The Volokh Conspiracy

(Update.  Megan McArdle has a number of interesting comments and posts on foreclosure, modification, the effect of securitization, and the processes for recording title and other things.  This blog post has very interesting comments as well.)

Adam Levitin writes at the ForeclosureBlues blog about the Ibanez decision in the Supreme Judicial Court of Massachusetts (pdf via Creditslips blog), handed down last Friday.  (Actually, I think Adam’s post originated at CreditSlips.) This is an important decision in addressing the exceedingly vexed and, as Megan McArdle notes, highly technical legal questions surrounding the property issues – chain of title, etc. – in foreclosures on mortgages that have been securitized.  Levitin offers this assessment of the holding in Ibanez (I recommend also his article with Anna Gelpern, Rewriting Frankenstein Contracts):

The Ibanez case itself is actually very simple. The issue before the court was whether the two securitization trusts could prove a chain of title for the mortgages they were attempting to foreclose on.

There’s broad agreement that absent such a chain of title, they don’t have the right to foreclose–they’d have as much standing as I do relative to the homeowners. The trusts claimed three alternative bases for chain of title:

(1) that the mortgages were transferred via the pooling and servicing agreement (PSA)–basically a contract of sale of the mortgages

(2) that the mortgages were transferred via assignments in blank.

(3) that the mortgages follow the note and transferred via the transfers of the notes.

The Supreme Judicial Court (SJC) held that arguments #2 and #3 simply don’t work in Massachusetts. The reasoning here was heavily derived from Massachusetts being a title theory state, but I think a court in a lien theory state could easily reach the same result. It’s hard to predict if other states will adopt the SJC’s reasoning, but it is a unanimous verdict (with an even sharper concurrence) by one of the most highly regarded state courts in the country. The opinion is quite lucid and persuasive, particularly the point that if the wrong plaintiff is named is the foreclosure notice, the homeowner hasn’t received proper notice of the foreclosure.

Regarding #1, the SJC held that a PSA might suffice as a valid assignment of the mortgages, if the PSA is executed and contains a schedule that sufficiently identifies the mortgage in question, and if there is proof that the assignor in the PSA itself held the mortgage. (This last point is nothing more than the old rule of nemo dat–you can’t give what you don’t have. It shows that there has to be a complete chain of title going back to origination.)

I don’t think it is too much to ask the financial services industry to follow the rules on title and transfer.  I have been surprised by how many people, including lawyers, have simply said that intentions were clear even if the requirements of transfer were not followed.  I don’t think that’s good enough, not for the past and less so going forward.  There are reasons why we treat transfer of property, and real property and associated rights, differently than contract.  I have no doubt that things are much more complicated than I imagine, but with computerization and technology, on a regulatory reform basis, shouldn’t we be able to do a whole lot better than this?

What would a rational, going forward system of title and transfer look like – tell me in ways that take advantage of technology as it is, not some imagined possible world, and tell me ways that match up to things already being done in the securities industry.

While everyone is at it, tell me how we should address the Frankenstein hangover of the past.

(Note: I was writing this on the plane without quite being able to see the computer screen, so I’ve gone back and corrected some grammar and spelling, and tried to make a couple of things clearer.  I’ll post separately as well on the topic of national security and the financial crisis, and the role of executive discretion in responding.  But I also wanted to note that over at The Conglomerate, the compadres there are also having a discussion of Professor Skeel’s book, including my friend David Zaring, who, along with the redoubtable Steven Davidoff, was responsible for a seminal article and concept in this question of discretionary regulation, “Regulation by Deal.”)

Flying to and from meetings this week at the Hoover Institution, I re-read David Skeel’s brand-new book, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (Wiley 2011), for a second time. I am even more impressed with this book the second time around, and I believe that it is one of the short list of essential books on the financial crisis and the regulatory aftermath. If you have any interest at all in these topics, this is a book to give serious consideration to reading.

The New Financial Deal is very far from being a dense, specialist book readable only by a lawyer, or law professor, or bankruptcy or finance expert. You might guess from the title that the book is a technically useful, but, for the general reader, impenetrable commentary on the Dodd-Frank bill. After all, the bill itself runs several thousand pages of impenetrable legislative language and Skeel himself one of the country’s leading bankruptcy scholars. It might seem from the title that it is simply an unpacking – at the technical level – of what Dodd-Frank says. Technical experts can benefit enormously from such unpacking, but not so much the policy person or general reader.

But it’s not that. On the contrary, Skeel’s considerable achievement in this book is to write accessibly and persuasively about the Dodd-Frank bill. Skeel is an an admirably clear and graceful writer on very difficult topics; it shows in the sentence by sentence prose, but equally in the overall organization and selection of topics for discussion. It doesn’t seek encyclopedic analysis of the zillions of legislative provisions, but instead makes a judicious and profoundly informed selection of the main achievements (and lack thereof) of the legislation. It then succeeds better than anything I’ve read on the topic of financial regulatory reform at placing this in the context of “political economy.”  I don’t mean politics in the day to day sense, but instead the interaction of these financial rules with the political process and the intended and unintended consequences.

II

Corporatism and Brandeis-ism, and the New Resolution Authority

The fundamental reform measures of the Dodd-Frank bill correspond roughly to financial institutions and financial markets. As to institutions, Skeel examines the new mechanisms designed to address systemic risk and the mechanisms created to address supervision of those institutions both before a crisis and after the effective failure of an institution.

The political economy of this institutional supervision is given as two alternative tendencies in American economic regulation. One is the “corporatist” tendency to create a quasi-partnership between government and the largest corporations, so that government is able to exercise in some respects closer control over those corporations but also bending them to its political will – but losing the distance between regulator and regulated that usually makes regulation more effective and more importantly ensuring that those privileged institutions will not be allowed to fail, at least if they play political ball.

The other is what Skeel astutely calls the “Brandeisian” tendency to break up the largest financial institutions so that they cannot become too big, or too interconnected, to fail. He notes – this might surprise some readers – that the New Deal, however empowering government in many matters, was essentially Brandeisian on the treatment of banks, insisting on confining them in function (Glass Steagall, etc.) and in many other ways.

The tendency adopted by both the Bush and Obama administrations has been firmly corporatist. It is evident in the definitions in the Dodd-Frank bill of institutions formally designated as systemically important, but also thereby too big to fail. The corporatist tendency is also a founding feature of Freddie and Fannie, and the extraordinarily politicized activities of both firms as integral to their business models – both buying off Congress and yet chanelling the political will of administrations and bureaucracies – is what Skeel suggests will result from the corporatist model, quite apart from the problem of a lack of moral hazard leading to a regime of permanent bailouts.  (Too big to fail is sometimes correctly criticized as really meaning “too systemically interconnected to fail.”  This is right, but that translates to systemically interconnected firms that, with respect to this feature of risk, are “cartelized” as though they were a gigantic, if loosely, connected enterprise.)

Skeel’s other fundamental point concerning institutions is that the nature of regulatory authority is essentially unconstrained discretion. It is not discretion of the kind exercised by a bankruptcy judge – gap filling and interpretive and discretion existing only for defined issues, existing yes, but within a tightly bound box. It is, instead, one single non-discretionary norm – that certain institutions are too big to fail – but that everything else is discretionary (I exaggerate some, but it helps illustrate the point). It is discretion not as filling in the inevitable gaps, but instead deliberately widening discretion to cover as much as possible. Though Skeel does not frame it this way, I would describe it as “discretion as strategic ambiguity” in which the rule of law is set aside for the purpose of making it impossible to know how you will be treated: allowed to fail in some cases, taken over in others, not allowed to fail and not taken over, with no standards for knowing what results in what. This is the criticism that Skeel makes of the new “resolution authority” for institutions.

Skeel’s deepest normative point, however, is that the regulatory model deliberately undermines the rule of law – particularly the careful establishment of judicial discretion contained with bankruptcy’s special rules of law. Instead, the Dodd-Frank model finds predictable rule-based regulation inapposite to the task at hand and seeks to displace it by deliberate uncertainty, on the one hand, infused with government’s political preferences, on the other. The political preferences are analyzed against one of the most provocative but also, to my mind, persuasive turns of Skeel’s argument: to show how the auto bailouts are the template for the future bailout regime of the financial institutions. The short, accessible yet expert discussion of the treatment of senior creditors in the auto bailouts is outstanding – but most important is how Skeel shows that this, rather than the earlier bailouts in the financial services industry, is the template for future behavior under Dodd-Frank. That, and Fannie and Freddie. Continue reading ‘David Skeel’s Excellent Book, and Comparing Discretion in the Financial Crisis and National Security’ »

I am curious as to whether any law school offers a (seminar?) course on the law and regulation of central banking, either specifically on the Fed in US domestic law or else something like “comparative central banking” in the transnational law curriculum.  I’d be interested in responses as to courses, syllabi, reading, and course topics.  Serious responses please; no rants or off topic responses.  (Let me add that I don’t mean exactly what typically features in the banking course, which is, in my experience, less about the law governing central banking than the legal mechanisms by which the central bank interacts with the rest of the banking and financial services sector.  They are not quite the same thing.)

The legal powers of the Fed – and their limits, regulatory, statutory, and Constitutional – are obviously a question of importance today.  The financial crisis, the response, and the continuing unemployment rate make the question of the Fed’s mandate, independence, and limits germane in a way that has only rarely been true in the economic history of the US since creation of the Federal Reserve.  Consider one of the latest arguments – will the Fed move to monetize the fisc, meaning the fiscal deficits of states and municipalities, as a source of – not liquidity of last resort – but instead as a provider of solvency?  A George Will column expressed the concern, set against public pension issues, this way:

People seeking backdoor bailouts hope that the fourth branch of government, a.k.a. Ben Bernanke, will declare an emergency power for the Federal Reserve to buy municipal bonds to lower localities’ borrowing costs. This political act might mitigate one crisis by creating a larger one – the Fed’s forfeiture of its independence.

Will obviously has a side in this debate, but that is not what interests me; it is that the law governing central banking is up for serious debate in a way that is historically not often true.  Please leave aside any comments as to the policies involved, good or bad.  I am interested in understanding the underlying sources of law and regulation at issue here.  If the Fed were so to act, are there legal limits on the ability of the Fed to act in this way – and does it matter one way or another, as a matter of law, if Congress has declined to provide a fiscal bailout?

I am also particularly interested in anything offered somewhere in the law school curriculum on comparative central banking, in universities here in the US or elsewhere.  Again, same interest in curricula, syllabi, readings, etc.

Update:  Thanks for the responses below, they are very helpful, and I’ll be in touch with Eric and some others mentioned below.  I’ve deleted some comments that are not relevant to my inquiry; I’d like the comment thread to be useful to people who are searching for the same materials I mention in the post, and don’t want other things there.  Also, I should add that I’m not actually contemplating teaching a class on this topic – I don’t know whether there is enough material for a course on the law of the Fed or not, although I do think that a comparative central banking course surely offers sufficient materials.  Rather, I would like to know more about the area substantively, and this seemed like an easy way in.  As well as helpful to others looking for materials in the field.  Thanks everyone.

Over at the business law professor blog, The Conglomerate, the book club has been reading Bethany McLean and Joe Nocera’s book on the run-up to the financial crisis, All the Devils Are Here: The Hidden History of the Financial Crisis.  David Zaring introduces the book, his brief take, and the book club discussion here - then scroll up for the other mini-reviews and comments.  The Conglomerators think the book is worth reading, and I’ve just ordered it.  (For my own part, I have just finished a second, closer read of David Skeel’s The New Financial Deal, which is outstanding, and on which I’ll post a short review later.)

Although I have a few reservations about the tone of the article being just slightly conspiratorial, Louise Story’s front page NYT story today on the evolution of derivatives clearinghouses is highly informative and very well done.  The graphics showing how the bilateral trades would turn into centralized clearing are quite good and would be useful with a class.  On balance,  I think the overall shift to centralized clearing is a good move.  But I also have a bad, bad feeling about this in the context of Dodd-Frank and future expectations.  As I have said in past posts, in a future of financial regulation in which the central question of systemic risk and moral hazard has not been addressed, the result of what is otherwise a sensible move (yes, yes I’m skipping over all the concerns about end-users and Main Street, etc.) could turn out to create not so much a central clearing house but instead … a central address for depositing unwanted risk.

After all, why should any of these leading market participants believe at this point that the government would allow the central clearinghouse to burn down in a crisis?  And if they don’t believe that, then what is their incentive to set terms that will adequately address the risk as a matter of private ordering of fees, margin, whatever form of insurance the central risk-clearer needs? Having a central clearing counterparty is a great idea – if it and the actors that run and control it have the private incentives to make sure it is not a mechanism for accumulating and compounding risks.

Presumably the answer is that government regulators will set those requirements and solve the problem.  But the general theory of financial regulation used to be that systems would be monitored for risk-taking, after private parties (with well-structured incentives forcing them to internalize the risks) had already made the first round of risk-decisions.  Regulators would be kicking the tires for safety and soundness, as a second line of regulatory defense, not the first.  I am an admirer overall of Gensler’s efforts, but he cannot be Batman to Financial Gotham.  The peculiarity is that a structure that ought, in principle, to reduce risk might wind up leveraging it.  The clearing house might turn out to be the one address market participants need to send their unwanted risks.

ps.  Here are a couple of possible unaddressed risk scenarios:

• The clearinghouse turns out to be pretty good at managing fairly predictable, day to day risks.
• The clearinghouse turns out to be okay at managing day to day risks, but is not good at identifying or dealing with risks that arise over a long run of time from relatively minor distortions in the system’s incentives, perhaps arising from conflicts and complexity of those who own and run the clearinghouse and their other activities, perhaps other things.  Those distortions over time start out small but turn out to be large and compounding and structurally invisible or discounted until they blow up.
• The clearinghouse’s private managers turn out to be good at managing day to day risk; Mr. Gensler, et al. turn out to be okay at forcing the clearinghouse and its private owner-managers to internalize risks caused by apparently minor distortions as they arise, because the public regulator is pretty good at spotting conflicts, even amidst complexity, and has an institutional mandate to pry apart conflicts of interest, even if it angers the banks.
• The system centralizes tail-risk, radical uncertainty.

If the clearinghouse system could achieve the third as its long term behavior, then I think it is on balance a good move.  The fact that the fourth exists is not a reason not to create an otherwise rational scheme of regulation; if it is, nearly by definition, unforeseeable with sufficient specificity to prevent it from happening, that might be a pretty good definition of what the role of institutional and liquidity provider of last resort is supposed to be.  One of the peculiarities of financial regulatory reform, after all, is that one can always object to nearly everything on the grounds that there is radical uncertainty and there might be unforeseen and unpredictable consequences … so better not do that.  Or that, or that, or that.  But of course not doing anything at all is also doing something with equally radical uncertainty.

I sometimes think that we should all re-take Philosophy 101 in Skepticism and Rationality in embarking on academic discussion of financial regulation and risk.  What is the appropriate kind of skepticism about the limits of our rationality in creating regulatory systems for complexity?  Sometimes I ask a question about what I think is a fairly concrete, rationally predictable thing in financial regulation – close, in my mind, to asking what the weather is likely to be tomorrow – and get an answer back that sounds a bit too much like, “We cannot say, because after all we have no proof of the existence of the external world.  La vida es sueno.”

Hmm, I think, vale. It is a little like what the late philosopher of mind Rogers Albritton referred to as the skeptic’s devious willingness to shift to another existential form of skepticism just when we thought we had answered him on this one, but not quite saying that he had shifted skeptical grounds.  (“Shapeshifting skepticism,” one might call it.)  We ordinarily wouldn’t worry much about this possibility, obviously – except that many people think we just experienced this radical uncertainty, come to pass, in the financial crisis.

Other people think, of course, that it was imminently foreseeable, if not because of the actual (disputed) causes, then because the procedural combination of complexity, conflicts of interest, and moral hazard driven complacency strongly implied something that could not go on as it was going – a matter of a visibly flawed process, so to speak.  If that is one’s view, however, then the lurking question of number four is less whether the tail risk was actually foreseeable and preventible, but instead whether relations of complexity of systems, conflicts of interest, and attendant complacency meant that no one had enough at stake to find it.  In which case, the prescription for public regulators in regulation is less to try and find it, than to give all those other, deeply interested, but also potentially deeply conflicted, parties reasons to overcome their complacency and conflicts, and have them dig through the complexity to find it, instead.

(Moreover, the point of providing liquidity as the provider of last resort in number four is in order to allow markets to make an orderly path to price discovery that is not simply a strategically forced run on the banks.  It can’t magically remake insolvency into solvency except by fiat – or fiat money.)

The Wall Street Journal and New York Times each have good, comprehensible explanations of the eurozone sovereign debt crisis on the front pages today.  (The Journal has a particularly useful graphic that breaks out each country.)

While I wait for David Skeel and William Cowan’s new book on the Dodd-Frank financial reform bill to appear next month (The New Financial Deal), I have tried to make my own assessment of what the bill means in the aggregate.  In order to do this, I have read the bill in its entirety twice.  The first time was when the bill was first passed, and this was in order to see if anything in it took me by total surprise.  That amounts to a search for particular nuggets that jump out at you, not the “totality” of the bill.  I’ll add that he experience of reading the entire thing as a “thing” made clear to me why “reading” bills before you pass them, if it is a good idea, needs to mean “reading” in a really different way.  You have to read the bill with all the cross references to other legislation being amended to hand in advance, and a staff of experienced people to make sure that you know the context into which this change or that fits.  One hopes, of course, that this was also part of the drafting of the bill … but let’s pass over that detail.  (Update:  I just ordered Skeel-Cowan from Amazon.)

The second time around reading it was not for nuggets, but instead to try and understand the whole thing, as a comprehensive thing.  I realize that this makes little sense given that it is not a “thing” but an agglomeration of many things, some of which fit together and some of which don’t.  But this second time, I read it with some research help, and more importantly with the several hundred page bill summary to hand.  This was partly to understand the bill, but partly to get a reality check, at least for parts of the bill in which I have a good grasp of the issues, whether the summary is accurate as to the bill and its impacts.  I can report that for at least sizable chunks of the bill where I think I’ve got a strong sense, the summary is outstanding, and unless someone points out to me big areas where it is not, I’d urge those working with the bill to go to it.  I am open to correction on this point, if you are genuinely expert in these matters.

My one graf takeaway on the bill is this, however.  Parts of the bill have little relevance to the financial crisis, although they might still be part of an overall package of reform of financial regulation; one can always tell a story about how they have an impact on crisis through accumulations of bad issues, but realistically, whatever point they might have or not have – the consumer protection provisions come to mind – they are adjunct.  If the underlying rationale and point of the bill is to alter the regulatory conditions that allowed for the development of the crisis, then it should be fundamentally about addressing systemic risk, too big or too interconnected to fail, and attendant moral hazard; complexity, complacency, and conflicts, as Steve Schwarcz says.  As a substantive matter, however, the bill in total effect does not address too big or too interconnected to fail as a matter of private ordering, and so has the regulatory authority assume the moral hazard.  Which leads to this dismaying conclusion:  There are important parts of the bill that would make a great deal of sense (leave aside various particulars), in a regulatory environment that properly put the moral hazard of systemic risk on the private actors.  To take one example – and leaving aside the WSJ editorial today about Main Street’s risk management issues – the proposal to move OTC standard derivatives onto centralized clearinghouses that would both provide greater transparency and reduce the scary information asymmetries and provide for centralized clearing.  Great idea, with appropriate tweaks, in my view – until it becomes clear that because the bill does not put the risk burden on the private actors ultimately – does not force the private players to internalize their risks in derivatives trading, the clearing house and ultimately the taxpayer serve as the guarantor of last resort.  The effect of an otherwise sensible regulatory change in the derivatives market, under conditions in which moral hazard has not been addressed, is not to reduce systemic risk, but to leverage it up by centralizing it in the ultimate public counterparty.  The ironic result of the bill, in other words, is that by failing to address the systemic risk problem other than by telling the Fed and the Treasury and the “council” to figure it out, and so leaving too big or too interconnected to remain in place, otherwise sensible regulatory reforms that should reduce risk and increase transparency and informed pricing instead turn out to ratchet it up, leverage it up, for the ultimate government counterparty of last resort.  That’s not what I was hoping for.

Long graf, yeah, I know.  But while I await Skeel and Cowan’s book, I am willing to be told that this is not correct and I don’t understand what the bill does.  However, if you’re going to correct me, please confine discussion to the main issue here, which is the overall impact of the bill, taken as a whole, as defined by the systemic risk question.  I should also note, as I have earlier, that a very impressive theoretizing of systemic risk has just appeared from Steven Schwarcz and Iman Anabtawi, Regulating Systemic Risk.  It is the most striking attempt to give an account of systemic risk that I have seen in several years; what it consists in and how it propagates.  (I re-read it yesterday, and looking at the turmoil in the eurozone, wondered whether this same account could be applied to what we might call “sovereign systemic risk.”  I wonder.)

UPenn law professor and corporate finance and bankruptcy specialist David Skeel has an important article in this week’s Weekly Standard talking about the possibility and utility of bankruptcy for states.  The article argues first that a new chapter for states in the Federal bankruptcy statute would be constitutional, and then turns to argue, second, that the benefits to the public would be considerable:

When taxpayer-funded bailouts are inserted into the equation, the case for a new bankruptcy chapter becomes overwhelming. And it’s a case for Congress to move now on the creation of a state bankruptcy law.

With the presidential election just two years away, the pressure to bail out California, Illinois, and perhaps other states is about to become irresistible. As we learned in 2008 and 2009, it is impossible to stop a bailout once the government decides to go this route. The rescue of Bear -Stearns in 2008 was achieved through a “lockup” of its sale to JPMorgan Chase that flagrantly violated corporate merger law. To bail out Chrysler and General Motors, the government used funds that were only authorized for “financial institutions,” and illegally commandeered the bankruptcy process to give the car companies a helping hand. There is, in short, no law that will stop the federal government from bailing out profligate state governments like those in California or Illinois if it chooses to do so.

The appeal of bankruptcy-for-states is that it would give the federal government a compelling reason to resist the bailout urge.

This is an important piece of public advocacy by a leading scholar, agree or disagree with its two main contentions, and repays close reading.  (The illustration above is a thumbnail from the WS.)

Update:  Thanks, Glenn, for the Instalanche – but also for the very interesting updates at Insta, including some important comments and emails that I encourage VC readers to check out.

Also, Co-Conspirator Todd notes above the Stanford Law School conference on the Constitution and the Financial Crisis, at which both he and I spoke a couple of weeks ago.  It was a great conference, and CSPAN, as he notes, has put online a couple of the sessions.  One of them includes a discussion of bankruptcy and the auto bailout, and the lineup includes both Todd and David Skeel, UPenn professor and author of the above Weekly Standard article.

I have not tried to comment on the constitutional questions, as I do not have the expertise to do so.  But I wanted to make a different kind of point about bankruptcy processes that involve quite important areas of judicial discretion – equitable discretion in a generic sense – within a given structure of rules that can force creditor-parties who otherwise would not be likely to overcome collective action problems to come together.  Leaving aside constitutional questions that I am not competent to address, I favor as a policy matter something like Professor Skeel’s position.  Likewise, I favored bankruptcy as the proper process in the auto bailouts, among others.

That said, I express one caution (I’ve put up a longer version of it as a separate, later VC post).  When in a crisis, or contemplating responses to crises, we naturally look around and see an existing mechanism that seems to have worked pretty well.  Bankruptcy judges and courts, for example, in parts of the financial crisis.  We think that they have worked out pretty well how to cabin judicial equitable discretion in these matters within rules, precedents, codified law, etc.  So we collectively think, let’s assign them this big new thing – sure, it’s kind of a stretch (such as bankruptcy for states), but these mechanisms and actors have a stable procedural path that has been well worked out and well trod.

The risk here is that we do not take into account the way in which the addition of this new social and political and legal task is not just stretching existing institutions – taking on these new functions involves addressing whole new categories.  Bankruptcy of sovereign entities, for example.  It is categorically different, and has the effect of altering the nature of judging, because it just is, by its nature, political in way that no commercial activity is.  It alters the nature of discretion, the role of the judges, and how the judges see their role – how they cabin their discretion within a body of rules.  It alters the terms of legitimacy when they shift from purely commercial and private players to sovereign actors.

Now, I describe this as a risk and I perhaps overstate by calling it a category rather than a stretch.  After all, municipalities have been in these processes before, and states have defaulted before, and so an existing system might well simply grow into this role without warping it out of identification.  But it is a risk.  At a minimum, it should not be assumed that the mechanisms established by law for dealing with private actors within a structure of sovereign law can automatically work with sovereigns themselves, without altering the notion of “cabined discretion.”

Finally, note that this problem is by no means limited to this kind of financial crisis and bailout problem.  The same conceptual problem arises whenever judges are proposed to be tasked with some kind of new activity – precisely because we think that they embody both legitimacy and discretion.  Discretion that carries legitimacy because it is limited in many ways.  Think about arguments that we could have federal judges giving advance and necessarily secret review of targeting decisions for drone warfare attacks; or issues related to detention and rendition before the fact; or many other related issues.

The assumption is that judges have this legitimate discretion as an attribute of being a judge and that it can be carried around from political activity to political activity as an independent quality.  But of course it does not work that way.  Legitimacy, and equitable discretion that carries legitimacy, is a function of the activity and how it is not just legally, but also socially and culturally embedded with particular structures of law and sovereignty.  The exercise of those powers in ways that are alien to the terms of the judiciary – a judicial function that is embedded within the domestic structure of constitutional law, not a writ that runs to the world, to start with – seems to me inevitably to shift the nature and self-perception of the judiciary itself.

Judges start out reviewing national security decisions; they are gradually drawn in, as one speculative possibility, to police and enforce some rights concepts, until a bunch of Americans get blown up; and eventually the judges see themselves as being the political actors who make the decisions about the tradeoffs between security and liberty.  The judges that result from that process will not be the same, in their self-perception or legitimacy, as the judges that preceded it.

These are risks, not certainties.  But whether in the national security area or the financial crisis area – I draw here on some of Eric Posner’s comments at the Stanford conference on comparisons between the two – one must take appropriate account of the dynamic social nature of the process by which one assigns activities to actors that are attractive because they have discretionary authority and the legitimacy to exercise it.  The exercise of that authority changes with its exercise in new venues – and in ways that one might not anticipate or particularly want.

Having done a fair amount of work in microfinance and closely related areas (development finance involving business clients with larger-than-microfinance loans) in the developing world, I am overall a big fan.  As many people are.  The question that has long loomed, however, is whether it can or should scale upwards to become a full-fledged part of the global capital markets, or whether it should remain a highly subsidized development activity for very poor people or, most plausibly, some of both.  I wrote about this problem in an article in 2002 – asking whether sufficient attention had been given in the conceptualization of microfinance to the question of whether it was supposed to serve as:

• a genuinely economic connection between very poor people and the capital markets, or instead
• a kind of “faux-market” in which the tools of the market were deployed as a form of artificially sustained discipline over the efficient use of resource, but nonetheless massively subsidized and, in that sense, never genuinely part of the global capital markets but instead always some sort of philanthropy.

I, like everyone else I have known in this field, have wanted to see some of the first, some of the second and, most crucially, some kind of “venture philanthropy” merger of the two that would somehow combine:

• the discipline of genuine capital markets to induce efficient use of capital to promote geniune economic growth;
• access to much larger pools of capital than are available to government aidagencies or NGOs, through the commercial capital markets;
• subsidies or guarantees to facilitate the entry of for-profit entities into the sector, in order to help them gain experience with loan-making, monitoring, default, and other costs of microfinance, and to overcome the problem of microfinance’s problematic diseconomies of scale compared to other commercial lending;
• the many social benefits of microfinance for both very poor people and not-so-poor but still poor people as separate groups; and above all,
• scalability.

So, back in the 1990s, I proposed internally to the Open Society Institute structures of credit guarantee facilities that would allow a consortium of philanthropic and government aid agencies to offer part-guarantees to banking institutions seeking to enter the sector, with the aim of doing all the above good things.  At the time – and in most situations in which I’ve inquired about this since, with the very particular exception of India – the response from the microfinance organizations was, well, that’s nice – but as a matter of fact, at this point we don’t suffer from a general lack of capital.  We can get capital at a zero or negative capital cost in the form of interest free loans from governments or straight out donations.  We don’t need to tap the capital markets, even in a subsidized form at this point, thanks very much.  Maybe someday; not now.

The reasons why this is so are important.  The microfinance providers with whom I was speaking were generally in the business of microfinance for poor people in which the transaction costs were clearly extraordinarily high for the size of the loan and possible rate of return, if one took into account all the monitoring and active involvement with the borrowers, etc., etc.  And that was leaving aside completely the transaction costs of the foreign donors and any other upstead costs; it was just the narrow cost of a local NGO engaging in microfinance loans.  Everyone likes to tout – or anyway did like to tout – the fantastic repayment rates of these microloans as evidence of client creditworthiness .  But within the sector, practitioners have always been very clear that this is on account of large investments at the front end of monitoring and reliance upon the heavy hand of social stigma and joint and several liability (as a substitute for material collateral) of other members of a “lending circle” as disciplinary mechanisms to ensure repayment.

This is nothing new; microfinance practitioners, although sometimes evangelical in their zeal for it as a development tool, have a pretty decently practical streak, and recognize that this is a subsidized – heavily subsidized – activity when it comes to most clients.  It is another instance of the problem that much of development, as William Easterly tirelessly points out and Jeffrey Sachs seems gradually to be acknowledging, is not a scalable activity.  It takes place at the capillaries, and the blockages are not the mass flows of capital – it is what happens in the “last mile.”  Talking with a finance academic who has decided to start teaching in this area – he remarked somewhat ruefully, I can’t get my students interested in this because the whole point of finance is scalability.  But there are many extraordinarily bright and experienced finance experts, people who perhaps made some money on Wall Street and decided to do something more personally satisfying in the last fifteen years, who have been bringing an immense amount of sophistication to the problem of applying finance to development.  Parts of it have worked, and parts of it are showing the problems, which is a somewhat understated way of stating the current banking for the poor crisis in India.

The grail of transforming at least part of the sector into something that is genuinely economically sustaining, in the sense of covering its costs, and being able to scale up to the point that tapping the commercial markets for capital, has never gone away.  The attraction is greatest in India – second would perhaps be South Africa – places with many very poor people, many pretty poor people, many poor people, but globally connected, globally sophisticated, utterly first world banking sectors.

India, particularly, because the size of the internal market – in this as in many other things – but also an underdeveloped and underserved one, with takeoff underway in so many other sectors, has reasons to be attracted to this model.  Economic takeoff is going to require banking models that can reach to poor people in a commercial way; it’s not precisely microfinance, and not microfinance in the “faux-market” development sense I suggested earlier.  It is the search for a genuinely commercial product of banking for the poor that provides capital and banking services – but which manages to cover costs and return a profit.  NGO development programs cannot possibly serve the needs of all those people at that level; their specialization is with a different population of very poor people.

For all these reasons and more, I have been supportive of the efforts to try and commercialize banking for poor people, in India and elsewhere.  I’ve supported rich philanthropists putting money into these businesses in an effort to try and meld the doing good and doing well.  However, the melt-down underway in India of the current model certainly gives me pause, and the belief that a fundamental rethink of the intersection of doing good and doing well is in order.  The New York Times and the Economist each have good stories this week on the crisis in India for a company that went public in India as a microfinance lender.

It’s an economic, political, and social mess in India.  Yet, although it will indeed set back the commercialization of banking for the poor for quite a while, I am persuaded that it is not a bad thing to have to sit down and re-consider the premises of venture philanthropy and combined social-profit motivations.  I say this as someone who if, for example, the Open Society Institute or some philanthropist had invited to get involved in advising things, would have leaped in – I am confident I would have led down exactly this path.  I plead no special powers to have seen ahead.

However, with the benefit of hindsight, a couple of things are becoming clear.  The banking for the poor model has important similarities to the US subprime crisis.  Particular regions of India were deluged with capital that came cheap, in part because of the subsidies for it both implicit and explicit. Lending standards were relaxed, in part because the lenders were seeking to overcome the enormous hurdle of diseconomies of scale in tiny loans – the monitoring and loan-making costs for tiny loans.  But let’s add one important difference.  So far, microcredit – crucially and more exactly, within the analytic terminology of this post, “banking for poor people” – has not yet been securitized directly, nor has it had credit derivatives built on top of it.  As someone who has been occasionally involved trying to dream up upstream financing structures that could do securitizations and derivatives in this sector, I just would like to say that I’m glad that up to this point, the sector has not yet been leveraged up in those ways.  I’m not opposed in principle to the idea that “prudent” leverage could draw more capital efficiently into the sector; I just don’t think we have any way at this point of figuring out short of meltdown what that level is.  This should, of course, sound familiar.

The problems in India are problems of an excess of capital; poor incentives among the lenders (volume not quality, for example); and a failure to be realistic about the rates of return actually achievable by poor people even when they have availability to capital; etc., etc.  But they are still mostly at the level of the limits of poor borrowers; or, again, more precisely, what happens when poor borrowers meet global capital, in the form of expected returns that can’t really be expected (i.e., opportunity cost for global capital).  That is half of it – if you’re going to attract real global capital, you have to somehow manage to pay global capital rates and that requires economic activities that produce at least that net rate of return.

But, crucially, the other half that drives this sector is apparently opposite, but actually helps crucially swell the bubble, ratchets it up, because it is the nip that draws the cat of capital out of some better return elsewhere and into this particular place, so producing a bubble.  That other half consists of rich people, rich philanthropists, for whom the amounts are simply too tiny to worry about, not really.  It helps lead the herd of capital to indisciplined lending – not the only thing, of course, but an important component, and important component in the lack of clarity that surrounds rational choice in the sector.

But it also arises from some of the most celebrated new lending models that take advantage of the “retailization” of every encounter globally via the internet; one can exchange illegal child porn, or play chess, or make microloans all the way around the world.  The model, growing in popularity, for direct person to person lending, individual rich-worlder to individual poor-worlder, is great in one way – but let’s ask ourselves, is it such a good idea to have one-to-one lending on this basis?  Should we maybe ask ourselves why in the developed world, we use intermediaries and banks.  Sure, one answer is that a huge amount of informal lending takes place through friends and family, not intermediaries, and in a sense this model replicates that.  But, well, it doesn’t, because as we all know by now, the internet creates internet friends and family, not actual friends and family.  The social virtues, as Adam Smith would have described them, are not precisely the same across continents and over the internet as they are with people with whom one has actual, not virtual, social intercourse.

And then there is the problem that what is little money to George Soros or to me or you is really big money to someone in the poor world.  They need the money, but its efficient use requires that we take it seriously and that they take it seriously.  We don’t take it seriously.  How could we?  And yet the consequences of us not taking it seriously are an unsustainable bubble, asset inflation in already poor zones, many other bad things.  We just log off and go back to our real lives, but the effects can be – are – very real.

This is what makes The Onion so hilariously right, as it nearly always is – the ludicrousness of anyone in the first world pretending that this “lending” is anything other than “donating”:

Representatives from One World Finance, a U.S.-based microcredit provider, confirmed Monday that they had initiated foreclosure proceedings on a goat in southern India following a borrower’s repeated failure to make her $2.20 monthly loan payments. “I tried to work with Ms. [Subha] Thangam on this, but once she fell a full $6.10 behind, I had to repossess the goat,” said loan officer Michael Conrad, who stated that he was just doing his job and that it was “not [his] fault” if certain subsistence farmers were living beyond their means.

Let me be utterly clear that this is not an argument for not deploying the money; anything but.  It is needed in many places.  But the combination of easy money from the rich world that, if liberated from market discipline on the local end, can create vast problems, is one that has to be re-thought at this point, in the actual practice and alignment of incentives in this sector.  We are not willing to take the goat; but if we wish to avoid bubbles and the very real damage they cause, as well as what we somewhat too anodynely call “efficiently allocate capital,” we need to ensure that our capital goes to some entity that is willing to contemplate something close to that.  Otherwise it is not operating on the margin that matters in that society, and the results are almost certainly a bubble.  I can’t do that; you can’t do that; we need not to interact in a touchy feely way with our borrower-donee, but instead hand our money over to an intermediary that has the right incentives to find that margin.

One can pile up important similarities and differences, in other words, between India’s microfinance bursting bubble and the subprime crisis.  But let me focus on one that is perhaps less noticed.  I notice it as a similarity because it’s something that (as someone who works out in the gym in Fannie Mae’s basement in Washington DC), I have heard a lot over the past dozen years: a tendency to play a self-deceptive bait and switch between doing good and doing well.  I.e., the many conversations with Fannie Mae senior staff who, when things were going well, thought (what they thought of as) their mixed social-profit model must be great, and as things weren’t going so well, took comfort in the idea that they were doing good and this was merely a cost of doing “good” business.  Something like that seems to have been present here – which hardly surprises me because I confess to having been tempted to it many times, working in or advising organizations with similarly mixed motives.

The invitation to self-deception is high, in other words.  Bertolt Brecht wrote a play – famous in its day, and one of his writings that deserves to  live on – The Good Person of Szechuan, in which a young woman of tender and generous heart inherits a tiny shop, but discovers that she cannot keep it afloat because she cannot say no to all the need around her.  So she goes on a journey and then her cousin comes to run the shop – ruthlessly and with an iron hand to make it profitable again.  And so it goes several times round.  Brecht thought of this as a condemnation of capitalism; it is perhaps rather more instructive of the virtues of not mixing motives.  I remain as committed to microfinance, as a development tool for the very poor in “faux markets,” on the one hand; and to banking for poor people as a genuinely commercial activity, on the other, subsidized in various ways.  But I do think it is time for some deep reconceptualization of the latter, particularly, and its model of capital and its social uses.

ps.  There is a vast literature, much of it excellent, on the theory and practice of microfinance.  But if you’re interested in further academic reading on this particular topic, the “upstream” funding issues, let me recommend two recent law articles.  The first is by Kevin Davis and my American University colleague Anna Gelpern.  The second is by my co-author on financial regulation, Duke University’s Steven L. Schwarcz.  My own essay on this topic, as mentioned above, is here.  And, okay, let’s acknowledge, as usual, The Onion got there first.  (HT: Insta commenter.)

In the terrific conference on the Constitution in the Financial Crisis that Co-Conspirator Todd and I were privileged to attend last week at Stanford Law School, one of the panelists (this was a panel looking at the peculiar incentives and disincentives created for corporate governance by having government as a controlling shareholder, as in GM) pointed out something I had completely missed and apparently a number of other people in that highly expert audience, too.  A WSJ article of November 3, 2010, by Randall Smith and Sharon Terlep, points to a little-noticed IRS ruling on GM’s tax-loss carryforwards from years prior to the bailout.  The amount at issue is potentially $45 billion.   (Thanks to commenters for links to ruling.)

Although ordinarily a company in the midst of major restructuring would have limits on its ability to use the carryforwards – and ordinarily the Treasury’s 61% stake would trigger such limitations – the IRS has ruled that companies receiving TARP bailout funds will not be subject to the restructuring limits.  (Someone can correct me, since is from memory (one of my first assignments in practice back when I started as a tax lawyer was on this very question, but I have long since dropped out of corporate tax), but I believe this is a classic section 382 problem (corrected per comment).)  The WSJ story puts the argument and counter-argument over the ruling this way:

But the federal government, in a little-noticed ruling last year, decided that companies that received U.S. bailout money under the Troubled Asset Relief Program won’t fall under that rule.

“The Internal Revenue Service has decided that the government’s involvement with these companies, both its acquisitions plus its disposals of their stock, means they should be exempt” from the rule, said Robert Willens, a New York tax consultant who advises investment banks and hedge funds.

The government’s rationale, said people familiar with the situation, is that the profit-shielding tax credit makes the bailed-out companies more attractive to investors, and that the value of the benefit is greater than the lost tax payments, especially since the tax payments would not exist if the companies fail.

In terms of the “internal” question as between GM and taxpayers, one takes the point that this can be seen as saving money for the taxpayer, or at least simply moving the losses from one pocket to another.   But even granting that, in another way it’s part of the problem.  The tax losses were generated under circumstances in which the losses and associated tax attributes, good and bad and with the tax code limitations as understood then, were about a company in which it was on one side and the Treasury as a revenue collection machine on the other.  All of a sudden, the US government has a very different interest in the company, no longer at arms length, and so now we simply see it as a shift from the taxpayer’s right to left pockets, net position unchanged.  That is true at this moment; it is not true of the situation seen over time.

But probably the biggest question the ruling raises is not about the “internal” question for GM and its USG owner, it is about its relative position to its competitors.  Even if this is just shifting from one pocket to another now that the owner is the USG, it is not merely that for GM’s competitors, who have to cope with a company that, relative to them, now has in effect “found” money.  Which, as the panelists at Stanford pointed out last week, is a real issue for the government as privileged competitor in the marketplace.  Just saying that it doesn’t matter as between government and company is not the whole story; it is also how a change in otherwise long-standing rules changes the relative positions of competitors in the marketplace.

The often very interesting Room for Debate blog at the New York Times has a new discussion on the question of whether it is good policy to allow outsiders to invest in someone else’s lawsuit.  Here’s the opening to how the question is framed:

With litigation costs rising, many plaintiffs and their lawyers do not have the money to hire expensive experts or pay for years of trial preparation. To fill this need,specialized litigation lenders are stepping in to bankroll lawsuits — often providing millions of dollars at very high interest rates because conventional banks typically do not offer such loans.

Richard Epstein, Anthony Sebok, Paul Rubin, Laurel Terry, and Susan Lorde Martin take part.

My overall take is that this creates yet another system of side bet financing, in which there are the typical problems of not having an insurable interest.  The counterargument is that the liquidity provided allows for more socially efficient litigation to take place; the response is that a liquid but also disconnected system of derivatives creates downstream bad incentives.  One does not have to reach to the financial crisis to find examples; the tobacco settlements – pathbreaking achievements in their way in structured finance – solve some problems but create some new ones.

The New York Times Bucks Blog (of August 6, 2010) has a fascinating article by Jennifer Saranow Schultz on the first-ever offering in the United States of divorce insurance, the WedLock policy issued by a start up insurance company in North Carolina, Safeguard Guaranty Corp.  Markets in everything, etc.

The casualty insurance is designed to provide financial assistance in the form of cash to cover the costs of a divorce, such as legal proceedings or setting up a new apartment or house. It is sold in “units of protection.” Each unit costs $15.99 per month and provides $1,250 in coverage. So, if you bought 10 units, your initial coverage would be $12,500 and you’d be paying $15.99 per month for each of those units. In addition, every year, the company adds $250 in coverage for each unit.

Then, if you get divorced and your policy has matured (see below for the maturation rules), you would send WedLock proof of your divorce. In return, you’d receive a lump sum of cash equivalent to the amount of coverage you had purchased.

There are a couple of classic insurance questions explored in the NYT article.  One is how to prevent people who know they are going to get divorced from signing up; the key element is a maturation clause (a little bit like suicide riders in life insurance policies) that requires 48 months (reducible to 36 if you buy an additional rider) before the policy will pay off.  A second is how the company sets its rates – it does so based around the factors summarized,  more or less, in its “divorce probability calculator,” for which it claims a 13% margin of error (curiously, I thought, it does not ask how many years a married person has already been married, but maybe I err in thinking that is especially relevant).  A third is moral hazard, in the sense of inducing riskier behavior, in this case presumably lowering the inhibitions on behaviors that might lead to divorce; the approach of the policy seems to be to treat it like any other accident insurance, as an independently bad enough thing (even if monetarily compensated) so that in effect moral hazard doesn’t really operate.

The article finally explores the question of whether, at the premiums charged, it is such a good deal for a consumer couple; Schultz suggests it is not.  Will this kind of policy catch on?  My guess is not too widely, for the same reasons that prenup agreements haven’t become a standard part of marriages.  I myself would probably try to market this insurance not to couples as such, but as the “responsible” thing to take out with the children as beneficiaries – the economic effects might be exactly the same, but were I marketing it, I’d market it as the right thing to do in advance for the kids.

But the policy is a new kind of insurance, and it is hard to say what will happen.  Might such policies – this one really is modeled closely on standard casualty insurance – evolve into something quite different, something closer to a system of side-bets?  A swap market in divorce annuities, anyone?  How might we securitize marriage – or divorce?  Not to mention the problems of insurable interests and empty creditors.  (I wonder what the newly-wed Megan McArdle thinks, actually.)

(I’ll have more to say about this in another post about ‘theatre for a post-credit society’, but I will add that in some ways, this resembles a bit that very great play from the 1950s, Friedrich Durrenmatt’s somewhat forgotten The Visit of the Old Lady.  I will leave this as a cryptic teaser for the moment, however.)

Update: Folks, I have a worry that the comment thread is going to slide into various proposals for how to scam the policy, based on my summary above. I’d suggest people read the NYT article, and then if you want to propose ways to game the system, go to the company site and read the policy before proposing something. I think you’ll find that the insurance lawyers who drafted the policy are not quite as dumb as one might think based on a two graf summary above.

I have always appreciated the structure of the classic “problem of evil” argument – appreciated it on aesthetic and elegance grounds.  You perhaps recall the general formulation: all powerful, all knowing, and all good.  Any two are compatible with the existence of evil; not all three.  There are many forms of argument roughly set up in this way; this one says that the three taken together are incompatible with an additional condition, the existence of evil.

Another related structure of argument is that any two conditions are compatible, but not the third, as among the three of them (even without reference to a fourth condition).  And so on.  So, just on elegance of structure alone, I appreciated Professor Mankiw’s NYT column from yesterday, setting out the classic argument over incompatible policy goals in international economics, The Trilemma of International Finance:

What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:

• Make the country’s economy open to international flows of capital. Capital mobility lets a nation’s citizens diversify their holdings by investing abroad. It also encourages foreign investors to bring their resources and expertise into the country.
• Use monetary policy as a tool to help stabilize the economy. The central bank can then increase the money supply and reduce interest rates when the economy is depressed, and reduce money growth and raise interest rates when it is overheated.
• Maintain stability in the currency exchange rate. A volatile exchange rate, at times driven by speculation, can be a source of broader economic volatility. Moreover, a stable rate makes it easier for households and businesses to engage in the world economy and plan for the future.

But here’s the rub: You can’t get all three. If you pick two of these goals, the inexorable logic of economics forces you to forgo the third.

Professor Mankiw goes on to point out that the United States, China, and Europe have each chosen a different set of two in the trilemma – and part of the political and economic pressure they put on each other reflects those preferences.

But back to the form of argument – it is something that shows up sometimes in formulating arguments in the law and other places.  Other instances of recourse to this kind of argument form?  (I seem to recall that corporate law scholar, Dean Bob Clark, used something along these lines in a corporate law setting once.)

Mean Professor Anderson made his first year law and economics class memorize Greg Mankiw’s ten basic principles of economics, including … incentives matter.  Also, people make decisions at the margin.  One of the interesting questions – more than interesting, genuinely crucial to how one understands and interacts with other people – is when those heuristics don’t apply, however.  Spheres of social, interpersonal, intimate, familial, etc., life in which one eschews making decisions at the rationality margins, and instead goes with relational and affective values that are not “scalable” in the sense that marginal decision-making requires.

And then there is the vexed question of when one might think in terms of one, or the other, or both … which brings us to the question of the estate tax, as this Wall Street Journal article observes.  Last year, people had an incentive to stay alive, and their heirs had an incentive to keep them alive, until January 1, 2010, in order to avoid the estate tax.  It will go into reverse, however, at the end of the year:

When the Senate allowed the estate tax to lapse at the end of last year, it encouraged wealthy people near death’s door to stay alive until Jan. 1 so they could spare their heirs a 45% tax hit.  Now the situation has reversed: If Congress doesn’t change the law soon—and many experts think it won’t—the estate tax will come roaring back in 2011.  Not only will the top rate jump to 55%, but the exemption will shrink from $3.5 million per individual in 2009 to just $1 million in 2011, potentially affecting eight times as many taxpayers.  The math is ugly: On a $5 million estate, the tax consequence of dying a minute after midnight on Jan. 1, 2011 rather than two minutes earlier could be more than $2 million; on a $15 million estate, the difference could be about $8 million.

It is a question of incentives for the wealthy person, of course – but also a question for their heirs.  There is the question of perverse incentives but also, as the article discusses further, many questions of regulatory uncertainties clouding the very calculation of incentives.  Will Congress act?  At what rates and what exemptions?  Crucially, will any of it be retroactive?  Which leads to another basic principle … uncertainty raises costs.

Advisers say the estate-tax dilemma is especially awkward for heirs. “At least in December 2009, people wanted to keep their relatives alive,” says Ronald Aucutt, an estate-tax attorney with McGuire Woods in the Washington area. Now he and others are worried that heirs may be tempted to pull plugs on Dec. 31. Economists might call the taking of a life to reap a tax advantage a “perverse incentive.” District attorneys might call it homicide.

I suspect the plug-pulling problem or potential homicide problem by heirs exaggerated.  So I’d like to think, anyway.  Still, perverse incentives are perverse incentives.

The American Association of Law Schools section on financial regulation is seeking paper proposals for the January meeting on all topics of financial regulation and regulatory reform.  The deadline for proposal submissions is August 1, fast approaching; I have posted details below the fold, and you can also contact my colleague Anna Gelpern with any questions … agelpern at wcl dot american dot edu.  I encourage to take advantage of this opportunity for exploring these issues; as I suggested in a recent talk to a student group that was later published as an informal essay, lawyers and law professors do have certain comparative advantages in relation to economists and others in addressing financial regulatory reform.   Continue reading ‘Financial Regulation Reform – AALS Call for Papers’ »

In my earlier post from last night on the Dodd-Frank financial reform bill, I asked whether the highly discretionary provisions in the legislation addressing aspects of systemic risk have the effect of “returning” us to the 2008 crisis policy of “regulation by deal.”  That term comes from a paper by Steven M. Davidoff and David Zaring that was posted to SSRN in November 2008; I realize looking at some of the comments that many readers were not familiar with the term, so here is an approximate definition from the abstract to the 2008 paper (Professor Davidoff also discusses the idea in his excellent and highly readable book Gods at War, in chapter 10, beginning particularly at p. 269):

The government’s team, largely staffed by investment bankers, pushed the limits of its statutory authority to authorize an ad hoc series of deals designed to mitigate that crisis. It then decided to seek comprehensive legislation that, as it turned out, paved the way for more deals. The result has not been particularly coherent, but it has married transactional practice to administrative law. In fact, we think that regulation by deal provides an organizing principle, albeit a loose one, to the government’s response to the financial crisis. Dealmakers use contract to avoid some legal constraints, and often prefer to focus on arms-length negotiation, rather than regulatory authorization, as the source of legitimacy for their actions, though the law does provide a structure to their deals. They also do not always take the long view or place value on consistency, instead preferring to complete the latest deal at hand and move to the next transaction.

The marriage of “transactional practice” to “administrative law” – yes; Davidoff and Zaring’s description of it was shrewd in 2008 and it remains a shrewd way to characterize it now.  My question today was whether the embrace of discretionary authority in the Dodd-Frank bill effectively enshrined this statutory authority, with further questions about the effects on future moral hazard.  Professor Zaring has been kind enough to email me something to post.  David’s comment emphasizes not so much the question of a return to regulation by deal as the question of whether anything in the financial reform bill replaces it, e.g., through the new resolution authority.  To which his comment is (and my thanks to David for weighing in with this; you can read more of David’s comments at The Conglomerate, where he is much more sanguine that I about the overall bill):

Have we replaced regulation by deal?  The answer is probably not – because governments have been bailing out banks, often by deal, so many times over the course of the twentieth century that one would have to conclude that it is a very hard habit to break.  And I think that is an implicit part of the message of Kenneth Rogoff’s and Carmen Reinhardt’s This Time Is Different, which goes even deeper into that not-so-enviable history.

The way that Congress hopes to end the emergency dealmaking lies in the new grant of resolution authority, summarized here, which would continue to try to force the government to swing into action before desperation sets in, and extend the ability to seize and bankrupt insolvent institutions to financial holding companies, as well as to banks and thrifts (thereby reaching the Lehmans – an investment, rather than FDIC insured bank – and AIGs – an insurer – of the future).  The superquick bankruptcies would be paid for by an assessment on large banks.  It’s an important grant of authority, but will it be exercised in a pinch?  The banking regulators have had a hard time pulling the trigger on resolution authority – hence the dealmaking that ensues when times get really bad.  And, of course, the fact that the government had the power to “resolve” Fannie Mae and Freddie Mac (which it did) has not prevented either precipitous action or a big bailout.

So I’m not sure that the bill ends regulation by deal, but that is very hard to do.  And the bill will probably change the way that big banks operate, depending on the way it is enforced by the regulators, and not in altogether bad ways.

The reference to This Time Is Different is apt – it makes for (what would be the right adjective?) rueful reading late at night.  As I say, I am much less sanguine that David about this bill (see his Conglomerate post linked above); my view is approximately that of Nicole “After the Fall” Gelinas, in a quick summary for a popular audience in the New York Post today.  But I also think David is quite right about resolution authority and regulation by deal, whether before this bill or after it.  And thanks to him for the comment.

Update:  I’m happy to see that the WSJ today has more or less the same view that I’ve put out here:

The Treasury, which bailed out institutions willy-nilly without consistent rules, will now lead the Financial Stability Oversight Council that will have the arbitrary power to define which financial companies pose a “systemic risk” and which can be shut down without recourse to bankruptcy. Willy-nilly will now be the law.

(Update:  Thanks, Glenn, for the Instalanche!  If readers want a further discussion of this, including a short response from one of the co-authors of the “Regulation by Deal” paper, David Zaring, go here.  One reason to look at that further comment is that it gives an approximate definition of “regulation by deal” from the paper.)

I have spent a lot of the weekend reading summaries – I grant, I have not yet read the text of more than a couple of bits and pieces in the derivatives materials – of the financial regulation reform bill.  (Here is a pretty good summary from the front page of the New York Times, Saturday, June 26, 2010, by Edward Wyatt and David M. Herszenhorn.  But if you are looking for a good graphic summary of the highlights, see this graphic, “The Hope and the Worry,” that accompanies the article at page A12.)

With regard to the bill overall, well, I share the concerns raised by the editors of the Wall Street Journal and many others.  Far from eliminating too big to fail, or too systemically connected to fail, etc., the bill instead enshrines it and all the moral hazard accompanying it.  Much of the important systemic risk stuff is left in the discretionary authority of the Fed, however.  This leads me to a particular question about it.

In a certain way, this seems like a return to the phenomenon that Steven Davidoff and David Zaring identified in an article early on in the crisis – the so-called crisis response of “regulation by deal.”  Meaning by that, regulatory actions taken on a deal by deal, firm by firm basis, running through, of course, Bear, Fannie-Freddie, and so on.  Does this new discretionary authority amount to a return to the policy of regulation by deal?  A certain amount of ‘regulation by deal’ seemed justified at the moment of crisis.  But very soon into the process of regulation by deal, everyone had to consider its limitations.

What was it, from a downside view?  There was already a toxic combination of liabilities in existence – triple whammy, simultaneously massive; yet widely diffused throughout the financial system; and yet also interconnected with one another so that one failure might trigger another in unforeseen directions – based around the assumption that in any moment of crisis, they would be put to the Fed. That is, lingering moral hazard and its mis-leveraged fruits, on the one hand.  And yet completely discretionary behavior by governmental authorities as to how they would respond to crisis in any particular firm  at that particular moment, on the other.  Presumably the freedom to respond to Bear but not to Lehman would choke off the moral hazard.  The problem was, given that the liabilities and the leverage that the moral hazard had permitted had already created rafts of really-existing securities with really-existing obligations, things could not be stuffed back into Pandora’s box simply by a policy that eliminated (supposedly) the moral hazard.

Even if the regulation by deal policy was the right way to re-center the market players around risk, that policy would have to act into the future, not the past.  The result was that, at least for purposes of addressing the crisis as it was then unfolding, it merely increased uncertainties without addressing the already-ripened fruits of moral hazard.  (I’m sure if I worked at it, I could come up with a One Ring LOTR metaphor here.  But I will refrain.)  Regulation by deal could not address the moral hazard, because the externalities comprising it had been created by a vast number of deals over years; suddenly putting back in the “threat” of not getting bailed out did not make any of that go away.  At the moment of crisis, it merely increased the uncertainty.  If you were a firm, you didn’t know whether or not you would get bailed out – but since you could not really unwind all the moral hazard assuming risks all at once, in the moment of crisis, there was no “compliance” behavior that could respond to the supposed incentive.  The only result would be the same risk as before since the relevant securities had already been created – and a new dollop of uncertainty.

My question is, does the discretion now handed off to the Fed return us to “regulation by deal”?  And is this a good idea or a bad idea?  After all, in favor of it is that if it truly resolved the moral hazard problem by introducing genuine strategic uncertainty as to the Fed’s actions for any particular firm, then if this is supposed to be regulation for the future, maybe it is a good idea.    Against it?  Well, to start with, the markets would have to believe it – and believe it in the context of everything else that is in the bill.  I don’t believe it.  In fact, I think the bill should have been titled, The Dodd-Frank Put.  I think it’s a bad idea.  But do you?

(I leave aside, for now, certain public choice consequences that seem to me highly problematic with regard to the Fed role.  I also leave aside the topic in this that I follow most closely, the details of derivatives.)

If David Zaring (David blogs at The Conglomerate, but I don’t see anything from him on the new bill as yet) has any views on this, I would be delighted to post them here as a guest post.

This week’s The New Republic features a cover story by Harvard Law School’s Jack Goldsmith on cyberwar.  (June 24, 2010.)  It’s a long, serious review essay, using Richard A. Clarke and Robert K. Knake’s new book, Cyber War, as the hook.  But Jack goes well beyond a book review into the rapidly expanding literature on the subject – expanding across technical computer science and engineering, software, security, strategic, and legal lines.  Terrifically well written and intelligent, I strongly recommend it (full disclosure: I haven’t read the book under review) – whether you know the field or are looking to get an overview of it.  One thing is clear, it is not going away.

Years ago I decided my inner geek comparative advantage was in robotics, but I read this essay with particular attention to its discussion of complexity of systems, and just how hard it is to get a handle on cyber systems, and their diffuse, distributed natures:

Many factors make computer systems vulnerable, but the most fundamental factor is their extraordinary complexity. Most computers connected to the Internet are general-purpose machines designed to perform multiple tasks. The operating-system software that manages these tasks–as well as the computer’s relationship to the user–typically has tens of millions, and sometimes more than one hundred million, lines of operating instructions, or code. It is practically impossible to identify and to analyze all the different ways these lines of code can interact or might fail to operate as expected. And when the operating-system software interfaces with computer processors, various software applications, Web browsers, and the endless and endlessly complex pieces of hardware and software that constitute the computer and telecommunications networks that make up the Internet, the potential for unforeseen mistakes or failures becomes unfathomably large.

The complexity of computer systems often leads to accidental mistakes or failures. We have all suffered computer crashes, and sometimes these crashes cause serious problems. Last year the Internet in Germany and Sweden went down for several hours due to errors in the domain name system that identifies computers on the Internet. In January of this year, a software problem in the Pentagon’s global positioning system network prevented the Air Force from locking onto satellite signals on which they depend for many tasks. The accident on the Washington Metro last summer, which killed nine people and injured dozens, was probably caused by a malfunction in the computer system that controls train movements. Three years ago, six stealth F-22 Raptor jets on their maiden flights were barely able to return to base when their onboard computers crashed.

The same complexity that leads to such malfunctions also creates vulnerabilities that human agents can use to make computer systems operate in unintended ways. Such cyber threats come in two forms. A cyber attack is an act that alters, degrades, or destroys adversary computer systems or the information in or transiting through those systems. Cyber attacks are disruptive activities. Examples include the manipulation of a computer system to take over an electricity grid, or to block military communications, or to scramble or erase banking data. Cyber exploitations, by contrast, involve no disruption, but merely monitoring and related espionage on computer systems, as well as the copying of data that is on those systems. Examples include the theft of credit card information, trade secrets, health records, or weapons software, and the interception of vital business, military, and intelligence communications.

This drew my attention in part because of my interest in complexity and complex systems interacting one another in another part of my work – finance and financial regulation.  Duke’s Steve Schwarcz and I are doing a book on financial regulation reform, and our approach – in a field currently getting saturated with books on this very topic – is to offer pragmatic, basic heuristics, rules of thumb, really, for how financial regulation needs to be designed.  Not some super deep conceptualization, but something much more practical.

The same pragmatic assessment applies to diagnosing What Went Wrong, so to speak, in financial regulation.  We have settled on the three homely, but still useful, categories of complexity, complacence, and conflicts (cupidity we take for granted).  They’re useful because they’re homely.  Complexity hides conflicts that undermine basic duties of loyalty, and breeds complacency that undermines basic duties of care, and they feed back into the development of more complexity.  They stoke each other.

Professor Schwarcz has a Washington University Law Review paper on the issue of regulating complexity in finance and financial regulation, from which we are drawing for the book.  I recommend it, partly for those interested in financial regulation issues and complexity – but I also recommend it as a way of thinking comparatively about complexity in other settings that cross-weave technological and legal-regulatory divides.

I want to return again briefly to how the traditional distinction of liquidity and insolvency in a crisis applies to sovereign states such as Greece.  Liquidity is usually thought of as a gap in information that causes investors, creditors, depositors or others to suddenly question an institution’s financial position. In the classic bank run, the information gap becomes a self-fulfilling prophecy of insolvency; in other cases, insolvency is discovered, not made, as information becomes available and indicates that the institution is genuinely not solvent. But in either case, insolvency is a condition of an institution, such as a bank or financial institution, discovered or made in the present.

In the case of sovereign states, the analogy is apt, but not entirely so. Sovereign states, even when they default on their obligations, do not simply disappear “into” (much less “in”) bankruptcy the way a private firm would, unless the firm had the deus ex machina of a government bailout.  States don’t just go away, their assets sold off and distributed out to the creditors.  The question of solvency or insolvency – the urgent information gap that has driven much of the recent Greek debt crisis – is not so much a question of solvency today, as whether a state can muster the political will to be solvent into the future.

Questions of political will across a long time horizon are by their nature deeply uncertain, not least from an investor’s point of view.  So it seems likely that in the absence of a flat out guarantee from a trusted party – the EU or its leading members – liquidity issues (including not just risk premiums, but much volatility in debt pricing, reflecting genuine uncertainties) will trouble Greece, and other shaky euro economies.  The special sovereign uncertainties arise as investors seek to bridge an information gap that is fundamentally about the special solvency issue for a sovereign state – long term political will.  Can a trillion-dollar euro fund allay the uncertainties, not just today, but over the required time horizon?

(Whatever the answer to that question, it seems to me that Professor Anna Gelpern, whose Roubini blog post I earlier referenced, is right in saying that Greece does not have much reason to seek a restructuring at this point in time.)

Anna Gelpern’s post on the Roubini blog (that I posted on earlier) had an interesting point I wanted to follow up.   She remarks in passing, “apropos commitment, isn’t it interesting that the European Commission will issue collateralized debt (secured by its €141bn budget)?”  Indeed, and even more interesting that the bulk of the bailout fund will come via a vast intergovernmental SPV.  If you follow her link, it takes you to a Financial Times article discussing the legal-financial structure of the EU bailout, which describes the bailout fund:

The so-called European stabilisation mechanism will consist of two parts with separate legal bases.

The €60bn extension of the EU’s existing balance of payments facility – used to help Hungary, Latvia and Romania – to members of the eurozone will be based on Article 122.2 of the EU treaty which allows for support for governments during “exceptional circumstances”. It thus circumvents the eurozone’s no-bailout principle.

The €440bn loan guarantee mechanism will be organised on an intergovernmental basis between the 16 eurozone member states.

Why the intergovernmental structure for the overwhelming bulk of it?  For political and legal reasons – first, to deal with German constitutional legal concerns and, second, to deal with British political concerns that it could be dragged into indirect liability if the fund were handled through Brussels institutions.  The governments will provide credit guarantees; the intergovernmental SPV will use the guarantees to raise money on the capital markets.  The 60 bn euro piece from the EU directly will come in the form of debt collateralized by the EU’s own budget.

My colleague and a rising star in sovereign debt studies, Anna Gelpern, has a new and important post at the Roubini blog, on the question of where Greece goes with the new announcement of a trillion-dollar fund.    The opening:

Leading economists and editorialists say Greece will restructure its debt (here, here, here, here and here are just a few examples).  Many say so because they see so much in common between the spiraling European crisis and past crises in the emerging markets.  The analogy has merit, and until recently, I too subscribed to it.  Now I am not so sure.  This is because the benefits of restructuring now are oddly remote, because Greece has the legal leverage to extract a deep debt haircut if and when it can maximize its benefits, because the EU needs time to get its act together and seems willing to pay for it—and because, as a descriptive matter, the global political commitment behind the no-restructuring option is without precedent.  And sovereign debt is nothing but political commitment.

The post goes on to offer six reasons why restructuring is not likely for now.  Trenchant analysis, highly recommended.

Many commentators have raised the idea of requiring banks and financial institutions to issue contingent convertible debt that can be converted to equity as a sort of pre-set form of re-capitalization in case of trouble.  Greg Mankiw has said that it is his favorite idea in financial regulation reform.  He has pointed to reports that Swiss authorities are going forward with a version of it for large Swiss institutions.  Here is how Mankiw described the idea in a recent NYT column:

MY favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

Bankers may balk at this proposal, because it would raise the cost of doing business. The buyers of these bonds would need to be compensated for providing this insurance.

But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.

I agree it is a good idea.  But I’d like to ask what this would look like from the finance lawyer’s drafting point of view.  Suppose you proposed to do what Professor Mankiw says above.  First off, can anyone point me in the direction of any actual examples of what this is – any examples of convertible bond documents online designed to do this?  Any bond documents for this exist in real life?

Second, what would be the basic functional terms of the bond that would make this happen – what would the triggers be?  And finally, what would be the covenants and protections for, e.g., the regulator, the financial institution, and the bondholder?  What would they want to be protected against, respectively?

For that matter, is there any reason to think that while aligning some interests in controlling leverage, this proposal either creates other unintended perverse incentives, or perhaps creates other kinds of possibly unresolvable conflicts of interest between these three parties (and potentially the existing shareholders as well).  Put on your bond lawyer hats!

Update:  The Lincoln version of the derivatives legislation clears the Senate Agriculture Committee today (which raises another set of issues, different from the ones under discussion below):

Democrats won the support of a senior Republican who voted in a Senate committee Wednesday for a sweeping overhaul of the market for derivatives, the complex financial instruments at the heart of the financial crisis.  The backing from Sen. Charles Grassley (R., Iowa) is the first sign of what Democrats hope will be an eventual wave of Republican support …  The move was also significant because Mr. Grassley said he favored one of the bill’s most controversial elements, a provision that could force Wall Street banks to spin off their derivatives trading desks.   The 13-8 vote in the Senate Agriculture Committee came as Senate lawmakers appeared to be inching closer to a deal on a broader remake of market rules.

The New York Times reported yesterday on negotiations over financial regulation legislation, and included this comment on derivatives regulation and Wall Street:

The derivatives bill, which is expected to be folded into the sweeping overhaul of the nation’s banking system, would also require most derivatives trades to be routed through a third party, known as a clearing agent. That would provide each of the parties a guarantee that they would be paid if the other party defaulted or went out of business. The bill would also require most derivatives to be traded on an open exchange.

Currently, the only way to trade many derivatives is to call up various dealers and ask for the price at which they are willing to buy or sell. The securities dealer profits from the difference between the prices at which it buys from one party and sells to another. Investors rarely, if ever, see details on the other side of the trade. Wall Street has signaled that it can live with a clearinghouse approach, but it is strongly opposed to exchange trading of derivatives, which would introduce price competition and lower the profits.

I think it’s fair to quote those two grafs from the lengthy article, which covers many aspects of the bill negotiations.  Here is my question – and it’s a genuine question, I’m not sure exactly what to think.

I had more or less assumed that Wall Street would be bothered more by a clearinghouse than an exchange, if it were one or the other and not both.  Why?  I assumed Wall Street would be concerned that a clearinghouse serving as a centralized counterparty would be motivated to contain its risk, by limiting margin and generally limiting leverage on the contracts for which it ultimately was responsible to clear.  The exchange seemed much weaker as a regulatory device because it would not have the ability, or at least the same incentives, to limit margin.  The exchange would help matters by making public the prices and counterparties, but not act to clear and, so, have to think about its own risk.  (If you had both, however, you would have the advantages of an entity motivated to limit risk and with public information on prices by which to help the determination of regulatory margin.  But we’re assuming here it is one or the other, although I myself strongly would like to see both.)

So I was surprised to read this passage and see my assumptions turned on their head.  And maybe I should never have been surprised, and this ordering preference should have been obvious.  But it did surprise me.  Which then leads me to the further thought, what is Wall Street’s assumption on the NYT’s description of its ordering preferences?  Wall Street prefers a clearinghouse that takes central counterparty risk but which should then address attendant risks?  Why?  Is it because of an assumption that – in a market that does not publicly post prices for everyone to see – if leverage gets out of control, the central clearinghouse will serve as the clearer of last resort?

In other words, does a clearinghouse without a public posting of exchange prices increase or decrease the likelihood that the central clearinghouse (in practical effect backed by the Federal government, which blessed the system through legislation after all) run the serious risk of serving as the next Wall Street bailout mechanism?  The New Fed-Market Put Option?

I don’t know the answer to this; this reporting surprised me, so I put the proposition to you.  Or have I misconceived Wall Street’s motivations or misunderstood what this ordering preference is all about?  Please stay on topic here and directly address these issues.

(Update 2.  Also see Gary Gensler urging a clearinghouse in the Wall Street Journal today, and Thomas Jackson and David Skeel, also in today’s WSJ, urging that derivatives be treated like other contracts in bankruptcy as a mechanism by which failed parties could have the regular bankruptcy protection against contract enforcement and so avoid cascading risk – and financial firms would not have to put (or give up) their customized derivatives onto exchanges (i.e., make everything into a uniform plain vanilla derivative).)

I’m sure many VC readers have been looking at the papers today, trying to sort out facts versus allegations, in the SEC suit against Goldman Sachs for fraud involving CDOs.  The Wall Street Journal, New York Times, Washington Post, and Financial Times all have good stories, to take the papers from my front lawn.

One of those stories (they have all, ahem, melded together in my mind) remarked that if sustained in court, and quite possibly even if not, the fraud suit and the narrative it tells, has the possibility of significantly altering the perception of the financial crisis, or at least its relationship to complex derivatives.  Away from a (possible, anyway one I share) perception of banks that didn’t much care about the down-stream performance of their products because they would get paid up-stream anyway – a perception of a systemically driven indifference, but not necessarily fraudulent, toward knowing, deliberately constructed malfeasance, understanding pretty well that these CDOs were headed to the dust-bin of history.

Such a shift in perception might come about regardless of whether this narrative is established as factually correct or not.  Another version might be that most of Wall Street was complacent and badly incentivized, so as to not care about credit quality – whereas Goldman Sachs, being the Masters of the Universe and Smarter Than the Average Bear (Stearns -ed.), uniquely saw it coming  and, in this case at least, protected itself and even figured out how to profit, but alas through fraud.

One of the problems with trying to say much at this stage about the legal analysis is that it is so factually driven.  If the facts are as the SEC alleges, well, then, bad, bad Goldman!!  But  on these allegations, there’s not a lot of room for legal nuance, although I am happy to be corrected on that in the comments, not being a securities litigator.  So, here’s my question for the comments.  Assume that the facts are as alleged.  In that case, is there an important legal issue, or is it the application of straight securities fraud principles?  Is there an alternative, plausible reading of the facts?  And is there an alternative, plausible factual reading that creates an important legal question?

That’s with respect to the fraud case on its own.  Assume the facts as alleged by the SEC.  What would that argue as a matter of long term regulatory reform in financial markets and institutions and regulation?  Although, frankly, at this stage, I’m more interested in the comments in trying to see whether there’s an important legal issue in the case at hand, as a legal issue.  As the New York Times Room for Debate blog exchange seemed to show, at this stage the systemic lessons people seem to be drawing out of the suit against Goldman are pretty much whatever they thought before the suit against Goldman.

I just finished reading Alan Greenspan’s paper for the spring Brookings economics confab, The Crisis, and then a bunch of reactions around the econo-blogosphere.  The paper is well worth reading – it’s time to get beyond the blame game and the mea culpas and mea non-culpas, in order to get to longer term regulatory reform.  Of the blog reactions, the most interesting, I thought, was Greg Mankiw, who was a respondent on the paper at Brookings:

Alan proposes raising capital requirements and reducing leverage, but he suggests that there are limits to how much we can do so. If we reduce leverage too much, he argues, financial intermediaries will be not be sufficiently profitable to remain viable. He offers some back-of-the-envelope calculations that purport to show how much leverage the financial system needs to stay afloat.

When I read this part of the paper, my first thought was: What about the Modigliani-Miller Theorem? Recall that this famous theorem says that a firm’s value as a business enterprise is independent of how it is financed. The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners. But it does not affect whether the firm is fundamentally viable as an on-going concern. It seems to me that, as least as first approximation, the logic of this theorem should apply to financial intermediaries as well as other types of business. If not, we need some explanation as to why.

Note that this is a different objection to imposing higher/firmer/objective/fixed minimum/what have you capital versus leverage requirements than is sometimes made – viz., that no one, least of all regulators, is in any good position to be able to determine the proper level, and that, therefore, the problem ought to be to ensure that risk falls so as to ensure that those that should care, do care.  Greenspan is suggesting, rather, that without some minimum level of leverage that might well turn out to be crisis-inducing risky, financial firms will not have a sufficient level of profitability to remain in business.  I might have misunderstood that reading the paper, so if (and only if) you have read the paper, feel free to correct me in the comments.

If my understanding of the paper is correct, I think my reaction would be … as compared to what alternative on a risk adjusted basis?  It seems to me that the problem identified here is a “gotta get up and dance” issue – if on a short term basis, all your competitors are engaged in a certain level of leverage, and are hitting certain rates of return while, in fact, taking inefficiently high risks considered over a longer run, then, sure, you might not remain in business.  If, on the other hand, leverage for all market players (at least in the taxpayer guaranteed sector) is constrained, sure, rates of return will be lower.  But if the effect, on a long term basis, is to force return to take into account risk, and properly price it for all players, then capital will flee the sector and threaten, perhaps, to put financial firms out of business only insofar as capital wants to take greater risks for greater returns in other asset classes and investment opportunities.

But of course I might have misunderstood something fundamental, particularly since Greg Mankiw zooms in on something quite different, Miller and Modigliani.  He asks what M&M would have to say about Greenspan’s argument – and maybe he is saying something similar to what I suggest above, although I have focused on short term versus longer term risk versus return:

I have a hunch as to where, from the Modigliani-Miller perspective, Alan’s calculations go awry. Alan assumes that the rate of return on equity must be at least 5 percent. But this number should be endogenous to the degree of leverage. If a bank is less levered, its equity will be safer. (It will be like a combination of today’s equity and bonds.) As a result, the required rate of return should fall.

Thus, Mankiw goes on, a less levered – indeed, wholly unlevered – bank should do just fine with a rate of return that reflects the decreased risk.  Investors who want that kind of safety as part of their portfolio will gravitate to that bank.  The problem, as I suggest above, is when risk and return in the capital market for all firms is skewed so as to favor getting up to dance in the short term.  But then Mankiw raises the general question of the applicability of M&M to this case:

To put the point most broadly: The Modigliani-Miller theorem says leverage and capital structure are irrelevant, while undoubtedly many bankers would claim they are central to the process of financial intermediation. A compelling question on the research agenda is to figure out who is right, and why.

Actually, this seems to me to put M&M in a highly specific context – rather than being the classic question, does capital structure matter to the value of the firm? – this question is quite exact – do leverage and capital structure matter to the process of financial intermediation?  If the question is financial intermediation alone – so-called narrow banking – I’d hazard that it still matters.  Mankiw proposes a thought experiment with a wholly unleveraged bank – could it supply financial intermediation?  Answer, presumably yes, at least if the playing field for capital is level, so that return reflects risk.

But isn’t the more difficult question, if one is following the symmetry of M&M, to ask, can a bank perform the functions of financial intermediation with something close to total leverage?  Wouldn’t M&M suggest it should be able to do that as well?  And hasn’t the meltdown suggested that, for some reason, it doesn’t work that way – rather than being symmetric as pure M&M in a pure world would suggest, in our world, firms, leverage and assets are asymmetric?  To be sure, the financial intermediation part might have worked just fine, which, true, confirms Mankiw’s point.  But the firm itself seems not to have worked – meaning, those arguing that in our world, capital structure and degree of leverage matter, and even matter with respect to a firm conducting financial intermediation, given that if the firm goes kaput on account of overleverage, the intermediation collapses with it?  Which is another way to say, Mankiw suggests through the unlevered thought experiment that financial intermediation can be “unbundled” from the rest of a financial services conglomerate, and that seems right.  But it seems equally right – and not consistent with “pure” M&M in a “pure” world – that you can’t successfully “bundle” them, at least not to the leveraged limit. Continue reading ‘Greenspan’s ‘The Crisis’ and Modigliani and Miller’ »