Tuesday, March 30, 2010

ObamaCare Highlights Weaknesses Of CBO Cost Estimating Process

To prevent unrealistic Congressional Budget Office projections of the effects of proposed legislation on the US deficit and budget, CBO must make changes to its process for evaluating the cost of new legislation.

In passing health care reform, Congress was mindful of the Congressional Budget Office's tally over the next decade of the net cost of the final legislation. In particular, Congress manipulated the structure and timing of the law's taxing and spending provisions to meet Obama's $900 billion cost target.

CBO does an honest, best guess analysis of the expected costs of proposed legislation, but CBO works within the cost estimating guidelines established by Congress. For example, CBO projects expected revenues and costs from new legislation under the assumption of a static economy, and it ignores the effect of other likely legislation.

Unrealistically, CBO estimates that new taxes or new mandated employer costs do not change consumption or tax revenue estimates. When economists model tax or price changes, they use more realistic dynamic stochastic general equilibrium (DSGE) models and not static models. DSGE models attempt to accurately reflect behavioral changes caused by tax, cost and price changes. DSGE models of the new health care reform law would show that the new law slows economic growth, slows employment growth, and that tax revenue will be lower than expected.

Furthermore, CBO follows rules that require it to evaluate only the legislation under review and not to consider other likely Congressional laws. For example, in recent years, Congress passed a one-year law delaying legally mandated Medicare cuts. When CBO evaluated ObamaCare, it included the new Medicare cuts in ObamaCare as potential cost savings because they are legally mandated. It ignored the high likelihood that Congress would pass another law delaying or reducing the proposed Medicare cuts. It also ignored that Medicare cost increases were unsustainable and that Congress would pass cuts out of necessity without the passage of ObamaCare.

As a result of CBO's process, the new health reform law contains tax and cost saving provisions that reduce CBO's cost estimate and increase CBO's revenue estimates but that do not reflect realistic, real world, estimates of those numbers.

A President and a Congress who truly cared about the long-term US deficit, the looming high taxes, and the continued affordability of government social programs would modify CBO's process for assessing the costs and revenues of new programs, taxes, and legislation to reflect real world effects.

To accurately reflect the growth, employment, tax and cost effects of new legislation, the CBO must modify its legislative cost and revenue estimating process. CBO needs to switch to a dynamic, as opposed to static, modeling of the economic effects of new legislation. It also needs to take into account likely subsequent legislation that would undo part of the revenue or cost benefits of the legislation under review.

It would make a lot more sense for CBO to give separate numbers and a range as part of its analysis instead of one net number. CBO should give a range, under dynamic modeling, for likely costs and likely revenue of the new legislation and a likely high and low net cost. Additionally, CBO should forecast the effects of the passage of other likely legislation that would significantly affect the costs or revenue impacts of the legislation under review.

The proper changes to CBO's cost estimating process would eliminate a lot of the unrealistic political budget deficit gamesmanship that occurred during the debate for health care reform. The suggested changes would improve the accuracy and usefulness of CBO's forecasts. A better CBO forecasting process will also help the US reduce its long-term budget deficit.

Sunday, March 28, 2010

The New Health Care Law Is a Temporary Duct Tape Solution: It Ignores The Basic Economic Forces At Play

Drafting a good [health care reform] bill would have been easy, he [Nobel Economist Gary Becker] continues. Health savings accounts could have been expanded. Consumers could have been permitted to purchase insurance across state lines, which would have increased competition among insurers. The tax deductibility of health-care spending could have been extended from employers to individuals, giving the same tax treatment to all consumers. And incentives could have been put in place to prompt consumers to pay a larger portion of their health-care costs out of their own pockets.

"Here in the United States," Mr. Becker says, "we spend about 17% of our GDP on health care, but out-of-pocket expenses make up only about 12% of total health-care spending. In Switzerland, where they spend only 11% of GDP on health care, their out-of-pocket expenses equal about 31% of total spending. The difference between 12% and 31% is huge. Once people begin spending substantial sums from their own pockets, they become willing to shop around. Ordinary market incentives begin to operate. A good bill would have encouraged that."
From "'Basically an Optimist'—Still: The Nobel economist says the health-care bill will cause serious damage, but that the American people can be trusted to vote for limited government in November," by Peter Robinson in the Wall Street Journal on March 27, 2010.

Just because the new health care reform law was a tough political battle, it will not be the end or the solution to US health care problems.

The new health care law, including its amendments, does little or nothing to undo the economic incentives and forces created by the tax deduction to the employer of the health care employee benefit, the exclusion from employee taxable income of the value of their health care benefit, the expectation that health insurance will cover all health related costs, that health related costs are primarily paid by third party payers with no incentive for the user to limit or negotiate costs, government mandates of excessive minimum coverage, and the inability to risk price insurance.

Any architect who ignores the physical laws of nature, such as gravity and the structural strength of his materials, will watch his building collapse before his eyes. The new health reform law ignores all the economic and incentive forces at play in current health care and attempts to contain these forces through patches and duct tape. The new health care law is doom to failure. It is just a matter of time until the forces created by the employer tax deduction, the third party insurance payment system, and the lack of price transparency to the end user make the new law unworkable.

Additionally, the new law uses extensive government subsidy to avoid accurate price setting and price transparency. Without market pricing, poor allocation of resources and rationing will occur.

Just as gravity never ceases, the old economic forces that remain after health reform will create a mess of US health care costs and use under the new law.

See my December 15, 2009, post, "Health Care Reform Is Easy: Politics Is Hard"

Wednesday, March 24, 2010

What's Next For US Healthcare?

The new health care law, with or without amendments, is a yet to be built structure. It is an architect's plan of an interpretation of a vision of health care. There are stated and unstated goals that will or will not be met in the final structure once it is erected.

No one truly knows what the final health care system will look like. No one understands how all the parts, all the regulations, all the economic forces, all the wealth distribution, all the changes to health insurance, health care, Medicare, and taxes will interact.

No one knows what GDP effects the new law will have on the health care sector or the entire US economy. No one knows what effect the new spending and most likely increased US debt will have on the Treasury market and on the US dollar.

It will be years before the law is fully implemented and the parts that are set into motion are then again stable.

The Second World War wage freeze indirectly created the employer health care employee benefit and it became one of the prime movers of health care problems 60 years later. Likewise, the new law in a couple of decades will put the US in an economic and political situation it never envisioned.

There are risks to rolling stones down hills. Sometimes, they create avalanches. Sometimes, they are just a few stones rolling down hill.

It is impossible for anyone to say the US will be better or worse for the new law at this time. It will be years before any accurate assessment of the new law will occur.

Like any new house built from plans, there will be some good parts, some minor, easily fixed structural problems, some emergency repairs, some wish list changes and some I learned my lesson never to do again problems.

As of Tuesday, US health care is a ship that has entered uncharted waters. Whether it easily reaches port or faces dangers along the way is unknown. Let us hope enough watchful eyes know how to keep health care on course as it navigates new, uncharted waters. Let us hope the architect's plans of the new structure were enough to build a lasting and sound edifice.

My best guess is that the parts of current health care that people like that are no longer available will be put back into health care. The new parts that people like will stay. Proposed spending cuts that are politically difficult will not be made.

In the end, the US will wind up with an amalgam of old and new health care in a structure that no one envisioned as part of the new legislation with a cost structure very different than projected.

Monday, March 22, 2010

Kling On Mankiw On Banks And Modigliani-Miller

A comment I posted on EconLog, "Banks and Modigliani-Miller" by Arnold Kling:
The Fisher separation theorem says that the investors (shareholders, depositors) are not concerned with the investment choice opportunities (the fruit trees) of the bank, as long as the bank invests in positive NPV (net present value) projects. Investors choose their own positive NPV investment opportunities for their own funds separate from the bank's investment opportunities.

MM [Modigliani-Miller] says that the value of the firm, and consequently, the NPV (net present value) of the projects, is independent of the way that the projects and the firm (bank) are financed.

To the extent that a firm can take a tax deduction for interest payments, the deduction is a government subsidy to firms. It allows borrowers to pay, and the lenders to demand, a higher interest rate due to the government subsidy, which by itself should offset the benefit of the tax deduction. If the lender is also taxed on the interest income, then the two taxes will offset each other. If the taxes are equal, then it will be as if there were no interest deduction and if the two taxes are different amounts, a new equilibrium supply and demand point (interest rate cost of borrowing) will occur depending on which tax is higher and by how much. If the two taxes are equal, as they most likely are, the interest deduction will have no effect on leverage. Likewise, if there is only a tax deduction there will be no effect on leverage due to the higher interest rate. It is only when there are different income and deduction tax rates, that there will be some minor leverage effect.

Deposit insurance is a put option (all insurance is a put option) given to the depositor through the bank by the FDIC. Because deposit rates do not risk adjust due to the put, the bank can invest in a greater number of projects with apparent positive NPVs due to low cost deposits. Some of these projects would have a negative NPV if the deposit interest rate adjusted for the riskiness of the project and the bank. The market, however will risk adjust the rate and treat some apparent positive NPV projects as negative NPV projects and decrease the value of the publicly trade stock of the bank.

Deposit insurance fools management, not depositors, as to their available investment projects.

The deposit insurance will have little or no value to the depositor as long as the market value of the assets of the bank is greater than the value of the deposits. The put option will be out of the money. As the market value of the assets declines, due to bad investments, and no longer covers the amount of the deposits, the put option (the FDIC insurance) becomes in the money and increases substantially in value.

Since the bank transfers its assets to the FDIC for the insurance (put) payment of the deposits to the depositors, the FDIC bears all the risk and monetary loss. The FDIC insurance is only paid when deposits exceeds assets. The FDIC pays the full amount of the deposits and loses the excess amount of the deposits over the value of the assets it receives, deposits minus assets.

The essential transparency that is lacking is the value of the FDIC insurance put by institution. However, the publicly traded equity of the bank reflects both the true NPV of the projects on a risk-adjusted cost of financing and reflects the decrease value of the bank due to the value of the put due to the probability of the exercise of the FDIC put and takeover of the bank by the FDIC.

In effect, tax deductions do not increase leverage because it will increase the cost of borrowing and are probability probably completely offset by the tax on interest income.

Deposit insurance allows banks to invest in otherwise negative risk adjusted NPV projects. While deposit insurance allows banks to invest in unprofitable and negative NPV endeavors, the market price of the asset will be independent of deposit costs or deposit insurance. This is the liquidity funding problem. Banks can have enough funds to invest in a positive NPV valued asset that does not have enough market value to roll over as collateral to fund the asset.

Long-term rates are just the (geometric) average of expected short term rates except for the short-term liquidity premium, and banks will on average just make a small liquidity premium spread. Since long-term rates are just expected averages of short-term rates, half the time the short-term rates will be less then the long-term rates and half the time more than the long-term rate [after adjusting for the short-term liquidity premium]. Half the time, the bank will have a positive interest rate spread and half the time it will have a negative interest rate spread.

Sunday, March 21, 2010

The New Health Care Law Until The Reconciliation Bill Passes

HR 3590, "The Patient Protection and Affordable Care Act" will be the law of the land and the current version of health care law when signed by the President as expected on Tuesday.

The House also passed a subsequent Reconciliation Bill, HR 4872, "Reconciliation Act of 2010" to amend the health care bill they just passed.

The Reconciliation Bill requires a Senate vote to become law and will not become an amendment to the new health care law until the Senate and the House pass, and the President signs, the same reconciliation amendment.

Saturday, March 20, 2010

CBO Scoring Convention Assumes GDP Unchanged By Health Care Reform And Other Laws

When they [CBO] estimate the budget impact of a bill like this [Health Care and Education Affordability Reconciliation Act of 2010], they assume the path of GDP is unchanged....it is just one of the conventions of budget scoring.
From Greg Mankiw's Blog, "A Warning about CBO Scoring."

Wednesday, March 17, 2010

Did A M3 Decline Blindside The Fed And Cause The Economic Crisis

wondering how M3 has behaved compared to M2 or M1 during this crisis. Based on [Gary] Gorton's discussion it would seem that M3 would better reveal the impact of the crisis.
From "The Correct Money Supply Measure for This Crisis" by David Beckworth on the Macro and Other Market Musings blog.

FYI: Money Supply Definitions from Wikipedia:
  • M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.
  • M2: M1 + most savings accounts, money market accounts, retail money market mutual funds,and small denomination time deposits (certificates of deposit of under $100,000).
  • M1: The total of all physical currency part of bank reserves + the amount in demand accounts ("checking" or "current" accounts).
Gary Gorton's paper mentioned by Beckworth with thanks to Mark Thoma is well worth a read. It is an excellent explanation of the mechanism that turned a housing crisis into a banking crisis and an economic recession. The upshot is that the Fed was not watching the repo market as it collapsed and failed to take timely corrective action to replenish this loss of liquidity.

[Addendum: regulation2point0 blog mentioned Gorton's paper on March 6, 11 days before Thoma.]

Large And Small Financial Bubbles Are Similar

Statistically speaking, size doesn’t matter when a financial bubble bursts.

The big crashes may hurt a lot more, but new analyses of “microbubbles” presented March 15 at a meeting of the American Physical Society find that the same mathematical laws underlying massive economic crises are also at work in tiny fluctuations that occur on the order of milliseconds.

The new understanding of economic fluctuations both big and small doesn’t predict when the next economic meltdown will wreak havoc on retirement accounts, said study coauthor H. Eugene Stanley of Boston University. But the results help describe complex financial fluctuations and reinforce the idea that governments ought to have a contingency plan in place for the calamitous collapses that his research describes as inevitable, Stanley said.
From "Big or small, financial bubbles burst alike: Even when they inflate and collapse in milliseconds, the same rules" apply By Laura Sanders in ScienceNews.

Intrade Obamacare Security Collapses Overnight: Loses 50% Value

The Intrade prediction market security that tracks Obamacare lost 50 percent of its value overnight as Bloomberg reported "Health-Care Bill Faces Delay as Democrats Struggle With CBO."

The contract closed on Tuesday at 70.3 and last traded this morning as of 3 AM ET at 35.1.

The security terms require 'Obamacare' health care reform to become law before midnight ET 30 Jun 2010.

Tuesday, March 16, 2010

Users Rationally Reject Security Advice

It is often suggested that users are hopelessly lazy and unmotivated on security questions. They chose weak passwords, ignore security warnings, and are oblivious to certi ficates errors. We argue that users' rejection of the security advice they receive is entirely rational from an economic perspective. The advice offers to shield them from the direct costs of attacks, but burdens them with far greater indirect costs in the form of effort. Looking at various examples of security advice we find that the advice is complex and growing, but the bene fit is largely speculative or moot.
From "So Long, And No Thanks for the Externalities: The Rational Rejection of Security Advice by Users" by Cormac Herley, Microsoft Research. (HT:Slashdot)

Madoff Is A Case Of SEC Dysfunction

Below is a comment I posted on "Regulators are from Mars, Investors are from Venus?" by Lisa Fairfax on the Conglomerate Blog.
Madoff is a case of SEC dysfunction.

Madoff's crime is a simple form of affinity fraud. A gullible group with some cohesion, similarities and member trust is targeted, such as church groups, religious groups, ethnic groups, immigrant groups, country club members, etc. The fraudster relies on members of the group to introduce other members to the fraud. The referral and implicit trust among members of the group makes the job of the fraudster easier than if he targeted strangers.

The SEC has prosecuted affinity frauds for years. Yet, it does not ask questions during an exam to determine if the investors have any commonality that would suggest the possibility of an affinity fraud. A simple question such as how did you find the investor would have indicated to the SEC that most of Madoff's investors were referrals from a few small social circles and indicated the extremely high likelihood of affinity fraud.

Similarly, standard audit procedures include selectively confirming transactions with third parties, such as vendors, banks, customers, etc. Only in the last year, after Madoff, has the SEC adopted these well-established audit procedures. A true audit process would have found that the assets did not exist. The SEC at the time of Madoff's fraud did not even have standards for outside audit firms or standards to determine if there were possibilities of conflict and collusion between the auditors and the firms.

Furthermore, Madoff's reported long run of positive returns to investors should have been a signal to the SEC. The returns were too good to be true and unlike the returns of other investment managers. Several banks and brokerage firms did not do business with Madoff because his returns were suspicious. Why is the SEC isolated from the information available to other investment firms on the street?

We have an SEC that does not incorporate its own knowledge of fraud into its examinations, does not use standard business practices and audit procedures and has isolated itself from common industry knowledge. It is not due to a lack of staff or funding. It is an SEC internal cultural problem. The SEC had enough funds to investigate and examine Madoff. The SEC did a poor job and did not find any problems.

The Madoff case shows that the SEC is ill prepared to protect investors. The Commission needs to develop heuristics based on its history with investor fraud and act more wisely with the funds and tools it has. It needs to improve communication between itself and firms on the street. It needs to rid itself of most of its lawyers and remove the adversarial process that is part and parcel of its culture.

If one actually reviewed the SEC's ability to prevent investor fraud since its founding, I think one would probably find that the SEC does a poor job of preventing investor fraud.

GDP Bond Addition To My February 18 Post "Limits Of Econometric Models ..."

The following is an addendum to my February 18, 2010 post, "Limits Of Econometric Models Of The Macro-Economy". It is reprint of a comment I wrote in early 2009 about using GDP bonds to reveal investor expectations of future US GDP growth.
Why not try a different approach to forecast the economy directly based on rational expectations and the securities markets. Along the lines of TIPS securities, the US Treasury (at the insistence and lobbying of economists) could issue securities whose prices are transparently dependent on future GDP. Different, acceptable forms of securities based on future GDP are possible.

One form could be a US Treasury bond that had a semi-annual interest payment that was a single, fixed percentage (determined at issuance time by a Treasury auction process) of published US nominal GDPs (nominal since cash flows are discounted by nominal interest rates) at the time of the scheduled semi-annual interest payments. Issuance of securities with differing maturities and with the aging of seasoned securities would allow computation of a GDP forward rate yield curve and computation of expected future real GDP growth for different periods. Of course, some might want to make corrections for tax effects, risk premiums, and other possibly distorting and biasing effects.

Another possible form of the security could be a discounted single principal payment at maturity bond that paid a fixed percentage (also determined at issuance through an auction) of US published GDP at time of maturity. Obviously, this percentage would be cumulative for the missed interest payments during the life of the bond, similar to principal only US Treasuries.

Whatever final forms this type of security took, as long as it is transparently dependent on future GDP, it would allow the computation of future real GDP expectations for different future periods. Additionally, other securities based on different macro-economic values can be developed.

A GDP security would also allow for event studies of the US economy and for studies of real time price movements due to government, geo-political, Fed and other actions. The volatility of these securities' prices will reflect a measure of the uncertainty of future GDP growth faced by businesses and others that must make decisions in anticipation of future economic growth. The securities could be used to determine a risk premium of the US economy and to see if it is time varying. It would also allow event studies of the effects of governmental actions on different future period GDPs.

Businesses could use options, futures and other derivatives on these securities to cheaply hedge against future GDP slowdowns and downturns. For example, while the auto industry, and other manufacturing industries, can hedge many raw material and commodity input costs, the new security would allow for a hedge for an unexpected economic slowdown that would cause an excessive inventory buildup.

Therefore, if macro-economic modeling has shortcomings, possibly some of them can be overcome by the use of the expectations embedded in a GDP dependent US bond. Of course, the assistance of the US Treasury Department in issuing a bond of this type is essential.
The above is a reprint of a comment I originally published over a year ago, February 13, 2009, on "Why Macro-Econometric Models Don't Work" on the EclectEcon blog.

Monday, March 15, 2010

Full Lehman Bankruptcy Examiner Report Publicly Available

The law firm of Jenner & Block is providing links to the 2200 page Lehman bankruptcy examiner report in nine PDF parts. The chairman of Jenner & Block, Anton R. Valukas, is the Examiner.

The Lehman Examiner's report is available here.

Sunday, March 14, 2010

Scientists, Social Scientists, Economists Do Not Understand Statistics

Still, any single scientific study alone is quite likely to be incorrect, thanks largely to the fact that the standard statistical system for drawing conclusions is, in essence, illogical. “A lot of scientists don’t understand statistics,” says Goodman. “And they don’t understand statistics because the statistics don’t make sense.”
****
“Replication is vital,” says statistician Juliet Shaffer, a lecturer emeritus at the University of California, Berkeley. And in medicine, she says, the need for replication is widely recognized. “But in the social sciences and behavioral sciences, replication is not common,” she noted in San Diego in February at the annual meeting of the American Association for the Advancement of Science. “This is a sad situation.”
From the excellent article, "Odds are, it's wrong: Science fails to face the shortcomings of statistics" by Tom Siegfried, ScienceNews, March 27th, 2010; Vol.177 #7 (p. 26).

Also see my previous blog, "Limits Of Econometric Models Of The Macro-Economy."

Tuesday, March 9, 2010

Why New Drug Prices Are So High

Recently, Pfizer abandoned the development of a new drug after spending a billion dollars. Finding new drugs and navigating the FDA regulatory process is a risky endeavor. As Pfizer and other drug companies know, there are few successes, many failures and the cost of searching for and finding effective new medicines is high.

Despite the high costs of developing new drugs, the actual production cost of an effective and approved drug can be low. Companies that make generic versions of useful drugs can take advantage of low production costs and sell the medicines at a reduced price, once the original patents lapse. These generic drug companies do not have to recoup the funds they paid for finding, developing, proving effectiveness and marketing. They know the chemical formulas for the approved medicines, which work and have a market.

Let's make up an example to see how a generic drug company can sell a drug for a significantly lower price than a developing drug company can.

Let's say only 1 in 10 drug prospects is effective, gets regulatory approval and has a consumer market. If pharmaceutical companies spend a billion dollars on each of these prospective drugs, for each $1 billion spent on a successful drug, they spend $9 billion on unsuccessful drug efforts.

To attract funds to invest in new drug research, companies and investors expect a fair return for their money. Companies however do not know beforehand which drugs will be successful and which will be failures, which will pay them a return and which will lead to investment losses.

Let's say for this example a realized 5 percent return on the invested funds is a fair return. Since there is only a 1 in 10 chance of a successful drug and getting the fair return, an investor in all the drugs would like to see a 50 percent expected return from each project. Since there is a 1 in 10 chance of success, a 50 percent expected return from a project is a 5 percent expected value.

For a $1 billion investment, the investor wants a return of $50,000,000 but to get that $50,000,000 return, on average, $10,000,000,000 is invested. The $10,000,000,000 must have an expected 5 percent fair return and profit of $500,000,000. Only 1 in the 10 investments will succeed and the successful $1 billion investment must pay $500,000,000 to have a fair 5 percent return on the total $10 billion invested, which is a 50 percent return on the one successful drug's investment of $1 billion.

Suppose, a generic company can sell a drug to make a 5 percent return, but a research and development drug company must make a 50 percent return. The research drug company must make a profit that is ten times the amount of the generic company.

Let's say a generic drug company can make a pill for 60 cents and sells it at 70 cents (10 cents profit) to make a fair after tax profit. The developing drug company must sell the same drug at $1.60 to make a fair return ($1.00 profit).

When politicians and consumers look at a drug's selling price and costs, they look at only that drug's production costs and investments. They only look at the successful drugs in the marketplace. They ignore all the false starts and costs associated with those failed efforts. To stay in business and attract new investment funds, a pharmaceutical company must be able to recoup its lost funds on unsuccessful efforts in the profit it makes on successful drugs.

New drugs are expensive and cost more than the later generic version because the cost of finding and proving the effectiveness of new medicines is high. The generic drug companies do not bear the cost of finding new medicines and can set drug prices based solely on production costs, which are a small part of the cost of most drugs.

The price of a new drug represents more than the cost of its development and production. It also represents a fair return on all the funds invested, including the investments on the failures without which the drug company could not find and bring to market successful medicines.

Thursday, March 4, 2010

Capital Is The Fool's Gold Of Banking

Is capital important for the health and safety of the banking industry? Was a shortage of capital the reason there was a financial crisis and would higher capital levels prevent another crisis? Wasn't liquidity the real cause of the recent banking problems?

One of the proposed solutions to prevent another banking industry crisis is to require banks to hold more capital. However, the banks that needed bailing out or failed in the recent crisis all satisfied the existing capital requirements. Capital is just a naive and confused patent medicine approach to a complex problem.

Bear Stearns and Lehman failed because they had a liquidity crunch and Citibank needed government help because it was experiencing a run on the bank, a liquidity shortfall.

Capital is a balance sheet approach to bank supervision and control. It is a regulatory concept computed by a regulatory formula. It does not represent the residual liquidation value of the bank after its debts are paid. It does not represent the bank's net worth, the accounting or market value of the banks assets less it liabilities. It does not represent the future earnings capacity of the financial institution. It does not measure the liquidity health of a financial institution.

Regulators establish guidelines for bank capital levels and monitor the capital levels of banks. Governments, and their agencies, such as the banking industry regulators, cannot act arbitrarily. Capital levels are the way that the government banking regulators justify their actions. When capital levels are threatened or below regulatory requirements, federal banking supervisors act to preserve deposits, and the deposit insurance fund. They close banks, merge unhealthy banks with healthy banks, or put banks under protective orders with restrictive requirements. They act with a consistent, predefined purpose and as such are not easily subject to judicial review to overturn the regulators' actions and interventions. Capital levels are just trigger points that allow the government to act in a consistent manner.

Suggested proposals to prevent another crisis are mere refinements to the current capital requirements. The arguments for change are that the risk adjustments were inadequate, incentives were wrong; the levels were too low, or inconsistent, etc. However, any set of capital rules will not cover all situations, will create a new set of economic incentives and will always be too low for some catastrophe, just as a dike cannot restrain all levels of water.

Often a banking crisis is a liquidity crisis. Customers notice bank problems when banks are having a liquidity problem, a run on a bank, because the bank does not have the funds to pay depositors' withdrawals or the funds to make loans.

Regulators like high capital amounts because it allows them to delay classifying a bank as a troubled bank and delay government intervention. It does not guarantee an improvement in the deposit insurance fund or a positive net worth at a bank. It does not measure or help a bank's liquidity needs.

Capital does nothing to prevent liquidity problems at banks. When a bank is experiencing a shortfall of funds, the institution must borrow funds to pay depositors, and fund new loans and meet daily cash needs. To borrow funds, a bank must often put up collateral, assets it has on its books. Usually, the liquidity lender to a bank wants the collateral amount, in market value, to exceed the amount of funds lent. Bear Stearns failed because as it needed more liquidity, the value of its collateral was decreasing due to the declining value of real estate and the increasing default rates on mortgage loans. Some of its mortgage backed securities it was using as collateral declined in value by as much as 70 percent. Eventually, Bear ran out of collateral and could not fund it daily operational needs.

Capital is nice to talk about because the regulators find it easy to measure, not subject to dispute or interpretation under the regulations and consistently applied to all banks. It is easy to explain when a bank is above or below required capital levels and requires government involvement.

Liquidity is a much more difficult concept to use because the liquidity needs of each bank are different and can vary within an individual bank over a short time. It is more difficult to monitor, more difficult for the public to see when a bank is short of funds and more difficult to explain to politicians and the general press. Furthermore, publicly disclosing a liquidity shortfall at one bank can create a panic and run on another bank. Using liquidity as a guideline for bank troubles can cause a broader financial problem and make it much more difficult for regulators to contain a problem to a sole bank.

The contagion in the recent crisis was, in effect, a run on the banks. Everyone feared that the financial institutions were running out of liquid assets and that the collateral was declining in value in excess of the liquidity needs of the institutions. There was a wide spread fear that the banks did not have enough cash for their daily operational needs.

Capital is easy to understand and for regulators to measure. It is a convenient and acceptable trigger for regulatory intervention. Capital, however, does little to minimize future banking problems. It does nothing to promote the best practices for preventing future banking crises. Capital does not promote good banking, which must include asset diversification, sound business strategies and decisions, quality management, expense control and strong, sustainable earnings.

Reform, instead of focusing on capital levels, should instead focus on promoting sound banking practices as previously mentioned. Best business practices are the best way to prevent another crisis. Raising capital requirements by itself does not promote best practices. It just makes the regulators feels happy and allows them to offer patent medicine to those in search of a tonic.

Capital is a fool's gold that has little value, if any, in a severe financial crisis. The real gold is asset diversification, sound business strategies and decisions, quality management, expense control and strong, sustainable earnings.

Monday, March 1, 2010

More Funding And Staffing At The SEC Will Not Reduce Fraud

The following is a comment I posted on the Conglomerate Blog, "Funding the SEC: Dependent on the Kindness of the Regulated?" by Erik Gerding.
What indications are there that more funding and staffing at the SEC will reduce fraud? The failure to stop Madoff was not due to a shortage of staff or inadequate funding. Dysfunction at the SEC is the core issue. For example, the IRS has statistical profiles of IRS returns to identify likely tax evaders. In all its existence, the SEC has failed to develop a manageable, efficient system to identify fraud at the corporate level, at the investment level, or to evaluate the likelihood that an investor complaint to the SEC is true.

SEC staff investigated Madoff and fundamental procedures that have been in existence in auditing for decades, such as verifying payments, receipts and funds at other institutions, were not part of SEC investigations until after Madoff.

Madoff is a form of affinity fraud, which is a type of fraud the SEC has known about for years. It is based on investor commonalities to form referrals based on unfounded trust. Immigration groups based on country of origin, religious groups, country club membership, etc and other forms of referrals allow affinity fraud to succeed. Does the SEC even attempt to determine if the investors are part of an affinity group that would alert the SEC that there is a high likelihood of affinity fraud? It did not at Madoff. Does anyone remember ever seeing an ad or other outreach informing the public of this kind of fraud? The SEC has a 2009 pamphlet (after Madoff) and a 2006 press release, but what is the best preventative measure at the investor level and at the SEC to limit affinity fraud?

Option backdating was discovered because a professor published a statistical study showing its likely existence. Shouldn't a SEC priority be finding and funding research in important areas of potential fraud to help it efficiently identify corporate fraud? More staff would not have found backdating.

The SEC today is like a ship lost at sea that keeps asking for more stargazers to help identify its position instead of asking for a GPS navigation system. It is a 1930s organization with a 1930s culture that does not know how to function in the modern world. It is heavily staffed with lawyers whose culture is to avenge a fraud instead of prevent a fraud.

More money and staff are not the answer. A complete rethinking and restructuring is in order.

Furthermore, contractual legal rights are a powerful mechanism for protecting the rights of parties to commercial transactions. In fact, most transactions are based on contractual protections as opposed to regulatory protections. Shareholders and other interested private parties, and not the SEC, often sue to enforce their legal rights in securities transactions, when courts have recognized their right to sue to protect themselves.

While the counterfactual of life without 75 years of an SEC is difficult to envision, the existence of the SEC did not prevent major securities and investor fraud. Additionally, the SEC is always requesting more funding and staffing to investigate and litigate fraud. It is unclear that the 33 and 34 Acts have decreased fraudulent activities.