Will A Value Added Tax (VAT) Help US Exports?

If you are interested in whether a Value Added Tax (VAT) will help increase US exports over imports, read Greg Mankiw's post, "Is a VAT good for exports?"

Basically, the foreign currency exchange rate will adjust to remove any hoped for price advantage created by an import export tax difference.

Video Of Rachel Maddow's Commencement Speech At Smith College

Rachel Maddow gave the commencement speech at Smith College's 132nd graduation ceremony on Sunday, May 16, 2010, in Northampton, MA. Following is a YouTube video and transcript of that speech. Her speech was very well received. Overall, it was less political and more cautionary than usual for Maddow.



Above video available on YouTube.

[Added May 19, 2010]
Transcript of Rachel Maddow's Smith 2010 Commencement Address on Sunday, May 16:

This is very impressive -- all of you.

Thank you for asking me to be here today. I know by virtue of the achievement that earned you these seats down front today that you are too smart to take advice from anyone who hasn't earned it; let alone an erstwhile Northampton radio show D.J.

However, I do have a story to tell that I admit is a little woolly.

In June of 1900, a self righteous, by all accounts quite unpleasant woman in Kansas had a religious vision. Her name was Carry Nation. And years later when she wrote her autobiography in which she all but named herself a saint, she said that while she was praying in June 1900 and lamenting, weeping, trying to find a way to be a better Christian, she said that God spoke to her in a clear voice and directed her to go destroy saloons. God told her to leave Medicine Lodge, Kansas, and go and Kiowa, Kansas, and destroy any saloons she found there, and she did.

She stormed these turn-of-the-century bars, these saloons with their long mirrors, and she had a big rock and she used the rock to smash bottles of liquor -- she just laid waste to these barrooms.

Turns out Carry Nation had a hankering for this. She lustily enjoyed destroying property and terrifying people.

She soon made both a habit and a career of it. She traveled all over: Kansas first, and ultimately all over the country, destroying barrooms. She first used a rock and then a hatchet. She adopted the hatchet as her symbol. She called her saloon smashings "hatchetations," which is probably the one really cool thing about Carry Nation: "hatchetations."

Carry sold these tiny pewter hatchet pins and fundraising souvenirs. You can buy them on eBay. I have one. It looks like a labrys though. It's a nice idea but different.

Carry Nation's fundraising was actually for herself so she could market herself as essentially a sideshow act, as a “saloon smasher,” and she had a traveling sideshow manager promoting this traveling saloon-smashing road show she did around the country.

As a person who has become not a little obsessed with Carry Nation, I have come to think of her as mostly an American huckster, just promoting herself. But she was also promoting her cause: temperance, outlawing drinking, prohibition. And that campaign worked – she was one of the reigning symbols of the Prohibition movement from when she started smashing saloons in 1900 to when she died in 1911. By 1917, the combined effort of activists like her and the women's temperance union had actually succeeded in passing an anti-booze amendment to the United States Constitution -- as if we didn't have other things to do.

It passed overwhelmingly through both houses of Congress less than a year and a half later, ratified by two-thirds of the states; and, starting in 1920, the incredible stupid idea of Prohibition was the law of the land -- and it was a disaster.

Alcoholism went up. Dozens and then hundreds and thousands of illegal drinking establishments opened up. Bootleggers ran the black market to end all black markets. A whole new variety of organized criminal activity blossomed.

With the massive surge of profits flowing through that criminal underworld, this country reached whole new levels of government corruption that puts anything we've got today to shame -- except for maybe the Interior Department of the Bush administration.

It's not about the Bush administration -- remember they put the Abramoff guy as the Number Two guy in charge of the Department of Interior and there was that one office where they were snorting meth off the toaster oven and the people who worked in the office regulating the oil industry were actually having affairs with oil industry lobbyists? So the Bush administration Interior Department maybe can compete.

And actually, when you think about it, there was that morning last summer when 44 people got arrested all at once in New Jersey on corruption, and then there's Rod Blagojevich -- so alright maybe we can imagine what super corrupt criminal government looks like. But in Prohibition it was really bad.

In the Depression, the criminal economy that was a side effect of the Carry Nations of the world convincing us to ban booze -- that criminal economy was big enough that it crowded out a lot of the real economy. Trying to recover from the Great Depression meant, in part, finding a means of stimulus spending that wouldn't just disappear into the gangster economy, which was quantitatively an actual competitor to the legitimate economy.

Now granted, we do remember some cool things from that era -- flapper dresses, every drink you've ever had with orange juice because they needed something with a strong flavor to disguise the taste of the disgusting bathtub gin -- but basically it was a huge public policy failure.

I'll give you just one more concrete example of how barbaric and stupid this time was in American public policy. Consider industrial alcohol. There's alcohol for drinking and then there's alcohol for solvents -- rubbing alcohol. People were so desperate to drink that they would sometimes drink industrial alcohol, or people in the wildly profitable business of bootlegging would steal or rip off industrial alcohol and then redistill it to make it vaguely drinkable.

The government decided during Prohibition that that must be stopped, and their genius idea to stop it was to poison the industrial alcohol. Deborah Blum wrote about this for Slate.com recently. The government took industrial alcohol and they added things like kerosene, gasoline, benzene, mercury salts, nicotine, ether formaldehyde, acetone. They would add known poisons to these things that they knew people wanted to drink and then people would still drink them and they would die. It's been estimated that as many as 10,000 people may have been killed by government actions in this way during Prohibition when the government decided to discourage people from doing things that people already knew was bad for them but they wanted to do it anyway.

Prohibition was really stupid on a million different levels. Finally after 13 long, dumb years, it was repealed in 1933, and then we as a country promptly set about forgetting we had ever done it.

I think it's important to remember Prohibition because enacting it was a huge disaster for our nation, but it was a personal triumph for Carry Nation.

I would like to offer the hypothesis on this beautiful graduation day that personal triumphs are overrated.

If you think about it, when Jack Abramoff got the White House to install his on- the-take, corrupt, patsy as the Number Two job at the Department of Interior thus leading to the snorting-meth-off-the-toaster-oven, sleeping-with-the-oil-lobbyist vibe at the Department of the Interior, that was a personal triumph for Jack Abramoff.

Someone at Yum Brands this year achieved their personal triumph by getting KFC to remove the bun from a cheese and bacon sandwich and replace that bun with pieces of fried chicken -- the double-down sandwich-designer's personal triumph.

When the current president hit upon the strategy of co-opting his political opponent's wish list in order to get a climate bill passed this year, President Obama, adopting “Drill-Baby-Drill,” was lauded in the Beltway press as a political and personal triumph.

Someone invented the AMC Gremlin and got a car company to build it for nine years -- that was a personal triumph.

There's a Tennessee businessman who has mass-marketed a legal means of charging 400 percent interest on something called "payday loans" despite laws against usury and loan-sharking in this country. He made so much money off of ripping off Americans that way that he built himself a full-scale college football stadium with lights and seating and a field house and everything in his backyard for his personal use, and he hires college football teams to play there for his own enjoyment, he markets himself as a great American personal triumph.

Al Capone rose from humble beginnings in Brooklyn to build a huge crime empire that essentially owned Chicago during Prohibition -- a personal triumph.

All these people dream their dreams and work hard and achieve their dreams.

Some dreams are bad dreams.

[Stopped to recognize a cheer]

Will you do that again? Yah? The hooting -- that's very nice, thank you.

Everybody always says around occasions like this: life is short. It might be. If it is for you, I'm sorry. I wish that was not the case. But I would caution against believing life is short and to live everyday as if it is your last as if you're ever only going to be roughly the age you are now.

Frankly, if all goes well, life is long. So if you might take advice for me I would offer this, hopefully life is long. Do stuff you will enjoy thinking about and telling stories about for many years to come. Do stuff you will want to brag about.

No one brags to the grandkids that they were one of the geniuses behind poisoning all the industrial alcohol in the country. Nobody's going to brag to grand kids about "Who-needs-wetlands? Let's-have-a-subdivision-and-a-shipping-canal-instead" decisions that made New Orleans the tragedy and the distant hope that it is today -- and the 40 percent of our nation's wetlands that is Louisiana's beaten, bloodied coast.

Nobody's ultimately going to brag to their kids about having told the country that we ought to invade Iraq because, you know 9/11, and it ought to be easy. Imagine in the family history: "Yeah, then granddad went onto TV and said war in Iraq would take six weeks, max." Nobody wants to remember that about granddad.

So I would advise, if you have the choice, don't be the granddad, don't be the grandma whose temporal personal triumph is something you only hope is something that gets forgotten in history.

In the big picture, standing at the age 22-ish or 40-ish or 62-ish -- Ada Comstockers, right on -- standing at the age you are now at graduation, looking for your own deep-water horizon, consider the possibility that you might very well get old -- everybody hopes you do. Be part of good decisions because the stuff you do now you will want to be bragging about when you become 90.

How do you become part of good decisions in the absence of a crystal ball? The best way to guess what is going to work out in the future and to figure out what you'll be glad you played a role in is to get smart and get smart fast, to take the opportunities you've got very seriously, to continue your education not necessarily in a grad school way, but in a lifelong way, be intellectually and morally rigorous in your own decision-making and expect that the important people in your life do the same if they want to stay important to you.

Gunning not just for personal triumph for yourself, but for durable achievement to be proud of for life is the difference between winning things and leadership; it's the difference between nationalism and patriotism; it's the difference between running for office and devoting yourself to public service; it's agreeing that you're part of something; taking as your baseline that you will not seek to reach your own goals by stepping on your community; it means coming to terms that your country needs you, Smith Class of 2010.

There will come times in life and career ahead when you have to choose between integrity and more short-term temptations. You will be the press secretary who is asked to lie to the press; you will be the regulator asked to approve the drilling with the Mickey Mouse safety plan; you will be the artist commissioned to make what you suspect is propaganda; the engineer pressed to use the cheaper, unsafe welds; the job applicant asked to cross the picket line; the research scientist expected to round to the nearest publishable conclusion; the spouse tempted to cheat; the physician tempted to schill; the staff sergeant asked to keep quiet; the politician confronted with the focus group that proves how well appeals to racism poll in your district; the pundit offered the talking point; the procurement officer offered the kickback.

In the short term it's always crystal clear what advances you further, what makes you famous, what gets you your boss' job, what gets you elected, what gets you rich.

In the end, though, blood will out.

History has a way of not remembering that some of those Iraq War press secretaries had real talent in the White House press room; or that BP and Trans-Ocean had a real talent for drilling down to find oil deeper than anyone else.

When given the choice between fame and glory, take glory. Glory has a way of sneaking up on fame and stealing its lunch money later anyway.

Life might very well be long, keep your eye on the horizon and live in a way that you will be proud of. You will sleep more. You'll be a better partner. You'll be a better mom. You'll be a better friend. You'll be a better boss, and you will not have to remember any complicated lies to brag about at the old age home because you can brag about the truth of your well-lived life.

In conclusion, I'm not going to be egotistical enough to ask you to remember any of this advice. I might ask you, though, to remember Carry Nation. Carry Nation got what she wanted against the odds -- a product of her hard work -- it's not meant to be inspiring. It's meant to worry you. You are graduating from Smith College. You are well prepared. You are poised. You're well connected. You are wicked smart. You are already accomplished.

Do not for yourself today, but for yourself to be proud of at the end of your life. Do not for the fame, but for the glory – learn the difference. Do not just for your own life, but for the life of your nation, that is still, for all its challenges and its flaws, is in many ways the best hope on earth. A country that needs you and the best you have to offer and your best judgment.

Thank you for asking me to be here. Thank you for already having done the hard work that got you here, and please enjoy this moment. Be proud of yourself. We're all so very, very proud of you.

Gulf Naturally Leaks 48 Million Gallons Of Oil Each Year, 5X To 25X BP Leak

In comparison to BP's leak in the Gulf of Mexico, the natural oil leaking in the Gulf from the ocean floor is 5 times to 25 times greater the amount of oil that BP's well is leaking into the Gulf.

[Thomas] Shirley, the marine biologist [at Texas A&M University], notes that oil is not a foreign substance in the gulf: "What most people haven't considered is that there's 48 million gallons of oil that's leaked naturally in the gulf every year.

Ian MacDonald, the Florida State University professor who has gained attention with his estimate, based on aerial images, that the leak is five times the official estimate of 5,000 barrels a day, said nature will ultimately have to fix the gulf mess. "BP is not going to clean up this spill," he said. "The Coast Guard is not going to clean up this spill. What's going to clean up this spill is the physical, chemical, biological process of the good ol', poor, downtrodden Gulf of Mexico."

From "Oil spill imperils an unseen world at the bottom of the gulf" by Joel Achenbach in the Washington Post.

[Also, see later post, "Human Use Causes Much More Ocean Oil Than Drilling Accidents"]

Remove Credit Rating Agencies From Financial Institution Regulatory Oversight Process

A comment I posted on "Find the Mistake" by Robert Waldmann on Angry Bear blog.

CDOs (including synthetics) and other combinations of mortgage securities and indices of mortgage securities used models to determine their pricing and expected returns. All models contain a finite set of explicit and implicit assumptions. No set of assumptions will reflect real world events under all future scenarios. CDOs in addition to normal market price risk of expected cashflows also have modeling risk. All pricing based on models will contain modeling risk. No pricing model will accurately predict outcomes under all circumstances.

Traded securities prices reflect investor cashflow expectations of those who think it is fair valued, over valued and under valued. Private placement underwritings, such as CDOs, do not have a trading market price. A potential investor who thinks a CDO underwriting is too risky or overpriced will walk away from the deal, not participate, and have little if any effect on valuation. In a trading scenario some overvalue investor will sell their holdings or find ways to short and will affect valuations.

In a trading market, there is a tension between investors who believe a security is over or under valued. In CDOs, the tension between over and under value investors did not exist and all pricing relied on a single valuation model. Investors, who believed they were overvalued or too risky, did not participate in the deals and did not influence the pricing of the deals.

It does not take a PhD in math or structured finance to understand that it is naïve to rely solely on models of future real world events. Investors in CDOs failed to account for modeling risk of the pricing and expected return.

One of the reasons that investors overlooked modeling risk was the desire to invest in highly credit rated securities. Regulators (Basel capital requirements among others) created the appetite for safe credit rated securities. The regulators embedded the credit ratings in their oversight criteria for capital, solvency and safety of financial institutions.

While many are blaming the credit rating agencies, the credit raters also will use models and under some set of scenarios, their models will fail.

The solution is not to blame the model of CDOs or that credit raters fail to accurately rate the securities. The solution is to remove credit raters from the regulatory process of overseeing financial institutions. Removal of the credit raters from the regulatory process would have reduced the appetite for these securities by financial institutions. A lower appetite would mean fewer CDOs, fewer loans with poor credit scores, and a reduced investor appetite in general for home mortgages

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2005 Bankruptcy Reform Increased Mortgage Defaults By 200,000 Per Year

The 2005 US bankruptcy reform increased the severity of the financial crisis and caused the number of mortgage defaults to increase by around 200,000 per year.

Abstract: [The] U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession. When debtors file for bankruptcy, credit card debt and other types of debt are discharged—thus loosening debtors’ budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. We argue that an unintended consequence of the reform was to cause mortgage default rates to rise. We estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage defaults to rise, using a large dataset of individual mortgages. Our major result is that prime and subprime mortgage default rates rose by 14% and 16%, respectively, after bankruptcy reform. We also use difference-in-difference to examine the effects of three provisions of bankruptcy reform that particularly harmed homeowners with high incomes and/or high assets and find that the default rates of affected homeowners rose even more. We find that bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 per year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.

From "Did Bankruptcy Reform Cause Mortgage Default to Rise?" May 2010, NBER Working Paper No. w15968, by Wenli Li, Federal Reserve Bank of Philadelphia, Michelle J. White, University of California, San Diego - Department of Economics; National Bureau of Economic Research (NBER) and Ning Zhu, University of California, Davis - Graduate School of Management; Yale School of Management; China Academy of Financial Research (CAFR).

Ungated version is available here.

Can't Bad Investments Just Be A Mistake Without Blame?

A comment I posted in response to Arnold Kling's blog, "Cognitive Failure or Moral Failure" on Econlog.

To call it a cognitive failure, doesn't one have to show that prices of trades in a liquid market substantially deviated from fundamental value? An underwriter's CDO price based on models and ratings is a guess at the value of a market based price. In the case of CDOs, the guess was off the mark.

The financial crisis began because CDO collateral value (a type of market price) declined, requiring more collateral to fund overnight borrowing, which created the liquidity and solvency crises at Bear Stearns and Lehman. No cognitive failure here.

As equity market participants recognized that the booked par value of CDOs was higher than the market value, bank stocks such as Citi, tumbled, reflecting the lower value of bank assets, the need for more capital and the potential of insolvency. No cognitive failure here.

Additionally, initial investors in CDOs chose these investments because they promised a higher yield than the equivalently rated US Treasury security. Investors switched from US debt to CDOs because of a promised higher yield. Higher yields mean higher risk and were required by investors to switch to CDOs. If investors truly believed the CDOs were AAA and not more risky than US debt, they would not have wanted a higher yield from CDOs. No cognitive failure here.

I have not seen any analysis that says that the ex ante promised yields of CDOs was not commensurate with the higher expected risk at the time of investment.

Analysis after known losses does not reflect the investment world before the losses. It is easy to recognize a poor investment after it loses money. It is not so easy to recognize one before the losses occur.

No one claiming they saw the coming housing crisis and bubble is claiming they sold their home(s) before the downturn, rented and then bought an equivalent home at a lower price and pocketed the profit.

Investors without cognitive failure make investment mistakes. Why can't all the housing market investment just be a mistake without resorting to all kinds of cognitive, modeling and analytical failings?

Is there really any surprise, that a bureaucratic, rigid regulatory scheme using the rating agencies did not reflect real world events? Doesn't that happen all the time with all regulatory agencies?

The future is always difficult to predict. Do we always need to blame someone or something for our inability to predict tomorrow's events?

Market Circuit Breakers Are Really Censorship

Market prices, price changes and price volatility of publicly traded shares and commodities convey important information about company valuation, relative sector valuation, the economy and geopolitical risks. Circuit breakers prevent trades, hide prices, and decrease apparent price changes and volatility.

Circuit breakers prevent prices from reflecting new information, whether based on speculation, rumor or fact. Algorithm computerized trading, while disparaged by many for the wild up and down US stock market price swings of last Thursday, use public information, such as last trade, relative prices, price changes, trade volume, etc. to determine if stocks should be sold, bought or held.

As computerized trades sold stocks on Thursday, as prices dropped to low levels, other computerized trades bought stocks. Sure, some stocks were sold at very low prices only to see the prices recover to near their old, higher levels very quickly. To the extent that the way trades are allocated among stock markets caused the price swing, that should be fixed to avoid a future occurrence. However, sharp price swings over short time periods in themselves are not a cause for reform or circuit breakers. Short term volatility captures the information uncertainty about risky political events and other risk at the time of the trades.

The European Finance Ministers, frightened by the price drop in global stock indices including the intra-day 1000-point drop on Thursday in the Dow Jones Industrial average, worked over the last weekend through Sunday night before Asian markets opened to put together an enhanced and bigger Greece bailout package to calm Monday morning financial markets.

On Monday in response to the EU's new, larger Greece bailout package, global stock markets surged.

With Greece facing default on its debt, with news coverage of Greeks rioting in the streets, and geopolitical uncertainty about the stability of Greece, other European countries, the EU and the Euro currency, it not not surprising that there was a large volume of shares traded last Thursday. It should also not be shocking that with so much geopolitical risk and uncertainty that there would be sharp price swings in share prices over very short time frames.

With geopolitical risk, there are no press releases as events unfold. Speculation and the merest hint of a rumor could cause trades and price swings. Information, speculation, rumors and political fear travels in microseconds across the globe among traders and investment managers these days. Without a press release or a defining moment, such as a declaration of war, or a military coup, market investigators will be hard pressed to discover any triggering event for the sharp price drop or price swing.

If markets had remained smooth and not reflected the markets' concerns about the first Greece bailout package through Thursday's price volatility and price drops, would the EU's finance ministers' work over the weekend to enhance the Greece bailout and finish before Asian markets opened Monday?

Circuit breakers do not change the underlying events that increase market and political risks. Circuit breakers are just makeup that hides blemishes without fixing the underlying condition. Short-term price volatility measures risks, rumors, speculation and other indicia of geopolitical and economic concerns of the market. Masking trades through circuit breakers, masks volatility and price drops and hides the riskiness of world events.

Political leaders, central banks, and finance ministers need to see markets unnerved. It motivates these government servants to action. Positive market responses, such as Monday's global market surge, visibility rewards and appreciates these government efforts.

Those that sell shares as their prices sharply drop only to see the prices quickly recover may feel they were unfairly treated by their brokers and the stock market. Market regulators and leaders can decide under what conditions these kind of trades can be voided.

Political leaders dealing with geopolitical and global economic risks need to see markets unnerved with increased short-term volatility. It motivates governments to act quickly and appropriately to the crisis. A positive market response through decreased volatility and increased prices acts as a positive indicator and a sign of an adequate response to these officials.

Market circuit breakers are really just government censorship of geopolitical risk and uncertainty expressed through price swings and drops.

Five Forces Reshaping The Global Economy: McKinsey & Co Survey

An ongoing shift in global economic activity from developed to developing economies, accompanied by growth in the number of consumers in emerging markets, are the global developments that executives around the world view as the most important for business and the most positive for their own companies’ profits over the next five years. Executives also identify two other critical positive aspects of globalization: technologies that enable a free flow of information worldwide and, increasingly, global labor markets.

From "Five forces reshaping the global economy: McKinsey Global Survey results" in the May 2010 McKinsey Quarterly.

Using A Reproducible Evidenced Based Scientific Method In Economics

My thanks to Greg Mankiw for posting on his blog the following excellent video of a talk by Esther Duflo. She is one of the leading younger economists today. What distinguishes her from many other economists is that her economics is evidenced based, experimentally reproducible and not purely theoretical or model based.

Many other economists make policy recommendations based solely on theory and models. Esther is willing to use reproducible experimental results in real world settings to make her economic policy recommendations.

Congratulations to Esther Duflo for bringing the scientific method to real world economic problems.

The SEC's Dilemma

The SEC is in an unenviable situation. It will dishonor itself by either winning or losing its case against Goldman Sachs.

The SEC initiated civil charges and a Justice Department criminal inquiry against Goldman Sachs for fraud in the mortgage CDO and mortgage trading businesses.

A criminal fraud conviction of Goldman through a trial or through plea agreement will almost certainly put the firm out of business. Firms in the service and financial industries that primarily rely on their credibly credibility and trustworthiness, as in market making, trading, money management and advisory services, cannot retain customer relationships with governments and top international corporations after a criminal conviction. Goldman will die from a criminal conviction as the public accounting firm Arthur Anderson died. Goldman likely will recover from a civil conviction without a criminal conviction, but it is will require luck and hard work from Goldman Sachs, and there is always the possibility Goldman could fail.

If Goldman goes out of business, without doubt given Goldman's international government connections, multinational corporation business and political relationships, there will be a strong backlash against the SEC and the Justice department. Goldman's punishment will be far worse than the crime, especially since the alleged criminality did not lead to subprime lending excesses, the housing bubble or to the recession. Additionally, Goldman's actions are not deliberate and blatant securities fraud.

Furthermore, it is extremely likely that what Goldman did was common practice on Wall St. and the SEC could make the same warning shot through prosecution of another firm or through a warning letter after one of its industry examinations of common practices in the mortgage CDO and trading areas. Moreover, the SEC will have to answer difficult questions as to why it targeted only Goldman.

If Goldman is found not guilty, the SEC's image of an ineffectual and bubbling bungling securities industry regulator will be reinforced.

The SEC must carefully thread a needle to avoid losing stature as a securities industry regulator as the case against Goldman Sachs proceeds. Goldman is fighting for its existence. The SEC needs to be strong, but not too strong, and the harm against Goldman has to be real but not too great to create a backlash against the regulator. The end has to be a win-win for both parties and it is difficult to see and execute endings that allow the double win.

Both a win and a loss can further damage the SEC's reputation, if it is not very careful. The backlash from a win will be much greater than the SEC has anticipated.

Is The SEC Unfairly Using Reputation Risk To Pressure Goldman To Settle?

News outlets, New York Times, Bloomberg, etc., are reporting that Goldman Sachs is under criminal investigation by the US Attorney for mortgage trading fraud. Goldman's shares dropped over 9 percent today on the news and about 25 percent since its peak about 6 months ago and prior to the SEC's announcement of its investigation into the ACA Paulson Abacus deal.

It is not at all surprising that the SEC referred the Goldman case for criminal review. The SEC often refers civil cases to the Justice Department for criminal review and it is not at all surprising that the SEC referred this high visibility case with populist appeal to the US Attorney for criminal review. It makes the SEC's case look stronger and criminal charges would make it easier to settle the case with Goldman.

Goldman's risk of losing to the government on the criminal or civil case is not high. Many SEC criminal referrals quietly disappear without charges against the firms. Goldman's greatest risks right now are its reputation and lost business.

My impression is that the price drop in its shares is not due to fact that Goldman is under criminal investigation. A criminal referral is expected. The share price dropped because the information is now in the public media.

The government does not announce criminal investigations and waits until an indictment to issue a press release. The government appears to have leaked the information about the investigation directly to the press or to parties with contacts with the press as a strategy to win this case.

Many entities will not do business with a firm under possible criminal indictment and the news stories will make many entities aware of the criminal investigations and make it harder for them to avoid acting upon the news and stop doing business with Goldman.

It appears the government is using reputation risk, lost business, and an Arthur Anderson scenario to pressure Goldman to settle with the SEC and admit guilt.

Revised Bank Secrecy Act Anti-Money Laundering Examination Manual Released

Just a few years ago, during the height of the housing bubble, the major issue facing the banks and bank regulators was anti-money laundering. Large fines were levied against Riggs, AmSouth, Arab Bank, Union Bank of California and Wachovia. As usual, there were Congressional hearings and concerns about regulatory oversight.

Today, the Federal Financial Institutions Examination Council (FFIEC) released the revised Bank Secrecy Act/Anti-Money Laundering (BSA/AML) Examination Manual.

Now the hearings are about the financial crisis and, guess what else, regulatory oversight.

US Presidents Foreign Sources Oil Percentage

From "Foreign Oil Dependency by U.S. Presidential Exhortation" By Paul Kedrosky.

Goldman's Senate Testimony Was Not Laughable Or Obscene

The following is a comment I posted on "Making markets" by Mark Crosby on Core Economics Blog:

Goldman's testimony about market making is neither obscene nor laughable. I do not see the import of Goldman's view of the product. On one side, a party asks Goldman for an investment product with a yield higher than US treasuries and with a good credit agency rating. On the other side, the party asks for a product that is inversely linked (shortable) to high-risk residential mortgages. In between the two parties is Abacus Synthetic CDO. Both parties at the time of investment got what they wanted. Yes, at times the market maker is approached by one side of a transaction and has to find and sell the other side to complete a deal. No one forced IKB, ACA and others to buy into the deal. A salesperson called investors likely to be interested, described the product as all salespersons describe products, and they took the long side. They invested. Market makers are not investment advisers. The investing firms have their own analytical ability. Goldman is an intermediary, a finder, a matchmaker.

There were only 90 mortgages in the synthetic CDO. Did any long investor ask for the credit scores or geographical locations of the homes? Did any investor analysts look at available data for residential mortgage default rates in the areas of the homes?

Suppose a restaurant customer asks the chef to heavily salt, overcook (extremely well done, crispy, burnt), and add lots of Tabasco sauce to hide the flavor of the chef's specialty fish dish. When served, the customer says it is exactly what he wanted. Is it important to know that the chef in the kitchen says the dish will be crap and he would not eat it? Suppose the chef thinks pasta is best al dente and lightly sauced but many customers complain and ask for over cooked pasta that is drowned in sauce, and the restaurant regularly serves the pasta heavily sauced and overcooked to attract customers and make money. Who cares if the chef would not eat it that way?

A market maker matches a long investor with a short investor. It is impossible for the market maker to agree with both parties' opposite investment outlooks. If the product is crap for one side, it is a great investment for the other side. Sometimes, the quantities on both sides do not match and the intermediary, the market maker, takes a position so the both sides of the transaction can be completed. Furthermore, the risk management part of the company might short the same instruments because it is aware that the firm tends to hold long positions as part of transactions.

Suppose Goldman instead of saying the deal was crap, say it was great for the long investors and it bought long positions for itself. Did Goldman then deceive Paulson for whom it created the synthetic CDO?

Either Goldman deceived Paulson or ACA and IKB by your point of view. Market makers are in the middle, match longs and shorts and do not deceive either party, no matter what the market maker's point of view of the transaction is.

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.