Regulators Increase Systemic Risk: Comment to "Great Moments in Financial Regulation"

A comment I wrote to the Wall Street Journal article, "Great Moments in Financial Regulation: Apple IPO deemed too risky" by Paul Atkins:

"Markets froze in the fall of 2008 because no one could be sure of the financial condition of financial institutions and their counterparties. For all the government's extraordinary intervention, the markets showed their greatest improvement after the Fed's imperfect stress tests were made public in early 2009."

It was not uncertainty about the condition of the financial institutions that caused the markets to crash. It was the uncertainty about government intervention that created the mess. The Government arbitrarily backstopped Bear but not Lehman. Unlike with the investment banks, the government can step in and takeover commercial banks at anytime by declaring them unsound.

Investors did not know or understand the government's game plan (if there was any at all) for dealing with the housing crisis effects on bank asset values and whether the banks were going concerns or going out of business concerns. Was the government going to close large banks or keep them open? What was the status of uninsured creditors and collateralized lenders? The private sector did not know or understand what contractual rights it had with troubled banks and companies, or whether the government would shut them down or allow them to continue.

Passing the stress test, even though it was a charade for the most part, meant the government was going to leave those banks alone. The markets began to breathe again because investors understood the government was backing away.

The markets froze in response to the government's action, not because the government was inactive, did too little or was ineffectual. Once the stress tests clarified that the government was done meddling in the banks, the markets began to clam calm down. The stress tests revealed more about the likelihood of future government action than it did about the condition of the banks. The stress tests added clarity to future government action; not clarity to the banks' balance sheets.

The Dodd bill will increase systemic risks and market failures because it will give more power and discretion to the regulators to act against financial institutions. Powers that allow government intervention in markets and financial institutions increase systemic risks exactly because regulators do not act as investors or perceive risk the same way investors and other market participants perceive risk. Government and regulators are an additional, unpredictable, non-diversifiable risk that restricts investors' options during a financial crisis.

When regulators intervene, investors lose the value of their investments in the financial institution. Since the financial crisis, all corporate bondholders, not just GM's and Chrysler's, mortgage lenders, and collateralized lenders face more systemic risk than before the crisis.

Giving more financial regulatory power to government will spread and increase the systemic risk in the financial sector. It will not lower systemic risk.

[See my previous post, "Obama's New Bank Restrictions Increase Systemic Risk: The VIX Rose 19 Percent"]

Goldman Sachs Wells Submissions

I am posting links (via the Wall Street Journal server) to copies of Goldman Sachs Wells Submission and Wells Supplement Submission to the SEC's Wells Notice.

The links are also available in the sidebar to this blog.

The crux of Goldman's case is that the parties knew or were aware of all material information and that Paulson was a relatively unknown person at the time and immaterial information.

(HT: Mark J. Astarita, Esq. of the SECLaw.com Securities Law Blog).

Earnings Decline After Losing A Job During A Recession

Earnings After Involuntary Job Loss:
In both the short and the long term, people who lose a job for reasons other than poor performance or misconduct and then find a new job see their earnings decline, on average. Short-term declines in earnings—those in the first few years after a job loss—tend to be larger for people who lose a job during or shortly after a recession....

For people who have acquired a substantial amount of firm-specific knowledge, the loss of a job can be associated with a relatively large decline in earnings in the short term.

From CBO Report: "Losing A Job During A Recession." Also available for download here.
Losing a Job During a Recession: CBO

Embedded Copies Of Senate And House Financial Reform Bills

Embedded copies of Senate and House Financial reform bills, S3217, Restoring American Financial Stability Act of 2010 and HR4173, Wall Street Reform and Consumer Protection Act of 2009. The Senate bill is also known as Sen. Dodd's bill and the House bill is also know as Barney Frank's bill.

Senate Financial Reform S3217

House Financial Reform HR4173

Texts Of House And Senate Financial Reform Bills

Text of Senator Chris Dodd's financial reform bill, S3217, "Restoring American Financial Stability Act of 2010."

Summary text of Senate financial reform bill as filed.

Committee Report for S3217.

Text of Representative Barney Frank's financial reform bill, HR4173, "Wall Street Reform and Consumer Protection Act of 2009" as referred to the Senate and passed by the House.

Comment I Posted To "Did Goldman deceive...?" On The Conglomerate Blog

Comment I posted on the Conglomerate Blog, "Did Goldman deceive the collateral manager? Why it matters" by Erik Gerding.

I think the case is more complicated. The CDO is synthetic and, by definition, will include various derivatives (CDSs and other forms of derivatives). All derivatives are zero sum and have counter parties. The derivatives in use here are bespoke or not standardized, exchange traded derivatives. All the parties understood these facts.

The long investors, IKB, ACA and any other investor understood that there was a counter party to the derivatives with economic interests adverse to their interest. If there was not, the derivatives could not exist.

In non-standard, non-exchange traded derivatives, both sides to the derivative have input and negotiate the terms.

All the long investors understood that there was a short party(ies) to the transaction negotiating pricing and terms including the mortgages to be included. While it is not in the complaint, it is safe to assume that ACA (and the other investors) understood a party economically adverse to the long side of the transaction was suggesting mortgages. ACA is an experienced party to this type of transaction.

Since ACA understood there was an adverse party suggesting mortgages, is it relevant or material if it is Paulson? I think not unless you believe Paulson used fraud, undue influence or coercion to get ACA to accept a mortgage. The facts in the complaint do not support this since, ACA rejected some of the mortgages suggested by Paulson and ACA suggested mortgages not on Paulson's list that Paulson and the other parties accepted.

Is The Goldman Sachs Case Mary Schapiro's Waterloo?

Despite the anger and the populist sentiment against the investment banks and a general populace belief that the banks caused the housing bust, the banking crisis and the economic recession, many knowledgeable attorneys, based on the facts as presented by the SEC in its civil complaint against Goldman Sachs, believe that Goldman Sachs did not violate any existing securities laws.

Unfortunately, SEC Chairman Mary Schapiro's timing looks political despite claims of denial by the White House and the SEC. The SEC filed its case against Goldman just before Congress began consideration of financial reform legislation and as President Obama pushed financial reform as a priority. Additionally, she was the deciding 3-2 vote to bring the case against Goldman.

Goldman Sachs is looking to rid itself of this case as soon as possible to protect its remaining reputation and to put a chill on other governmental investigations and investor lawsuits.

Settlement at this point is out of the question. The SEC will extract too high a price from Goldman. One of Goldman's options is to ask the court to either dismiss the case or grant summary judgment. Goldman will almost certainly file court motions for dismissal or summary judgment. It is just a matter of when.

If the court grants either a dismissal or summary judgment in Goldman's favor, it will make the SEC look even more politically motivated in bringing the case then it does now. It will be another major embarrassment for the SEC, along with the embarrassing settlement attempt with Bank of America over the Merrill Lynch deal, and the Madoff and Stanford scandals. Major changes will be called for at the SEC including a call for a new SEC Chairman.

Mary Schapiro is a loyal public servant with years of service at the SEC, the CFTC, NASD and FINRA. The Goldman Sachs case could turn out to be the end of Mary Schapiro's career at the SEC and possibly in government service. In being a loyal public servant in a populist administration, she may have put her career on the line in being the SEC Chairman and the deciding vote to bring an extremely weak case against Goldman Sachs.

Comment On Bankruptcy Reform Will Limit Bailouts Article In Wall St. Journal

A comment I posted to the Wall Street Journal article, "Bankruptcy Reform Will Limit Bailouts" by Thomas Jackson And David Skeel.

This is an old issue. The 1982 revision to the Bankruptcy code put in place exemptions for derivative contracts from the automatic stay provisions of Bankruptcy law. The automatic stay of filing for bankruptcy gives a firm time. It means a firm does not have to pay its debts immediately. The exemption to the stay means that going into bankruptcy does not prevent a firm from having to pay its derivative debts immediately even while it is in bankruptcy proceedings.

At least two professors, Columbia Business School Prof Franklin R. Edwards and Columbia Law School Prof Edward R. Morrison believe this provision increased the systemic risk of the Long Term Capital Management hedge fund collapse in 1998 and created the need for the Federal Reserve to step in after LTCM suffered investment losses.

See their 2005 paper, "Derivatives and the Bankruptcy Code: Why the Special Treatment?" at:
https://scholarship.law.columbia.edu/faculty_scholarship/2425/
It is ironic because the derivative exemptions to the bankruptcy stay were added to do just the opposite and decrease systemic risk.

House Congressional Democrats 2010 Reelection Chances Hurt By Goldman Charges

Surprisingly, the Democrats chances of maintaining control of the US House of Representatives declined from Friday to Monday after the SEC charges against Goldman Sachs were announced. The Intrade share price dropped 6 points from 56 to 50 on Monday and dropped another 3.2 points to 46.8 as of close of trading on Tuesday, April 20. The decline from 56 to 46.8 is a loss of almost 16.5 percent.

Following is the Intrade security for 2010 US House of Representatives Control as of close April 20, 2010:

The Democrats to control the House of Representatives after 2010 Congressional Elections:

Following is the Intrade security for 2010 US House of Representatives Control as of close April 20, 2010:

The Republicans to control the House of Representatives after 2010 Congressional Elections:

The Republicans chances of gaining control of the US House of Representatives increased from Friday to Monday after the SEC charges against Goldman Sachs were announced. The Intrade share price rose 3.2 points from 46.8 to 50 on Monday and rose to 50.3 as of close of trading on Tuesday, April 20. The increase from 46.8 to 50.3 is an increase of almost 7.5 percent.

Goldman's Abacus 2007 AC1 Flipbook

The Goldman Sachs Abacus Flipbook is no long available at the below article link, but is available on the NYU faculty webpage of Marco Avellaneda, Professor of Mathematics, Courant Institute of Mathematical Sciences, New York University at http://www.math.nyu.edu/faculty/avellane/ABACUS.pdf

Goldman Sach's Abacus 2007 AC1 Flipbook (from ritholtz, aka Barry Ritholtz of The Big Picture blog). It contains information about the synthetic CDO that is the basis of the SEC fraud complaint against Goldman Sachs:
30036962-Abacus-2007-AC1-Flipbook-20070226
The Goldman Sachs Abacus Flipbook is no longer available at the above link, but is available on the NYU faculty webpage of Marco Avellaneda, Professor of Mathematics, Courant Institute of Mathematical Sciences, New York University at http://www.math.nyu.edu/faculty/avellane/ABACUS.pdf

Another Comment On Goldman Vs SEC

Another comment I wrote to a Wall Street Journal article, "The SEC vs. Goldman: More a case of hindsight bias than financial villainy."

Goldman could have structured the whole deal and allowed Paulson to both own the equity position and short at the same time. Paulson would only have had to increase his short position to offset the addition of the equity portion. The fact that that there is no need to go through a charade of Paulson taking equity when he could have taken a real equity position to perpetrate the fraud, shows that no one was trying to perpetrate a fraud on the investors.

The WSJ opinion piece is correct that this appears to be nothing but a political play by Obama to get his financial reform passed.

The fact that the SEC asked Goldman in 2008 for info on this deal does not clear the SEC of politics. The SEC often asks Wall St firms for additional info about deals and securities. The SEC went to its file and found this older info inquiry about CDOs to make it appear non-political.

Emails from employees that the sky is falling are also irrelevant. Who has not worked in a company and heard the employees say the firm does not know what it is doing, or that it is ripping off customers, or if the customers only knew. It is normal office talk among cohorts, who think they know more than their bosses and everyone else. Many times the employees are just reflecting their own job frustrations.

Comment On Sec Challenges With Materiality Of Goldman Charges

A comment I posted to a Wall Street Journal article, "SEC Faces Challenges With Goldman Case" by Kara Scannell:

As a first step, the SEC will have to show that Paulson's involvement and shorting was material information to investors. I do not see it.

Paulson had no control or non-public information about the individual default rates of the mortgages. His involvement was to suggest more mortgages in the few states with the biggest housing bubble and with borrowers with lower fico scores. The mortgages in the pool and the selection criteria are disclosed in the offering documents. Furthermore, there is nothing to indicate that ACA did not have a final say about mortgage inclusion as the independent adviser.

Sophisticated investors at the time knew generally, that Paulson was shorting the residential mortgage market, as were other investors. Paulson's shorting did not begin with this offering and he had lost money shorting during the earlier stages of the housing bubble.

The fact that Paulson asked for Goldman to put together a portfolio to short against is not material. The fact that Paulson asked for more mortgages in bubble states with high risk borrowers is also not material since the mortgages are disclosed in the offering documents and by definition subprime mortgages are high risk borrowers and most likely in hot real estate bubble markets.

In fact, given Paulson's poor track record in shorting at the time, knowledge of his involvement probably would have led to more interest in the portfolio than less.

Paulson's involvement and shorting does not change the risk or expected returns of investing in subprime mortgages and the mortgages were fully disclosed by Goldman.

Investors who invested in the Goldman portfolio would have done so at the time even knowing Paulson was shorting it and asked for its creation.

Remember, all the parties involved were questioned by the SEC after they had all lost money investing in subprimes. Of course, they are going to say it was not their fault and Goldman misled them by not telling them of Paulson's involvement. They are just trying to protect their reputations by saying it was Goldman's fault.

This case will never go to trial. A judge will dismiss the complaint as a matter of law for a lack of materiality.

Comment On Goldman Sachs' SEC Complaint

The following is a comment I posted to the Wall Street Journal article, "Goldman Is Charged With Subprime Fraud" by Joe Bel Bruno, Fawn Johnson and Joseph Checkler:

Paulson & Co did not engage in any fraud. Shorting is a legal activity, even when one knows another party is long securities. It is also legal to submit requests of securities to include in a portfolio. There is often a give and take between institutional investors and underwriters about structure, portfolio and pricing so that the underwriting sells and meets the needs of the buyers.

There is no claim in the SEC complaint that the securities in the portfolio were misrepresented or that the portfolio was not as described. Saying that they were mostly from a few states and low fico scores is irrelevant because those were the states with the hottest home markets and all mortgage portfolios were heavy in those mortgages. If it were not the case, only this portfolio would have collapsed, but just about all subprime portfolios from all underwriters from the same time period lost most, if not all their value.

ACA was hired to select the portfolio and was named in the offering documents. The SEC is saying that Paulson influenced ACA's MBS selections and that Goldman should have disclosed Paulson's involvement and his short interest.

Even if ACA was influenced by Paulson, it is unclear Goldman had any duty to inform investors that Paulson & Co was involved or that it t had an effective short interest in those securities. ACA was not forced or coerced to accept Paulson's recommendations and could have objected to specific securities to include in the portfolio or removed itself from the underwriting.

ACA either agreed with Paulson's assessments or was completely negligent is accepting them. ACA and not Goldman may be at fault here but the SEC cannot sue ACA for a bad analysis or for outsourcing the analysis to Paulson.

The SEC will have to show that Goldman intended to defraud investors and set ACA up as a front to hide Paulson's involvement. It does that appear to be the case.

With or without Paulson's involvement, the offering would have lost a lot of its value shortly after issuance due to the collapse of the subprime mortgage and housing markets.

ACA seems to be covering itself and rewriting history to make it appear the subsequent portfolio losses were not due to its poor analytical ability to assess MBS and CDOs.

As often happens, after a risky investment loses a lot of its value, the SEC sues. Lawyers and SEC personnel do no understand risky investments and that risky investments can lose most or all their value without any fraud by the underwriter.

The issue is not that the investments lost most of their value. The issue is Paulson's involvement and whether Goldman had a duty to disclose Paulson's activity with ACA.

SEC's Civil Complaint Against Goldman Sachs For Securities Fraud

SEC's civil complaint against Goldman Sachs for securities fraud in underwriting a [synthetic] mortgage backed security (MBS) collateralize debt obligation (CDO) of subprime mortgages in early 2007. Specifically, Goldman failed to disclose Paulson & Co. was actively involved in selecting the mortgage portfolio while effectively holding a short position in the same mortgage portfolio through a credit default swap:
SEC Complaint - Goldman Sachs

Obama And Biden 2010 Income Tax Returns For 2009 Taxable Year

President Obama and Vice President Biden released their 2010 tax returns for the 2009 taxable year.

The Obama's reported an adjusted gross income of $5,505,409 and paid $1,792,414 in federal taxes. They paid $163,303 in Illinois state income taxes.

The Biden's reported an adjusted gross income of $333,182 and paid $71,147 in federal income taxes for 2009. They paid $12,420 in Delaware income taxes and $1,477 in Virginia income taxes.

The president's and Vice President's 2009 tax returns filed April 2010 are embedded below.

Obama and Biden taxable year 2010 tax returns filed April 2011 are available here.

President Obama's 2010 tax return for 2009 taxable year:
President Obama 2010 Complete Tax Return

Vice President Biden's 2010 tax return for 2009 taxable year:
VP Biden 2010 Complete Return For 2009 Taxable Year

Cutting Funding For Education Without Negatively Affecting Student Outcomes

Despite the more than double per pupil expenditure of inflation adjusted tax dollars on k-12 education from 1970 to 2005, there has been little, if any, improvement in student outcomes. Reading, Math levels and high school graduation rates have remained flat and unaffected by the increase in education expenditures.

The above chart is from the September 2008, Heritage Foundation report "Does Spending More on Education Improve Academic Achievement?"

The above chart is from the 2002, Hoover Institution report "Can Money Buy Better Schools?"

The obvious question, during these very difficult fiscal times of state and local finances and large federal budget deficits, is can we significantly cut k-12 per pupil expenditures without negatively affecting student outcomes?

If we can double per pupil outlays without positive impacts on student educational results, can we substantially reduce our education expenses, maybe by even half, without reducing student reading and math scores and without reducing high school graduation rates?

It seems likely.

See also the following, among many others, consistent studies of the lack of any positive relationship between per pupil education outlays and student outcomes, "Spending Increases Don't Improve Student Achievement: Report" and "PUBLIC SCHOOL SPENDING AND STUDENT ACHIEVEMENT: THE CASE OF NEW JERSEY."

CBO Discusses Limtations And Challenges Of Health Care Budgetary Estimates

Congressional Budget Office Presentation to the World Health Care Congress, "The Effects Of Health Reform on the Federal Budget" on April 12, 2010 by Douglas W. Elmendorf, Director, CBO.

The Effects Of Health Reform on the Federal Budget

Federal Regulators Faulted For Poor Bank Supervison

Regulators failed for years to properly supervise the giant savings and loan Washington Mutual, even as the company wobbled under the weight of risky subprime mortgages, a federal investigation has concluded.

The two agencies that oversaw Washington Mutual, the investigation found, feuded so much that they could not even agree to deem the company “unsafe and unsound” until Sept. 18, 2008.

By then, it was too late. A week later, amid a wave of deposit withdrawals, the government seized the bank and sold it to JPMorgan Chase for $1.9 billion. It was by far the largest bank failure in American history.

From "U.S. Faults Regulators Over a Bank" by Sewell Chan in The New York Times, April 11, 2010.

Are Lower Wages American Workers' Future?

The only way many of today's jobless are likely to retain their jobs or get new ones is by settling for much lower wages and benefits. The official unemployment numbers hide the extent to which American workers are already on this downward path. But if you look at income data you'll see the drop.

Among those with jobs, more and more have accepted lower pay and benefits as a condition for keeping them. Or they have lost higher-paying jobs and are now in new ones that pay less. Or new hires are paid far lower wages than the old. (In January, Ford Motor Co. announced that it would add 1,200 jobs at its Chicago assembly plant but didn't trumpet that the new workers will be paid half of what current workers were paid when they began.) Or they have become consultants or temporary workers whose pay is unsteady and benefits nonexistent.
***
The likelihood, therefore, is that as the economy struggles to recover and today's jobless begin to find work, the median wage will continue to fall—as it did between 2001 and 2007, during the last so-called recovery.

More Americans will be working, but for pay they consider inadequate. The approaching recovery will be tepid because so many people will lack the money needed to buy all the goods and services the economy can produce.

From "The Jobs Picture Still Looks Bleak" by Robert Reich in the Wall Street Journal Opinion, April 12, 2010. Reich is a professor of public policy at the University of California at Berkeley and former secretary of labor under President Clinton.

SEC Proposal On Asset Backed Securities

SEC Proposes Rules to Increase Investor Protections in Asset-Backed Securities

FOR IMMEDIATE RELEASE
2010-54

[Firefox browsers will need to install Microsoft's Window Media Player Plugin]

Video: Open Meeting

Chairman Schapiro Discusses ABS:
Windows Media Player
QuickTime

Washington, D.C., April 7, 2010 — The Securities and Exchange Commission today proposed rules that would revise the disclosure, reporting and offering process for asset-backed securities (ABS) to better protect investors in the securitization market.

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Additional Materials

• Proposal on Asset-Backed Securities
• Submit comments on this proposal

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The proposed rules are intended to provide investors with more detailed and current information about ABS and more time to make their investment decisions. The proposed rules also seek to better align the interests of issuers and investors by creating a retention or "skin in the game" requirement for certain public offerings of ABS.

"The rules we are proposing stem from lessons learned during the financial crisis," said SEC Chairman Mary L. Schapiro. "These rules if adopted would revise the regulatory regime for asset-backed securities in order to better protect investors."

Asset-backed securities are created by buying and bundling loans — such as residential mortgage loans, commercial loans or student loans — and creating securities backed by those assets, which are then sold to investors. Often, a bundle of loans is divided into separate securities with different levels of risk and returns. Payments on the loans are distributed to the holders of the lower-risk, lower-interest securities first, and then to the holders of the higher-risk securities.

Most public offerings of ABS are conducted through expedited SEC procedures known as "shelf offerings." ABS offerings also are sold as private placements which are exempt from SEC registration. ABS private placements are typically sold to large institutional investors known as qualified purchasers (QIBs).
Public comments on the proposed rules should be received by the Commission within 90 days after its publication in the Federal Register.

# # #

FACT SHEET

Overview:

During the financial crisis, ABS holders suffered significant losses and the securitization market has been relatively dormant ever since. The crisis revealed that many investors were not fully aware of the risk in the underlying mortgages within the pools of securitized assets and over-relied on credit ratings assigned by rating agencies, which, in many cases, turned out to be wrong.

The proposed rules seek to address the problems highlighted by the crisis and to head off the next one, by giving investors the tools they need to accurately assess risk and by better aligning the interests of the issuer with those of the investor.

The Proposed Rules:

Specifically, the Commission's proposals would:

Require the Filing of Tagged Computer-Readable, Standardized Loan-Level Information

Under the current ABS rules, information about the loans in an ABS pool is required only at the pool level. The SEC will consider whether to propose new disclosure rules that would require ABS issuers to provide specific data for each loan in the asset pool both at the time of securitization and on an ongoing basis.

The loan-level data would cover items such as the terms and underwriting of the loan, credit information about the borrower, and/or characteristics of the property securing the loan. To make the required information comparable among issuers of the same asset class and more useable to investors, the rules require that the data be provided according to proposed standards and in a format tagged in eXtensible Markup Language (XML) so that it may be processed by computer. This would enable investors to synthesize large amounts of data about the underlying assets.

Examples of the types of information that would be provided for each loan in the pool include:

• A number identifying each loan so that the loan and its performance can be tracked throughout the life of the security.
• Disclosure of whether or not the loan was made without following the stated loan underwriting standards.
• Disclosure of the extent to which the obligor's income was verified (e.g. did the lender look at W-2 forms and tax returns?).
• Detailed information about the steps being taken by the servicer to limit losses on loans that are not being paid in full.

The proposal requiring loan-level information would apply to ABS issuers that offer securities backed by residential mortgages, commercial mortgages, automobile loans and leases, equipment loans and leases, student loans, floorplan financings, corporate debt, and ABS backed by other ABS.

ABS that are backed by credit card receivables may have millions of accounts in the pool, so those offerings would be exempt from loan-level information requirements. However, proposed new rules would require issuers to disclose more granular information regarding the underlying credit card accounts in tagged, computer-readable and standardized groupings. Under the proposed rules, issuers of ABS backed by credit cards would present statistical data about accounts with similar characteristics grouped by credit score range, age of account, payment status, and geographic location.

Require the Filing of a Computer Program That Gives Effect to the Waterfall

The SEC will consider a proposal requiring, along with the filing of a prospectus for an ABS transaction, the filing of a computer program that demonstrates the effect of the "waterfall." As noted above, the waterfall dictates how borrowers' loan payments are distributed to investors in the ABS, how losses or lack of payment on those loans is divided among the investors and when administrative expenses such as servicing those loans are paid to service providers. Currently, a narrative description of the waterfall must be disclosed to investors in the prospectus. The computer program of the waterfall would allow the user to input the loan level data that would also be required to be provided, as described above, giving investors and the markets better tools to analyze an ABS offering.

Provide Investors with More Time to Consider Transaction-Specific Information

The SEC will consider whether to impose time limits before a sponsor of the ABS can conduct the first sale in a shelf offering. Under current rules, issuers may sell ABS almost immediately, without providing investors a minimum amount of time to review the disclosure in the offering materials.

The SEC will consider whether to propose requiring that issuers, for each off-the-shelf takedown or offering, file a preliminary prospectus at least five business days before the first sale in the offering. This would give investors time to consider transaction-specific information, including the loan level data described above, before an investment decision needs to be made.

Repeal the Investment Grade Ratings Criterion for ABS Shelf-Eligibility

Under existing rules, an ABS offering is not eligible for an expedited offering unless the securities are rated investment-grade by a credit rating agency. The SEC will consider whether to propose new ABS "shelf" eligibility criteria to enhance the type of securities that are being offered and the accountability of participants in that securitization chain.

The proposals would require, as a condition for shelf-eligibility, that:

The chief executive officer of the ABS issuer certify that the assets have characteristics that provide a reasonable basis to believe that they will produce cash flows as described in the prospectus.

The ABS sponsor hold five percent of each class of asset-backed securities and not hedge those holdings.

The ABS issuer provide a mechanism whereby the investors will be able to confirm that the assets comply with the issuer's representations and warranties, such as representations and warranties that the loans in the ABS pool were underwritten in a manner consistent with the lenders' underwriting standards.

The ABS issuer agrees to file Exchange Act reports with the Commission on an ongoing basis (rather than stop reporting with the Commission in the first year, which the Exchange Act currently permits many ABS issuers to do).

While ratings would continue to be allowed for ABS offerings, the proposed rules would eliminate the ratings requirement from the SEC's expedited shelf-eligibility test. Additionally, the added information and time provided under the proposals should allow investors to perform their own analyses and rely less on ratings.

Increase Transparency in the Private Structured Finance Market

The SEC will also consider whether to propose disclosure requirements that would increase transparency in the exempt private structured finance market where some types of asset-backed securities, such as collateralized debt obligations (CDOs), are sold. Under these proposals, where an SEC safe harbor (e.g., Rule 144A or Regulation D) is relied upon for the unregistered sale of securities, the issuer must provide investors, upon request, at the time of the offering and on an ongoing basis, the same information that would be required if the offering were registered with the SEC or if the issuer were required to report with the SEC under the Exchange Act.

The SEC also will consider a proposal to require that an ABS issuer file a public notice of the initial placement of securities to be sold under Securities Act Rule 144A. This notice would require information about those ABS offerings and would be publicly filed with the SEC in its EDGAR database. Form D, the notice of an offering made in reliance on Regulation D, also would be revised to collect information on structured finance products.

Make Other Revisions to the Regulation of ABS

The SEC also will consider whether to propose other revisions regarding ABS. Among other things, the SEC will consider whether to propose to:

• Standardize certain static pool disclosure.
• Amend the Regulation AB definition of an "asset-backed security" to better ensure that investors have sufficient information about the securities.
• Require additional information regarding originators and sponsors, such as information for certain identified originators and the sponsor relating to the amount of the originator's or sponsor's publicly securitized assets that, in the last three years, has been the subject of a demand to repurchase or replace.
• Lower the threshold change in the material pool characteristics that triggers the filing of a Form 8-K (pursuant to Item 6.05) from five percent to one percent.
• Specify, in addition to the loan-level proposed requirements, the disclosure that must be provided on an aggregate basis relating to the type and amount of assets that do not meet the underwriting criteria that is described in the prospectus.

http://www.sec.gov/news/press/2010/2010-54.htm

Bond Markets Predicting An Almost Doubling Of The 5 Year Treasury Rate

The US Treasury Bond Market, as of 2:00 PM in NY, is predicting an almost doubling of the interest rate on future 5-year US Treasury Bonds.

Bloomberg reported yields show the 10-year Treasury yield at 4.00 percent and the 5-year Treasury yield at 2.75 percent.

The market is expecting 5-year US Treasury Bond yields to jump to 5.27 percent. Rates are expected to rise by more than 2.5 percent, or almost double the current rate.

The market expectation of the 5-year bond interest rate after the maturity of the current 5-year US Treasury bond can be derived from the yields on the current 5 and 10-year bonds.

The 10-year yield is the average of the yield of the current 5-year Treasury bond and the expected yield of a 5-year Treasury bond issued at the maturity of the current five year bond for the remaining 5 years until the end of the term of the current 10-year Treasury bond.

Similar types of calculations can also be computed for inflation from the Treasury Inflation bonds (TIPS) and the regular US Treasury Bonds.

The inflation rate for the next five years is expected to average around 2.2 percent and then rise to an average 2.3 percent for the following five years.

The modest change in expected inflation shows that the increase in future interest rates will mostly come from an increase in the real rate of interest. The real rate of interest is expected to rise from the current .52 percent to around 2.37 percent, as the Federal Reserve stops artificially keeping short-term interest rates low, and as the economy recovers.

Markets Bet Against The Discovery of A Higgs Boson Particle

Observation of the Higgs Boson Particle
Higgs Boson Particle to be observed on/before 31 Dec 2013.


Intrade markets bet against a Higgs Boson particle found before December 31, 2013. The price has dropped from 50 to 29 in the last few months even as the Large Hadron Collider began to smash sub-atomic particles together and record the data of their collisions for analysis.

The Higgs Boson is considered the most likely current candidate for our understanding of mass. If the LHC does not find a Higgs Boson then alternative theories of mass will become much more likely.

if the Higgs Boson does not exist, then the very successful Standard Model of particle physics will have to be reworked.

To date all tests confirm the Standard Model, which unites and explains the three of the four main forces of nature, the weak force, the strong force and the electromagnetic force. It does not explain or unite with the other three forces, the fourth force, gravity. It also does not explain dark matter or dark energy.

Broken Window Fallacy Video

(HT: Cafe Hayek, Don Boudreaux)

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.

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"

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.

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.

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.

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."

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. [Article link updated.]

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.

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 certificates 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 benefit 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.

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.

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."

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.

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 bank's assets less its 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.

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.