However, the court rightly held that this is not the sort of deliberate failure – like a complete absence of any oversight system – that will establish Caremark liability. Basically, as long as you’re going through the motions and not ignoring distinct whiffs of smoke and bright flashes of fire you’re ok.

And as Chancellor Chandler pointed out, it has to be that way. The court simply cannot get into the habit of second-guessing business decisions, particularly when this second-guessing leads to personal liability and the extreme risk-aversion that breeds.

So the case is not wrongly decided, but it shows clearly why at least one prong of the corporate monitoring system – fiduciary duties – provides very little assurance that corporate managers are actually doing their jobs. The other prongs – shareholder voting, director oversight – similarly provide little comfort. That’s why, as I’ve discussed (most recently here, with other links) we need uncorporations, particularly in the financial sector.

Third, and perhaps most intriguingly for me, there’s the question of how these cases relate to a notable recent Delaware Supreme Court case dealing with a publicly held LLC, Wood v. Baum. As I’ve discussed, Wood indicates that the court will apply a lighter contractual standard of care in uncorporate cases, rather than adhering to the rigid corporate standard regardless of business form.

Interestingly, while VC Strine did not discuss Wood in AIG,Chancellor Chandler discussed and cited Wood several times in Citigroup. So what is going on here? Is Wood spilling over into the corporate realm or not?

Chancellor Chandler arguably was merely citing Wood for the proposition that the court will apply whatever the applicable standard is in determining excuse. Yet the Chancellor never indicated any difference in standards. That’s despite the fact that the operating agreement in Wood arguably did apply a looser standard of care -- “bad faith violation of the implied contractual covenant of good faith and fair dealing” -- than the one applicable in corporate cases under 102(b)(7). This standard suggests that to be liable you not only have to violate the contract, but you have to do so in bad faith. By contrast, the corporation statute does not allow waiver of the duty of loyalty, which can include some version of Caremark duties.

In short, Citigroup says that whether demand is excused in both corporate and uncorporate cases depends on the applicable fiduciary standard, whatever that might be. This doesn’t preclude the possibility of applying a lower contractual standard in an uncorporate than in an uncorporate case. There is no problem with all that. But I'm concerned that convergence of corporate and uncorporate standards could have the perverse effect of transmitting the corporate virus to uncorporations -- inflexible rules and costly indeterminacy. 

What I wish the President hadn't said

Yesterday I suggested that hope for our economy lies in the "incredible creativity that has been unleashed on the world by our vibrant economic system."

In that vein I wish the President last night had told Congress something like this:

The weight of this crisis will not determine the destiny of this nation. The answers to our problems don’t lie beyond our reach. They exist in our laboratories and universities; in our fields and our factories; in the imaginations of our entrepreneurs and the pride of the hardest-working people on Earth. Those qualities that have made America the greatest force of progress and prosperity in human history we still possess in ample measure. What is required now is for this country to pull together, confront boldly the challenges we face, and take responsibility for our future once more.

Oh, wait. He did say that.

The problem, as discussed by Holman Jenkins, is that he went on (and on) to talk about a lot of other stuff that no longer makes sense, if it ever did, particularly including (in Jenkins' words) “rais[ing] taxes on small business, on investment, and on the incomes of the most productive job creators.” In other words, not harnessing our creative efforts but dissipating them in stuff that no longer makes sense, if it ever did.

The President is going to have to decide soon enough which part of his speech he really believes.

More on the uncorporation and investment banking

James Glassman and William Nolan get on the Michael Lewis bandwagon in today's WSJ by arguing that that the root of Wall Street's excessively risky ways was abandoning the partnership model:

[I]n a $14 trillion economy, you can't hire enough overseers to pore over everyone's books. There is, however, a better solution: expose players in the financial game to greater personal loss if their risk-taking fails. When you worry that a mistake will cause you to lose your second home, your stocks and bonds and your club memberships, then you're less likely to take the kinds of risks that expose the rest of society to your failures. A simple mechanism exists to achieve this purpose: the private partnership. Partners face liability that extends to their personal assets. They aren't protected by the corporate shield that limits losses to what the corporation itself owns (as well as the value of the stocks and bonds the corporation has issued). * * *

[I]nvestors -- and governments -- should recognize the extra safety inherent in doing business with partnerships. In the end, the partnership -- not more regulatory intrusion -- is an efficient, even elegant, answer to the thorny risk-mitigation problem. Partnerships are less likely to make big mistakes, but, even if they do, their smaller size means they pose less of a threat to the financial system as a whole, and to the taxpayers who have to pay for the clean-up.

I have for months been making a similar argument about the role of the corporation's role in Wall Street collapse.  See, e.g., here, here, here, here, and here.  My longer paper, which itself caps years of research and publications and antedates the meltdown, is here. A shorter version will be published soon in the University of Chicago Law Review, and this is part of my longer book-length project on the Rise of the Uncorporation.

My specific remedy is not, however, the same as Glassman, Nolan and Lewis.  I don't think we should necessarily go back to the general partnership, with partner liability. Over the last generation, better governance technologies have evolved through private equity, venture capital and hedge funds.  This should be the model for the reorganization of Wall Street, and much of the rest of what used to be called "corporate" America.

A corrective rant

Well, since every story you read now is about how bad things are, I thought I would offer a corrective: “We live in an amazing, amazing world, and it's wasted on the crappiest generation of spoiled idiots."

Now let's apply this to our current economic situation.  Inventions like airplanes, the internet, and internet in airplances result from the incredible creativity that has been unleashed on the world by our vibrant economic system. Bill Gates made a lot more money for the rest of the world than he did for himself.  There's potentially a lot more where that came from. How can we predict what's next?

And yet mostly what we hear is about the greed of business people and how our infinitely wise government leaders will get us out of our current situation by nationalizing and regulating everything, including incentives.  Our leaders are so wise that they can predict the deficit out to 2019, as the President did a couple of days ago. Who predicted the current world in 1999?

While I have no data to support this, I suggest that one of the things the market is suffering from right now is what I would call the "hopelessness of audacity."  I would prefer from our leaders less audacity and more hope.

Handouts and incentives

The NYT’s Thomas Friedman said yesterday:

You want to spend $20 billion of taxpayer money creating jobs? Fine. Call up the top 20 venture capital firms in America, which are short of cash today because their partners — university endowments and pension funds — are tapped out, and make them this offer: The U.S. Treasury will give you each up to $1 billion to fund the best venture capital ideas that have come your way. If they go bust, we all lose. If any of them turns out to be the next Microsoft or Intel, taxpayers will give you 20 percent of the investors’ upside and keep 80 percent for themselves.

That’s a lot better than some ideas I’ve heard. But it misses some of the point. Friedman reasonably guesses VC funds will do a better job with the money than other possible recipients because they’ve done a good job in the past helping grow the economy. But it is important to understand that they did so not because they were called “venture capital” or because of some accident of nature but because, unlike now-moribund banks and investment companies, they got the incentives right. This was a product of their “uncorporate” governance structure, as I’ve stressed repeatedly (e.g.).

The incentives include managerial compensation. Friedman recognizes they need to keep some of the gain.  They also should be subject to discipline, such as giving investors access to the cash through distributions and limited life. And the same goes for hedge and private equity funds, which bring similar incentives to bear on more mature firms.

This raises some important questions.  How much of that 20% compensation that Friedman is allotting to the fund managers will they get to keep after the taxes on fund manager compensation Congress is promising?  Also, to the extent that managers are disciplined by investors' demand for the cash, how does that work when the investor is the US government?  If we're going to continue to rely on non-government investment, what will their incentives look like under the new tax regime the President and Congress are threatening?

On the latter point, note that it was the reduction of individual rates in the 1980s that fueled the rise of partnership-type entities in which there is no tax penalty on distributions. Raising those rates could well return us to the higher corporate agency costs of the pre-Reagan era.

The basic point is that even more important than throwing money around is getting the recipients’ incentives right.  I don't see any sign the government is moving in the right direction on that front.

California's anti-employment bill

One would think that with labor (and other) markets in the tank, our lawmakers would be working on ways to bolster them rather than tear them down. And that states would be trying to compete for business rather than driving it away.

Choice of law and choice of forum provisions are powerfully pro-market, as discussed at length in my and Erin O’Hara’s new book, The Law Market (first chapter and summary here). Among other things, the market for law backed by these contract provisions provides predictability, deters wasteful forum-shopping, coordinates law in a world where all contracts cross geographic borders, and disciplines interest group attempts to pass laws that impose costs on society.

To be sure, it is also the case that choice of law and forum can undermine efficient state regulation. But state lawmakers need to take a nuanced approach to invalidating these clauses. And that's not just because enforcing the contracts can serve public policy. Contracting parties always have the option of avoiding the state completely, hurting its residents. Moreover, the firms whose contracts are thwarted can turn to Congress for protection and add to the increasing marginalization of state law.

Unmindful of all that, a stupid bill in the California legislature would invalidate all choice of law and forum selection clauses in contracts for employment in California. Here’s the bill via California Civil Justice Blog and PoL.

“Nuance” is something this bill avoids assiduously. Many states void some choice of law and forum clauses that would undercut some kinds of mandatory provisions. This bill applies to any employment contract. Even to the ceo of a Fortune 500 company? It protects not only mandatory state laws but also default rules.  This prevents interstate firms from getting standardized interpretation of their contracts even where this would not interfere with state policy.

Not only that, the bill includes an escape clause that is sure to provide ample grist for litigation:

(d) Nothing in this section affects the right of an employee to voluntarily agree to a choice of law or forum selection provision that is not required as a condition of employment and that is the subject of independent consideration.

Does this mean that the job can have two pay scales – minimum wage without the clause and 100,000 a year with? Or what?

O’Hara and I do recommend in our book that if states are going to outlaw these clauses, they do so by explicit statute rather than by court decision. That gives competing interest groups a chance to fight it out in advance (this bill has already gone down once), and affected parties an opportunity to avoid states that impose these restrictions on contracting. 

Is that what the legislator who introduced this monstrosity, Felipe Fuentes, has in mind – less employment in California to go with an already tailspinning economy and 42 billion dollar deficit?

The Obama market

Evidence is here (HT TOTM). 

As suggested by one of the comments to the post linked above, somebody should study market reaction to Obama-favorable events through the election campaign. I suspect even before November the market had the sign (though not the magnitude!) of the Obama effect. 

Iseman suit settles

I wrote in December about Vicki Iseman's suit against the NYT for falsely insinuating she had an affair with McCain. I thought the suit posed a risk to the Times' fraying reptuation. 

Now the suit's been settled.  Here's the story from Politico, via Overlawyered.  The Times is publishing what an assistant managing editor called a "sui generis" "Note to Readers":

The article did not state, and The Times did not intend to conclude, that Ms. Iseman had engaged in a romantic affair with Senator McCain or an unethical relationship on behalf of her clients in breach of the public trust

You decide if it's a retraction. At any rate, it would have been more in keeping with Times' traditions if the story had been written so that it did not require this clarification.

Cell phones in public: the revenge plan

About four years ago, totally fed up with loud rude cellphone users, I wrote this:

A self-help plan occurred to me a couple of weeks ago as I waited for a plane in the Indianapolis airport. Just across from me a guy filled the terminal with news of the accounting problems the university he worked for was having regarding a major gift, and how he was planning to deal with them. He was talking so loudly I could barely make out the details of the LLC operating agreement the guy down the row was drafting over the phone.

Here's my plan: do what you can to piece together the details of the conversation. Then ask the speaker some questions to fill in the blanks. If the speaker is annoyed, flustered and suddenly reticent, point out that you're curious enough to turn to Google for help with the rest. It would be nice if you could figure out your seatmate's name, from the conversation, briefcase, laptop screen, or whatever. * * * [D]oing this on a large scale might cut the rude, self-important creeps down to sizes

Now consider this, from ATL:

Last night, we received this information, from a law student traveling from D.C. to New York: This afternoon I boarded a train from Washington bound for Penn Station.... I, along with all of the other passengers, were sitting quietly when the man directly behind me decided to make a phone call using his bluetooth. He was talking so loudly that I think most people in the car were able to hear him. His conversation, though he stressed how necessary it was to be kept secret (ah, the irony), detailed the current plans of Pillsbury to lay off somewhere in the range of 15-20 attorneys from four offices by the end of March, including a few senior associates with low billable hours and two or three first-year associates.

The caller identified himself and named names over the phone. All of this, plus the names and partial verification, is laid out for ATL's thousands of readers.

My reaction:  AHHH!