"Misapplying the theory I mislearned in college."
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.
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.
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.
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.
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.
By James Kwak
Today my daughter’s combined first and second grade class wrote down their individual wishes for the world. The wishes are part of a wish tree. Here they are:
I wish people could always be happy.
I wish the world was more fair.
I wish for a world of peace and a world of kindness.
I wish everyone would care about each other and never fight.
I wish everybody could have have food.
I wish they would tax the rich and help the poor.
I wish, I wish, I wish there were more trees, I still wish that, so remember.
I wish there was no poaching and there was friendship for all animals and people.
I wish the land was fair and everyone had a friend.
I wish I could have money to donate to orphans and the world would have no guns and people could be in peace.
I wish that big arguments didn’t turn into wars and people didn’t get hurt.
I wish everybody will have shelter.
I wish everybody will not get sick.
I wish there were no guns.
I wish everybody would have food and water.
I wish everybody had time to finish their coffee every morning.
I wish that I had a million dollars so that I could help people who needed help.
I wish everyone could never die and never get sick.
I wish that everyone was kind to old mother nature.
I think I know which one was my daughter’s (although it could also have been the one about coffee).
By James Kwak
Over the years, Tim Geithner has come in for a lot of well-deserved criticism: for putting banks before homeowners, for lobbying for Citigroup when it wanted to buy Wachovia, for denying even the possibility of taking over failed banks, and so on. The release of his book, whatever it’s called, has revived these various debates. Geithner is certainly not the man I would want making crucial decisions for our country. But it’s also important to remember that he was only an upper manager. The man who called the shots was his boss: Barack Obama.
That’s the theme of Jesse Eisinger’s column this week. I’m on Eisinger’s email list, and he described the tendency to focus on Tim Geithner—while ignoring the role of the president—as “If only the Tsar knew what the Cossacks are doing!” I wasn’t familiar with the Russian version, but I’ve always been fond of the seventeenth-century French version. In September 2009, for example, Simon and I wrote this about the financial reform debate:
“During the reign of Louis XIV, when the common people complained of some oppressive government policy, they would say, ‘If only the king knew . . . .’ Occasionally people will make similar statements about Barack Obama, blaming the policies they don’t like on his lieutenants.
“But Barack Obama, like Louis XIV before him, knows exactly what is going on.”
In his column, Eisinger describes Geithner as a foot soldier in an administration full of hesitant bureaucrats who “compete to see who can bow more quickly to what they perceive as the political realities of the moment.” Obama took particular pains to stand behind Geithner throughout his term as treasury secretary. Whom should we blame for that?
By James Kwak
The Harvard Law Review recently published a multi-book review by Adam Levitin, the go-to guy for congressional testimony on toxic mortgages, illegal foreclosures, and homeowner relief (or, rather, the failure of the administration to provide any). It’s a tough genre: Levitin had to write something coherent about six very different books by Bernanke, Bair, Barofsky, Blinder, Connaughton, and Admati and Hellwig, whose sole point of commonality is that they all had something to do with the financial crisis. I don’t agree with all the aspects of his discussions of each individual book, but I think Levitin did a good job using the books as a starting point for a discussion of the incentives problem in financial regulation: the problem that regulators have stronger incentives to favor the industry than to defend the public interest.
HLR asked me to write an online “response,” which in some ways is an even less appetizing prospect—writing something interesting about something someone else (whom I generally agree with) wrote about six other things by different people. On the other hand, they only wanted 2,000 words, so I said yes.
My response focuses on a separate reason that regulation can be captured by industry: ideology. This is something that Levitin does discuss in the body of his article, but I think is not directly addressed by his proposed solutions. If you want to read more, you can download it from SSRN or read it at the HLR site.
By James Kwak
Credit Suisse’s guilty plea to a charge of tax fraud seems to be a major step forward for a Justice Department that was satisfied both before and after the financial crisis with toothless deferred prosecution agreements and large-sounding fines that were easily absorbed as a cost of doing business. A criminal conviction certainly sounds good, and I agree that it’s better than not a criminal conviction. But what does it mean at the end of the day?
Most obviously, no one will go to jail because of the conviction (although several Credit Suisse individuals are separately being investigated or prosecuted). And for Credit Suisse, business will go on as usual, minus some tax fraud—that’s what the CEO said. A criminal conviction can be devastating to an individual. But when public officials go out of their way to ensure that a conviction has as little impact as possible on a corporation, it’s not clear how this is better than a deferred prosecution agreement.
The reason for the kid-glove treatment, of course, is the fear that Credit Suisse is too big to jail. Otherwise, why would the DOJ have been so concerned to get regulators’ assurances that they would not pul Credit Suisse’s licenses? In fact, that’s the bank’s main defense against harsher punishment, since it’s clearly guilty, guilty, guilty. (Who ever thought that Swiss banks were not abetting tax fraud? Isn’t that the whole point?)
But the thing is, they’re not too big to jail. The regulators could have revoked their banking license without bringing on the end of the world. I make that argument in my Atlantic column today, but the basic point is that a solvent bank (and everyone says they’re solvent) can be wound down without spillover effects; if it can’t, it isn’t solvent to begin with.
In the end, it seems like the Department of Justice has managed to take something that seems like it should have teeth—a criminal conviction of a corporation—and turn it into just another slap on the wrist. And so the world turns.
By James Kwak
A couple of weeks go I wrote an op-ed about a proposal in Connecticut to create a new tax-preferred retirement plan that would, by default, include almost all workers who don’t currently have access to an employment-based plan (like a 401(k)). That proposal took some major steps forward when it was included in an end-of-session bill that was passed by the Connecticut legislature. As it stands, the bill authorizes a feasibility study and implementation plan for the new retirement option, which must contain a number of features (default enrollment, portability, default annuitization at retirement, a guaranteed return to be specified at the beginning of each year, etc.).
As I said in the op-ed, this is a decent step forward that will increase the amount of retirement saving by low- and middle-income workers, put those savings in a relatively low-cost, low-risk investment option, and spread some of the benefits of the retirement tax break to those workers (although you do have to pay income tax to benefit from the deduction). One of the claims made by the plan’s opponents is that it cannot be managed for less than the 1 percent of assets mandated by the bill, but that seems laughable to me: the State of Connecticut’s current retirement plans for its employees have administrative costs of 10 basis points, plus investment expense ratios as low as 2 basis points (for index funds from Vanguard). This is a slightly different animal, since the idea is to invest in low-risk securities and buy downside insurance, but still it doesn’t follow that you have to pay more than 1 percent for asset management is.
Connecticut is one of several states, most famously California, that are in the process of implementing these public retirement plans to cover people who are left out by the current “system,” which favors people who work for large companies. They can solve several of the common problems with 401(k) plans: nonexistence (at many employers), low participation rates, investment risk, pre-retirement withdrawals, lump-sum distributions at retirement, to name a few.
But they can’t solve the underlying problem, which is that many people just don’t make enough for saving 3 percent of their salary each year to make much of a difference. A big constraint is that the Connecticut plan was designed to not cost taxpayers any money: administrative fees will come out of plan balances, and the insurance is there to limit the chance that the state will have to bail out the plan in the future. If we really want to protect people against retirement risk, we need to actually spread risk by making either the funding mechanism or the benefit formula progressive, which means we can’t regard the idea of the untouchable individual account as sacrosanct. (See my recent paper for more on this topic.) That’s what Social Security does, and it’s vastly popular. But in today’s political environment of me me me me me, and so we’re stuck with treating symptoms.
By James Kwak
More than a year ago I wrote a post titled “What Is Social Insurance?” about a passage in President Obama’s second inaugural address defending “the commitments we make to each other – through Medicare, and Medicaid, and Social Security.” In that post, I more or less took the mainstream progressive view: programs like Social Security are risk-spreading programs that provide insurance against common risks like disability, living too long, poor health in old age, and so on.
Since then, I undertook to write a chapter on social insurance for a forthcoming Research Handbook in the Law and Economics of Insurance, edited by Dan Schwarcz and Peter Siegelman. In writing the chapter, I decided that things were somewhat more complicated.
In brief, I still think that social insurance programs—or, rather, the programs that are generally thought of as social insurance, since there is no good definition of them out there—provide risk-spreading insurance when viewed over a long time horizon. So from a lifetime perspective, the insurance function means that most people are made better off, even though a program as a whole may be a zero-sum game in dollar terms. But in the short term, it’s pretty clear that Social Security and programs like it are largely redistributive rather than risk-spreading, because in the short term I have no chance of collecting retirement benefits and little chance of collecting disability benefits. (Given the nature of my work, there aren’t that many disabilities that would prevent me from earning more than I would make in disability benefits.)
In other words, I think a crucial feature of social insurance is that it is redistributive in the short term (in an ex ante sense, not the trivial ex post sense that is true of all insurance) but risk-spreading in the long term. I happen to think that the world would be a better place if we considered the long term and, therefore, decided to maintain these programs. But I don’t think it’s obviously true that a lifetime perspective is correct and a one-year perspective is incorrect.
In particular, if you think that Social Security won’t be around when you retire, then you would logically take a short-term perspective in which you pay taxes but never receive benefits (unless you go on disability, or you die while Social Security still exists). Then you should rationally want to eliminate Social Security as soon as possible. Conversely, if you believe that Social Security will be around when you retire, then you will evaluate the whole thing, including its insurance value, which will make you more likely to vote for it. So it’s not surprising that a major component of the anti-Social Security campaign consists of trying to convince young people (who ordinarily gain the most from insurance, since they face the most uncertainty) that Social Security cannot exist when they retire.
If you want to read more, the draft chapter is up on SSRN. Enjoy.
By James Kwak
Roger Myerson, he of the 2007 Nobel Prize, wrote a glowing review of The Banker’s New Clothes, by Admati and Hellwig, for the Journal of Economic Perspectives a while back. Considering the reviewer, the journal, and the content of the review (which describes the book as “worthy of such global attention as Keynes’s General Theory received in 1936″), it’s about the highest endorsement you can imagine.
Myerson succinctly summarizes Admati and Hellwig’s key arguments, so if you haven’t read the book it’s a decent place to start. To recap, the central argument is that under Modigliani-Miller, the debt-to-equity ratio doesn’t affect the cost of capital and therefore doesn’t affect banks’ willingness to extend credit; the real-world factors that make Modigliani-Miller untrue (deposit insurance, taxes, etc.) rely on a transfer of value from another party that makes society no better off.
Myerson’s main point, accepting Admati and Hellwig’s position, has to do with the politics of bank regulation. Financial crises can have huge costs for society, as we know, and fundamentally they are about a failure of trust—trust that the banks are solvent, or that the bankers know what they are doing. As capital regulation has become more technical and complex, we have been increasingly asked to simply rely on the expertise of the regulators, since we cannot rely directly on the disclosures provided by the banks.
In 2008, we learned that relying on the regulators was a catastrophic error. Six years later, however, we have no better solution. Politicians, regulators, and bankers have engaged in a great deal of ritual display to try to make us believe we should trust them (resolution authority! living wills! clearinghouses! Volcker Rule! contingent convertible bonds!). But the basic nature of Dodd-Frank was more complexity, more rulemakings, more back-alley rulemaking, and less transparency. Dodd-Frank has probably helped in several ways, but it hasn’t given us any reason in general to have more confidence either in banks or in regulators. Instead, I think most people throw up their hands and move on because they have no other option.
As Myerson writes:
“With so much money in the banking system, our hope that regulators and officials will not be induced to falsely certify unsafe banks must depend on confidence that a failure of appropriate regulation could be discovered, reported in the press, and understood by voters well enough to cause a ruinous scandal for the responsible officials. . . .
“If there are abstruse financial transactions that generate risks which cannot be adequately represented in standard public accounting statements, then perhaps such transactions should be off limits for banks that are in the business of issuing reliably safe deposits.”
In other words, it’s not just that complexity can cause banks to blow up. It’s also that complexity makes it impossible for regulators to monitor banks, which is a critical ingredient in the financial crises that we all supposedly want to avoid.
Besides the primary reason for higher capital requirements—safer banks—this is the political reason for higher capital requirements (and other simple, structural fixes like smaller banks). More equity, based on standards that cannot be gamed by banks, is crucial to ensuring that the safety of the financial system does not depend on a secretive cadre of technocrats whose personal interests (whether or not they act on those interests) are decidedly aligned with those of the banks they regulate. Otherwise, as Myerson warns, “if nobody outside of the elite circles of finance can recognize a failure of appropriate regulation, then such failures should be considered inevitable.”