Ideoblog

Financial crisis as a "game-changer"

David Zaring has some “praise of the government’s game-changer” in today’s Dealbook Dialogue:

The government’s response to the financial crisis — through deals, creative new programs and a policy of trying everything and hoping that some of it works — presents, in my view, not just a challenge to the old order of financial regulation, but to the process of regulation itself.

The results — at least so far — call some of our cherished notions of stability and organization into account. Unmeasured desperation may have saved us from financial calamity. So what remains of the case for measured action, public participation in important decisions and judicial review?

I think that the case should be qualified, and I think this may be one of the lasting lessons of the financial crisis. The government’s response has been a game-changer, but it has not been, in any sense, business as usual. Like many real-world game-changers, it hasn’t been pretty. * * *

I have certainly had moments during the last year where I thought that the latest government program was both ridiculously illegal and a very bad idea. But neither I nor anyone else could do much about it, because we were bystanders in the process of policy formulation and immense spending.

But so what? There have been some results. Companies can borrow money again. They are making their payrolls. The stock market has recovered. The real economy could be a lot worse. * * *

Maybe we should encourage this sort of creativity and try-everything ethos elsewhere. Ordinary bureaucratic process may not always be the right approach, at least in a crisis. * * *

So far, one year later, doing things differently looks like it was the right idea. We should learn from this approach to government policy-making and, perhaps in the future, look at the rule book the government threw out a little more skeptically than we usually do.

I have a lot of respect for David and his deep knowledge of the administrative processes he’s willing to relax.  But there are big problems with this particular position. 

First, how do we know what the effects of game-changing are?  David says everything looks fine, mainly because the hysteria has subsided.  But we are left with a massively government-controlled economy, with all kinds of potentially unforeseeable side effects. 

Second, how do we know any of this was necessary?  Sure the economy got better, or at least seemed to.  But markets, left alone, are quite resilient.  We don’t know whether this happened because of, or despite, government.  To be sure, it’s equally difficult to speculate that government made things worse. It’s because of the imponderability and lasting effects of much of what government does that we have checks built in to slow it down. 

Third, now that we’ve changed the game, what are the rules?  Specifically, when do the usual rules apply, or when are we going to have another “crisis” where we need to suspend the rules, or create new ones?   Predictability is an essential basis of a complex market economy. 

In other words, I agree with what Joe Grundfest said in his own Dealbook contribution:

[L]arge portions of the common wisdom are immune to reason because they serve emotional or political objectives. These emotional or political components of our common wisdom are doomed to lead us astray in the long run, but they are exceptionally effective in the moment. The error of our ways becomes broadly apparent only with the benefit of hindsight as the force of time reshapes the common wisdom, and as further experience generates facts that were unknown at the time we decided to act. This is, in a sense, the difference between journalism and history.

Anyway, like it or not, there are fortunately limits to how much Congress can change the rules in a crisis.  We should learn something soon about what those limits are.

Update:  Zaring responds. He says I'm focused on substance.  But in fact I was focused on the same process point he was.  I just came out differently, noting that "it’s because of the imponderability and lasting effects of much of what government does that we have checks built in to slow it down."  Anyway, I'll have a chance to discuss this with David as he appears tomorrow in our Illinois Corporate Colloquium (see our events page).  (Apologies to folks coming here from the Glom -- I did something stupid and broke the link that David used).

Paredes on the costs and benefits of financial regulation

Last week I talked up SEC Commissioner Troy Paredes who, as I said, "has quietly been doing a great job speaking up against a looming tide of financial regulation." On Saturday some Paredes remarks were posted on the Harvard blog that further support this evaluation.

The specific subject was the SEC's proposed amendment of Rule 602 of Regulation NMS to prohibit flashing of marketable orders. Paredes argues that before banning this practice we should consider (1) the benefits of the practice, including increased market liquidity; (2) whether a less restrictive alternative would be appropriate; and (3) the extent to which a ban might constrain other types of trading.

This cost-benefit analysis is welcome and an important part of what the SEC should be doing. Indeed, the Commission has been judicially slapped down for not doing it.

More importantly, Paredes used this talks to lay down some general principles of financial regulation:

[C]ompetition and choice are fundamental. Exchanges and other trading venues need flexibility to innovate new products, services, and trading opportunities that advance the varied interests of market participants by affording them choice. * * *

[R]esearch, development, and innovation need to be rewarded. * * * When the regulatory regime erodes a market participant's opportunity to profit from its legitimate competitive advantage, the incentive to innovate is dampened. * * *

[T]he analysis of markets and their regulation should be grounded in data to the extent possible. * * * It is one thing to posit that a problem exists; it is another to demonstrate it empirically. Data has a way of disciplining decision making and can help channel regulatory efforts to where they are most productive. * * *

Paredes concluded:

Risk is unavoidable. When we regulate one risk, something else pops up. The responsibility we have as lawmakers is to engage in the kind of demanding analysis that will best position us to identify and evaluate the range of consequences — both good and bad — that attend our decisions so that we can make conscious tradeoffs. * * *

[S]ome risks are worth taking if avoiding them is too costly because legitimate, wealth-creating enterprises and transactions are stifled. * * * This is a particular risk when it comes to regulating complex dynamic markets. Indeed, with sufficiently competitive markets, market discipline may effectively substitute for burdensome regulation that runs the risk of going too far.

All of this bespeaks caution before enacting prophylactic regulations. It is possible to be too precautionary. Good data helps guard against this. * * *

Our increasingly complex markets will be better served if the Commission has more economists, quantitative analysts, and others with strong backgrounds in trading and finance actively engaged in every aspect of what the SEC does. When it comes to market structure, the Commission also could benefit from deeper expertise in industrial organization, not just financial economics and trading. For an agency that regulates the world's largest securities markets to be so dominated by lawyers is ill-advised.

We have seen that our financial markets are dynamic and self-correcting. Market mistakes are temporary; regulation, particularly at the federal level, can be forever. It's a little comforting that somebody in power realizes this.

Manne on Paredes

Geoff Manne has some welcome praise over at TOTM for SEC Commissioner Troy Paredes, who has quietly been doing a great job speaking up against a looming tide of financial regulation.

It occurs to me that Troy is an important part of a generation of influential corporate scholars, regulators, judges and practitioners who learned important lessons from Geoff's father, among others. Maybe it's my imagination, but I see more pushback against the once inevitable regulatory backlash in the wake of a market collapse than in past generations. I'm even getting hopeful we won't have another SOX.

Maybe this is progress. Or maybe we just have health care to thank for this particular green shoot.

Time for a federal snow commission?

Snow resorts lie about snow, according to Zinman and Zitzewitz, Snowed: Deceptive Advertising by Ski Resorts. Here's the abstract:

Casual empiricism suggests that deceptive advertising is prevalent, and several classes of theories explore its causes and consequences. We provide some unusually sharp empirical evidence on the extent, mechanics, and dynamics of deceptive advertising. Ski resorts self-report 23 percent more snowfall on weekends; there is no such weekend effect in government precipitation data. Resorts that plausibly reap greater benefits from exaggerating do it more. We find little evidence that competition restrains or encourages exaggeration. Near the end of our sample period, we observe a shock to the information environment: a new iPhone application feature makes it easier for skiers to comment on resort ski conditions in real time. Exaggeration falls sharply, especially at resorts where iPhones can get reception.

The authors suggest that this is just one example of how "deceptive advertising can prevail when consumer search or switching costs are high."

Fortunately these conditions don't prevail in liquid securities markets, where many devices serve the purpose of the iPhone app in reporting on ski conditions. So maybe the SEC's efforts can be redirected.

SOX for the little guy

From the unincorporated business blog comes a report on the Incorporation Transparency and Law Enforcement Assistance Act (S569). The motivation for this piece of legislative detritus seems to be that since a tiny percentage of LLCs are being used for criminal activity let’s wreck LLCs for all firms. Hey, sounds sensible to me.

The bill requires all state-law corporations and LLCs to make disclosures about their beneficial owners, defined as “an individual who has a level of control over, or entitlement to, the funds or assets of a corporation or limited liability company that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the corporation or limited liability company.”

There is no definition of “control, manage, or direct,” but who cares, given “as a practical matter” and “directly or indirectly”?  Does this mean voting power? Financial leverage? Family ties? There are civil and criminal penalties for false beneficial ownership information. State laws are not preempted if they require additional information or impose additional limits on public access to the provided information. Someday the courts will decide how much of the rest of state business association law is preempted.

Note that the law only applies to corporations and LLCs. No doubt this will lead to a boom in limited partnerships, etc., and end the LLC era. But never fear: the act calls for study of whether we need to be worried about other business entities.

Not to be outdone by Congress, the National Conference of Commissioners on Uniform State Laws has a draft of a "uniform" law (which means it's uniform if all of the states are silly enough to adopt it): The Uniform Law Enforcement Access to Entity Information Act (pronounced “youleeay”). The theory here seems to be that any state law beats any federal law. 

Youleeay fills the gaps left by the federal bill by applying generally to state business entities that require filings. Youleeay requires disclosure of holders of various types of “governance” and “interest” holders, including shareholders, members, limited and general partners, LLCs members, etc. A “material” non-compliance with the statute warrants judicial dissolution in an action brought by the state attorney general as well as administrative dissolution, but no other penalties, including piercing the veil.

If this law is passed in your state, whether you need to worry depends on whether you’re a criminal. If you’re a criminal, no problem: you just form a general partnership or a non-profit entity, which the law effectively doesn’t reach. Of course you can’t earn a profit or get limited liability, but if you’re a criminal using the entity to hide ownership of property, do you care? Also, keep in mind that the penalty for non-compliance is dissolution. So you have to form another of these things. Big deal.

On the other hand, if you’re not a criminal, alas, you’re in trouble if this statute applies in your state. You might find your firm blowing up unexpectedly if, like many (most?) small business owners you make a mistake or fail to update a filing. Then who knows whether the liability shield will apply (the statute protects against veil-piercing, but not necessarily if the business has been dissolved and wound up). Your partner or co-member might welcome dissolution in some situations and so might whisper in the AG’s ear that there’s a problem with the ownership disclosures.

Remember: if business associations are illegal, only criminals will have business associations.

Email comments.

(Minor revisions 7/13/09)

Obama proposes SOX II

Here's a nifty summary, and Bainbridge's early critique.

I haven't evaluated the proposal closely, and won't be able to for awhile because I'm about to get out of range for a couple of weeks. But I do have a few quick thoughts on particular elements of interest. 

First, we have to keep in mind that this isn't really a legislative package, but a kind of starting gun to let the intense lobbying begin.  It will be interesting to compare the proposal to the sausage that emerges at the other end of the grinder.

Second, since we're about to embark on SOX II, wouldn't it be useful to look again at what happened with SOX I?  Here's Butler and my analysis.  At the end of our book we have some suggestions for regulatory humility, such as optional provisions and sunsetting.  I fear that in the end we will find that we learned very little from the SOX debacle.

Third, the Obama proposal suggests (p. 13) requiring hedge fund registration under the Investment Advisers Act overseen by the SEC.  It also proposes that hedge funds be required to make reports on funds under management sufficient to indicate whether they pose a threat to financial stability. 

This is particularly misguided.  The best commentator on that is Houman Shadab.  See here and here.  The bottom line is that hedge funds are more a solution to problems of the financial system than a cause. 

The "systemic risk" argument is totally misguided.  As Jon Macey has noted, hedge funds actually combat systemic risk by, essentially, betting against the "system."  One way to make them part of the problem is to force enough disclosure that other financial institutions can follow them off any cliffs they seek to explore.  See Macey, PROMISES KEPT, PROMISES BROKEN 265-72(2008).

And what's with this regulation by the SEC?  Are we satisfied with the great job that agency did supervising Madoff?  See here (detailing the SEC's massive regulatory incompetence in Madoff) and here (suggesting that the SEC was actually Madoff's unwitting accomplice). 

Fourth, the proposal calls for (p. 40) "increased national uniformity through either a federal charter or effective action by the states." Butler and I show that this objective in insurance regulation is misguided and offer a better alternative.

Finally, let's keep in mind that the US is no longer alone in the world.  Regulatory overkill here could be a boon for places like Singapore and Hong Kong.

Dismantling the foundations of capitalism: the TARP repayments

Banks are now being told, per the WSJ, that in order to repay TARP funds, which several want to do to escape from regulation of TARP debtors, they have to show that they don't need the FDIC guarantee of unsecured debt made available last fall. 

As John Carney shows, this appears inconsistent with a provision in the relevant law making repayment subject to "consultation" with banking regulators, not "approval" as in the agreements for the original TARP loans. See also here and here.

Is this new requirement a legitimate interpretation of the law? Does anybody care?  We should, because as pointed out in my previous post, respect for these rules is a critical requirement for a well-functioning capital system.  Whether or not the new requirement is prudent, our system demands that the rules in place at the time transactions occur will be respected even if some bureaucrat changes his mind later on.

Dismantling the foundations of capitalism: the Chrysler haircut

Over centuries the US has built the greatest capitalist system in the world. Though capitalists make lots of mistakes, but they have strong incentives to fix these mistakes, and will do so as long as the underlying structure remains sound.

But over recent weeks, the Obama administration has been dismantling this structure out of short-term political expedience: let’s get nice headlines, cover that pig with lipstick, and damn the long-term consequences. It’s the kind of short-term thinking that hedge funds have been accused of. But even if hedge funds were inclined in this direction, they don't have the powers the federal government can wield.

More specifically, what business needs is a clear idea of what the rules are when investors put their money at risk, and full disclosure of these risks. Government’s job in our capital markets is to follow and enforce the rules, including those on disclosure. If these conditions aren’t met, risks and the costs of capital rise and investment declines. Worse, resources are allocated to the bribers, favor-seekers and cheaters rather than the builders and suppliers of productive assets.

I’m going to consider examples of what’s been happening over the last few weeks, beginning here with the Chrysler haircut. 

First some background. Firms raise money by promising certain terms to their creditors. Equity holders take more risk and get more reward. Secured lenders take the least risk because they have rights to specific company assets. But these rules are inconvenient for a government that has different priorities about who should get what in a high-profile US company like Chrysler. The UAW wants some of what the secured lenders are contractually entitled to. The Obama administration, in addition to having been elected with key labor support, finds it politically expedient to get union support for the deal by extracting benefits from secured lenders. Specifically, the government wanted the lenders to settle for a third of what they were owed while labor got half. The lenders can agree to modify their rights, but they don’t particularly want to.

Against that background, the President calls the lenders “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”

These words distort reality. It’s the banks that are getting the bailouts. The hedge funds just wanted what they had paid for. They have not gotten bailed out. Moreover, the “sacrifice” Obama is calling for is, by another name, a breach of fiduciary duty by the managers to their investors.

At one level these are just words. But keep in mind that Congress is as we speak considering regulating hedge funds, that tax changes are in the air, and that executive branch lately has been wielding some awesome powers.

The President’s remarks elicited an angry, and perhaps courageous, response from Clifford S. Asness, managing partner of AQR Capital Management, which is not involved in Chrysler. Asness pointed out in an open letter that when “hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back.” Bankruptcy law has certain procedures and protections, set forth in “rules of the game lenders know before they lend. . . . [W]ithout this recovery process nobody would lend to risky borrowers. Asness points out that investment managers are not allowed to “give away their clients’ money to share in the “sacrifice”.” When they do this, “they are stealing” – including from pension funds. “Shaking down lenders for the benefit of political donors is recycled corruption and abuse of power."

Maybe you don’t feel sorry for the hedge funds and their investors. But consider what else Asness has to say:

Let’s also mention only in passing the irony of this same President begging hedge funds to borrow more to purchase other troubled securities. That he expects them to do so when he has already shown what happens if they ask for their money to be repaid fairly would be amusing if not so dangerous. That hedge funds might not participate in these programs because of fear of getting sucked into some toxic demagoguery that ends in arbitrary punishment for trying to work with the Treasury is distressing. Some useful programs, like those designed to help finance consumer loans, won’t work because of this irresponsible hectoring.

The bottom line is that the rapidly increasing power of government over recent months entails a rapidly increasing opportunity for abuse, a toxic entanglement of government with business, and an accelerating loss of confidence in markets just when we most need this confidence.

More evidence on short-selling

I've argued, most recently here, that government's periodic war against short-selling amounts to killing the messenger, in view of mounting evidence of the shorts' contribution to market efficiency.  The latest evidence on the informational benefits of short-selling is Drake, Rees & Swanson, Trading Against the Prophets: Using Short Interest to Profit from Analyst Recommendations:

We find that positions taken by short sellers that conflict with consensus analyst recommendations are highly informative about future returns, and investors can profit by trading with the shorts. A six-month, abnormal return of 9.6% can be earned from a zero-investment strategy that 1) shorts firms with highly favorable analyst recommendations (buy signal) but high short interest (sell signal), and 2) buys firms with highly unfavorable analyst recommendations (sell signal) but low short interest (buy signal). To understand why this strategy is so profitable, we investigate whether shorts and analysts differ in their use of information that prior research shows to be predictive of future returns. We find that analysts tend to over-recommend stocks with high growth and high accruals - despite a negative association with future returns. In contrast, short sellers correctly use this and other fundamental analysis information to identify situations when analysts' recommendations are misleading.

Licensing history

You need a license to talk about history for money in Philly (also NYC and Washington).  The WSJ has the story.  The Institute for Justice is suing to free the Philly tour guides from having to get a license, which requires them to take a test on Philadelphia's version of history.

Not too surprisingly, the law was a tour guide's idea.  No doubt he is sincere, but it's worth noting that this is one way to reduce the competition. Philadelphia agreed because it wants to preserve its "branding, messaging and identity." Sounds like a business talking, but with a government stick. 

This would seem to be an easy case of pure speech rather than protecting citizens from economic harm.  But as the IJ points out:

The United States is in the midst of an explosion of occupational licensing. * * * Roughly 20 percent of American workers are now forced to meet government-imposed licensing requirements to work in their chosen field, up from only 4.5 percent in the early 1950s. * * * [I]n occupation after occupation—from floristry to interior design—the meteoric growth of arbitrary and unreasonable barriers to entry is making it more difficult for entrepreneurs to break into the career of their choice.* * *

The plight of Philadelphia’s tour guides is not unique. It is easy to single out this new regulation as unjust because the government’s goal—protecting people from hearing things that the government does not want them to hear—is patently illegitimate. But individuals have a right to be free from unreasonable restrictions on their choice of occupation no matter what that occupation is—be it braiding hair, arranging furniture or giving tours.

So, now let's talk about legal services.  What kind of talking about law should the government regulate?  Glad you asked.  See Lawyers as Lawmakers:  A Theory of Lawyer Licensing, 69 Mo. L. Rev. 299 (2004), online version.