Miracle on Wall Street

Actually, it's no "miracle," it's just theft. (Nod to WH)

Grand Game: Remarkably Dumb Economics Edition

"Discredited marginal productivity economics"?  Seriously?  One can say that there are problems with banks (barriers to entry, overly friendly regulation, etc.) without deciding to just make up your own personal theories of economics, pumpkin.

Enjoy?

Identify the speaker....

Let's play...WHO SAID IT?

Here is the quote:

"The yawning inequality of income and wealth is not because the middle class isn’t working hard enough or because the richest fraction of a percent is making an enormous contribution,” [BLANK] told Salon. “Much of the reason is what economists call ‘rent seeking,’ or extracting money without doing anything useful, mostly in the financial sector. It’s a wonder the economy has the strength to get out of bed in the morning.”

Wow.  That actually sounds right to me.  Of course, when you read it in context, it's a little creepy.  Still, interesting.


 

Paul Craig Roberts: The Failure of Laissez Faire

Paul Craig Roberts on his new book.  What do you think?  Was the financial crisis of 2008 caused by deregulation?  Or STUPID regulation?  I vote for B.  PCR votes for A.

The TBTF Subsidy

How Much Did Banks Pay to Become Too-Big-To-Fail and to Become Systemically Important?

 Elijah Brewer III,DePaul University, and Julapa Jagtiani,Federal Reserve Bank of Philadelphia

September 2, 2011

Forthcoming in Journal of Financial Services Research

 
This paper estimates the value of the too-big-to-fail (TBTF) subsidy. Using data from the merger boom of 1991–2004, we find that banking organizations were willing to pay an added premium for mergers that would put them over the asset sizes that are commonly viewed as the thresholds for being TBTF. We estimate at least 15 billion in added premiums for the eight merger deals that brought the organizations to over 100 billion in assets. In addition, we find that both the stock and bond markets reacted positively to these TBTF merger deals. Our estimated TBTF subsidy is large enough to create serious concern, particularly since the recently assisted mergers have effectively allowed for TBTF banking organizations to become even bigger and for nonbanks to become part of TBTF banking organizations, thus extending the TBTF subsidy beyond banking.

Poison Pills Reduce Competitiveness

Management would generally prefer to be insulated from an outside takeover.  Because then you can suck, and take lots of profits in the form of inefficiency and perks, and be sheltered from those scolding winds of M&A hammers.

Since the SEC largely works for existing corporations, and has little interest in promoting competition,* they are considering adopting a rule that would make poison pills more deadly.  Ick.

(*After all, the SEC is a lap dog for powerful congressmen who depend on contributions from rent-seekers; you can't get contributions from companies that don't exist, even if those companies would have been larger, healthier, and more productive)

Sarbox vs Competition as Regulating Powers

The Disciplining Role of the Market Versus Government Regulation: The Case of Sarbanes-Oxley and the Earnings Quality of M&A Targets

Ilanit Gavious & Mosi Rosenboim
American Law and Economics Review, forthcoming

Abstract:  This study examines whether and how the passage of the Sarbanes-Oxley Act (SOX) affected earnings quality, proxied by accrual measures, prior to mergers and acquisitions (M&A). Given that the capital markets underwent unusual vicissitudes in the period leading up to the passage of SOX, we subdivide the pre-SOX period into four sub-periods: (1) the pre-technology bubble (1992-1997); (2) the technology bubble (1998-3/2000); (3) the bubble collapse (4/2000-9/2001); and (4) the pre-SOX scandal period (10/2001-7/2002). We document that abnormal accruals moved from significantly positive to significantly negative during the period of the major corporate scandals immediately preceding SOX, and remained negative in the post-SOX period. However, abnormal accruals in the post-SOX period were significantly less negative than during the scandals. Thus, a reduction (increase) in abnormal accruals (earnings quality) seems to have occurred concomitantly with the scandals, not as a result of the passage of SOX. We also document that investors' awareness of earnings manipulation by sellers consistently grew after the bursting of the technology bubble, as reflected in an increase in the discount applied to transaction prices throughout the sub-periods. Hence, concomitantly with the decrease (increase) in the levels of abnormal accruals (earnings quality) occurring during the scandals, the discount to transaction price due to suspected earnings manipulation also increased. Furthermore, the higher discount applied after SOX, relative to that immediately prior to SOX, implies that investors do not rely on SOX to prevent management from manipulating their earnings prior to a sale transaction. We conclude that changes in earnings quality prior to M&A transactions cannot be attributed to SOX. Rather, other events such as the bursting of the technology bubble and revelations of major accounting scandals seem to have affected managers' propensity to manipulate earnings. It seems that market response has a greater effect on managers' behavior than government regulation.

Nod to Kevin Lewis

Sarbox, Dodd-Frank, and Now the Drug War

I am always amazed that my colleagues think that Sarbox or Dodd-Frank increase regulation, and are therefore good.  What they do, and what they are designed to do, is to advantage the big financial companies  (Goldman in particular, but generally the large outfits) at the advantage of small nimble companies that would otherwise make the industry competitive.

All Sarbox or Dodd-Frank really do is the raise the cost of doing business legally.  As an intercept shift, just a bunch of fixed costs.  If you already have a giant accounting and compliance office, like the big shops, then this is just a small extra cost, one that is easily passed on to customers as fees.  But if you are a small shop, or are considering entering the industry, the effect is devestating.  You have to make a much bigger nut to pay off your accountants and compliance people, before you can run even your first transaction.  If you want to lie, the SEC won't catch you, so the Bernie Madoffs of the world are perfectly safe.  This regulation doesn't affect actual criminal behavior, it just represents an entry barrier for new firms that want to do business legally.

It's true that compliance costs fall on big banks also, but you have to think about Bastiat's "seen and unseen."  What we don't see is the new firms that are not there, the start-ups that do not happen.  The big firms would prefer no regulation, perhaps, but this is the next best thing: regulation that reduces competition.

This is hardly surprising.  The Obama administration, and the Democratic party generally, is bought and paid for by the dinosaurs of the financial industry.  Goldman, et al. are desperately trying to defend what they see as their birthright of keeping what they win--if they win--and getting bailed out at taxpayer expense--if they lose.  Gotta keep the little guys out.  That's what regulation is designed to do, and that is what regulation does in fact do.  The idea that Dodd-Frank was "better" regulation is risible.  I'm laughing at it right now, in fact.  Ha.  Ha ha!

What I did not expect is that this logic would extend also to ILLEGAL business.  Consider:

The paradox of the war on drugs is that the harder governments push the fight, the higher drug prices become to compensate for the greater risks. That leads to larger profits for traffickers who avoid being punished. This is why larger drug gangs often benefit from a tougher war on drugs, especially if the war mainly targets small-fry dealers and not the major drug gangs. Moreover, to the extent that a more aggressive war on drugs leads dealers to respond with higher levels of violence and corruption, an increase in enforcement can exacerbate the costs imposed on society.

Insider Trading: Grand Game "Mad-Enough-to-Spit" Edition

Wow. Wowdie wow wow. Exec thinks company has had good month. Exec posts happy note to this effect on Facebook. Regulatory thugs call this "insider trading", and prosecute.

This was not a secret note to investors.  It. was. on. Facebook.

For reasons I have never understood, "insider" trading makes lefties insane. Drvies them mad. And so on.

I actually find this argument persuasive: if we allowed insider trading, prices would be more accurate.
But you can stop well short of that view and still think it's okay to post accurate information on Facebook. I mean, IT WAS ON FACEBOOK.

Judge for yourself, friends.  That's the law.  And here is the Facebook post.  Click for an even more public and open image:

And then, go crazy, folks, go crazy.

Nod to Angry Alex.
 

Are Workers in Finance "Over"Paid?

Wages and Human Capital in the U.S. Finance Industry: 1909–2006

Thomas Philippon & Ariell Reshef
Quarterly Journal of Economics, forthcoming

Abstract: We study the allocation and compensation of human capital in the U.S. finance industry over the past century. Across time, space, and subsectors, we find that financial deregulation is associated with skill intensity, job complexity, and high wages for finance employees. All three measures are high before 1940 and after 1985, but not in the interim period. Workers in finance earn the same education-adjusted wages as other workers until 1990, but by 2006 the premium is 50% on average. Top executive compensation in finance follows the same pattern and timing, where the premium reaches 250%. Similar results hold for other top earners in finance. Changes in earnings risk can explain about one half of the increase in the average premium; changes in the size distribution of firms can explain about one fifth of the premium for executives.

Nod to Kevin Lewis

CFPB: Cheers (?)

Don B raises the key point. And I don't know the answer. Don makes some good arguments. But it's not a slam dunk case.

  Here is the example. Worth reading.

 Now, the question: Suppose it is true that C is naive. One of the problems of being naive is not knowing the full extent and impact of one's naivete.

 Now, suppose that we know that there are people like D, people who take advantage of naivete. D is capable of making bright shiny things, or complicated things, that will induce C to pay more than that thing is "worth."

 Then, along comes B. B is a hand-wringer, the sort who really REALLY cares about other people. But B thinks B should get paid for caring about people, because he doesn't really care about other people THAT much, to work for free. So, B proposes we create a government agency whose job it is to protect C from being taken advantage of by D.

 Except that, to make this work, we will also have to tax A. A thinks C is an idiot, and that D is morally defective. But A would never buy D's product, and wonders why C would do it. After all, C should be able to figure it out, if he tried.

 But, there it goes: We tax A to pay B to prevent C from being exploited by D. Don asks, "Is this justified?" I think the right question is "When MIGHT it be justified." Still, Don asks a good question.

How Ya Gonna Know The Players, Without a Scorecard

John-O sends this scorecoard, almost an encryption key actually, for decoding secret messages sent by your progressive friends.  It's fun to learn what they really mean!

An example: 

Elizabeth Warren

Definition: An “Elizabeth Warren” is any brilliant scholar who both thinks we can fix the U.S. financial system simply by adding another giant bureaucracy with near unlimited power, and who can, by dancing vigorously in a circle, make it rain. Both equally as likely.

Dodd-Frank Causes Much More Harm than Help

KPC friend Amar Bhide has an interesting piece in Barrons.

In an email, Amar writes:

This is a general problem. Well-intentioned securities laws work only too well, turning judgment and relationship based finance into anonymous, arm’s length transactions. This also discriminates against financings that can’t be easily securitized; thus we get lots of mortgaged backed securities, fewer small business loans.

Tell that to the next person who tries to say that "lack of regulation" caused the financial crisis.  It's not true.  STUPID regulation caused the financial crisis, and Dodd-Frank is even more stupid than what we had in 2007.

Excerpt from the article, since it's gated:

When little else was regulated in the 19th and early 20th centuries, lawmakers kept banks on a tight leash. Even so, we didn't get all the pieces of bank regulation right until the 1930s. In contrast, the securities markets functioned adequately under the private rules of the stock exchanges.

Shine on you crazy Dimon

JP Morgan has taken a $2 billion loss on derivatives trading. As I've tweeted, that's around .1% of their assets and 1% of their equity, so on the surface it's hard to see what the fuss is about.

Over at Bloomberg, I found a clue:

It’s not often that a huge company calls an emergency teleconference on short notice to discuss an intra-quarter trading loss that’s equivalent to only 1 percent of shareholder equity. So when a Deutsche Bank AG stock analyst named Matt O’Connor asked Dimon why the company had disclosed it at all, the answer was bound to be revealing. “It could get worse, and it’s going to go on for a little bit unfortunately,” Dimon replied. The meaning was clear. Worse could mean disastrous.

So maybe the $2 billion is just the tip of the iceberg? Still it would have to be a very big iceberg to cause much worry about systemic risk and taxpayer involvement, wouldn't it? Maybe it is a very very big iceberg. That would be bad.

The other open question is what exactly were they doing, hedging or betting?

A classic hedge involves taking a position in the derivatives market that is opposite to your position in the "real world" to achieve certainty about future costs or revenues. If you are hedging to avoid a decline in price of an asset you own, and the price of that asset goes up, you will in all likelihood suffer a loss in the derivative that offsets the gain in the "real world". It's unlikely, though that JP Morgan would report such an outcome as an overall loss.

Even if you set up your hedge correctly, if the correlation between the "real world" asset and the derivative asset is not perfectly predictable, you can suffer an overall loss in your hedge. This is basis risk.

Maybe that is what JP Morgan is reporting; a good hedge gone bad due to basis risk.

My man at Bloomberg doesn't think so though:

Here’s what little Dimon said of the trades in question: “The synthetic credit portfolio was a strategy to hedge the firm’s overall credit exposure, which is our largest risk overall in this stressed credit environment. We’re reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective as an economic hedge than we thought.” 


There is a tantalizing clue in this language. Read the statement carefully and you can see this wasn’t a bona fide hedge. That means it probably was no different, in substance, than a speculative wager. The definition of an “economic hedge,” literally, is an investment that doesn’t qualify for hedge accounting, meaning its effectiveness at offsetting a given risk isn’t sufficiently reliable. Otherwise the wiggle word “economic” wouldn’t be needed.

This made me happy, as I learned a new term, "economic hedge" that apparently can be a synonym for "shitty hedge" or used as a fig leaf for a speculative bet.

In general, I think we want banks and businesses to hedge risk. Structured finance is not an unmitigated bad. And I think we need to recognize that even a well-executed hedge can produce losses, so we can't judge the quality of a hedge purely by its ex-post outcome. On the other hand, in this environment, banks and firms have incentives to misrepresent failed speculation as a problematic hedge and regulators need to be sensitive to that.

The question is whether it's possible to write a rule that distinguishes clean hedges from "economic hedges", especially when you realize that for many real world assets a clean hedging instrument may not even exist.

If it's not possible (and I don't think it is), then should we make banks pay for insurance against the creation of systemic risk? If so, isn't pricing that insurance going to have the same issues as writing the rule?

Or maybe we should put size caps on banks so that one bank's behavior, no matter how shitty, cannot cause systemic risk. But does it matter for systemic risk if one big bank makes bad "economic hedges" or 3 smaller banks each make the same bad bets?

I just don't see a simple rule or magic bullet that gets us out of harms way that doesn't also throw the structured finance baby out with the "economic hedge" bathwater.

Mortgage market facts and theories of the financial crisis

A fascinating new paper on the causes (and non causes) of the financial crisis lays out 12 "facts about the mortgage market" that its authors consider crucial for determining the causes of the crisis.

The paper is not overly technical and I highly recommend reading it. It presents a strong case both against the "Inside Job" and the "the government did it" views of the crisis.

It also points out how little we know about the causes of asset price bubbles.

Hat tip to Mark Thoma.

Antitrust Paradox?

Look: It's simple. The job of government is protect large corporations. Not consumers, not new entrants into the marketplace. Existing large corporations.

I know, you can IMAGINE a government that does something else. I can imagine unicorns. Neither your fantasy nor mine actually exist.

Fortunately, for once Big Gov and the Boyz got their big sweaty hands slapped.

Aleynikov goes free--Posted By Felix Salmon On February 17, 2012 (10:27 pm).

Count me in, with Choire Sicha, as being very happy that Sergey Aleynikov is once again a free man. To cut a long story short, Aleynikov used to work in high-frequency trading for Goldman Sachs, earning $400,000 a year. He then got offered a job in Chicago, earning three times that amount. So he accepted the new job. On his last day at Goldman, he uploaded to an external server various bits of code that he had worked with at Goldman. He claimed that the code was benign open-source material; Goldman claimed that it could be used to “mani! pulate markets”.

Goldman’s claim backfired in one respect, in that it sparked a thousand semi-informed articles about high-frequency trading and how dangerous it is: articles which did Goldman’s reputation no good at all.

On the other hand, the claim did have its chief intended effect — it got U.S. authorities extremely excited, to the point at which they charged Aleynikov with criminal activity under the Economic Espionage Act.

Now the EEA was designed — and was initially used — to prosecute very different behavior, chiefly employees at defense contractors taking top-secret information and giving it straight to the Chinese government. The kind of thing which can absolutely be considered espionage.

The secrets at defense contractors, of course, are secret for reasons of national security. The secrets at investment banks and hedge funds, by contrast, are secret purely for reasons of profit: they reckon that if they have some clever algorithm which nobody else has, then that makes it easier for them to profit from it. Which is why it was always a stretch for the government to use the EEA to prosecute Aleynikov — indeed, it is why it was always a stretch for Aleynikov to be criminally prosecuted at all. Goldman could have brought a civil case against him, but instead they got their wholly-owned subsidiary, the U.S. government, to come down on him so hard that he ended up with an eight-year sentence. Violent felons frequently get less.

The forthcoming decision from the Second Circuit is likely to be a doozy; I’m told that the judges shredded the prosecutors during the oral hearing. And certainly their decision to enter a judgment of acquittal, rather than any kind of retrial, is a strong indication that they handed down this order with extreme prejudice against prosecutorial overreach.

Is it the government’s job to expend enormous prosecutorial resources protecting Goldman Sachs from competition? The Second Circuit certainly doesn’t seem to think so, and neither do I. Aleynikov’s actions were certainly stupid, and quite possibly illegal. But the way that Goldman managed to sic New York prosecutors on him bearing the sledgehammer of the EEA was far from edifying. And I’m glad that both Goldman and the Manhattan U.S. Attorney are surely feeling very chastened right now.

Nod to Joel R.

Extremely disturbing stuff

Wow. Some really cool things have come out lately, for the those interested in disturbing coolness.

First, from my student Bill English (with whom I am well pleased!), a paper with Evan Charney on geneti-nonsense. I predict LeBron / A-Tab will like it.

Second, a swashing and martial outside, from EconTalk. William Black--the best way to rob a bank is to own one. Outstanding.

Third, California once again leads the way in idiocy. The only way to save money is to spend MUCH more money than you save. All last night sat on the levee and moaned, Thinkin' about me baby and my happy home. ...

Fourth, and scarily: Frontline on meth. An 18 minute "Chapter 1" from that Frontline.

Watch The Meth Epidemic on PBS. See more from FRONTLINE.

(A nod to Kevin Lewis)

Christmas Wisdom from LeBron

"good regulation should take account of our rather extreme ignorance. That means emphasizing the more general protections, as embodied in a ready supply of safe liquid assets, rather than obsessing over the regulatory micromanagement of particular bank activities."

More here.

Man, I Hate Republicans

So, check this out:

How is it that a Republican House that claims to be pro-jobs can't pass a regulatory reform so modest that even President Obama's jobs council endorses it? Part of the answer is that the accounting cartel fighting reform has one of its own in the Republican ranks. A GOP presidential candidate also can't be bothered to show up for a critical vote.

In September we told you about Tennessee Representative Stephen Fincher's plan to relieve small public companies from Sarbanes-Oxley's most burdensome and duplicative accounting rules. "Useless" might be a better description for these rules, after MF Global became the latest company in the Sarbox era to hide catastrophic transactions outside its balance sheet—exactly what the law was supposed to prevent.

On Tuesday night, the House Financial Services Committee had to yank the Fincher reforms from a scheduled Wednesday vote. With all committee Democrats expected to vote against reducing paperwork, the Republicans would need almost all hands to send the measure to the House floor.

But House sources say Michele Bachmann wouldn't return from the campaign trail to vote. Meanwhile, California Republican John Campbell has been leading an effort to water down or kill the Fincher reforms. Mr. Campbell is an accountant carrying water for his former industry colleagues. New Mexico Republican Steve Pearce, who styles himself an opponent of federal regulation, is also blocking reform.

Sarbox was supposed to punish accountants, but like much regulation in practice it guarantees a lucrative business to a cartel dominated by four big firms. The mandate for an external audit on top of the traditional financial audits has helped accounting fees rise as fast as the bureaucratic burden.

That editorial was not from the WaPo or the HuffPo. That's the Wall Street Journal. Could the idiot Republican possibly be any more worthless? Every chance they get they vote for anti-competitive regulation increases and bailouts for their campaign contributors. They vote against millions for widows and orphans, but support billions in tax money for corporations. Man, I hate Republicans.

(If you are thinking of offering a "yeah, but Dems are bad, too!" defense....just shut up. The Dems are honest. They say they are going to take money from people who earned it and use it to buy votes. Despicable, but honest. The Republicans are LIARS on top of being thieves.)

(Nod to Kevin Lewis)

Kenneth Arrow on Occupy Movement

I find that reading Kenneth Arrow's articles takes me a while. They are usually very dense and closely reasoned. But once I have read them I feel like I have learned something.

This "article" is something else entirely. A truly remarkable claim:

The notion of a well-running market is applicable to manufactured goods; different items are produced to be alike and can be evaluated by consumers. But the products of the finance and health industries are individualized and complex. The consumer cannot seriously evaluate them—a situation that economists call “asymmetric information.”

This casts light on the claim that the problem is one of personal ethics, of greed. After all, the search for improvement in technology, and consequently in the general standards of living, is motivated by greed. When the market system works properly, greed is tempered by competition. Hence, most of the gains from innovation and good service cannot be retained by the providers.

But in situations of asymmetric information, the forces of competition are weakened. The individual patient or financial client does not have access to all the relevant information. Indeed, when the information is sufficiently complex, it may be impossible to provide adequate information.

If Prof. Arrow is correct, and he may be, then we are left with two choices. We can recognize that information is asymmetric, scarce, and difficult to obtain, and warn consumers to be careful. Or we can assume, as Prof. Arrow does, that the government can solve this problem completely and insulate people from all risk.

That is what happened in 2007, in a nutshell. Everyone thought that regulation had solved the asymmetric information problem, and they were free to invest without risk.

Regulation makes the problem worse, not better. Government has no special ability to obtain information, and has no particular incentive to provide the information it does have, since Wall Street firms use campaign contributions dominate the oversight committees. If anything, the oversight committees in Congress are simply wholly owned subsidiaries of Goldman-Sachs et al.

What makes this so upsetting is that the poor buyers were duped into believing that since the system was regulated it must be safe. All the people I know who lost heavily in the market in 2007 were lefties, secure in the knowledge that their government was there to help them. People like me saw that the risk was unsupportable, and pulled out.