Business Law Prof Blog

Mises Vesus Keynes: And the Winner Is Politics

The current economic crisis has the two schools of economic theory, one associated with Keynes and the other with Von Mises, at odds over the cause and cure.  Mises would blame government expansion of credit for the boom and recommend that government stop intervening and let the market readjust for the cure.  Keynes would blame private risk taking and recommend that the government stimulate the markets with spending and lending.  What recent events have shown is that Mises failed to take into account politics -- the need for politicians to do something in a crisis.  With the illusion of control, Keynes theory will usually win in a crisis -- as it currently has.

Suing Auditors

The Madoff mess will test the limits of suits against auditors.  Madoff's auditor, an obscure three person firm run out of a strip mall, is not likely to have much cash.  Lawyers are not suing the auditors of fund of funds managers that sent individual investors to Madoff.  The auditors of the intermediaries should have, apparently, warned the intermediaries of the shaky auditing of Madoff.  The suits are novel and a stretch. Madoff's auditor suffers from a classic auditor's conflict, trying to keep a client happy and, at the same time, performing sound auditors for the client's investors.  The auditors of the intermediaries do not have the clear conflict  -  their audit clients, the intermediaries, have a clear stake in knowing the truth about the health of a fund into which they put individual's cash.  An argument againt the auditors of intermediaries will rest on a test prudent and reasonable actions.  A duty of care, not a duty of loyalty argument, is harder to win.  In any event, there is also the nagging third party beneficiary problem in the case (can investors sue?? for what??) that dogs even traditional cases..   

Suing the SEC

A frustrated Madoff investor has sued the SEC for not acting on tips that Madoff was running a Ponzi scheme.  The suit is an extreme long shot, given the SEC's sovereign immunity.  But who knows what the right judge may do. [Hint: Try Judge Kaplan.]

Cerberus and Chrysler

Cerberus is apparently willing to dump its equity in Chrysler if bond holders or others will take equity for their debt.  Indeed, Cerberus could simply give the company to its workers in exchange for a full release from all worker obligations (including health care and pensions).  Then we would see how the UAW could do running a company

FASB and Mark-to-Market

The FASB has begun a review of the mark-to-market rules that have attracted the ire of so many in the financial community.  The major complaint -- financial institutions have to write down assets that they do not intend to sell and the write downs adversely affect required capital ratios (both in legal regulations and in financial covenants in debt instruments requiring collateral).  If the capital ratios slip under limits, the financial institution must sell assets to raise cash (a distress sale), further lowering asset values.  The standard financial institutions want -- no forced write downs unless the holders are going to trade -- is unworkable.  Any standard must depend on the nature of the market for the assets.  If the assets are illiquid, there is an argument for not applying mark-to-market rules; if the assets are liquid and an established market is deep, there is no argument.  FASB must then set market definition rules for write downs.  This will not be easy.  If financial institutions to not like the affect of write downs on assets traded in liquid and deep markets they should 1) argue for exemptions in regulatory capital requirements in tough times and 2) not agree to silly financial covenants in their negotiated agreements with creditors.  FASB should not bail them out. 

Government Bailouts

The current crisis has sent most to the history books, and I am no different.  I have been reading about Margret Thatcher's response to the petition from 364 economists in 1979 when they objected to her reduction of government debt, about Reddy's, India's finance minister, response to the credit bubble in the past decade (very unpopular until recently), Japan's lost decade (in the 90s), Sweden's solution (in the 90s), our response to the S&L and foreign government bond crises (mi9d-80s), our response to the panic of 1907 and the collapse of LTCM (late 90s) and our depression in the 30s (did the New Deal work?).  As everyone who reads the financial papers know, opinions on historical crises, like those on the current crises, are all over the map.  A few of my personal conclusions:  1) If government gets it must get in big--there is no half-way solution that works; 2) If government gets in big it may work and may not depending, often on the views of one person (Reddy was smart; Japan's Finance Minister was not) which is a high risk alternative; 3) When government gets in big it bets the house; and 4) the predominate government error is a failure to focus on market trust by private players -- things turn around only when the private players in the market can trust banks and operating companies.  If the government acts to instill trust (Sweden; India; UK), things work; if the government inhibits trust (Japan) things stagnate.  Our government's current response is to hinder trust -- the markets do not know the market value of toxic assets, cannot predict government policy, and cannot predict the effect of workouts by struggling companies.  We are acting more like Japan than the UK.            

GM and Chrysler Bailout Terms

The President announced that the administration would use TARP money to bailout GM and Chrysler.  Ford Motor Company did not make a request.  The "Fact Sheet" from the Bush administration states that GM and Chrysler will receive $13.4 Billion from TARP funds immediately and another $4 Billion in February if Congress approves the second tranche of TARP funds.  There are a series of "conditions", most of which are illusory. Some are not however.  First, the real conditions:  limits on executive pay and perks, warrants for non-voting stock, government debt is senior, government can block any large deals (over $100M), no dividends.  The illusory conditions request that the companies "use the funds to become viable" and set goals and targets for viability.  The condition is illusory because the they are "non-binding," open-ended, and can be reset or relaxed by the Obama administration in January.  Points to consider:  1) There is no strike price or amount set on the warrants and both numbers will be of considerable interest to shareholders. 2) Paulson, once again, has played the fool, arguing that he had no authority to use TARP money under the Congress language establishing the statute (oops).  3)  The targets can only be accomplished realistically (because of the size and complexity of any negotiation) in a bankruptcy reorganization.  You do not exchange debt for equity, reduce wages under a Union contract, and alter existing contracts in a company this size outside of a bankruptcy reorganization (there are too many hold-out possibilities).  Obama will not use bankruptcy so we are in for a penny in for a pound.

Mark to Market Rules

The attack on mark to market accounting rules has many friends.  Under the rules banks must carry on their balance sheets liquid securities at fair market values.  When bank derivatives lost value, banks had to recognize write offs -- "even though they were not selling" -- and the write offs threatened bank capital requirements--forcing banks to sell assets to generate cash--and causing more write offs as the distress value of the sold securities had to be reflected on the balance sheets of all the banks.  Mark to market accounting applies only to liquid securities and does not apply to may classes of bank loans -- which are recorded at initial cost with reserves for potential losses.  Many banks, even with mark to market accounting, are trading at prices that are below book value (or even tangible book value).  This means that even with mark to market accounting, book value amounts do not represent, they exceed, market value.  Those who attack mark to market accounting are barking up the wrong tree. 

Tax Incentives Matter

Taxes are in the news with a discussion of a 1997 tax break for the sale of homes (a $500,000 exclusion from capital gains for homes sold that an owner lived in for two years and owned for five) [how much did it contribute to the crisis?] and a discussion of the carry back of losses from the Madoff scandal for three years [ should the government will pay for part of the losses due to lack of investor oversight?].  They remind us that tax incentives matter.

Madoff and Fraud: Is American Corrupt? No.

The size of Madoff's fraud is dominating the news.  The SEC has issued an apology of sorts for not catching him on a complaint from inside the industry in 1999.  There are other frauds in the news as well.  A Dane has recorded the largest fraud in that country's history and and major New York law firm is winding up due to the fraud of its named founder, Drier.  Financial crisis bring revelations of fraud as those in trouble try to hold on until the good times return -- it's the gambler's curse ("one more roll").  If the SEC had caught Madoff there would have been someone else they had not caught that would be dominating the news.  Fraud is an inevitable part of capitalism and is also how we learn, or get reminded periodically, of the importance of prudence in investing our cash.  It is not a signal that capitalism is flawed or that American is corrupt.  Capitalism and fraud go together like rubber tires and flats -- like electricity and power outs.