Ideoblog

The cheap bailout

Yesterday the FASB and the SEC relieved banks from marking securities to market prices that reflect “fire sale” values. The market rose 500 points, making up two thirds of Monday’s drop, even without a bailout. Holman Jenkins thinks there’s a connection.

But wait: mark-to-market accounting just tells us reality. Shutting our eyes to that just kills the messenger, doesn’t it? Why would killing the messenger send the market up 500 points?

Maybe marking to market isn’t reality if the market price is unrealistic.

But wait: Can’t efficient markets see that, and adjust their expectations accordingly?

Enter regulation, according to Jenkins. Mark to market can put banks below capital requirements, forcing them into closure or forced sale.

[T]he essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?

But wait: if capital regulation is intended to ensure solid capital values, and mark to market gives us this value, why is it a "trap"?

Jenkins suggests the accounting rules can be self-fulfilling – the unrealistic “fire sale” price becomes the highest price at which the bank to sell. So only private equity has been buying subprime securities because they don’t have to mark them to market.

But wait: isn’t the market the market? Why should anybody pay more than that.

Maybe the Paulson plan collides with mark to market if it ends up forcing banks to sell at these fire sale prices. In other words, the federal government would just join private equity as a vulture investor.

But wait: if that’s the value, how can our government justify paying more?

Maybe the short-sellers are making things worse, driving down asset values and making the accounting value a self-fulfilling prophecy.

But wait: aren’t short-sellers betting that shares are over-valued? Mark to market is supposed to get prices to their actual value. If the rule causes unrealism, it’s on the low side, not the high side, isn't it? Short selling is a good thing because it enables bets that help us see what assets are really worth.

As you can see, I’m confused.

Here's a shot at what's going on: The only way changing mark to market gets us out of this mess is if market psychology is driving it. In other words, changing the accounting rule is a bet that (1) markets are inefficient; and (2) we can make them more efficient by eliminating an accounting rule based on real transaction prices. Whoa.

But wait: if all mark to market does is reveal values that the efficient market should know already, then the rule doesn’t make much difference, does it? Jenkins point is that we may as well try this gambit.

Hey, it’s a lot cheaper than 700 billion.

One last point:  if we get rid of short selling, then all bets about the market knowing what's really happening are off. In other words, should we get rid of both mark to market and short selling?

The uncorporation and social responsibility

Matt Bodie and Steven Greenhouse discuss this subject in relation to Greenhouse’s book, The Big Squeeze. I haven’t read that yet, but it seems to argue that shareholder primacy is driving companies to squeeze profits out of workers. Bodie links my posts suggesting that uncorporate governance gives social activist shareholders, including unions, a narrower platform (a point I’ve also made in my Uncorporating the Large Firm). On the other hand, he notes that they might be able to tailor their governance to reduce shareholder primacy. So, as Greenhouse says, “For those so inclined, forming an uncorporation makes it easier to treat workers generously, but evidently, for those otherwise inclined, forming an uncoporation can also make it easier to treat workers ungenerously.”

Here’s a few clarifications and responses:

1. It’s important to distinguish the issues regarding closely held firms from those relating to uncorporations, which may or may not be closely held. As I argue in Accountability and Responsibility in Corporate Governance, publicly held firms (both corporate and uncorporate) may be more socially responsible than closely held, contrary to arguments some have made. That’s because markets encourage long-run profitability, which requires attention to customers, employees and others, while owner-managers of closely held firms may engage in “irresponsible” consumption.

2. Though publicly held uncorporations can tailor their governance to reduce social activist voice, it doesn’t follow that they will operate less “responsibly.” See 3 and 4, below.

3. I don’t buy into the “good” and “bad” company distinction that Greenhouse seems to be making (though, in fairness, I should emphasize that I haven’t read the book). In other words, “generosity” to workers may or may not be a good thing. The firm’s main responsibility to all of its constituencies is long-term survival. This prime directive should temper the firm’s generosity. Perhaps in these lean times workers can better appreciate this point.

4. The effect of shutting out worker voice is not necessarily suboptimal generosity. Instead, it might help the firm’s managers avoid super-optimal generosity.

5. As I emphasize in Accountability and Responsibility, these arguments aren't really all that relevant to reforming corporate governance, since corporate managers already have enough discretion to be socially responsibility if they want to be.  However, the tighter discipline of uncorporate managers may make this debate more relevant than it's ever been. In particular, expect to hear social activist shareholders argue that publicly held uncorporations should be run like publicly held corporations. Of course that will present a dilemma for unions, which have to care both about workers on current wages and those living off their pensions.

Expelling a partner for unpopular views

ATL reports that an Orrick, Herrington & Sutcliffe of counsel emailed the firm complaining that a partner’s contribution to California’s Yes on 8 campaign (opposing same sex marriage)

damages the reputation of Orrick as a progressive law firm supportive of equal rights for gay and lesbian people. This can adversely impact the firm in many ways, including hurting our ability to attract gay and lesbian recruits; turning off clients, existing and potential, that support equal rights for homosexuals; and making our current gay and lesbian work force feel like second class citizens.

The email suggests that "we should try to counteract the damage that has occurred."

Professor B asks about the partners’ power and right to expel the pro-Yes on 8 partner under various assumptions about the applicable law and the partnership agreement.

The simple answer is that this depends on the partnership agreement. The partnership statutes don't provide by default for expulsion by partner vote in this situation. They do provide for expulsion per the partnership agreement and for judicial dissociation (or the close equivalent of dissolution and continuation) for partner misconduct (unpopular views probably wouldn't qualify).

Can the partners take action that has the effect of expulsion without an expulsion provision in the agreement? Cadwalader, Wickersham & Taft, 728 So. 2d 253 (Fla. App. 1998) says no. Dawson v. White & Case, 88 N.Y.2d 666, 672 N.E.2d 589, 649 N.Y.S.2d 364 (1996) seems to allow it, though that opinion didn't resolve the fiduciary duty issue.

If the partners’ action is permitted by the partnership agreement, then it’s probably not a breach of fiduciary duty or bad faith – the courts are pretty generous in enforcing the partners’ right to decide whom they associate with. See my article, Law Partner Expulsion, 55 Business Lawyer 845 (2000), and Bromberg & Ribstein on Partnership, Section 7.02(f).

Any questions?

The bailout and the appalling quality of public policymaking

The market is telling us as I write this that the only thing that's worse than a bailout is not having a bailout.  The more basic problem is that the government lacks any clue about what it's doing.  Or, more precisely, it's telling us that we absolutely need to do something (thus helping propel markets down), but we absolutely have no idea what (thus sending them down further). 

So far, Henry Paulson has proposed a massive government expenditure that will certainly provide a market for questionable assets of his former firm. Congress then added 107 pages. As Steve Davidoff puts it: “if the bill is passed in this form, the Democrats will claim a victory through [the] executive and corporate governance provisions as well as the warrant provisions.”

The warrant provisions give the taxpayers contingent rights in the assets that we still don’t know the value of.

What about the executive compensation and governance provisions?  Here’s a summary:

Treasury will promulgate executive compensation rules governing financial institutions that sell it troubled assets. Where Treasury buys assets directly, the institution must observe standards limiting incentives, allowing clawback and prohibiting golden parachutes. When Treasury buys assets at auction, an institution that has sold more than $300 million in assets is subject to additional taxes, including a 20% excise tax on golden parachute payments triggered by events other than retirement, and tax deduction limits for compensation limits above $500,000.

In other words, Congress has taken care of their constituents’ envy and resentment issues. But at best these provisions will be counterproductive. Financial firms need today more than ever executives who have high-powered incentives, not lower incentives. As I’ve written, it was the lack of such incentives that arguably led to this mess. And golden parachutes, though they can be abused, at least encourage the ineffective executives to step aside, or maybe even pro-actively seek value-increasing sales.

Anyway, it looks like it doesn’t matter. As Davidoff observes, “the executive compensation and corporate governance provisions are unlikely to be implemented for any companies.”

Meanwhile, we still have no clear idea whether this was necessary in the first place. Here’s Peter Klein (HT Josh Wright).

We've heard a lot recently about market failure, but what we're seeing now is government failure on a massive scale.  Theoretically a government intervention of some sort might be a good idea.  But the actuality leaves me skeptical.

So long Fast Eddie

Paul Newman was one of the great screen actors – maybe not towering acting ability, but you could point a camera at him for two hours and you had at least a decent movie.

But my readers know I’ve got a particular take on film. From that perspective, Paul Newman is defined by The Hustler. The dominating character in that film wasn’t Newman’s pool hustler, Fast Eddie, but his money man Bert, played by George C. Scott (Jackie Gleason’s Minnesota Fats was a close second in a fantastic understated performance).

The film was basically about Fast Eddie changing from a loser to a winner. But since this is Hollywood, as I've written in Wall Street & Vine, there had to be an anti-capitalist theme lurking there somewhere. So, at the end, Fast Eddie’s triumph is over Bert, and there’s no mistaking that this is about honor vs. money. When Fast Eddie tries to stiff Bert for his cut on the rematch with Fats, Bert says, "You owe me MONEY!" Bert's going to break his thumbs and right arm if he doesn't get paid. That's because, as he says, "I'm a business-man, kid."

Interestingly, Bert’s line sort of came back in the classic anti-capitalist film, Oliver Stone’s Wall Street. Here’s an excerpt from my article on that film, Imagining Wall Street:

Carl says [to his son Bud], “What you see, son, is a man who never measured success by the size of a man's wallet.” (Martin Sheen explained in the DVD documentary that when he shouted the word “wallet,” he intended to evoke George C. Scott, the venal promoter in The Hustler, when he said to Eddie, “you owe me MONEY.”)

In Wall Street & Vine I explain the anti-capitalism of Hollywood films in terms of the tension between the artists in Hollywood and the money guys they feel beholden to. It's very easy to see that in the relationship between Bert and Fast Eddie imagined by writer-director Robert Rossen.

Paul Newman played rebel-types, including in all of his H films. But, in fairness, one of his most memorable characters fought against labor, not management.

The Hustler was one of the great films of the baby boomers’ teenage years. Fast Eddie is part of a lot of us.

The bailout, Canada, and what to watch on television

Ok, so in the news tonight, Congress approved a buyout of possibly overvalued and certainly stupidly managed assets of approximately a zillion dollars, except that this will be in installments, just in case the markets were thinking things were getting too predictable.  SOX II to come.

Now for the important stuff.  I just got a big television.  The price was awesome, but compared to the bailout -- hey, what the heck.  Front projector, 92 inch screen, big sound.

And my question:  which movies should I watch first.  I'm headed to Canada, to present this, so unfortunately I will be distracted for a couple of days.  But when I get back I want to hit the remote running, so to speak. So fire away, and I'll get Netflix on the case.  And, no, I'm not going to start with the "debate."

Update:  Finally the "bailout" is getting interesting.

The future of banks: private equity?

Yesterday I observed after the last big Wall Street investment banking firms became Fed-supervised banks:

These firms apparently did not have a governance model suited to investing in an increasingly complex world. The regulators (SEC) couldn’t be expected to fill the gap. I have already discussed where this is headed: nimble, highly incentivized partnerships such as hedge funds, private equity, venture capital.

I linked my post from the previous week noting:

[I]t’s the hedge funds that avoided the big risks because they were the best governed. And now it’s the similarly governed private equity firms that are waiting in the wings to pick up the wreckage. And so the financial industry will return, in a way, to its partnership roots.

And now from today’s news:

The Federal Reserve, unleashing its latest attempt to inject more cash into the nation's ailing banks, loosened longstanding rules that had limited the ability of buyout firms and private investors to take big stakes in banks. * * *

Monday's move should encourage private-equity firms, government investment funds and others to buy stakes in banks, transferring capital from those that have it to those that need it. Previously, if the Fed determined that a private-equity firm had a controlling stake in a bank, it could classify the investor as a "bank holding company," directly supervise the parent firm and impose restrictions on outside investments. The rules were designed to prevent investors from abusing their bank stakes to benefit their nonfinancial investments.

The Fed showed flexibility in three main areas: allowing certain investors to hold board seats, communicate with bank management and own larger amounts of stock.

Opting out of the short-sale list

The argument against short-sale restrictions is that short-sales help load more information into stock prices. More efficient markets reduce risk and therefore the cost of capital. In other words, they help the firms whose stock is being traded.

That’s supposed to be the rationale for the securities laws – a sort of government subsidy to the stock markets. So it’s ironic that while providing this subsidy the government would actually undercut the market for information.

One would expect firms themselves to see the problem and take themselves out of the short-sale ban. Indeed, a couple of firms have done so. These firms arguably gain from the short-sale ban in the sense that the ban enables them to send a positive signal to the market.

As NYT Dealbook notes:

Why take oneself off the list? “Short-selling is an important activity in terms of providing information to market participants,” Rob Dillon, the chief executive of Diamond Hill, told The Times on Monday. “What is so frequently misunderstood by so many, whether regular investors or C.E.O.’s, is that the goal of marketplace is to have stock price be accurate reflection of fundamentals of your business. They think goal is to have stock price as high as it could be.”

So why aren’t more firms doing this? Could it be because it’s in managers’ personal interest (if not their firms) to keep information out of the market that negatively reflects on their performance?  These firms may have a higher cost of capital than the firms that opt out, but not as high as the firms that disclose negative information.  Thus, the ban provides cover for bad managers. 

From Wall Street to Connecticut

So the Fed has taken over Wall Street. Here’s the WSJ, and David Zaring (who has emerged as a point man on these issues) on the SEC as potted plant.

These firms apparently did not have a governance model suited to investing in an increasingly complex world. The regulators (SEC) couldn’t be expected to fill the gap.

I have already discussed where this is headed: nimble, highly incentivized partnerships such as hedge funds, private equity, venture capital.

In other words, Wall Street moved to Main Street, and the action has gone to Connecticut.

Some thoughts about SOX II

The government is going to throw a lot of money (up to $700,000,000 “outstanding at one time,” which could be repeated purchases up to that amount followed by sales at lower amounts). Comforting to know there’s a “possibility that taxpayers could profit from the effort.” (CR notes the humor.)

But unfortunately that trillion bucks or so is only the beginning of the problem.  It's going to be surrounded and followed by lots of regulation. See my Bubble Laws, 40 Houston L. Rev. 77 (2003). In other words, get ready for SOX II.

There’s a general view that recent events show a failure of the capital markets to deal with their problems, necessitating government interference. At the risk of shouting into a noisy wind, let me suggest that it’s not so simple. Yes, the capital markets have floundered. But that doesn't mean we want or need another SOX. 

The big problem we face now is finding out how much assets are worth. Only markets can do that.  Surely the government hasn't a clue.

Some say that it’s evil over-complex derivatives that got us into this fix. Well, if the problem is over-complexity, we might ask why the market would produce more complexity than it needs. Tyler Cowen links an old Jane Galt post that provides part of the reason: 

Pundits continue to link the Enron debacle to a need for increased regulation, especially of derivatives. What most of these people . . . don't appreciate is that regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship. * * *

I strongly suspect that substantive regulation of the derivatives markets will lead to still more complexity by inducing the markets to work around the additional regulation.

The above post goes on to suggest we need more disclosure.  I wonder. The market is already buried under a mountain of disclosure. Clearly ordinary investors can’t sort through this, and the sophisticates probably don’t need it. For example, while “mark to market” may not have caused all of our problems, I seriously doubt that it helped.

Is this really a disclosure problem? As I have discussed, the problem was really fairly simple -- the mortgages on which the derivatives were based were valued based on patently unrealistic assumptions about real estate prices. This wasn't as much a disclosure problem as a governance problem with the managers who were buying all this junk.  The response is better incentives.

As I noted in my post, a possible answer to governance problems is partnerships like hedge funds, which have actually had fewer problems than financial corporations in this whole mess. For much more on this, and must reading, see Houman, Shadab, The Law and Economics of Hedge Funds. Houman will be making an exceptionally timely presentation of his paper in my Illinois Business Law and Policy Colloquium tomorrow.

Despite these considerations, expect hedge funds -- a perennial scapegoat -- to be a potential target of regulation in the aftermath of this crisis.

We do need more information.  Efficient securities markets could provide that information even without more disclosure laws.  This makes it all the more surprising that regulators should seek to clamp down on short selling.  Always seeing the glass as half full may be a nice comforting philosophy, but it's not going to illuminate the way out of the current crisis.

So we need is better managerial incentives and more information. Yet by regulating short-selling and hedge funds, we might get less of both. In other words, unless we really try to understand what went wrong, throwing more regulation – more disclosure, more regulation of hedge funds, more government ownership of overpriced assets -- at the problem not only won’t help, but is likely to hurt.

At the end of our book, The Sarbanes-Oxley Debacle, Henry Butler and I suggested some guidelines for better future regulation: Periodic review and sunset Provisions, optional rather than mandatory rules, nuanced regulation focusing on the specific problems that cannot be dealt with by optional rules, investor education and deregulation.  We might consider these recommendations now.

SOX was sold as the way to prevent future market bubbles and crashes. Obviously, in addition to imposing huge costs, it utterly failed to deal, not only with some indefinite future, but with problems that were already brewing at the time SOX was enacted. Indeed, SOX may well have hurt by helping to make investors complacent. Enough is enough. Let’s try to think before we leap again off the regulatory cliff.

Wave of stupid politics sweeps over financial markets

Here’s a sample of the silly ideas floating around, and some sane reaction.

Repeal Gramm Leach Bliley.

--No. [from Marginal Revolution]

The Act enabled financial diversification and thus it paved the way for a number of mergers. Citigroup became what it is today, for instance, because of the Act. Add Shearson and Primerica to the list. So far in the crisis times the diversification has done considerably more good than harm. Most importantly, GLB made it possible for JP Morgan to buy Bear Stearns and for Bank of America to buy Merrill Lynch. It's why Wachovia can consider a bid for Morgan Stanley. Wince all you want, but the reality is that we all owe a big thanks to Phil Gramm and others for pushing this legislation.

Bring back Glass-Steagall

--No. (Again from MR).

Many wise people are now recognizing that the repeal of Glass-Steagall was one of the few saving graces of the current crisis. Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates. Randall Krozner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks. A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham. My colleague, Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor).

Add a host of new regulations:

--No, from David Brooks, HT MR.

[T]he idea that our problems stem from light regulation and could be solved by more regulation doesn’t fit all the facts. The current financial crisis is centered around highly regulated investment banks, while lightly regulated hedge funds are not doing so badly. Two of the biggest miscreants were Fannie Mae and Freddie Mac, which, in theory, “were probably the world’s most heavily supervised financial institutions,” according to Jonathan Kay of The Financial Times. * * * [T]his supposed new era of federal activism is going to confront some old problems: the lack of information available to government planners, the inability to keep up with or control complex economic systems, the fact that political considerations invariably distort the best laid plans

Banning short selling

There’s a lot of evidence that short-selling increases market efficiency. Do we really want less information about the value of financial stocks?

Voting. Well, McCain hasn’t exactly covered himself in glory. Prof B calls his attack on Cox “moronic.” I sympathize, but what’s Obama’s plan? To let the dynamic free market handle this? Not.

Meanwhile, we need information. As indicated above, Marginal Revolution has been a great source of sanity. Another one, John Carney, is moving to new digs. Let's hope he gets even noisier.

All the news that's fit to print

We've heard a lot about how those wicked shorts are driving down the financials.  But did they do anything as bad as this?

Some ramifications of AIG and the crash

Federalism: It’s not just the federal government buying an insurance company. It’s the federal government probably re-writing, or at least messing up, an existing contract. It’s the federal government owning a company in what has been until now, a state-regulated industry. Could this be part of Paulson’s plan to federalize insurance regulation?

Politics. McCain lost more ground in the Iowa market today than Morgan Stanley did in the stock market. Basically, because of what happened today, he’s probably toast. Of course Republicans as well as Democrats deserve some blame.  I fear, though, that this reflects a taste for regulation.  Remember the last time we got a regulatory frenzy after a bust? See below.

SOX. Speaking of the devil. It was supposed to stop excessive risk. But as I have predicted since it was enacted, SOX accomplished nothing other than creating a false sense of security. Will we remember any of the lessons of SOX?  No, of course not.

Corporate governance. While people were obsessing over venality, we learned that the big problem was stupidity.  Hey guys, let's bet the company that the real estate market will always keep going up. There’s obviously been a failure of corporate governance here. On that Carl Icahn and I agree. Of course that doesn't mean that I think the government is smart enough to clean this up.  See above.  The lesson nobody seems to learn is that, while markets make mistakes, they're flexible and self-adjusting.  Government keeps making the same mistakes over and over.

Some questions (and answers) on the AIG buyout

Questions from Steve Bainbridge (possible answers from me):

(1) On what basis does the Fed have authority to use the discount window to bail ouit an insurance company? (Section 13.3 Federal Reserve Act.)

(2) Who would have standing to challenge the Fed action, if anyone? (NA)

(3) Why was AIG to big too fail but Lehman wasn’t? Was AIG’s role in the credit default swap market really that important?  (Yes.)

(4) Why extend the moral hazard inherent in federal bailouts from banking to the insurance business? (See 3)

(5) Has the federal government ever taken an equity stake--let alone a controlling stake--as part of a bailout before? Was there any equity stake in Chrysler? (?)

(6) Does it make policy sense for the federal government to put itself in the position of owning an insurer? (See 3)

(7) How can the federal government take a security interest in AIG’s assets? Presumably AIG had debt securities outstanding that include negative pledge covenants. If so, why doesn’t this deal violate the trust indentures? This one really bugs me.  (Arguably violates the Contracts Clause. But the Contracts Clause doesn't apply to the federal government.)

(8) Are we going to see regulation of the credit default swap sector or of derivatives more generally?  (Yes) Are the regulators going to think before they act (no) or pull a SOX and just throw a bunch of crappy ideas at the problem? (yes)

(9) Regulation of insurance has been a matter for the states rather than the federal government, so what legal basis is there for any of this? (They're not regulating insurance. So it's dicey that the feds now own a state-regulated business. Kinda throws a spanner into federalism in this area.  As for the current federalism issues in insurance (pre AIG) see my article with Butler.)

The market effect of the AIG buyout

If the Treasury stepped in and saved AIG, why is the market still plummeting (as of mid-day)? Of course nobody knows what drives the market, but here are some plausible inferences.

1. By finally stepping in after much protestation about no bailouts, the government signaled that, on the close examination only government could provide, the situation was indeed dire.

2. Notwithstanding 1, the cost of the AIG bailout suggests (at least to Holman Jenkins) a limit on future bailouts.

3. Notwithstanding 2, it seems likely that the government will step in again to prevent an equally catastrophic collapse – particularly of an insured institution.

On that score, I take back what I said about not being concerned about moral hazard. Steve Davidoff observes that

Bank of America is actually now asking that its capital requirements be reduced. Bank of America is looking to take on more leverage now! BofA is definitely in the too-big-to-fail category.

BoA, as an insured bank, is clearly a matter of more central government concern than an insurer.

So, at this hour, Morgan Stanley is plummeting, investors are jittery about continued risk, and waiting for the next bad shoe to fall.

The AIG buyout

So the government's joined the private equity business. It got a pretty hefty start, buying out AIG. 

David Zaring:

Emergencies are emergencies, and when that happens the rules go out the window, and hopefullly regular elections mean that the officials the people trust are dealing with the emergency. Abraham Lincoln adopted that reasoning, and he won the Civil War. I suspect we're at the "anything goes in an emergency" stage of things. But maybe reasonable minds could disagree.

Gordon Smith:

In short, this move is not aimed at protecting AIG's policyholders, but rather at protecting the financial institutions that purchased AIG's credit-default swaps. Moral hazard, anyone?

Was this an emergency? Consider the exigencies I noted yesterday. But is this really 9/11? One might say that it’s more like Pee Wee Herman: a bunch of grownup companies living in a child's world in which real estate prices always go up. When they go down, should we prop up the stage set anyway?

On the other hand, maybe we should disregard whether Wall Street acted rationally in the first place and focus on the current mess. 

I'm still not sure.  But my problem isn't moral hazard. The firms acted heedlessly of the real risks.  I doubt in the future that similarly run firms would be acting on the expectation of a government bailout.

Rather, the problem is agency costs. Is the significant short-term dislocation from an AIG failure worse than the agency costs of having the government run a multi-billion dollar business? Think of Fannie and Freddie, where the government's interest was less direct than here. Speaking of Pee Wee Herman, can there be anything worse than having the US Congress as a board of directors?

More on agency costs from Dealbreaker:

If the money lent out to AIG is not paid back, Hank Paulson and Ben Bernanke will not suffer financially. If you ever wanted to see an agency cost roaring, the AIG takeover is your dream come true. What's more, the deal allows government officials the rare thrill of feeling that they are not only very, very relevant. They are now the masters of the universe, the warrior kings of Wall Street.

Sell

There was a Cubs no-hitter on Sunday.  The time before that was April, 1972.  I was just entering law practice, so I remember well the loooong and totally depressing miasma of market despair that followed. Just saying. HT Dealbreaker.

The market meltdown and the regulators

Remember when SOX was supposed to, at enormous cost, expose the weaknesses and risks lurking in companies so they could be addressed to avoid another Enron? As Tom Kirkendall and I have been observing for awhile:  fat lot of good SOX did.  Could we please think about that when we try to regulate in the wake of this catastrophe?

And while we’re at it, let’s think about yesterday afternoon’s market plummet. That happened (and it's likely to continue this morning) because AIG, facing catastrophic downgrades of its securities, needs 70 billion by tomorrow to avoid bankruptcy.

Should we worry about that? Here’s what the WSJ has to say:

The company, whose stock fell 61% yesterday, is such a big player in insuring risk for institutions around the world that its failure could shake the global financial system. much of its exposure is related to credit default swaps, insurancelike contracts tied to corporate defaults. * * * The market for credit default swaps is immense, trading against about $62 trillion of debt. Some participants in the largely unregulated market worry that the default of a major player such as AIG could trigger chaos. * * *

[T]he firm is used by many companies world-wide to manage a range of risks, including exposure to investments in subprime mortgages. Its demise would potentially make it harder or more expensive for businesses to control their risks.

How did this happen? Well it’s worth speculating that it had something to do with AIG being left without its long-time leader, Hank Greenberg, for which we can thank Eliot Spitzer. As I’ve noted, per the WSJ (last May):

A careful and lengthy look at the evidence available so far . . . suggests that the AIG case, like so many others that Mr. Spitzer brought, was an example of prosecutorial excess. Instead of uncovering some great fraud by a titan of industry, its main result has been to damage the company, and harm innocent managers and shareholders. * * *Trading above $72 in February 2005 before it was Spitzerized, AIG shares closed yesterday at $39.57. The company's directors defend themselves by saying Mr. Spitzer gave them little choice but to dismiss Mr. Greenberg. Whether that was true at the time, they – and Mr. Spitzer – owe an apology to AIG shareholders.

And, of course, now we know it only got worse.  Thanks Eliot.

Gretchen Morgenson: what the birds read

I mentioned over the weekend that I was getting my Black Sunday news from Dealbreaker, Calculated Risk and WSJ.com, and not from MSM like the NYT and WaPo. Now from Calculated Risk itself is evidence that I made the right decision: a report on the latest extreme idiocy from the NYT’s prominent financial journalist, Gretchen Morgenson. [Although CR calls this “the single dumbest thing Morgenson has ever written,” I gotta be skeptical. Peruse my year-long Gretchen Morgenson archive for other examples.]

It seems that Gretchen wants to force Fannie and Freddie to disclose details on every mortgage it guaranteed or purchased in the last 10 years. What would that entail?  CR runs the numbers: about $10.013 trillion in mortgage loans, or 62,581,250 loans based on an average of 160k per loan.

That’s so we taxpayers can see what we now own. Taxpayers could, of course, download these onto their little Excel 2003 spreadsheet – 950 spreadsheets at the maximum of 65,536 rows per spreadsheet; or a 625,812 page pdf at 100 loans/page (small font). No estimate on the cost of toner cartridges.

Conclusion:

You know you are in the presence of a not very well hidden agenda when someone proposes something this dumb. . . . All Morgenson is doing here is making a ridiculous demand that won't be met, so that she can then claim that Fannie and Freddie "refuse to disclose fully."

Morgenson's been engaging in this sort of stupidity for her entire dubious career. Instead of trying to actually help us understand finance, we get endless screeds on supposedly overpaid executives. Indeed, expect her to unload this weekend on John Thain’s parachute, with no understanding of what Thain managed to accomplish for his pay.

Maybe this weekend convinced at least some people that finance is too serious to be trusted to clowns like Morgenson. I doubt the NYT will ever dump her, but perhaps people will dump the NYT, saving it for bird cages and reviews of middle of the road entertainment.

Black Sunday: the implications for corporate (and uncorporate) governance

The title of one of my favorite films is also an apt moniker for what happened in the financial sector today – Lehman, AIG, and Merrill.

Where will it end, and what does it mean?

As odd as it might seem seven years after Enron, I think this is the wake up call for corporate governance. Despite all the regulators, independent directors and Gretchen Morgenson, big firms were taking catastrophic risks under the radar.

And, yes, the culprits were the conventionally governed big corporations. As it said in its 2007 annual report:

Lehman Brothers continues to be committed to industry best practices with respect to corporate governance. Below you will find links to the Firm's corporate governance guidelines and code of ethics, as well as charters for the Audit, Compensation and Benefits, and Nominating and Corporate Governance Committees of the Firm's Board of Directors.

All that governance apparently didn't do a lot of good.

Almost exactly three years ago I wrote about the expectation that it was the hedge funds, like Long Term Capital, that would bring the system down. That turned out to be wrong.  As I discussed last month, it’s the hedge funds that avoided the big risks because they were the best governed. And now it’s the similarly governed private equity firms that are waiting in the wings to pick up the wreckage.

And so the financial industry will return, in a way, to its partnership roots. Here’s my longer analysis of what's happening, and why.