Roiling Financial Regulation

Today's the day that Treasury Secretary Paulson publicly rolls out his plans, as I understand it, to turn the Federal Reserve into a super regulator of all things business and eliminate a number of independent agencies, including the Securities and Exchange Commission. Although I'm all for trying to have one set of regulations for a given industry - for example, have mortgage lenders responsible to one agency - I think that has natural limitations. At issue is two aspects of firms: how they interact with the global financial infrastructure, and how they interact with shareholders.

The two topics are really separate. If you are focused, by your nature, on the greatest efficiency for doing business, you aren't necessarily looking at the need to keep company shareholders informed and making corporate decisions as transparent to the investors as possible. Putting everything under one roof could be a conflict of interests, and one side or the other might be slighted. Even if you wanted to argue for the combination of the two areas, would doing it under the Fed really be that wise? The agency is semi-autonomous and doesn't directly answer to the government, even if it must keep everyone informed of what it does. I'm not sure that I'd want more extensive power over markets and financial activities regulated by such a body.

JP Morgan to Sweeten Bear Honeypot

It sounds as though JP Morgan may have to up its offer for Bear to $10 a share, and the entire situation is creating an interesting dilemma. ON one hand, the Fed is looking to ensure that commerce continues. It's not that Bear Stearns itself is so important to the economy so much as its position as a middleman in so many transactions. The problem is that if Bear had gone into bankruptcy, then the court would have had no choice under the law but to freeze all transactions in which it took part, no matter what it was actually doing. That could be a big enough hiccough to derail enough commerce that suddenly everything would come tumbling down.

So the Fed wanted to keep this from happening, and I can understand that. But Bear Stearns is a publicly-traded company, and the public that trades the company was pretty upset about the price being only $2 a share when it had gone for as much as $30 on Friday - and that was a loss of two-thirds of its value. According to a New York Times story, shareholders were ready to head to court.

On one hand, I don't have a lot of sympathy for the shareholders. They wanted the high return and were happy to overlook the questionable nature of the business that the bank was doing. Hey, it's capitalism, and there's risk. Why is it that so often so many people who have money to invest suddenly want welfare for the rich? But the intriguing issue is which governmental (quasi or not) agency has precedence when it comes to the conflict of interests? Can the Fed encourage a fire sale, or does the SEC have to come in on the side of investors, who want as much money per share as they can get?

The new offer must be approved by the Fed, which had initially balked at the new price.

If the Fed balks, does the deal come apart? This seems like a deal that is so important to the economy that the Fed is effectively powerless to say no, which means it has little leverage in a negotiation.

A new deal could raise even more questions about the Fed’s involvement in the negotiations. As part of the original deal, the Fed guaranteed to take on $30 billion of Bear’s most toxic assets. The central bank had also directed JPMorgan to pay no more than $2 a share for Bear to assure that it would not appear that the Bear shareholders were being rescued, people involved in the negotiations said Sunday night.

Might not the SEC say, "Sorry, folks, but the directors can't legally agree to such a deal?" I don't know that different branches of business regulation have ever clashed in such a way.

Wikileaks Reports JP Morgan Document on 10B5-1 Trading Plans: Claims Inider Trading

Wikileaks is reporting sudden discovery of the 10B5-1 trading plan:

A confidential memo obtained by Wikileaks shows that not only has the U.S. Securities and Exchange Commission created an insider trading loophole big enough to drive a truck through, but that Wall Street is taking full advantage of it, establishing 'how-to' programs and even client service divisions to help well-heeled clients circumvent insider trading regulations.

However, life just isn't that simple. There are several ways of structuring these plans, and there has been some evidence that these plans may be getting better results than you might mathematically think.

But the story isn't new, and the SEC is hardly ignoring potential abuse. Also, if someone uses the particular approach mentioned in this leaked document, they will probably lose the legal protection that 10B5-1 plans offer. Also, an executive wishing to game the system has much more effective and invisible methods of doing so. I covered the topic last December in Corporate Secretary.

Can Brands Make You Behave Differently?

According to Physorg.com, a recent study from Duke University and the University of Waterloo suggest that even brief exposures to a known brand can significantly change audience reactions and behavior. The research, which is to appear in the Journal of Consumer Research (they've been coming out with some pretty interesting things), exposed college students to subliminal flashes of Apple and IBM logos. Then they were asked to come up with uses, outside of building a structure, for a brick:

People who were exposed to the Apple logo generated significantly more unusual uses for the brick compared with those who were primed with the IBM logo, the researchers said. In addition, the unusual uses the Apple-primed participants generated were rated as more creative by independent judges.

Apparently a follow-up study found that those who saw a Disney logo behaved more honestly than those who viewed one for the E! television channel. One of the researchers said that this might suggest to company to spend more on product placement and other opportunities for "brief brand exposures." But I wonder 1) just how well-established the brand needs to be, 2) how much advertising you'd have to do to make the flashes do anything, and 3) whether that would actually translate into any market advantage for the companies, or if the only result would be changes in non-purchasing behavior.

Did the Feds Topple Bear?

New Jersey Institute of Technology management professor Michael Ehrlich has an interesting premise. A former government arbitrage trader himself, his research and background suggest to him that by announcing that it would make $200 billion available to finance securities from investment banks, the Fed may have unintentionally set off the panic that claimed Bear Stearns.
"I think it's a bad thing for Bear Stearns shareholders, but a brilliant thing for public policy," Ehrlich says. We've established a precedent that they're prepared to bail out firms to protect the little guys ... but that the people responsible bear the costs."

As he says, that means management and the shareholders. I think some of those shareholders often may be little guys, but, realistically, this is capitalism and they continued were holding stock in a company making ever riskier trades because they liked the returns.

The minute the Federal Reserve made the announcement, everyone in the markets started asking whether the Fed knew something that they didn't, which may well have triggered speculation about Bear Stearns - smallest of the investment banks - that turned into "a classic run on the bank," according to Ehrlich.

I keep asking myself the question of whether the Fed's new willingness to lend to investment banks might be handing more money to the very organizations that have proven themselves so tremendously reckless. Ehrlich thinks I'm looking at it the wrong way, and that the effect is to keep the financial system propped up while the shareholders take the brunt of the heat.

But I still feel unconvinced, because I think businesspeople are likely to take this as a tacit guarantee that no matter how stupidly they act, someone will pull their chestnuts out of the fire. All they need to do is keep diversified enough that their estates don't get clobbered like those of the Bear employees.

In any case, Ehrlich also thinks that this is by no view charity on the part of JP Morgan. As he deemed the Fed's move for public policy, so he called the acquisition a "brilliant" move that will probably give the new owner a profit of several billion dollars. Guess I don't see that as something to dissuade behavior in the future - because all the high-powered type A's will assume that they will be the ones coming out on top. We've seen the same behavior in virtually every man-made financial calamity in history, and there's no reason to think that people will act much differently. The only question is how much time it will take them to get back to the usual business.

Cracks in the Financial Fissure

So JP Morgan Chase & Co. is going to buy Bear Stearns. That may seem like a rescue, but it's not. This is yet another crack in the world's money foundation. First the UK government felt it had to take over North Rock, then the Fed was trying to support Bear Stearns through JP Morgan, but it has instead turned into an outright acquisition at $2 a share. Let's get some perspective on this. If you look at a chart, like this one from the Wall Street Journal, notice that the 52-week stock high was $170.23 and the low was $26.85. This isn't a "fire sale" as some in the media portray. This is bankruptcy and selling off the assets without the intervention of a court. And what is the Fed doing? Here's how the WSJ phrases it:

The Federal Reserve announced one of the broadest expansions of its lending authority since the 1930s in an effort to stem a credit crisis that is engulfing the financial system and threatening a deep recession.

For the first time securities dealers, effective today and for at least the next six months, may borrow from the Fed on much the same terms as banks. The Fed also lowered the rate charged on such borrowings from what's known as its discount window by a quarter of a percentage point, to 3.25%, and extended the maximum term to 90 days from 30.

This is a panicked attempt to keep everyone from taking that final plummet that Bears enjoyed. There isn't money because many people are no longer trusting the systems. But to keep things afloat, the Fed has potentially opened the flood gates. After all, it was large investment houses and banks - and the greedy credulity of investors - that landed everyone here in the first place. So now the country is supposed to trust their judgment with even more money? Maybe it's necessary to keep the whole system from freezing up, like an engine without oil, but only at the risk of having so much money out there that they dollar loses a lot more value.

I know there's the theory that some institutions are too large to fail, because you can't afford to have them out of business. But I'm wondering if what we're facing is more like a case of fiscal gangrene, in which you amputate a limb or the patient itself dies. Those who worship at the altar of capitalism must realize that can't adopt a deity and then insist on only the friendly parts. That's like saying you want to be a fundamentalist Christian but believe in only heaven and not hell. and I'm afraid that we're only just beginning to see the literal hell that we'll all be forced to pay.

Light Dawns on This Marblehead - Lenders, Fear, and Liquidity

The title of this post refers to an old Massachusetts put down of someone who suddenly grasps an idea - light dawns over Marblehead, which is a city on the north short of the state. And that's how I felt this morning, when looking at the latest problems with credit prices going higher.

I find that many financial stories, particularly those about the credit crunch, either assume that one understands the dynamics in advance, or assumes that the dynamics don't exist - that is, "And while I wave my hands, the credit markets seize up like an internal combustion engine running without oil." My flash of understanding was on the simple dynamic of what is happening at banks. The underlying driver is fear, as we keep hearing in the stories. But that fear does two things. One, is that the lenders are now afraid that because they've been making bad decisions for so long, any more reasonably drawn decision will be just as risky. So they price risk higher. For example, I received the following in an email from the Financial Times this morning:

Rising credit spreads meant AAA-rated General Electric paid a higher rate on a recent five year bond issue that it did for a comparable bond last May, according to Bloomberg calculations.

Alright, so it's the FT quoting Bloomberg. But consider the substance: GE is having to pay more for credit. It's not that the conglomerate is a worse credit risk. It's that the lenders have frayed nerves, and figure that since stupid decisions went wrong, then all decisions will go wrong.

Compounding that outlet of fear is another. Lenders have been caught having to restate financials to take into account unexpected losses. So they are taking cash and not only paying off the debts that came about from their ill-considered investments in the credit derivative markets, where essentially they create bonds and pay interest based on what they expect to get from payments on underlying assets like mortgages, but they are putting cash in reserves for future screw-ups. That means they lend a lot less of the money they have than they used to, and supply and demand then drives up the cost of interest.

Paulson Adresses Everything But Real Problem

I was driving about on errands with my daughter and was listening to NPR when I heard US Secretary of the Treasury Henry Paulson speak at the National Press Club talk about how the Bush administration was going to fix the credit crisis:

1. Wag a finger at the regulators for not making mortgage lenders explain in plain English to borrowers just what the hell they were in for.


2. Plead with lenders to keep lending, because, after all, if the public isn't borrowing, it's not spending.


3. Actually toughen licensing standards for all those mortgage lenders who can't make loans anyway because no one will front the money because of the mess the mortgage market is in.


4. Have regulators "catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it."


5. Cluck at sloppy lending practices.


6. And, of course, let industry self-regulate.

He managed to miss the major issue: when you've got people who are incredibly greedy and who have forgotten their duties to business, the markets, and the public in general, then they will continue to create complex, crackpot schemes to extract cash from the pockets of others and put it into their own. If the financial industries could regulate themselves, don't you think they might have by now? They don't because they don't want to be limited in what they do. The people in charge of all these stupid Ponzi schemes want to continue their quest for unending and unrestrained profits. That's like saying you want so much water from a well that you pump it dry. Now you're left with no water, and no prospect of getting any.

This is a case where self regulation will do nothing. The longer the federal government waits, the more cash it will have to create out of thin air to grease the market's wheels, and the more value of the dollar it will burn off, probably never to return, at least in our lifetimes.

Operations Research Valuable in Netflix Prize

Netflix has been running a contest to see who could significantly improve its ability to predict how much someone will like a movie. Lots of high-powered (and less so) groups have been applying huge amounts of scary math to reach the goal. But, as Wired reports, someone suddenly appeared out of nowhere last fall, approaching the few in the lead and making progress at a rate that took them months. What I find amusing about this story is that the guy isn't primarily a mathematician. Instead, he got an undergrad degree in psychology, a masters in operations research, and is a retired business consultant.

His trick? He's taking human psychological factors into account rather than treating this as nothing but a numbers game. I think this is a great lesson. Too often companies want to reduce people to numbers, and, certainly, you can look for mathematical patterns in group behavior. But sometimes the individuals will start acting in ways you never expected, demonstrating sudden shifts in behavior. The math doesn't explain it because the math is looking at the results, not at the causes. What might be predictable if you could follow the emotional contours of people turns into a jarring lurch if you're sitting blindfolded in a car and couldn't see the dip in the road before the auto dropped down. Will most companies learn anything from this? Probably not. They might nod and say, "Yes, we really should focus on psychology," but they don't grasp this in a practical way in how they do business today. And given that areas like marketing are pure psychology, if they don't get it by now, they never will.

When the Best Marketing Is Keeping Your Mouth Shut

I've run into a couple of interesting stories of marketing. In one, an organization sponsored a class at Hunter College, with the class content being a covert marketing campaign. The other came from a friend who owns an HP computer and who recently received something about extending the warranty - but said invitation explicitly excluded hardware. Leaving what? Telling her to reload software in case of trouble?

There are times that companies make the most horrendously stupid mucks of marketing communications. They lie, they twist things, they try being clever, and the upshot of all that effort is egg on their faces. If marketing isn't about the customer, then it's essentially a con game, in which the company tries to extract revenue without providing any benefit. And if a company's marketing communications is designed along such practices of trickery, it is probably costing the company more in good will and long term financial value than company management will ever realize. If the managers did get it, they'd replace the marketing staff immediately.

The Next Big Financial Debacle?

Some experts on a risk management mailing list I'm on are guessing that there's a new finanical bugaboo on the horizon, credit default swaps derivatives, that could make the sub-prime problems look like small change. Two parties enter into an agreement. One pays the other a fixed sum periodically though a coupon bond - which means that the second has purchased the bond from the first. The second doesn't have to pay anything else, and keeps collecting interest over the life of the bond (and, presumably, recaptures the initial investment) unless some pre-determined credit event - such as a debt restructuring, bankruptcy, or a drop in credit rating - occurs. In such a situation, the second party pays a fixed sum to the first and then the entire arrangement is terminated.

The derivates can become a form of credit insurance, with the second party being the insurer. However, they can also allow third parties to speculate on an entity's ability to repay a debt - legalized gambling, I think it should be called. So long as you only have the occasional credit explosion, the system can work. But what happens when you have one comapny after another in trouble? Now you have to wonder whether the insurers actually have the money to cough up - and some of the big players in that market are the very financial institutions that have been pouring money out because of the sub-prime mess.

According to an article in Wikipedia (link above), these are the most widely traded credit derivative product. More so than mortgage-backed bonds. The outstanding swaps currently top $46 trillion - with a t. To add some perspective, the US stock market is only $22 trillion, with mortgate securites hitting a mere $7 trillion. And an article in Bloomberg notes that this is the fastest-growing form of derivative on the market.

This could bear out Warren Buffet's remarks from 2003, in which he called derivatives in general "financial weapons of mass destruction" that could hurt the entire global financial system, and not just the people involved with the specific transactions.