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Published on Leave a comment on Say No to Bailouts

Paul Krugman tells us to "Say No to Bailouts" in his column today, and he's largely right:

Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, as Gretchen Morgenson recently pointed out in The Times, the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.

Today, however, the mortgage broker who made the loan is usually, as Ms. Morgenson says, “the first link in a financial merry-go-round.” The mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets that Moody’s or Standard & Poor’s were willing to classify as AAA. And the result is that there’s nobody to deal with.

This looks to me like a clear case for government intervention: there’s a serious market failure, and fixing that failure could greatly help thousands, maybe hundreds of thousands, of Americans. The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts.

I don't see the market failure, but I don't disagree with the last paragraph if that assertion is removed. We had financial innovation that lowered the upfront costs of financing real estate transactions and raised the costs in the event of default. That we are now "in the event of default" and seeing the higher transaction costs does not mean we have a market failure. That, by itself, does not warrant the government involvement.

However, in addition to the shift on financing arrangements, we had fraud at various points in this process, and determining the financial penalties in those instances would likely have to be worked out over years in protacted legal battles. Congress can pass legislation to substitute for those battles. I haven't seen a better idea than Dean Baker's, which I discussed in the last post.

The consequence of passing it is that it gives the borrower the upper hand in the workout negotiations--the borrower can stay and pay rent as a substitute for the mortgage, and the holder of the mortgage can hold or sell the property (without evicting the tenant) in light of that. I presume that most dispositions will be in either of two forms. Some borrowers will realize that they really cannot afford the house and find a more affordable one, without being evicted unless they also cannot pay rent. In other cases, the holder of the mortgage will sell the property back to the borrower at a discounted price, with new financing on more sensible terms from a new lender. This avoids the need for the government to get actively involved in the terms of the workouts, placing the cost of disposing the property on the lending community where it belongs.

And what of the Wall Street entities that have taken a financial beating as the bottom dropped out of this market? They get to be the roadkill on the capitalist highway, food for scavengers in the financial market. You wouldn't know it from the headlines dominating the news media today, but there are plenty of financial institutions that have been prudent and maintained their liquidity though this chaos. They are going to get some bargains in the months to come.

Published on Leave a comment on Extreme Risk in Financial Markets

Via Tanta at Calculated Risk, here's a post by Dean Baker that I would co-sign if I could. The teaser:

The whining from Wall Street is growing louder. Those brilliant high-flying hedge fund managers are now facing the prospect of financial ruin. It seems that they are holding hundreds of billions of dollars of mortgage debt, some of which is worthless, and much of which is worth considerably less than it was a few weeks ago. Since the hedge funds are heavily leveraged (they borrowed heavily to buy assets), many of them could be wiped out.

Given the gravity of the situation, the hedge fund crew is doing what all good capitalists do when things go badly: run to the government.

Specifically, they want the Federal Reserve Board to bail them out with lower interest rates. They hope that this will buy them the time needed to dump their mortgages on less well-informed investors.

The hedge fund folks say that this is the Fed’s job, that it must step in as the lender of last resort and restore order to the market. That ain’t necessarily so.

He's diagnosed this exactly right and proposes a novel idea at the end of his post about how to protect some of the mortgage borrowers who may lose their homes. Read the whole thing.

Keeping with the theme of betraying conservatism, I should point out that government bailouts of risky or stupid businesses are right near the top of the list. I thought St. Louis Federal Reserve Bank President Bill Poole had it right in his speech last month. A key excerpt:

The Federal Reserve had followed developments in housing and the non-prime mortgage markets very closely this year (Bernanke, 2007a, 2007b, 2007c). A highly visible development is the growing amount of financial stress among some of the millions of households with non-prime mortgages. We know that many non-prime mortgage lenders and brokers have gone out of business or tightened their lending standards this year, reducing the flow of mortgage credit to borrowers unable to access the prime market. Financial markets have dealt harshly, but on the whole appropriately, with banks, hedge funds and certain other investors who were heavily exposed to the riskiest segments of the non-prime securitized mortgage market.

While none of these developments is pleasant for the lenders and financial firms most directly affected, one cannot help being impressed with the even-handedness of it all. Until we receive clear evidence that basically sound financial decisions and arrangements were disrupted by erratic and irrational market forces, I believe we should conclude that this year’s markets punished mostly bad actors and/or poor lending practices. Lenders who made loans to borrowers without documentation, or who did not check borrower documents that proved fraudulent, or who made adjustable-rate loans to borrowers who could not hope to service the debt when rates adjusted up, deserved financial failure. As is often the case, the market’s punishment of unsound financial arrangements has been swift, harsh and without prejudice. While I cannot feel sorry for the lenders who have gone out of business, my attitude is entirely different toward the relatively unsophisticated, but honest, borrowers who have lost their homes through foreclosure. Many are true victims.

Read the whole thing.

Published on Leave a comment on In Praise of Kenneth Griffin

Earlier this week, we read that the three top hedge fund managers--James Simons, Kenneth Griffin, and Edward Lampert--each earned more than a billion dollars in compensation last year. In his column today, Paul Krugman has this to say:

Consider a head-to-head comparison. We know what John D. Rockefeller, the richest man in Gilded Age America, made in 1894, because in 1895 he had to pay income taxes. (The next year, the Supreme Court declared the income tax unconstitutional.) His return declared an income of $1.25 million, almost 7,000 times the average per capita income in the United States at the time.

But that makes him a mere piker by modern standards. Last year, according to Institutional Investor’s Alpha magazine, James Simons, a hedge fund manager, took home $1.7 billion, more than 38,000 times the average income. Two other hedge fund managers also made more than $1 billion, and the top 25 combined made $14 billion.

How much is $14 billion? It’s more than it would cost to provide health care for a year to eight million children — the number of children in America who, unlike children in any other advanced country, don’t have health insurance.

The hedge fund billionaires are simply extreme examples of a much bigger phenomenon: every available measure of income concentration shows that we’ve gone back to levels of inequality not seen since the 1920s.

For reasons that will be clear below, I'll focus on the case of Ken Griffin, who earned $1.4 billion. This makes him (1.4/1.7)*(38000/7000) = 4.5 times as high-income relative to the typical person as J.D. Rockefeller according to Krugman's metric. Krugman's use of the term "mere piker" suggests that he thinks these hedge fund managers are even worse in some way than Rockefeller.

Let's continue the comparison. Consider that Rockefeller's Standard Oil had the advantage of being a near-monopoly. Griffin has no such luxury--he's in one of the most fiercely competitive industries you will ever find. He makes his money not by shrinking from competition but by surpassing it. According to some estimates, his firm, Citadel Investments, is responsible for over 3 percent of the average daily trading volume in New York, London, and Tokyo. It takes a very unusual person to build a business that can do that.

I know whereof I speak. I was an acquaintance of Ken's both in high school and in college. He attended a rival high school in the same county, and we competed in math tournaments. He and I entered Harvard the same year, both majored in Economics, and both graduated in three years. But let me not suggest to you that we were similar in too many ways. Most significantly, while I was busy with my studies and my interest in economics inside the classroom, Ken was pursuing his interests in economics outside the classroom. I didn't see him on campus more than a handful of times. This profile gives a good description of his background, how he got his start in finance, and his business strategy.

What emerges is someone who is intensely intelligent--in the sense of being able to integrate knowledge from disparate sources to solve a specific problem--and extremely independent-minded--it's his way or the highway, at least at Citadel. He builds the financial capacity to pick up the pieces where others fail--whether Amaranth or Enron--at a bargain price. He doesn't pull his punches--I don't think anyone who offers the "toxic convert" is shy about being a financial intermediary. He's also not trying to win the "Boss of the Year" award. But these are details. To sum him up in three words, he is successful because he is confident, contrarian, and accurate.

I spend a lot of time around college students. I spend a lot of my energy trying to get them to display those three characteristics. Krugman seems to think that one "Kenneth Griffin" is overvalued at 4.5 "John D. Rockefellers." On the contrary, I think it's a buy.

Published on Leave a comment on Investment Advice for Presidential Candidates

The latest New York Times headline about Barack Obama's financial investments has the candidate claiming that they did not present a conflict of interest. From what I can tell, there is no ethical problem here. The problem is that Senator Obama should have a better stockbroker. Or, better yet, he should have no stockbroker.

If I were seeking or holding political office, I would not put my financial assets in a blind trust. I would never want to put myself in a position of having to claim, as Obama is now doing, "At no point did I know what stocks were held. And at no point did I direct how those stocks were invested." This is terrible language for a candidate to have to say. It combines the phrasing of a legal technicality with the shifting of blame to an employee. The speculative investments also present the candidate as taking advantage of opportunities that are not available to ordinary folks. This is not the image that a candidate wants to present.

Compare that with a candidate who does not establish a blind trust--no abdication of responsibility, no suggestion that someone else is working in secrecy on his or her behalf. With no blind trust, the candidate shouldn't hold individual stocks, to avoid any suggestion of favoritism. Instead, the candidate can put all stock investments in a low-cost, broadly based index fund, like this one. Now, the candidate is setting an example that all American savers can follow. The candidate is also not playing favorites among companies. He or she does well when every company listed on a major exchange does well.

That's a much better strategy, particularly since the get-rich-quick element of politics can always come later, on the lecture circuit or the book tour.

Published on Leave a comment on Senator Clinton’s Letter and Speech

In the wake of last week's market volatility, Senator Clinton made a speech on the floor of the Senate and sent a letter to Chairman Bernanke and Secretary Paulson. Greg Mankiw characterized one part, appropriately in my view, as xenophobic. PGL at AngryBear responded with other parts that were, in his view (and to a lesser extent, mine) appropriately critical of our current macroeconomic policies.

The main problem with Clinton's argument is that there is no particular connection between the amount of U.S. debt that China and Japan hold and what happened last week. Is she really saying that the U.S. market wouldn't have dropped after the Chinese market dropped if we ran a trade surplus with China? Or if we still ran a deficit but China's resulting portfolio holdings were in some other country's federal liabilities rather than ours? Our economy is connected to the Chinese economy via both current account and capital account transactions. We might want to be more mindful of the latter than we have been. But that doesn't mean that the high ownership of U.S. debt by China caused the transmission of price movements from China to the United States.

Read this excerpt and see if she actually justifies the leap she makes in going from the red to the blue sentences below:

I have long argued that a great source of vulnerability is the fact that other countries, including China, own so much of our debt. Today, foreign nations according to the most recent Treasury statistics hold over $2.2 trillion or 44% of all publicly held United States (U.S.) debt with Japan and China alone holding nearly $1 trillion. In essence, 16% of our entire economy is being loaned to us by the Central Banks of other nations. Having so much debt owned by other countries can be economically unsound. Yesterday it was the sell off of foreign stocks that had reverberations in U.S. markets. But if China or Japan made a decision to decrease their massive holdings of U.S. dollars, there could be a currency crisis and the U.S. would have to raise interest rates and invite conditions for a recession. While it can and will be debated whether yesterday's market disruption was just a blip or a larger indicator of our economy's vulnerabilities, it is clear that interdependence between our economy and that of other nations can pose a risk if we do not pursue smart policies. Precipitous decisions by any country with our debt could create much graver economic problems than what we saw yesterday. The writing may not be on the wall, but yesterday, the writing was on the Big Board.

Her "in essence" sentence is not a sensible comparison. It does not make sense to compare a stock of money--the total holdings of U.S. federal debt by foreign investors--with the flow of money that is U.S. GDP. A sensible comparison might be the flow of interest that we pay to these foreign investors, a much smaller number as a share of GDP. (For example, I don't get too worried about the fact that a bank has lent me more than 100% of my income in the form of a mortgage. The reason is that the interest on that mortgage is a very reasonable fraction of my income.)

The statement in green above is a true statement. Not only would the problems be more grave--they might actually be problems and be related to what the creditor nations did. But even this scenario that she discusses is, in Mankiw's word, alarmist. There would have to be a reason why China or Japan would intentionally precipitate a selloff of their holdings of U.S. debt, particularly since the Chinese and Japanese holders of the debt would be the first ones to suffer the capital loss due to this action. It couldn't simply be that their own economies faltered--the U.S. debt they hold is an asset to them. When my income falters, I am typically quite grateful for the assets I have in the bank (somebody else's liabilities). Their economies would have to falter so badly that they needed to liquidate their holdings of U.S. debt to pay off some of their own debts. Not too likely, unless, perhaps, we close our markets to them.

Clinton's rhetoric, particularly these statements about being "held hostage" or "losing our economic sovereignty," suggest that she's thinking about a scenario in which a policy maker in Beijing or Tokyo decides that the U.S. debt is overvalued and wants to unload it en masse. About the only thing that could really convince me to do this, were I the policy maker in Beijing, is a credible belief that my counterpart in Tokyo was about to do the same thing.

While that is something over which Washington has very little control, even in that case, all that would happen--unless you think the U.S. government wouldn't pay the interest or principal on its obligations--is that the U.S. dollar would depreciate and domestic interest rates would rise. Exports would pick up a bit, and the government would find deficits more costly to finance. I'd prefer if that didn't happen, but in the grand scheme of things, it's neither very likely to happen nor very severe in its real consequences if it does.

Published on Leave a comment on Market Jitters

Barry Ritholz wonders today about the spike in his blog's traffic yesterday as markets around the world were losing value. I admit that I contributed to his site's traffic as I used these three posts to explain to my undergraduate finance theory students how to try to make sense of large market movements. We are passed the lectures on bubbles, noise trading, and herd behavior, and so we spent only a little time assessing what occurred.

In the first of these linked posts, Barry contrasts the explanation based on China's 8.8% drop with other events that also occurred yesterday, including news stories related to subprime lending and the weakness in the Advanced Durable Goods report. I don't buy any explanation based on China--its stock market is too small, the effect on other Asian markets was not particularly large, and weakness in the Chinese economy would indicate that we are likely to be able to run our trade deficit with China at lower cost. That shouldn't be bad news. I don't know enough about the subprime lending issues to know how important they were--I think it's a fairly marginal part of the real housing sector, so I'm skeptical there as well.

That would leave us with the weakness in durable goods. If this is to be the explanation, then it is interesting that it generated a downward movement. Typically, when there is unexpected strength in the other major monthly economic releases like GDP and Employment, the market does poorly. The rationale is that unexpected strength in the economy will make the odds of a Fed increase in short term interest rates more likely. That increase, in turn, depresses stock market values. The same process, probably to a milder extent, should operate in reverse for unexpected weakness in the macroeconomy.

So this durable goods report was unexpected weakness--why didn't the market hold steady or even go up? According to this view, the answer would have to be that, unlike GDP and Employment, the Durable Goods report also tells us directly about economy-wide investment and thus future business growth. So weakness there could be greeted not just with the lower inflationary expectations but lower profit expectations as well. Plausible--a good event study to do for an undergraduate finance major, perhaps.

My preferred explanation is that we have plenty of investors, both individual and institutional, who treat stock markets like a speculative exercise. There is noise trading and herd behavior aplenty, and so a drop of over 3% in the U.S., and larger drops in more thinly traded markets, shouldn't be all that surprising. I didn't even check my portfolios yesterday.

Via the Opinionator, here are some anecdotes from Daniel Gross about the way some professional investors in China viewed the events:

Special World is Flat bonus anecdote. Note the way Chinese analysts have quickly assimilated the technique, developed over several decades by U.S. analysts, of using fatuous cliches to explain baffling market activity.

''The most important reason for today's decline was pressure for profit-taking,'' said Peng Yunliang, a senior analyst at Shanghai Securities.

''People viewed 3,000 as a psychological benchmark. It's understandable they might want to pull back after the market hit that peak,'' Peng added.

It truly is a global capital market.

Published on Leave a comment on Well, That Was Easy Money

We learn today that US Airways has withdrawn its offer to buy Delta Airlines for what turned out to be about $9.8 billion. As I noted back in November when this madness was announced at the lower value of about $8 billion, "US Airways doesn't have it and Delta isn't worth it." For that reason, I also expected Delta's creditors to leap at the offer (and dump the US Airways stock immediately upon doing so). But here's how the deal was undone:

US Airways dropped its hostile $9.8 billion bid for Delta on Wednesday after Delta's creditors threw their support behind the airline's plan to emerge from bankruptcy on its own.

Delta Air Lines Inc.'s official unsecured creditors committee said in a statement it reached its decision after a lengthy review of both Delta's proposal and US Airways Group Inc.'s proposal.

So it was the creditors who pulled the plug after "extensive discussions." That's a surprise.

What was not a surprise was that there was money to be made here by the ordinary investor. Here's a chart of US Airways' stock price over the past three months:

That big spike in the middle of November was the roughly 16 percent increase in the stock price when the announcement was made, plus some continued appreciation. This was very unusual--the classic result from the finance literature is that upon announcement, the acquirer's stock price is either unchanged or slightly lower. It is the target's stock price that goes up. The reason, I think, is that acquirers often overpay, probably because they overstate the amount of "synergies" they'll get from the acquisition.

I could see no reason for this acquisition to be such a good thing for US Airways, so I sold short. You can see that the position was not always in the black, but eventually, it seemed pretty clear that that gain would be reversed. I managed to pocket a cool 10 percent based on when I got in and out of the position.

Published on Leave a comment on US Airways Makes a Bid for Delta

This is the strangest news in a while from a very strange industry.

US Airways offered today to acquire Delta Air Lines, now under bankruptcy-court protection, for $8 billion.

The combined company would carry more passengers each year than any other airline in the world, eclipsing American Airlines, the current leader.

The offer, extended to Delta’s bankruptcy lenders, is an attempt by the chief executive of US Airways, W. Douglas Parker, to circumvent Delta’s top management, who rebuffed two earlier approaches from Mr. Parker about merging the two airlines.

In a letter today addressed to Delta’s chief executive, Gerald Grinstein, Mr. Parker said he was disappointed that the two executives could not reach an agreement.

US Airways said today that it is offering $4 billion in cash, plus US Airways stock that was valued at $4 billion at the close on Tuesday. That price would represent a substantial premium for Delta’s creditors over what the airline’s unsecured debts now trade for. The creditors would own about 45 percent of the combined company.

Today, shares of US Airways jumped $8.57, or 16.8 percent, to close at $59.50 on the New York Stock Exchange. Other airline stocks including Continental and Airtran Holdings also rose.

Let's see. US Airways doesn't have it and Delta isn't worth it. Other than that, a lovely idea. I would expect Delta creditors to leap at the offer and US Airways stockholders to pocket these gains (which I cannot really explain) and run.

Published on Leave a comment on More on Executive Compensation

Mark Thoma and Brad DeLong have picked up the theme of this earlier post on executive compensation. Brad makes three points:

First, at-the-money options do not make CEOs "long" their company as much as long the volatility of their company. It's clear that direct ownership of stock--ideally, restricted stock--is a better mechanism for aligning managers' interests with shareholders.

I agree with Brad's conclusion--restricted stock is a better method of aligning the interests of managers and shareholders.

Second, when I looked at the data I thought I saw an important difference between entrepreneurial-CEO-owners (like Bill Gates, with stock) and manager-CEO-nonowners (with options). I think there is an important difference.

True as well--there is an important difference. My point in the original post is that there are very few examples one can find in which, through options, manager-CEO-nonowners accumulated ownership stakes that were large enough so that their compensation was meaningfully different from what Jensen and Murphy were describing in the data. My issue with Krugman's column was that he was implicating J&M in the option mess--I don't think that's warranted.

Third, we do have a big organizational problem here. We need diversity of ownership--both to raise capital on the scale required for modern business organizations and to spread risk. But once you have diversified ownership, monitoring and supervising managers becomes a public good from the shareholders' perspective, and it is very hard to get market or market-like or indeed voting political mechanisms to adequately supply public goods: the difficulties of collective action by dispersed owners of corporations has been one of the institutional flaws of modern capitalism for more than a century.

The fear today is that mechanisms of corporate control and governance that used to constrain the ability of top managers to raid the corporation have broken down even more than in the past. Why and how much and indeed whether this is true is a very hard question. To say that "corporate boards are failing" to do their job is true, but leaves the questions of why they are failing and whether they are failing any more than in the past unanswered.

True again. The problems resulting from the separation of ownership and control in large corporations are the central problem in corporate finance. I did not intend to raise the two questions posed at the end of Brad's post but only to assert that corporate boards are the last line of defense against problems of corporate governance. If the recent use of options is perceived as abusive, hold the Boards that were complicit or clueless to account.

Published on Leave a comment on Mixed Reviews for Krugman Today

In "Incentives for the Dead" (reposted by Mark Thoma for those of you without TimesSelect), Paul Krugman addresses the social and economic aspects of option backdating and repricing. He gets some things right--this is accounting fraud, it is also tax evasion, and the perpetrators should be prosecuted fully. But he gets some of the economic aspects wrong. Consider:

To understand the issue, we need to go back to the original ideological justification for giant executive paychecks.

In the 1960’s and 1970’s, C.E.O.’s of the largest firms were paid, on average, about 40 times as much as the average worker. But executives wanted more — and professors at business schools provided a theory that justified much higher pay.

They argued that a chief executive who expects to receive the same salary if his company is highly profitable that he will receive if it just muddles along won’t be willing to take risks and make hard decisions. “Corporate America,” declared an influential 1990 article by Michael Jensen of the Harvard Business School and Kevin Murphy of the University of Southern California, “pays its most important leaders like bureaucrats. Is it any wonder then that so many C.E.O.’s act like bureaucrats?”

Jensen and Murphy's article does not provide a theory to justify "much higher pay" or "gigantic executive paychecks." The article provides a theory to justify higher pay-performance sensitivities, for any level of executive pay. Apart from the (relatively minor) increase in expected compensation that must compensate the added risk exposure imposed by the pay-performance sensitivity, there is no justification presented for higher levels of pay unless the incentives work, the value of the firm rises, and the CEO's compensation rises via that pay-performance sensitivity. And, obviously, nothing in Jensen and Murphy's paper justifies backdating or repricing--quite the contrary.

Krugman continues:

The claim, then, was that executives had to be given more of a stake in their companies’ success. And so corporate boards began giving C.E.O.’s lots of stock options — the right to purchase a share of the company’s stocks at a fixed price, usually the market price on the day the option was issued. If the stock went up, these options would pay off; if the stock went down, they would lose their value. And so, the theory went, executives would have the incentive to do whatever it took to push the stock price up.

In the 1990’s, executive stock options proliferated — and executive pay soared, rising to 367 times the average worker’s pay by the early years of this decade.

But the truth was that in many — perhaps most — cases, executive pay still had little to do with performance. For one thing, the great bull market of the 1990’s meant that even companies that didn’t do especially well saw their stock prices rise.

The last sentence continues to be something of a mystery in the economics literature--why don't we see more relative performance evaluation? Fair enough. I've done some research on this myself, so perhaps I'll blog about it at some later time.

But the statement just prior to it is extremely misleading, if not simply wrong. If options were being used in this way, then they should have been used instead of cash compensation, not in addition to cash compensation. Furthermore, the data suggest a more limited role for options in generating large pay-performance sensitivities (what Krugman calls a "stake" in the company).
Among CEOs, the median incentives received from options are roughly the same as the median incentives received from direct holdings of stock. However, the mean incentives through stock are much higher than the mean incentives from options, and almost every instance of truly high incentives that I have observed has come from stock, not from options. (The source for these comparisons is the Standard & Poor's ExecuComp data, tabulations of which are in my August 2003 paper in the Journal of Finance.) For example, Bill Gates got rich as the CEO of Microsoft, but not due to options. He's rich because of his original stock holdings and what happened to their value as the company flourished.

So I think Krugman is overstating the link between Jensen and Murphy's paper--or any economic theory--and the particular way that options have been used in compensation contracts. My reading of the data is that the grants haven't been large enough--even if they were not repriced or backdated--to have moved CEO compensation away from the "bureaucratic" model. (Although see the article by Brian Hall and Jeff Liebman in the Quarterly Journal of Economics for a different assessment.)

So my revision of Krugman's argument, at least as it pertains to the economics, is not that there was a bait-and-switch, but that there was too little bait on the hook to begin with. Why did this happen? In my view, the explanation is simply that CEOs have been pushing their boards of directors to grant them pay increases, the tax code and accounting regulations have favored options as the easiest and most advantageous way to do that, and corporate boards have acquiesced.

Ultimately, all problems of corporate governance derive from inadequate monitoring of the managers by the shareholders. Corporate boards are supposed to do this. Some are obviously failing.