"Misapplying the theory I mislearned in college."

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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.

My Daughter’s Wish

Thu, 05/29/2014 - 15:00

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).

Czars, Kings, and Presidents

Thu, 05/22/2014 - 12:34

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.”

And I reused that phrase as the epigraph for the short article I wrote for the Harvard Law Review (which I blogged about yesterday).

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?

Why Regulation Goes Astray

Wed, 05/21/2014 - 09:25

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.

Is Credit Suisse Really in Jail?

Tue, 05/20/2014 - 14:44

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.

Connecticut Public Retirement Plan Passes, More or Less

Mon, 05/19/2014 - 13:48

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.

What Is Social Insurance? Take Two

Tue, 05/13/2014 - 11:48

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.

Finance and Democracy

Fri, 05/09/2014 - 09:08

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.”

Tax Policy Revisionism

Wed, 05/07/2014 - 13:42

By James Kwak

In an otherwise unobjectionable article about The Piketty, the generally excellent David Leonhardt wrote this sentence: “In the 1950s, the top rate exceeded 90 percent. Today, it is 39.6 percent, and only because President Obama finally won a yearslong battle with Republicans in early 2013 to increase it from 35 percent.”

Is “yearslong” really a word?

But that’s not what I mean to quibble with. It’s that “yearslong battle with Republicans.”

Let’s review the facts. The 39.6 percent tax rate dates from the first Clinton budget act in 1993. It was lowered to 35 percent by the 2001 Bush tax cut, which had a sunset provision at the end of 2010 because Bush couldn’t get 60 votes to pass it, so he had to use reconciliation, which under the Byrd Rule couldn’t be used to increase the deficit more than 10 years in the future. The 35 percent rate was then extended for two years by the December 2010 tax cut, which was supported by President Obama and passed with overwhelming bipartisan support. It finally expired on January 1, 2013, at which point the 39.6 percent rate reappeared in its original form. A few hours later, Congress passed a new tax cut for just about everyone, except households with income over $450,000, who were left with the 39.6 percent rate.

In other words, President Obama didn’t fight a battle with Republicans. He fought a battle with himself. In 2010 and 2012 he could have restored the top tax rate to 39.6 percent simply by doing nothing and letting the Bush tax cuts expire. The January 2013 tax bill also locked in big tax preferences for capital gains and dividends, though not quite as big as envisioned by President Bush.

President Obama talks a good game when it comes to inequality, but he hasn’t backed it up with actions. There may have been extenuating circumstances, sure. But when it comes to tax policy, his main impact has been to make permanent most of the inequality-increasing tax cuts that his predecessor’s most treasured legacy.

The “Chicken(expletive) Club”

Fri, 05/02/2014 - 06:30

By James Kwak

Update: See notes in bold below.

The only “Wall Street” “executive” to go to jail for the financial crisis was Kareem Serageldin, the head of a trading desk at Credit Suisse, according to Jesse Eisinger in a recent article. Serageldin pleaded guilty to—get this—holding mortgage-backed securities at artificially high marks in order to minimize reported losses on his trading portfolio.

Now if that’s a crime, there are a lot of other people who are guilty of it. In fact, a major premise of the federal government’s crisis response strategy was exactly that: allowing banks to keep assets at inflated marks in order to pretend they were solvent when they weren’t. FASB changed its rules in April 2009 in order to make it easier for banks to inflate their marks. And the Obama administration’s “homeowner relief program” was designed to allow banks to delay realizing losses on their mortgage loans by dragging out—but generally not preventing—foreclosures. (Remember “foam the runway”?)

Combine Serageldin’s story with the story of the vigorous prosecution of Abacus Federal Savings Bank—a little Chinatown bank that, if anything, was probably allowing its borrowers to underreport their income on loan applications—which Matt Taibbi tells in the first chapter of his latest book, and the picture you get isn’t pretty. It’s a picture of the immense resources of the American criminal justice system being deployed against bit players, with no consequences for the people responsible for the financial crisis. The judge in Serageldin’s case even called his conduct “a small piece of an overall evil climate within the bank and with many other banks.”

Eisinger’s article attempts to explain why the Justice Department hasn’t even tried to convict anyone at a bank with any significant responsibility. And it’s not like they haven’t been given the opportunity. What about Standard Chartered, where manually overtyping data fields to circumvent money laundering controls was a written procedure? According to Eisinger, it’s a combination of blowback from the Arthur Andersen conviction, lack of resources, lack of practice in prosecutions, and court cases disallowing some of the DOJ’s more aggressive tactics.

There are also the usual suspects. There is the Federal Reserve protecting the banks, warning the DOJ not to go after PNC Bank because of financial stability concerns. There is the revolving door: “According to numerous former criminal-division employees, [Lanny] Breuer almost immediately signaled his interest in bigger things.”

There is the thrill of the easy victory. Exhibit A: Preet Bharara’s 80–0 record in insider trading cases. As a former Southern District prosecutor said: “They made our careers, but they don’t change the world.” [I originally wrote that Bharara himself said this, but I misinterpreted the subject of the sentence in Eisinger's article.] By contrast, Eisinger quotes James Comey, a deputy attorney general in the second Bush administration: “We have a name for prosecutors who have never lost — the ‘Chicken(expletive) Club.’”

What’s missing is any reason to think things will change. Basically, everyone is well served by the current arrangement. Prosecutors rack up impressive winning records, the revolving door spins, and the banks continue doing what they do. Even as we amass more evidence of their basic incompetence and out-of-controlness, in the form of Lehman CFO Ian Lowitt saying the bank had $42 billion of liquidity—five days before it went bankrupt. “When Lowitt came to talk to Jenner & Block,” Eisinger continues, “he explained that he had not fully understood the issues when he assured investors of its liquid assets.” Not very reassuring.

The Conspiracy Behind the B of A “Mistake”

Wed, 04/30/2014 - 08:37

By James Kwak

Some very clever people deep in the bowels of Bank of America’s accounting and regulatory compliance departments came up with a clever strategy to show, once and for all, that their bank is too big to manage. On Monday, the bank admitted that it had misplaced $4 billion in regulatory capital because of an error in accounting for changes in the value of its own debts. Coming less than two months after Citigroup misplaced $400 million in cold, hard cash in its Mexican subsidiary, this latest mixup is clearly part of a concerted campaign by employees of the big banks to definitively prove that their top executives have no idea what is going on.

This shadow lobbying campaign can be traced back to its origins in the LIBOR scandal (“Let’s rig the world’s largest market and see if Vikram Pandit notices.”) and the London Whale trade (“Let’s make a colossal bet on the relative values of different corporate bond indexes and see if Jamie Dimon notices.”). The only possible explanation for this seemingly never-ending stream of embarrassing disclosures is the existence of a conspiracy, orchestrated by some of the smartest bankers in the world, designed to broadcast to the world the message that regulators and politicians somehow failed to take from the financial crisis: the Masters of the Universe can’t even figure out what’s going on four floors down in their own buildings. The Bank of America accomplices even managed to miscalculate the bank’s regulatory capital for five full years before tipping off their bosses, showing the premeditation behind their scheme.

Or, the other possibility is that the banks are both incompetent and unmanageable. But that can’t be true, can it?

Retirement Accounts for Everyone

Mon, 04/28/2014 - 16:36

By James Kwak

The Connecticut legislature is considering a bill that create a publicly administered retirement plan that would be open to anyone who works at a company with more than five employees. Employees would, by default, be enrolled in the plan (at a contribution rate to be determined), but could choose to opt out. The money would be pooled in a trust, but each participant would have an individual account in that trust, and the rate of return on that account would be specified each December for the following year. Upon retirement, the account balance would by default be converted into an inflation-indexed annuity, although participants could request a lump-sum deferral.

The legislative session ends in less than two weeks, and while the bill has passed through committees, I believe it’s not certain whether it will be put to a floor vote. On Friday I wrote on op-ed for The Connecticut Mirror about the bill.

The requirements for businesses are relatively modest. The main one is that they have to allow employees to make contributions by payroll deduction. If they don’t outsource their payroll (which most companies do), that will involve a little more administrative hassle, but nothing terribly complicated. (Employers already have to deal with federal and state income tax withholding, payroll taxes, workers’ compensation insurance, and unemployment insurance contributions, to name a few.) And compared to a 401(k), this plan has the huge benefit that the employer isn’t a fiduciary. Retirement benefits are paid solely out of participants’ contributions and investment returns, so there’s no fiscal impact.

I think one controversial aspect of the bill, at least for some people, is the annually pre-specified rate of return. This is nothing new, by the way. TIAA-CREF, for example, has an account in its retirement plans that pays a pre-set rate of interest on a quarterly basis. But the downside is that if the interest rate is going to be guaranteed, it can’t be that high. In this respect the accounts will be similar to the myRA, which will pay an interest rate based on Treasury yields.

But if you want a guaranteed return, this is the way it has to be. One of the central rules of finance is that if you want a higher expected return, you have to be willing to take on more risk. So the underlying question is how much risk people without a lot of income should be taking in their retirement accounts. (For the most part, if you have a lot of income, you already have an employer-sponsored retirement account or a SEP-IRA if you’re self-employed.)

This is a question on which smart people differ. The argument for stocks is that they have a higher expected return, but that means they also have higher potential losses. While stocks tend to do better than other asset classes over thirty-year periods, there’s no fundamental reason why they have to (and there have been twenty-year periods during which they haven’t been the top asset class). My general thinking is adopted from Zvi Bodie: In finance, you should match your assets to your liabilities, and to the extent that your liabilities are fixed (i.e., the minimum you need to live in retirement), your assets should be as safe as possible. In addition, while stocks can be a better investment, they introduce countless possibilities for making bad investment choices, and human beings have tried out all of them.

In any case, I think SB 249 is a modest step forward. The underlying problem, unfortunately, is that many people just don’t make enough to save enough money for retirement. But that’s a much harder problem to solve.

I’m Shocked, Shocked!

Thu, 04/24/2014 - 14:13

By James Kwak

Technology-land is abuzz these days about net neutrality: the idea, supported by President Obama, (until recently) the Federal Communications Commission, and most of the technology industry, that all traffic should be able to travel across the Internet and into people’s homes on equal terms. In other words, broadband providers like Comcast shouldn’t be able to block (or charge a toll to, or degrade the quality of), say, Netflix, even if Netflix competes with Comcast’s own video-on-demand services.*

Yesterday, the Wall Street Journal reported that the FCC is about to release proposed regulations that would allow broadband providers to charge additional fees to content providers (like Netflix) in exchange for access to a faster tier of service, so long as those fees are “commercially reasonable.” To continue our example, since Comcast is certainly going to give its own video services the highest speed possible, Netflix would have to pay up to ensure equivalent video quality.

Jon Brodkin of Ars Technica has a fairly detailed yet readable explanation of why this is bad for the Internet—meaning bad for the choices available to ordinary consumers and bad for the pace of innovation in new types of content and services. Basically it’s a license to the cable providers to exploit a new revenue source, with no commitment to use those revenues to actually upgrade service. (With an effective monopoly in many metropolitan areas and speeds already faster than satellite, the local cable provider has no market pressure to upgrade service, at least not until fiber becomes more widespread.) The need to pay access fees will make it harder for new entrants on the content and services side; in the long run, these fees could actually be good for Netflix, since it won’t have to worry as much about competition. The ultimate result will be to lock in the current set of incumbents that control the Internet, ushering in the era of big, fat, incompetent monopolies.

Not only is this bad for consumers and for innovation, but it’s a reversal (or at least a severe watering-down) of the FCC’s earlier position on net neutrality, established in 2010 under a different FCC chair. Why did this happen? Well, look at this:

That’s from another article that Brodkin published yesterday, on the revolving door at the FCC. To summarize: Tom Wheeler, the current chair of the FCC, has previously been the CEO of the industry organizations for both the cellular industry (CTIA) and the cable industry (NCTA). The NCTA is currently headed by Michael Powell, a former chair of the FCC. The CTIA announced that its next CEO will be Meredith Attwell Baker. Her résumé goes like this: lobbyist for the CTIA; lobbying firms; National Telecommunications and Information Administration (part of the Department of Commerce), where she sided with Comcast against the FCC; FCC commissioner who voted for the Comcast-NBC merger (that’s Kabletown, for 30 Rock fans); head lobbyist for the NBC division of Comcast; and now CEO of the CTIA.

To put things in more familiar terms, this is roughly like Tim Pawlenty leaving the Financial Services Roundtable to become chair of the Federal Reserve and Ben Bernanke leaving the Fed to become head of the American Bankers Association, or Phil Gramm becoming a senior bank executive after shepherding the Gramm-Leach-Bliley Act and the Commodity Futures Modernization Act. (Wait, one of those things actually happened.)

Many business groups like to say that they are against regulation because of free market, big government, economic efficiency, consumer choice, blah blah blah. But in fact, the history of regulation is one of large incumbents (or well-funded, well-connected newcomers) buying politicians and using them to extract rents, raise barriers to entry, erect tariff barriers, and do other things to pad the bottom line. Very occasionally, like in 2009–2010, people sit up and take notice. But most of the time, the casino is open and everyone looks the other way.

* There’s a separate issue about peering deals between different parts of the Internet backbone, which conceptually is a net neutrality issue, but is not addressed by the FCC’s net neutrality rules.

Where Do You Want to Be Born?

Tue, 04/22/2014 - 13:11

By James Kwak

That seems like a nonsensical question. Of course, each of us born where he or she was born, and we didn’t have much choice in the matter. But, philosopher John Rawls asked, if you lived behind a veil of ignorance, not knowing what position you would occupy in the socio-economic hierarchy, what rules would you choose to govern society?

Rawls was reasoning from a situation in which people could decide on any set of rules.* In the real world, the set of existing countries gives us a limited set of options to choose from; among those, if you didn’t know if you were going to be rich or poor, where would you choose to be born? On Friday, I was discussing this question with a scholar who is in the United States for a year, and one thing we noted was the instinctive tendency of many Americans to assume that we must be the best at everything and have the best of everything in the world (best health care, best Constitution, best hockey team, etc.).

The data-driven answer is probably the Netherlands or Canada. Here are the changes in median after-tax per capita income in the Netherlands (black) and the United States (red) over the past three decades, courtesy of The New York Times (you can ignore the text that I included in the screenshot).

In words, poor people do a lot better in the Netherlands, middle income people do almost as well, and rich people do less well. Since the thing you want to hedge against is being born poor (and let’s not get into the question of social mobility, which makes the United States even worse), you should be willing to trade off extra income in the 95th percentile for extra income in the 5th percentile.

Canada also looks pretty good, and probably has a higher median income than we do today. (Norway looks even better, but that data series doesn’t go as far as the other ones.)

When you look at the red lines, this is just another way of looking at rising inequality. Note in particular the negative slopes for people in the 5th and 10th percentiles. But in comparative terms, it’s increasingly clear that while we like to think of ourselves as the richest country in the world (leaving aside a few anomalies like oil states and tax havens), that’s only true for practical purposes if you’re in the top  half of the income distribution. Remember that rising tide floating all boats thing? Not so much.

Current trends are not in our favor, either:

There are lots of reasons for these outcomes, but one is a tax system that, by comparison with other advanced economies, takes less from the rich and redistributes less to the poor. And, of course, the current trend in tax policy is getting worse, not better, with the extension of most of the Bush tax cuts and the freezing of taxes on investment income at 20 percent.

How is any of this making ours a better country?

* This is the subject of a very brief and undoubtedly simplistic discussion in White House Burning, in the context of social insurance programs.

Rumsfeldian Journalism

Wed, 04/16/2014 - 06:30

By James Kwak

I still have Nate Silver in my Twitter feed, and I used to be a pretty avid basketball fan, so when I saw this I had to click through:

Just how bad were the @DetroitPistons‘ Bad Boys? http://t.co/q7A05JunDn#Detroitpic.twitter.com/SOOkfzCqq4

— FiveThirtyEight (@FiveThirtyEight) April 15, 2014

In the article, Benjamin Morris tries to analyze how “bad”* the Detroit Pistons of the late 1980s and early 1990s (Bill Laimbeer, Rick Mahorn, Dennis Rodman, etc.) were, with full 538 gusto: “That seems like just the kind of thing a data-driven operation might want to quantify.” But the attempt falls short in some telling ways.

First, Morris has to find a quantitative proxy for “badness.” He selects technical fouls. Huh?

Morris’s own sources define “badness” this way:

  • “physical, defense-oriented style of play” (Wikipedia)
  • “on-court mayhem” (Sports Illustrated, although in the original that’s in the same sentence as “class” and “smothering defense”)
  • “gritty, hard-nosed players who didn’t back down from anyone . . . the willingness to do seemingly anything to win (ESPN)

Morris runs with that last phrase and questionably defines it as unsportsmanlike conduct (even though most people associate the will to win with, say, Michael Jordan). From there, he uses technical fouls as a measure of unsportsmanlike conduct, concluding, “this stat is the closest we have to an official determination of ‘bad’ behavior.” (Foreshadowing: sometimes close isn’t good enough.)

That’s really weak. Any basketball fan old enough will tell you that the Pistons were known for physical play, for pushing and shoving under the basket and fouling rather than giving up layups, but none of this has anything to do with technical fouls. At the end of the day, Morris uses technical fouls because he doesn’t have anything else to use. This is called looking for your keys under the lamppost, and it’s generally considered a bad empirical method.

Morris then makes his argument even more tortured by saying that unsportsmanlike conduct alone does not constitute “badness”—it has to be unsportsmanlike conduct in the pursuit of winning: “For a team to earn a nickname prominently declaring how ‘bad’ it is, the players should be using their badness to make them better.” Now, it is true that the Pistons combined a high technical foul rate with a high winning percentage. But I’m mystified at what the point is here. We already knew that the Pistons were a very, very good team—we wouldn’t be talking about them otherwise. So I’m not sure how it adds anything to the analysis at this point.

Anyway, let’s stipulate for the point of argument that unsportsmanlike conduct constitutes “badness.” Morris makes the rather dodgy assumption that technical fouls accurately measure unsportsmanlike conduct. But there are other reasons why the Pistons might have gotten a lot of technical fouls. For one, once they acquired a reputation for being “bad,” referees almost certainly looked at them differently. Players’ reputations affect the calls that referees make against them; Larry Bird could complain about a call without getting a technical, while Dennis Rodman would get one for far less. In other words, technical fouls are partially measuring perceptions of badness. This means they are pretty unreliable as a vehicle for measuring the actual badness of a team that had a reputation for it.

This is pretty basic stuff when it comes to statistics. You have to think about whether a variable is an accurate measure of some underlying characteristic. But when technical fouls are all you have to deal with, you end up ignoring this kind of issue.

Finally, there is if not the worst chart of all time, certainly the worst chart produced by an outfit that claims to specialize in analyzing and presenting data:

The observations are individual team-years. The Y axis is the team’s technical fouls divided by the league average for that year. What’s the X axis? It says “More technical fouls relative to the average,” but that could just as well be the label for the Y axis.

I’m pretty sure that all the team-years are just arranged sequentially from left to right, from fewest relative technicals to most relative technicals. Which is a pretty unhelpful way to display this information. If you only have one dimension (number of technicals), you don’t need a chart: just say the Pistons had 7 out of the top X seasons, including the top 2, and save the ink. If you want to show the extent to which the Pistons were outliers, use a frequency distribution so we can see the mode around 1 and the Pistons out in the tail. Don’t use two dimensions to tell a one-dimensional story.

Donald Rumsfeld famously said, “You go to war with the army you have.” Well, this is what happens when you try to answer a vague and complicated question but you only have one data series—and not a particularly appropriate one.

Morris triumphantly concludes, “For once, a harder look at the data seemingly confirms rather than undermines a popular sports narrative.” I think XKCD (see the previous link) still has the last word.

* “Not bad meaning bad but bad meaning good,” that is.

Defending Kickbacks

Tue, 04/15/2014 - 13:39

By James Kwak

The Wall Street Journal reports that the SEC will soon decide (well, sometime this year) whether brokers should be subject to a fiduciary standard in their dealings with clients, as registered financial advisers are today. At present, brokers only need to show that investments they recognize are “suitable” for their clients—roughly speaking, that they are in an appropriate asset class.

Not surprisingly, the brokerage industry is up in arms. They want to be able to push clients into the products for which they receive the highest commissions—a practice that (they say) could be more difficult under a fiduciary standard. According to one lobbyist,

“a universal fiduciary standard could end up hurting many investors. Lower- and middle-income investors often turn to brokers who are compensated through product commissions, he says, because such clients are less attractive to financial advisers who are compensated based on a percentage of assets under management. Higher costs could prompt some brokers to drop commission-based accounts in favor of more-lucrative accounts that charge a percentage of assets under management, leaving many lower- and middle-income investors without anyone to turn to for investment advice.”

(That’s a paraphrase by the Journal writer, not a direct quotation.)

First of all, note the underlying chutzpah here. The SEC is thinking of requiring brokers to act in the interests of their clients. The defense is, “We’ll have to change the way we do business.” How is that not an admission that they aren’t currently acting in the interests of their clients?

Second, let’s dig into the supposed benefits of commissions. Another word for “commissions” is “kickbacks.” Basically what’s going on is that some mutual fund company is charging a, say, 5 percent load, and then it’s paying some of that back to the broker who steered you into the fund. In other words, the only reason the fund company is paying a kickback to the broker is that it is making an even higher profit from the customer.

With the sales load, it’s obvious. But it’s also the case for a “no-load fund” with a high expense ratio. Brokerage commissions are not supposed to be included in fund expense ratios. But expense ratios do include 12b-1 fees, which are used to pay kickbacks to brokers.* Again, the kickback is just a way for the fund company to share with the broker the excess profits it earns from the customer who buys that fund—as opposed to, say, the index fund with an expense ratio of 10 basis points or less.

Now, sales commissions can make sense in some markets. For example, say there are two products in the market. A is worth $100 and costs $100 to make; B is worth $110 and costs $100 to make. But only professionals know which is worth more. In that case, if B is priced at $108 and $4 of the profits go to the broker as a commission, then your broker is more likely to steer you into B, and everyone is better off. (Of course, on these facts, the broker would still steer you into B even with the fiduciary duty, so a fiduciary duty rule would do no harm.) Or there can be a market in which ordinary customers have to go through brokers—that is, every product has a sales charge, one way or another.

But that’s not the case with mutual funds in liquid asset classes, which you can buy directly from Vanguard, Fidelity, and many others. There’s no reason to believe that, on an expected basis, a higher-priced product (in expense ratio terms) will have higher returns than a lower-priced product. Higher-fee funds are a combination of higher expenses on pointless things (“research,” trading costs) and higher profits for the fund company, which they are willing to share with brokers as a cost of doing business.

In other words, the sole reason the broker gets a commission is that he is selling you a worse product than the low-fee index fund. The excess profits and the kickback go together; you can’t have one without the other. If brokers choose to drop lower-income clients, then said clients are better off for not getting bad advice. If they need advice, then they should consult a fee-only adviser; the amount they spend in fees will be more than made up in avoiding poor investments recommended by brokers with hidden agendas.

* The Investment Company Institute, apparently in all seriousness, says, “Rule 12b-1 plans have provided an important addition to the choices investors have in how to pay for their fund shares.” Like, you could pay less, but now you can choose to pay more!