A few weeks back (I am catching up on my blogging), the Economist featured a terrific essay on “A History of Finance in Five Crises.” The conclusion of the essay – “successive reforms have tended to insulate investors from risk” and “this pins risk on the public purse … [t]o solve this problem means putting risk back into the private sector” – resonates. However, the Economist makes a few surprising errors of omission in reaching this point.
First, many financial crises occurred without much of a state bailouts or safety net. The Economist starts its history with the Panic of 1792 in the United States. By that point England had already experienced a crisis in the late 1690s and the South Seas Bubble in 1720 and France had suffered through the searing Mississippi Bubble (I discuss all of these in Chapter 2 of my book). The Economist then hopscotches to the Panic of 1825. Roughly every ten years after that, Britain experienced another bubble and crash (also detailed in my book). It is less than clear how government safety nets triggered these crises.
These crises point to a second omission: each of these 19th Century British crises – the Panic of 1825, the Panic of 1837, the Crisis of 1847 (it is a mystery to me what causes some incidents to qualify as a “Panic” and others to be a “Crisis”), the Crisis of 1857, and the Overend Gurney Crisis of 1866 – was preceded by a liberalization of corporate law or an expansion of limited liability for corporate shareholders. Some scholars wax poetic about the “sine curve” of regulation without tracing that back in history. Well, British corporate law (see also Chapter 2 of my book) provides the caffeine for that coffee. This corporate law history has several important implications:
State intervention in financial markets takes other forms than deposit insurance and government bailouts. This intervention often occurs before crises. Indeed, I argue that booming markets and bubbles create strong incentives for interest groups to lobby for, and policymakers to provide, legal changes that further stimulate markets. What I call “regulatory stimulus” goes beyond “deregulation” and includes government subsidies or legal preferences (think bankruptcy exemptions for swaps) for particular markets. It also includes active government investments in markets (think all those state land and money giveaways to 19th Century railways).
Regulatory stimulus in the form of changes to corporate law has particularly powerful effects. The corporate form provides ideal for lobbying for regulatory favors: corporations solve collective action problems by centralizing decision-making and allow managers to lobby with “other people’s money.”
Moreover, as the Economist hints but doesn’t quite hammer home, limited liability can generate moral hazard, which becomes particularly vicious if risk-taking can be externalized onto financial markets and taxpayers.
The Economist’s third omission is the most amusing (at least to nerds like me). The magazine notes that after the Overend Gurney Crisis in 1866, “Britain then enjoyed 50 years of financial calm, a fact that some historians reckon was due to the prudence of a banking sector stripped of moral hazard.” Many economists reckon that these years of calm owe more to the Bank of England finally assuming the mantle of lender of last resort in a banking crisis. The intellectual godfather of this was none other than Walter Bagehot, the legendary editor of the Economist. Perhaps this failure to provide credit where it is due owes to some intellectual Oedipal issues at the journal?
The fourth omission in the essay is perhaps the most unforgivable. The Economist talks about the Great Crash of 1929 without mentioning the critique that the Federal Reserve failed to serve as lender-of-last-resort and pursued a destructive monetary policy at critical junctures. Indeed, these are state interventions that many economists advocate that central banks take in the face of a banking crisis. These state interventions also provide a government safety net that can create moral hazard.
Which leads to the most biting criticism of the Economist piece: letting the economy burn in the wake of a financial crisis is pure but risks being purely destructive. Rather than focusing on unravelling government safety nets for markets, we should be thinking about how to regulate financial firms given their inevitability.
After over four years of work, my book Law, Bubbles, and Financial Regulation came out at the end of 2013. You can read a longer description of the book at the Harvard Corporate Governance blog. Blurbs from Liaquat Ahamed, Michael Barr, Margaret Blair, Frank Partnoy, and Nouriel Roubini are on the Routledge’s web site and the book's Amazon page. The introductory chapter is available for free on ssrn.
Look for a Conglomerate book club on the book on the first week of February!
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As in a bad horror movie (or a great Rolling Stones song), observers of the current crisis may have been disquieted that one of the central characters in this disaster also played a central role in the Enron era. Is it coincidence that special purpose entities (SPEs) were at the core of both the Enron transactions and many of the structured finance deals that fell part in the Panic of 2007-2008?
Bill Bratton (Penn) and Adam Levitin (Georgetown) think not. Bratton and Levin have a really fine new paper out, A Transactional Genealogy of Scandal, that not only draws deep connections between these two episodes, but also traces back the lineage of collateralized debt obligations (CDOs) back to Michael Millken. The paper provides a masterful guided tour of the history of CDOs from the S&L/junk bond era to the innovations of J.P. Morgan through to the Goldman ABACUS deals and the freeze of the asset-backed commercial paper market .
Their account argues that the development of the SPE is the apotheosis of the firm as “nexus of contracts.” These shell companies, after all, are nothing but contracts. This feature, according to Bratton & Levin, allows SPEs to become ideal tools either for deceiving investors or arbitraging financial regulations.
Here is their abstract:
Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together — a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership.
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.
The paper should be on the reading list of scholars in securities and financial institution regulation. The historical account also provides a rich source of material for corporate law scholars engaged in the Theory of the Firm literature.
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Here is a highly productive way for business law professors to procrastinate from grading exams:
The National Bureau of Economic Research just circulated a new version of a paper that provides a medieval complement to the law & finance literature and to Gilson's lawyer as transaction cost engineer idea. The paper by Davide Cantoni and Noam Yuchtman presents evidence that the training of commercial lawyers by new universities contributed to the expansion of economic activity in medieval Germany. Here is the abstract:
We present new data documenting medieval Europe's "Commercial Revolution'' using information on the establishment of markets in Germany. We use these data to test whether medieval universities played a causal role in expanding economic activity, examining the foundation of Germany's first universities after 1386 following the Papal Schism. We find that the trend rate of market establishment breaks upward in 1386 and that this break is greatest where the distance to a university shrank most. There is no differential pre-1386 trend associated with the reduction in distance to a university, and there is no break in trend in 1386 where university proximity did not change. These results are not affected by excluding cities close to universities or cities belonging to territories that included universities. Universities provided training in newly-rediscovered Roman and Canon law; students with legal training served in positions that reduced the uncertainty of trade in medieval Europe. We argue that training in the law, and the consequent development of legal and administrative institutions, was an important channel linking universities and greater economic activity.
A very interesting read.
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Update 12/24: I wrote this post before I learned that Larry Ribstein had fallen ill two days ago. Sadly, Larry passed away early this morning, The University of Illinois press release is here.
I will always be touched by how generous Larry was as a scholar and a person. He reached out to me at a conference several years ago. I was dumbfounded that someone of his stature cared about the scholarship of someone just starting out and someone who didn't share his (occasionally strong) views. I will miss him and know my colleagues here will as well.
When the shock dulls a little, I will share more memories of Larry.
Just in time for the Holidays, the corporate law blogosphere has all lit up. The less-than-festive occasion: a draft paper by John Coffee (not on ssrrn, but I have a copy), in which Coffee, among other things, criticizes Roberta Romano, Stephen Bainbridge, and Larry Ribstein for being members of academic “Tea Party" that has opposed Sarbanes Oxley and other recent federal corporate law reforms. (Posts by Ribstein, Bainbridge, Bodie, Leiter).
Coffee usually doesn’t stain permanently, I don’t like doing laundry, and I know little about civility. So I will make a few questions and observation to switch the discussion to a more productive track. Hopefully, this might focus on some important differences in ideas among a group of scholars who I admire.
The immediate debate about Professor Coffee’s civility is obscuring a big difference between two very different scholarly approaches to the political economy of law and “bubbles.” This is a topic near and dear to me. I’ve written about it before, and am feverishly working to finish a book on the topic before Winter Break ends.
First, two introductory points: One, as I’ve written before, the greatest cost of Sarbanes Oxley and its debate was that it distracted attention from the growing storm of the financial crisis. While scholars and policymakers were debating whether or not that statute was too little, too much, or just right, financial institutions were making decisions that would do far greater and more lasting damage to the competitiveness of U.S. capital markets than anything SOX did.
Two, I have yet to be convinced that corporate governance was a first order cause of the crisis or that fixing corporate governance should be a first-order response. The crisis was about financial institutions, not corporations generally. Instead of focusing on executive pay at the Caterpillars of the corporate world or the board composition at Google, we should be worried about the leverage of the Bank of Americas and risk concentrations at the BONYs. Even if corporate governance played a role,it's financial institutions, smarty.
Now onto the main course… I do think there is an important difference in focus between Coffee on the one hand, and Romano, Bainbridge, and Ribstein on the other. The latter group has labeled SOX as an example of mis-regulation after financial crises and asset price bubbles. For example, Ribstein, in an article I enjoyed quite a bit, includes SOX in a history of “bubble laws.”
Even if you disagree with Ribstein, Romano and Bainbridge with respect to SOX, there is a long history of misguided legal responses to financial crises and bubbles. Some of this legal history is downright ugly. For example, the collapse of one of the first stock market bubbles, that of England in the 1690s, led to restriction on the number of Jewish stock brokers in the City of London. (See my article, p. 406, n. 74.) (As a footnote, the infamous “Bubble Act,” by which Parliament imposed legal restrictions on the formation of new joint stock companies, was not technically a response to a collapsed bubble. In fact, it was passed at the urging of insiders of the notorious “South Seas Company” before the collapse of the eponymous bubble. The law was an attempt to prevent competitors from entering English capital markets (see that same paper, p. 408)).
However, the focus on legal reactions in the wake of bubbles is only half the historical and political economy story. The criticism of bubble laws misses the ways in which legal change contributed to the formation of bubbles and financial crises. By legal change, I mean more than just deregulation, but also under-enforcement of laws and, in many cases, government subsidization of booming asset markets.
One way governments provide these subsidies is by granting legal monopolies to certain investment ventures. These monopolies are intended stimulate financial investment, foreign trade or the development of certain industries. In my book, I am tracing this practice from the royal charters in the South Seas and French Mississippi bubbles all the way to Freddie and Fannie in the present day. Corporate governance can and has been a part of the bubbles, just not in the way the SOX debate suggests. Indeed, it can be helpful in looking at history to see corporate law as an important tool (albeit a crude one, often used to dangerous effect) in the greater set of financial market regulations. Corporate law and corporate monopolies have been used to stimulate markets. The problem is that it is hard to pull away the punch when the party gets rockin’.
The focus on bubble laws misses the contribution of laws to bubble formation. By contrast, Coffee, in the disputed paper, provides an analysis of the political economy of financial regulation pre-crisis. However, his analysis is too spare. It focuses on Mancur Olson’s writings and leaves out the broader spectrum of theories – public choice and otherwise – that attempt to explain regulation and deregulation of financial markets and otherwise. It also misses the fact that law and regulation can stimulate markets beyond just deregulation and rollback. I argue that governments also subsidize have a history and incentive to provide excessive subsidies to particular financial markets, through corporate law and otherwise.
Coffee seems to miss the government subsidy story and the potential for misregulation. By contrast, Romano and Ribstein focus on the risk of legal overreaction to bubbles, but do not focus on the perverse political incentives to deregulate or stimulate financial markets during boom times.
I’ll save my analysis of this political economy of law and bubbles for another day. The story or regulation and bubbles I am writing doesn’t fit into neat political boxes in which de-regulation or re-regulation alone is to blame. Like cloying good cheer at this wintry time of year, there is plenty of blame to go around and provoke (if not inflame).
Our frequent guest, Anna Gelpern, and the editors of the new American University Business Law Review have put together a great conference on financial reform this coming Friday, April 8th in the nation’s capital. The conference theme is “Law, Finance, and Legitimacy after Financial Reform.”
You can register here.
Here are some of the highlights. The lunch will feature as keynote speaker Brooksley Born, former Chair of the Commodity Futures Trading Commission and member of the Financial Crisis Inquiry Commission.
The conference will also feature three scholarly panels:
Panel #1 – REGULATION OF FINANCE: Presentations will focus on Dodd-Frank’s living will provisions, transparency in financial regulation, and a retrospective look at the Panic of 1873.
Presenters: Adam Feibelman (Tulane University), Caroline Bradley (University of Miami), Arthur Wilmarth (George Washington University), Erik Gerding (University of New Mexico) Panelists: Melissa Jacoby (University of North Carolina), Mehrsa Baradaran (Brigham Young University), Daniel Schwarcz (University of Minnesota)
Panel #2 – FINANCIAL REGULATION AND LEGITIMACY: Presentations will focus on loopholes in legislation, regulation of information quality, important truths of Too Big To Fail, and the regulation of risk management strategies.
Presenters: Brett McDonnell (University of Minnesota), Richard Painter and Claire Hill (University of Minnesota), Onnig Dombalagian (Tulane University), Kristin Johnson (Seton Hall University) Panelists: Jose Gabilondo (Florida International University), Peter Conti-Brown (Rock Center for Corporate Governance at Stanford University), Lisa Fairfax (George Washington University)
Panel #3 – FINANCIAL REFORM POLICY ROUNDTABLE DISCUSSION
Panelists: Eric Pan (Cardozo University, Securities and Exchange Commission), Saule Omarova (University of North Carolina), Heidi Schooner (Catholic University), Chris Brummer (Georgetown University).
I'm looking forward to hearing the presentations. I'll also be presenting on the legal history of the Crisis of 1873 in Germany, Austria, and the United States. If you are there, come say hello. We'll have great fun saying Gruenderboom and Gruenderkrach!
When Rosa Parks declined the bus driver's "invitation" to move to the back of the bus, she was arrested. Today, she died at age 92.
Rosa Parks was 42 years old -- exactly my age -- when she defied the law requiring blacks to yield their seats to whites, triggering a boycott of the Montgomery, Alabama bus system. She was not the first to take such a stand, and she would not be the last, but she was the most famous because Martin Luther King, Jr. used her case as a rallying point for the bus boycott.
The laws that Parks was protesting are startling to the modern eye. Here is a city ordinance of Montgomery that was declared unconstitutional by the United States Supreme Court in 1956:
Every person operating a bus line in the city shall provide equal but separate accommodations for white people and negroes on his buses, by requiring the employees in charge thereof to assign passengers seats on the vehicles under their charge in such manner as to separate the white people from the negroes, where there are both white and negroes on the same car; provided, however, that negro nurses having in charge white children or sick or infirm white persons, may be assigned seats among white people
In a challenge to this ordinance (not brought by Parks), the lower court (a three-judge district court panel) held unconstitutional this ordinance and the Alabama statutes that authorized it on grounds that they violated the due process and equal protection of the law clauses of the Fourteenth Amendment to the Constitution. The dissenting opinion argued for a continuing place in American constitutional jurisprudence for the doctrine of "separate but equal":
If that doctrine has any vitality, this is such a case in which it has been applied fairly. According to its teaching not absolute, but substantial equality is required. Such equality is not a question of dogma, but one of fact. Under the undisputed evidence adduced upon the hearing before us practices under the laws here attacked have resulted in providing the races not only substantially equal but in truth identical facilities
The Supreme Court affirmed the majority opinion in the lower court with this per curium opinion:
The motion to affirm is granted and the judgment is affirmed. Brown v. Board of Education, 347 U.S. 483, 74 S.Ct. 686, 98 L.Ed. 873; Mayor and City Council of Baltimore v. Dawson, 350 U.S. 877, 76 S.Ct. 133; Holmes v. Atlanta, 350 U.S. 879, 76 S.Ct. 141.
I have often wondered about this photo. It is obviously staged, but who is the white man behind Parks? I am assuming that the photo was taken after the Montgomery ordinance was declared unconstitutional, but is there a story behind this photo?
One last tidbit: Did you know that Rosa Parks' name is mentioned only once among Supreme Court decisions: In the case of LaFace Records v. Parks, 540 U.S. 1074, 124 S.Ct. 925 (2003), the record company for the hip hop group Outkast petitioned the Supreme Court for a writ of certiorari from a decision of the 6th Circuit Court of Appeals. The dispute revolved around Outkast's song entitled "Rosa Parks," which Parks argued was a violation of her rights under the Lanham Act and under the common law right of publicity. The Court of Appeals sided with Parks on these two issues, and the Supreme Court denied the petition. The case settled.
James Lindgren spoke to the Federalist Society at the University of Wisconsin today about his extensive work debunking the claims contained in Michael Bellesiles’s Arming America: The Origins of a National Gun Culture. Jim's law review article on the subject is here, and there is no shortage of stories in the popular press.
The debate is about levels of gun ownership in early America. I don't spend much time on guns, and I was only vaguely aware of the controversy. But even if this isn't your bailiwick, I think you would find Jim's story simultaneously compelling and horrifying.
Here is the abstract from his law review article:
Probate inventories, though perhaps the best prevailing source for determining ownership patterns in early America, are incomplete and fallible. In this Article, the authors suggest that inferences about who owned guns can be improved by using multivariate techniques and control variables of other common objects. To determine gun ownership from probate inventories, the authors examine three databases in detail—Alice Hanson Jones’s national sample of 919 inventories (1774), 149 inventories from Providence,1778 WILLIAM AND MARY LAW REVIEW [Vol. 43:1777 Rhode Island (1679-1726), and Gunston Hall Plantation’s sample of 325 inventories from Maryland and Virginia (1740-1810). Also discussed are a sample of 59 probate inventories from Essex County, Massachusetts (1636-1650), Gloria L. Main’s study of 604 Maryland estates (1657-1719), Anna Hawley’s study of 221 Surry County, Virginia estates (1690-1715), a sample of 289 male inventories from Vermont (1773-1790), and Judith A. McGaw’s study of 250 estates in New Jersey and Pennsylvania (1714-1789). Guns are found in 50-73% of the male estates in each of the eight databases and in 6-38% of the female estates in each of the first four databases.
Gun ownership is particularly high compared to other common items. For example, in 813 itemized male inventories from the 1774 Jones national database, guns are listed in 54% of estates, compared to only 30% of estates listing any cash, 14% listing swords or edged weapons, 25% listing Bibles, 62% listing any book, and 79% listing any clothes. Using hierarchical loglinear modeling, the authors show that guns are more common in early American inventories where the decedent was male, Southern, rural, slave-owning, or above the lowest social class—or where the inventories were more detailed.
The picture of gun ownership that emerges from these analyses substantially contradicts the assertions of Michael Bellesiles in Arming America: The Origins of a National Gun Culture (Arming America). Contrary to Arming America’s claims about probate inventories in seventeenth and eighteenth-century America, there were high numbers of guns, guns were much more common than swords or other edged weapons, women in 1774 owned guns at rates (18%) higher than Bellesiles claimed men did in 1765-1790 (14.7%), and 87-91% of gun-owning estates listed at least one gun that was not old or broken. The authors replicated portions of Bellesiles’s published study in which he both counted guns in probate inventories and cited sources containing inventories. They conclude that Bellesiles appears to have substantially misrecorded the seventeenth and eighteenth century probate data he presents. For the Providence probate data (1679-1726), Bellesiles has misclassified over 60% of the inventories he examined. He repeatedly counted women as men, counted about a hundred wills that never existed, and claimed that the inventories evaluated more than half of the guns as old or broken when fewer 2002] COUNTING GUNS IN EARLY AMERICA 1779 than 10% were so listed. Nationally, for the 1765-1790 period, the average percentage of estates listing guns that Bellesiles reports (14.7%) is not mathematically possible, given the regional averages he reports and known minimum sample sizes. Last, an archive of probate inventories from San Francisco in which Bellesiles claims to have counted guns apparently does not exist. By all accounts, the entire archive before 1860 was destroyed in the San Francisco earthquake and subsequent fire of 1906. Neither part of his study of seventeenth and eighteenth-century probate data is replicable, nor is his study of probate data from the 1840s and 1850s. (emphasis added)
In light of the stories Jim told at his presentation today, the highlighted portion of the abstract seems quite charitable. Over a period of several years, evidence of academic fraud or gross incompetence accumulated, resulting in Bellesiles' resignation from Emory University.
I found two aspects of this story particularly troubling. The first was the manner in which professional historians circled the wagons around Bellesiles when the evidence of problems first emerged. The root problem is that no one who was defending Bellesiles had checked his sources. Those who had checked the sources (Jim and some others) were the people crying foul. For all of the criticism leveled against student-edited law journals, they at least provide that check.
Second, if Jim's reports are accurate, the media stumbled badly on this, sometimes out of an abundance of caution, and other times for what appears to be political motivation. (Bellesiles' book was seen as useful to anti-gun activists.) An interesting detail from this aspect of the story is that Ana Marie Cox (i.e., Wonkette) was working on a story about Bellesiles' book for The Chronicle of Higher Education. After interviewing Jim, she became convinced that the book had problems. Wonkette was ultimately fired from the Chronicle, and Jim suggested a possible connection between that event and this story. [Jim gives "the rest of the story" in his own post at Volokh Conspiracy.]
UPDATE: Jim menioned that Glenn Reynolds was on this story from the beginning. Was he ever! Here is list of Instapundit posts with the word "Bellesiles," dating back to April 17, 2002. In one recent post, Glenn takes professional historians to task for their disdain of legal scholarship. Worth the read.
UPDATE 2: Ann Althouse was also at the talk, and she blogs it here.
UPDATE 3: Welcome Instapundit readers! Feel free to look around. We have a lot of stuff here that might interest you.