"Misapplying the theory I mislearned in college."

Baseline Scenario

Syndicate content The Baseline Scenario
What happened to the global economy and what we can do about it
Updated: 56 min 41 sec ago


Fri, 09/19/2014 - 15:40

By James Kwak

You may have noticed that my blogging has tailed way off over the past few months—to, well, just about nothing. You probably noticed that it was pretty spotty for a long time before that. The main reason is that I’ve been busy with a new teaching job, which requires some effort on academic publications, and raising two small children. The other major factor is that I often just find I don’t have much that’s original to say. Financial regulation is a pretty heavily covered field, and I don’t have the time to be a real expert on, say, derivatives clearinghouses, and—believe it or not—I generally try to avoid posting if I don’t have something new to add. I tried to get back into the flow in the spring semester, when I was only teaching one class, and that worked for a while. But at the beginning of the summer I started doing some part-time consulting for my old company (I’m on unpaid leave from my law school this semester), and that’s made it impossible to keep up with the news, much less write something interesting about it.

That said, I still like to write. I’ve started posting occasionally on Medium, which I like both for the gorgeous interface and because it isn’t organized as a reverse-chronological list—which means that I don’t have to worry as much about saying something newsworthy before the moment passes. This week I wrote about playing Minecraft with my daughter (OK, it’s mainly about the Microsoft acquisition) and one of my favorite topics, why megabanks run on bad software.

I don’t know how long I’ll be keeping this up, but in the meantime my plan is to write an occasional post here summarizing things that I write on Medium or elsewhere on the web. As usual, I’ll also post new articles to Twitter more or less immediately after publishing them.

Thanks for reading.

An Elizabeth Warren for New York

Sun, 09/07/2014 - 08:00

By Simon Johnson

These days, almost everyone likes to complain about institutional corruption – and various forms of intellectual capture of government orchestrated by big corporate interests. But very few people are willing to do anything meaningful about it.

Zephyr Teachout is an exception. Not only has she written about the history of political corruption in the United States, both in long form (her recent book) and in many shorter versions (e.g., see this paper), she is competing for the Democratic nomination to become governor of New York.

In many countries, Ms. Teachout would sweep to victory. She has smart ideas about many dimensions of public policy (here are her economic policies), she has assembled a strong team, and – most of all – she represents exactly the kind of responsible reform that we need at this stage of our republic.

Elizabeth Warren offered exactly the same sort of promise to the people of Massachusetts in 2012 – real reform through pragmatic and effective politics. She has delivered on this promise and there is every indication that her influence will only grow in the years to come.

On Tuesday, New York has an opportunity to head in the same direction. I’ve work with policy makers around the world and across the political spectrum in the United States. Ms. Teachout is completely credible as a potential governor.

And we need her brand of reform. In spring 2009, I wrote about the capture of the American federal government by big financial interests. But the problem is much broader – it is rooted in our electoral system and the ways that money effectively buys votes.

I’m often asked – what can ordinary Americans possibly do about this? The only reasonable answer is: seek out plausible reform candidates, donate to their campaigns, and vote for them. Too few such candidates have come forward in recent years. But Elizabeth Warren offered (and offers) exactly this sort of opportunity, and so too now does Zephyr Teachout.

If you live in New York and are eligible to vote in the Democratic primary, vote for Zephyr Teachout – or stop complaining.

How to Get Thrown Out of a Luxury Hotel

Mon, 07/07/2014 - 14:41

By James Kwak

That’s one of the subplots of Big Money, by Politico reporter Kenneth Vogel, a book that I reviewed for yesterday’s issue of the New York Times Book Review. You can read that review, so I won’t re-review it here, except to say that if you were wondering how political operatives get rich people to part with their money, you’ll find out here.

Corporate Political Contributions and Bad Faith, Whatever That Is

Mon, 06/23/2014 - 23:08

By James Kwak

In an earlier paper (blog post here), I argued that corporate political contributions can in many cases be challenged by shareholders as conflicted transactions that further insiders’ personal interests (e.g., lower individual income taxes) rather than the best interests of the corporation. The argument (to simplify) was that if a political contribution is in the CEO’s individual interests, the resulting conflict of interest should make the business judgment rule inapplicable, placing on the CEO the burden of proving that the contribution was actually in the best interests of the corporation.

In a new paper, law professor Joseph Leahy has outlined a new theory under which shareholders can contest corporate political contributions. He argues that such contributions in many cases will constitute bad faith, since they have a motivation other than serving the best interests of the corporation. This line of reasoning exploits the vagueness of the concept of good faith as it has been established by the Delaware courts in Disney (the case over Michael Ovitz’s $140 million severance package) and later cases. Of course, that is only what the Delaware courts deserve for making such a hash out of the concept. In effect, they first said that any action not motivated by the best interests of the corporation constitutes bad faith, but then in specific cases tried to absolve any actual board of directors of ever actually acting in bad faith.

It is far from clear that a lawsuit brought on these grounds would have much chance of success in court. But by the letter of the case law, they should have a chance. And the more that plaintiffs contest corporate political contributions, the more likely it is that companies will decide that they aren’t worth the trouble. Or, even better, they will decide that they should only make contributions that are actually good for the bottom line and for shareholders—which is the way things should be.

Larry Summers and Finance

Tue, 06/10/2014 - 16:38

By James Kwak

I think some people didn’t understand the point I was making about the question of whether the government made money on TARP in my earlier post. Summers said, “The government got back substantially more money than it invested.” This is true, at least if you give him some slack on the word “substantially.” The money repaid, including interest on preferred stock and sales of common stock, exceeded the money invested.

My point begins with the observation that, as of late last year, the government had earned an annual return of less than 0.5%. My point itself is that it is silly to evaluate an investment by whether or not it has a positive return in nominal terms. You can only meaningfully evaluate an investment by comparing it to some benchmark. Saying that a nominal return of 0.5% is greater than 0% is meaningless, since the 0% benchmark is meaningless. Most obviously, it doesn’t account for inflation; since inflation has been about 1–2%, the government lost money in real terms.

But even saying whether an investment made or lost money in real terms isn’t very meaningful. You should at least compare it to the risk-free rate of return—the rate you could have gotten by investing in Treasuries. As I said in the post, if the government had instead invested in 5-year Treasury notes, it would have gotten an annualized return of 2.4%.

Actually, you should evaluate your investment against other investments of comparable riskiness. Preferred stock in big banks in October 2008  was pretty risky. If you compare TARP (which was concentrated in one very volatile industry) to investing in the broad stock market, the latter returned more than 18% annually.

And, really, you should evaluate investments ex ante, not ex post, by comparing the amount you paid to the at-that-moment value of what you were buying. And by that measure, the government paid high for preferred stock and sold insurance guarantees low.

It’s fine to argue that TARP was good financial stability policy, and that goodness more than compensates for the fact that it was a bad investment. I may not agree, but that’s plausible. But it’s highly misleading to talk about the government’s positive nominal return as a good thing without evaluating it the way you evaluate any other investment.

Larry Summers Should Keep His Mouth Shut

Mon, 06/09/2014 - 11:04

By James Kwak

Larry Summers is well on his way to rehabilitating his public image as a brilliant intellectual, moving on from his checkered record as president of Harvard University and as President Obama’s chief economic adviser during the first years of the administration. Unfortunately, he can’t resist taking on his critics—and he can’t do it without letting his debating instincts take over.

I was reading his review of House of Debt by Mian and Sufi. Everything seemed reasonable until I got to this passage justifying the steps taken to bail out the financial system:

“The government got back substantially more money than it invested. All of the senior executives who created these big messes were out of their jobs within a year. And stockholders lost 90 per cent or more of their investments in all the institutions that required special treatment by the government.”

I have no doubt that every word in this passage is true in some meaninglessly narrow sense or other. But on the whole it is simply false.

Yes, the government got back more money than it invested, if you are looking solely at TARP disbursements. But if Larry Summers evaluates his own investments that way, then he should find someone else to manage his money. The government systematically bought preferred stock in banks for more than it was worth, and it sold assets guarantees to banks for less than they were worth. The fact that it got lucky doesn’t mean those weren’t bad investments.

For example, the government guaranteed a pool of assets owned by Bank of America for something like $5 billion plus warrants. Six months later, after the worst of the crisis passed, Bank of America decided it no longer needed the insurance and wanted out of the deal; Treasury let them out for a payment of $425 million. Larry Summers counts that as a good deal, since Treasury netted $425 million. But that just means they got lucky. By that logic, Summers could sell earthquake insurance on California homes for $10 per year and call himself a genius after one year without an earthquake. Treasury should have collected the difference between the value of the insurance when the deal was struck and when Bank of American wanted out, which would have been a whole lot more than $425 million.

If that’s confusing, there’s an even easier way to think about it. TARP made its first round of investments on Monday, October 13, 2008. As of November 21 last year, TARP was about to turn a paper profit, at least according to the Treasury Department, getting $432 billion back on $422 billion in investments. That’s a 2.4% total return over more than five years, or an annualized return of less than 0.5%. If the government had instead put its money into the stock market on Friday, October 10, 2008, it would have earned a total return of 132% over the same period, or more than 18.3% per year. If Treasury had simply used TARP to buy 5-year Treasury bonds and held them to maturity, it would have earned an annual yield of 2.8%. In short the government only got back “substantially more than it invested” if you ignore the time value of money and risk.

Next, Summers says, “All of the senior executives who created these big messes were out of their jobs within a year.” I’m sure he has a list of the “senior executives” who “created these big messes.” Maybe it includes Chuck Prince (Citigroup), Angelo Mozilo (Countrywide), Dick Fuld (Lehman), and Martin Sullivan (AIG), all of whom were actually gone before Summers showed up on the scene. Maybe it includes Ken Lewis (Bank of America), who left at the end of 2009. But it must not include Jamie Dimon, Lloyd Blankfein, Vikram Pandit, and dozens of other “senior executives,” since there’s little indication that the administration made any effort to force anyone out, except at AIG, where the Bush administration pushed aside the placeholder who had replaced Sullivan.

Finally, “stockholders lost 90 per cent or more of their investments in all the institutions that required special treatment by the government.” Summers must have a pretty narrow definition of “special treatment.” Here’s the Goldman stock price from its 2007 peak to today:

There’s no 90% fall in there no matter where you look.

But even if you say Goldman didn’t get “special treatment” (OK, come on—what else do you call the emergency transformation into a bank holding company and the back-door bailout through government-controlled AIG?), this is Bank of America, which did get the extra bailout in January 2009:

This time there is a 90% fall, but only if you go from October 2007 to March 2009—which means it only applies to shareholders who sold at the bottom. But what does that 90% fall mean, anyway? On January 16, 2009, when Bank of America got its special bailout, its stock was worth $8.32 (that’s the previous day’s close). The stock had already lost most of its value, which is what is supposed to happen when a company blows up. Its price was only distinguishable from zero because of option value predicated on the possibility of a government bailout. The government delivered on the bailout, and although the stock fell to a low of $3.14, by the end of the year it was up to $15.06. In other words, from the point where the government gave Bank of America “special treatment,” its stock almost doubled in less than a year.

All of this is before I got to the real howler, where Summers says he was in favor of mortgage cramdown and that it was rejected for political reasons. But Adam Levitin already called Summers on this blatant attempt to rewrite history, so I’ll let him take care of that one. I’ll just add that Summers claims the administration didn’t pursue cramdown because it didn’t have the votes, while prior reporting has indicated that the Obama economic team was against it in principle.

If Larry Summers could just keep quiet, someday people will think of him as a respected elder statesman (hey, it happened to Ronald Reagan and even Henry Kissinger). But if he continues trying to prove that he was right about everything that every happened in the universe, it isn’t going to happen.


Worse Than We Even Imagined

Fri, 06/06/2014 - 14:03

By James Kwak

I’m giving a talk at the UConn Law School reunions tomorrow, and one of my closing points is about the plethora of banking crimes/scandals/whoopsies that we’ve seen in the past few years—even those having nothing to do with the financial crisis. This is the slide I created to illustrate the point:


I know I’m forgetting a few, but I figured that was enough. It does really take your breath away.