ProfessorBainbridge.com

Derivatives and the Legal Origin of the 2008 Credit Crisis

My friend and UCLAW colleague Lynn Stout has posted an interesting paper to SSRN entitled Derivatives and the Legal Origin of the 2008 Credit Crisis:

Experts still debate what caused the credit crisis of 2008. This Article argues that dubious honor belongs, first and foremost, to a little-known statute called the Commodities Futures Modernization Act of 2000 (CFMA). Put simply, the credit crisis was not primarily due to changes in the markets; it was due to changes in the law. In particular, the crisis was the direct and foreseeable (and in fact foreseen by the author and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.

Derivative contracts are probabilistic bets on future events. They can be used to hedge, which reduces risk, but they also provide attractive vehicles for disagreement-based speculation that increases risk. Thus, as an empirical matter, the social welfare consequences of derivatives trading depend on whether the market is dominated by hedging or speculative transactions. The common law recognized the differing welfare consequences of hedging and speculation through a doctrine called “the rule against difference contracts” that treated derivative contracts that did not serve a hedging purpose as unenforceable wagers. Speculators responded by shifting their derivatives trading onto organized exchanges that provided private enforcement through clearinghouses in which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives risk. In the twentieth century, the Commodity Exchange Act (CEA) largely replaced the common law. Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. For many decades, this regulatory system also kept derivatives speculation from posing significant problems for the larger economy.

These traditional legal restraints on OTC speculation were systematically dismantled during the 1980s and 1990s, culminating in 2000 with the enactment of the CFMA. That legislation set the stage for the 2008 crises by legalizing, for the first time in U.S. history, speculative OTC trading in derivatives. The result was an exponential increase in the size of the OTC market, culminating in 2008 with the spectacular failures of several systemically important financial institutions (and the near-failures of several others) due to bad derivatives bets. In the wake of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). Title VII of the Act is devoted to turning back the regulatory clock by restoring legal limits on speculative derivatives trading outside of a clearinghouse. However, Title VII is subject to a number of possible exemptions that may limit its effectiveness, leading to continuing concern over whether we will see more derivatives-fueled institutional collapses in the future.

Stochastic Process Models of Accounting Fraud

My friend Mike Guttentag has posted an ambitious and very interesting paper to SSRN etitled Stumbling into Crime: Stochastic Process Models of Accounting Fraud:

This book chapter introduces the use of stochastic process modeling to the analysis of how a sequence of minor and seemingly innocuous transgressions may lead to accounting fraud.

Wondering what "stochastic process modeling" is? Candidly, so was I:

Stochastic process models are a mathematical tool used to analyze a phenomenon in which observable “macroscopic” behavior is produced by the cumulative effect of numerous “microscopic” events. Such a model is especially useful when the “microscopic” events cannot be easily observed. This is likely the situation if seemingly minor and inconsequential transgressions lead to accounting frauds.

Three related types of stochastic process models are well-suited to describe the dynamics within a firm that could lead to accounting fraud. The first type of model is based on the movement of a random walker. To apply a random walk stochastic process model to accounting fraud, it is helpful to assume that the illegality of behavior within a firm can be measured along a single dimension and that movement along this “illegality” dimension is determined by a sequence of minor decisions. The resulting random walk stochastic process model of accounting fraud yields testable hypotheses about when and where accounting frauds are likely to occur.

However, a simple random walk model fails to incorporate several important aspects of the process by which minor transgressions might lead to accounting fraud. For one thing, a random walk model is non-stationary, so that over time the walker wanders farther and farther away from the starting point. However, one would not expect the level of lawful or unlawful activity within a firm to become more and more extreme over time. To account for the fact that the level of misbehavior within a firm usually stays within a given range, a mean-reverting force can be added to the simple random walk stochastic process model. The resulting stochastic process model is stationary, which may better describe the dynamics within a firm that lead the level of misbehavior to only occasionally become highly aberrant.

A second limitation of the simple random walk model is that it cannot be used to model a situation in which, once a certain boundary is crossed, it is difficult to return to where one has been. There are likely many instances during the process leading to accounting fraud in which actions are taken which are difficult to undo. For example, once a firm makes a public disclosure about its financial condition, the firm’s ability to restate past performance will be limited. To take into account the likelihood that certain behaviors (such as publicly reporting financial performance), once made, will be difficult to reverse, the random walk model can be supplemented with a running maximum. This is the third type of stochastic process model I consider in this Chapter.

It makes you think

Greg Mankiw passes along this quote from Larry Summers:

Never forget, never forget, and I think it’s very important for Democrats especially to remember this, that if Hitler had not come along, Franklin Roosevelt would have left office in 1941 with an unemployment rate in excess of 15 percent and an economic recovery strategy that had basically failed.

Conspiracy theorists may wish to start figuring out who Obama's going to go to war with in late 2012.

Hybrids don't necessarily help the environment

Autoweek reports that:

Car buyers who think they are helping the planet by choosing a hybrid vehicle to aid in cutting emissions don't always get the biggest bang for their buck, according to an environmental interest group.

A report from the Union of Concerned Scientists shows that some hybrids come at a much higher price tag than their similarly equipped, conventional-powertrain counterparts, yet offer little in the way of environmental gain.

These not-so-green hybrids compromise their value or eco-friendliness in a variety of ways.

For example, rarely is the hybrid powertrian offered on a vehicle's base model. That forces customers to take premium features that are packed with the hybrid version, adding to hybrid's price disadvantage.

Other times, a hybrid might not be built to achieve fuel-saving performance in the most cost-effective manner.

Well, duh, as fans of Top Gear have long known:

Teaching Business Associations

Interesting roundtable discussion at the Conglomerate of current issues in teaching the basic Business Associations course. teachers of BA will want to check out the website for the Klein, Ramseyer & Bainbridge Business Associations case book.

7-19

That's the Ninth Circuit's record in the last Supreme Court term. Seven affirmations versus 19 cases reversed or vacated:

It was another bruising year for the liberal judges of the U.S. 9th Circuit Court of Appeals as the Supreme Court overturned the majority of their decisions, at times sharply criticizing their legal reasoning.

Appeals from the nine Western states of the circuit dominated the high court's docket, as usual, supplying more than 30% of the 84 cases taken up by the justices during the term that ended last month. ...

In their reversals, the justices often expressed impatience with what they see as stubborn refusal by the lower court to follow Supreme Court precedent. One of the circuit's most renowned liberals, Judge Stephen Reinhardt, was seen by judicial analysts as the main target of the justices' pique.

"It’s baaack: The Shareholder Protection Act"

Ribstein doesn't like it any better than I do.

Say on Pay Proves Ineffective, but Still Problematic

In my article, Dodd-Frank: Quack Federal Corporate Governance Round II, I argued that say on pay was likely to prove ineffective:

The effectiveness of say on pay is highly contested. The Senate committee report argued that:

The UK has implemented ‘‘say on pay’’ policy. Professor John Coates in testimony for the Senate Banking Committee stated that the UK’s experience has been positive; ‘‘different researchers have conducted several investigations of this kind . . . These findings suggest that say-on-pay legislation would have a positive impact on corporate governance in the U.S. While the two legal contexts are not identical, there is no evidence in the existing literature to suggest that the differences would turn what would be a good idea in the UK into a bad one in the U.S.’’

In contrast, Professor Jeffrey Gordon argues that the U.K. experience with say on pay makes a mandatory vote a “dubious choice.” First, because individualized review of compensation schemes at the 10,000-odd U.S. reporting companies will be prohibitively expensive, activist institutional investors will probably insist on a narrow range of compensation programs that will force companies into something close to a one size fits all model. Second, because many institutional investors rely on proxy advisory firms, a very small number of gatekeepers will wield undue influence over compensation. This likely outcome seriously undercuts the case for say on pay. As we have seen, proponents of say on pay claim it will help make management more accountable, but they ignore the probability that say on pay really will shift power from boards of directors not to shareholders but to advisory firms like RiskMetrics. There’s good reason to think that boards are more accountable than those firms. “The most important proxy advisor, RiskMetrics, already faces conflict issues in its dual role of both advising and rating firms on corporate governance that will be greatly magnified when it begins to rate firms on their compensation plans.” Ironically, the only constraint on RiskMetrics’ conflict is the market—i.e., the possibility that they will lose credibility and therefore customers—the very force most shareholder power proponents claim doesn’t work when it comes to holding management accountable.

As for the U.K. experience, Gordon’s review of the empirical evidence finds that shareholders almost invariably approve the compensation packages put to a vote. He further finds that while there is some evidence that pay for performance sensitivity has increased in the U.K., executive compensation has continued to rise “significantly” in the U.K. Indeed, the growth rate for long-term incentive plans has been “higher” than in the U.S.

Gordon concludes “that ‘say on pay’ has some downsides even in the United Kingdom, downsides that would be exacerbated by a simple transplant into the United States.” He recommended that any federal rule be limited to an opt-in regime or, if some form of mandatory regime was politically necessary, that it be limited to the very largest firms. As we have seen, Congress went in a different direction, despite the considerable uncertainty as to whether say on pay will be effective.

With the first proxy season since say on pay became law behind us, we now see that it has indeed proved ineffective. Broc Romanek reports:

 

Last month, Premiere Global Services became the 40th company to file a Form 8-K reflecting a failure to get majority support for it's say-on-pay agenda item (47%). ... 40 failures is less than 2% of all companies that had say-on-pay on their ballot this season.

So what can we conclude? First, I must confess to be surprised how little influence ISS had on the process. ISS recommended no votes at about 12% of listed companies it analyzed. Pay packages at companies that got a negative ISS recommendation received a lower percentage of favorable votes than those at companies where ISS made a positive recommendation, but the vast majority still passed with room to spare. This assuages concerns that ISS would prove to be the proverbial 800 pound gorilla, but it does not eliminate the conflict of interest ISS has. Government regulators still need to take a hard look at ISS and other proxy advisory firms.

Second, I come away persuaded activist investors remain rare. The data suggest that shareholder governance activism is still concentrated among state and local government pension funds, union pension funds, and individual gadflies. It's good news that they remain a minority, but their activism remains troubling since they are often the investors most likely to use governance activism to advance a private agenda.

Third, and back to surprises, I must admit to being surprised at the number of lawsuits filed against firms at which there was a no vote. What part of advisory and nonbinding do the plaintiffs and their lawyers fail to understand?

If I were the czar of corporate governance, I'd throw out the Dodd-Frank say on pay rules and replace them with an opt-in regime.

Les Forts de Latour (Pauillac) 1995

Served with a lamb shank tagine and couscous with dried fruits, for which it was an excellent match.

Huge bouquet. Dark fruits, cedar, leather, tobacco. Good acidity on the palate made it a good match for the rich lamb. Medium body. Moderate finish of prunes and dried blackcurrants.

Well integrated and mature. Will last a little while longer, but drinkable now. Indeed, probably start drinking up, as it's not quite as good as it was back in 2006.

Grade: B+/A-

Bebchuk tries to revive support for shareholder control of political spending

In his continuing effort to let shareholders micromanage corporations, Lucian Bebchuk is trying to revive interest in his proposal to "establish special corporate-governance rules for deciding when corporate resources may be spent on politics." "These rules would require extensive disclosure, a role for independent directors, and shareholder approval."

I explained why these proposals are bad policy in my post Shareholders and corporate political speech:

As Delaware’s Chancellor William Allen observed, our “corporation law does not operate on the theory that directors, in exercising their powers to manage the firm, are obligated to follow the wishes of a majority of shares. In fact, directors, not shareholders, are charged with the duty to manage the firm.” Paramount Communications Inc. v. Time Inc., 1989 WL 79880 at *30 (Del. Ch. 1989), aff’d, 571 A.2d 1140 (Del. 1990).

Allen further recognized that the fact that many, “presumably most, shareholders” would have preferred the board to make a different decision “done does not . . . afford a basis to interfere with the effectuation of the board’s business judgment.” In short, corporations are not New England town meetings.

It's also worth remembering that the beneficiaries of Bebchuk's incessant pressing of ever expanding shareholder power and that of acolytes like Jackson is not going to benefit ordinary investors. Instead as Roberta Romano observed with respect to union and public pension fund sponsorship of shareholder proposals:

It is quite probable that private benefits accrue to some investors from sponsoring at least some shareholder proposals. The disparity in identity of sponsors—the predominance of public and union funds, which, in contrast to private sector funds, are not in competition for investor dollars—is strongly suggestive of their presence. Examples of potential benefits which would be disproportionately of interest to proposal sponsors are progress on labor rights desired by union fund managers and enhanced political reputations for public pension fund managers, as well as advancements in personal employment. … Because such career concerns—enhancement of political reputations or subsequent employment opportunities—do not provide a commensurate benefit to private fund managers, we do not find them engaging in investor activism.[1]

---

[1] Roberta Romano, Less Is More: Making Shareholder Activism A Valued Mechanism Of Corporate Governance, 18 Yale J. Reg. 174, 231-32 (2001).

I've dealt with these issues in greater length elsewhere, most notably The Case for Limited Shareholder Voting Rights, 53 UCLA Law Review 601-636 (2006) ....

Those nights at the printer

Broc Romanek reminisces about those nights those of us of a certain age spent at the financial printer supervising document preparation. I for one don't miss them at all.

Gambling on the debt limit

The sell price on the Intrade contract Congress to approve increase in US debt ceiling to $15.1T or more before midnight ET 31 Jul 2011 is currently $4 per contract, which translates into a prediction that there's a 40% chance the debt limit will be raised by 7/31. Looks like a good investment to me.

But what do we make of the sell price on the Intrade contract Congress to approve increase in US debt ceiling to $15.1T or more before midnight ET 31 Aug 2011? The current price to sell that contract is $6.40/ unit, the current price to buy that contract (i.e., to predict that there will be debt limit increase by 8/31) is $6.70, which translates into a prediction that there's a 66.7% chance the debt limit will be raised by 8/31. This also looks like a good investment to me. Whatever you make of the merits, I don't think Congress will be able to stand the pressure from the business community for long. Plus, the GOP will end up losing the public relations battle, as they always do, once Grandma stops gettng her social security check.

Curiously, there seems to be no Intrade contract available on the US defaulting on its debt. Why not?

 

Gold is not money

I don't understand gold bugs like Ron Paul. Despite the patent absurdity of his views, he persists in bugging people about gold:

Chairman Ben Bernanke faced-off with Fed-hating Representative Ron Paul during his monetary policy report to Congress on Wednesday.  The head of the Fed was forced to respond to accusations of enriching already rich corporations while failing to help Main Street, while he was pushed on his views on gold.  When asked whether gold is money, Bernanke flatly responded “No.” ...

“Gold’s at about $1,580 [an ounce] this morning, what do you think of the price of gold?” asked Rep. Paul.  A stern-faced Bernanke responded people bought it for protection and was once again cut-off, with Ron Paul once again on the offensive.

“Is gold money?” he asked.  Clearly bothered, Bernanke told the representative, “No. It’s a precious metal.”

After Paul interrupted him to note the long history of gold being used as money, Bernanke continued,”It’s an asset.  Would you say Treasury bills are money? I don’t think they’re money either but they’re a financial asset.”

I am reminded here of Terry Pratchett's wonderful Discworld novel Making Money, in which Lord Vetinari maneuvers reformed criminal and current Ankh-Morpork Postmaster General Moist von Lipwig into taking on the job of running the Bank of Ankh-Morpock and the Royal Mint. Lipwig eventually discovers that the 10 tons of gold supposedly in the bank's vaults is now longer there. Panic almost ensues. Naturally, however, Lipwig saves the day, gets the girl, and persuades the citizens of Ankh-Morpock to abandon the gold standard.

In doing so, Lipwig is interviewed by The Ankh-Morpork Times' crack reporter Sacharissa Cripslock, in the course of which Lipwig comes up with what I have always regarded as a compelling argument against the gold standard:

"The world is full of things worth more than gold. But we dig the damn stuff up and then bury it in a different hole. Where's the sense in that? What are we, magpies? Is it all about the gleam? Good heavens, potatoes are worth more than gold!"

"Surely not!," [said Ms. Cripslock]

"If you were shipwrecked on a desert island, what would you prefer, a bag of potatoes or a bag of gold?," [replied Moist]

"Yes, but a desert island isn't Ankh-Morpork!"

"And that proves gold is only valuable because we agree it is, right? It's just a dream. But a potato is always worth a potato, anywhere. A knob of butter and a pinch of salt and you've got a meal, anywhere . Bury gold in the ground and you'll be worrying about thieves for ever. Bury a potato and in due season you could be looking at a dividend of a thousand per cent."

"Can I assume for a moment that you don't intend to put us on the potato standard?" said Sacharissa sharply.

QED. Game. Set. Match.

News Corp and free cash flow

News Corp has decided not to go forward with its bid to buy the shares of BSkyB that it did not already own. As somebody who teaches mergers and acquisitions, I was struck by one aspect of the story:

News Corp. benefits from strong liquidity, with $11.8 billion of cash and over $2.5 billion of annual free cash flow. Additionally, credit metrics remain strong, with leverage of 2.7 times (x) at March 31, 2011, below Fitch's 3x target. News Corp. retains significant financial flexibility to pursue merger and acquisition (M&A) and share buyback activities without impacting its 'BBB+' ratings. ...

Fitch believes that News Corp. will seek to deploy much of its cash over the next 12-24 months, with the company stating multiple times that the high cash balance is inefficient. In Fitch's view, BSkyB had been the best possible use of this cash, given the free cash flow, geographical diversification, and recurring revenue associated with the acquisition.

Apparently News Corp also thought buying BSkyB was the best use for all that cash it had lying around, which brings us to the lesson of the day: Managers with too much free cash flow do dumb things.

Successful managers end up with a lot of cash for which they have no good use. In technical terms, they end up with cash flows greater than the positive net present value investments available to the firm. Disbursing these free cash flows to shareholders in the form of dividends would (a) be costly because of the double taxation on dividends and (b) increase management risks because a smaller asset pool increases the risk of firm failure in the event of financial reverses. Accordingly, even well-meaning managers have an incentive to retain free cash flow by making negative net present value investments.

Venal managers have even more incentives to abuse free cash flows. They can splurge on perks. The annals of American business corporations are replete with examples of both forms of shirking, ranging from congenital unluckiness, to incompetence, to outright theft.

They can protect their own interests through inefficient intra-firm diversification. Around the middle of the 20th Century, the idea grew up that good managers could manage anything. This view was operationalized via conglomerate mergers, in which companies intentionally sought to diversify their product lines and business activities horizontally across a wide array of unrelated businesses. The theory was that a cyclical manufacturer could buy a noncyclical business, making the combined company stronger because some division would always be doing well. Diversification necessarily reduces the maximum gains a conglomerate can produce. When one segment is doing well, it is being pulled down by a segment that is doing less well. To be sure, diversification reduced the conglomerate’s exposure to unsystematic risk. But so what? Investors can diversify their portfolios more cheaply than can a company, not least because the investor need not pay a control premium. Management of a conglomerate may be better off, because their employer is subject to less risk, but the empirical evidence is compelling that intra-firm diversification reduces shareholder wealth. The self-correcting nature of free markets is demonstrated by what happened next: during the 1980s there was a wave of so-called “bust-up” takeovers in which conglomerates were acquired and broken up into their constituent pieces, which were then sold off. The process resulted in a sort of reverse synergy: the whole was worth less than the sum of its parts. Unfortunately, managers with too much free cash flow still sometimes pursue this strategy.

They can engage in empire building. Bigger is typically better from management’s perspective. Just like putting oriental rugs down on the floor, bigger organizational charts on the wall are a management perk. If size reduces the chances of firm failure, management even has a financial incentive to pursue such acquisitions. As with acquisitions motivated by a desire for intra-firm diversification, empire building acquisitions doubtless reduce shareholder wealth. Free markets are self-correcting, however. Empirical studies confirm that bidders motivated by considerations other than shareholder wealth maximization themselves tend to become targets.

Managers with excess free cash flow thus have a couple of choices. They can spend it on negative net present value investments, like empire building, and hope that their poison pill and other takeover defenses can insulate them from the forces of the free market.

Or they can sop up that free cash flow by getting it out to the shareholders, typically via a share repurchase. Stock repurchase programs should have the desirable effect of supporting the company’s stock price by (1) lessening the number of outstanding shares and (2) acting as a signal that management is supportive of shareholder interests. As a high stock price is an excellent takeover defenses, such repurchase programs have become a common feature of corporate governance.

Interestingly, even though News Corp reincorporated in Delaware (from Australia) a few years ago for the express purpose of being able to adopt a poison pill, its management seemingly has decided that hiding behind the pill is not the right thing to do in this environment. So News Corp has announced that instead of buying BSkyB, its board of directors has approved a $5 billion stock repurchase to start later this year.

Given that News Corp has $2.5 in annual free cash flow, however, a one time repurchase is just a temporary solution. As a takeover defense, stock repurchases will be most effective when the corporation has a large amount of free cash (cash for which there are no positive NPV transactions), but no substantial free cash flows. If the corporation has on-going free cash flows, a one-time stock repurchase is unlikely to have a permanent stock price effect. In order to make such a target a less attractive takeover candidate, an on-going program of regular stock repurchases will be necessary.

It'll be interesting to see what News Corp does next.

I don't understand Obama's foreign policy

This is not a partisan poke, for once. I really don't get what drives Obama's foreign policy decision making.

Libya had given up its WMD program and been very careful for a long time to avoid antagonizing the USA. When the Libyan government uses force to put down an insurrection, Obama goes to war with Kadaffi. Yes, I know, Obama supposedly turned the Libyan adventure over to NATO, but the reality is that the US military is still deeply involved in prosecuting the war against Kadaffi. Except, we're not really fighting Kadaffi or anybody else. We seem to be going to great lengths to only blow up buildings, not our putative enemies, which strikes me as a very odd sort of war. In any case, hundreds of millions of US taxpayer dollars have been sunk into that quagmire. Meanwhile, the French who did so much to get Obama into this mess are about to cut and run, leaving Obama where exactly?

Meanwhile, there's Syria. Front-line state that still hasn't made peace with our key ally Israel. State sponsor of terrorism. Long-time f*cker-uper of Lebanon. Patron of Hezbollah and Hamas. History of brutal repression. Currently, using security forces armed with heavy military weapons to kill thousands of protestors against the regime. Provoked protests aimed at breaching Israel's borders so as to distract Syrians from problems at home. And now the Syrians are aping their Iranian masters by sending government thugs to attack the US embassy, not to mention the US ambassador's residence.

The French fought off a similar embassy attack using live ammo.

Meanwhile, what does Obama do about Syria? He has a minion give them a very stern "tsk, tsk."

So the policy seems to be use force when no US interests are at stake and don't use force when US interests are at stake. If that's not the policy, I'd sure be curious to know what the policy in fact is.

And how about adopting a policy of only going to war with people who actually attack us or our vital national interests?