Archives For financial regulation

Contemplating Disclosure-Based Insider Trading Regulation

Thom Lambert —  15 June 2012

TOTM friend Stephen Bainbridge is editing a new book on insider trading.  He kindly invited me to contribute a chapter, which I’ve now posted to SSRN (download here).  In the chapter, I consider whether a disclosure-based approach might be the best way to regulate insider trading.

As law and economics scholars have long recognized, informed stock trading may create both harms and benefits to society.  With respect to harms, defenders of insider trading restrictions have maintained that informed stock trading is ”unfair” to uninformed traders and causes social welfare losses by (1) encouraging deliberate mismanagement or disclosure delays aimed at generating trading profits; (2) infringing corporations’ informational property rights, thereby discouraging the production of valuable information; and (3) reducing trading efficiency by increasing the “bid-ask” spread demanded by stock specialists, who systematically lose on trades with insiders.

Proponents of insider trading liberalization have downplayed these harms.  With respect to the fairness argument, they contend that insider trading cannot be “unfair” to investors who know in advance that it might occur and nonetheless choose to trade.  And the purported efficiency losses occasioned by insider trading, liberalization proponents say, are overblown.  There is little actual evidence that insider trading reduces liquidity by discouraging individuals from investing in the stock market, and it might actually increase such liquidity by providing benefits to investors in equities.  With respect to the claim that insider trading creates incentives for delayed disclosures and value-reducing management decisions, advocates of deregulation claim that such mismanagement is unlikely for several reasons.  First, managers face reputational constraints that will discourage such misbehavior.  In addition, managers, who generally work in teams, cannot engage in value-destroying mismanagement without persuading their colleagues to go along with the strategy, which implies that any particular employee’s ability to engage in mismanagement will be constrained by her colleagues’ attempts to maximize firm value or to gain personally by exposing proposed mismanagement.  With respect to the property rights concern, deregulation proponents contend that, even if material nonpublic information is worthy of property protection, the property right need not be a non-transferable interest granted to the corporation; efficiency considerations may call for the right to be transferable and/or initially allocated to a different party (e.g., to insiders).  Finally, legalization proponents observe that there is little empirical evidence to support the concern that insider trading increases bid-ask spreads.

Turning to their affirmative case, proponents of insider trading legalization (beginning with Geoff’s dad, Henry Manne) have primarily emphasized two potential benefits of the practice.  First, they observe that insider trading increases stock market efficiency (i.e., the degree to which stock prices reflect true value), which in turn facilitates efficient resource allocation among capital providers and enhances managerial decision-making by reducing agency costs resulting from overvalued equity.  In addition, the right to engage in insider trading may constitute an efficient form of managerial compensation.

Not surprisingly, proponents of insider trading restrictions have taken issue with both of these purported benefits. With respect to the argument that insider trading leads to more efficient securities prices, ban proponents retort that trading by insiders conveys information only to the extent it is revealed, and even then the message it conveys is “noisy” or ambiguous, given that insiders may trade for a variety of reasons, many of which are unrelated to their possession of inside information.  Defenders of restrictions further maintain that insider trading is an inefficient, clumsy, and possibly perverse compensation mechanism.

The one thing that is clear in all this is that insider trading is a “mixed bag”  Sometimes such trading threatens to harm social welfare, as in SEC v. Texas Gulf Sulphur, where informed trading threatened to prevent a corporation from usurping a valuable opportunity.  But sometimes such trading creates net social benefits, as in Dirks v. SEC, where the trading revealed massive corporate fraud.

As regular TOTM readers will know, optimal regulation of “mixed bag” business practices (which are all over the place in the antitrust world) requires consideration of the costs of underdeterring “bad” conduct and of overdeterring “good” conduct.  Collectively, these constitute a rule’s “error costs.”  Policy makers should also consider the cost of administering the rule at issue; as they increase the complexity of the rule to reduce error costs, they may unwittingly drive up “decision costs” for adjudicators and business planners.  The goal of the policy maker addressing a mixed bag practice, then, should be to craft a rule that minimizes the sum of error and decision costs.

Adjudged under that criterion, the currently prevailing “fraud-based” rules on insider trading fail.  They are difficult to administer, and they occasion significant error cost by deterring many instances of socially desirable insider trading.  The more restrictive “equality of information-based” approach apparently favored by regulators fares even worse.  A contractarian, laissez-faire approach favored by many law and economics scholars would represent an improvement over the status quo, but that approach, too, may be suboptimal, for it does nothing to bolster the benefits or reduce the harms associated with insider trading.

My new book chapter proposes a disclosure-based approach that would help reduce the sum of error and decision costs resulting from insider trading and its regulation.  Under the proposed approach, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic in­formation, and the nature of her trade.  Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decod­ing,” while (2) reducing potential costs stemming from deliberate misman­agement, disclosure delays, and infringement of informational property rights.  By “accentuating the positive” and “eliminating the negative” conse­quences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.

Please download the paper and send me any thoughts.

In 10b-5, corporate law, disclosure regulation, error costs, financial regulation, insider trading, markets, regulation, securities regulation, SSRN
permalink

Wise and Timely Counsel from John Taylor, F.A. Hayek, and Reagan’s Economic Advisers

Thom Lambert —  2 June 2012

In light of yesterday’s abysmal jobs report, yesterday’s Wall Street Journal op-ed by Stanford economist John B. Taylor (Rules for America’s Road to Recovery) is a must-read.  Taylor begins by identifying what he believes is the key hindrance to economic recovery in the U.S.:

In my view, unpredictable economic policy—massive fiscal “stimulus” and ballooning debt, the Federal Reserve’s quantitative easing with multiyear near-zero interest rates, and regulatory uncertainty due to Obamacare and the Dodd-Frank financial reforms—is the main cause of persistent high unemployment and our feeble recovery from the recession.

A reform strategy built on more predictable, rules-based fiscal, monetary and regulatory policies will help restore economic prosperity.

Taylor goes on (as have I) to exhort policy makers to study F.A. Hayek, who emphasized the importance of clear rules in a free society.  Hayek explained:

Stripped of all technicalities, [the Rule of Law] means that government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge.

Taylor observes that “[r]ules-based policies make the economy work better by providing a predictable policy framework within which consumers and businesses make decisions.”  But that’s not all: “they also protect freedom.”  Thus, “Hayek understood that a rules-based system has a dual purpose—freedom and prosperity.”

We are in a period of unprecedented regulatory uncertainty.  Consider Dodd-Frank.  That statute calls for 398 rulemakings by federal agencies.  Law firm Davis Polk reports that as of June 1, 2012, 221 rulemaking deadlines have expired.  Of those 221 passed deadlines, 73 (33%) have been met with finalized rules, and 148 (67%) have been missed.  The uncertainty, it seems, is far from over.

Taylor’s Hayek-inspired counsel mirrors that offered by President Reagan’s economic team at the beginning of his presidency, a time of economic malaise similar to that we’re currently experiencing.  In a 1980 memo reprinted in last weekend’s Wall Street Journal, Reagan’s advisers offered the following advice:

…The need for a long-term point of view is essential to allow for the time, the coherence, and the predictability so necessary for success. This long-term view is as important for day-to-day problem solving as for the making of large policy decisions. Most decisions in government are made in the process of responding to problems of the moment. The danger is that this daily fire fighting can lead the policy-maker farther and farther from his goals. A clear sense of guiding strategy makes it possible to move in the desired direction in the unending process of contending with issues of the day. Many failures of government can be traced to an attempt to solve problems piecemeal. The resulting patchwork of ad hoc solutions often makes such fundamental goals as military strength, price stability, and economic growth more difficult to achieve. …

Consistency in policy is critical to effectiveness. Individuals and business enterprises plan on a long-range basis. They need to have an environment in which they can conduct their affairs with confidence. …

With these fundamentals in place, the American people will respond. As the conviction grows that the policies will be sustained in a consistent manner over an extended period, the response will quicken.

If you haven’t done so, read both pieces (Taylor’s op-ed and the Reagan memo) in their entirety.

In economics, financial regulation, Hayek, politics, regulation
permalink

Potential Problems with an FDA Model for Regulating Financial Products

Thom Lambert —  2 April 2012

New York Times columnist Gretchen Morgenson is arguing for a “pre-clearance”  approach to regulating new financial products:

The Food and Drug Administration vets new drugs before they reach the market. But imagine if there were a Wall Street version of the F.D.A. – an agency that examined new financial instruments and ensured that they were safe and benefited society, not just bankers.  How different our economy might look today, given the damage done by complex instruments during the financial crisis.

The idea Morgenson is advocating was set forth by law professor Eric Posner (one of my former profs) and economist E. Glen Weyl in this paper.  According to Morgenson,

[Posner and Weyl] contend that new instruments should be approved by a “financial products agency” that would test them for social utility. Ideally, products deemed too costly to society over all – those that serve only to increase speculation, for example – would be rejected, the two professors say.

While I have not yet read the paper, I have some concerns about the proposal, at least as described by Morgenson.

First, there’s the knowledge problem.  Even if we assume that agents of a new “Financial Products Administration” (FPA) would be completely “other-regarding” (altruistic) in performing their duties, how are they to know whether a proposed financial instrument is, on balance, beneficial or detrimental to society?  Morgenson suggests that “financial instruments could be judged by whether they help people hedge risks – which is generally beneficial — or whether they simply allow gambling, which can be costly.”  But it’s certainly not the case that speculative (“gambling”) investments produce no social value.  They generate a tremendous amount of information because they reflect the expectations of hundreds, thousands, or millions of investors who are placing bets with their own money.  Even the much-maligned credit default swaps, instruments Morgenson and the paper authors suggest “have added little to society,” provide a great deal of information about the creditworthiness of insureds.  How is a regulator in the FPA to know whether the benefits a particular financial instrument creates justify its risks? 

When regulators have engaged in merits review of investment instruments — something the federal securities laws generally eschew — they’ve often screwed up.  State securities regulators in Massachusetts, for example, once banned sales of Apple’s IPO shares, claiming that the stock was priced too high.  Oops.

In addition to the knowledge problem, the proposed FPA would be subject to the same institutional maladies as its model, the FDA.  The fact is, individuals do not cease to be rational, self-interest maximizers when they step into the public arena.  Like their counterparts in the FDA, FPA officials will take into account the personal consequences of their decisions to grant or withhold approvals of new products.  They will know that if they approve a financial product that injures some investors, they’ll likely be blamed in the press, hauled before Congress, etc.  By contrast, if they withhold approval of a financial product that would be, on balance, socially beneficial, their improvident decision will attract little attention.  In short, they will share with their counterparts in the FDA a bias toward disapproval of novel products.

In highlighting these two concerns, I’m emphasizing a point I’ve made repeatedly on TOTM:  A defect in private ordering is not a sufficient condition for a regulatory fix.  One must always ask whether the proposed regulatory regime will actually leave the world a better place.  As the Austrians taught us, we can’t assume the regulators will have the information (and information-processing abilities) required to improve upon private ordering.  As Public Choice theorists taught us, we can’t assume that even perfectly informed (but still self-interested) regulators will make socially optimal decisions.  In light of Austrian and Public Choice insights, the Posner & Weyl proposal — at least as described by Morgenson — strikes me as problematic.  [An additional concern is that the proposed pre-clearance regime might just send financial activity offshore.  To their credit, the authors acknowledge and address that concern.]

In economics, financial regulation, Hayek, Knowledge Problem, law and economics, regulation
permalink

FTC Mobile Payments Workshop on April 26, 2012

Josh Wright —  29 January 2012

The Federal Trade Commission conference announcement is below; note that public comments on the date of the conference.  This is an important space and should attract some excellent speakers.  The topics suggest a greater focus on consumer protection than competition issues.  Here is the announcement:

The Federal Trade Commission will host a workshop on April 26, 2012, to examine the use of mobile payments in the marketplace and how this emerging technology impacts consumers. This event will bring together consumer advocates, industry representatives, government regulators, technologists, and academics to examine a wide range of issues, including the technology and business models used in mobile payments, the consumer protection issues raised, and the experiences of other nations where mobile payments are more common. The workshop will be free and open to the public.

Topics may include:

  • What different technologies are used to make mobile payments and how are the technologies funded (e.g., credit card, debit card, phone bill, prepaid card, gift card, etc.)?
  • Which technologies are being used currently in the United States, and which are likely to be used in the future?
  • What are the risks of financial losses related to mobile payments as compared to other forms of payment? What recourse do consumers have if they receive fraudulent, unauthorized, and inaccurate charges? Do consumers understand these risks? Do consumers receive disclosures about these risks and any legal protections they might have?
  • When a consumer uses a mobile payment service, what information is collected, by whom, and for what purpose? Are these data collection practices disclosed to consumers? Is the data protected?
  • How have mobile payment technologies been implemented in other countries, and with what success? What, if any, consumer protection issues have they faced, and how have they dealt with them?
  • What steps should government and industry members take to protect consumers who use mobile payment services?

To aid in preparation for the workshop, FTC staff welcomes comments from the public, including original research, surveys and academic papers. Electronic comments can be made at https://ftcpublic.commentworks.com/ftc/mobilepayments. Paper comments should be mailed or delivered to: 600 Pennsylvania Avenue N.W., Room H-113 (Annex B), Washington, DC 20580.

The workshop is free and open to the public; it will be held at the FTC’s Satellite Building Conference Center, 601 New Jersey Avenue, N.W., Washington, D.C.

In antitrust, economics, financial regulation, technology, wireless
permalink

Notes from the tea party caucus of corporate academia

Larry Ribstein —  20 December 2011

Roberta Romano has just posted her paper, Regulating in the Dark. Here’s the abstract:

Foundational financial legislation is typically adopted in the midst or aftermath of financial crises, when an informed understanding of the causes of the crisis is not yet available. Moreover, financial institutions operate in a dynamic environment of considerable uncertainty, such that legislation enacted even under the best of circumstances can have perverse unintended consequences, and regulatory requirements correct for an initial set of conditions can become inappropriate as economic and technological circumstances change. Furthermore, the stickiness of the status quo in the U.S. political system renders it difficult to revise legislation, even though there may be a consensus to do so. This essay contends that the best means of responding to this dismal state of affairs is to include, as a matter of course, in crisis-driven financial legislation and its implementing regulation two key procedural mechanisms: (1) a requirement of automatic subsequent review and reconsideration of the legislative and regulatory decisions at some future point in time; and (2) regulatory exemptive or waiver powers, that encourage, where feasible, small scale experimentation, as well as flexibility in implementation. Both procedural devices will better inform and calibrate the regulatory apparatus, and could thereby mitigate, at least on the margin, the unintended errors which will invariably accompany financial legislation and rulemaking originating in a crisis. Given the centrality of financial institutions and markets to economic growth and societal well-being, it is exceedingly important for legislators acting in a financial crisis with the best of intentions, to not make matters worse.

It’s worth noting that Henry Butler and I, in our book about SOX (at 96-97, footnotes omitted), also suggested “sunset” provisions as an antidote to crisis-driven regulation:

[S]ignificant new financial and governance regulation like SOX that displaces and supplements prior regulatory approaches should be subject to periodic review and sunset provisions. Although Congress, of course, can always undertake such reviews, prior experience indicates that it will not. Legislation is a one-way regulatory ratchet. It arises when the conditions for reform are ripe for a regulatory panic. The conditions for a “deregulatory panic” are less likely to develop. Firms learn to live with the extra costs and may not be willing or able to bear the costs of lobbying for repeal, at least in the absence of a regulatory cataclysm. Thus, it is not surprising that SOX sponsor Michael Oxley, despite recognizing that SOX was “excessive” in some respects, and admitting that it had been rushed through Congress, suggested that Congress would not be revisiting the issue, even as to the seriously affected small companies. He said, “If I had another crack at it I would have provided a bit more flexibility for small- and medium-sized companies.” In other words, Congress normally does not have “another crack” at regulation. A sunset or review mechanism would change that.

Perhaps Congress can learn some lessons from itself. The USA Patriot Act was passed less than one year before SOX and, like SOX, was passed by an overwhelming majority. Unlike SOX, the USA Patriot Act includes sunset provisions for some of its most controversial provisions. The Patriot Act’s sunset provision forced Congress and the president to reevaluate and debate those provisions, in an atmosphere far  removed from the immediate post-9/11 panic. American investors would benefit from a sober reevaluation of SOX. Perhaps the courts will provide that opportunity. For future regulatory panics, Congress would do well to remember the lessons of the Patriot Act.

One footnote in Romano’s article particularly grabbed my attention.  Referring to Jack Coffee’s criticism of sunset provisions in a non-yet-public manuscript (“The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated”), Romano notes:

Coffee (2011:4, 6,9) sweepingly seeks to dismiss the scholarship with which he disagrees by engaging in serial name calling, referring to the authors, Steve Bainbridge, Larry Ribstein and me, as “the ‘Tea Party Caucus’ of corporate and securities law professors” (a claim that would have been humorous had it not been said earnestly), “conservative critics of securities regulation,” (a claim, at least in my case, that would be accurate if he had dropped the adjective), and further referring to Bainbridge and Ribstein, as “[my] loyal adherents.”

 She also observes in this footnote:  

[I]n the American political tradition and academic literature, advocacy of sunsetting has historically cut across political party lines. It has had a distinguished liberal pedigree, having been advocated by, among others, President Jimmy Carter, Senator Edward Kennedy, political scientist Theodore Lowi, and Common Cause (Breyer 1982; Kysar 2005).”

Like Butler and me, she cites the Patriot Act precedent.

Well, I’m proud to be included in Romano’s and Bainbridge’s “tea party” and surprised at being there because I advocated an idea also endorsed by Carter, Kennedy, Lowi and Common Cause.  It’s sad a scholar of Coffee’s stature sees a need to resort to such rhetoric, though almost understandable since Romano’s devastating critique doesn’t leave him much of a ledge to sit on.

 As for Romano’s article, definitely do read the whole thing.  Rather than simply condemning Dodd-Frank, she argues persuasively for a way to avoid future financial over-regulation.

Update:  Matt Bodie confuses blogs and scholarly articles, statutes and people. Bainbridge sets him straight, and Leiter agrees.  But do read Bodie’s post anyway because he links to some great Gretchen posts which even I had forgotten.

In financial regulation, sarbanes-oxley
permalink

Lawyers as responsible business advisors

Larry Ribstein —  6 December 2011

Katherine Franke argues that lawyers are partly responsible for the financial misdeeds protested by OWS (HT Leiter):

Implicit in the OWS protests is a condemnation of an approach to lawyering that regards all legal rules simply as the price of misconduct discounted by the probability of enforcement* * *

In recent years we have seen the increased blurring of the boundary between law and business, between the lawyer and the businessperson, and between legal and business education. Too often, being a “good lawyer” has meant taking on the role of consiglieri, providing effective legal cover for otherwise borderline, or worse, practices. Effective and ethical representation of business interests does not relieve lawyers of responsibility for the harmful effects on others created by our clients’ actions, taken pursuant to our counsel. * * *

Servicing law school debt after graduation drives many of our students to highly compensated legal work for the financial services industry. * * *

The widely held public outrage at corporate overreaching given voice in the OWS protests reminds us of the degree to which the legal profession has fallen short of its traditional role as “republican” citizen, obliged to act as guardian of public interests even when — indeed especially when — representing private interests.

Without getting deeper into the psyche of the Occupiers, let’s grant that Wall Street’s improvidence was a cause of its Occupation and that lawyers were partly to blame for this improvidence. (I hope Franke will accept the friendly amendment that the lawyers worked for the government as well as the banks.)   What should we do about this? 

For starters, and recognizing that it has become obligatory to drag the high price of legal education into everything, I don’t think the answer to this particular problem is getting lawyers out of “highly compensated legal work” in finance.  (Indeed, not that many of today’s law school grads are even being tempted by such jobs.) Nor does the answer lie in simply hoping that lawyers will feel more obliged to “act as guardian of public interests.”  Indeed, the latter strategy is a prescription for their irrelevance.

Rather, the answer is training lawyers to get more into business and finance, where they can be respected and full-fledged participants in business decisions.  Law schools don’t adequately train lawyers on the complex financial instruments and deals they’re being called to advise on. Although lawyers may come to law school with this knowledge or learn it after they leave, law school generally doesn’t train them to integrate financial expertise with law practice.  For example, they may understand how a deal works, but not necessarily what material facts about the deal need to be disclosed, or when the transaction comes too close to the regulatory line.  And even if they might have such knowledge, they need to be able to speak the client’s language in order to be sure of being listened to.

Integrating lawyers more fully into business should make businesses in and out of finance more rather than less responsive to legal considerations.  In retrospect it’s clear that the lawyers who didn’t fully advise their clients of the legal risks inherent in their complex deals and securities didn’t just let the public down — they didn’t serve their clients’ interests.

Not every deal or new security that eventually blows up should have been squelched by a lawyer.  Risk can be healthy and perfectly legal.  Anyway, clients will tend to ignore legal advisors who just say no rather than try to find ways to get things done.  But the right course of action is often unclear.  Finding it requires matching high-level business expertise with knowledge of black-letter law and underlying policies.

Taking the lawyers out of finance or blunting their authority by turning them into preachers will not get the results Franke hopes for.

In financial regulation, lawyers, legal profession
permalink

Filmmakers imagine finance

Larry Ribstein —  14 November 2011

Margin Call is the best film to come out of the recent financial crisis. This is no polemic masquerading as a “documentary” (Inside Job) or good vs. evil melodrama (Money Never Sleeps). It is serious film, with superb acting, script, direction and photography, which uses the financial crisis as the realistic backdrop for a timeless story.

And yet the film is fatally flawed. Its serious qualities make more transparent its defects, which it shares with most films about business—filmmakers’ sour view of capitalists, which colors their view of business and perennially hobbles their efforts to make credible films about the business world.

In a nutshell: Eric Dale (Stanley Tucci), a risk management employee of a large securities firm becomes one of many casualties of a downturn in the firm’s business. On the way out the door he hands subordinate Peter Sullivan (Zachary Quinto) a USB drive. Sullivan, a rocket scientist who chose a career in finance, learns from this information that the firm’s substantial mortgage-backed security portfolio was based on a flawed real estate pricing model, and now threatens the firm’s financial soundness. Moreover, since the rest of Wall Street used the same model, the whole financial world is vulnerable (obviously an oversimplification of the causes of the financial crisis, but this is movieland). The revelation works its way up the corporate hierarchy, including executive Sam Rogers (Kevin Spacey), all the way to the top, CEO John Tuld (Jeremy Irons). Tuld and Rogers must decide whether to solve the firm’s problem by dumping the portfolio on its unsuspecting customers.

Unlike so many films about business, this one makes the business credible. The audience understands the setup. Though a few of the firm’s employees, including Dale, had an inkling this could happen, nobody acted on this information. The firm’s dilemma is also clear: selling the securities could save the firm in the short term but destroy it in the longer term because the firm will lose its customers’ trust. Hence the tension between the coldblooded Tuld and the conscience-ridden Rogers. This realism contrasts starkly with the hokey business scenarios in films like Wall Street I and II, which derived their limited dramatic power more from foreboding atmospherics than inherent logic.

Margin Call also differs from other business films in the depth of its characters and absence of obvious villains. There is no looming “corporation” that somehow is able to motivate its employees to behave like evil automatons. Here the corporation dissolves into its all-too-human employees.

Having shed the defects of the typical business film, Margin Call had a chance at greatness. Lurking in the film is an existentialist core, the story of how a crisis brings people to question the worth of what they are doing. While they were surfing the financial wave the universe was in a perfect harmony, where hard work created deserved wealth and happiness all around. But when the wave crashes their world loses its meaning. Finance looks like a zero-sum game, a way to transfer wealth from starving dogs to fat cats, as Tuld says. Nothing is immune. Dale laments leaving his former career as an engineer where he built a bridge that saved time and money. But his former subordinate Will Emerson (Paul Bettany) points out that maybe the drivers wanted to take the long way around. Rogers says digging holes would be better than what he does. At least he loves his dying dog and clings to it as his anchor. But then the dog dies and ends up in the hole he has dug. Where is the value?

In a better world, the film’s characters might have confronted the void and, possibly, found something to hold on to. But instead the deeper message vanishes leaving the simplistic point that the problem lies in the financiers and their sandcastles built of money. The characters are moral monsters obsessed with how much they and others make. When they flank a cleaning lady on the elevator we see and hear through her eyes their nasty conversations.

The characters’ search for meaning might, in this better world, have started with their jobs. But their self-rationalizations are lame. Tuld says, “It’s not wrong,” but the only reason he can offer is that “it’s all just the same thing over and over; we can’t help ourselves,” –followed by a list of years of financial crashes in recent world history. Will Emerson says, “If you really wanna do this with your life, you have to believe you’re necessary.” But the only necessity he finds is that “people wanna live like this in their cars and big . . . houses they can’t even pay for.” The film judges the characters for us — the cleaning lady, Rogers left with nothing but his dead dog, his childless woman subordinate, Sarah Robinson (Demi Moore) who threw her life away for an empty career, Tuld’s death’s-head face.

This is what happens to so many films about business. In my study of films about business and my law review articles How Movies Created the Financial Crisis and Imagining Wall Street I see a common theme: The artists who make films resent and distrust the capitalists who provide their money under the condition that the artists satisfy merciless markets that have no time for art. Of course the market’s judgment has to be shown to be irrational. So capitalism is often presented as a zero-sum game, where results depend on chance. Crashes happen, and people suffer. It has nothing to do with anything real.

In most business films (e.g., Oliver Stone’s Wall Street), this diminutive narrative of business shrinks the whole film: the characters are cardboard, the drama forced, the technical features marshaled to shore up the weaknesses. But since Margin Call is a serious film, its failure to fulfill its promise is more obvious. This film forces us to consider why filmmakers are so unable to reckon with the lives that so many Americans lead within large firms.

Perhaps the most prominent American filmmaker who could create a plausible narrative of big business was Billy Wilder. His films, such as The Apartment and Double Indemnity, had characters who found personal meaning even if some of their co-workers had not. But, then, Wilder was not subject to the anti-capitalist disease of modern filmmakers. He had not led his entire life in Hollywood or in movie theaters. His early years in Nazi Germany made him appreciate that free enterprise was not the worst thing in the world.

There was another story to be told in Margin Call, if only the filmmakers had been receptive to it. Finance is not basically a zero-sum game. It brings the resources together that create the worthwhile dreams that people do have. Where did the money come from to build Eric Dale’s bridge? The financiers who assembled the cash to build the construction and design firms were as responsible for the bridge as the engineers who worked for those firms. Financial engineering doesn’t create just instruments only rocket scientists can understand, but also the institutions that encourage investors to hand over their money.

If finance, even so envisioned, is worthless, then we can more readily believe that the rest of the world is, too. But we are also receptive to an existentialist construction of a reason to live. In the end, Rogers might have found that reason in constructing a financial solution to the financial dilemma instead of caving in to Tuld’s demand for a short-term solution that sacrificed both the firm’s customers and its own reputation. Or Rogers might have rejected this solution and taken the cash, just as Fred McMurray succumbed to murder in Double Indemnity. But at least we would have seen that finance gave him the same kind of choices that people have in other walks of life.

In the end the film can claim at least one important accomplishment. It shows that a realistic portrayal of business can be dramatic. Business does not have to be a generic prop. But it also shows that filmmakers’ anti-finance bias has real artistic costs. Filmmakers’ impoverished narrative of business can dilute the drama inherent in what so many people do with their lives.

Note:  This review was written for the Atlas Society’s Business Rights Center and was first published on their website.  My thanks to the Atlas Society for encouraging me to think and write about this film.

In economics, film, financial regulation
permalink

The Bulldozer Solution to the Housing Crisis

Hal Singer —  24 October 2011

My inaugural blog on two-sided markets did not elicit much reaction from TOTM readers. Perhaps it was too boring. In a desperate attempt to generate a hostile comment from at least one housing advocate, I have decided to advocate bulldozing homes in foreclosure as one (of several) means to relieve the housing crisis. Not with families inside them, of course. In my mind, the central problem of U.S. housing markets is the misallocation of land: Thanks to the housing boom, there are too many houses and not enough greenery. And bulldozers are the fastest way to convert unwanted homes into parks.

(Before the housing advocates lose their cool, an important disclaimer: Every possible effort should be made to keep a family in their homes, including taxpayer-financed principal modifications for deserving, underwater borrowers. My proposal applies only to vacated homes that have completed the foreclosure process.)

Until the Washington Post ran an article last week, titled Banks turn to demolition of foreclosed properties to ease housing-market pressure, I was reluctant to admit my position in public. I had whispered my idea into the ears of several finance professors, but none was willing to stand behind it. And for good reason: How can one advocate bulldozing a home when so many families are losing their homes?

According to the Post, some of the nation’s largest banks have begun giving away abandoned properties to the state and even footing the $7,500 bill per demolition. In 2009, Ohio passed a law creating “land banks” with the power and money to acquire unwanted properties and put them to better use, like community gardens. Similar laws were passed in Georgia, Maryland, and New York. Wells Fargo donated 300 properties nationwide last year, and Fannie Mae donated 30 properties per month to the Cuyahoga (Ohio) land bank. The story even identified a “land bank expert” at Emory University. Now that the Post has given me cover of plausibility, let’s discuss the costs and benefits.

One of the first lessons in an undergraduate microeconomics class is that bulldozing homes to create construction jobs is a bad idea. Even after those new construction workers rebuild the bulldozed homes, society has the same amount of homes as before but lacks whatever output those workers could have created in the alternative. The objective of economic policy is not to maximize jobs—if that were the case, entire cities would be bulldozed and reconstructed—but rather to allocate resources efficiently. Because so many economists have this lesson in mind (and because so many are pacifists), it is hard to embrace any policy that involves a bulldozer.

But this bulldozer scheme is motivated for different reasons. Too much land has been allocated to homes, many of which were built in bubble during the early half of last decade. As a result, too many neighborhoods in America are afflicted with abandoned properties. A vacant house is estimated to be worth half its normal market value. Imagine trying to sell your house at market rates when a close facsimile is available across the street for half the price! To add insult to injury, the excess supply of abandoned houses invites vandalism and neighborhood blight—the textbook negative externality—further depressing home values. Using data from foreclosures in the Cleveland area, Kobie and Lee (2010) show that the length of time that a home is in foreclosure has a significant drag on neighboring home values.

Well-functioning markets tend to equilibrate supply and demand, but housing markets are highly inefficient in this regard because of the time lag between beginning construction and selling a home: A housing boom sends signals to builders that new construction will be profitable. By the time the housing bust comes, the new builds become permanent mistakes.

To illustrate this “market failure,” consider downtown Miami. A drive down Brickell Avenue reminds one of New York City. Whereas there used to be one row of high-rises on the bay-side, the avenue now boasts rows and rows of developments as far as the eye can see. Had the developers known that many of these complexes would stand empty—the Census Bureau estimates that a whopping 18 percent of Florida’s homes stood vacant in March 2011—they would have tempered their enthusiasm. According to the Florida Association of Realtors, the inventory overhang has sent home prices plunging: the median price for homes sold in January 2011 was seven percent less than January 2010, and prices are expected to fall by another five percent in 2011.

And why is this so troubling for the economic recovery? According to the Fed, the nation’s stock of household real estate declined by $6.5 trillion since 2006. A family spends its income based in part on its perceived wealth; when housing values decline, families spend less. Economists call this the “housing-wealth effect.” Case, Quigley and Shiller (2006) found a statistically significant and rather large effect of housing wealth upon household consumption, and weak evidence of a stock market wealth effect.

A robust stock market might offset this decline in wealth (and hence spending), but the Dow hasn’t cracked 13,000 since April 2008. In the meantime, families are hoarding their cash. The $6.5 trillion elimination in household wealth puts the President’s $300 billion jobs-stimulus program in perspective: If the housing-wealth effect is dragging down spending, then a one-time injection of $300 billion dollars won’t have much of an impact. In contrast, a 10 percent increase a housing wealth—housing values are off 30 percent since 2006—would increase consumption between 0.4 and 1.4 percent according to Case, Quigley and Shiller.

When applied to vacated homes that have completed the foreclosure process, the bulldozer scheme would eliminate some of the excess supply of housing, which would temper the downward pressure on home values. In the place of a cluster of abandoned homes sucking the life of a neighborhood, imagine a children’s park, a dog park, or a community garden. Now that the banks have figured out bulldozing can be cheaper than maintaining the properties, paying taxes, and marketing the properties, the only thing stopping this idea from gaining traction is public sentiment.

My lunch crowd, comprised of economists, retort that the elimination of excess housing supply via bulldozers might be a boon to existing homeowners but would punish future homeowners. But wouldn’t a future homeowner prefer to invest in a slightly more expensive asset class with expected growth over a less expensive asset class with negative expected growth for the foreseeable future?

Finally, the bulldozing scheme need not be mutually exclusive with other schemes to relieve the housing crisis. Other ideas are worth trying, even if they wouldn’t spur much economic activity. Some are calling on Congress to eliminate the barriers keeping underwater homeowners from refinancing their mortgages. According to Macroeconomic Advisers, such a plan might boost GDP growth by 0.1 to 0.2 percentage points, as it merely redistributes money from lenders to borrowers. Others have called for massive debt forgiveness, achieved via a federal program to purchase troubled mortgages and give homeowners better rates. As Ezra Klein of the Post points out, however, the politics of using taxpayer dollars to pay off mortgages are impossible to crack. To stabilize the housing market, Larry Summers calls on government sponsored enterprises to finance mass sales of foreclosed properties to those prepared to rent them out, and to drop their posture of opposition to experimentation for programs such as principal reductions.

Whichever course we take, speed is of the essence: The housing drag is not going away on its own. According to RealtyTrac, the nation’s banks, along with Fannie Mae and Freddie Mac, have an inventory of more than 816,000 foreclosed properties, with an additional 800,000 working their way through the foreclosure process. Insisting that each of those homes be paired with a family—a noble cause—is tantamount to pushing off recovery for several more years.

I modestly propose to remove a fraction of these homes from inventory. If you don’t like the ring of a bulldozer scheme, how about “The Neighborhood Parks” scheme? Even if I can’t convince any economists to get on board, environmentalists should be pleased.

In banking, consumer protection, economics, financial regulation, markets , , , ,
permalink

A new approach to consumer regulation: firm ownership

Larry Ribstein —  24 October 2011

We have heard a lot about how business exploits consumer biases and therefore we need more regulation and disclosure.  By the time the Consumer Financial Protection Bureau gets up to speed, maybe the regulators will realize their dream of consumers behaving as they should.  In the meantime, Ryan Bubb and Alex Kaufman have another approach in their new paper, Consumer Biases and Firm Ownership: have the consumers own the firms. Here’s the abstract:

In this paper we show how ownership of the firm by its customers, as well as nonprofit status, can prevent the firm from exploiting consumer biases. By eliminating an outside residual claimant with control over the firm, these alternatives to investor ownership reduce the incentive of the firm to offer contractual terms that exploit the mistakes consumers make. However, customers who are unaware of their behavioral biases, and consequent vulnerability to exploitation, may fail to recognize this advantage of non-investor-owned firms and instead continue to patronize investor-owned firms. We present evidence from the consumer financial services market that supports our theory. Comparing contract terms, we find that mutually owned firms offer lower penalties, such as default interest rates, and higher up-front prices, such as introductory interest rates, than do investor-owned firms. However, consumers most vulnerable to these penalties are no more likely to use mutually owned firms.

Now, I am all for business forms competing with each other, including co-ops and capitalist owned firms.  As Henry Hansmann has written extensively, there is a place for non-shareholder-owned firms.

But Bubb & Kaufman go further.  It’s not enough for them just to let co-ops and capitalist-owned firms compete for consumers’ business.  They conclude that since misguided consumers continue to buy from the wrong firms, their judgment can’t be trusted.  Therefore, “policies that expand the market share of mutuals may be an effective way to reduce the social costs that result from consumers’ mistakes.”

I’m interested in seeing what these “policies that expand the market share of mutuals” might be.  Not to get too overheated or to indulge in slippery-slopism, but this seems to be an argument that capitalism plus regulation isn’t working, which would seem to lead to regulation of which types of firms can compete in which markets.

How far would this go? The authors suggest that “firm ownership plays a similar role in attenuating firms’ incentives to exploit consumer biases in other markets, such as education and health care.” And obviously consumers aren’t the only ones getting hurt. What about “policies that expand the market of” employee-owned firms?

Before we get on this slope, we might ask how far Bubb & Kaufman’s evidence can take us.  It’s hard to believe that, what with Elizabeth Warren and all, consumers could not have gotten the message that the capitalists are trying to cheat them, particularly in the financial services industry.  Could it be that their stubborn insistence on buying from these firms even when they have a choice means they just don’t believe it?  Or that capitalist-owned firms provide better value and products overall even if they insist on grabbing a bit more consumer surplus than customer-owned firms?  Or maybe even that the capitalist owned firms aren’t cheating the consumers after all because one-sided terms aren’t as bad as the pro-regulatory commentators would have us believe?

Before we start to regulate against capitalist-owned firms I’d like to see more evidence than just that consumers insist on dealing with them even when behavioral theories suggest they shouldn’t.

In consumer protection, financial regulation
permalink

The Fate of the FCC’s Open Internet Order–Lessons from Bank Fees

Hal Singer —  17 October 2011

Many thanks to the Truth on the Market bloggers for having me.  I’ve long enjoyed reading the blog and am delighted to be contributing.  A quick disclaimer up front to apply to all my posts:  The views expressed here are my own and do not express the views of my employer or clients.

 

Economists have long warned against price regulation in the context of network industries, but until now our tools have been limited to complex theoretical models. Last week, the heavens sent down a natural experiment so powerful that the theoretical models are blushing: In response to a new regulation preventing banks from charging debit-card swipe fees to merchants, Bank of America announced that it would charge its customers $5 a month for debit card purchases. And Chase and Wells Fargo are testing $3 monthly debit-card fees in certain markets. In case you haven’t been following the action, the basic details are here. What in the world does this development have to do with an “open” Internet? A lot, actually.

The D.C. Court of Appeals has been asked to consider several legal challenges to the FCC’s Open Internet Order. Passed in December 2010, the Open Internet Order was the regulatory culmination of an intense lobbying campaign by certain websites and so-called consumer groups to regulate the fees that Internet access providers such as Comcast or Verizon may charge to websites.

Although the challenges to the Open Internet Order largely concern the FCC’s authority to regulate Internet access providers and the proper scope of the regulations—for example, whether they should apply to wireline networks only or to all broadband networks including wireless—here’s to hoping that the rules are also judged according to the FCC’s public-interest standard. Along that dimension, the FCC’s experiment in price regulation clearly fails.

Just as Internet access providers bring together websites and users, banks provide a two-sided platform, bringing together merchants and customers in millions of cashless transactions. Because banking networks cost money to create, banks can’t be expected to provide their services for free. If you tell a bank that it can’t charge one side of a two-sided market—particularly when that one side (the merchant side) is less price sensitive than the other (the customer side)—then expect customer fees to rise. It’s not because banks are evil; it is because the profit-maximizing price charged to customers by a bank depends on the price charged to merchants.

Ignoring this economic lesson of two-sided markets, the Durbin Amendment to the Wall Street Reform and Consumer Protection Act instructed the Federal Reserve Board to cap swipe fees charged by banks to merchants. Prodded by consumer advocates to eliminate the fees entirely, the Fed cut the fees in half, to about 24 cents per transaction from an average of 44 cents per transaction. Paradoxically, the smaller the merchant fee, the larger is the debit fee—this is the “seesaw principle” of two-sided markets in action. Say hello to $5 monthly debit fees.

In a classic case of one regulation spawning another, now there is talk of regulating the banks’ debit-card charges. In response to the new debit fees, some members of Congress asked the Justice Department to investigate the major banks, suggesting that the higher fees resulted from a pricing conspiracy and not from their own bone-headed price regulation.

Months before the new debit fees came into effect, Bob Litan of the Brookings Institution predicted in a paper that “consumers and small business would face higher retail banking fees and lose valuable services as banks rationally seek to make up as much as they can for the debit interchange revenues they will lose under the [Federal Reserve] Board’s proposal.” As noted by Todd Zywicki in the Wall Street Journal, Litan’s prediction proved prescient.

Although both the Durbin Amendment and the FCC’s Open Internet Order are price regulations, there are important differences. Unlike the Fed’s rulemaking on swipe fees, the Open Internet Order was not directed by Congress. This shortcoming alone might be fatal for the Appeals Court. And unlike the Fed’s rulemaking, the FCC’s rulemaking regulates the merchant fee out of existence. Regulating prices below market-levels (as the Fed did) is one thing—regulating them to zero (as the FCC proposes) is beyond the pale.

Under the Open Internet Order, Internet access providers are banned from charging websites a surcharge for priority delivery. Indeed, the mere offering of such a fee to one website would be “discriminatory” and thus presumptively anticompetitive, even if the same offer were extended to other websites. Self-described public interest groups advocating for the Open Internet Order believe that if the smallest website in America can’t afford a surcharge for priority delivery, then no one should be allowed to buy it.

Assuming the FCC’s Order withstands legal scrutiny, the rules will clearly retard innovation among application developers: Why develop the next, killer real-time application if you can’t contract for priority delivery?

And if the Durbin Amendment is any guide, the effect of the Open Internet Order will be higher Internet access prices for consumers.

The same Bob Litan who accurately predicted price hikes in banking caused by price regulation made a similar prediction for broadband networks: “Even according to a theoretical model championed by net neutrality proponents, end users are unequivocally worse off under net neutrality regulation, as the end-user price of broadband access is always higher when ISPs are barred from raising revenues from content providers.” Will his sage advice be ignored by regulators twice in the same year?

The Appeals Court should force the FCC to defend the notion that the agency’s Open Internet Order is consistent with the public interest: If higher access prices and less innovation among application developers are the unintended consequences of an “open” Internet, then the FCC will fail on this score. With luck, the Open Internet Order will be seen as the ugly cousin of the Durbin Amendment, and the FCC’s experiment in price regulation will be curtailed.

In consumer protection, credit cards, economics, federal communications commission, financial regulation, net neutrality
permalink