Simon Johnson's Blog, page 45

Why Do Investors Pay Lower Taxes Than Workers?

By James Kwak

I don't know, but we do it anyway. Yesterday's Atlantic column discusses the arguments for and against.

Of course, the last word on our capital gains tax policy comes from Peter Steiner.

Mark Zuckerberg and Tax Policy

By James Kwak

Some people have been claiming that Marc Zuckerberg is subject to a high tax rate, with Robert Frank even claiming,

"Mr. Zuckerberg's tax bill will also provide an important counter-point to the notion that the rich pay lower tax rates than the rest of America. That may be true for professional investors and private-equity chiefs, but not for dot-commers and many entrepreneurs."

I'm surprised that Robert Frank, whose column "looks at the culture and economy of the wealthy," made this mistake, assuming it's an honest mistake. He's right about the specific transaction. Zuckerberg is exercising 120 million options with a strike price of 6 cents. Those are non-qualified options (not ISOs, for which the tax treatment is different), so the paper gain is taxable as ordinary income (35 percent) at the moment of exercise.

But Zuckerberg also owns more than 400 million shares free and clear already. Those are probably shares that he bought for a token amount on the day that Facebook incorporated. Zuckerberg's primary contribution to Facebook has been labor, not capital: the man had an idea, and he worked at it for years. But as a company founder, most of his compensation has taken the form of capital gains (appreciation of his founder stock). If he ever sells that stock, he will pay tax at the capital gains rate, which is currently 15 percent, not 35 percent.

In short, the only reason Zuckerberg is paying 35 percent on his option exercise is that he got more options in 2005, after getting founder stock worth $20 billion today. If he hadn't gotten those options, he would be paying tax at a 15 percent rate. So yes, Mark Zuckerberg does pay taxes at a lower rate than most Americans.*

In the Times, David Miller tells the real story. It's likely that Zuckerberg will never sell any of his stock; even if he does sell, we can be sure he'll only sell a tiny fraction of it. (If he does sell, he will be sure to sell some of the 120 million shares from his option exercise, since those will have a cost basis equal to the market value on the date of exercise. Since that would net him several billion dollars, it's hard to imagine why he would ever sell any of his founder stock.)

Instead, other people will inherit it, and no one will ever pay tax on the appreciation during his lifetime. Or he'll donate it to charity, and no one will ever pay tax on any appreciation, ever. (But he'll be able to take a tax deduction for the full value of the stock on the date of donation, even though he won't have paid tax on that stock.)

Miller suggests that we switch to mark-to-market taxation, so we pay tax on the appreciation of our assets each year. There are various technical problems with mark-to-market taxation, but he gets around them by limiting his proposal to the super-rich and to  publicly traded securities, which would be easy to liquidate in order to pay the new annual tax. It sounds like a good idea to me. Another possibility would be to eliminate step-up of basis at death, which allows the very wealthy to escape tax by passing assets on to their heirs.

Sure, Mark Zuckerberg is warmer and more cuddly than Mitt Romney or John Paulson. But let's not make him out to be a martyr to the Internal Revenue Code. All rich Americans get gifts from the tax code.

* And speaking as another entrepreneur, albeit a much less successful one, I can say that we do just fine by the current tax code.

Stock or Cash?

By James Kwak

I'm sure many of you saw the article featuring David Choe, the artist who painted the walls of Facebook's first offices and received stock that now could be worth $200 million. Nice story. I was thinking, though: why was Facebook paying its vendors with stock?

I understand what you pay your early employees with stock: (a) you have to in Silicon Valley and (b) you want their fortunes aligned with those of the company. Outside board members also will often demand stock. But in most circumstances, you should pay your vendors with cash.

Giving a vendor stock instead of cash is equivalent to raising capital from that vendor—at the existing valuation. When you're an early-stage startup, you want to raise as little money as possible, at as high a valuation as possible—because the whole point of the startup is that it should be getting much more valuable over time. There are tactical considerations, like not letting your bank balance get too low (because then your VCs will have too much negotiating power). But in general, you want to delay raising more capital until you reach some milestone that will boost your valuation significantly.

Obviously, things turned out just fine for Facebook. But it doesn't seem like the smartest business move.

Mean-Spirited, Bad Economics

By Simon Johnson

The principle behind unemployment insurance is simple. Since the 1930s, employers – and in some states employees — have paid insurance premiums (in the form of payroll taxes, levied on wages) to the government. If people are laid off through no fault of their own, they can claim this insurance – just like you file a claim on your homeowner's or renter's policy if your home burns down.

Fire insurance is mostly sold by the private sector; unemployment insurance is "sold" by the government – because the private sector never performed this role adequately. The original legislative intent, reaffirmed over the years, is clear: Help people to help themselves in the face of shocks beyond their control.

But the severity and depth of our current recession raise an issue on a scale that we have literally not had to confront since the 1930s. What should we do when large numbers of people run out of standard unemployment benefits, much of which are provided at the state level, but still cannot find a job? At the moment, the federal government steps in to provide extended benefits.

In negotiations currently under way, House Republicans propose to cut back dramatically on these benefits, asserting that this will push people back to work and speed the recovery. Does this make sense, or is it bad economics, as well as being mean-spirited?

(For details on the current benefit situation, see this information from California, as well as this on the political background. After a two-month extension of benefits at the end of last year, the terms of continuing it are currently before a House-Senate conference committee.)

The United States has lost more jobs than in any other recession in the last 70 years – and jobs have been slower to return, as this chart shows.

In raw numbers, we lost more than eight million jobs, most of which have not returned. Paul Solman of the PBS NewsHour prefers a measure he calls U-7, which includes "the underemployed and those who want a job but have been out of work so long that the government no longer counts them; this currently stands at 16.9 percent of the workforce (see this story and also, for background, a discussion Paul and I had in the fall on the "shape" of the recovery, in which we rely on the B.L.S. data.)

However you want to count it, the financial crisis of 2008 brought on a jobs disaster — and the scale of this disaster is still with us. We like to say that the recession is "over," but this just means that the economy is growing again. In no meaningful sense is the jobs crisis over.

Typically in the United States, most people are unemployed for relatively short periods of time, with a lot of movement in and out of unemployment. The fraction of long-term unemployed as a percentage of all unemployed is usually 10 to 15 percent. In the early 1980s, it briefly reached almost 25 percent.

Again, however, our experience since 2008 has been dramatically different – the share of long-term unemployed in total unemployed is close to 45 percent. And it appears to be staying at or near that level for the foreseeable future.

The House Republicans now propose to change many rules under which the federal government provides "extended benefits" to people who have exhausted their state benefits.

In most countries, unemployment insurance is managed primarily by the central government and its agencies – in our federal structure we have preferred, as with other kinds of emergencies (such as natural disasters) to have the states provide the first line of defense, with the federal government providing back-up. It is the federal government that has the strongest ability to borrow at low interest rates; most states are much more strapped for cash.

Do not be deceived by claims that the federal government is "broke," in the sense that it cannot afford to provide additional support to states and people at this level. This is a myth, pure and simple.

Perhaps the most obvious – and most obviously wrong – proposal is for the federal government to support extended benefits only when unemployment is higher now than it has been on average over the previous three years (in legislative jargon, this is known as a three-year look-back). But three years ago was early 2009 – when the jobs crisis was already well under way. In you were caught up in the initial downdraft from the collapse   of Lehman Brothers, you would be left on your own.  The look-back should either be updated or, preferably under these circumstances, suspended entirely.  Neither the GOP nor – amazingly – the Obama White House have yet taken any steps in that direction.

Along with other policy changes, the Republican proposal would cut up to 40 weeks from the existing available federal unemployment benefits.

The jobs crisis was caused by recklessness in the financial sector, made possible by irresponsible deregulation (including when Republicans controlled Congress and the White House) and resulting in enormous unconditional bailout protection for the bankers at the heart of the disaster (under both President George W. Bush and President Obama).

Let's be generous for a moment and simply state that mistakes were made – on an enormous, macroeconomic scale with gut-wrenching consequences for families around the country. Why would anyone now seek to punish these people when they seek work but cannot get it?

In some parts of the Midwest, there are roughly four unemployed people for every job vacancy; there are similar figures in many other parts of the country. Simply telling people to move is also not helpful – where exactly do you see hiring on a scale that would put a dent in these overall numbers?

Extended unemployment benefit provides on average about $300 a week – one-third of the average weekly wage and only about 70 percent of the poverty level for a family of four. If you strip even this money from people who remain out of work through no fault of their own, you will push more individuals and families onto the streets and into shelters. The cost of providing those fall-back services is very high – and much higher than providing unemployment benefits.

How does it help any economic recovery when the people who lose jobs cannot even afford to buy basic goods and services – enough to keep their family afloat?

This was the profound insight – under tragic circumstances – learned from the Great Depression. Unemployment insurance and Social Security were introduced together in the 1930s and funded in the same way – through payroll taxes. As President Franklin Delano Roosevelt said at the time (quoted by David M. Kennedy in "Freedom From Fear," on Page 267):

"We put those payroll contributions there so as to give the contributors a legal, moral and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my Social Security programs."

That logic worked for nearly 80 years. In the face of our modern mean-spiritedness, it now seems likely to collapse.

An edited version of this post appeared this morning on the NYT.com's Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Facebook and Mark Zuckerberg

By James Kwak

I must admit that I find Facebook's impending glory a bit awkward, as it touches on two themes I have written about previously. One is that I just don't like Facebook. And, I confess, I don't really understand it. I sort of understand why people like it, but I don't really understand why it's going to be the most valuable technology company on the planet in a few years. I don't understand why anyone would ever click on an ad within Facebook (or why anyone would even see them, since you could just use AdBlock), since I don't understand why you would want your shopping choices to be dictated by who is willing to spend the most money for your attention. (When I want to buy something, I prefer using organic Google search results, since at least they aren't affected by ad spending.) Maybe I'm just too old.

At the same time, it's pretty clear by now that Facebook does whatever it is that it does pretty well. $1 billion in annual profits is impressive, and it's also considered a pretty good place to work. And who is the CEO of Facebook? A twenty-seven-year-old kid with no other work experience. So while, as a customer ("user," in software industry parlance), I'm less than thrilled, I can't deny that Zuckerberg is doing something right as a CEO. Which is further evidence that the myth of the experienced CEO and the cult of the generalist manager are just a myth and a cult, as I've written about before. According to Reuters, Zuckerberg will soon be the fourth-richest person in America, after Bill Gates, Warren Buffett, and Larry Ellison. Which means that, like Gates and Ellison, it's a good thing he never let anyone convince him that his company needed an experienced CEO.

Private Equity and "Job Creation"

By James Kwak

The phrase "job creation" always makes me a little queasy. The personal computer has probably contributed to the elimination of tens of millions of clerical jobs, yet I think most of us feel that computers are a good thing: they make people more productive, meaning more goods and services for everyone . . . and hopefully the people who lost those jobs will find work doing something else. In boom periods, like the 1990s, it seems to work, at least for most people, but I doubt that there's any proof that productivity-increasing innovation always increases employment. But this line of thinking quickly leads to questions like whether the invention of the automatic toll booth is a good thing (because it eliminates what must be a pretty unpleasant job) or a bad thing (because it results in the layoff of people who may not have good alternatives), and those questions are above my pay grade.

Anyway, job creation these days usually refers to growing companies, making stuff people want, which tend to hire new workers—leaving aside the question of whether the products they make are causing other people to lose their jobs. This is the kind of job creation that Mitt Romney (and the private equity industry, at least publicly) wants to be associated with.

But private equity, as I wrote about last week, is just a way of taking over existing companies. While it's possible for a private equity fund to invest in growing companies, they are more likely to invest in mature companies, for various reasons: it's easier to borrow money against a company that has hard assets; mature companies are more likely to have the kinds of inefficiencies that build up over decades of poor management; you need steady cash flow to service debt, and high-growth companies are often spending most of their cash flow on new investments; and you're more likely to find undervalued companies in sleepy industries.

Taking one step back, private equity firms are just investors. The contemporary glorification of the investor class is based on the idea that their money is what fuels the creation and growth of dynamic companies. And in principle, that's true—if the investors are contributing new capital to a company. If you buy newly issued shares of stock in a company, you are giving it cash that it can use to grow (build factories, research new products, hire workers, etc.). The same is true if you buy bonds issued by that company (although the proceeds from the bond sale may be going to by back shares from other investors). But if you buy shares on the secondary market, you are not contributing new capital. (You are providing benefits to the economy, but they have to do with pricing and liquidity, which have an indirect impact on providing new capital to businesses.)

Private equity firms, in general, are buying shares on the secondary market (this is what "taking a company private" is all about), not contributing new capital. They are not increasing the amount of cash available for investment by companies. In fact, since they make money by paying themselves special dividends, they are reducing the amount of cash available for investment. In some circumstances this may be the best thing for shareholders, but it certainly has nothing to do with job creation—especially since we know that the dividends paid back to those private equity funds are only going to be used to buy more mature companies. The goal of a private equity firm is to make its companies more profitable: sometimes that means new products and new jobs, but it can just as easily mean the opposite (eliminating unprofitable product lines and fewer jobs).

So who is investing in new, high-growth companies? In the technology sector, at least, it's largely venture capital firms. Venture capital and private equity firms have similar structures, they charge the same outrageous fees and share the same ludicrous carried interest exemption, and their partners tend to be very rich, but the similarities end there. When VC funds invest in a company, they usually buy newly-issued stock (convertible preferred shares), which means new cash is available for investment and hiring. In early-round deals, at least, they don't take money out in fees and dividends. And while private equity firms need to maximize current profits to pay off all the debt they load onto their companies, venture capital firms are often willing to sustain losses for years in hopes of building something new.

Venture capitalists have numerous flaws, of course. In later rounds their interests can diverge from the company's interest, and they have a tendency to think they know more about running a company than they actually do. (That seems to happen to people who become very rich managing other people's money.) But the basic function of the industry is to collect capital from investors and funnel it to new companies building new things and hiring people. The same is not true of private equity.

What Did the SEC Really Do in 2004?

By James Kwak

Andrew Lo's review of twenty-one financial crisis books has been getting a fair amount of attention, including a recent mention in The Economist. Simply reading twenty-one books about the financial crisis is a demonstration of stamina that exceeds mine. I should also say at this point that I have no arguments with Lo's description of 13 Bankers.

Lo's main point, which he makes near the end of his article, is that it is important to get the facts straight. Too often people accept and repeat other people's assertions—especially when they are published in reputable sources, and especially especially when those assertions back up their preexisting beliefs. This is a sentiment with which I could not agree more. One of the things I was struck by when writing 13 Bankers was learning that nonfiction books are not routinely fact-checked (Simon and I hire and pay for fact-checkers ourselves). As technology and the Internet produce a vast increase in the amount of writing on any particular subject, the base of actual facts on which all that writing rests remains the same (or even diminishes, as newspapers cut back on their staffs of journalists).

I'm not entirely convinced by Lo's example, however. He focuses on a 2004 rule change by the SEC. According to Lo, in 2008, Lee Pickard claimed that "a rule change by the SEC in 2004 allowed broker-dealers to greatly increase their leverage, contributing to the financial crisis" (p. 33). That is Lo's summary, not Pickard's original. This claim was picked up by other outlets, notably The New York Times, and combined with the observation that investment bank leverage ratios increased from 2004 to 2007, leading to the belief that the SEC's rule change was a crucial factor behind the fragility of the financial system and hence the crisis.

Not so fast, Lo says (pp. 34–35):

While these "facts" seemed straightforward enough, it turns out that the 2004 SEC amendment to Rule 15c3–1 did nothing to change the leverage restrictions of these financial institutions. In a speech given by the SEC's director of the Division of Markets and Trading on April 9, 2009 (Sirri, 2009), Dr. Erik Sirri stated clearly and unequivocally that "First, and most importantly, the Commission did not undo any leverage restrictions in 2004". . . .

[T]wo aspects of this story are especially noteworthy: (1) the misunderstanding seems to have originated with Mr. Pickard, a former senior SEC official who held the very same position from 1973 to 1977 as Dr. Sirri did from 2006 to 2009, and who was directly involved in drafting parts of the original version of Rule 15c3–1; and (2) the mistake was quoted as fact by a number of well known legal scholars, economists, and top policy advisors.*

However, the statement that "the Commission did not undo any leverage restrictions in 2004″ is true only in a very narrow sense. Lo is correct that the allowable leverage ratio did not change. He is also correct that the real issue for broker-dealer firms is not a traditional leverage ratio (assets to equity), but net capital (a measure of financial position). But the rule did change the way that broker-dealers were allowed to calculate their net capital; in other words, it changed the way you calculate the denominator. In fact, Sirri concedes this (quoted in Lo, p. 34, note 26.):

The net capital rule requires a broker-dealer to undertake two calculations: (1) a computation of the minimum amount of net capital the broker-dealer must maintain; and (2) a computation of the actual amount of net capital held by the broker-dealer. The '12-to-1' restriction is part of the first computation and it was not changed by the 2004 amendments. The greatest changes effected by the 2004 amendments were to the second computation of actual net capital.

You can read the rule (and I did, while writing 13 Bankers): the SEC rule change is at SEC release 34-49830, and the current rules are here. In particular, Rule 15c3-1(c)(2) defines net capital as "net worth" subject to various adjustments. Paragraph 15c3-1(c)(2)(vi) says that you have to take deductions ("haircuts") for different types of securities; conceptually, it's like the risk weightings for Basel capital adequacy ratios.

The 2004 rule change said that certain broker-dealers could stop using the haircuts in 15c3-1(c)(2)(vi) and, instead, could use their own internal mathematical models to calculate haircuts, according to the rules in what is now Appendix E to Rule 15c3-1. The Summary to the rule change (p. 34428) says, "This alternative method permits a broker-dealer to use mathematical models to calculate net capital requirements for market and derivatives-related credit risk."

And the whole purpose of the rule was to allow broker-dealers to take smaller deductions when calculating net capital. It's also in the Summary (p. 34428):

These amendments are intended to reduce regulatory costs for broker- dealers by allowing very highly capitalized firms that have developed robust internal risk management practices to use those risk management practices, such as mathematical risk measurement models, for regulatory purposes. A broker-dealer's deductions for market and credit risk probably will be lower under the alternative method of computing net capital than under the standard net capital rule.

(We quoted the first sentence of that passage as the epigraph for chapter 5 of 13 Bankers). How much smaller? Well, the SEC worked that out, too, when estimating the "benefits" of the rule change (p. 34455):

A major benefit for the broker-dealer will be lower deductions from net capital for market and credit risk that we expect will result from the use of the alternative method. . . . In the Proposing Release, we estimated that broker-dealers taking advantage of the alternative capital computation would realize an average reduction in capital deductions of approximately 40%. We estimated that a broker-dealer could reallocate capital to fund business activities for which the rate of return would be approximately 20 basis points (0.2%) higher.

In summary, a broker-dealer could increase its net capital, for the same portfolio of assets and liabilities, by switching to the new calculation method. Since it now had excess net capital in the broker-dealer business, its holding company could transfer capital out of the broker-dealer and into other businesses. So without raising more capital, it could now expand its operations in those other businesses, and hence its balance sheet.

How much did this rule change contribute to rising leverage ratios between 2004 and 2007? I don't know; perhaps not that much. In any case, while high leverage contributed to the fragility of the big investment banks and hence the fragility of the financial system, the banks could also have done plenty of damage to the world without high leverage—simply by manufacturing toxic securities and selling all of them to investors (instead of eating their own dog food, as Citi and Merrill notably did). So I would not argue that the SEC rule change caused the financial crisis all on its own. But I also would not say that the rule change did not affect leverage at all.**

Now let's go back to the "mistake" that people allegedly made describing this rule change. This is what Pickard said, as quoted by Lo (p. 33, emphasis added by me):

[Before the rule change] the broker-dealer was limited in the amount of debt it could incur, to about 12 times its net capital, though for various reason broker-dealers operated at significantly lower ratios. . . If, however, Bear Stearns and other large broker-dealers had been subject to the typical haircuts on their securities positions, an aggregate indebtedness restriction, and other provisions for determining required net capital under the traditional standards, they would not have been able to incur their high debt leverage without substantially increasing their capital base.

I'm not sure there's a mistake here, except perhaps for the word "substantially," since I don't know how big an impact this rule change had. There might be one, but I don't see it.

Now, it's entirely possible that other people picked up the story, repeated it, and added their own errors. It's also possible that the rule change has been blown entirely out of proportion. That's one of Lo's arguments (pp. 34–35): leverage was as high in 1998 as in 2007, so what's the big deal? That's the essence of this chart from the Economist article:

But two things stand out for me here. One is that leverage did go up after 2004 for every bank. Second, 1998 was when we had the LTCM crisis, so for me a return to 1998 leverage levels is bad—not a justification for 2007 levels.

Still,  at the end of the day, we have correlation without causation: the rule change very well might have contributed to higher leverage, but we can't tell how much. It was certainly not the sole cause of the financial crisis. But if I were looking for a clear factual "mistake" that got picked up and circulated by the press and academics, I would not have chosen this one.

* I should point out here that Lo does not include Simon and me among the people quoting this "mistake." We did refer to the SEC rule change—probably because we referred to it (correctly) as a change in the way net capital was calculated, not an increase in the allowable leverage ratio. So I have no dog in this fight.

** On p. 34, note 26, Lo says, following Sirri, that the 2004 rule change was mainly about increasing regulatory supervision: "By subjecting themselves to broader regulatory supervision—becoming designated "Consolidated Supervised Entities" or CSEs—these U.S. firms would be on a more equal footing with comparable European firms." Lo quotes Sirri saying that the rule change added "an additional layer of supervision." We all know how that ended up—with the SEC's Inspector General calling the CSE program a complete failure—although that's neither here nor there for this blog post.

What Is Private Equity?

By James Kwak

Recently, a lot of the political debate has been about whether private equity—and by extension Mitt Romney—is good or bad. The argument on one side is that private equity firms are vultures who destroy firms to make money; on the other, that private equity is just capitalism at work, creates value, and creates jobs.

A private equity firm is an asset management company. It creates investment funds that raise most of their money from outside investors (pension funds, insurance companies, rich people, etc.), and then manages those funds. As opposed to a mutual fund, however, instead of buying individual stocks, these funds usually make large investments either in private companies or in public companies that they "take private" (more on that in a minute). While mutual funds and most hedge funds try to make money by guessing where securities prices will go in the future, private equity funds try to make money by taking control of companies and actively managing them. (There is a bit of a spectrum here, since mutual funds and hedge funds can exercise pressure on company management and private equity funds do take minority positions, but that's the ideal-typical distinction.)

A private equity firm is just a rebranded version of what were called LBO (leveraged buyout shops) in the 1980s, before they got a bad name. The classic transaction is to take over a company by contributing a small amount of equity and borrowing a lot of money. So if a company has $100 in assets, $100 in equity, and no debt, a private equity fund might chip in $20 in equity and then borrow $80 in the credit markets. That $100 in cash goes to buy out all the current shareholders, so the private equity fund now has 100% ownership of a company that has $20 in equity and $80 in debt—and the debt is owed by the company, not the private equity fund. (The 100% ownership means the company's stock no longer trades, hence the "going private.") Because of that leverage, small increases in company value mean high returns for the private equity fund: if the company's value goes up by $20, from $100 to $120, the value of the equity doubles, from $20 to $40, because the burden of debt remains fixed in nominal terms.

The argument for private equity is that it increases the value of companies. In practice, if a company's market value is $100, the private equity fund will have to pay a premium to buy it—say, $120. Then, for the fund to make money, it has to increase the company's value up above $120; otherwise, the fund will lose money on the deal. And in principle, if you can take some set of assets and make them worth more than they were worth before, that's a good thing.

And in a frictionless world, this would be true. But that's not the world we live in.

The discussion of the power of leverage above should have reminded you of something: the credit bubble and financial crisis. Leverage means higher expected returns, but it also means higher risk, transaction costs, and the potential for looting. So, for example, a private equity fund could use $20 to take 100% control of a company with $120 in assets (by making the company take on $100 in debt). Then it could use that control to liquidate assets and pay itself $30 in cash, giving it an instant 50% return; since there aren't enough assets left to pay off the creditors, the company could then go bankrupt. Taking a company with ongoing operations and forcing it into bankruptcy generally destroys value, not only because of transaction costs but also because the whole point of a company is to have ongoing operations that are worth more than its assets.

And this happens, though not as nakedly as in the example above. In 2003, for example, THL bought Simmons (the mattress company) for $327 million in cash and $745 million in debt. In 2004, Simmons (now run by THL) issued more debt and paid a $137 million dividend to THL; in 2007, it issued yet more debt and paid a $238 million dividend to THL. Simmons filed for bankruptcy in 2009.

Now, if we had perfect capital markets, this couldn't happen. Investors would not lend money to a company if they knew that both (a) the cash was going straight through to the private equity fund that owned it and (b) the company would be unable to service the new debt. But if we had perfect capital markets, the housing bubble couldn't have happened, either. Instead, during the credit bubble, banks were falling over each other trying to lend money into private equity deals, whether as syndicated loans or as bond offerings. There was too much money going into private equity deals just like there was too much money going into mortgage-backed securities, and for the same reasons: bankers whose bonuses were based on up-front fees that were in turn based on deal size; credit rating agencies that were either too clueless or too corrupt to see what was going on; bank sales forces that pushed debt into investors hands; and investors who didn't read their prospectuses, didn't understand what they were doing, or had too much faith in Alan Greenspan.

With perfect capital markets and perfect monitoring, private equity firms probably would be a good thing—but so would credit default swaps and collateralized debt obligations. In the real world, it's much less clear. When it's easy to make money just by piling on debt and paying yourself hefty "dividends" and "fees," why go to the bother of actually making a company better? In that case, it's simply a case of shareholders (private equity funds) taking money from creditors, with employees left as collateral damage.

So what should we make of the private equity kings themselves, since this whole debate is really about Mitt Romney? The good ones are good at making money for their investors (the people who invest in their funds), which in practice means a combination of both improving undervalued companies and raiding them to transfer cash from the company treasury to their funds. In this respect, I'm not sure they're that different from most of the class of people we call "bankers": they do a job that is good for society in principle, but in practice is more ambiguous; some contribute more to society than they take out, some take out more than they contribute.

I have no idea which category Mitt Romney falls into. Personally, I'm less concerned about the fact that he was a Bain Capital executive than by (a) his positions on virtually every significant policy issue and (b) the fact that many of those positions have complete shifted since he was governor of Massachusetts.

Breakthrough: Eric Schneiderman To Chair Mortgage Crisis Unit

By Simon Johnson

As reported first in the Huffington Post, President Obama is creating "a special unit to investigate misconduct and illegalities that contributed to both the financial collapse and the mortgage crisis".  This will be chaired by Eric Schneiderman, the New York attorney general.

For more background on why this makes sense and could represent a major policy breakthrough, please see this column: http://www.politico.com/news/stories/0112/71788.html.

 

Should We Trust Paid Experts On The Volcker Rule?

By Simon Johnson

On Wednesday morning, two subcommittees of the House Financial Services Committee held a joint hearing on the Volcker Rule.  The Rule, named for former Fed chair Paul Volcker, is aimed at restricting certain kinds of "proprietary trading" activities by big banks – with the goal of making it harder for these institutions to blow themselves up and inflict another deep recession on the rest of us.

The Volcker Rule was passed as part of the Dodd-Frank financial reform legislation (it is Section 619) and regulators are currently in the process of requesting comments on their proposed draft rules to implement.  Part of the issue currently is claims made by some members of the financial services industry that the Volcker Rule will restrict liquidity in markets, pushing up interest rates on corporate debt in particular and therefore slowing economic growth.

This argument rests in part on a report produced by Oliver Wyman, a financial consulting company.  Oliver Wyman has a strong technical reputation and is most definitely capable of producing high quality work.  But their work on this issue is not convincing.  (The points below are adapted from my written testimony and verbal exchanges at the hearing; the testimony is available here.)

The report, "The Volcker Rule: Implications for the US corporate bond market," was commissioned by the Securities Industry and Financial Markets Association (SIFMA) and it is available on the SIFMA webpage that contains its comment letters to regulators.  On p. 36 of the report, the disclaimer begins, "This report sets forth the information required by the terms of Oliver Wyman's engagement by SIFMA and is prepared in the form expressly required thereby."  This does not mean – and I am not implying – that Oliver Wyman was instructed to find a particular kind of result.  But the incentives of SIFMA and its most prominent members are worth further consideration in this context.

The current chair of SIFMA is Jerry del Missier, a top executive at Barclays Capital.  The board also includes executives from Morgan Stanley, Societe General, UBS, BNP Paribas, HSBC, Deutsche Bank, Goldman Sachs, Citigroup, RBS, JP Morgan Chase, Credit Suisse, RBC, and Merrill Lynch.  All of these companies would be affected by the Volcker Rule, in the sense that they would have to give up some of their "proprietary trading" activities and perhaps be subject to other restrictions – this is according to the Oliver Wyman report, p. 11, which lists "the institutions that will be most affected by the Volcker Rule"; more than half of these institutions are on the SIFMA board.

Such very large banks are perceived as "too big to fail", because their failure would likely cause massive damage to the rest of the financial system.  As a result, the downside risks created by these institutions are borne, in part, by the government and the Federal Reserve – as a way to protect the rest of the economy.  In effect, these banks benefit from unfair, nontransparent and dangerous government subsidies that encourage reckless gambling – most notably in the form of "proprietary trading" (jargon for placing bets on which way markets will move).  When things go well, the benefits of these arrangements are garnered by the executives who run these firms (and perhaps shareholders).  When things go badly, the downside costs are pushed in various ways onto the taxpayers and all citizens.

The Volcker Rule is intended to limit the implicit subsidies received by large banks that also operate proprietary trading at any significant scale – this is clear from the repeated public statements of both Mr. Volcker (who had the original idea) and Senators Carl Levin and Jeff Merkley, who turned it into meaningful legislation as an amendment to Dodd-Frank.  We should therefore expect executives from big banks to oppose removal of these subsidies.  To the extent that such subsidies may be expected to benefit shareholders, it can be argued that these executives also have a fiduciary responsibility to do all they to ensure the subsidies continue (i.e., that the effectiveness of the Volcker Rule be undermined).

SIFMA itself has a clear mission: "On behalf of our members, SIFMA is engaged in conversations throughout the country and across international borders with legislators, regulators, media and industry participants."  There is nothing in their public materials to suggest the research they sponsor is designed to uncover true social costs and benefits; rather their goal is to advance the interests of their members – this is a lobby group, after all.  SIFMA claims to represent the entire securities industry but more than one-third of its board is drawn from very large banks that would find their implicit subsidies cut and constrained by an effective Volcker Rule.  Given this context, it is not clear why the Olivier Wyman study would be regarded as anything other than – or more convincing than – a relatively sophisticated form of special interest lobbying.

There is also a serious methodological issue.  The Oliver Wyman study draws heavily on a paper by Jens Dick-Nielson, Peter Feldhutter, and David Lando, which looks at the liquidity premia for corporate debt in recent years and which contains plausible results: "Illiquidity premia in US corporate bonds were large during the subprime crisis. Bonds become less liquid when financial distress hits a lead underwriter" (quoted from http://www.feldhutter.com/).  (Disclosure: Until recently I was on the editorial board of the Journal of Financial Economics, where the paper appeared, but I was not involved in the publication of their article.)

However, the Olivier Wyman study goes far beyond those academic authors when it claims that the Volcker Rule will make corporate bonds less actively traded – less "liquid" – and therefore increase interest rates on such securities.  In particular, the Oliver Wyman approach appears to assume the answer – which is not generally an appealing way to conduct research.

Specifically, the Oliver Wyman study assumes that every dollar disallowed in pure proprietary trading by banks will necessarily disappear from the market.  But if money can still be made (without subsidies), the same trading should continue in another form.  For example, the bank could spin off the trading activity and associated capital at a fair market price.  Alternatively, the relevant trader – with valuable skills and experience – can raise outside capital and continue doing an equivalent version of his or her job.  Now, however, these traders will bear more of their own downside risks.

If it turns out that the previous form or extent of trading only existed because of the implicit government subsidies, then we should not mourn its end.

The Oliver Wyman study further assumes that the sensitivity of bond spreads to liquidity will be as in the depth of the financial crisis, 2007-2009.   This is ironic, given that the financial crisis severely disrupted liquidity and credit availability more generally – in fact this is a major implication of the Dick-Nielson, Feldhutter, and Lando paper.  If Oliver Wyman had used instead the pre-crisis period estimates from the authors, covering the period 2004-2007, even giving their own methods the implied effects would be 5-20 times smaller (this adjustment is based on my discussions with Peter Feldhutter.)

And the Oliver Wyman study makes no attempt to estimate the benefits of the Volcker Rule, for example in terms of lower probability for a major financial collapse.

The biggest disaster for the corporate bond market in recent years was a direct result of excessive risk-taking by big financial players.  The Volcker Rule is a step in the direction of making it harder to repeat that awful experience.

Powerful players in the financial sector are entitled to make their arguments against the Rule.  But for-hire "research" that shows the Volcker Rule will hurt the broader economy should not be regarded as convincing evidence.

An edited version of this post appeared last week on the NYT.com Economix blog; it is used here with persmission.  If you would like to reproduce the entire post, please contact the New York Times.