Archive | Finance

Rating Agencies Doing Fine, Thanks

The Lex column in the Financial Times reports that the rating agencies – Standard & Poor’s and Moody’s – are doing financially just fine and, well, even better than fine:

McGraw Hill this week showed the ratings business is on the increase …  Its Standard & Poor’s credit ratings agency, which accounts for the vast majority of the publisher’s profits, produced its first quarterly rise in revenues in two years.

In a business with large fixed costs, any upturn makes a substantial impact on the bottom line. Profitability in McGraw Hill’s financial services division, which includes lower-margin data and research businesses as well as ratings, never hit the lofty peaks of rival Moody’s with an operating margin of some 55 per cent. Nevertheless, S&P still managed to reach a 40 per cent margin, having merely dipped to 34 per cent at the end of 2008.

I have found it remarkable how little scrutiny has been focused on the rating agencies, and how little has been done – sensibly or foolishly – to revamp their incentives and business models.  There was some discussion of cutting off the implicit regulatory monopoly created by regulations specifying their services; I am not sure even that has gone anywhere, though I haven’t checked recently.  However, Lex adds this cheerful thought:

In spite of widespread gnashing of teeth over rating agencies’ role in the crisis, both companies are even thought to have increased their fees this year. Furthermore, proposed regulation looks less onerous than first feared. McGraw Hill estimates that extra regulatory costs, such as more compliance personnel, will be half what it originally thought.


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Market Discipline? What Market Discipline?

The New York Times reports that Congress and the administration might soon reach some kind of view on legislation for addressing “too big to fail” institutions.  Off the table is Paul Volker’s proposal to re-establish some line between commercial banking and proprietary trading – some updated Glass-Steagall demarcation.  On the table is the Treasury’s proposal to designate various institutions as “too big to fail” in various degrees and subject them to greater capital requirements, limits on risk-taking, and in addition require a so-called “living will” that would make clear how to disentangle these institutions from others in a crisis.  I think the “living will” idea is not a bad one on its own, as long as we all understand the limits of what it gets you.

Much, much more puzzling to me is this description in the Times, quoting Michael S. Barr, assistant Treasury secretary for financial institutions (italics added to show the quote):

The White House plan as outlined so far would already make it much more costly to be a large financial company whose failure would put the financial system and the economy at risk. It would force such institutions to hold more money in reserve and make it harder for them to borrow too heavily against their assets.

Setting up the equivalent of living wills for corporations, that plan would require that they come up with their own procedure to be disentangled in the event of a crisis, a plan that administration officials say ought to be made public in advance.

“These changes will impose market discipline on the largest and most interconnected companies,” said Michael S. Barr, assistant Treasury secretary for financial institutions. One of the biggest changes the plan would make, he said, is that instead of being controlled by creditors, the process is controlled

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Dividing Financial Institutions into Utilities and Casinos?

One proposal for addressing too big to fail, or to systemically interconnected to fail, among financial institutions is to separate out the proprietary trading and other “casino” activities from the “utilities” business of commercial banking with the public.  In some ways (not all) it is a revival of the Glass-Steagall approach.  Paul Volker has urged such a policy, as have others.  The Obama administration has not so far shown any appetite for such it, preferring, in its Treasury blueprint for reform, to allow the functional interconnections within holding company structures, and identifying institutions that are regarded as too big or too systemically interconnected to fail and apply “regulation and last resort lending” to apply to them.

Something like the same debate is taking place in Britain, and the Financial Times’s Martin Wolf makes a comment on why one could see the functional separation desirable, but also why it is hard to do and hard to ensure that it actually reduces the systemic risk.  In response to a recent speech by Mervyn King of the Bank of England calling to separate out the “casinos” from the “utilities,” Wolf says:

it is evident why this distinction is appealing. If we define the utility parts of the financial system narrowly, as management of the payment system, it works like clockwork. It is in the management of risk (and the advice given to its clients) that the financial system fails. The limited liability businesses at the heart of our credit-based monetary system have a tendency to mismanage risk (and uncertainty), with devastating results.

However, he ultimately says that he is unpersuaded that a modernized form of Glass-Steagall can work as a structural solution to systemic risk:

Yet I remain unpersuaded that the structural solution – the separation of utility from casino finance – is

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Treasury Inc.: Is the Government a Controlling Shareholder?

In my last post I opened a discussion about my new paper, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, which you can download here.  My thesis is that corporate law and theory goes haywire when the government, while enjoying sovereign immunity protection from corporate and securities law, takes control of a company by owning shares.  But does the government really control TARP companies?

When Treasury initially sold Congress on the bailout, the plan was to create all sorts of nifty market-oriented structures to reinvigorate the market for troubled assets.  But once the government got the money, it used most of the first $300 Billion to buy stock in over 600 troubled banks (from Citigroup and Bank of America to your local First State bank).  Eric Posner warned us about this sort of surprise.  Some of the stock is non-voting preferred stock that gives Treasury the ability to appoint directors in certain circumstances, for other companies like Citigroup the stock is voting common equity.  The share purchase program was later extended to the automotive sector by Tim Geithner.  The question is whether the government is a controlling shareholder based on its percentage of share ownership, the fact that the government regulates banks, and the fact that it  loans them a lot of money.

Control is an elusive concept.  What does it mean to control something?  Is it the power to dictate demands, to encourage, to threaten, or maybe the power to destroy something if you wanted?  Some forms of control require force.  Then again, sometimes control can be exhibited more powerfully through a sublime and unspoken understanding, the Godfather-esque “I give him an offer, he don’t refuse.”  It is a question not lent to easy answers, and yet corporate and securities law is riddled with special [...]

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A Transaction Tax on Financial Transactions?

The Wall Street Journal has a new story from over the weekend on Democratic proposals, in Congress and the administration and from outside groups, to impose a tax on financial transactions (John D. McKinnon, Democrats Weigh Tax on Financial Transactions, WSJ, October 10, 2009):

Taxing financial transactions on Wall Street is gathering support in high places.

With federal budget deficits soaring, policy makers and other advocates are eyeing the huge sums that could be raised as a way to cover the costs of new initiatives.

Labor unions, in particular the AFL-CIO, have proposed a financial-transactions tax as a way to defray costs of a health-care overhaul. Lawmakers have discussed a similar fee as a way to cover the cost of future financial oversight. Liberal advocates are pushing the tax to pay for new stimulus spending.

Financial transactions taxes, whether on the US domestic level or the often-proposed international “Tobin tax,” are sometimes described simply as broad based revenue raisers, and sometimes described as ways of deliberately slowing down the movement and flow of capital.  As a revenue raiser, one current proposal operates this way:

This week, the left-leaning Economic Policy Institute floated the idea of a national transaction tax that would raise $100 billion to $150 billion a year. The tax, at a rate of 0.1% to 0.25% of the value of the trade, would be levied on all financial transactions such as stock trades, but not on consumer transactions such as with credit cards.

The money would be used initially to pay for temporary aid to states, hiring incentives for public- and private-sector employers and school construction money.

“We are in a difficult time right now, so people are looking at every opportunity to gain some revenue to fund” new initiatives, said Rep. Stephen Lynch (D., Mass.), a

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Proposing New Law School Finance Courses – Bleg

I’m considering submitting two new course proposals to our curriculum committee at our law school here in DC.  I’d be grateful for your pedagogical advice.

One would be a reading-research seminar in law and economics on the current state of debate over the Efficient Market Hypothesis.  I imagine we would read some standard economics articles and material running back over the last few decades, including classics like A Random Walk Down Wall Street, but also a couple of recent books on the debate, including Justin Fox’s The Myth of the Rational Market, and perhaps Dick Posner’s book, among other things.   One specifically law school connection would be to help students understand how the theory underpins much regulation, how courts view cases, many parts of the law itself.

The second class would be on financial derivatives, considered as contracts.  We already have a class on derivative regulation at my school – this would be a class specifically on the contracts themselves, and the economic context in which the derivatives are used.

Would those seem like useful seminar courses for business law students in their third year of law school?  Or yet another example of professor doing what interests him without much attention as to pedagogical utility?  We are a solid mid tier school, in DC; many, many of our students go into government regulatory agencies dealing with the economy. [...]

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The Davis Polk Financial Crisis Manual

Via TaxProfBlog, I discovered the Davis Polk Financial Crisis Manual, in pdf.  I read it quickly while covering my wife’s classes at St. Alban’s today – all quizzes and tests, so I had time to read while the boys were struggling with conjugating the pluperfect in Spanish.  It’s really very good.  279 pages and available free online.  Congratulations to Davis Polk – so many of these law firm publications are just not readable; they tell you something about the limits of lawyers, not so much as writers but as editors.  This manual is genuinely useful.  I’ll certainly be using it, and I will be certain my students do as well. [...]

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