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. [...]
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 [...]
(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 [...]
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
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 [...]
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 [...]
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
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, [...]
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 [...]
Two items in today’s Wall Street Journal (Tuesday, March 9, 2010) capture two different views of regulatory reform of credit default swaps. The first is the emerging European view:
European leaders pushed for a ban on speculative bets against government debt following recent financial turmoil in Greece … German Chancellor Angela Merkel said Tuesday that her government is backing an initiative to curb the credit-default swaps market, together with France, Greece and Luxembourg, and she suggested Europe would forge ahead on its own even if the U.S. didn’t go along.
José Manuel Barroso, president of the European Commission, the European Union’s executive arm, said the commission would examine closely the possibility of banning outright “purely speculative” trading of the swaps …
The ban now being discussed in Europe would allow investors to use the contracts to hedge against possible defaults by government borrowers, but prevent them from taking purely speculative positions. “It’s hard to justify why market players should purchase insurance against risks to which they are not themselves exposed,” Mr. Barroso said.
There are a number of responses one could make to the EU’s Barroso (below the fold, I put what appears to be the implied Obama administration view). Contrast this, however, with the March 9, 2010 speech by CFTC Chair Gary Gensler on CDS regulatory reform. Gensler did not suggest attempting to ban “speculative” trading in CDS, but did endorse three general reforms to the CDS (and more generally the OTC derivatives) market:
The 2008 financial crisis demonstrated how over-the-counter derivatives – initially developed to help manage and lower risk – can actually concentrate and heighten risk in the economy.
A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, no matter where traded or marketed. It should include interest rate swaps,
Not everyone is quite so fascinated as I with CDS spreads on Greek sovereign debt. However, the issues raised by the Greek debt difficulties and the urgent discussions in the Eurozone over a possible bailout, attendant moral hazard, and the like are far more than merely fiscal or monetary questions. Rather, this crisis is one of those instances in which the deep economic and financial problems directly reflect the questions of founding political design. Political economy in its purest sense. Regardless of what one thinks the right policy for the EU, Germany, Greece, and others, is at this moment, economist Otmar Issing’s Financial Times comment today (Tuesday, February 16, 2010) lays out a lucid statement of the foundational political issue of monetary union without political (or fiscal) union:
It seems that quite a number of observers have forgotten what Emu is, and what it is not. The monetary union is based on two pillars. One is the stability of the euro, guaranteed by an independent central bank with a clear mandate to maintain price stability. The other is fiscal solidity, which has to be delivered by individual member states. Member countries are still sovereign. Emu does not represent a state; it is an institutional arrangement unique in history.
In the 1990s, many economists – I was among them – warned that starting monetary union without having established a political union was putting the cart before the horse. Now the question is whether monetary union can survive without such a political union. The current crisis must be handled in such a way as to produce a positive answer. The viability of the whole framework – nothing less – is at stake.
By joining Emu, a country accepts its rules. Greece, moreover, also knew that adopting a stable currency that was not
The former General Counsel of Long Term Capital Management – it of the late 1990s near global financial meltdown – James Rickards, had a comment in the Financial Times a few days ago (Feb 11, 2010) on the credit default swap market and Greek sovereign debt. Key section:
Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?
When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.
Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.
Eventually the money flow will be
Political scientist Jeffrey Friedman has an excellent article arguing that political ignorance by both regulators and voters played a key role in causing the financial crisis:
You are familiar by now with the role of the Federal Reserve in stimulating the housing boom; the role of Fannie Mae and Freddie Mac in encouraging low-equity mortgages; and the role of the Community Reinvestment Act in mandating loans to “subprime” borrowers, meaning those who were poor credit risks. So you may think that the government caused the financial crisis. But you don’t know the half of it. And neither does the government….
Given the large number of contributory factors — the Fed’s low interest rates, the Community Reinvestment Act, Fannie and Freddie’s actions, Basel I, the Recourse Rule, and Basel II — it has been said that the financial crisis was a perfect storm of regulatory error. But the factors I have just named do not even begin to complete the list. First, Peter Wallison has noted the prevalence of “no-recourse” laws in many states, which relieved mortgagors of financial liability if they simply walked away from a house on which they defaulted. This reassured people in financial straits that they could take on a possibly unaffordable mortgage with virtually no risk. Second, Richard Rahn has pointed out that the tax code discourages partnerships in banking (and other industries). Partnerships encourage prudence because each partner has a lot at stake if the firm goes under. Rahn’s point has wider implications, for scholars such as Amar Bhidé and Jonathan Macey have underscored aspects of tax and securities law that encourage publicly held corporations such as commercial banks — as opposed to partnerships or other privately held companies — to encourage their employees to generate the short-term profits adored by equities investors…..