Ideoblog

Gerding on Disclosure 2.0

This week in the Illinois Corporate Colloquium Erik Gerding presented his early draft paper, Disclosure 2.0: Leveraging Technology to Address "Complexity" and Information Failures in the Financial Crisis. This was the latest in several interesting papers we've had in the Colloquium addressing possible causes and cures of the crisis.

As Eric summarizes in his abstract:

This article advocates leveraging advances in computer software, information systems, and the Open Source movement to enhance securities disclosure and remedy some of the information asymmetries that exacerbated the current financial crisis. This article responds to a critique of mandatory securities disclosure by several legal scholars (Troy Paredes and Steven Schwarcz) that disclosure overloads investors with too much information and fails to help investors analyze the complexity of modern financial instruments and markets.

However, because the financial crisis stemmed in large measure from information failures, it would be counterproductive to dilute securities disclosure for failing to stop the crisis. Instead, disclosure must be radically enhanced to enable investors to better analyze intricate financial instruments, such as asset-backed securities and derivatives; the models used to price these instruments, set risk management policies, and guide trading strategies; and the complex market interactions of these instruments and trading strategies.

Various technologies can revolutionize disclosure including: "tagging" assets that underlay asset-backed securities and derivatives to allow investors to trace which assets affect which financial instruments; access to underlying data that is aggregated in financial statements; "open source" risk models; real-time financial disclosure; and interactive disclosure that allows users to change certain assumptions or accounting methods to see how financial disclosure would change. Employing these technologies poses certain risks and costs, which this article analyzes. The article argues that an "open source" approach to technologically-enhanced disclosure can mitigate agency costs and advocates experimental testing of disclosure effectiveness.

This proposal substitutes a sort of bottom-up for a top-down disclosure model. Investors get the tools to penetrate bottom line results down to a more granular level, and to fiddle with the assumptions that underlie particular disclosures. Among other things, this makes it harder for regulators to mess up disclosure by imposing their own assumptions. Gerding shows how this could avert mispricing that can arise under more rigid disclosure models.

The proposal implicitly relies on efficient market mechanisms to create and filter the new information Gerding would make available. In other words, it does not envision that ordinary investors would be using tags to trace assets. Rather, market intermediaries would do the work and apply the results to their investment decisions. These decisions, in turn, should drive more accurate market pricing of risk.

Some possible issues that arise under the proposal:

1. To what extent would the costs the proposal imposes on issuers outweigh the benefits? Compare proposals that simply involve reformatting of information that must already be disclosed with those that require issuers to come up with new information.

2. To what extent does the proposal inefficiently erode property rights in information? Requiring disclosure of formerly proprietary risk models could discourage the development of innovative models.

3. Should we be concerned about creating a new type of information asymmetry which favors those who develop or have expertise concerning the new disclosure technologies? I would say no. After all, the proposal emphasizes the importance of efficient securities markets. At some point we have to decide that market efficiency trumps ensuring equality of information.

4. Real-time disclosure could present the "overload" problem that Paredes has warned about. In other words, we may end up with more data but less usable information because of limits on the market's processing power. Subject to the next point, I'm not very worried about this.

5. Perhaps most fundamentally, it is important to emphasize the proposal's reliance on market efficiency. To the extent that securities laws undercut efficiency by, for example, over-regulating hedge funds and short selling, we will hamstring investors from using the new tools Gerding would make available. Then information overload becomes more of an issue.

In general I thought the paper was a productive suggestion as to how to improve disclosure, and I look forward to Erik's developing the proposal and addressing some of the underlying issues.

Barney Frank and the dummy

Per today's WSJ, Barney Frank's House Financial Services Committee voted to have the CFTC regulate derivatives.

Elsewhere in today's Journal, Peter Wallison notes that attempts to blame the private sector for the meltdown have to contend with the fact that the FHA, a government agency, had 20-30% delinquency rates on the loans it guaranteed. He explains this resulted from a government policy to loan to low-income borrowers and concludes that "[i]f the financial crisis was caused by subprime mortgages and predatory lending, the government's own policies made it happen."

The problems in the derivatives market that Frank seeks to regulate stemmed significantly from these loans which, as Wallison reminds us, Frank himself enabled.

Which reminds me of a comment I made in my article Bubble Laws (40 Houston L. Rev. 77 (2003)) that

regulation [following crashes] has an analogy in the story about the ventriloquist who was recounting what happened when he made some wisecracks his audience did not like. Referring to his heavily bandaged arm he said: "If you think this is bad, you should see the dummy."

Think of derivatives as the dummy in this story and Barney Frank as the ventriloquist, except the latter has avoided any injury so far.

Zaring on charter switching and the financial crisis

Yesterday the Illinois Corporate Colloquium hosted David Zaring of Wharton, who presented his paper Charter Switching and the Financial Crisis. It was a good pairing with Monday's presentation by Richard Squire because here we see another possible cause of the meltdown. Squire's paper focused on the problem of shareholder opportunism through investing in instruments that pay a premium to the shareholders when the firm is solvent, but are most likely to explode when the firm is insolvent and the shareholders are no longer around. Zaring's paper provides a possible reason why nobody was paying attention: the most problematic firms shopped for the laxest regulator. Interestingly, AIG figures in both stories.

Zaring and his co-author Dain C. Donelson show that savings institutions regulated by the Office of Thrift Supervision (OTS) that converted their federal bank charters to federal thrift charters were riskier than banks and other thrifts, and did worse in the financial crisis than those other institutions even controlling for their higher risk. Zaring concludes that

at least in financial regulation, and during a crisis, risky, underperforming financial institutions are likely to shop for charters, arguably racing for the bottom. It suggests that while regulatory competition may sometimes have value, the market for OTS charters may not.

The paper helps isolate the effects of the financial meltdown on returns from other things that were happening by including an event study – that is, showing the relationship between thrift returns and various events that were likely to specifically affect thrifts.

Readers won't be surprised that I hesitate to accept strong implications of the study for the corporate charter competition generally. The key difference between the two types of competition is that, with banks and thrifts, the effects of the competition are felt significantly by depositors and taxpayers (given deposit insurance), rather than mainly by shareholders, the key parties affected by the corporate competition. When you take markets out of the picture the regulatory competition is bound to be less disciplined.

But the paper does have a useful lesson for bank charter competition: when you let banks choose their regulators while insuring their deposits stuff happens.

Indeed, the paper's historical background is interesting even apart from the empirical findings. It seems that the regulatory approaches of the OTS and OCC had significantly converged over time. Of course, if the financial institutions can shop by changing their business profiles, bureaucrats at both agencies will have incentives to build or preserve their regimes by offering the same advantages. Banks wanted the full preemption of state law and ability to branch that thrifts had, and eventually they got these features.

The main difference that was left between the two regimes would seem to have been the requirement that thrifts focus their loan portfolios on mortgages and other household credit. Many thrifts switched to banks because they didn't like that restriction. Why would banks want to go the other way and subject themselves to this restriction? One possible reason is that the OTS is a laxer regulator. The paper quotes Barney Frank as saying that being "regulated by the OTS . . . was like being regulated by the meter maid." The study provides evidence for the "meter maid" (Lovely Rita?) hypothesis.

Yet there is room for alternative hypotheses. Maybe financial institutions with thrift-like loan portfolios (e.g., Countrywide) wanted a regulator that understood the special problems of managing such portfolios. This puts a different spin on the paper's results: institutions whose portfolios made them riskier and worse performing switched, rather than being made worse by the switch.

The study of course lends support to the single-regulator idea – not just for banks and thrifts, but for financial institutions generally. That would certainly end the ability to shop. But I'd like to see more evidence before we go there. For example, why not look at all bank/thrift charter switches – not just bank-to-thrift, but thrift-to-bank. If overall the switchers did better, perhaps because they were getting better or more appropriate regulators, maybe regulatory choice isn't so bad.

Taking it one step further, we should remember why this perverse result happens, assuming it was perverse (and not just a sorting story): the absence of true market discipline because of deposit insurance.

Anyway, a very interesting and useful paper, and good introduction for both faculty and students to the bank regulation part of the meltdown story.

Squire and the regulatory implications of contingent liabilities

Yesterday Richard Squire of Fordham presented his very interesting paper, Shareholder Opportunism in a World of Risky Debt, forthcoming in the Harvard Law Review.

Squire has managed to find something new and different to discuss in connection with the financial crash. He identifies a previously overlooked problem with "contingent liability instruments" such as credit default swaps, put options and loan guaranties. He shows that firms will seek to enter into these instruments precisely when they present the most danger to their creditors – that is, when the firm that is liable on the instrument becomes insolvent. In other words, the contingent debt correlates with the firm's insolvency risk. Since the shareholders won't be around in insolvency to suffer the harm, the instruments let corporations transfer wealth from creditors to shareholders. A notorious example is AIG, which bought assets that were likely to lose value just as large liabilities on its credit default swaps were triggered. Legal doctrines do not account for this hazard because they use principles better adapted to dealing with fixed than with contingent liabilities.  

Squire has proposed ways to address the problem, including by reconfiguring the law of fraudulent conveyances and transfers to deal with the special type of shareholder opportunism presented by contingent claims.

I'm particularly interested in the implications of Squire's analysis for existing and proposed regulation. As Squire points out, the problem has been completely ignored in the June 2009 Treasury report outlining a broad regime for regulating derivatives. For example, although the report highlights AIG's "excessive risk taking" as a cause of the financial crisis, it attributes this problem to the sheer size of AIG's CDS portfolio rather than to the more important problem that AIG's risk on these instruments was shifted to its creditors (or, more precisely, the taxpayers as it turned out).

One specific regulatory implication of Squire's analysis concerns the proposal to increase minimum capital requirements. This increase, while raising financing costs for derivative users, will do nothing for the problem of the derivatives' risks being correlated with insolvency, and therefore shifted to creditors. Better targeting these requirements to the correlation risk can reduce regulatory costs while raising regulatory benefits.

But it gets worse and deeper than that. Consider the question of why credit markets alone can't take care of this problem. In other words, why can't creditors watch debtors, raise credit costs and impose loan covenants that restrict them from taking on correlated contingent claims? This would discipline shareholders who attempt to impose risks on creditors. Squire explains the problems creditors might have perceiving and monitoring the problem, but in an unregulated world these problems do not seem insurmountable.

The problem is that we cannot necessarily rely on creditor monitoring in the world that actually exists. In the first place, derivative counterparties have a special exemption under the Bankruptcy Code that gives them priority over other creditors regarding the collateral they have posted. As Squire points out, this gives them less incentive to monitor each other by insulating them from loss on their collateral and shifting the risk to other, likely less sophisticated, unsecured creditors. As Squire points out, "if AIG's sophisticated swap counterparties had been more exposed to the risk that AIG would fall insolvent, they might have tried to prevent the company from reallocating so much of its investment portfolio into risky mortgage-backed assets" (footnote omitted).

It gets worse still when you add the toxic effects of "too big to fail." If unsecured creditors know they're insulated from the risk of being wiped out in bankruptcy, they lack incentives to monitor "correlation-seeking." The government (i.e., the taxpayers) is stuck with the risk.

Another interesting implication has to do with executive pay. Managers can be considered creditors to the extent that they have their human capital locked up in the firm. They might not be so anxious to engage in "correlation-seeking" behavior if this makes their jobs more precarious. The increased focus on incentive compensation seeks to better align managers' interests with those of shareholders. But this can increase managers' incentives to engage in correlation-seeking that transfers wealth from creditors to shareholders. Getting pay exactly right is a very tricky problem.

The overall lesson here is that there's a lot we still don't know about financial markets in general and the financial meltdown in particular. Before we create more havoc by stumbling around in the dark we ought to get some understanding. Reading Squire's paper is one place to start.

The regulatory risks of behavioral finance

John Carney has a great post about the dangers of regulating based on behavioral finance theory, focusing on the "endowment effect." He concludes that in financial markets this effect is likely not irrational behavior (and therefore ripe for regulatory "protection"), but an efficient reaction to risk. Here's a snip:

The trade wariness that was mistaken for the Endowment Effect actually helps keep us from becomes victims of losses stemming from financial and legal complexity.  The real risk isn't irrationally applying the Endowment Effect, it is too many people rationally overcoming it. * * * The Behavioral Economists have gotten a lot of mileage out of the notion that market participants sometimes act irrationally. But [if] a discovery so central to their school as the Endowment Effect is actually a misreading of human behavior, we might want to hesitate before rushing headlong into adopting the public policies many Behavioral Economists advocate

A few years ago I wrote a broader cautionary note (Fraud on a Noisy Market) about behavioral finance generally. Here's a blog post about that article, also discussing a WSJ op-ed by Henry Manne on that subject.

And, as discussed in my post, let us not forget that regulators can be irrational too, only without market constraints on their irrationality.

As I concluded in my article and blog post:

[T]he rapid growth in behavioral finance theories should remind us how much we still do not know about how capital markets work. Just twenty years ago the Supreme Court in Basic was confident enough about the efficient capital markets hypothesis to make it a foundation of liability for securities fraud. Now both Congress and the Court have expressed significant reservations about FOM. We should remember this history before remaking securities fraud law in the image of behavioral finance and risking another round of expansion and retrenchment. Behavioral finance theory teaches that people can be overconfident. Courts and regulators should keep this in mind.

Update: Gordon Smith responds to Carney by asking "What's wrong with the endowment effect." Josh Wright answers the question.

Was the South Sea Bubble a bubble?

Maybe not, depending on how you define a "bubble." See the new article by Frehen, Goetzmann and Rouwenhorst, New Evidence on the First Financial Bubble. Here's the abstract:

The first global financial bubble in stock prices occurred 1720 in Paris, London and the Netherlands. Explanations for these linked bubbles primarily focus on the irrationality of investor speculation and the corresponding stock price behavior of two large firms: the South Sea Company in Great Britain and the Mississippi Company in France. In this paper we examine a broad cross-section of security price data to evaluate the causes of the bubbles. Using newly collected stock prices for British and Dutch firms in 1720, we find evidence against indiscriminate irrational exuberance and evidence in favor of speculation about two factors: the Atlantic trade and the incorporation of insurance companies. The fundamentals of both sectors may have led to high expectations of future growth. Our findings are consistent with the hypothesis that financial bubbles require a plausible story to justify investor optimism

And of course if you can't recognize a bubble, or if bubbles are necessarily at least somewhat rational, how can you sensibly impose regulation to stop them? Or more precisely, any such regulation is likely to prevent productive investment.

Here's a post from five years ago on more evidence of the rationality of "bubbles." And see my article, Bubble Laws, 40 Houston L. Rev. 77 (2003), about the dubious nature of bubble-borne financial regulation.

Lehman, AIG and the government as systemic risk regulator

We hear a lot about the need for more systemic risk regulation in the wake of the last year's crash. The idea is that market actors can't see the forest for the trees, but the government can. The government's actions on Lehman and AIG a year ago can teach us something about that.

The failure to rescue Lehman has gotten a lot of criticism because of the failure's bad effects on the markets. But I suggested at the time:

Although the markets arguably are less vulnerable now than in March, I think we'll get a glimpse of what would have happened if Bear had been allowed to fail. Apparently Lehman will go into liquidation, but it will be a slow liquidation. Probably not a disaster. * * * If things hold together this time, it will probably be a long time before anybody suggests another government bailout of a Wall Street financial firm.

But then I was on board with the AIG rescue in answering some questions about it:

(3) Why was AIG to big too fail but Lehman wasn't? Was AIG's role in the credit default swap market really that important?  (Yes.) * * *(6) Does it make policy sense for the federal government to put itself in the position of owning an insurer? (See 3)

Yesterday Joe Nocera said:

Almost everyone I've ever spoken to in Hank Paulson's old Treasury Department agrees that without the immediate panic caused by the Lehman default, the government would never have agreed to make the loans needed to save A.I.G., a company it knew very little about. In effect, the Lehman bankruptcy caused the government to panic, which in turn caused it to save the firm it really had to save to prevent catastrophe. In retrospect, if you had to choose one firm to throw under the bus to save everyone else, you would choose Lehman.

Putting all this together, (1) if Lehman had been rescued, AIG might not have been; (2) the AIG rescue occurred in the midst of a "panic"; (3) if the Lehman failure had been given a little more time to work itself out, and the panic had subsided, AIG might not have been rescued; (4) the AIG rescue was a good thing.

Then is Nocera right that the Lehman failure was lucky in retrospect? That the failures occurred in just the right order to get us to the right public policy? I'm not sure now, despite my conclusion at the time. For all we know, the AIG failure might have worked itself out too if given more time. That would suggest that the timing was actually unlucky.

All we know is that the government was acting in a panic, like a headless chicken. Even if it did the right thing, this was the result of pure luck, as Nocera suggests. And we still don't know if it did.

This doesn't give me a great deal of comfort about the government standing above it all, seeing things the market doesn't, and taking wise risks.

The second coming of Hank Greenberg

More than four years ago Eliot Spitzer was responsible for Hank Greenberg's departure from AIG. As I said In August 2005, reporting on the decline in AIG's stock price since then, "history will probably demonstrate that AIG was better off with him in charge, or trusting to corporate governance processes to replace him, than with Spitzer's political maneuvering."

I followed up here, and more recently suggested that Spitzer's improvident action may have helped trigger AIG's collapse, which figured prominently in the crash.

Today we learn via Dealbook:

Shares of the troubled insurance giant American International Group soared Thursday following a report that its new chief executive, Robert H. Benmosche, had sought a reconciliation with his estranged longtime predecessor, Maurice R. Greenberg. * * *Bill Bergman, a senior analyst at Morningstar, attributed Thursday's gains in the stock to "the notion that there's a reconciliation under way between Greenberg and the company." Mr. Bergman told Reuters that Mr. Greenberg could help attract new private capital investment to the company.

Decoupling: a good idea from the UK

Lord Myners, the U.K. minister overseeing London's financial center has suggested that shareholders should be able to buy and sell their voting rights:

"Some shareholders who never vote could sell their voting rights to others who do want to vote," he said in an interview last week. "That would introduce some market discipline into voting. It would have to be limited -- voting could not go beyond two votes per share, say.

There's some disagreement, of course:

Of Lord Myners's proposal to buy and sell voting rights, Alain Grisay, chief executive of U.K. fund manager F&C Asset Management, said: "Renting the right to vote would potentially open the floodgates to all sorts of trouble. That sort of practice is no longer tolerated in the public life of any functioning modern democracy, so I suspect most people would be deeply uncomfortable with it being introduced into the business world."

For an economic rationale favoring decoupling of ownership and vote, see my article with Bruce Kobayashi.

I don't understand why the proposal "would have to be limited."  Bruce and my rationale for decoupling is that in some situations enabling a bidder for control to amass voting rights without buying the underlying stock can facilitate efficient transactions.  But this can happen only if the vote buyer can aggregate significant rights.

And of course the criticism that this is "undemocratic" is nonsense.  Voters in a democracy have stakes in their countries that corporate voters do not have.  A business is not a political entity.  At least not yet.

Spitzer, AIG and the crash

The WSJ puts yesterday’s $15 million SEC settlement with AIG’s Hank Greenberg into perspective:

More than four years later [after Eliot Spitzer filed fraud charges against Greenberg], the federal government has decided that it cannot even make a civil case for fraud against Mr. Greenberg, never mind a criminal one. The SEC has essentially settled with Mr. Greenberg on the charge that he was the CEO at the time that “material misstatements” in earnings occurred. As the WSJ notes, the mistatements “add up to less than 1% of AIG’s net income during the period at issue. . . [and] represent less than 10% of the restatement AIG filed to justify the Greenberg firing demanded by Mr. Spitzer. The impact on retained earnings was roughly $250 million, when AIG’s total retained earnings at the time were approaching $70 billion.”

On the other hand, consider the costs of this prosecution.  As the WSJ notes, the charges led to Greenberg’s removal from AIG, which led directly to loss of its AAA credit-rating, a foundation of its financial business. It also left the company Greenberg had built without his firm hand or a competent successor. The result was AIG’s disastrously increased bets on the housing market. As I noted (discussing Michael Lewis’s recent article on AIG):

Lewis’s article does break new ground in explaining in more detail why this happened. Lewis blames everything on Joe Cassano, head of AIG Financial Products, whom Lewis dubs “the man who crashed the world.” According to Lewis, Cassano was not a financial wizard – just a back office guy with “a real talent for bullying people who doubted him.” He became ascendant when the man who put him in power, and who could control him (Hank Greenberg), was forced to resign by Eliot Spitzer (so, hey, let's blame all this on Spitzer).

The bottom line:  if Joe Cassano was the "man who crashed the world," Spitzer was the guy who gave him the keys to the car. And all this for his supposed non-fraudulent responsibility for a barely material (if that) accounting mistake, plus, of course, the boost to Spitzer's then career.