Business Law Prof Blog

Mises Vesus Keynes: And the Winner Is Politics

The current economic crisis has the two schools of economic theory, one associated with Keynes and the other with Von Mises, at odds over the cause and cure.  Mises would blame government expansion of credit for the boom and recommend that government stop intervening and let the market readjust for the cure.  Keynes would blame private risk taking and recommend that the government stimulate the markets with spending and lending.  What recent events have shown is that Mises failed to take into account politics -- the need for politicians to do something in a crisis.  With the illusion of control, Keynes theory will usually win in a crisis -- as it currently has.

Suing Auditors

The Madoff mess will test the limits of suits against auditors.  Madoff's auditor, an obscure three person firm run out of a strip mall, is not likely to have much cash.  Lawyers are not suing the auditors of fund of funds managers that sent individual investors to Madoff.  The auditors of the intermediaries should have, apparently, warned the intermediaries of the shaky auditing of Madoff.  The suits are novel and a stretch. Madoff's auditor suffers from a classic auditor's conflict, trying to keep a client happy and, at the same time, performing sound auditors for the client's investors.  The auditors of the intermediaries do not have the clear conflict  -  their audit clients, the intermediaries, have a clear stake in knowing the truth about the health of a fund into which they put individual's cash.  An argument againt the auditors of intermediaries will rest on a test prudent and reasonable actions.  A duty of care, not a duty of loyalty argument, is harder to win.  In any event, there is also the nagging third party beneficiary problem in the case (can investors sue?? for what??) that dogs even traditional cases..   

Suing the SEC

A frustrated Madoff investor has sued the SEC for not acting on tips that Madoff was running a Ponzi scheme.  The suit is an extreme long shot, given the SEC's sovereign immunity.  But who knows what the right judge may do. [Hint: Try Judge Kaplan.]

Cerberus and Chrysler

Cerberus is apparently willing to dump its equity in Chrysler if bond holders or others will take equity for their debt.  Indeed, Cerberus could simply give the company to its workers in exchange for a full release from all worker obligations (including health care and pensions).  Then we would see how the UAW could do running a company

FASB and Mark-to-Market

The FASB has begun a review of the mark-to-market rules that have attracted the ire of so many in the financial community.  The major complaint -- financial institutions have to write down assets that they do not intend to sell and the write downs adversely affect required capital ratios (both in legal regulations and in financial covenants in debt instruments requiring collateral).  If the capital ratios slip under limits, the financial institution must sell assets to raise cash (a distress sale), further lowering asset values.  The standard financial institutions want -- no forced write downs unless the holders are going to trade -- is unworkable.  Any standard must depend on the nature of the market for the assets.  If the assets are illiquid, there is an argument for not applying mark-to-market rules; if the assets are liquid and an established market is deep, there is no argument.  FASB must then set market definition rules for write downs.  This will not be easy.  If financial institutions to not like the affect of write downs on assets traded in liquid and deep markets they should 1) argue for exemptions in regulatory capital requirements in tough times and 2) not agree to silly financial covenants in their negotiated agreements with creditors.  FASB should not bail them out. 

Government Bailouts

The current crisis has sent most to the history books, and I am no different.  I have been reading about Margret Thatcher's response to the petition from 364 economists in 1979 when they objected to her reduction of government debt, about Reddy's, India's finance minister, response to the credit bubble in the past decade (very unpopular until recently), Japan's lost decade (in the 90s), Sweden's solution (in the 90s), our response to the S&L and foreign government bond crises (mi9d-80s), our response to the panic of 1907 and the collapse of LTCM (late 90s) and our depression in the 30s (did the New Deal work?).  As everyone who reads the financial papers know, opinions on historical crises, like those on the current crises, are all over the map.  A few of my personal conclusions:  1) If government gets it must get in big--there is no half-way solution that works; 2) If government gets in big it may work and may not depending, often on the views of one person (Reddy was smart; Japan's Finance Minister was not) which is a high risk alternative; 3) When government gets in big it bets the house; and 4) the predominate government error is a failure to focus on market trust by private players -- things turn around only when the private players in the market can trust banks and operating companies.  If the government acts to instill trust (Sweden; India; UK), things work; if the government inhibits trust (Japan) things stagnate.  Our government's current response is to hinder trust -- the markets do not know the market value of toxic assets, cannot predict government policy, and cannot predict the effect of workouts by struggling companies.  We are acting more like Japan than the UK.            

GM and Chrysler Bailout Terms

The President announced that the administration would use TARP money to bailout GM and Chrysler.  Ford Motor Company did not make a request.  The "Fact Sheet" from the Bush administration states that GM and Chrysler will receive $13.4 Billion from TARP funds immediately and another $4 Billion in February if Congress approves the second tranche of TARP funds.  There are a series of "conditions", most of which are illusory. Some are not however.  First, the real conditions:  limits on executive pay and perks, warrants for non-voting stock, government debt is senior, government can block any large deals (over $100M), no dividends.  The illusory conditions request that the companies "use the funds to become viable" and set goals and targets for viability.  The condition is illusory because the they are "non-binding," open-ended, and can be reset or relaxed by the Obama administration in January.  Points to consider:  1) There is no strike price or amount set on the warrants and both numbers will be of considerable interest to shareholders. 2) Paulson, once again, has played the fool, arguing that he had no authority to use TARP money under the Congress language establishing the statute (oops).  3)  The targets can only be accomplished realistically (because of the size and complexity of any negotiation) in a bankruptcy reorganization.  You do not exchange debt for equity, reduce wages under a Union contract, and alter existing contracts in a company this size outside of a bankruptcy reorganization (there are too many hold-out possibilities).  Obama will not use bankruptcy so we are in for a penny in for a pound.

Mark to Market Rules

The attack on mark to market accounting rules has many friends.  Under the rules banks must carry on their balance sheets liquid securities at fair market values.  When bank derivatives lost value, banks had to recognize write offs -- "even though they were not selling" -- and the write offs threatened bank capital requirements--forcing banks to sell assets to generate cash--and causing more write offs as the distress value of the sold securities had to be reflected on the balance sheets of all the banks.  Mark to market accounting applies only to liquid securities and does not apply to may classes of bank loans -- which are recorded at initial cost with reserves for potential losses.  Many banks, even with mark to market accounting, are trading at prices that are below book value (or even tangible book value).  This means that even with mark to market accounting, book value amounts do not represent, they exceed, market value.  Those who attack mark to market accounting are barking up the wrong tree. 

Tax Incentives Matter

Taxes are in the news with a discussion of a 1997 tax break for the sale of homes (a $500,000 exclusion from capital gains for homes sold that an owner lived in for two years and owned for five) [how much did it contribute to the crisis?] and a discussion of the carry back of losses from the Madoff scandal for three years [ should the government will pay for part of the losses due to lack of investor oversight?].  They remind us that tax incentives matter.

Madoff and Fraud: Is American Corrupt? No.

The size of Madoff's fraud is dominating the news.  The SEC has issued an apology of sorts for not catching him on a complaint from inside the industry in 1999.  There are other frauds in the news as well.  A Dane has recorded the largest fraud in that country's history and and major New York law firm is winding up due to the fraud of its named founder, Drier.  Financial crisis bring revelations of fraud as those in trouble try to hold on until the good times return -- it's the gambler's curse ("one more roll").  If the SEC had caught Madoff there would have been someone else they had not caught that would be dominating the news.  Fraud is an inevitable part of capitalism and is also how we learn, or get reminded periodically, of the importance of prudence in investing our cash.  It is not a signal that capitalism is flawed or that American is corrupt.  Capitalism and fraud go together like rubber tires and flats -- like electricity and power outs. 

Merkel's Experiment

I have been watching with interest the approach of the German Chancellor Angela Merkel to the financial crisis.  In contrast to our approach of throwing government money at anything and everything, she has taken a very conservative approach, spending less than $44 billion in a stimulus package.  She is planning to spend another $28 billion.  We have spent trillions.  The variety of approaches of the several capitalist economies to this crisis will offer, when this is all over, some interesting reading to historical economists.  My money's on Merkel, not Paulson.

Madoff and Hedge Fund Regulation

The Madoff fraud has reporters seeking comments from my colleagues in the academy on the "failure of the system" and many -- most-- of my colleagues who have pushed for increased regulation for their entire professional careers are more than willing to use the fraud to push their old causes.  "The Madoff fraud proves......  that the current SEC is incompetent.....that hedge funds need regulation.....that capitalism is a failure...that Bush is a failure... that Sarbanes Oxley did not go far enough.... [fill in the blank]."  In truth it proves none of the above.  Regulation can never stop all major frauds.  Regulation can force frauds to be more difficult to accomplish and can penalize those who are discovered.  Madoff co-oped an auditing company and filed, voluntarily, disclosure forms with the SEC under the SEC's hedge fund disclosure rules.  Danger signs were 1) the family structure, 2) the smooth returns in turbulent times, 3) the use of an unknown audit firm; and 4) the difficulty of actually doing the advertised trading strategy given the low volume in some of the options markets that the fund claimed to use very heavily.  Of the signs, number 4) is the most telling.   The market has responded.  Fund of funds (FOFs) that did not check out Madoff are suffering massive redemption's.  Fund redemption's are the investors extra-legal protection in the hedge fund business.  To raise funds the hedge funds lowered "lock-in" barriers, a major concession to investors.

The toxic byproduct from our economic downturn will be, as in this case, over-regulation as frustrated central planner types push their years old philosopy on a now pliant federal government.  As Rahm has said, in effect, "We should not waste a good crisis."

The Car Czar

We are on the verge of appointing a "Car Czar" to dole out federal money to domestic automobile makers.  As far as I can tell, his power is negative -- he will pass on federal bailout money unless various parties sit down and "negotiate."  Translation -- he will set the terms of the bailout and force parties to comply -- threatening bankruptcy it they do not.  We will put tremendous faith in such a "czar." "Is he sympathetic to the unions? ...to green cars?"  He will fail, of course.  Moreover, the czar, whoever she is, will become an industry lobbyist, seeking new funds from Congress to make his plan "work."  The obvious solution, which is politically impossible, is three fold: 1) Repeal CAFE standards and other standards that affect the domestic car industry consumer choices; 2) Let the domestic auto makers restructure in Chapter 11 with DIP financing from, if necessary the federal government; and 3) tax gas up to $4.00 a gallon (if you are serious about alternative energy cars). 

Union wages for domestic automobile production are too high; there is no "right" to get a certain amount of money for line work in domestic automobile plants.  Their wage ultimately depends on whether the cars they make are selling.  If workers produce cars that do not sell better than cars produced in a domestic plant of a foreign manufacturer, they should get less, not more, or even an amount equal too, the workers of the foreign manufacturer.  Union also must learn that retiree benefits are not 1) an invitation to a federal takeover and bailout of retiree packages and 2) that they count against current wage costs of a product.      

A Hidden Problem in the Economic Crisis: State Protectionism

On of the jobs of the drafters of the Constitution was to stop state protectionism in the Articles of Confederation.  States wanted to put tariffs on all goods coming across their borders from other states.  The drafters knew that this was economic chaos.  State protectionism has never left us. It is just more subtle.  States have many, many forms of legislation that favor state industry and producers.  State anti-takeover legislation, state protection for local franchises, state protection for local workers, and the list goes on and on.  Now state protection for local automobile dealers is in the way of the restructuring of the American automobile industry.  The Big Three need to close down dealers and the state legislation makes it very, very expensive to do so.  Another example of state protectionism hurting the general welfare.

Lou Jiwei of China Comments: A Must Read for All Pundits

Lou Jiwei is the head of China's sovereign-wealth fund, a fund awash in dollars (over $200 billion) seeking to invest.  Our current Secretary of State, Hank Paulson, went to China to encourage China to invest in the United States financial system.  Lou Jiwei said no, bluntly.  Why?  He has "lost confidence" in the United States government due to its lack of consistency in its actions and plans.  He will wait.  There are two very, very important lessons here.  First, the United States government cannot itself bailout out or restart our economy -- the government's goal is to encourage voluntary private investment to come back.  This simple point is lost on my colleagues at work, journalists who write about the market, and many, many economists who write editorials.  The governments job is to get private investment up and running -- not to be the primary investor itself.  The government can solve the problem only if it is not the the sole investor, only if it is a stimulant to the private markets.  Second, our government has deterred voluntarily private investment from reentering the markets; its actions are doomed and silly.  The most important three means of encouragement - certainty, more certainty, and maximum certainty.  Our government is doing the opposite -- backtracking, lurching, and sputtering.  Wise people with cash will wait our zany government out -- until it has exhausted itself and admitted defeat-- and becomes predictable -- then they will get in. 

SEC Posts New Rules for Rating Companies

The Securities and Exchange Commission announced new rules for ratings companies.  Some of the rules are designed to limit conflicts of interest --firms cannot rate debt they helped structure, for example -- and some are designed to increase the disclosure of the rating process.  Rating firms must randomly disclose a sample of 10% of their credit ratings (with a delay of six months) on issuer-paid ratings and must disclose rating change percentages (upgrade, downgrade and defaults) in each asset class rated.  The changes are sensible so sensible that one wonders why they are 40 years overdue.   

Big Three Auto Companies' Pleas for a Bailout: A Hook??

The CEOs of our big three domestic automobile companies are back in Congress today, asking for emergency loan funds to stave off bankruptcy.  They drove, rather than flew in private jets, in energy efficient cars the 520 miles to Washington.  They submitted "viability plans" and they came with fresh union concessions (no more "job bank" payments and delay in payments to a new health care fund).  Congress will give them funds -- at issue is whether this Congress or the next one that takes over in early January will do it.  Republicans still have the votes to block the funding in this rump Congress. 

Several notable features of the "plans" spell trouble. 

First, the companies structural changes (selling brands and shutting dealerships) will take time and not produce immediate cash savings. 

Second, the new plans show the need for a $9 billion increase in funds over the amount that the Big Three asked for two weeks ago. 

Third, their emphasis on "green" cars comes when gas prices have fallen to historic lows and when the sales of green cars are falling substantially worldwide.  Moreover, green cars are often subsidized sales -- their price does not cover their costs. 

Fourth, labor costs of $75 an hour are not reduced and are too high compared to the labor costs of domestic plants of foreign auto companies ($45 an hour) and other manufacturing in the United States ($31 an hour).  Instead of reducing wages the companies, and this is classic, are firing workers and saving the high wages of senior workers who remain. The simple fact is that the company need to reduce hourly wages.  Short of wage cuts, my reading of their situation suggests that the most profitable move they could make would be to shut down most all their domestic manufacturing and import cars into the United States from their overseas plants in Brazil, for example.

Fifth, what are they going to do with the cash?  Pay down debt?  I hope not.  Debt holders should be taking haircuts and any bailout money should not be absorbed immediately by debtholders who are otherwise giving interest rate concessions.  My reading of their situation suggests that the most profitable move they could make would be to shut down most all their domestic manufacturing and import cars into the United States from their overseas plants in Brazil, for example.

And sixth, and most important perhaps, no one is doing a thorough due diligence on the companies and their plans.  When have their normal financials and 37 page plans but, as would happen in a normal acquisition or a normal workout, there is no due diligence being performed by anyone on the companies.  Government officials, before any bailout, should check all the company's confidential books and records, just like bank examiners do for banks.  Will they?  I doubt it. 

All this adds up to trouble.  The amount requested looks to be a hook for more requests later.  Once the initial money is gone, one could conservatively estimate that another $75 billion of successful requests will follow.  A popular suggestion is to  loan some now and some later with the later money coming only on the condition that benchmarks have been met.  Either meet the conditions or take Chapter 11, but the problem is Congress's stomach for Chapter 11 -- it could later rescind the conditions. 

Will the government take warrants or other equity with the loans?  The bailouts of the banks and AIG came with grants of equity.    We are now seeing the AIG and bank bailouts come back to bite us -- "Why bail out Wall Street and not Main Street (with 2.5 million workers)" is the public cry from Michigan.

More Lawsuits

Icahn's investment partnership, an investor in the buyout of Realogy Corp. is suing to prevent the company from refinancing $1.1 billion in debt (a workout).  The $1.15 billion in old debt, below, Ichan's will be transformed into $500 million new debt, of which $237 is senior to Ichan's.  Not so fast, says Icahn, the move violates my debt covenants.  He, in essence, is unwilling to take a hit in the workout.  Realogy with threaten bankruptcy as an alternative and the parties with play a game of chicken in a tense negotiation.  Ichan will win. 

Novel Lawsuits Fly

A hedge fund, run by William Frey, has sued Countrywide and its parent, Bank of America, on their agreement with 15 state attorney generals to modify 400,000 mortgages originated and serviced by Countrywide.  In the lawsuit the hedge funds states that the settlement is fine but that Countrywide has offered to modify mortgages that it no longer owns - investment trusts own them.  The hedge fund, an investor in securities issued by the trusts and backed by the securities, says that Countrywide must repurchase the mortgages in the trusts at par in order to modify them.  The outcome of the case will turn on the contractual language in the pooling and servicing agreement between Countrywide and the investment trusts. If the hedge fund prevails, Countrywide will have to pay MBS security holders to modify the mortgages (with government bailout money??) A demand for redress, filed with HUD and awaiting HUD action, alleges that subprime mortgage originators discriminated against minority groups in pushing and selling subprime mortgages.  These will be just two of many, many lawsuits that will occupy lawyers for years as a result of the mortgage default crisis.