Last month, the Glom hosted a book club for Bethany McLean and Joe Nocera's new book, All the Devils are Here.  Today, McLean has an insightful editorial in the NYT on the 30-year mortgage.  No one seems to be supporting Fannie Mae and Freddie Mac, and all seem to call for the end of government guarantees of residential mortgages.  However, MacLean points out that ending government guarantees will almost certainly end the ubiquitousness of the 30-year mortgage.  Investors will not want a piece of an unguaranteed residential mortgage that carries the risk that the homeowner will be creditworthy, and the interest rate profitable, for three decades.

Of course, these long-term mortgages wouldn't dry up overnight, but they would only be available to the most creditworthy borrowers, who are willing to make large down payments, at a higher interest rate.  So, what would that mean?  Are we ready to go back to a world where folks have to save more than a few years for a down payment?  Where we have neighborhoods that are filled with owners and renters, instead of owners with substantial equity and owners with very little equity?  Will this make a difference?  We have preached the saving grace of home ownership for so long now it's hard to imagine middle America without the 30-year home mortgage.

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If you are in San Francisco for the AALS Meeting in 2 weeks, check out the AALS Insurance Law Section's program on behavioral economics and Insurance regulation on Saturday, January 8th from 10:30 AM-12:15 PM in the Hilton. Daniel Schwarcz (Minnesota) will be moderating the following panel:

Tom Baker (University of Pennsylvania Law School);

Michelle E. Boardman (George Mason University School of Law);

Russell Korobkin (University of California, Los Angeles School of Law);

Joshua C. Teitelbaum (Georgetown University Law Center)

As an editorial aside, there is still much good work to be done in the application of behavioral economics to law, particularly as this field grows out of its adolescence.  We are past the stage of whether behavioral biases and cognitive limitations affect individual decision-making and moving to much more difficult questions such as: which of the laundry list of biases is at work on any given decision?  When and to what extent does a particular bias affect a particular decision?  How do different groups of inviduals exhibit different biases?  The low hanging fruit has been picked clean.  There are lots of data in all sorts of fields showing anomalies inconsistent with rational actor models.  But the challenge is now to move beyond speculating that a particular bias causes the anomaly and then proposing a policy remedy towards providing clearer links between particular biases and particular changes in behavior.  If the easy pickings are gone, there is still a lot of ripe fruit higher up in the tree.  Check out this section meeting!

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The efficient markets hypothesis has come under heavy attack in the last couple of years.  For defenders of EMH, the fallback position appears to be that, even though the theory may not be technically correct, it is the best approximation of market behavior.  The implication is, therefore, that it is still a useful descriptive tool.

I’m not sure this position is sustainable, however.  EMH says that stock prices are right—not in some absolute metaphysical sense, but at least in that they represent society’s best guess based on available information.  Behavioral finance scholars point out, however, that there are ubiquitous limits to arbitrage that stand in the way of the market reaching this happy equilibrium. 

We can’t, therefore, merely look at a stock’s price and assume it is accurate.  What behavioral finance tells us is that what we see is the result of the interaction of a complex set of factors.  A better description of market prices, therefore, may be that they are inaccurate, with the extent of the inaccuracy (anywhere from mild to wild) being a function of how constraints to arbitrage are interacting with and influencing market trading at any given time.  

On a related point, even if EMH were correct, I think its usefulness can be questioned.  EMH claims that stock prices represent society’s best guess based on available information.  But what does that tell us?  Nassim Taleb’s work would suggest not very much.  Today’s stock prices are based on predictions of future events, specifically how future events will impact corporate profits and dividends.  But if the future is dictated by “black swans” that are unpredictable a priori, then stock prices can only be accurate in an impoverished sense of the word.  And even if we are not fully convinced by the black-swan metaphor, it still stands to reason that even if stock prices were rational, they would merely represent guesses regarding a cloudy future. 

Most broadly, what all of this suggests is that we should adopt a more modest and skeptical view of market prices, rather than casually assuming market perfectionism.

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Too Big to Fail.

Bailouts of megabanks preserved our financial system-for better and for worse. Next time around, Dodd-Frank allows winding down of big firms that cause systemic threats.  But as I far as I can tell, the Act doesn’t require any liquidations—it’s up to the Treasury Secretary to decide whether to appoint the FDIC as receiver, (and up to the FDIC to pass the actual rules ).  So it’s not clear whether there will be political courage to use this power in a future crisis; likely there will be bailouts again. 

The obvious solution to the too-big-to-fail problem is to start breaking up the too-big ones that almost failed last time, and to prevent any more from getting that big.  Then we can see a little creative destruction now and again.  [How to do it?  Luckily, I don’t have to bother with that part, since this forum is about the next two years and this is so not going to happen any time soon (if ever).]

Monetary policy: [Yes, I know this is mostly Fed policy, not legislative]

 One has to wonder: the economy almost self-destructed because of easy credit, and the solution is…to ease up on credit? 

I understand, and generally sympathize with, demand-side economics, and it may be the only way to mitigate the current pain of job losses.  And I find it hard to believe there’s currently a real danger of inflation in the near term (those who claim to be worried about these days are probably most concerned about bond prices).  But in the longer term, economic growth based entirely on expanding domestic demand seems like a snake eating its own tail.  Is it prudish--or radical--to suggest there’s something wrong with our culture of consumption?   If it needs fixing, punishing savings with low/negative interest rates ain’t the way to start.  I don’t profess to have a palatable alternative.  Maybe that’s the point—it’s time to take the nasty medicine….But I have tenure, so it’s too easy for me to say that. 

 Do nothing:

Looks like I'm not the only wishing I'd written Dave Hoffman’s post, but since he got there first, let me polish the apple a bit: Instead of passing new laws, how about actually enforcing the laws already on the books?    Oh, yeah, enforcement is the job of the executive branch.  Then how about Congress just refrains from obstructing the enforcement of the ones it just passed?  [Edit: Underbelly has more juicy stuff on this.] Just a thought.

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I'm a bit late to this, but this speech by World Bank head Robert Zoellick, a lawyer, ripping into the applicability of economic research to development is pretty interesting.  He's even unsure that randomized controlled trials, the current gold standard, is scalable enough to be useful.  Why is the head of the World Bank denouncing economics?

I am not an economist. Enough said, you may argue. Why meddle? Why open such a Pandora’s Box? For the simple reason that policymakers look to economics, and policymakers in developing countries look to development economics even more. It matters.

Anyway, he wants to make the data collected by the bank, and the tools developed by it, much more open source, which would appeal, presumably, to open source zealots like Yochai Benkler and Matt Bodie.  And he even says that, given that every fast developing country has pushed industrial policy pretty far, that maybe we ought to look again at that bugaboo of free market enthusiasts.  Dani Rodrik is impressed.

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EconTalk is one of the best podcasts going, and the latest edition features a fascinating interview with David Kennedy of Stanford, talking about the New Deal and the Great Depression. Those who are inclined to compare our present circumstances to those in the 1930s should take a dose of caution from Kennedy and EconTalk host, Russ Roberts, who complexify those comparisons in helpful ways.

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While we're blithely looking at rankings, you might be interested in this top young economist list over at IDEAS.  You've probably heard that the graduate programs are increasingly international, and that is reflected in the rankings, but to this casual empiricist, the interesting thing is the sort of international that they are.  I could be missing something, but these people largely seem like they are from one continent: Europe.  Most of them teach here of course.  And some of those Marcs and Michaels might be Americans. But you rarely hear about Old European economic puissance over our own domestics and the young tigers of East Asia and the Middle East.  Maybe you should be.  Anywhere, here's the top 25 to whet your appetite:

Rank	Score	Year	Author
1.	3.05	2002	Marc J. Melitz
2.	3.7	2001	Ricardo Reis
3.	5.87	2001	Urs Fischbacher
4.	6.97	2002	Esteban Rossi-Hansberg
5.	7.99	2001	Monika Piazzesi
6.	9.08	2003	Raj Chetty
7.	9.64	2001	Matthias Doepke
8.	11.12	2001	Jean Boivin
9.	12.27	2002	Marc P. Giannoni
10.	15.2	2001	Axel Dreher
11.	15.3	2001	Jesus Fernandez-Villaverde
12.	16.16	2002	Benno Torgler
13.	17.28	2004	Ben Jann
14.	17.3	2002	Thomas Lubik
15.	17.7	2001	Michael Golosov
16.	18.01	2001	Chad Syverson
17.	18.2	2002	David Malin Roodman
18.	18.66	2002	Noah Williams
19.	19.21	2001	Juan F Rubio-Ramirez
20.	19.85	2002	Pedro Carneiro
21.	20.04	2003	Paresh Kumar Narayan
22.	21.53	2001	Hanming Fang
23.	23.43	2001	Mark Aguiar
24.	24.13	2004	Dean S. Karlan
25.	24.87	2001	Francesco Trebbi

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Or a "puzzler"?

Hayek was a puzzler. Or, if you prefer, a "muddler." 

I am, too.

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I thought I would revisit a post I wrote in November on two types of credit derivatives, because it may prove to be a useful way of thinking about how to regulate CDOs, synthetic CDOs, and credit derivatives generally.

We shouldn’t lump all of these complex financial products together. They can have very different values to society and pose radically different kinds of costs. The key distinction is whether at least one of the parties is using the transaction to hedge and existing credit risk – or whether neither party has a pre-existing risk and the financial instrument is a pure bet.

Pure bets have no net social value but no net social cost with a very big EXCEPT

Pure bets have no social value because they are zero sum games. Except one party may default on its obligations. One reason it may default is because it made too many bad bets and may go insolvent. If it defaults, it may cause a chain reaction of defaults by other parties. Fanciful theory? Well domino risk from credit derivatives this is the reason the government gave for bailing out AIG.

If these bets have no social benefit and possible risks, the obvious solution is to do away with them. Lynn Stout (UCLA) who has been analyzing this type of pure bet derivative for years, has argued for a return to the old common law rule that these bets are not enforceable contracts because neither party has an insurable interest. In other words, courts would refuse to enforce pure gambles. She recently reframed this proposal as “regulate derivatives by deregulating them.”

Hedging risk is great…

For hedges, when one of the party is using a derivative to hedge a pre-existing risk, the financial instrument may indeed have great social value in allowing risk to be reallocated and spread efficiently. Mortgage-backed securities and traditional “cash” CDOs perform this same risk spreading function. Credit derivatives, mortgage backed securities and CDOs also allow credit to be funneled from investors back to borrowers. If a party holding bonds or loans can either hedge the credit risk with a credit derivative or sell part of the bonds or loans in a securitization, it can take the money and re-invest or re-lend. That extra money can make its way back to borrowers like home buyers.

…except when it’s not: manufacturing leverage and printing money

So if these derivatives may have social value, what's the cost? Well they may have the same counterparty and mispricing risk of the pure bets. But they also pose another kind of danger of injecting too much liquidity and leverage into the entire market. An investor can use credit to purchase a CDO bond. And a credit derivative counterparty may need to set aside only a fraction of its potential obligations (post collateral) – which is also a form of leverage. Higher leverage means higher potential returns in good times and higher losses in bad.

With increased leverage, more money is funneled back to borrowers. This can increase the effective supply of money and cause a boom in asset prices. Essentially, the network of securitization and credit derivatives – what is called the “shadow banking system” – effectively printed more Monopoly money that could be used to buy Park Place. In turn, booming asset prices can raise the value of collateral for loans and lead to more leverage. Margaret Blair and I wrote a short piece last summer that included a brief explanation of how this second type of credit derivative can increase system-wide leverage.

So hedges need some regulation too beyond just dealing with massive counterparty risk and the risk of falling dominoes. Controlling excessive leverage is the problem.

Synthetic CDOs

The CDO at the heart of the Goldman suit was a special kind of CDO called a synthetic CDO. That means instead of the investment vehicle purchasing bonds or securities, it entered into credit derivatives that would pay out as if the investment vehicle actually held bonds. It was a pure bet. So it didn’t necessarily increase overall leverage in the economy or help pump up housing prices. It didn’t have any social value though other than giving us all an opportunity to fight over fraud, which is something we desperately need.

Full employment for securities lawyers!

Could a party use a synthetic CDO to hedge actual risk? Theoretically yes, but that is not likely to happen. For one thing, there are much simpler ways to hedge risk – like entering into a simple credit default swap, buying bond insurance, or selling interests in the bonds or mortgages you own. According to media accounts, Paulson & Co. was looking to create new synthetic CDOs but because it couldn’t find enough ways to short mortgage-backed securities.

Addenda: 

1.  Per a comment from John Walker below, I should clarify that Professor Stout is focusing on an insurable interest requirement only for OTC derivatives.

2.  Professor Bartlett provides an example of an early synthetic CDO product created by JP Morgan in which banks hedged at least some risk in their portfolio.  It looks like this product was largely designed to help banks arbitrage regulatory capital requirements. This potential purpose should be a another big concern with using credit derivatives. This arbitrage can undermine the effectiveness of capital requirements and can lead us into a false sense of security that financial institution leverage is limited.
So to the extent credit risk was being hedged, this JP Morgan product would fall under my second category of credit derivative. And then we have to worry about its effect on injecting leverage in financial markets.  It is also interesting to see another example of a product that had early, even arguably beneficial use, evolve into the device in the Goldman case.

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In thinking about ways to integrate the financial crisis into the basic business associations course, the topic that keeps coming to mind is the Efficient Market Hypothesis (EMH). What does the recent financial crisis tell us about EMH? And what are the implications of our newfound knowledge on market regulation?

Inspired by my Markopolos post, Glom friend Darren Roulstone has nudged me in the direction of some answers, courtesy of a recently published paper by Ray Ball of the University of Chicago entitled, The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned? This short paper provides an excellent description of the insights and limitations of EMH, but for present purposes, I am most interested in the implications of EMH for market regulation.

Ball begins with the emerging conventional wisdom on efficient markets:

The reasoning boils down to this: swayed by the notion that market prices reflect all available information, investors and regulators felt too little need to look into and verify the true values of publicly traded securities, and so failed to detect an asset price “bubble.”

As applied to investors, the argument is silly. As applied to regulators ... well, that's not so obvious. Back to Ball:

The crisis has prompted many to conclude that financial regulators were excessively lax in their market supervision, due to a mistaken belief in the EMH. This conclusion is made explicit in the UK’s Turner Review. Perhaps not surprisingly, the report advocates more regulation. It reasons as follows:

The predominant assumption behind financial market regulation—in the US, the UK and increasingly across the world—has been that financial markets are capable of being both efficient and rational and that a key goal of financial market regulation is to remove the impediments which might produce inefficient and illiquid markets…. In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism.

This characterization of what the EMH implies for regulators makes sense in one respect. If the market does a good job of incorporating public information in prices, regulators can focus more on ensuring an adequate flow of reliable information to the public, and less on holding investors’ hands. Consistent with this view, in recent decades there does appear to have been increased emphasis by regulatory bodies worldwide on ensuring adequate and fair public disclosure.

Otherwise, the characterization of the role of the EMH in the crisis falls short of the mark. If regulators had been true believers in efficiency, they would have been considerably more skeptical about some of the consistently high returns being reported by various financial institutions. If the capital market is fiercely competitive, there is a good chance that high returns are attributable to high leverage, high risk, inside information, or dishonest accounting. True believers in efficiency would have looked more closely at the leverage and risk-taking positions of Lehman Brothers, Bear Sterns, AIG, Freddie Mac and Fannie Mae, and banks and investment banks generally. They might have questioned the source of the trading profits of hedge funds like Galleon, and discovered some using inside information. And they would have been exceptionally skeptical of the surreally high and stable returns reported over an extended period by Bernie Madoff.

Nifty argument. The problem wasn't that regulators believed too much in EMH. The problem was that they didn't believe it enough! 

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The New Yorker has an interesting piece on budget protests at Berkeley.  One lingering question from the article: why don't the protestors spend more time marching on Sacramento and less picketing the Chancellor's office?  It may be more convenient to walk across campus, but how much blood can a university administration wring from the stone the legislature gives them?  If the charge is that the UC leadership isn't making a good enough case in Sacramento, no one can do that better than students and parents.

The problem is that if you march on the legislature, you also have to confront the naked fact that universities are competing for dollars with other good claimants - like K-12 education.

This brings to mind two types of characters and arguments that you are all probably intimately familiar with no matter what kind of organization you work in.

First are the romantics who think that budget woes are simply a mirage or even a theater in which a battle between good and evil will play out.  Romantics don't want to hear about scarce resources and opportunity costs.  Or they will talk about how the pie can always get larger.  Most of us academics are by nature romantics.  Otherwise we never would have foregone private sector salaries for the joyless task of grading.

On the other hand. some administrators will trot out the simple "there isn't money in the budget" argument over and over again.  This obscures the fact that there is almost always some money in the budget, with the real question being how it will be allocated.

Institutions can find more money too, but that can have consequences.  Donors, even if they can be squeezed in a tight economy, may want strings -- a point the New Yorker article demonstrates.  And the last three years should have taught us all a chilling lesson that incurring debt is never a free ride.  Taxes can be raised, but no one ever wants to talk about that.  Of course, there are significant costs of higher taxes too.

Ultimately, budgets for any institution are about tough value choices.  Which sometimes makes for good political theater and sometimes not.

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Here's a fascinating interview with Niall Ferguson. I was particularly interested in his comments a la Douglass North crediting the rule of law with the success of Western economic powers and asserting that China must fundamentally change its legal system or fail. It's not a novel point, but it sounds wonderful in Ferguson's accent. If you don't have time for the whole thing, start at 19:07.

Via Paul Kedrosky.

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So begins an article that mainly focuses on the following facts:  (1) donating one's own plasma in return for being compensated (for one's time) is legal in the U.S.; (2) mostly people who need the money donate plasma (other people donate blood for free or don't donate any blood product); (3) companies who use plasma to create helpful and pricey medical products know this and so locate plasma collection centers near poor people, including near the U.S.-Mexico border; (4) because of the economic downturn, more people are donating plasma for compensation. 

However, nowhere in the article is there any suggestion that because companies compensate plasma donors, the plasma supply is unsafe.  There is a comparison with free blood donations:  one argument for not compensating blood donors is that we don't want them to lie about their medical history to donate -- so the blood received is theoretically cleaner than if we induced people to donate blood.  However, plasma donations are screened more carefully (which blood centers apparently don't have the manpower to do) and seem to be able to be "cleaned."  The only other connection of the facts to the headline is these two sentences, which stand alone: 

Away from the border as well, many plasma collection centers have historically been located in areas of extreme poverty, some with high drug abuse. That troubles some people, who say it might contaminate the plasma supply or the health of people who sell their plasma.

The "some people" could not be reached for comment.  Also, it's not just the poor drug users who may be tainting the blood supply.   The author, without quoting anyone or citing anything, states "One issue is whether novel pathogens that perhaps are found in Mexico but not in the United States might enter the plasma supply. "  The words "perhaps" and "might" appear here more than in a first-year law school exam.

What seems to bother the author is not the state of safety in the plasma supply, which the author spends almost no time investigating.  What bothers the author is that people can sell their plasma for money, which repels him.  Even though plasma regenerates, he hates it.  I'm sure he feels sorry for Jo March when she cuts her hair off to earn desparately needed money for her family and would have preferred that Jo and her sisters starve with their long hair intact.  However, the plasma donors seem happy that this option is available to them.  That author suggests that donating plasma may in fact be harmful to the donors, again without any type of factual support: 

Some Americans have been giving plasma this way as often as twice a week for decades, with no apparent ill effects. But there have not been many studies devised to detect long-term effects.

Another thing that seems to bother the author is that the companies that purchase the plasma make a lot of money from turning it into medical products. We are told that a $30 donation can create $300 worth of medicine. We are supposed to be shocked that donors don't share in more of the revenue, even though we have no idea what the cost is to turn ordinary plasma into life-saving medicine. But, companies that do this are becoming successful, having IPOs, and enriching venture capital funds. So, there's obviously a problem here.  The author also seems upset that because plasma-related products are so expensive, sometimes insurance companies balk at paying for them, even though they are useful.  And making it illegal to compensate plasma donors will surely help that problem.

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Sunday's Washington Post's had a story about the "unbanked" and "underbanked."  You are considered unbanked if you don't have a checking or savings account, while you are underbanked if you have a checking or savings account, but rely on non-bank alternative financial services such as check-cashing services, payday loans, or pawnshops.  The story noted that the FDIC had conducted the most comprehensive survey to date on the unbanked and underbanked, and the survey found, among other things, that 17 million Americans are unbanked and 43 million are underbanked.  Hence, the Washington Post story noted that some 60 million Americans "conduct their day-to day financial business outside the banking system."  The story concluded that the survey was a good first step in shedding light on a problem that consumer advocates have been trying to address for years, particularly because the problem leaves many people potentially open to being preyed upon by institutions that charge high interest rates and fees for their services.  Indeed, the FDIC met this month to discuss the results of the survey, noting that information from the survey would help broaden consumers' access to the financial mainstream.  While I found the story interesting and its bottom line essentially non-controversial, the comments to the story seemed to differ dramatically, raising at least two criticisms.

The first seemed to be along the lines of the cure being worse than the disease.  That is, a lot of comments noted that criticism of alternative financial services may be unwarranted or at least unduly harsh.  This is because while those services may charge high fees and interest rates, they also may prove beneficial for some consumers.  Indeed, even the survey noted that consumers steer clear of banks often because of issues associated with fund availability and preferable services.  Hence the survey noted that efforts needed to be made to create opportunities for banks to better serve these markets "both profitably and effectively."  The survey also noted that consumers cited high fees and other penalties as some of the primary reasons why banking services were less attractive.  To be sure, the Washington Post story seems to recognize this problem, noting that the current crisis has demonstrated that "the traditional banking system can be as abusive as the non-bank financial institutions." 

The second set of criticisms seemed to focus on the problem of unintended consequences.  That is, many seemed concerned about history repeating itself in the form of government attempts to incentive banks to support the underserved.

In the end, I think the comments suggest that while the survey may have important aims of providing more information about the unbanked and underbanked population and ensuring that more consumers have access to effective banking products, those comments also remind us that we need to proceed with caution.

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I was talking about conglomeration (horizontal integration) today in class ... then returned to my email to find Steve Bainbridge's post describing differences between horizontal and vertical integration. Inspired by this W$J article, Steve wonders whether recent moves toward vertical integration mean that George Geis was wrong about outsourcing or whether outsourcing is a management fad. 

My impressionistic take, for what it's worth: George was right about outsourcing, and outsourcing is not a fad. Outsourcing still makes sense in some contexts. As noted in the W$J article:

In the past two years, Boeing bought a factory and a 50% stake in a joint venture that make parts for its troubled 787 Dreamliner jet. The moves partially reversed Boeing's aggressive outsourcing strategy to assemble the Dreamliner from parts made by hundreds of suppliers. Supply and assembly problems have knocked the Dreamliner more than two years behind schedule. Boeing CEO Jim McNerney says the company is still committed to outsourcing.

I don't see any reason to privilege one form of organization over the other in all circumstances. Even if transaction costs were the only motivator of organizational structure -- or perhaps I should say, especially if transaction costs were the only motivator of organizational structure -- we would still expect some institutional diversity to account for different frictions in different contexts.

Oh, and just in case you forgot, transaction costs are not the only motivator of organizational structure.

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