Archive | Financial Crisis

GM Benefits from Tax Law Ruling

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

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Did Dodd Read His Own Bill?

In the past few days there has been speculation that President Obama would name Harvard law professor Elizabeth Warren to be the interim head of the new Consumer Financial Protection Agency (CFPA) created by the Dodd-Frank financial reform legislation.  What did Senator Chris Dodd think of this? TPMDC reports:

In dismissing the rumor last night, though, Senate Banking Committee Chair Chris Dodd — who authored the law — claimed he’d never heard of the interim appointment power.

“I don’t know what it is. I never heard of it before,” said a flabbergasted Dodd to TPMDC. “It’s kind of unique isn’t it?”

Yes it is somewhat unique — the interim appointment would be different than, say, a recess appointment — but the Dodd-Frank legislation provides for interim stewardship of the agency. From TPMDC:

The authority for the Treasury Department to grant an interim appointment — distinct from a “recess appointment” — comes from the financial reform law itself.

To be fair to Senator Dodd, the law does not use the phrase “interim appointment,” but it expressly authorizes the Treasury Secretary to “perform the functions of the Bureau . . . until the Director of the Bureau is confirmed by the Senate.”  This authority would entail naming someone to head the agency until an official director could be confirmed by the Senate.  Presumably this provision was included for a reason, such as to ensure that the new agency could begin work even if either the President or the Senate drags their feet in naming or confirming a new agency head.  But don’t ask Senator Dodd about it.  Even though he was lead sponsor on the bill, he can’t be expected to know everything that’s in it.

(Hat tip: Daniel Foster at NRO) [...]

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Systemic Risk, the Fed, and ‘Regulatory Casuistry’

With an eye to Ben Bernanke’s upcoming testimony to the Financial Crisis Inquiry Commission during the two days of hearings on “too big to fail” – in other words, systemic risk – the WSJ has an editorial in today’s paper raising various questions about the basis on which the Fed, the FDIC, and other agencies concluded that AIG, Bear Stearns, Wachovia, and others qualified as “systemic risk” exceptions allowing for extraordinary actions – i.e., bailouts.

I follow the systemic risk discussions pretty closely, as part of a current writing project, but I realized that I had not been tracking the FOIA requests surrounding some of the US government actions – in part because the government doesn’t seem to be much interested in responding to them.  The general point of the FOIAs is to try and get an understanding of what particular government agencies, and the Fed and FDIC in particular, believed constituted systemic risk, along with an account of how the concept was applied in practice in 2007-2009.  The conclusion of the editorial is, I think, right in the question it poses:

Two years after the bailouts and more than a month after President Obama signed into law new authority for the government to prevent “systemic risk,” Washington still won’t tell us what this term means. Releasing the history of 2008 would at least allow us to know what regulators thought it meant at the time, with lessons for the future.

I agree that the question takes on more importance given the new legislation that confers even more discretionary authority on the Fed to address questions of systemic risk.  What the Fed understands by that term as applied in particular circumstances – which is to say, as a concrete regulatory term, and not just as a matter of a conceptual [...]

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David Zaring Offers a Comment on ‘Regulation by Deal’

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 [...]

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A Return to ‘Regulation by Deal’?

(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 [...]

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Mallaby on Soros and the Pound, and Some Other Summer Reading in Philosophy and Economics

The Atlantic is running an excerpt from Sebastian Mallaby’s new book, More Money Than God: Hedge Funds and the Making of  New Elite, which is out on June 14.  The excerpt covers the famous moment when George Soros broke the pound in 1992.  (It was then that I went to work for him, as general counsel to his charities, but mostly I remember people running in and out of rooms bringing him faxes while he was holding simultaneous meetings on assisting Eastern Europe.)  Mallaby is a terrific writer, and if you have any interest at all in the topic – and Mallaby is outstanding at bringing together the matters of finance and money with politics and power – you are likely to be interested in this book.  It is definitely on my summer reading list, although I am desperately hoping for a Kindle version, as I will be traveling and can’t haul around a lot of stuff.

On hedge funds and private equity in a different direction, I received an examination copy of a new textbook, An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm, by David P. Stowell.  It is excellent – clear, informative, well-written.  It is aimed at an undergraduate course audience, perhaps in the upper classes, but would also be perfectly useable in business school as an intro text, as well as in law school as an introductory class in these topics, if the professor were able to supplement it with legal materials.  (In fact, that might make an easy way to create something that does not now seem to exist for law school – a private equity-hedge fund text that covers both the business and legal aspects.  A fix for that might be to use this book, with a detailed [...]

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How to Make the Bureau of Consumer Protection More Consumer Friendly:

From the beginning of the financial reg reform debate I’ve supported the idea of a more coherent and integrated institutional approach to consumer financial protection.  I’ve also consistently argued that a failure of consumer protection was not a major cause of the financial crisis, misaligned incentives were the problem.  In my view the two questions are distinct–I think we need streamlining of the system of consumer protection regardless of whether it caused the crisis, in order to make it more responsive to market dynamics and consumer choice.

And, in fact, there are a few things in the legislation that do that–for example, there is a requirement that the new agency create a new, single form for mortgage disclosures that should help consumers.

So what’s my gripe?  Mainly that the philosophy of the CFPB is predicated on bad economics and a faulty understanding of consumer behavior and that the overall effect of the agency will be negative for consumers–higher prices, less innovation, less competition, less access to mainstream credit and greater use of “fringe” lending products, and ironically, increased threats to the safety and soundness of the banking system.  The fact that the House and Senate appear to be headed for the enactment of some sort of legislation is pretty strong evidence that the Democratic majority in Congress disagrees with me.

I’ve not heard any supporters of the CFPB credibly argue that the overall effect of the new bureaucracy will be to make credit cheaper or more widely available.  Some have argued about the size of the effect–whether it will make consumer credit a lot more expensive or just a little bit more expensive.  But I don’t know of anyone who has contested the sign of the effect–that it will make credit more expensive.

So with that in mind, here’s three [...]

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More Musing on Liquidity and Solvency Distinctions in Sovereign Debt Crises

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 [...]

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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. [...]

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Bankruptcy Reform Instead of Bailouts

Nobody likes bailouts, but what’s the alternative?  Stanford economist John Taylor has an interesting op-ed in today’s WSJ suggesting that proper reforms of the bankruptcy code could reduce the need for the federal government to retain legal authority to bail out ailing financial firms.  Here is the core of his proposal:

During the past year since the administration proposed its financial reforms, bankruptcy experts have been working on a reform to the bankruptcy law designed especially for nonbank financial institutions. Sometimes called Chapter 11F, the goal is to let a failing financial firm go into bankruptcy in a predictable, rules-based way without causing spillovers to the economy and permitting, if possible, people to continue to use its financial services—just as people flew on United Airlines planes, bought Kmart sundries and tried on Hartmax suits when those firms were in bankruptcy.What would a Chapter 11F amendment look like? It would create a special financial bankruptcy court, or at least a group of “special masters” consisting of judges knowledgeable about financial markets and institutions, which would be responsible for handling the case of a financial firm.

In addition to the normal commencement of bankruptcy petitions by creditors or debtors, an involuntary proceeding could be initiated by a government regulatory agency as prescribed by the new bankruptcy law, and the government would be able to propose a reorganization plan—not simply a liquidation. Defining and defending the circumstances for such an initiation—including demonstrating systemic risk using quantitative measures such as interbank credit exposures—is essential.

Third, Chapter 11F would handle the complexities of repurchase agreements and derivatives by enabling close-out netting of contracts in which offsetting credit exposures are combined into a single net amount, which would reduce likelihood of runs.

Fourth, a wind-down plan, filed in advance by each financial firm with its regulator,

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An Unwelcome Endorsement

According to The Hill, Goldman Sachs CEO Lloyd Blankfein endorsed the financial regulation reform legislation during his Senate testimony today.

“I’m generally supportive,” Blankfein told the Senate Permanent Subcommittee on Investigations.

Wall Street will benefit from the bill because it will make the market safer, Blankfein said.

“The biggest beneficiary of reform is Wall Street itself,” he said. “The biggest risk is risk financial institutions have with each other.”

I don’t think this says much about the merits of the legislation, particularly because Blankfein also confessed not to know all of the bill’s details, but I suspect it could affect the politics. [...]

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Contingent Convertible Debt

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 [...]

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The SEC Split Over Goldman

The Washington Post has an interesting story on the 3-2 split on the Securities and Exchange Commission over whether to file charges against Goldman Sachs.  According to the story, Republican appointees Kathleen Casey (a former Hill aide) and Washington Univeristy law professor Troy Paredes, “were skeptical that the evidence showed that Goldman had misled its clients because the investors were big, sophisticated firms who should have known what they were doing.”  They also raised concerns that filing a flawed case could hurt the agency’s reputation, which is already smarting from its failures to uncover the Madoff ad Stanford fraud schemes.

The dissenting commissioners are not the only ones to raise questions about the SEC’s case.  Sebastian Mallaby and David Zaring also have questions.  Professor Bainbridge also looks at the suit’s timing. [...]

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Derivatives Clearinghouses and Exchanges

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

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The Goldman Fraud Suit

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, [...]

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