Posts Tagged ‘Economic Crisis’

Ohio AG Takes On Ratings Agencies

Friday, November 20th, 2009

“The attorney general of Ohio sued the country’s largest credit rating agencies on Friday, alleging that they had cost state retirement funds some $457 million by approving high-risk Wall Street securities that went bust in the financial collapse,” The New York Times reports. The paper quotes Ohio Attorney General Richard Cordray as saying: “We believe that the credit rating agencies, in exchange for fees, departed from their objective, neutral role as arbiters. At minimum, they were aiding and abetting misconduct by issuers.”

Writing in 2007 for his column on SmartPros.net, Smeal’s Edward Ketz addressed this conflict of interest between rating agencies and the companies they’re supposed to be objectively rating:

Moody’s and the other agencies make money by charging the business entities who are issuing debt.  It doesn’t take a genius to see the conflict of interest.  The credit agencies lean on the issuer for more money or they risk receiving a poor rating.  Payment not only entitles one to a good rating, but also it gives one the privilege of not receiving a downgrade unless bad news becomes public.

… Policy-makers can reduce the problems by reducing the very real conflict of interests that perniciously raises its ugly head from time to time.  The solution is to prohibit credit rating agencies to receive any funds from the issuers.  If the ratings have any merit, then investors will be willing to pay for them.

Tags: Banking, Business Law, Economic Crisis, Ketz
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Glass-Steagall Redux

Wednesday, October 21st, 2009

The New York Times reports today that former Fed Chair Paul Volcker’s call to forbid commercial banks from mixing with investment banks is falling on deaf ears within the Obama administration.  Volcker, head of the president’s Economic Recovery Advisory Board, believes keeping banks from owning and trading securities will keep them out of the trouble they have experienced in the current recession.

According to Smeal’s Jean Helwege, Volcker’s plan would likely make future economic crises less costly than this most recent one, however, it won’t keep the Fed from spending taxpayer dollars to bail out poorly run banks in the future.

More from Helwege:

Paul Volcker, former Federal Reserve chairman and adviser to President Obama, recommends that we go back to the good old days when commercial banks and investment banks were kept separate. The logic now, as it was in the 1930s when Glass-Steagall was enacted, is that investment banking is too risky a business to mix with consumer deposits. In a speech earlier this fall Volcker stated, “I do not think it reasonable that public money—taxpayer money—be indirectly available to support risk-prone capital market activities simply because they are housed within a commercial banking organization.” Volcker recognizes that his views are hardly “progressive,” noting that “people say I’m old-fashioned and banks can no longer be separated from nonbank activity.”  But he points out, “That argument brought us to where we are today.”

The $64,000 question is whether we would be where we are today had we pursued different regulatory policies leading up to this recession. Whatever the policies regarding mergers of banks and investment houses, we would have experienced a housing bubble and it would still have popped, bringing massive losses to homeowners across the nation and a retrenchment in homebuilding that would last years. Fannie Mae and Freddie Mac would still be in conservatorship, having overleveraged themselves to peddle the American dream of home ownership. Investors would still have lost money on mortgage-backed securities built on subprime mortgages. Those losses would still have led to concerns that safer mortgages might default, expanding the breadth of losses in the MBS market. We would be in a deep recession as a result of the housing downturn regardless of whether banking activities are segregated.

However, Volcker’s arguments are more geared toward preventing the next near-Great Depression and redefining the policy responses to such crises. If we still had Glass-Steagall, we would not have seen the merger of JPMorgan Chase (a bank) with Bear Stearns (an investment bank) in 2008, which might have prevented people from expecting a similar deal with Lehman and some other commercial bank and thus the fallout when Lehman was dropped like a stone from the list of firms “too big to fail.” If we still had Glass-Steagall, Goldman would never have decided to convert to a bank holding company and potentially would not have received the largesse it did. Nor would Bank of America have had its arm twisted into acquiring Merrill Lynch. Bringing back Glass-Steagall might bring us back to the days of more narrowly defined policy responses by the Federal Reserve. And it might mean that the next crisis will not be worse than today’s now that the investment banks are so strongly encased in the regulatory womb of the Federal Reserve.

Reinstating Glass-Steagall is a simple response to a complex issue.  While simple may be all we can swallow, it remains the case that the Federal Reserve has not been successful in striking a balance between helping out the economy and condoning bad behavior by financial firms.  The Fed identified AIG as strong enough to get a loan (i.e., the Fed was sure it would get paid back) and Lehman as incapable of repaying new funds. It deemed CIT too unimportant to deserve aid but was willing to help out the entire money market mutual fund industry. The Fed’s willingness to extend its hand to all manner of poorly run firms is a concern and Volcker’s efforts to rein in this independent agency may help, but unfortunately it’s more likely that the Fed will find another way to expand its role as lender of last resort regardless of whether we revert to Glass-Steagall.

Tags: Banking, Economic Crisis, Finance, Helwege, Politics
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Tax Credits for Hire

Monday, October 12th, 2009

An editorial in today’s Wall Street Journal takes aim at proposals floating in Washington to offer tax credits to firms that hire new empoyees. “One plan would grant a $3,000 tax credit to employers for each new hire in 2010,” according to the editorial. ”Under another, two-year plan, employers would receive a credit in the first year equal to 15.3 percent of the cost of adding a new worker, an amount that would be reduced to 10.2 percent in the second year and then phased out entirely.”

Smeal’s Charles Enis argues that these tax incentives, which were tried once in the late 1970s resulting in mixed reviews, are unfair to firms who resisted layoffs during the recession, essentially punishing them for keeping their employees working. By making the tax code even more complicated, however, the tax credits will likely succeed in creating some jobs—in tax accounting.

More from Enis:

Imagine buying a car and learning that you could have made the purchase a week later and received a generous rebate. Firms that resisted layoffs may have a similar sentiment if one of the proposed credits is enacted. These credits reward firms that increase the size of their workforce or add significant hours of work. Firms that laid off many workers will likely increase their hiring when the economy improves and thus benefit from the credit. What about firms that absorbed the cost of keeping excess people? What do they get?

The income tax regime is one of many policy tools available to combat economic difficulties. However, the tax code has been summoned to remedy virtually all of our problems (e.g., pollution, health care, energy, etc.). These well intentioned provisions have contributed to the complexity of a tax system described as “a national disgrace” as far back as President Carter.

The tax system as a policy tool raises cost-benefit dilemmas. Straightforward provisions result in benefits to unintended taxpayers at substantial costs to the Treasury relative to the economic goals achieved. Provisions targeted toward intended taxpayers must be laden with many complex features (e.g., phase-outs, caps, restrictions, uncertainties regarding extensions, etc.). Such features frustrate small businesses, which are important job creators. The jobs credit that was enacted for 1977-1978 had a mathematical specification too complex to explain in this short blog post. The former credit was tied to the federal unemployment tax regime, while the proposed credit is tied to the Social Security tax regime, and is likely to be even more complex after it is “tweaked” by political compromises.   

Whether the ’77-‘78 jobs credit was successful depends more on one’s political perspective then on evidence from rigorous economic analyses. The complexity and poor promotion of the ’77-’78 credit rendered the findings of traditional analyses tenuous and mixed. Economists believe that the new hires from the ’77-’78 credit were largely lower-skilled workers, which is not a bad thing. However, the tax code already contains the Work Opportunity Tax Credit, a provision aimed at encouraging businesses to hire individuals who are disadvantaged in the labor market. Is another credit really necessary or can the existing credit be updated?

The enactment of the proposed jobs credit will significantly increase the hours of work for tax practitioners, IRS personnel, tax form printers, HR departments, software writers, and hopefully many otherwise unemployed Americans.

Tags: Economic Crisis, Economy, Enis, Politics, Taxes, Unemployment
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Pay Czar Targets Pay

Wednesday, October 7th, 2009

The Wall Street Journal reports that “the Obama administration’s pay czar is planning to clamp down on compensation at firms receiving large sums of government aid by cutting annual cash salaries for many of the top employees under his authority.”

However, according to Smeal’s Tim Pollock, it’s going to take a cultural shift, not a government edict, to really rein in exorbitant CEO salaries:

The problems with executive compensation can’t be solved with regulation, or by a pay czar, because they are deeply embedded in the culture of Wall Street, in the case of financial services, and in the culture and belief systems of the executive suite and boardroom, more generally.

CEOs and senior executives, while always well compensated, were not always as lavishly compensated as they are today. What we see now largely began in the 80s when stock options began to be used more widely as a consequence of proscriptions derived from the logic of agency theory, which argues that executives will act in a risk averse and self-interested manner unless provided with incentives to behave otherwise.

The problems with stock options are that, unlike actual stock, which can go down in value as well as up, stock options can’t go below zero in value. And until recently they received favored accounting treatments that essentially made them a “free good”. As a consequence of the former problem, executives really face no downside risk from stock options. Thus, rather than take reasonable risks, they are more likely to take excessive risks because they bear no real costs from failure; they just might not (in theory) make any gains. However, even this rarely comes to pass, because boards swoop in to reprice the options, or to give the executives new grants at lower exercise prices, in order to keep them sufficiently “motivated.”

This problem was exacerbated by the Clinton administration’s well-meaning but disastrous attempt to limit executive pay by limiting  its tax deductibility unless it was tied to firm performance, which meant more stock options. Further, the favored-accounting treatment options received made them a cheap form of compensation, so it was easy for boards to load CEOs up with huge option grants that turned into phenomenal amounts of compensation in the 1990s’ bull market, which, by the way, raised all boats, even those of marginal and incompetent CEOs. Because it was easier to ascertain the value of an executive’s compensation package due to the new reporting requirements implemented in 1993, CEO pay packages could be compared to each other, and the executive pay arms race was off and running.

Today, the use of stock options, and the phenomenal levels of pay that CEOs, investment bankers, and traders receive, have become taken-for-granted parts of the corporate landscape. Restricting or modifying the pay of a few executives and firms by the government will not lead to a sustained change in pay practices,  and could lead to the poaching of the competent individuals left at the troubled firms by firms not bound by these restrictions. We’ve already seen that it’s business as usual again at most Wall Street firms.

Until executives feel real pressure from shareholders, and each other, to rein in pay, not much is going to change, I’m afraid. This isn’t going to happen as long as the mantra of “maximize shareholder value” (And what does this even mean? Over what time frame? In what way? If firms compete successfully in delivering the best products and services, won’t this happen anyway?) continues to drive decision making.

Tags: Economic Crisis, Executive Compensation, Politics, Pollock
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Pennsylvania and the G-20

Thursday, September 24th, 2009

With 20 world leaders meeting today and tomorrow for the G-20 summit in Pittsburgh to discuss the health of the world economy, Smeal’s Terrence Guay has penned an article outlining the importance of this meeting for Pennsylvania’s economy. Here’s an excerpt from the article, which appeared in the Patriot-News on Monday, and the Morning Call and Centre Daily Times today:

Why does all of this matter to Pennsylvanians?

The main reason is because the commonwealth’s economy is intertwined in the global economic web. With almost $35 billion in merchandise exports, Pennsylvania sent more goods abroad than all but 10 states in 2008. And it is not just multinational companies that are doing the exporting.

Of the 12,295 companies that exported goods from Pennsylvania in 2007, 10,900 (89 percent) were small and medium-size firms with fewer than 500 employees. Additionally, foreign-controlled companies employed 249,000 workers in Pennsylvania in 2006, the fourth-highest total among the U.S. states, with almost one-third of these jobs in the manufacturing sector.

This means as the global economy goes, so goes Pennsylvania’s economy. The statewide unemployment rate was 8.5 percent in July—the highest in 17 years.

Residents are concerned about the security of their jobs, stability of household incomes and the future well-being of their families. The sooner the global economy recovers, the sooner Pennsylvania’s economy will recover.

Improvement in the health of the global economy will result in more goods and services exported from Pennsylvania to the rest of the world, more investment in the commonwealth by foreign companies, a more stable tax base and more good-paying jobs.

You can hear more on the G-20 summit from Guay and Smeal’s Fariborz Ghadar here.

Tags: Economic Crisis, Economy, Globalization, Guay
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Feel-Good Regulations

Friday, September 18th, 2009

Speaking on Wall Street this week, President Obama renewed his call for a Consumer Financial Protection Agency to “make certain that consumers get information that is clear and concise, and to prevent the worst kinds of abuses” by financial institutions. Smeal’s Edward Ketz, in a forthcoming column, says this proposed new regulatory agency amounts to little more than politics:

What Obama is really trying to do is give American voters the impression that he is in charge, that he cares about them, and that he is improving matters so that the chances of another financial meltdown is infinitesimal.  It is political legerdemain.

As long as managers have perverse incentives to cheat investors and as long as the SEC goes after only the little  guys and ignores managers at Enron, WorldCom, Madoff Investments Securities, and GE, nothing is going to change.  If the Congress and if the president want to improve matters—and I have no idea if they really do—then they must change the set of incentives and disincentives.  To effect real change, the system must punish managers and directors who lie and steal and cover it up with scandalous financial reporting.

More regulation might make society feel better, but that is just an indication that most Americans have little understanding of economics.  They will continue to lose in the stock markets until they insist elected officials do something substantive.

My fear is that Democrats will rally around Obama while Republicans vilify him, similar to the previous administration when Republicans rallied around Bush and Democrats denigrated him.  There is too much partisanship in this country and not enough rational analysis.  Americans need to understand that both presidents have failed us by supporting new legislation and by crippling better enforcement.  (For whatever it is worth, this is one of the reasons I am an Independent.)

Tags: Banking, Economic Crisis, Finance, Ketz, Politics
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Breaking Up Fannie and Freddie

Thursday, September 10th, 2009

The Mortgage Bankers Association last week called for “Congress to transform Fannie Mae and Freddie Mac into several smaller privately held companies that would issue mortgage securities carrying an explicit government guarantee,” The Wall Street Journal reports.

Smeal’s Brent Ambrose, director of the Institute for Real Estate Studies, explains a few of the pros and cons of the industry group’s plan and details some of the issues currently surrounding Fannie and Freddie:

What do we do with Fannie Mae and Freddie Mac? These Government Sponsored Enterprises (GSEs) were created by Congress to provide liquidity and stability to the U.S. mortgage markets. They carry out this mission by purchasing mortgages from originators and then repackaging them into mortgage-backed securities (MBS) or holding them in their retained portfolios. In 2008, Fannie and Freddie purchased 80 percent of all mortgages originated in the United States and the value of their combined mortgage assets was $1.5 trillion (as of June 30, 2008). They were placed into conservatorship by the Federal Housing Finance Agency (FHFA) on September 7, 2008, as a result of the rapid decline in their capital base during the economic turmoil of last summer. As the housing and capital markets weakened last summer, the value of their assets (i.e. their mortgage holdings) declined significantly while the value of their debt issued to purchase these assets remained fixed. Effectively, Fannie and Freddie were insolvent. Unfortunately, as GSEs, the close relation between them and the federal government created the impression among investors that the debt securities issued by Fannie and Freddie were guaranteed by the federal government. Since being placed into conservatorship, the government converted this “implicit” guarantee into an explicit guarantee and Fannie and Freddie have continued to purchase and securitize mortgages. Their actions are a critical link in the Obama administration’s efforts to support the housing market. However, the future of Fannie and Freddie remains uncertain.

(more…)

Tags: Ambrose, Economic Crisis, Politics, Real Estate
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Audit the Fed?

Tuesday, September 1st, 2009

Rep. Ron Paul told The Wall Street Journal that Rep. Barney Frank, chairman of the House Financial Services Committee, backs Paul’s legislation that would give Congress new authority to audit the monetary policy operations of the Federal Reserve.

Smeal’s Jean Helwege argues that the monetary policy work of the Fed should be independent from second-guessing by Congress, however, she says that Fed Chairman Ben Bernanke needs to maintain the Fed’s impartiality and put an end to its picking and choosing winners and losers in the capital markets:

Rep. Ron Paul has been pushing to rein in the Federal Reserve and has proposed a bill to give the General Accounting Office (GAO) powers to audit it. The Fed is already subject to audit by the GAO when it comes to consumer protection laws and banking regulation, but not with regard to monetary policy. This bill would change that situation, although not so dramatically that the Fed would lose its independence (it’s not clear what the penalty is for any agency failing to live up to a GAO audit, but the Fed would surely get away with even more than the typical government group). Recently, Rep. Barney Frank, who surely is as far along the spectrum away from Ron Paul as any politician can get, voiced support for expanding the GAO’s powers to more thoroughly audit the Fed.

The Fed has pumped billions into financially distressed firms in the last year as part of its effort to revive the economy. These actions clearly fall under the category of monetary policy, not banking regulation, even though most of the money went to banks. Because the Fed traditionally sends more than 95 percent of its revenues to the U.S. government (i.e., it is a source of revenue on the U.S. Treasury budget), any money lost on firms like AIG is truly money spent by the U.S. taxpayer. For that reason, Ron Paul would like to see less of it spent in ways that seem wasteful and bad for the economy in the long run. I suspect that Barney Frank is on board with the plan because he wants some reassurance that the money going to AIG is not being paid out in the form of bonuses to the higher-ups there. 

In contrast, Fed Chair Ben Bernanke would argue that, as part of monetary policy, the Fed, through the FOMC, should be allowed to pursue whatever policies are most helpful toward maintaining price stability and economic growth. He undoubtedly would argue that whatever waste and distaste is associated with AIG, the payoff to society is worth the relatively minor cost. Bernanke believes Americans should trust the Fed chairman to do what is best for the U.S. economy, even if some of it seems illogical or annoys those who want to punish the people who got us into this mess.

Bernanke is right to fight for Fed independence on monetary policy. Determining where the economy is at and how best to maintain low price inflation is a difficult job that is not made any easier by having the public or Congress second-guess the decisions that are ultimately made by the Fed. However, Bernanke’s form of monetary policy involves a tremendous amount of policy that essentially picks winners and losers in the capital markets. By choosing to bail out AIG and not bail out Lehman; by choosing to drag its feet with regard to GM and CIT but to propel Bear Stearns at lightning speed into the arms of JP Morgan Chase; and by choosing to slowly offer assistance at the discount window to insurers but to immediately open it up to investment banks are all decisions that most Americans would rather not leave to Ben Bernanke or any other Fed chairman. These decisions seem capricious and poorly justified in terms of monetary policy and this perception is not at all helped by the e-mails regarding the merger of Bank of America and Merrill Lynch. Either the Fed strictly maintains its independence and avoids bailing out specific institutions or it should expect the people ultimately footing the bill to take notice when several hundred billion dollars are showered on what appear to be worthless ventures.

Tags: Banking, Economic Crisis, Economy, Helwege
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Charged by an Angel

Thursday, August 20th, 2009

The New York Times reports that angel investors are tightening their purse strings during the recession and some are even “levying fees on entrepreneurs for guidance on finance and introductions to sources of capital.”

Smeal’s Anthony Warren, Farrell Clinical Professor of Entrepreneurship, comments:

The belt-tightening in the current economy has spread to so-called angel investors who invest their own money into startup companies. This is making it even harder for entrepreneurs to find money to build their companies. Unfortunately this has spawned a group of intermediaries that promise to “train” entrepreneurs on how to make a pitch to investors and then make introductions. For this, the entrepreneurs pay a fee of perhaps a few thousand dollars out of their already meager funds. And to little end. If you cannot figure out how to make a good pitch and locate and approach possible sources of money, then you are hardly the person to build a successful company in any case. Finding investors and pitching them is your first challenge. Smart entrepreneurs network to narrow their targets to just a few potential investors who are a great fit to their company, and use free resources such Smeal’s IdeaPitch Web site, which provides all an entrepreneur needs to put together the perfect investor pitch.

That is not to say that getting advice is not a good idea. But it is important that the objectives of the entrepreneur and mentors are aligned. This is hardly the case when advisers take a fee just for a meeting. It’s much better for both parties when they have a common  interest in long-term outcomes. This can be through a small investment with a lot of networking provided by the investors. New “micro-equity” programs such as Y Combinator and DreamIt Ventures provide much better opportunities for budding entrepreneurs.

So hold onto your limited funds, use them to “bootstrap” your idea to the first milestone. Then work on your pitch targeted to a narrowly defined investor audience. After all, if you are not the best person to tell your story, then maybe you do not really believe in it yourself.

Tags: Economic Crisis, Entrepreneurship, Warren
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The Case Against Pessimism

Wednesday, August 19th, 2009

The current issue of BusinessWeek makes “The Case for Optimism” in our economy by focusing on positive outcomes, including lower shipping rates and increased metal prices. Another reason to be optimistic? Research by Smeal’s Anthony Kwasnica finds that pessimism in our stock markets may actually be the cause of our struggling economy, rather than just an indicator of it.

Kwasnica says that short-selling and other techniques that reward negative performance communicate pessimism about the economy that can infiltrate the markets and may actually cause economic performance to dip into the negative. 

In the current U.S. economy, with the news media constantly focused on the stock market’s performance, the negative effect of perceptions can do even more damage, according to Kwasnica. As more and more bad news is conveyed by the stock markets, pessimistic beliefs are reinforced over and over again and the markets can make a bad economy worse, and do so quickly.

To get out of this vicious cycle, Kwasnica and his coauthors say there are at least two fixes that are already at work in the U.S. economy now. The first option is to quiet some of the pessimistic views on the economy by disallowing investors to profit from negative predictions that come true. The proposed rules regulating short-selling fall into this category.

The other fix is through leadership. The actions of a highly visible and trusted public leader may convey market confidence and instill optimism in other investors.

“Ultimately, some balance between government intervention and industry leadership must be struck to ease the negativity currently in our markets,” Kwasnica says.

Tags: Economic Crisis, Economy, Finance, Kwasnica
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