Friday, July 30, 2010

Dodd-Frank VII: Joseph Stiglitz Says it Will Happen Again



Joseph Stiglitz gave a remarkable interview recently on the Australian Broadcasting Company. During the course of this interview Noble laureate Stiglitz echoed many of the points previously highlighted on this blog ranging from the weak state of the economy, to the failure of the Dodd-Frank Act to resolve the problems posed by the megabanks and the likelihood of expanded powers to bailout TBTF firms, to the possible impotence of both fiscal and monetary policy.

But the most disconcerting point he makes concerns the probability for another crisis after Dodd-Frank. Stiglitz was asked: can the whole thing happen again? His reply:

"It can and it almost surely will happen again, because we didn't deal with the problem of too-big-to-fail banks. It is one of the reasons why it will happen again. And we didn't really deal effectively with all the kinds of excessive risk-taking, all the problems of lack of transparency that were at the core of this crisis. And so, yes, we understand what the issues are, we understand the issues better than we did three years ago, but politics intruded, the power of the banks, was too great. They're making $20 billion off of derivatives. So rather than lending, they're engaged in all of these kinds of gambling and excessive risk-taking and generating large profits, but it's not helping the American economy and it's putting at risk American taxpayers."

Stiglitz highlights derivatives as yet another example where Dodd-Frank allows the economic and political power of the bankers to prevail over sound policy:

"the banks came in with their political power and gutted or at least eviscerated the provision. . . . [W]e said important for there to be transparency in financial markets, important for there to be transparency in derivatives. Remember, derivatives - the bailout of AIG was $180 billion. That's an amount of money that's hard to fathom. One company, and it was all caused by derivatives. So, everybody said we better regulate derivatives better, we oughta have more sunshine, we oughta have more transparency and they agreed on the principle, but 30 per cent of the market was exempt. Now, why? Why should you not have everything out in the sunshine? Not clear to me."

A review of Dodd-Frank regarding derivatives prohibitions illustrate Stiglitz's points. Under section 716 banks are generally prohibited from using derivatives. But, there is an exception for "bona fide hedging and traditional bank activities." This exception apparently would include 80 percent of the derivatives market. The section does not even take effect until July 21, 2012 and no prohibition regarding bank derivative activities takes effect until July 21, 2014, which regulators may extend until July 21, 2015. Thus, all of the derivative trading that fueled the crisis will continue for at least 4 or 5 years, and most derivatives trading will be permissible for banks thereafter.

Section 723 mandates that derivatives transactions be cleared; but regulators have one year for promulgating a process by which determinations are made for which derivatives must be cleared and which ones may remain over-the-counter. Moreover, they may exempt small banks, credit unions and farm credit institutions from the clearing and margining requirements. Finally, section 721 and 723 exempts end users if they are (a) not certain financial entities; (b) not "major swap participants;" (c) use swaps to hedge commercial risk, and (d) can demonstrate how they meet their financial obligations associated with entering non-cleared swaps. Highly customized derivatives also need not be cleared. So again, the exceptions threaten to swallow the rule and much depends upon regulatory rule making.

Anyone interested in the effect of D0dd-Frank must watch the entire extended interview (42 minutes) video, available here.

Wednesday, July 28, 2010

More Cowbell . . .

In recent weeks, two momentous occurrences have taken place in the United States corporate world. First, as discussed by Professor Joseph Grant on this blog, Goldman Sachs entered into a settlement with the Securities and Exchange Commission agreeing to pay a massive fine and second, as wonderfully discussed in great detail by Professor Steve Ramirez on this blog, the U.S. Congress recently passed a financial reform bill that will have long lasting repercussions for both good and ill. July has been a busy month on the financial front.

There has been lots of commentary and excellent reporting in connection with these two enormous stories, some providing critique, other context and background for where we currently stand. Here are a few of the best:

John Heilemann, New York Magazine writer and author of "Game Change" attempts to drill down into the relationship between Wall Street and Barack Obama in an article entitled "Obama is from Mars, Wall Street is from Venus." Within, Heilemann seeks to analyze ("psychoanalyze" in his words) the tightrope Obama attempts to maneuver in alternately supporting Wall Street capitalism and buying into the investment bank's "smartest guys in the room" chatter, while at the same time trying to regulate and enforce market discipline upon Wall Street's leaders. See the New York Magazine story here.

Judge Richard Posner, author of "A Failure of Capitalism" opines that the financial reform bill is "politics in the worst sense." Posner argues that much of what is contained in the 2, 300 page bill is redundant and superfluous and most of the measures mandated within could already be accomplished by existing agencies, regulators and administrators. See the Bloomberg News story here.

Hailing the passage of the financial reform bill from the left, see The Huffington Post.

Decrying the passage of the financial reform bill from the right, see The Washington Times.

Goldman Sachs' official statement, posted on its website, announcing its settlement with the Securities and Exchange Commission, including an admission that it provided marketing information to clients that "contained incomplete information."

Federal judge Barbara Jones approved the $550 million USD settlement between Goldman Sachs and the SEC.

Other articles of passing interest include this one on Enron's former CFO Jeffrey Skilling having a portion of his sentence overturned by the U.S. Supreme Court. Some of Skilling's charges might be dismissed on remand and his 24 year sentence reduced, because prosecutor's misused the honest services fraud law.

Finally, my own work on the financial market crisis includes a searching examination into the underlying causes of the meltdown and examines the racial implications of the attendant blaming and scapegoating called "Racial Coding and the Financial Market Crisis."

Tuesday, July 27, 2010

Dodd-Frank VI: Punting on Credit Ratings

The credit rating agencies played a central role in the entire subprime debacle, and as is evident from the chart at left profited mightily from the very bubble they helped inflate. The credit agencies work for investment banks that pay them, not investors. Thus it is no surprise that Congress found that section 931 that: "In the recent financial crisis, the ratings on structured financial products have proven to be inaccurate. This inaccuracy contributed significantly to the mismanagement of risks by financial institutions and investors, which in turn adversely impacted the health of the economy in the United States and around the world. Such inaccuracy necessitates increased accountability on the part of credit rating agencies."

What is surprising in that Congress took no real action to stop a repeat of the misconduct they so clearly identified. Section 931 further states: "In certain activities, particularly in advising arrangers of structured financial products on potential ratings of such products, credit rating agencies face conflicts of interest that need to be carefully monitored and that therefore should be addressed explicitly in legislation in order to give clearer authority to the Securities and Exchange Commission."

So what does Dodd-Frank do about this inherent conflict? Section 939D mandates a study within 18 months to address: "alternative means for compensating nationally recognized statistical rating organizations in order to create incentives for nationally recognized statistical rating organizations to provide more accurate credit ratings, including any statutory changes that would be required to facilitate the use of an alternative means of compensation."

This can only be termed a monumental punt.

To be fair, the Act does enhance the ratings agencies’ exposure to securities fraud liability (section 933 and 939G) and takes small steps toward professionalizing the ratings industry (section 936). The Act also lessons the clout of the ratings agencies (section 939). But these changes seem highly incremental. Does anyone really expect, for example, federal judges to suddenly see the perverse incentives they have created in recent years for credit rating agencies by consistently insulating them from liability? I confess to a high degree of skeptcism.

More dramatic and fundamental change was needed here, and my sense is that Congress simply stalled.

Dodd-Frank V: Glass-Steagall and the Disappearing Volcker Rule

In January 2010, in the wake of a stinging Democratic defeat in the Massachusetts election to fill Senator Ted Kennedy's seat, President Obama embraced the so-called Volcker Rule to split proprietary trading and hedge fund investments from banking. As John Cassidy highlights the rule rested on a simple premise: given the special safety nets that banks enjoy (deposit insurance and emergency lending) it makes little sense to subsidize securities and trading speculation. The Volcker Rule could well operate to diminish the size of the megabanks, as the Glass-Steagall Act did in the wake of the Great Depression, ushering in more than 70 years of unprecedented financial stability. Unfortunately, Dodd-Frank waters down the Volcker Rule and essentially leaves the megabanks intact for years to come.

The first problem with the Volcker Rule is that gives the banks years to comply, in some cases more than a dozen years. Instead of any divestiture mandate, the banks may seek multiple extensions. Under section 619, for example, the Fed may permit bank investments in illiquid hedge funds or private equity funds until 2022. Liquid funds may be held until 2017. Indeed, nothing changes at all until October of 2012 and no divestitures are required until October of 2014. While some transition time may be warranted a spin-off to shareholders or public investors could certainly occur within a year. In any event, bank capital will continue to be exposed to securities trading and hedge funds for years to come notwithstanding the so-called Volcker Rule.

The second problem is the exceptions to the trading and hedge fund ban under section 619. Hedging, underwriting and market making activities are permissible. Banks may still continue to organize and offer hedge funds and private equity funds. They may still devote up to 3% of their capital to trading and hedge fund investments. The regulators may further permit trading and investments that "promote the safety and soundness of the banking entity and financial stability of the United States." These exceptions may well operate to swallow the rule when it takes effect in coming years and decades.

Even Paul Volcker himself is uneasy with this final outcome. Personally, I think its worse. This rule will do little to protect us from excessive risks to bank capital over the short, medium, and even long term while continuing to accommodate the continued persistence of the dangerous megabanks.

Sunday, July 25, 2010

Dodd-Frank IV: A Revolution in Corporate Governance?

Pay Czar Ken Feinberg's final report on executive compensation is out and its findings that bankers' pay was "ill-advised" and the product of "bad judgment" is hardly new. As John Cassidy highlights economists and others have reached a "rare consensus" that managerial pay played a central role in the financial crisis. Far be it from me to argue with that conclusion, especially in light of my recent work Lessons from the Subprime Debacle which formalizes exactly that thesis. However, contrary to Cassidy's conclusion, I think the Dodd-Frank Act holds the potential for a revolution in corporate governance that could permanently alter the power of CEOs over public firms in America, and that Feinberg's report may ultimately facilitate change. Here is a run down of the key Dodd-Frank provisions touching upon corporate governance:

Section 951: Gives shareholders a say on pay via non-binding shareholder resolution to approve compensation including severance pay. Subject only to SEC exemption rules. Takes effect in 6 months.

Section 952: Requires all listed companies to have independent compensation committees with the power to directly retain compensation advisers including independent legal counsel. SEC rule making regarding the definition of independence is required and then the exchanges must implement SEC requirements. This process will take some time and the SEC can also issue exemptions. Nevertheless, companies must begin to comply within 1 year, and many issuers will no doubt take steps to comply very soon.

Section 953: Requires the SEC to issue rules requiring more expansive disclosures to shareholders re compensation, "including information that shows the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions." This could take time as the section includes no timetable for the SEC and they will certainly be busy on other fronts. But, when implemented it will another source of information that will exert market pressure on management.

Section 954: Requires SEC to require exchanges to require listed companies to promulgate policies authorizing compensation claw-backs. The policies must include a claw-back for inappropriate compensation based upon restatements of financial reports paid over the three years prior to any accounting restatement.

Section 957: Requires rules of exchanges to prohibit broker votes without shareholder direction in all "significant" votes, including compensation and director votes. This is a huge step toward real corporate democracy. According to the Council of Institutional Investors 16.5 percent of all votes cast at shareholder meetings in 2008 were broker votes, cast without direction from beneficial owners. These votes invariably benefited management. Moreover, this rule is effective now, meaning exchanges must promptly promulgate rules on this point or be put out of business. The SEC must promulgate rules defining what shareholder votes are significant, beyond director and compensation votes.

Section 971: Gives SEC power to require companies to give shareholders access to management's proxy to nominate directors. SEC rule-making is pending. Progress on this issue has been glacial at best. Perhaps this section can operate to break the log jam.

Section 972: Requires SEC regulations within six months to mandate disclosure regarding why or why not a public firm separates or does not separate the position of CEO and Board Chair.

In all, these changes hold the potential for a real revolution in corporate governance. The power of the CEO in the public firm has receded in the past 10 years with respect to such key elements of the public firm as the audit committee and the nominating committee. This is yet another step in the federal redesign of corporate governance to stem excessive CEO autonomy. Combined with prior steps and vigorous administrative rule making perhaps this changes will resolve problems associated with excessive CEO autonomy. If the SEC fails to act decisively prepare for more corporate scandals driven by excessive agency costs from too much managerial power.