Brookings: Topics - Securities and Exchange Commission

Getting Wall Street Accountability Right

Robert C. Pozen — Mon, 19 Nov 2012 14:36:00 -0500

When it comes to the financial crisis of 2008, there's certainly no shortage of blame. But who should be legally liable for any wrongdoing that occurred? In my view, enforcement actions should be brought for two primary purposes: to increase accountability and deter future wrongdoing. In most cases, that means focusing attention on the individuals who committed the alleged bad acts, not the corporate entities. Unfortunately, the SEC and other agencies have often brought actions against the corporate entities instead. Here are two particularly egregious examples.

Bank of America and Merrill Lynch

The SEC brought an enforcement action against Bank of America in connection with its acquisition of Merrill Lynch in the fall of 2008. The suit alleged that Bank of America failed to disclose in the merger proxy statement that Merrill was planning to pay $5.8 billion in year-end bonuses to top employees. As a result of this omission, Bank of America shareholders were allegedly defrauded: they might not have approved the acquisition had this information been revealed.

In August of 2009, Bank of America agreed to settle this case with the SEC by paying a $33 million fine. Because corporations are ultimately owned by their shareholders, this fine would have effectively been paid for by the victims of the alleged fraud-the shareholders of Bank of America. The settlement did not involve any enforcement actions against any of the Bank's executives responsible for the material omission in the merger proxy.

With these concerns in mind, Judge Jed Rakoff (a U.S. District Judge in New York) took the extraordinary action of rejecting this proposed settlement. He wrote that, by assigning liability to Bank of America's shareholders, the settlement did not "comport with the most elementary notions of justice and morality."

The SEC argued that such fines would deter future fraud by encouraging shareholders to more actively monitor management's activities. However, Judge Rakoff didn't buy this argument, and neither did John Coffee, a professor at Columbia Law School. In a paper on shareholder litigation, Coffee wrote:

"[E]nterprise liability in this context is akin to punishing the victims of burglary for their failure to take greater precautions. Although this strategy might produce some enhanced monitoring, it offends social norms, including the public's basic sense of fairness, to punish the victim for conduct that it did not cause."

In 2010, Judge Rakoff reluctantly approved a larger, restructured settlement, which was somewhat more effective at repaying the "legacy" Bank of America shareholders that were originally defrauded.

JPMorgan and Bear Stearns

In October, the State of New York filed suit against JPMorgan, alleging serious wrongdoing on the part of Bear Stearns (which JPMorgan acquired in the spring of 2008). The suit alleges that Bear Stearns caused harm to third parties by misrepresenting the quality of mortgages underlying securities that the firm sold to them.

If JPMorgan had purchased Bear Stearns under "normal" circumstances, JPMorgan's shareholders would have been a reasonable target of the lawsuit. Typically, if one corporation (call it A Corp.) buys another (call it T Corp.), A assumes all of T's former liabilities-its bonds, pension obligations, and, yes, its legal liabilities.

The transfer of legal liability relies on the logic that A could have performed due diligence prior to acquiring T, and reduced its offer price to account for any potential legal liability. Thus, the expected cost of future lawsuits flows through to T's shareholders, as it should in the normal case.

But JPMorgan's acquisition of Bear Stearns was different. JPMorgan purchased Bear Stearns at the behest of top federal officials-who needed JPMorgan to quickly announce a deal in order to quell a potential financial panic. Furthermore, the offer price was effectively set by these federal officials. There was no opportunity for JPMorgan to learn about Bear Stearns' legal liability, nor to adjust its offer price accordingly. Indeed, JP Morgan initially walked away from the acquisition because it did not have enough time for due diligence.

Thus, punishing JPMorgan's shareholders does nothing to align incentives-it merely punishes shareholders for acts in which they are blameless. Even worse, this fine discourages companies from engaging in "white knight" acquisitions at the request of federal regulators. In the future, company executives will demand broad guarantees against losses from the government before taking over any troubled institutions.

Target the individuals instead

Government officials should think twice before bringing securities cases against only a corporate entity. That typically punishes shareholders-who are likely to be innocent bystanders, or even victims themselves. Instead, officials should sue the individuals responsible for the alleged bad act

Targeting individuals can certainly be a challenge: criminal prosecutions must meet strict standards. In civil suits, individual damages or fines as part of settlements are usually covered by an executive's insurance policies or the company's indemnification provisions.

However, if officials can assign blame through a civil court judgment (or voluntary admission of culpability), they can generally force executives to pay out of their own pocket. Even if officials decide to settle these cases-allowing the individual to "neither admit nor deny" wrongdoing-they can insist that executives waive their insurance and indemnification rights from the relevant corporate entity. This approach would more effectively deter corporate officials from engaging in socially damaging behavior, while reducing the adverse impact on innocent shareholders.

Authors

Robert C. Pozen

Publication: Real Clear Markets

Image Source: © Chip East / Reuters

The SEC vs. J.P. Morgan

Robert C. Pozen — Tue, 13 Nov 2012 14:43:00 -0500

J.P. Morgan Chase & Co. announced last week that it had agreed to settle a multiyear probe by the Securities and Exchange Commission. The probe alleges that Bear Stearns (which J.P. Morgan acquired in early 2008) failed to disclose key information about the mortgage-backed securities it sold—such as the low quality of the mortgages underlying them. Under the proposed settlement, J.P. Morgan will pay an undisclosed amount, but no individuals will be charged.

The agreement punishes the wrong people. Instead of fining J.P. Morgan—which acquired a failing firm at the behest of the federal government—the SEC should take action against the individual executives who committed the alleged wrongdoing.

Typically, a corporation that buys another assumes all of its financial obligations, including its legal liabilities. The logic here is that the buyer will look into these obligations—perform "due diligence"—and adjust its offer price to account for any potential legal liabilities of the company that it wants to buy. This logic holds, for instance, in the case of the federal government's billion-dollar lawsuit against Bank of America regarding alleged wrongdoings by Countrywide Financial before the merger of those two companies.

But J.P. Morgan's acquisition of Bear Stearns was largely completed over the course of a single weekend at the behest of the federal government. Recall that on the evening of Thursday, March 13, 2008, Bear Stearns was forced to seek an emergency loan from the New York Federal Reserve in order to continue operations. The next day—Friday, March 14—its stock dropped by nearly 50%.

Federal officials believed that Bear Stearns would not survive another business day—and that its failure could trigger a wave of panic in the financial markets. So Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson took the exceptional step of asking J.P. Morgan to make an offer to purchase Bear Stearns. The deal needed to be announced—and the framework for the deal completed—before the Asian stock markets opened on Monday, March 17.

With that tight deadline, J.P. Morgan could never have completed its due diligence. For this reason, J.P. Morgan initially begged off—but acquiesced only after the regulators pressed hard. The firm agreed to absorb some of the costs of Bear's toxic assets.

As Rep. Barney Frank (D., Mass.), the co-author of the Dodd-Frank financial reforms, said last month, J.P. Morgan "would never have sought to acquire [Bear Stearns] absent that urging" from the federal government. The SEC's problematic actions in this case have broader implications for the future. If J.P. Morgan is punished for the actions of Bear Stearns, government officials might not be able to find any "white knights" when the next crisis arises.

So who should be held accountable if Bear Stearns did engage in a massive fraud involving mortgage-backed securities? Optimally, government officials should bring criminal or civil suits against the responsible senior officials at Bear.

To win a criminal case, however, a prosecutor must generally prove intentional misconduct by the defendant beyond a reasonable doubt. That is a tough standard to meet, especially when midlevel executives follow bad policies prevalent at a firm. And the Justice Department could not meet the standard when it tried to go after two former hedge-fund managers at Bear Stearns in 2009.

There is a better approach: The SEC can bring civil cases against the top executives who set the bad policies at a troubled institution. The agency has the authority to bring judicial or administrative proceedings against controlling persons of a firm for the acts of their subordinates. The remedies include imposition of significant fines on senior executives and barring them from the securities industry.

In the past when the SEC has settled such suits, senior executives were usually not required to admit the validity of the allegations. In such cases, any financial penalties are typically covered by insurance policies or indemnification, rather than being paid out of the executives' pockets. When executives are required to pay personally, there generally must be a voluntary admission or court judgment of culpability.

In the future, if regulators have provided substantial financial assistance to a troubled institution, they should litigate any charges of serious misconduct directly against its senior executives—settling only if these executives admit wrongdoing or waive their insurance and indemnification from the institution.

This approach would more effectively punish executive misconduct. And regulators would not feel compelled to seek damages for such misconduct from firms like J.P. Morgan that made acquisitions requested by the government.

Authors

Robert C. Pozen

Publication: Wall Street Journal

Image Source: © Shannon Stapleton / Reuters

SEC Passes Natural Resource Transparency and Conflict Minerals Rules: The Glass is Fuller than Expected

Daniel Kaufmann and Veronika Penciakova — Tue, 28 Aug 2012 16:19:00 -0400

Over two years ago, Congress adopted Sections 1502 and 1504 of the Dodd-Frank Wall Street Financial Reform Act, which focuses on conflict minerals and natural resource transparency. However, the Securities and Exchange Commission (SEC) was tardy in issuing the implementing regulations, but it passed both rules this past Thursday— more than 450 days past its April 2011 deadline.

A lot is at stake for citizens in dozens of countries, for investors and for multinational companies. Section 1502 mandates that U.S. companies sourcing minerals from the Democratic Republic of Congo (DRC) and adjacent countries perform due diligence on the source and chain of custody of minerals and disclose whether they use conflict minerals.

Section 1504 requires publicly traded oil, gas and mining companies to make project-level disclosures of payments made to governments around the world for the purpose of commercial development of natural resources. The aim of both provisions is to enhance corporate and government accountability. Yet, vague rules that allow for exemptions or do not require reporting on critical details would easily undermine the objective of effective transparency.

Was the wait worth it? That, of course, depends on who you ask. The wait appears worth it in the case of rules on the disclosure of resource payments to foreign governments (Section 1504), while the results are somewhat mixed for rules mandating the disclosure of conflict minerals (Section 1502).

The SEC first voted on disclosure rules for conflict minerals (Section 1502). The mere fact that after such a long delay the agency finally voted in favor of these regulations constitutes a step forward. The intent of Section 1502 of Dodd-Frank (and thus of SEC) was not to mandate penalties for sourcing minerals from mines controlled by armed groups in conflict-afflicted regions. Instead it relies on the adverse reputational effect of such disclosure. Reputable companies would want to avoid having their name associated with armed conflict, human rights violations, slavery and rape. Yet, an important segment of the industry opposed such disclosures on the basis that compliance costs would be high and that disclosure would be ineffective in addressing instability in the region.

But following the SEC’s ruling on Section 1502, the glass is only half full because the industry managed to get some reprieve from full disclosure. For all companies there will be a two-year phase-in period, and for smaller companies a four-year phase-in period. Other companies, such as Wal-Mart and Target, will be exempted from disclosure because the SEC does not require disclosure for store brand products manufactured by third-party suppliers. Further, companies using recycled or scrap minerals would also avoid the disclosure rules.

Thus, while human rights advocates and the industry (with the exception of some firms which were not opposed to Section 1502) were generally at odds about the provision, they agreed that the outcome of the SEC ruling was mixed. Many in the industry are displeased that the rules were passed, but are pleased that there will be significant implementation delays and exemptions. Civil society and human right advocates are pleased that the SEC voted in favor of adopting rules but fear that the rules are relatively weak.

Both sides do agree that the disclosure alone will not solve the conflict in the eastern DRC; and human rights activists feel that the measures passed by the SEC may help mitigate conflict and deter human rights abuses, even though they believe broader governance reforms are needed. It remains to be seen how effective the actual implementation of these provisions will be and whether broader complementary measures to tackle misgovernance and conflict in the DRC will be implemented.

In contrast to the “glass half full” ruling on Section 1502, the Section 1504 ruling on natural resource payment disclosure represented a much fuller glass. The American Petroleum Institute (API), big oil and several other extractive industry companies had lobbied heavily against rules that would require project-level disclosure and in favor of various exemptions, including the so-called “tyrant veto”, which would exempt companies from disclosing payments in countries where payment disclosure was prohibited by local law.

In its ruling, the SEC rejected the “tyrant veto” exemption and exemptions in cases where contracts stipulate secrecy. Further, the SEC also mandated that companies file disclosures, rather than merely furnish them, which is important because the requirement to file enables investors to litigate in certain cases of false reporting. The SEC also specified that payments above $100,000 must be reported and disaggregated by category, rejecting the arguments put forth by the industry for a materiality approach or a threshold of $1 million.

A key question prior to the final ruling was how the SEC would define a “project”. Industry lobbyists pushed for a broad definition that would allow disclosures at as aggregate a level as possible. Some even tried to equate a project with all operations in a country. In its ruling, the SEC acknowledged that the term “project” is commonly understood by issuers and investors, and granted companies some latitude in defining what constitutes a project. But, thanks to the guidance issued by the SEC with the rules, the amount of discretion that companies will have is rather limited.

Specifically, in its guidance, the SEC rejected several project definitions that were proposed by industry stakeholders and strongly opposed by civil society. It clarified that a project cannot be defined at the country level or following criteria driven by geological basin, reporting unit or materiality thresholds. At the same time, the SEC indicated that for the purposes of the rule, the notion of “project” should be guided by the relevant contract (since the payments made by companies to the government are usually stipulated in the contract). Thus, the ruling demarcated reasonable boundaries around what constitutes a project. As a result, reporting is expected to take place at a rather detailed and disaggregated level.

Further, the SEC decision not to rule on a project definition may have been a clever move, both substantively and tactically. Substantively, giving companies latitude in defining a project rather than imposing a “one size fits all” definition may result in disclosure of payments for segments of the industry outside of exploration and production. Tactically, by sticking to the wording of the original Dodd-Frank law, the SEC may fend off a possible source of litigation by the industry (API).

However, the SEC’s clever ruling on the project definition may not dissuade the API from litigation. If they do decide to litigate, the industry body may opt to focus on the costs associated with implementing transparency rules, which they claim will be huge, particularly with regard to compliance costs and loss of competitiveness. In fact, in issuing the rules, the SEC itself did acknowledge that some of these costs to industry may not be trivial.

When discussing compliance costs, it is important to distinguish between the total costs of reporting and the additional costs resulting from the new disclosure requirements. The latter are particularly relevant in assessing the potential costs of 1504, and are likely to be much lower than some companies claim. Most companies already have extensive internal systems in place for recording payments, and already collect project level information to handle their current reporting requirements. Adjustments due to the new set of rules are thus likely to be relatively minor and could be done in a timely and cost-effective manner.

Several companies also highlighted concerns that other market participants could use information disclosed by issuers to derive trade secrets such as contract terms, data on reserves, or other confidential information. These arguments have been rebutted by outside analysis and advocates of transparency. The SEC did not give them credence either, noting that the statute covers the amount of payments, not the manner in which payments are determined or other contract terms.

Companies were also concerned that they would become less competitive relative to companies not subject to the reporting obligations under 1504. The American Petroleum Institute (API) and companies like ExxonMobil and Rio Tinto are concerned that by becoming more transparent they will lose contracts in countries where the government either legally prohibits disclosure or prefers to work with companies that are not subject to payment disclosure. In its ruling, the SEC rejected this flawed notion that implies that corrupt or opaque governments would drive the provision of exemptions from transparency of companies listed in the U.S.

Furthermore, the impact on competitiveness would be minimal in the numerous jurisdictions where payment information is already publicly available, partly as a result of increased participation by governments and companies in the voluntary disclosure framework under the Extractive Industry Transparency Initiative (EITI).

There is also a clear trend toward the globalization of mandatory disclosure of payments by extractive sector companies. The European Union is soon likely to adopt laws similar to those set forth by the U.S. Together, U.S. and EU regulations would cover the vast majority of listed natural resource companies in the world. Moreover, mandatory rules were already adopted by the Hong Kong Stock Exchange and discussions are ongoing in other financial centers in Asia.

More generally, it seems misplaced to equate, as API and some companies have tried to, competitiveness and the ability to keep payments secret. Yes, there are some companies in the world that benefit from rent-seeking, monopolistic behavior, bribery of foreign officials and tax avoidance or outright evasion.

But, as previously argued, private companies around the world, including in dynamic sectors in the U.S., compete on the basis of efficiency, entrepreneurship, and high technical and innovation standards. A truly competitive firm would have little to gain from secrecy; to the contrary, it would benefit from the level playing field created by high levels of transparency.

Over the past two years, the discussion of the potential costs of disclosure has been long and detailed. By contrast, there has been far less said about potential benefits. It is the case that the benefits of transparency are not easy to quantify. Yet, as we have noted before, a body of empirical work has found the benefits of transparency, good governance and corruption control to be quite large and to accrue to multiple stakeholders, including citizens, investors and competitive companies in the extractive sector. In their submissions to the SEC, some investors noted that new disclosure requirements would help them assess the risks faced by companies operating in resource-rich countries and thus possibly promote investment and capital formation.

In fact, our own data and research suggests that in the long run there is up to a 300 percent development to citizens dividend from increased transparency, accountability and improved governance. In particular, improved governance can contribute to a threefold rise in incomes and two-thirds decline in infant mortality.

Further, project-level disclosure will empower citizens to obtain information on how much their governments earn from natural resources, advocate for a fairer share of revenues, and verify government-published budget data. Once the data is disclosed and processed by analysts and civil society, citizens should also be able monitor the flow of money from the central government to regional and local governments, thus helping ensure that they are receiving what is promised. Finally, more transparency in dealings between companies and governments may help companies sidestep attempts by some government officials to engage in unethical activities.

More generally, it is also important to emphasize that extractive-intensive countries need not be subject to the resource curse. Countries with transparent and enlightened leadership, and with satisfactory standards of governance and corruption control (supported by good corporate governance practices among multinationals), can harness their natural resources to achieve robust and inclusive growth and development. As seen in figure 1, extractive-rich countries that do well in controlling corruption also have higher income levels, in contrast with poorly governed ones. The challenge in coming years is raising the governance standards of many resource-rich countries that are lagging in this area.

The robust implementation of the SEC rules on transparency in natural resources as mandated by Section 1504 of the Dodd-Frank Act will be an important step forward, but it will not be sufficient. In order to make extractive industry transparency a global norm, the EU and other financial centers need to follow the lead taken by the United States. Building on its success in promoting the U.S. rules on Section 1504 advocacy organizations, such as the Publish What You Pay Coalition and its main NGO members, as well as key investors, need to now fully focus on the passage of a similarly strong set of transparency rules in the European Union.

Engaging China on this issue will also be important. And extractive-rich countries around the world need to do their part, deepening their work on transparency through the EITI and other such mechanisms. And important dimensions of opacity that still prevail in natural resources, untouched by Dodd-Frank 1504, will need to be addressed separately, such as promoting contract transparency; tackling the challenge of obscure “beneficial ownership” (to ensure the public is aware of who the ultimate owners/beneficiaries are of natural resource extraction and exploration); and the further analysis and codification of the considerable payoff to transparency reforms.

The original Dodd-Frank Section 1504 and the SEC rulings are a huge step forward toward transparency and are likely to resonate worldwide. But much of the concrete work remains ahead.

Authors

Daniel Kaufmann
Veronika Penciakova

Image Source: David Lewis / Reuters

SEC’s Day of Reckoning on Transparency: Dodd-Frank Section 1504 on Disclosure of Natural Resource Revenues

Daniel Kaufmann — Tue, 21 Aug 2012 10:29:00 -0400

On August 22, following a very lengthy delay, the Securities and Exchange Commission (SEC) is finally issuing the detailed implementing rules on natural resource transparency in Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, adopted by Congress in July 2010. Specifically, Section 1504 stipulated that companies in extractive industries listed in U.S. exchanges would be required to report payments made to governments around the world.

This may sound clear enough, but as often is the case the devil will be in the details. Tomorrow those details will be in the hands of the SEC and will determine whether ‘effective transparency’ is attained or continues to remain elusive. Namely the SEC will determine whether the information that needs to be disclosed by companies is sufficiently detailed, relevant and accessible, enabling effective monitoring and analysis by civil society, investors and government reformists.

Given the content of the 2-year-old Dodd-Frank legislation, the SEC has no choice but to mandate disclosure. However, effective disclosure is by no means guaranteed as the SEC could issue weak rules, rendering disclosure ineffective. Thanks to Dodd-Frank legislation mandating transparency, the main danger is no longer wholesale ‘transparency evasion’ by many companies, but the more nuanced risk of enabling ‘transparency elusion’ (or ‘transparency avoidance’) by companies that wish to skirt detailed disclosure, thereby masking possible misdeeds.

In fact, in the aftermath of the financial crisis and in the increasingly sophisticated legal and business environment of the 21st century, outright and explicit opposition to some form of disclosure by corporations is seen as increasingly costly, particularly from a reputation standpoint. Thus, tactics have shifted to an extent – as they previously did in the tax compliance field, when some corporations ceased focusing exclusively on tax evasion opting instead for tax elusion (or tax avoidance, eluding or avoiding taxes rather than just evading them).

But more concretely, how could the SEC possibly undermine the disclosure mandated by the Dodd-Frank Act in Section 1504, and permit ‘transparency elusion’ by corporations?

There are several ways this could take place watering down of the rules could take place, effectively enabling disclosure elusion: first, by ruling weakly and in favor of corporations who wish to elude disclosure by minimizing the level of detail required by companies to disclose on payments made to foreign governments. In particular, this would happen if the SEC fails to mandate companies to report disaggregated payments for each concession, lease or contract, and instead gives them latitude to either define themselves what constitutes a ‘project’, or, possibly worse, to allow reporting only at the aggregate country level (even though the latter is unlikely, since Dodd-Frank specifies that project-level disclosure should take place).

Second, the SEC would side in favor of companies that wish to avoid effective transparency by granting them significant exemptions from reporting payments for medium-scale projects, ranging from $75,000 to $750,000 (there is already consensus that it is reasonable to exempt very small projects, such as those below $25,000).

Third, although unlikely, the SEC could grant companies exemptions in not having to report payments made to opaque (and often authoritarian) governments with domestic laws that may ban disclosure (even though there is no evidence that companies would be hurt by disclosing payments for those settings).

Finally, some oil companies represented by the American Petroleum Institute (API) and supported by Shell and others, have opted for an additional tactic to elude transparency: threatening to litigate against the SEC irrespective of how it rules tomorrow. The threat has been an overt effort to influence and weaken tomorrow’s rule-making by the SEC, while acting on that threat after tomorrow would aim to further delay the implementation of the actual disclosure rules and to subsequently weaken the transparency rules themselves.

If the SEC issues weak rules on some of the above mentioned critical aspects, companies may be able to effectively skirt disclosing financial information, which in turn would jeopardize accountability to shareholder investors and would impair analysis of tax compliance, of potential diversion of funds away from government treasuries, and of possible corruption or fraud. There also lies the positive flip side: if the SEC issues strong and effective transparency rules and leaves little room for disclosure avoidance, then accountability to investors would be enhanced and a potent deterrent would be in place regarding tax evasion and tax elusion, as well as regarding bribery and corruption among companies and public officials.

Growing evidence suggests that the benefits of transparency are sizeable for various dimensions, including incomes per capita and other social and political stability gains for the host country citizens, as well as gains for countries in terms of investments, macro-economic (fiscal) stability, financial sector development, and control of corruption.

For instance, our own data and research from around the world suggests that in the long run, with increased transparency, accountability and improved governance, citizens could see up to a 300 percent development dividend from improved governance – i.e. their incomes per capita could triple, while infant mortality could decline by two-thirds. Furthermore, some studies by other authors suggest a positive impact of transparency specifically in the natural resources sector.

But how costly to the corporate sector would disclosure be? It would be naïve to suggest that every corporation would gain (or have no costs) from full disclosure, at least in the short term. This has little to do with the actual administrative expenses of data collection for disclosure, because the incremental cost for new data collection over what data the companies already collect for tax and internal purposes would be small.

Instead, the real reason that disclosure may be costly to some companies in the short term relates to a different strand of our research: there are two types of companies, those that focus on efficiency and innovation and can thrive in a competitive level-playing field, and those that derive gains from rent-seeking (and outright bribery), monopolistic behavior or tax avoidance. The latter group would have an interest in maintaining an opaque status quo and stand to lose from a more equitable environment resulting from effective transparency, while the former group would stand to gain, since the playing field would be leveled across all companies, benefitting the entrepreneurial and competitive firms.

Therefore not surprisingly, the corporate sector remains divided regarding these transparency rules. Some mining companies have come out publicly in favor of transparency, as have prominent investors and former top executives, while some of the big oil companies are strongly opposed to it. In fact, some companies such as the giant Statoil in Norway and Newmont Mining already disclose payments voluntarily.

Thus, if one assesses the transparency benefits against the legitimate company costs (not counting the private costs to some companies due to corrupt behavior), the net payoff of transparency could be very large. This not only applies to overall societal gains, but incipient evidence also suggests that the corporate sector as a whole would benefit from a transparent level playing field (even as some opaque companies may lose out in the short term). It is also noteworthy that highly reputable pro-market, pro-business competition publications such as The Economist and the Financial Times have written prominent editorials supporting tough and detailed rule making to attain effective disclosure by companies in the natural resources industries.

But the expected large net benefits of transparency do not necessarily mean that SEC will automatically rule effectively tomorrow. It is fresh in our collective memories that in terms of its overall mandate on financial sector supervision and regulatory oversight, over the past decade the SEC failed to perform and was held partly responsible for contributing to the global financial crisis. The SEC was seen as, at best, being afflicted by poor leadership and as an ineffective bystander while the excesses of financial overleveraging and financial deregulation occurred. At worse, it was seen as having been subject to regulatory capture by the corporate sector, ultimately leading to regulatory failure (while becoming further tainted by the Madoff fraud scandal).

While some efforts to improve the SEC have taken place in recent years, the jury is still out regarding its current effectiveness in issuing and implementing regulations. Further, in the specific case of issuing rules mandating disclosure to companies in oil, gas and mining, the SEC may be overly influenced by the lobbying efforts and litigation threats by some big oil companies, fronted by the API, who oppose effective transparency.

On the other hand as the SEC aims to improve its performance and reputation, it could end up issuing effective transparency regulations in all the key dimensions, pleasantly surprising observers and transparency advocates. A good ruling would have important repercussions worldwide, including in the European Union, where preparation of similar regulations are being debated and the lead already taken by the U.S. on revenue transparency is being closely watched before they finalize their legislation.

Yet even if the SEC were to issue a strong set of rules, its role in promoting revenue transparency would not cease the day after tomorrow. How effectively the SEC fends off challenges by big oil companies, and then implements its rules in the future will matter significantly as well.

Even effective SEC implementation will not suffice in itself. Financial centers around the world would need to follow suit, governments need to continue making progress in making transparent revenue payments, working with the Extractives Industry Transparency Initiative (EITI) and similar such programs, and civil society evidence-based monitoring and advocacy efforts need to expand further, through the initiatives of the Publish What You Pay (PWYP) coalition and its member organizations.

Finally, as information from companies begin to flow more freely and transparently, analysts in NGOs, think-tanks and academia would be encouraged to exploit more fully the ‘power of data’, to further learn about improving governance in natural resources, deter corrupt behavior, and benefit citizens and honest corporations worldwide.

Authors

Daniel Kaufmann

SEC Beware, Money Funds Can Bring System Down

The Squam Lake Group — Wed, 18 Apr 2012 10:38:00 -0400

Editor's Note: This piece was authored by the following twelve members of the Squam Lake Group: Martin N. Baily, the Brookings Institution; John Y. Campbell, Harvard University; John H. Cochrane, University of Chicago; Douglas W. Diamond, University of Chicago; Darrell Duffie, Stanford University; Anil K Kashyap, University of Chicago; Frederic S. Mishkin, Columbia University; David S. Scharfstein, Harvard University; Robert J. Shiller, Yale University; Matthew J. Slaughter, Dartmouth College; Hyun Song Shin, Princeton University and Rene M. Stulz, Ohio State University.

News reports suggest that the Securities and Exchange Commission may be backing away from a reform of money-market funds. This would be a mistake.

The debate over how to overhaul prime money-market funds has focused on preserving the commercial viability of these instruments while significantly lowering the threat they pose to financial stability. The latter objective should have priority.

The threat is a run by investors who believe they face impending losses on fund shares. In the two weeks after the failure of Lehman Brothers Holdings Inc., institutional investors reduced their investments in prime money-market funds by about 40 percent, amounting to almost $400 billion. Only a prompt guarantee by the U.S. Treasury—a measure that is no longer a legal option—stopped the withdrawals.

A handful of large bank-owned broker-dealers still borrow hundreds of billions of dollars each day from money-market funds. Clearly, a run would affect systemically important banks. Last week, Federal Reserve Chairman Ben S. Bernanke stated his concerns about the vulnerability of our financial system to a panic on money-market funds.

The Investment Company Institute, or ICI, the trade organization that represents fund sponsors, says the reforms that have been proposed are so expensive or so unattractive to investors that money-market funds wouldn’t survive if they were adopted.

Asset Value

Three types of changes are now under consideration. The first of these would eliminate the “stable net-asset value” rule, which allows fund shares to trade at the book-accounting value (not market value) of assets, rounded to the nearest penny per share. That means the shares typically trade at $1 each, until they lose more than a half penny per share. Under the proposal, fund shares would trade instead at a variable net- asset value, that is, at the actual market value of the assets held by the fund, as is the rule for other forms of mutual funds.

The second proposal is to require that investors in money- market funds be protected by a “capital buffer.” In January 2011, the Squam Lake Group -- our bipartisan panel of economists, which has offered proposals on reforming the financial system -- submitted a comment letter to the SEC in response to the President’s Working Group Report on Money Market Reform. We proposed that at least one of these two measures be adopted.

A third proposal has emerged. It would require that when an investor redeems money-market fund shares, a specified portion of the proceeds would remain in the fund and absorb its first losses over the next 30 days.

The ICI suggests that most investors won’t use money-market funds if they have a variable net-asset value or a hold-back rule. The trade group also suggests that a capital buffer would be prohibitively expensive for a fund sponsor and its investors to share. The ICI provides no cost analysis.

One industry representative suggests starting with a buffer of 3 cents per $100 of fund assets, and then building this buffer up to 30 cents per $100 over a number of years. Money- market funds often have loss exposures to individual U.S. and European banks of more than 3 percent, more than 100 times this proposed initial buffer. If one of these banks were to encounter solvency concerns, only a far higher buffer would protect fund investors, and thus reduce the incentive for a run.

If the maximum loss to fund assets can indeed be absorbed by a tiny buffer, then the cost of providing a substantially larger one would be small because the investor would expect to lose at most a tiny fraction of the buffer investment. In any case, the expected return demanded by a buffer provider is commensurate with the riskiness of the assets held by the fund. This provides a strong incentive to the fund sponsor to manage risk conservatively.

Commercial Viability

Suppose, however, that the ICI is correct that the proposed reforms would eliminate the attractiveness of money-market funds for investors. What then should be done? Should the commercial viability of money-market funds take priority over the stability of the financial system?

A “yes” answer implies that taxpayers should backstop this business in any future crisis, either through another bailout or by absorbing the costs to the broader economy of a run on some of our largest financial institutions. Taxpayers shouldn’t be forced to take this risk again.

Some have also raised concerns that if money-market funds become sufficiently unattractive, institutional investors will shift their funds to banks. Because most of a large institutional investor’s bank deposits aren’t insured by the Federal Deposit Insurance Corporation, this migration could increase the vulnerability of banks to runs.

Although we share this concern, regulators already monitor this risk through the extensive supervisory and capital-adequacy regime for banks. The Dodd-Frank Act charged the Financial Stability Oversight Council with controlling risks to the financial system. The FSOC’s first annual report identified money-market funds as a risk to the system.

The council should reaffirm this conclusion and publicly endorse meaningful reform by the SEC to address this risk. If the SEC fails to act, the FSOC should designate some or all money funds, or their sponsors, as systemically significant non- bank financial firms and regulate them as such.

Authors

The Squam Lake Group

Publication: Bloomberg

Transparency, Conflict Minerals and Natural Resources: Debating Sections 1502 and 1504 of the Dodd-Frank Act

Daniel Kaufmann and Veronika Penciakova — Tue, 20 Dec 2011 11:32:00 -0500

Editor's Note: On December 13, Brookings and Global Witness hosted The Transparency, Conflict Minerals and Natural Resources: What You Don't Know About Dodd-Frank, an event examining Sections 1502 and 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The agenda and full transcript can be found here.

With a focus on conflict minerals and natural resource transparency, Sections 1504 and 1502 of the Dodd-Frank Wall Street Financial Reform Act are unrelated to the U.S. banking system. Yet they have stirred up controversy. As is often the case with provisions that aim at changing the rules of the game, Sections 1502 and 1504 have pitted stakeholders that support their passage and full implementation against the interests of those that wish to water them down or greatly delay their implementation. Last Tuesday, Brookings and Global Witness hosted an event at the National Press Club to examine the debate surrounding these two provisions.

Representative Jim McDermott kicked off the event by explaining that passing Sections 1502 and 1504 is only half the battle. The eventual effectiveness of these provisions largely depends on how the final rules are written and implemented. If well implemented, they could contribute to increased transparency, empower citizens to capture the gains from natural resource wealth and deny financing to dangerous armed groups in the Democratic Republic of Congo and the surrounding countries. However, if opponents of these rules succeed in sufficiently watering them down, many of these gains will not be attained. With this in mind, panelists and participants from civil society, the private sector, financial sector and think tanks discussed the benefits, potential costs and implementation challenges of Sections 1502 and 1504.

The first part of the discussion, moderated by Simon Taylor from Global Witness, focused on the costs and benefits of Section 1504, which requires U.S. companies in extractive industries to report project-level payments made to foreign governments. Isabel Munilla from Publish What You Pay (PWYP) emphasized that with detailed information, citizens, civil society organizations and NGOs will be able to monitor corporate and government interactions, hold both groups accountable, and ensure that natural resource wealth contributes positively to local development and livelihoods. Daniel Kaufmann pointed out that data and research from around the world suggests that in the long run, with increased transparency and accountability, citizens could see up to a 300 percent development dividend from improved governance – i.e. their incomes per capita could triple.

Bennett Freeman from Calvert Investments suggested that transparent companies attract more investors because disclosure clarifies investment risks. And Laurel Green from Rio Tinto also supported implementation of these disclosure reforms, pointing out that such transparency can be a competitive advantage since firms can provide host governments with clear evidence of how they contribute to government revenues and communities. Yet not all companies may view such transparency reforms to their advantage. From an economic incentive standpoint, Kaufmann highlighted that, as with practically every rule, Section 1504 also means that there will be winners and losers. Companies that focus on efficiency and innovation stand to benefit, while those that derive gains from rent-seeking, monopolistic behavior or tax avoidance would have an interest in maintaining an opaque status quo.

Some large companies and industry associations that are opposed to the disclosure rule in Section 1504, such as Shell and the American Petroleum Institute, have suggested that project level disclosure will be very costly, position publicly traded firms at a competitive disadvantage, and possibly face in-country discrimination in places with lack of disclosure. There was discussion suggesting that these claims may be exaggerated during the panel. The reality is that companies already have systems in place to track revenues and payments. In fact, even though Section 1504 is not under implementation yet, some large corporations— like Rio Tinto, Statoil and Newmont Mining, among others— already disclose payments in every country of operation. Further, as reported by some companies that are already disclosing, there does not appear to be compelling evidence that companies will face major penalties by non-transparent governments.

Some companies are also concerned that competitors could use disclosed information to their advantage. First, the information that should be disclosed does not appear to fall under the proprietary trade secrets category. Furthermore, since the rules cover all companies listed on the U.S. stock exchange, major companies like Shell, Exxon and BP are covered, as are some state-owned ones, like Petrobras and Petrochina. Last, and not least, disclosure requirements along the lines of Section 1504 are already being drafted in the European Union, and consideration of similar rules is also taking place in South Korea and Hong Kong, which would widen the network of companies covered and further level the playing field. If anything, firms listed in the U.S. can get a head start on those companies not yet covered by disclosure requirements.

Since it will be virtually impossible to roll back Section 1504 on transparency in natural resources as well as difficult for companies to oppose transparency from a public relations perspective, the strategy by companies opposed to disclosure has been to lobby for watering down the eventual rules issued by the Securities and Exchange Commission and to delay the effective implementation of the rules. The most important component in watering down such provisions would be to make disclosure a requirement merely at the aggregate country-level rather than at the project-level. This loss of this crucial detail would greatly reduce the impact of the measure. All the panelists during this session, including those from the private sector, argued in favor of detailed project-level disclosure.

In the second session, panelists and participants discussed Section 1502, which requires companies that source minerals from Congo-DRC and adjacent countries to disclose whether they use conflict minerals. The rule relies on the adverse reputational impact of such disclosure rather than mandating penalties for actually sourcing minerals from conflict-afflicted regions where militias may be benefitting from this trade. No reputable company wants their product associated with armed conflict, human rights violations, slavery and rape. Yet again there are some companies that support these reforms, while others oppose them.

Corinna Gilfillan from Global Witness, Delly Sesete from CREDDHO in the DRC, and several participants in the audience from the DRC region emphasized that although Section 1502 will not itself end conflict in Congo, it could hold companies accountable for sourcing from mines controlled by militias. The U.N. Group of Experts on Congo has already found that since the signing of the Dodd-Frank bill, there has been a reduction in the portion of mined minerals that is funding the conflict. By denying financing to the armed groups that perpetuate violence in the region, the provision can contribute to increased stability and improved human rights.

As with Section 1504, some companies are claiming that implementation costs associated with conflict minerals in Section 1502 will be very high. There are numerous estimates of these costs, ranging from the SEC’s estimate of $71.2 million to the National Association of Manufacturers’ (NAM) estimate of $9-$16 billion. Recent estimates produced independently by the Claigan Environmental consulting firm and presented by Bruce Calder during this panel suggest that costs to the industry are expected to be less than $815 million.

In fact, some proactive companies (both domestic and foreign) are already showing that tracking supply chains is both practically and financial feasible. Sandy Merber from General Electric and Tim Mohin from AMD discussed how pooling industry resources could help offset individual firm costs. The Electronics Industry Citizenship Coalition and the Global e-Sustainability Initiative have partnered with firms to develop the "Conflict Free Smelters Program", which allows companies performing due diligence to trace their mineral supply chain down to the smelters who are certified as being either conflict free or not. Efforts are being made to now certify smelters in the DRC region under this program to help preserve access to the international markets for impoverished artisanal miners. Yet the companies that have already taken the lead in tracking the supply chain are a minority, and thus they are bearing a disproportionate share of the cost for so doing. Once the rules are issued and regulations implemented, this cost would be spread among a larger universe of firms.

There are concerns among some in the DRC that Section 1502 will have negative unintended consequences on citizens in the region. They suggest that the disclosure requirements are driving firms out of the DRC, citing falling mineral trade as evidence. Yet Section 1502, which has not yet even been implemented, cannot solely be blamed. Since April 2010, when the DRC-government-imposed six-month minerals embargo ended, trade in minerals has been on the rise. Sesete argued that much of the talk of unintended consequences was akin to fear mongering. He and others have pointed out that the mineral trade in that region is a relatively recent activity and citizens had (and continue to have) other sources to support their livelihoods. Further, he emphasized that the benefits of increased security and reduced violence and instability are too great to dismiss Section 1502 outright.

In the end, as pointed out by Mark Taylor from FAFO, the ability of Sections 1502 and 1504 to achieve their goals depends heavily on effective implementation. The final rules on these two provisions have yet to be released by the SEC. Therefore, the uncertainty surrounding the final rules has contributed to speculations on the cost (both to companies and countries) of implementation. The sooner these regulations come out and the clearer the standards they set are, the greater chance these provisions will have in maximizing the benefits to global transparency, accountability and governance.

As Senator Ben Cardin reminded the audience during his closing presentation, the importance of Sections 1502 and 1504 transcends U.S. companies and Central Africa. Indeed, while the SEC should carefully weigh potential benefits and costs in the implementation of Section 1502 and 1504, the balance should be in favor of transparency.

And the importance of leadership should not be ignored: these specific disclosures in Dodd-Frank will signal that the U.S. is taking the lead globally on these important aspects, potentially nudging other key financial centers to do likewise and thus benefitting governance, security and human rights in many corners of the world.

Authors

Daniel Kaufmann
Veronika Penciakova

Image Source: Â© STR New / Reuters

Judge Rakoff Challenge to the Security Exchange Commission: Can Regulatory Capture be Reversed?

Daniel Kaufmann and Veronika Penciakova — Fri, 02 Dec 2011 15:35:00 -0500

Last Monday, Federal Judge Jed Rakoff issued a potentially precedent-setting challenge to the Securities Exchange Commission (SEC) when he rejected the $285 million settlement between the agency and Citigroup. The bank is charged with negligence related to its misleading sale of toxic mortgage-backed securities, which ultimately cost investors nearly $700 million but earned the bank a handsome profit of almost $160 million.

Analysts have focused on the immediate and narrow concern of how the SEC and Citigroup will respond to this challenge and on second-guessing what may satisfy Judge Rakoff. Three options exist: the agency could renegotiate a deal with the bank for a higher settlement and insert vague (and non-incriminating) language hinting at the bank’s culpability; it could allow the case to go to trial; or it could appeal the Judge’s decision. Some even suggest that the ruling may result in the SEC pursuing more cases administratively in the future.

Rather than adding to these ongoing media and expert analyses on the immediate response of the SEC and Citigroup to Judge Rakoff’s ruling, we take a broader perspective. SEC v. Citigroup can be seen in the context of the intimate relationship between the agency and the powerful banks it regulates, one which has prevailed for years and weakened the regulatory power of the SEC.

The financial crisis and subsequent call for reform provided ample opportunity to tackle such undue influence and regulatory capture, which occurs when the regulator is unduly influenced by the interests of regulated entities. At the beginning of the new administration and during the early stages of the Dodd-Frank reform bill preparation, a rebalancing of power between the weakened regulator and powerful financial institutions was expected.

Yet, once the bill was adopted reality began to sink in. The reform bill failed to directly address the problem of banks that were too big to fail, and left crucial implementation matters to the discretion of weak regulatory agencies such as the SEC. It seemed that power shifted back from Washington to Wall Street again.

Rakoff’s challenge to the SEC exposes yet another example of how old power balances that favor financial institutions remain alive and well. The main question is not how the SEC can reword its settlement with Citigroup to satisfy judge Rakoff, but rather whether the judge’s ruling will serve as a wake-up call to the weak regulatory regime governing the behavior of financial institutions and prompt concrete changes to the rules of the game.

The SEC has a history of regulatory capture

Whether covert or overt, elements of regulatory capture have been evident for some time. In the decade leading up to the financial crisis, deregulation in the U.S. financial sector weakened regulatory agencies. More generally, seven years ago I codified the extent of “state capture” and “legal corruption” through a survey of enterprises in over 100 countries. The extent of capture afflicting the U.S. was very high; it not only rated well below other industrialized countries, but found itself among the bottom half worldwide (figure 1). But at that peak time of financial exuberance and deregulation, there was little appetite to take such data seriously.

It got worse. These data were collected months before an infamous meeting between bankers and the SEC in April 2004 when the SEC readily agreed to significantly relax its regulatory stance vis-a-vis the largest investment banks, allowing them to amass massive amounts of debt. In return, once the agency set up its supervisory program, the banks would submit reviews and restrictions on excessively risky activities. Yet the SEC hired only seven people to examine companies with combined assets of more than $4 trillion and completed no inspections after 2007.

Furthermore, preceding the financial crisis the SEC became aware that Bernard Madoff, who had served on the commission’s advisory committee and had been previously reported for securities violations, was mismanaging his customers’ funds in the tens of billions of dollars. Yet the agency failed to probe deeper and unmask his Ponzi scheme. The SEC also neglected to take action against financier R. Allen Stanford, who swindled investors out of $8 billion, although allegations of fraud and possible money laundering had been levied against him in the past.

Expectations of change were not realized

The onset of the financial crisis revealed the weakness of the financial sector and the extent to which regulators had been captured. It spurred public outrage and calls for change. When the new administration entered office it brought with it a clear appreciation for the problem of capture. As early as 2007, then Senator Obama, during a major address at Nasdaq in New York City, recognized that “turning a blind eye to cronyism in our midst put us all in jeopardy” and that “we [were] going to have to adapt our institutions to a new world.”

Over three years later, regulatory reforms were adopted through the Dodd-Frank bill, which, at least on paper, signaled a move in the right direction toward stronger regulations and the potential for somewhat reduced capture. Yet, recent events are exposing weaknesses in Dodd-Frank. The bill failed to address crucial implementation details and was vague in some regulatory matters, leaving discretion in the hands of weak regulators. Since the mid-term congressional elections last year, lobbyists for large financial institutions and their allies in Congress have been working hard to keep, as intact as possible, the deregulated status quo that prevailed prior to the financial crisis.

It is now evident that if not for the Federal Reserve Boards’ lack of transparency in supporting large banks during the crisis, the Dodd-Frank bill may have had a better chance at addressing the undue influence and systemic risk posed by these large financial institutions. The extent to which large banks teetered on the edge of collapse in 2008 and 2009 has only now come to light. This week, Bloomberg revealed that by March 2009 the Federal Reserve had secretly provided nearly $7.8 trillion in emergency funds to rescue the financial system, dwarfing the publicly known $700 billion Troubled Asset Relief Program (TARP). The trouble with this secret bailout is not the Fed’s emergency actions, but rather that the information remained so closely guarded for so long and that the Fed fought against its disclosure.

This secrecy may have been initially warranted to prevent further panic, but the lack of transparency in the medium-term had a significant impact on regulatory reform. Had the information been disclosed earlier, including to members of Congress and the public, the evidence of systemic risk posed by large banks may have persuaded some to adopt a tougher Dodd-Frank bill. A stronger bill may have more directly addressed the problem of large banks, and in this context, further empowered regulatory agencies such as the SEC. In fact, had the details of the Fed’s bailout been disclosed, there may have been more support in Congress to break up the biggest banks. Lobbyists for the largest recipients of relief funds made a winning case that such a breakup would punish “successful” institutions.

Regulatory capture of the SEC today impacts enforcement

The close ties between banks and the SEC is symptomatic of the sector’s influence over the regulator. A study by the Project on Government Oversight found that in the past five years, 219 former SEC employees filed nearly 800 disclosure statements for representing their clients’ dealings with the agency, and of these, about half (403) were filed by people who worked for the SEC’s enforcement division. Because former employees are only required to file such disclosures for two years after leaving the SEC, these figures only capture the most recent instances. Even the regulator’s top enforcement official has moved back and forth between the Justice Department, Deutsche Bank and the SEC.

Such close ties may ultimately affect enforcement. An internal investigation found that a former SEC official blocked the agency’s investigation of R. Allen Stanford for nearly seven years, and then went on to work for him. More recently, the SEC’s head enforcement official was investigated (but cleared) after Citigroup hired his former boss to participate in its defense against charges unrelated to the case before Judge Rakoff. Negotiations between the parties resulted in the charges against two executives being reduced. In an open investigation, the SEC’s inspector general is looking into allegations that the frequent hiring of former SEC attorneys by a particular firm has contributed to the agency’s failure to take appropriate actions against it.

One impact of such capture has been weak enforcement. While the SEC can take companies to court, extract civil penalties and bring contempt charges for repeat violations, the agency has only given ‘slaps on the wrist’ to those firms involved in the financial crisis. Instead, it has preferred to settle out of court with big banks. These settlements allow banks to merely pledge to desist from breaching antifraud laws again and pay penalties—which are typically not very onerous considering the bank’s breach and benefits they derived—without ever having to admit to any wrongdoing.

Following Judge Rakoff’s ruling, the SEC defended its practice of settling out of court by arguing that settlements deter future bad behavior because they make firms pledge to improve business practices and impose monetary penalties. The agency suggested that were it required to extract an admission of guilt, more institutions would take cases to court. This would tie up limited SEC resources and force the regulator to pursue fewer cases. This line of defense relies on two flawed assumptions – first, that current settlements deter future violations and, second, that a lower caseload would weaken incentives to comply with regulations.

Firms will opt to fully abide by the law (or not) depending on economic incentives – i.e. whether the benefits of abiding by the law significantly outweigh the costs. Currently, the costs imposed by the SEC are low. Pledges are virtually costless, and the penalties imposed by the SEC are small relative to the profits of these large institutions and the benefits they derive from improper behavior. Furthermore, the SEC has shied away from closely monitoring the banks’ compliance progress, and has done little to impose high penalties for failure to comply with pledges made.

Citigroup is a prime example. It is accused of negligence in the loss of $700 million of investor money, and agreed to pay $285 million, which is less than eight percent of the bank’s profits in just the third-quarter of 2011 alone. Moreover, because these settlements do not require companies to admit guilt, the bank is further shielded from investors taking them to civil court, and the Justice Department is in less of a position to press criminal charges against executives.

A New York Times analysis found that over the past 15 years, at least 51 cases have involved recidivism by 19 Wall Street firms. In many of these cases, the SEC could bring contempt of court charges, but it has not done so in at least 10 years. Most major banks are repeat violators. Bank of America, for instance, has four violations for purposeful or negligent fraud in interstate commerce, and four for purposeful fraud by securities firms since 1998. During the same period, Citigroup amassed five violations for purposeful or negligent fraud in interstate commerce, and three violations for purposeful fraud by securities firms. None of these past cases were even mentioned in the SEC’s charges against Citigroup in the case before Judge Rakoff, and no contempt of court charges have been made against the bank.

Finally, the SEC should be in a position to welcome a somewhat lower caseload if the cases it more forcefully pursues do substantially increase the cost of non-compliance. If any corporate firm has a somewhat lower probability of being investigated, but faces a substantially higher cost if probed, it will be far less likely to violate regulations because the expected costs associated with illicit behavior increases. Increased costs, in the form of higher penalties, investor lawsuits and possible jail time for executives, would serve as a strong deterrent. Currently, no executives have been successfully prosecuted for actions leading up to the financial crisis. This is in sharp contrast to the aftermath of the Savings and Loan (S&L) crisis of the 1990s when more than 1,100 cases were sent to the Department of Justice for prosecution, resulting in 800 bank officials going to jail.

Taking on very large firms and raising the costs of violating the law are not impossible tasks. It can be done. In fact, in 2008 American and European authorities went after Siemens, a German multinational company, for making large amounts of dubious payments globally. By 2010 Siemens had paid out nearly $3.4 billion in investigations, back taxes and fines to end the probe. Fines to authorities in the United States and Europe cost the firm $1.6 billion. In addition, in German court one senior manager and two executives were found guilty of wrongdoing and were fined and sentenced to probation.

Conclusions and Implications

Focusing only on the minimum needed for the SEC to settle with Citigroup and to satisfy the specific challenge presented by judge Rakoff misses the much larger picture. The judge’s ruling brings to light, once more, the extent to which the regulatory agency may have been subject to capture and undue influence by financial institutions, while also potentially challenging the status quo. Selectively, let us suggest five areas that warrant attention:

The debate on how to stem the undue influence of big banks should be revisited, and a spectrum of more stringent measures—even including the breakup of the biggest banks—ought to be seriously considered. Revolving door policies should be revisited. Cooling off periods should be extended, especially for persons occupying sensitive positions that are particularly vulnerable to capture.
The public should debate the implementation and application of regulations by the SEC under Dodd-Frank, focusing on how the bill is faring and codifying the interests and arguments behind the efforts by financial institutions and lobbyists to delay or water down implementation of relevant aspects of the bill.
The cost of violating securities laws should be increased substantially. Simply raising the monetary out-of-court settlement with no admission of guilt will not alter the incentive structure. Rather, the SEC and others should not avoid contempt of court challenges for recidivist banks. More generally, banks should end up in civil court more frequently; settlements should include admissions of guilt, thus facilitating criminal and civil litigation by wrong parties; and financial settlements with the SEC should be larger by a multiple factor. Congress should also seriously consider the recent request by SEC Chairperson Mary Schapiro to allow the agency to levy larger fines against securities law violators.
Like Judge Rakoff’s decision, the extent to which all judges exercise their due responsibility by not ignoring unfair out of court settlements that unduly benefit one party to the detriment of the social good and broader systemic risks, should be reviewed and publicized.
In a transparent and evidence-based manner, an in-depth review should be undertaken to discern whether the Department of Justice has been overly weak in failing to pursue criminal cases against senior bank executives. More generally, there should be increased transparency and disclosure regarding information in the financial sector, including on the Fed’s actions, as well as increased public debate on how campaign finance and lobbying contributions affect voting records in Congress and on politicians’ influence in implementing the regulatory regime and their agencies.

These tougher transparency, regulatory and enforcement incentives would further raise the costs of violating securities laws because companies would face the added risk of investor lawsuits, and possible criminal prosecutions by the Justice Department against executives.

Whether Judge Rakoff’s ruling will set a precedent is unclear, and it depends greatly on the White House, Congress, the SEC, other judges, civil society and reformists in the private sector to seize this opportunity and to address the persistent and costly phenomena of capture.

Authors

Daniel Kaufmann
Veronika Penciakova

Image Source: Â© Jonathan Ernst / Reuters

Conflict Minerals: An Assessment of the Dodd-Frank Act

Melvin Ayogu and Zenia Lewis — Mon, 03 Oct 2011 11:53:00 -0400

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which focuses on reforming U.S. financial regulation as a response to the financial crisis, was signed into law on July 21, 2010. Section 1502, which falls in the final ten pages of the 848 page act, imposes additional reporting requirements on U.S. companies regarding their sources of certain “conflict minerals.” The section is intended to address a concern by Congress “that the exploitation and trade of conflict minerals originating in the Democratic Republic of the Congo and adjoining countries (together called ‘DRC countries’) is helping to finance conflict characterized by extreme levels of violence in the eastern Democratic Republic of the Congo, particularly sexual- and gender-based violence, and contributing to an emergency humanitarian situation therein…” Presumably, this provision is the result of strong advocacy by interest groups concerned with restoring peace and stability in the DRC sub-region. Countries covered under this legislation are the contiguous nation states of South Sudan, Uganda, Rwanda, Burundi, Tanzania, Malawi, Zambia, Angola, Congo, Central African Republic, and Democratic Republic of Congo. While the humanitarian underpinnings of this legislation are commendable, much remains to be done.

The presence of this provision in a bill on financial sector reform is, to say the least, unexpected. Although it may have initially seemed a minor addition to such a major reform bill, media attention around it indicates otherwise. Moreover, the Securities and Exchange Commission (SEC) has yet to issue a directive on the provision despite the legislation being passed over a year ago. This reality and recent challenges to the constitutionality of some sections of the Dodd-Frank Act have kept the legislation on the front burner of current policy debates.

Primarily, the Act uses the instrumentality of “name and shame,” and is directed at companies engaging in economic activities in which conflict minerals are “necessary to the functionality or production” of their manufactures. The regulated minerals are together known as “3TG” metals—tin, tantalum, tungsten, gold (and others determined by the U.S. Secretary of State as financing conflict in the DRC countries)—and are modeled after a certification scheme for “conflict diamonds” commonly called the Kimberly Process. The breadth of industries affected includes aerospace, automotive, electronics and communications, jewelry, healthcare machines, and manufacturing conglomerates.

The burden on affected companies is deliberately severe to acknowledge the serious realities for which the provision is intended. For a company to be compliant, it must, in addition to filing three different forms of paperwork with the SEC, publish a “Conflict Minerals Report” in both its annual report and website. The report essentially requires the country of origin to affirm whether its conflict minerals are “DRC conflict-free” and provide evidence proving this conclusion. Therefore, companies will need to conduct supply chain due diligence and, where necessary, perform third-party verification and/or furnish details which may include the mine of origin. If the company is unable to ascertain the source of its conflict minerals, this fact must be disclosed in both its annual report and website.

Two important implementation issues offer insight into whether or not the law will be effective. Both issues—arrangements for compliance monitoring and enforcement machinery—have been delegated to three government agencies: SEC, State Department, and United States Agency for International Development (USAID). To appreciate the compliance challenges which are likely to confront regulators, it is important to consider different stakeholders’ reactions to the legislation. One group, comprised of U.S. businesses and artisanal miners in DRC countries, expressed concern over the adverse consequences on the corporate “bottom line” and on the income of poor miners whom have few alternative employment opportunities. Another group, comprised of U.S. corporations concerned about the victims of violent conflicts in DRC countries, note the costly implications of the legislation, but hope to implement constructive solutions to address the challenges posed.

The National Association of Manufacturers estimates compliance costs will fall between $9 billion and $16 billion, which are significantly higher than the SEC estimate of $71 million. The variation between the two estimates is huge; however, until the SEC finalizes the regulation, these estimates remain speculative and without a solid-basis for determining the true compliance costs. It is reasonable to expect the SEC will be mindful of certain complicating factors that could unnecessarily escalate compliance costs for companies already struggling under trying economic times. Additionally, such diligence will serve to minimize—to the extent feasible—the unintended adverse effects of the provision on people’s livelihood in DRC countries. Locals are already apprehensive that U.S. companies may nearly boycott conflict minerals originating from DRC countries as a matter of expediency. However, corporate anxiety over uncertainties regarding the severity of compliance regulations can be lessened by pointing out that the Conflict Minerals Report requires only a “reasonable” country of origin inquiry. This regulation contains an escape clause for companies struggling with verification issues—if a company is unable to determine the origin of its minerals, it must simply disclose that fact.

U.S. companies’ and local miners’ concerns are well founded; however, the law is intended to force a paradigm shift in the cost-benefit assessment of mining and thus induce the desired behavioral change in the players. By forcing beneficiaries of mining activities to bear the full costs of doing business—which previously fell upon society—the law partially achieves its purpose. Local beneficiaries would now have to consider alternative means of livelihood or participate in the trade in a manner that does not initiate violence. Similarly, companies that trade the minerals may either have to explore alternative sources of 3TG metals that do not fuel conflicts, or devise rules of procurement within the region which are conflict-free.

These are serious issues of not only economic survival, but also life and death. Clearly, the appealing formula is for all sides to craft a lasting solution to mitigate conflict in the sub-region. DRC, however, maintains little authority in the eastern region of the country where this conflict is most pronounced and is, therefore, incapable of stabilizing the zone. Additionally, some adjoining countries, which are expected to aid the peace process, are instead unscrupulously manipulating the disorder to their advantage. Many adjoining countries also knowingly fuel the crisis by exporting products originating within the borders of their neighbors. For example, Uganda has no significant gold resources and yet has historically been an important gold exporter in the sub-region.

Clearly, addressing trade-related drivers of the humanitarian crisis in DRC countries must go beyond value-chain verification by U.S. businesses. Fortunately, Congress has signaled it is aware of this limitation by pushing beyond supply chain due-diligence and has enjoined the Secretary of State to liaise with USAID in formulating a strategy for peace and stability in the sub-region. Recent media coverage suggests that Dodd-Frank has indeed brought increased awareness of the humanitarian crisis and its trade-related dimensions. However, as the law commands, the proposed partial solutions are incomplete and should, in our opinion, incorporate a far-reaching, global strategy on conflict minerals.

Meanwhile, we offer the following suggestions as a call to action for the SEC, State Department, USAID, and the US Congress. They will make the implementation of the regulation more effective and will inform all stakeholders—manufacturers, NGOs and the DRC countries—of possible ways to move towards a lasting solution to the humanitarian crisis.

The SEC should seize the opportunity to supplement its direct monitoring with whistle-blower support from the NGO community, whom are already interested observers. Although the SEC directly monitors compliance through corporation filings, its audit verification strategy can be improved by co-opting the NGO third-eye.

It is important that the SEC clarifies any ambiguities surrounding definitions and standards, particularly with regard to audit. Presumably many of these vexing issues would have been tabled during the consultation stage when industry and NGOs were allowed to submit comments for consideration by the SEC. Undoubtedly clarity will reduce the overall cost of compliance and discourage the tendency to subvert the law.

In its rule making, the SEC may find instructive the OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas. This guideline has been widely applauded as an outstanding outcome of a multi-stakeholder process. According to remarks by U.S. Secretary of State Hilary Clinton during the 50th Anniversary of the OECD Guidelines for Multinational Enterprises in May 2011, “… they do bring together labor, civil society, and business to create the broadest possible consensus behind them. This is truly the work of a global policy network in action.” The guideline has been endorsed, among others, by the NGO community and the U.S. State Department.

As the law currently stands, the most obvious punishment it carries is reputational, although other punitive measures could potentially be specified. Definitively articulated financial consequences for non-compliance will better enforce regulations than a threat to a company’s reputation, and complement threatening non-trivial compliance costs.

Congress should note that over the long term, coordinated pressure along the entire illicit value chain of conflict minerals would be more effective than a standalone intervention aimed solely at the extractive stage. For armed groups to purchase weapons, it may be necessary to launder part of the money from illicit sales that often involve human rights violation and crime. Therefore, additional remedial measures—such as supporting the global Anti-Money Laundering and Countering of Terrorism Financing (AML/CTF regime)—are indeed helpful. A good starting point would be to lobby state parties to domesticate the United Nations Convention against Corruption as well as support the implementation of Financial Action Task Force (FATF 40+9) recommendations.

Manufacturers should engage suppliers by enlightening them on how to best implement supply chain due diligence and third party verification. They can also clarify roles and expectations for suppliers as well as specify immediate and long-term implications for ongoing contractual agreements.

Create a stronger platform to promote U.S./Africa engagement aimed at establishing political order and legitimate regimes in the sub-region. This can be realized through forging a tripartite coalition of governments including the Africa Union, NGOs, and businesses. USAID’s new Community Mining Program, Friends of Congo, and Motorola Solutions for Hope are outstanding examples of ongoing initiatives by governments, NGOs, and businesses, respectively, to address the situation in the DRC from various angles. Harnessing the collective experience of these committed actors increases the likelihood of a breakthrough in the quest for a lasting peace.

Countries neighboring the DRC must help reduce the conflict minerals trade. Without support from the sub-region, the core problems of the conflict will not be fully addressed. Tanzania, as a DRC country that exports its own gold, has a good reason to partner with the government of DRC to control this problem. Uganda and other complicit states must work towards increasing accountability regarding their involvement in the conflict minerals trade.

Ultimately, resolving the multifaceted crises in the DRC requires coordination within the region and the support of the international community. Dodd-Frank is a good start at the international level. Unfortunately, the lack of a binding global due diligence regime leaves a gap in the fight to end the crisis. Activities of multinational enterprises, who do not face domestic constraints with regard to supply-chain due diligence, remain a challenge to mitigate conflict. This speaks to another reason why a coordinated global effort is an imperative. By working together to establish a lasting peace in the heart of Africa—a global public good—everybody wins: businesses reap cost savings driven by peace rather than by exploitation and opportunism, while locals enjoy peace and stability that are conducive to income growth and job creation.

Authors

Melvin Ayogu
Zenia Lewis

Image Source: Â© Mohamed Nureldin Abdallah / Reuters

Will the United States Become a Global Securities Policeman?

Robert C. Pozen — Thu, 05 Aug 2010 09:58:00 -0400

In June, the U.S. Supreme Court dismissed a class action alleging federal securities fraud by foreign investors regarding shares issued by a foreign company and traded on a foreign exchange: Morrison vs. National Australia Bank. Such class actions are often called “cubed” because the plaintiffs, the company and the trading market are all located outside of the United States.

The Supreme Court held that securities fraud claims under U.S. law do not apply extraterritorially. In particular, the Supreme Court rejected arguments that it was sufficient to bring suit in federal court if a cubed claim involved some conduct or effect in the United States.

In July, a federal district court in New York extended this Supreme Court decision to “squared” class actions – where American investors brought claims under U.S. securities laws for transactions in foreign shares traded on a foreign exchange: Cornwell vs Credit Suisse. In the district court’s view, the rationale of the U.S. Supreme Court precluded the federal courts from adjudicating claims under Section 10(b) of the Securities Exchanges Act with respect to “foreign securities trades executed on foreign exchanges even if purchased or sold by American investors, and even if some aspects of the transaction occurred in the United States”.

Both these court decisions seem to be superseded by Section 929P of the new financial reform legislation, at least for securities fraud claims under U.S. law brought by the Securities and Exchange Commission or the Justice Department. The legislation gives the U.S. courts jurisdiction to hear such claims involving foreign securities traded on foreign exchanges if there is sufficient conduct or effect in the United States. The legislation also requires the SEC to study the extension of the conduct and effect tests to private suits to enforce the U.S. securities laws with regard to foreign securities traded on foreign exchanges.

However, the impact of the legislation is unclear for technical reasons. In its June decision, the Supreme Court stressed that the territorial scope of the federal securities laws did not present a question of jurisdiction – whether federal courts have the power to hear the case. Rather, the Supreme Court viewed the case as presenting a question on the merits – whether the activities at issue should be prohibited by the federal securities laws. While the financial reform legislation clearly gives federal courts the power to hear extraterritorial claims under the federal securities laws, it does not expressly address whether these laws should cover activities by foreign parties regarding foreign securities traded on foreign exchanges.

This is much more than a technical debate about the proper interpretation of a new statutory section. The outcome of this debate will determine whether the SEC and the Justice Department can bring suits in U.S. courts to enforce American concepts of securities fraud in cases involving foreign securities traded on foreign markets – even though such American concepts may be much broader than those applicable in these other countries. In response to the legislation, Le Monde reported that a number of foreign capitals fear seeing the U.S. courts become the “financial policeman” of securities transactions across the globe.

Authors

Robert C. Pozen

Publication: Financial Times

Image Source: © Michael Leckel / Reuters

The Current Regulatory Battle

Douglas J. Elliott — Fri, 16 Apr 2010 17:00:00 -0400

We will not know for some time how important the Securities and Exchange Commission’s civil lawsuit against Goldman Sachs is, because it depends on the strength of the government’s case and the extent to which this is a forerunner of lawsuits against other firms.

It is important to remember that complicated securities fraud cases can be difficult to prove. But this could be a watershed event if the S.E.C. has a strong case and follows this suit with broadly similar lawsuits against other banks.

In the short run, the suit is likely to strengthen the hand of the Democrats who are pushing financial reform legislation. This case will raise the level of public anger still further, providing fuel to move the proposals through the Senate.

I already thought the odds of passage were high; this increases the odds further. However, politics is always difficult to forecast. For example, the Democrats could overplay their hand and succeed in completely uniting the Republicans, leading to a successful filibuster that kills the bill, at least for now.

If Democrats play their hand right, though, the suit will make it harder for Republicans to hold all 41 members in a Senate filibuster vote or to break away one or more Democrats. This is not a good time for a politician to be seen as defending Wall Street.

It is not clear that a different regulatory structure would have made a difference in this case. If the S.E.C.’s allegations are correct, the actions were illegal under current law. The S.E.C. could, perhaps, have done a better job of catching such actions earlier, but that is a matter of execution not broad structure.

Authors

Douglas J. Elliott

Publication: New York Times - Room for Debate

Learning from the Economic Mess

Alice M. Rivlin — Tue, 21 Oct 2008 12:00:00 -0400

Mr. Chairman and Members of the Committee. Past weeks have witnessed historic convulsions in financial markets around the World. The freezing of credit markets and the failure of major financial institutions triggered massive intervention by governments and central banks as they attempted to contain the fallout and prevent total collapse. We are still in damage control mode. We don’t yet know whether these enormous efforts will be successful in averting a meltdown. But this Committee is right to begin thinking through how to prevent future financial collapses and make capital markets work more effectively.

Pundits and journalists have been asking apocalyptic questions, “Is this the end of market capitalism? Are we headed down the road to socialism?” Of course not! Market capitalism is far too powerful a tool for increasing human economic wellbeing to be given away because we used it carelessly. Besides, there is no viable alternative. Hardly anyone thinks we would be permanently better off if the government owned and operated financial institutions and decided how to allocate capital. But market capitalism is a dangerous tool. Like a machine gun or chainsaw or a nuclear reactor, it has to be inspected frequently to see that it is working properly and used with caution according to carefully thought out rules. The task of this Committee is to reexamine the rules.

The essence of market capitalism is that individual incentives for economic gain (sometimes known as greed) can be harnessed to maximize economic growth; channel capital into its most productive uses; and even reduce the risks inherent in economic activity. Yet there are plenty of clear examples of unfettered gain-seeking leading to disastrous collective results—greenhouse gas emissions, for example. The answer to such misalignment of individual and collective incentives is not to abolish markets, but to realign incentives so that markets function better in the collective interest. Cap and trade systems for greenhouse gas emissions are an attempt to do just that.

The financial market crisis provides an opportunity to rethink why individual gain-seeking under current rules led to disastrous results and how to change the rules for the future. Getting financial market regulation right is a difficult, painstaking job. It is not a job for the lazy, the faint-hearted or the ideologically rigid--applicants should check their slogans at the door. Too many attempts to rethink regulation of financial markets in recent years have been derailed by ideologues shouting that regulation is always bad or, alternatively, that we just need more of it. The “less” v. “more” argument is not helpful. We don’t need more or less regulation; we need smarter regulation.

Moreover, writing the rules for financial markets must be a continuous process of fine-tuning. In recent years we failed to modernize the rules as markets globalized, trading speed accelerated, volume escalated, and increasingly complex financial products exploded on the scene. The authors of the financial market rule books have a lot of catching up to do. But they also have to recognize that they will never “get it right” or be able to call it quits. Markets evolve rapidly and smart market participants will always invent new ways to get around the rules.

Plenty of blame to go around

It is tempting in mid-catastrophe to point fingers at a few malefactors or identify a couple of weak links in a larger system and say, “Those are the culprits; if we punish them, the rest of us will be off the hook.” But the breakdown of financial markets had many causes of which malfeasance and even regulatory failure played a relatively small role. Americans have been living beyond our means, individually and collectively, for a long time. We have been spending too much, saving too little, and borrowing without concern for the future from whomever would support our over-consumption habit—the mortgage company, the new credit card, or the Chinese government. We indulged ourselves in the collective delusion that housing prices would continue to rise. The collective delusion affected the judgment of buyers and sellers, lenders and borrowers, builders and developers. For a while the collective delusion proved a self-fulfilling prophecy—house prices kept rising and all the building and the borrowing looked justifiable and profitable. Then, like all bubbles, it collapsed as housing prices leveled off and started down.

Bubbles are an ancient phenomenon and will continue to recur, no matter what regulatory rules are put in place. A housing bubble has particularly disastrous consequences because housing is such fundamental part of our everyday life with more pervasive consequences than a bubble in, say, dot.com stocks. More importantly, the explosion of securitization and increasingly complex derivatives had erected a huge new superstructure on top of the values of the underlying housing assets. Inter-relations among these products, institutions, and markets were not well understood even by the participants and certainly not by the rest of us. But it is too easy to blame complexity, as in, “Risk models failed in the face of new complexity.” Nonsense--too many people failed to asked common sense questions, as in, “What will happen to the value of these mortgage-backed securities when housing prices stop rising and begin to fall?” They didn’t ask because they were profiting hugely from the collective delusion and did not want to hear the answers. Bubbles always provide out-sized opportunities for quick profits. They exacerbate greed and fraud and provide excuses for the suspension of common sense. Can we fix this problem by regulation? I doubt it. It is hard to legislate common sense.

What needs to be fixed

Nevertheless, the bubble and the crash were exacerbated by clear regulatory lapses, perverse incentives that had crept into the system, and instances where regulated entities—and even the Federal Reserve--were being asked to pursue conflicting objectives at the same time. These failures present a formidable list of questions that the Committee needs to think through before it rewrite the rule book. Here are some of the items on that list.

Regulatory gaps. The most obvious regulatory gap is also the easiest to fill. We failed to regulate new types of mortgages—not just sub-prime, but Alt-A, no doc, etc—and the lax, sometimes predatory--lending standards that went along with them. Giving people with less than sterling credit access to home ownership at higher interest rates is basically a good idea, but it got out of control. Most of the excesses were not perpetrated by federally-regulated banks, but the federal authorities should have gotten on the case and imposed a set of minimum standards that applied to all mortgage lending. We can argue about what those standards should be, but they should include minimum down payments, proof of ability to repay, and evidence that the borrower understands the terms of the loan. Personally, I would get rid of teaser rates, penalties for pre-payment, and interest-only mortgages. We may not need a national mortgage lending regulator, but we need to be sure that all mortgage lenders have the same minimum standards and that these are enforced.

Another obvious gap poses a far more difficult question: whether and how to regulate complex derivatives? Much of the financial crisis stemmed from over-leveraged unregulated trading in complex financial derivatives. The question is: should we clamp down on the leverage or on the products themselves? I incline to think that we will be more successful if we operate on the leverage by imposing higher capital requirements on all financial institutions that have any claim on federal help if they are in danger of failing. We should also improve the transparency of derivatives, but I doubt it would be useful to screen classes of derivatives before allowing their sale. Charging a regulator with the task of weighing the risk-spreading value of a class of complex derivatives against the risk posed by the complexity itself strikes me as too hard to pull off.

Perverse incentives. One case of perverse incentives is that the commissions of mortgage brokers are bigger if they bring in higher interest (i.e., riskier) loans. I am not sure how to correct this, someone should be charged with making sure that the borrower understands how the mortgage broker is compensated and encouraged to shop around for a better deal.

Another clear case, it seems to me, is that rating agencies are compensated by the sellers of securities. We should find a way to have rating agencies paid by the buyers of securities instead. This suggestion is often scorned by economists, who say it poses a “free rider” problem, but I think that could be handled by requiring that all investment funds over a certain size pay a small percentage fee to support the services of rating agencies.

A much harder question is what to do about the fact that widespread securitization of mortgages (and other consumer lending) disconnects the lender from the borrower and creates incentives for the lender to ignore repayment risk. Don’t worry about the credit-worthiness of the borrower: just make the loan, sell it to someone else and move on. Securitization has many benefits—and we cannot go back to the days when small town bankers were afraid to lend to working people lest a local plant closure wipe out the bank’s mortgage portfolio. However, we certainly need to clear up the legal responsibilities of loan originators, servicers, packagers and owners of mortgage-backed securities (MBS). We need to ask whether the social utility of slicing up MBS into risk tranches to be sold to investors with different appetites for risk is worth the confusion that ensues when the loan has to be renegotiated. I would favor giving bankruptcy judges the power to adjust mortgages as they do can do with other debts, but it also has to be clear who is on the other side of the mortgage transaction.

Conflicting incentives. An example of conflicting objectives that need to be resolved concerns the future role of Fannie Mae and Freddie Mac. These institutions were told that they were private companies whose job was to make money for their shareholders and that they should not expect federal help if they failed. At the same time, they were told to further the public purpose of expanding affordable housing and put some of their profits into revitalizing low income communities. While the collective delusion held, these objectives were compatible. Fannie and Freddie borrowed huge amounts--arguably at marginally favorable rates because lenders did not believe they would be allowed to fail—bought a lot of mortgages, including subprime, made high profits, and supported a lot of worthy projects. But their rapid growth helped fuel the bubble, and when the collective delusion collapsed, they had to be taken over by the government. In the end we will have to decide whether we want Fannie and Freddie to be public utilities supporting the secondary mortgage market or truly private (and presumably much smaller) private entities that disappear into the private financial sector. But that is a discussion for the distant future. Right now we need Fannie and Freddie to provide support for the faltering mortgage market. Debate over their ultimate status will have to wait.

Another example of conflicting objectives is the responsibility of the Federal Reserve to mitigate asset price bubbles. The Fed has clear responsibility for the stability of the whole economy. It must use monetary policy (a limited tool at best) to keep the economy growing at maximum sustainable rates and restrain inflation when it threatens to derail growth. Asset price bubbles pose a difficult dilemma for monetary policy: when should the Fed try to slowdown growth in the whole economy to control an emerging bubble in some class of assets? The Monday morning quarterbacks of monetary policy have criticized the Fed for not raising interest rates in 1997-98 to curb the dot.com bubble. (Have they forgotten that inflation was falling and that the aftermath of the Asian/Russian financial crisis was causing a credit crunch?) Critics also blame the Fed for failing to raise interest rates in 2002-03 and the first half of 2004 to curb the housing bubble. (Have they forgotten the slow recovery from the recession of 2001?) While it is not realistic to expect the Fed to pursue several objectives simultaneously with the one blunt instrument (the federal funds rate), we certainly need to be more creative about curbing asset bubbles. Maybe we have to invent another instrument specifically aimed at slowing asset bubbles. At a minimum, we could charge the Fed or some other entity with issuing warnings that some class of asset prices is getting out of line. The entity so charged would need strong protection from political interference.

Moving the boxes on the organization chart

My partial list of hard questions does not include a grand new structure of regulatory relationships such on the U.S. Treasury’s Blue Print for a Stronger Regulatory Structure (2008). There is certainly both fragmentation and overlap in the current structure. State regulation of insurance companies is an extreme example of fragmentation, and the responsibilities of the Federal Reserve, the Controller of the Currency, and the Federal Deposit Insurance Corporation certainly overlap with respect to regulation of commercial banks. Nevertheless, I don’t think neatening up the organization chart deserves high priority in a campaign to make regulation more effective. I am skeptical both of the workability of the Treasury’s proposal for organizing regulation by objective rather than function and of the British model of centralizing regulation in a separate Financial Services Agency. Rather, I would start where we are and work to clarify and strengthen the roles of the agencies we have. I would beef up the mandate and resources of the Securities and Exchange Commission (SEC) and clarify the role of the Federal Reserve in insuring that bank holding companies manage their risk competently. In this role, the Fed could be required, not just to pose the common sense questions about risk to the executives of financial behemoths, but to meet periodically with their boards of directors to focus their attention on better risk management.

Thank you, Mr. Chairman and members of the Committee.

Downloads

Download

Authors

Alice M. Rivlin

Publication: House Committee on Financial Services

Ideas for a Second Stimulus

Martin Neil Baily — Mon, 20 Oct 2008 08:49:20 -0400

Key Points in this Testimony

The steps now being taken to ease the financial crisis are the right ones and I expect to see credit conditions easing gradually.

The Main Street economy of jobs and production is now very weak and the housing market has not yet stabilized. We are in a recession and the only question is how deep it will be.

Policymakers are debating a fiscal stimulus package of between $150 billion and $300 billion and that is the right range to be thinking about.

According to the Blue Chip forecast, GDP declined in the third quarter and there will be a mild recession with a further decline in the fourth quarter. With a mild recession scenario like this, a stimulus package of $150 billion would be enough to get the economy back on a growth path.

The Blue Chip is too optimistic, however, and the chances for a severe recession are pretty high, in which GDP would decline at a 4 percent annual rate in both the fourth quarter of 2008 and the first quarter of 2009, with continuing but smaller declines until late in 2009. Under this scenario a stimulus package of $300 billion would be enough to ameliorate the recession substantially, although it would not eliminate it.

Given the uncertainty involved, I recommend an immediate stimulus package of $200 billion and the preparation of an additional stimulus of $100 billion that is triggered if unemployment goes over 7.5 percent.

It is vital to stabilize the housing market. Some of the funds in the financial rescue package should be used to help households directly. If more funds are needed, a portion of the stimulus package should be used for this purpose. Enabling families to move into 30-year fixed rate mortgages through Fannie and Freddie at a rate of interest between 5 and 6 percent is an attractive approach to providing this assistance.

It is vital that a stimulus work quickly and provide as much boost to spending as possible. A further round of tax rebates to be distributed this fall would get help to the economy quickly.

Other possible approaches include assistance for unemployment insurance, and aid to states and localities. The latter could include funds for infrastructure, provided this does not slow down disbursement. Increased maintenance of our existing infrastructure is vital and would add to jobs quickly.

The explosion of federal debt is very troubling and must be addressed by Congress once the crisis is past. Concerns about the marketability of Treasury securities and about inflation are real but not great enough to counter the urgent need for a new fiscal stimulus.

The Outlook for the U.S. Economy[1]

The U.S. and global economies have been severely stressed by the crisis in financial markets. The drying up of lending has adversely impacted both the business and consumer sectors. Many economists at Brookings, along with others, have advocated the use of direct capital injection into financial institutions to recapitalize them and allow the resumption of bank lending and thanks to the actions of Congress, the Treasury has both the funds and the authority to accomplish this and has now started the process of recapitalization. It would have been better had this process started earlier, but I am cautiously optimistic that the steps now being taken here in the United States as well as by other countries will be enough to stabilize the financial sector. Given that this crisis has repeatedly turned out to be worse than expected, however, that may not be the case and Congress and the Administration must stand ready to do whatever is needed to restore an effective financial sector. A strong financial sector is essential to overall economic growth and the recovery of Main Street. It is reasonable to expect that taxpayers be protected as far as possible and share in any future capital gains that result from the rescue, but it would be a terrible mistake to let this sector go under, even though Wall Street has caused many of its own problems.

Even though the financial sector is likely on the right track, the housing market remains very depressed and home prices are still falling. The most important factor determining whether homeowners default is whether or not they are under water, with outstanding mortgage debt exceeding the value of the house. However, with a recession underway, families that face unemployment or loss of income for other reasons will find that it is impossible for them to pay their mortgages or credit card bills and they lose their homes. Policies have been put in place already to help homeowners, but they may not be enough. If the American economy is to move to a sustainable recovery, the housing market has to stabilize.

The economy of Main Street is headed in the wrong direction, with employment falling, unemployment rising and monthly data that suggest that GDP has been declining since mid year. GDP growth will likely turn negative when the data for the third quarter are tabulated, and the decline will be much larger in the fourth quarter of this year. GDP can be expected to fall for one or two more quarters in 2009. The biggest weight pulling the economy down has been the residential housing sector and, so far, there is no clear evidence that this has turned a corner. The data on housing starts released October 17 continue to show a pace of rapid decline and I expect to see further reductions in residential construction for the rest of this year and perhaps into 2009. The numbers on retail sales released last week were very weak especially since the figures for earlier months were revised down, auto sales are low, and industrial production is falling. Consumption is being adversely affected by the huge loss of wealth from the decline in home prices and equity prices and can be expected to decline at about a 3 percent annual rate in the second half of this year. Business investment held up well in the early stages of the crisis, but is now falling also. The U.S. economy is in a recession and the only question is how deep it will be. Unemployment tends to lag behind the business cycle and often continues to rise even after a recovery is underway. Based on the economic trends now at work, it is very probable that unemployment will hit the range of 7 to 8 percent and a deeper recession is quite possible. Unemployment hit 10 percent in the 1982 recession and, while I do not think we will reach that level in this recession, we cannot rule it out. It takes GDP growth at a rate between 2½ and 2¾ percent to keep unemployment from rising, and a higher growth rate to bring unemployment down. We may see a solid bounce back in growth in the second half of 2009, but it is more likely that it will take until 2010 before unemployment declines again.

One of the bright spots this year has been the performance of U.S. exports. After adjusting for inflation, exports grew at over 12 percent at an annual rate in the second quarter and are likely to match that pace or more in the third. In addition, inflation-adjusted imports are weak as a result of the fall in the dollar that began in 2002 and the weakening U.S. economy. Domestic demand actually remained flat in the second quarter and all of the GDP growth was accounted for by the improvement in net exports. Exports have been keeping us out of the graveyard. Looking ahead, I expect that exports will remain a positive and that imports will still be weak, but the effects of trade will not be large enough to offset falling consumption and investment. Currently, both Europe and Japan are weakening and likely will head into their own recessions, making for a slowing of U.S. export growth. The dollar has recovered some ground against the euro also, which will trim U.S. export gains.

One economic factor that is clearly helping and is likely to remain a positive is commodity prices. The price of oil fell below $70 a barrel on October 16^th, less than half of the peak price it hit earlier this year. Commodity prices fluctuate greatly and it is hard to tell exactly where they are headed, but a weakening global economy can be expected to depress commodity prices, so it is unlikely that they will return to anything close to their peak levels. The United States, of course, is a producer of commodities as well as a consumer, so there are companies and workers that are hurt when commodity prices fall. On balance, however, U.S. economic growth benefits from a fall in commodity prices, especially oil and food prices which very quickly affect the wallets of consumers. There is nothing like seeing oil at $140 a barrel to make oil at $70 a barrel look good.

In the early stages of the financial crisis it was notable that jobs and GDP were holding up rather well; in fact there was 2.8 percent growth in the second quarter. That good news about growth was deceptive, however. The financial crisis has set in motion the dynamics of an economic downturn. Even though the financial sector is probably on the road to recovery, its negative impact on growth will remain with us for a while yet.

This recession was not inevitable. Almost everyone was caught up in the belief that housing prices would keep rising and this encouraged speculation and over-borrowing by households, lax lending standards by mortgage providers and a failure to supervise and regulate banks effectively. Wall Street banks as well as foreign banks became overleveraged and took on excessive risks, credit rating agencies failed to do their job.[2] There is plenty of blame to go around. Congress, the Administration and the Federal Reserve should have done more to help and so should the economics profession. Given what has happened, there is nothing that Congress can do now that will allow us to avoid a recession, and so the goal now is damage control, avoiding a deep recession and putting in place the basis for a solid recovery.

What Can Policymakers Do to Ameliorate the Recession?

Given the economic weakness, there is a strong case for a new fiscal stimulus package that would boost spending and offset the chain reaction of declining spending and employment. Historically, the use of fiscal policy to smooth the business cycle has had a mixed record. It is hard to assess where the economy stands, so that fiscal stimulus can sometimes have an impact when the economy is already recovering and does not need the help. That problem does not apply to the current situation. It is clear that the economy is trending down and needs help to sustain aggregate demand and private sector employment. The more serious objection to a stimulus package is that it will contribute to the budget deficit and that is indeed a valid argument, but it does not carry the day. If the economy goes into a severe recession, tax revenues will fall sharply and the impact on the budget deficit will likely be even worse than the impact of the fiscal stimulus. Even if a stimulus package creates a net cost to the deficit, that cost is worthwhile to avoid the damage of a severe recession.

How large should the stimulus package be? Assume that there is a stimulus passed this fall that injects $100 billion into the economy in the first quarter of 2009, and that around 80 percent of this amount is spent over the first three quarters of 2009—$40 billion in the first quarter and $20 billion in each of the subsequent two quarters. (I have used $100 billion as a round number to make the arithmetic easier to follow. There is a good case for a larger stimulus package than this.) Such a package would add about 1.1 percent to GDP growth in that quarter about O.75 percent to the GDP growth rate in the second and third quarters of 2009. The overall, the increment to GDP growth in 2009 would be a little under 0.7 to the growth rate for the year (averaging the quarterly effects of 1.1, 0.75, 0.75 and 0.15). A larger stimulus package, I assume, would scale up the impact proportionately, with a package of $150 billion being 50 percent larger and a package of $300 billion having three times the impact.[3]

The current Blue Chip consensus forecast says that GDP declined 0.3 percent in the third quarter of this year and will decline 1.1 percent in the fourth quarter. The Blue Chip then says that GDP will decline by only 0.1 percent in the first quarter of 2009 and will resume positive growth after that. If this Blue Chip forecast is correct, a package of $150 billion would boost growth to 1 percent in the first quarter of 2009, and as high as 2.9 percent in the second quarter. Under this scenario, a stimulus of $150 billion seems plenty.

The Blue Chip consensus is too optimistic and many of the forecasters who contribute to this consensus have been revising down their forecasts. Consider a pessimistic scenario where there is about a 4 percent GDP decline in the fourth quarter of this year, about the same in the first quarter of 2009, about a 1.5 percent decline in the second quarter of 2009, about a 1 percent decline in the third quarter and a small positive growth rate in the fourth quarter. I do not think we will see a recession quite that bad, but that scenario is not out of the bounds of possibility. There is about a 25 percent probability that we will see a recession of this severity in the absence of offsetting policy actions. Suppose Congress were to enact a stimulus package of $300 billion—a number that is around the high end of the current debate. This would boost growth but even so there would be a GDP decline of 0.7 percent in the first quarter of 2009, followed by positive growth of about 0.75 in the second quarter and growth of just over 2 percent in the third quarter. The fourth quarter of 2009 would remain sluggish unless the stimulus had succeeded in reviving consumption. Under this scenario, a $300 billion stimulus would not result in buoyant growth in 2009, but it would substantially offset the severe recession.

What are the uncertainties around these estimates? I have assumed that 40 cents of each dollar of stimulus is spent in the quarter in which the money is received by families and 80 cents is spent over three quarters. Some economists will judge these numbers are too high and point to the impact of the first stimulus package in 2008 where consumption fell in the second quarter and is expected to fall in the third, despite the rebate checks. The difficulty with that view is that we do not know the counterfactual, what the situation would have been without the tax rebates. Very likely, consumption would have been significantly lower. Given that American consumers on average have been spending nearly all of their disposable income for many years, I find it hard to believe that they will save a huge fraction of any additional income from a new stimulus package for more than a few quarters. Initially, the 2008 tax rebates went into savings accounts or to pay off debts, but this strengthening of consumer balance sheets is allowing them to weather the economic conditions of today with smaller cutbacks in spending.

It is quite possible, however, that the lags will be longer than specified in this example. A stimulus package passed this fall might not get money into people’s hands until the second quarter of next year and the impact of that on spending might be lagged into the latter half of 2009 or into 2010. If the Blue Chip forecast turned out to be correct and, in addition, it took a while for the stimulus to work, we could find that the policy had over-stimulated an economy that was already well into recovery. My own judgment is that this recession is likely to be prolonged, so I am not too worried about that possibility. In addition, monetary policy could act to slow the economy if it turns out that it is overheating.

Given the dangers the economy is facing, I view $150 billion as being about the minimum amount that will have a serious impact on economic growth in 2009. Given the concerns about the budget deficit that I articulate shortly in this testimony, I would not exceed a $300 billion package. My specific proposal within this range of numbers is therefore to prepare a stimulus package in two tranches. The first to be enacted immediately would be for $200 billion. The second tranche for an additional $100 billion would be ready to go and would be enacted on the basis of a trigger. One possible trigger would be that if the unemployment rate moves over 7.5 percent, the second tranche is released.

What Form Should the Stimulus Package Take?

The important factors to consider are well-known to this committee and I recommend the analysis of stimulus design provided this spring by the Congressional Budget Office. In order to alleviate a recession that is already underway, it is important to get the money into the hands of Americans quickly and that this addition to income translates into additional spending as close to dollar for dollar as possible. Given the problem of the exploding budget deficit, it is important that the changes be temporary and do not contribute unduly to the worsening of the deficit in the long run.

Stabilizing the Housing Market. The economy will not return to sustained economic growth while the housing market continues to fall. And there is a two-way interaction between these two factors because supporting economic growth will help stabilize the housing market. Congress has already agreed to a substantial investment of capital into the GSEs to support the mortgage market. And the terms of the $700 rescue package allow for the purchase of mortgages as well as mortgage-backed assets. Since I do not know how much money it will take to recapitalize the banking system, so I am not sure how much is available for direct support of the housing market. If there is not enough money already approved, then I would urge the Committee to support additional funds for families facing default. It is very hard to do this without rewarding past misbehavior by either lenders or borrowers, but I find attractive the proposal from both Republican and Democratic economists to allow households to roll existing mortgages into new 30-year fixed rate mortgages available through Fannie and Freddie at an interest rate between 5 and 6 percent. These would particularly be valuable to families caught in interest rate re-sets to high levels, and the pre-payment penalties could be adjusted and rolled into the new mortgage, or eliminated altogether. The program would be restricted to owner-occupied properties.

Tax rebates. I urge the committee to pass quickly a new tax rebate package. If this were done very quickly, the IRS could use the same taxpayer list that was used earlier this year and the money would be released this fall. Having the rebates be refundable ensures that low and moderate income families get a benefit. The IRS got the rebate checks out quickly earlier this year and using this approach is simple and quick.

Unemployment Insurance. This program has traditionally been a backstop for the economy, serving as an important automatic stabilizer. With the job situation deteriorating there are many workers reaching the point where benefits are exhausted and it would make sense to extend the duration. Over the years, the fraction of the unemployed receiving benefits has declined and women seem particularly disadvantaged because they often work part-time. In 1975 Special Unemployment Assistance was enacted by a Democratic Congress and signed by President Ford to help persons that were not eligible under the usual rules. I would support such a program again now, particularly to help single mothers or fathers who have lost jobs but are not eligible for standard UI benefits and who will find it difficult to qualify for welfare. This program should be funded by the federal government and not by the states (the program was federally funded in 1975).

Infrastructure. Many House members are concerned about the deplorable state of the nation’s infrastructure and would like to devote some fraction of the stimulus package to infrastructure investment. I share the concerns about the state of our roads and bridges, but I am also aware of the objection to using infrastructure investment as a stabilization policy because it can be too slow to work. There are two ways in which this problem could be overcome: First, there is great need for improved maintenance of the infrastructure, including crumbling roads that need repair and bridges that may age prematurely or even collapse because they have not been looked after. Looking after the existing infrastructure is not as exciting as cutting ribbons on new projects, but it could generate jobs quickly and meet an important need. Second, there are state and local projects that are being cancelled because of the short term budget pressures. Sustaining such projects would avoid layoffs that would otherwise take place.

Aid for States and Localities. There are many states and localities that are feeling tremendous budget pressures because of the weak economy and the decline in property tax revenue. Providing assistance to them would prevent or ameliorate the cutbacks in spending that would otherwise occur.

General budget assistance, targeted perhaps to states with high unemployment and mortgage default rates

Assistance to sustain Medicaid spending. Some states are finding it difficult or impossible to sustain support for health care because of budget pressures.

Business Tax Changes. The marginal rate of corporate tax is higher in the United States than in many other countries with whom we compete internationally. At the same time, corporations do not pay a lot of tax—the average rate of taxation is pretty low. As part of a long run package of tax reforms I support the idea of broadening the base of corporate tax and lowering the rate. In my judgment, however, adjusting business taxes now is not attractive as a response to the recession. Capital gains taxes are already low. Investors are staying on the sidelines of the stock market because they are concerned about market risk and volatility, not because of concerns about the taxes they might pay on capital gains. In the past several years, non-financial corporations have improved their balance sheets and added to their cash holdings. It is much more important to get the balance sheets of the financial sector into better shape and free up lending to businesses and consumers. The fiscal stimulus package is sufficiently important, however, that if business tax changes are necessary to obtain bipartisan support for the package, I would support them on that basis.

The Threat of Inflation and the Fiscal Challenge: $700 billion here, $300 billion there and pretty soon we are talking about real money A year or so ago, when the economy was still growing it was clear that the problem of chronic budget deficits was real and urgent. We have known for years that the population is aging and living longer and that Medicare, Medicaid and, to a lesser extent, Social Security were going put pressure on the budget for years to come. I support fiscal discipline and believe that the federal budget should be balanced on average over a period of years. Can we really afford to pay for a fiscal stimulus package over and above the $700 billion for the rescue package together with the funds for Fannie, Freddie, AIG, and Bear Stearns? There are two possible economic arguments for why we might find it unwise to expand the deficit for a stimulus package. The first would be that it caused a flight from U.S. Treasury securities and perhaps a run on the dollar. The second is that it would result in inflation. It would take more space than is available to go into these issues in depth, but the simple answer is that neither concern is large enough to prevent passage of a fiscal stimulus.

Investors here in the U.S. and around the globe know the fiscal situation of the federal government and anticipate the likely expansion of the national debt. Despite that, there is no shortage of buyers for U.S. Treasuries. The interest rate on 10-year notes is under 4 percent and the U.S. dollar has appreciated against the euro in the past year and stands now at about $1.34. There has been a “flight to quality” recently as a result of the crisis and the benchmark of quality remains U.S. Treasury securities. I am deeply troubled by the persistence of federal deficits, the over dependence on foreign borrowing and the lack of a national debate about how to pay for federal spending and how to moderate its growth. But letting the economy go into a deep recession is not going to solve the long run fiscal challenge facing America. Global financial markets will let us borrow to pay for the stimulus package and we should go ahead and do that.

There is a working model of inflation that has guided policymakers over the years and its first ingredient is that inflation will increase when commodity prices go up and will decrease when these prices decline. Commodity prices are set in global markets and are only partly under the influence of the state of our own economy or our monetary policy. The second ingredient is that inflation will increase when there is excess demand in the economy, production capacity is strained and labor is in short supply. It will fall when there is slack in the economy. The third ingredient is linked by most economists to inflation expectations, so that when higher inflation is expected it can actually cause higher actual inflation. Of these three ingredients, the first two are pointing to an easing of inflationary pressures: commodity prices have come down and seem likely to stay well below their peak. The U.S. economy already has slack capacity and will have much more in the year ahead. For the third ingredient, there have been signs of an upward adjustment of inflation expectations, something that has troubled the FED in the past year. That seems to be fading, however, as the other drivers of inflation ease off. Adding huge amounts to federal borrowing is not a good thing for inflation, but that concern is not enough to change the case for the stimulus. I am old-fashioned enough to think about wage-price spirals as much as expectations, and on this score, there is little sign of the kind of wage price spiral that was so difficult to deal with in the 1970s. With good productivity growth, businesses are not facing an upward push of labor costs.

Conclusion

The American economy is in trouble and the balance of risks strongly favor a substantial fiscal stimulus. I urge Congress to act on this proposal as soon as possible.

[1] The discussion in this section has benefitted from my work as an advisor to the McKinsey Global Institute. I have also benefited from the analysis of Macroeconomic Advisers and other forecasters. The views are the author’s own.

[2] See the Brookings website for links to recent papers on the financial crisis and what to do about it.

[3]The U.S. economy produces and spends about $14 trillion a year or $3.5 trillion in each quarter. The first round effect of an additional $40 billion in spending, therefore, is to add 1.1 percentage points to the GDP growth rate in the first quarter of 2009. That increment to growth would drop to 0.55 percentage points in the second and third quarters. In a slack economy, a positive increment to consumer spending is likely to have a second round effect, as the increase in retail sales or other spending puts more money into the hands of the workers and businesses that provide the goods and services. I assume there would be the equivalent of about another $50 billion as a secondary effect for each $100 billion of initial stimulus. It is hard to know the timing of this secondary effect—it would likely be spread over 12 to 18 months after the passage of the stimulus package. To get a rough magnitude, I assume that the secondary impact would add 0.2 percent to growth in the second quarter of 2009, another 0.2 percent in the third quarter, 0.15 in the fourth quarter and the rest spread further into the future.

Authors

Martin Neil Baily

Publication: House Committee on the Budget

Making the Rescue Package Work: Asset and Equity Purchases

Martin Neil Baily and Robert E. Litan — Fri, 10 Oct 2008 12:00:00 -0400

Executive Summary

If the main purpose of the Emergency Economic Stabilization Act of 2008 is to give banks confidence in each other, then enabling Treasury directly to bolster the capital positions of banks that need more capital may be an even more effective way to restoring confidence to the inter-bank market than the purchased of troubled assets. Whatever Congress may have intended about the pricing of the distressed assets, it also authorized a much more direct way to recapitalize the financial system and weak banks in particular: direct purchases by Treasury of securities that individual institutions may wish to issue to bolster their capital. At this writing, Treasury reportedly is considering ways do this. In this essay, we outline a specific bank recapitalization plan for Treasury to consider.

In particular, Treasury could announce its willingness to entertain applications for capital injections, using a set pricing formula. For publicly traded banks, Treasury could buy at the price as of a given date, such as the price one or more days before its plan was announced. For privately-owned banks, Treasury could use a price based on the average price-to-book value for publicly traded banks as of that date. To prevent government intrusion into the affairs of the banks, the stock should be non-voting. Treasury would make clear that it only would take minority positions. There should be no takeovers of more companies—AIG, Fannie and Freddie are quite enough. Treasury also should announce that it will dispose (or sell back to the bank) any stock acquired through these actions as soon as the financial system has stabilized and the bank is in sound financial condition (perhaps a time limit, such as three years, should be a working presumption).

We believe Treasury can accommodate a systematic recapitalization plan within the funding it has been given – initially $350 billion and another $350 billion later upon request to Congress (unless it disapproves) – by using the required disclosures about its asset purchases as a way of jump starting private sector pricing and trading of these securities. This should conserve Treasury’s resources it might otherwise use for asset purchases, and thus free up funds to recapitalize weak banks directly, but in an orderly fashion.

Treasury will have to be careful when it buys distressed assets to guard against the possibility that banks will just dump their worst stuff on taxpayers. The Department will also have to be careful when buying equity in banks. There cannot be an open invitation for bank owners to move assets out of the bank and then, in effect, say: “We don’t want this bank, you buy it.” To avoid this problem, Treasury should work closely with the FDIC and other regulators to determine whether or not a particular bank is eligible for an equity injection. The Department also may need to limit the scope of the recapitalization program to larger national banks, if it becomes infeasible to allow smaller banks to participate.

Making the Rescue Package Work: Asset and Equity Purchases [1]

The unprecedented financial rescue plan – technically the Emergency Economic Stabilization Act of 2008 (“EESA,” the “Act”, or the “plan”) -- has now been enacted by the Congress. One of the goals of the plan is to end the immediate panic in inter-bank lending markets, and on this basis several omens are not encouraging.

The Dow Jones stock index has been dropping daily, by large amounts, since EESA was enacted. The TED spread measures the difference between the interest rate on short term Treasury bills and the interest rate banks pay to borrow from each other (the LIBOR) and is a widely accepted measure of perceived risk in the financial sector. For several years this spread had hovered around 50 basis points or half a percentage point, reflecting the fact that lending to other financial institutions was considered almost as safe as buying Treasury bills. However, the spread shot up to 2.4 percentage points in July 2007 as the financial crisis hit, and it fluctuated widely in subsequent months. Following passage of the plan it remains even more elevated than it was last July—it was 3.8 percentage points as of October 7 and broke 4 percent on October 8. Financial institutions simply do not trust each other’s credit worthiness. Some of the market worries, of course, reflect the fragile state of the U.S. and global economies, but clearly the passage of the rescue plan itself has not calmed markets.

A second and related goal for the plan, according to media accounts, is to facilitate the recapitalization of the financial system, but the language of the bill is surprisingly coy about this. While the Act aims to “restore liquidity and stability to the financial system” it also directs the Treasury Secretary to prevent “unjust enrichment of financial institutions participating” in the asset purchase program. It is not yet clear whether Treasury will choose to recapitalize banks through its asset purchases – by buying them at prices above the values to which banks and other sellers have already written them down – or whether Treasury will simply use its purchases to stabilize prices for these securities and thus provide liquidity to the market, even if it may result in additional write-downs of their values (and thus additional reductions in capital).

Whatever Congress may have intended about the pricing of the distressed assets, it also authorized a much more direct way to recapitalize the financial system and weak banks in particular: direct purchases by Treasury of securities that individual institutions may wish to issue to bolster their capital. Of course, in normal times, such authority would be unnecessary because financial institutions would seek to tap private sources of capital first. But these are not normal times, to say the least.

If the main purpose of the plan is to give banks confidence in each other, then enabling Treasury directly to bolster the capital positions of banks that need more capital may be an even more effective way to restoring confidence to the inter-bank market. Accordingly, we outline here a possible supplementary bank recapitalization plan that we believe Treasury should pursue, at the same time it purchases distressed assets. As this paper is being completed on October 9, 2008, The New York Times reports that the Treasury is now considering such a move. We are encouraged by this and in this essay we provide both a rationale for doing so and some concrete suggestions for how such a direct recapitalization program might work. We do not support further nationalization of the banking system beyond what has already been done but we believe that the crisis has become so severe that the asset purchase plan on its own will not be enough to turn the current situation around. Additional capital is urgently needed and could be supplied by Treasury purchases of minority, non-voting equity stakes, or by warrants.

Why Do Banks Need More Capital?

Financial institutions make money by borrowing money on favorable terms, that is, at low interest rates, and then lending it out at higher rates or by buying assets that yield higher returns. They may make money in other ways too, but the state of their balance sheets of assets and liabilities is crucial. In order to create a viable financial institution that can accommodate requests by depositors to take money out, someone has to put up capital and typically this comes from the equity in the company. The owners of the company have an incentive to keep this equity capital low and to build a large volume of borrowing and lending off a small base of capital—to increase leverage. This is because the profits earned are divided among the equity owners and the less capital there is, the higher the return on equity.

Governments for many years and in almost all countries have regulations in place setting capital requirements for banks in particular to stop them from taking too much risk in the pursuit of high returns and also protect any fund that insures their deposits against loss (the FDIC in this country). But some of our larger banks in recent years found a way around these rules by establishing “off-balance sheet” entities – Structured Investment Vehicles (“SIVs”) – to purchase mortgage-related and other asset-backed securities that the banks were issuing. In addition, large investment banks significantly increased their leverage in the years running up to the recent crisis, and were able to do so without mandated capital requirements. As a result, when the mortgage crisis hit, our financial system was weaker than was widely believed, and in the case of large banks in particular, than was officially reported.[2]

The mortgage crisis, which first surfaced in 2006 and has escalated rapidly since then, has hit bank balance sheets severely. As banks were forced to recognize losses on the mortgages they held in their portfolio, and especially to write down the values of their mortgage securities to their “market values” (even though the prices in those “markets” reflected relatively few “fire-sale” trades), they suffered reductions of their capital. Furthermore, the large banks that had created SIVs to escape such events found they could not hide from them when the SIVs could no longer roll over the commercial paper they had issued to finance their holdings of mortgage securities. To avoid dumping these securities on the market to satisfy their creditors, the banks took the SIVs back on their balance sheets, only to suffer further losses to their capital.

As we have seen, some of our largest banks – Washington Mutual and Wachovia, to name two – have not been able to survive all of this, and have been forced or are or being forced into the hands of stronger survivors. Other banks have been doing their best to shore up their capital bases by issuing new equity to replace the losses they have absorbed on delinquent loans and declining prices of their asset-backed securities. According to media reports, financial institutions (largely banks) worldwide have suffered over $700 billion in such losses to date, of which they replaced approximately $500 billion by issuing new equity.

But more losses are sure to come; indeed Secretary Paulson has said to expect further bank failures. Earlier this year, the International Monetary Fund projected that losses due to the credit crisis worldwide could hit $1 trillion. The IMF has recently upped that forecast to $1.4 trillion. If anything close to this latest forecast is realized, then many banks – here and abroad – will need to raise even more equity, but in a capital market that is now highly more risk averse than only a few months ago.

It is in this environment that banks have grown much less comfortable dealing with each other, even though they must to keep the financial system running. Every day, some banks have more cash on hand, or reserves, than they need to meet reserve requirements and ordinary demands for liquidity, while others are short of such funds. In the United States, banks thus trade with each other in the Federal Funds market while global banks borrow and lend to each other through the London Interbank market using the LIBOR rate of interest. The Federal Reserve’s main objective of monetary policy is to stabilize the “Fed funds” rate around a target, now just lowered to 1.5%, down from 2% where it has been for some months (and down from 5.25% before subprime mortgage crisis). To do so, the Fed has added a huge amount of liquidity to the financial system, even going so far this week as to buy up commercial paper issued by corporations, an unprecedented step. But the Fed does not and probably cannot control the longer term inter-bank market, in which banks lend to each other typically over a 3-month period.

The steep jump in the 3-month inter-bank lending rate – well over 4 percent – reflects two fundamental facts that EESA is designed to address. One is that banks don’t trust each others’ valuations of the mortgage and possibly other asset-backed securities they are all holding, precisely because the “markets” in those securities are so thin and thus not generating reliable prices. The second problem is that banks either are short of capital themselves, or fear that their counterparties are. No wonder that banks are so unwilling to lend to each other for a period even as short as three months – which in this environment, can seem like an eternity.

The capital shortage in the banking system, in particular, has severe implications for the rest of the economy. An institution that is short of capital is forced to cut back on its lending and this shows up in denials of lines of credit to companies and reductions in credit limits for consumers. Households cut back on spending; it is difficult to get a mortgage or a car loan; and companies reduce investment and curtail operations. And as we learn in any college course on banking, the impact of a loss of capital on bank lending can be multiplied. Each dollar of bank capital supports roughly ten dollars of overall lending in the economy. Each dollar of lost capital thus can result in ten dollars of lending contraction. The impact of an economy-wide bank contraction can be devastating for Main Street. The Great Depression was greatly exacerbated by the collapse of banks. The long stagnation in Japan was in large part the result of a failure to recapitalize the banks.

How bad is the current problem? We do not know how many banks, insurance companies or other financial institutions are in a weakened state, or perhaps even more important, may become weakened as the overall economy deteriorates. The official data published so far don’t really help on this score. The FDIC compiles information on the number and collective assets held by “problem banks,” or those in danger in failing. As of the second quarter of 2008, there were 117 such banks with assets of $78 billion up from 90 in the second quarter with assets of $28 billion., These figures did not include Washington Mutual, which would have failed had it not been bought by J.P. Morgan, or Wachovia, which at this writing, looks like it will be acquired by Wells Fargo (but also was in danger of failing without being acquired by someone). Together these banks hold more than $500 billion in customer deposits. Furthermore, according to recent media reports, even some large insurance companies (beyond AIG) may be having capital problems, having suffered large losses on the securities they hold in reserve to meet future claims.

Can the Asset Purchase Plan Succeed in Recapitalizing the Banks?

In principle, there are two ways in which the original Treasury asset purchase plan would recapitalize the banks. The first method is premised on the view that private markets are unwilling to supply capital to the banks because investors do not know how much their assets are worth. The Treasury, it is argued, would use its asset purchase plan as a way of revealing the prices of the assets and once that information is known, the banks will be able to raise new capital again from private markets. But better pricing will only attract capital if there are investors out there who are willing to supply it. Given the dramatic downturn in equities markets, finding such willing investors will be difficult, to say the least. Those investors that provided capital to banks early on in the crisis have been hit hard by the subsequent decline in equity prices and are reluctant to get burned again. When Bank of America said it would raise $10 billion from the markets, for example, its stock price fell sharply, suggesting there is a lot of market resistance to be overcome before private investors are willing to recapitalize the banking system.

Second, in principle, Treasury could recapitalize the banks by buying distressed assets at prices above those at which the securities are currently carried on the books of the institutions that sell them (original book or purchase value minus any write-offs).[3] In this case, the bank would be able to report a capital gain from its sale to the Treasury, a gain that would reverse, at least in part, the capital losses it had taken in the past and thereby add to its capital.

Treasury has said it will use reverse auctions[4] when it buys assets, and it is possible that the Department will be able to construct some auctions that will enable some holders of troubled assets to sell them to the Treasury at prices that earn a capital gain. But we are somewhat skeptical how many securities will fall into this category. For one thing, asset-backed securities are not homogenous, like traditional equity or bonds. In addition, it would be surprising in the current environment if reverse auctions would reveal prices that are above the written-down values of many of these securities. After all, an auction does not necessarily produce valuations that reflect the “hold to maturity” price rather than the “liquidation” price for the securities, as Fed Chairman Ben Bernanke suggested the purchase plan would accomplish.

Accordingly, we strongly suspect that Treasury will have to purchase many securities in one-on-one deals rather than through auctions. But in doing this, it may be both legally and politically difficult for the Treasury to pay prices in negotiations that are above the valuations banks or other sellers already have given them. Section 101 (e) of EESA specifically requires the Treasury Secretary “to take such steps as may be necessary to prevent unjust enrichment” of participating financial institutions, and Congress could construe such language to preclude such sales.[5] Furthermore, even if there were not a specific prohibition in the EESA, Treasury may wish to avoid the public criticism it would face if it purchased assets at prices that would allow participating institutions to book gains. And, in the case of sales at prices below the explicit or implicit price of the securities carried on an institution’s books, the sales will trigger further accounting losses and thus additional deductions from reported capital.

In short, we are not at all confident that the Treasury’s planned purchases of troubled securities, by themselves, will do much to recapitalize the banking system. This does not mean that the planned asset purchases will not deliver some needed help. Although at this writing the inter-bank lending market remains frozen even though EESA has been enacted and signed into law, one reason why banks and others may not yet have confidence that it will lead to a thaw in credit markets is that the guidelines for the asset purchases have not yet been issued. Once these guidelines are announced and the purchases begin, and the markets start to see real results, it is possible that some of the missing trust in the banking system will come back.[6]

However, Treasury may not need to spend, and for reasons elaborated below we do not believe it should spend, anywhere near the full $700 billion, or perhaps even most of the initial $350 billion tranche in borrowing authority, to liquefy the markets for mortgage and other asset-backed securities. EESA requires Treasury to publish (within two days) information about each of these purchases. We urge the Department to include in such publications (presumably on its website) regular data on the defaults and delinquencies to date of the loans underlying each batch of securities it purchases. Such information should enable financial institutions that are still holding similar securities not only to price them more accurately, but also to give market participants enough confidence to begin trading these securities without further Treasury purchases.

Husbanding its resources should be a prime objective for Treasury. In conducting its purchases of troubled assets, it should target first those asset categories that are the most illiquid. The main objective always should be jump-starting private sector activity or at least bringing greater clarity to the pricing of particular classes of securities. There is no need for Treasury, therefore, to make repeat purchases of similar securities (such as collateralized debt obligations issued within several months of each other, structured in roughly a similar way). Rather, the aim should be to make a market in as many different asset categories as are reasonably necessary to provide guidance to market participants, no more, no less.

Yet no one can be confident at this point that asset purchases alone will give banks sufficient confidence to begin dealing with each other at much lower interest rates. If the asset purchases do the trick, fine. But if they don’t, Treasury should make sure it has enough financial ammunition to pursue a second, more direct, strategy for restoring banks’ confidence – the direct bank recapitalization strategy to which we now turn.

Recapitalizing the Financial System Directly

Having the government put capital into financial institutions directly is not a new idea. It is the approach followed in this crisis for Fannie and Freddie and has been used in other countries. Sweden recapitalized its banks by adding capital to them during its crisis in the 1980s. Most recently, the British government has announced a sweeping bank recapitalization amidst the current crisis. And of more relevance to the U.S. situation, Congress specifically added authority in EESA for Treasury to make direct capital injections into banks.

In recent days, Treasury Secretary Paulson has acknowledged that the Department may take advantage of this authority and thus use some of its funds to buy equity in troubled banks. This is a welcome development. Even if Treasury’s asset purchase program restores confidence in the pricing of troubled securities, many banks still believe that many other banks lack sufficient capital, and thus can still be reluctant to lend to them. The fact that the FDIC stands ready (especially with its new unlimited line of credit at the Treasury) to assist acquiring banks in taking over failing banks is probably not sufficient, even with a successful Treasury asset purchase program, to provide this confidence. Bank lenders to failed banks can still lose money in such transactions, or at the very least may have difficulty accessing their funds for some period, at times when all banks seem to want or need as much liquidity as they can get.

How might such a capital injection program work? Treasury could announce its willingness to entertain applications for capital injections, using a set pricing formula. For publicly traded banks, Treasury could buy at the price as of a given date, such as the price one or more days before its plan was announced, as has been suggested by former St. Louis Federal Reserve Bank President William Poole.[7] For privately-owned banks, Treasury could use a price based on the average price-to-book value for publicly traded banks as of that date. To prevent government intrusion into the affairs of the banks, the stock should be non-voting. Treasury would make clear that it only would take minority positions. There should be no takeovers of more companies—AIG, Fannie and Freddie are quite enough. Treasury also should announce that it will dispose (or sell back to the bank) any stock acquired through these actions as soon as the financial system has stabilized and the bank is in sound financial condition (perhaps a time limit, such as three years, should be a working presumption).

The Treasury will have to be careful when it buys distressed assets to guard against the possibility that banks will just dump their worst stuff on the taxpayers. The Department also will have to be careful when buying equity in banks, especially if it decides to go for a broad, nationwide program. There cannot be an open invitation for owners to move assets out of the bank and then, in effect, say: “We don’t want this bank, you buy it.” This problem suggests that Treasury would need to work closely with the FDIC and other regulators to determine whether or not a particular bank is eligible for an equity injection. Treasury also may need to limit the scope of the program to larger banks, if it becomes infeasible to allow smaller banks to participate.

We presume that Treasury did not initially embrace the idea of a more systematic recapitalization of the banking system out of concern not to have any further government involvement in the banking system, especially on the heels of the Fannie/Freddie conservatorship and the Fed’s rescue of AIG. That Treasury is now considering direct capital injections indicates that this may no longer be a concern. In our view, limiting Treasury’s purchases to non-voting stock in any event would address this concern directly.

Conclusion

Ben Bernanke has compared the current financial crisis to a heart attack in the economy. For some heart attacks, it is enough to administer drugs and change diet and exercise habits. But in acute cases, major surgery is needed and the current crisis is in the acute phase. Direct surgery in the form of capital injected into financial institutions, along with direct asset purchases, should help calm the inter-banking lending market.

Based on recent monthly data it appears that GDP started to fall in mid-year and the economy is moving into recession so the proposals made here will not change that. Nor can the proposals compel banks to make loans to their traditional customers – consumers and businesses – in the current climate of fear. But Treasury can do something to mitigate that fear and thus, along with the recent further easing of monetary policy, likely additional fiscal stimulus and further homeowner relief, the Department will help reduce the severity of the current recession if it uses all the tools in its financial arsenal.

[1] Note: This is the second essay in a series on the financial crisis and how to respond. For the first essay, see http://www.brookings.edu/papers/2008/0922_fixing_finance_baily_litan.aspx

[2] The government’s reported bank capital ratios, for example, did not take account of the off-balance sheet assets and liabilities of the SIVs, which large banks later had to take back on their balance sheets directly.

[3] Some institutions holding these securities may not have fully marked them to “market” under current accounting rules, but instead simply have added to their reserves for possible future losses to reflect the likelihood of such write-downs. In the lattercase, the securities may implicitly be marked down by a percentage reflecting the loan loss reserve attributable to them. If this latter percentage is not publicly stated, Treasury may require participating institutions to break it out for the Department as a condition for participating in the program (and if the Department does not do this, it may be compelled to do so either by the Executive branch Oversight authority or the Congressional oversight committee established under the Act).

[4] A regular auction is where the seller puts an item out on the market and then potential buyers bid for it. The seller then takes the highest price. In a reverse auction, the buyer puts out a notice of what item he or she wants to buy and then sellers compete to supply this item. The buyer then chooses the lowest price. Reverse auctions are the way a lot of private companies and government entities manage their procurement processes.

[5] The rest of this subsection includes as an example of such unjust enrichment the sale of a troubled asset to the Treasury at a higher price than what the seller paid to acquire it. But this language is not exclusive. Congress, the public or the media could construe unjust enrichment also to include sales of securities at prices above those implicitly or explicitly carried by the institution on its books.

[6] The Treasury asset purchase plan would also a provide a valuable service by speeding the de-leveraging process. As we described earlier, banks are leveraged and hold capital that is only a fraction of their assets or liabilities. When they take a hit to their capital base, they must either replenish the capital or scale back their balance sheets. When it became impossible to sell the assets except at fire-sale prices, they were not able to do this. Selling the asset to the Treasury will help them scale down. To get bank lending going again, however, we want them to be able to make new lending, not to just scale back.

[7] Speech made at the National Association of Business Economists conference, Washington DC, October 6, 2008.

Downloads

Download

Authors

A “Broken” Branch? Four Lessons from Congress’s Great Financial Bailout Saga

Pietro S. Nivola — Wed, 08 Oct 2008 12:00:00 -0400

When the United States House of Representatives temporarily turned back the Bush administration’s colossal financial rescue plan on Black Monday, September 29, parts of the commentariat abandoned all restraint. In terms shrill and unsparing, the country’s political system was proclaimed to be gridlocked and dysfunctional.

The paroxysms of ridicule and contempt too often leveled at “politics in Washington” are careless and unwarranted. Incessantly declaring that the system is “broken,” we may make it so, by deepening an already alarming degree of distrust of our Republic’s venerable political institutions and its public servants, from top to bottom. It is high time to take a deep breath, and to start appreciating our democracy for what it is—a government, as the Founders stressed, of fallible human beings, not of angels. A good place to begin is by debunking some of the nonsense that was aired about the congressional bailout debate, and take from it a few valuable lessons.

First of all, the system proved to be anything but kaput. It was never likely that Congress would pass no legislation at all amid the growing economic turmoil. And sure enough, act it did—swiftly compared to, say, the EU. Yes, the House didn’t swallow hook, line and sinker the initial offer within hours of when it was floated, but as any dispassionate observer of Congress should know, it was highly implausible that the House’s protest vote would be the last word, and an irreversible abdication. Time and again throughout American history, in moments of crisis, the legislative branch, not just the executive, ultimately rises to the challenge.

There was no failure of leadership. However imperfectly, the congressional leadership of both parties rallied and performed their duties. So did President Bush who did what a president has to do: put the national interest ahead of partisan calculations. The fact that he did not prevail in the initial round had less to do with want of effort than with his (undeserved, in my opinion) abysmal public approval rating, as well as his lame duck status and shrunken political capital. Treasury Secretary Paulson and Fed Chairman Bernanke may have miscalculated how deeply skeptical the public would be of their original scheme, and how difficult it would be to ram through on inordinately short notice, but give them credit for taking the full measure of the emergency at hand, and for confronting it boldly.

Even the two presidential candidates deserve some respect for the roles they played, especially in the end. McCain was right to suspend the campaign’s business as usual in the hinterlands at a time when the real action and drama were here at the two ends of Pennsylvania Avenue. (For either of the would-be presidents to have sat irrelevantly on the sidelines at a juncture like this would have seemed even weirder than some of their fumbling maneuvers in the early going.) More than a few votes had to be changed in time for the make-or-break roll call on October 3, when the House reversed itself. As it happened, most of the members who eventually came around were hardcore liberals and conservatives. One wonders whether so many would have gone along with the final bill if either of the presidential candidates had not defended it. And Obama, in particular, should be commended for having helped convert many of the earlier defectors within his party.

Was the House vote on September 29 little more than a fit of partisan “pique and polarization,” as a Washington Post editorial concluded? Not really. Let’s be clear. The purpose of the biennially-elected “people’s house” is, as the Framers intended, to represent the people, and do so as faithfully as possible or face retribution at the polls within 24 months. The popular outcry two weeks ago against simply rubber-stamping a plan to put nearly unprecedented peacetime power in the hands of the Treasury, amid grave doubts that its enormous costs would actually achieve the desired results, was strong and extraordinarily broad in scope. A Pew survey taken at the end of September found that 63 percent of the public was profoundly worried that “government action won’t fix things that caused the problem” in the first place. Interestingly, clear majorities of all stripes—Republicans, Democrats, and Independents—expressed this skepticism. There was little chance that the House could have ignored so widespread a sentiment, especially with an election barely a month off and, no less importantly, too little time to deliberate.

It is true that, as my colleague Sarah A. Binder writes, about three-quarters of Republican conservatives voted against the original bill, and were joined by many of the most liberal House Democrats—an example of les extremes se touchent, as the French saying goes. “Ideological effects,” she observes, were “visible,” and not just among members with safe seats. The far Right may have seen the specter of “socialism.” The far Left seemed to prefer that homeowners who had overleveraged themselves be bailed out, instead of “Wall Street.” But the main story was less about the stubborn stance of polarized ideologues (or principled politicians expressing their convictions, take your pick) than about straightforward electoral imperatives—that is, elected representatives doing their job, which is to listen to their constituents. So, for example, in the 50-some House districts with seats that will be closely contested in November, their current occupants voted overwhelmingly against the bailout bill. As Binder concluded, the only perfectly sure pro-bailout votes on September 29 came from the two-dozen or so members who had announced their retirement.

Large numbers of skeptics in the House, like many taxpayers, were probably fearful that the extreme urgency with which Paulson pressed the mega-bailout had so raised the stakes that if it ultimately failed to deliver as hoped, the government would find itself out of options, thereby driving the financial panic from bad to worse. Members worried, in other words, that what they were being asked to adopt would not be the end, nor the beginning of the end, only the end of the beginning. One didn’t have to be a “lunatic” to harbor misgivings along these lines. Indeed, the way the stock market continued to tank after the bailout package finally passed last Friday should give pause.

Whatever the case, the administration and congressional leaders arguably made a mistake to be in too much of a rush. Sometimes, with projects of this magnitude and consequence, speed kills. After the initial popular uprising, there was bound to be a second wave of constituent and interest-group reaction, this time pressing for passage. Those powerful voices—call them “special interests” like the Chamber of Commerce, the Business Roundtable, the AARP, the thousands of local car dealerships, the Main Street banks, and so forth—needed a few more days to mobilize and weigh in, as they eventually did decisively.

To keep the House’s hyper-sensitivity to public opinion in check, the Founding Fathers crafted bicameralism. The Senate with its longer, staggered terms was deliberately designed to be less receptive to sudden swings in the popular mood, and its members to be perhaps less impulsive and more statesmanlike in times of need. Well, last week’s events followed that script almost to a fault. Immediately following Black Monday, the Senate took charge. Stepping over the rubble left by the House, the upper chamber forged ahead with a revised bill, and passed it by wide margin, thereby applying additional pressure on the other body to make an about-face. Senate rules, as everyone knows, can facilitate obstructionism. Critics would do well, however, to recognize the upside: the same institution also offers its members extraordinary opportunities to lead—and lead they did.

Of course, the measure that eventually cleared both houses had to be larded with provisions that would further entice a number of members to switch sides. The insertion of this bacon was met by sanctimonious Congress-bashers with the usual mockery. What those who lament “pork” and “earmarks” need to explain, however, is how else they would propose to grease the skids. Sure, some of the lubricants in this bill were unseemly and bizarre (how badly did it need a tax write-off for NASCAR racetracks?), but inasmuch as they were essential to winning passage of the overall rescue package, they amounted to a tolerable price to pay.

What, then, might be learned from all this? First and foremost, let’s call a moratorium on loose talk about Washington’s “broken” political practices and institutions, and pay them the realistic respect they’re often due. The U.S. economy is headed south. From the president on down, our public officials are trying to do what they can to avert a massive train wreck. Cut them some slack. Second, go easy on the harangues about “special interests” and even their life-blood, like “loopholes” and “earmarks.” They aren’t always pretty but (as the architects of the Constitution understood) a representative government without them is wishful thinking. Besides, as the bailout chronicle suggests, sometimes the political process even needs their services to get anything done. Finally, be a little more patient. Democracies do not typically deliberate well in a matter of hours or days. Institutions like the U.S. Congress ordinarily need a bit longer to think through their biggest decisions, even when time is running short. When Congress was called upon to fix another gargantuan banking upheaval, the collapse of the savings and loan industry in 1989, the legislators had six months to write legislation. To duly address the current crisis, six months or even six weeks on Capitol Hill was out of the question. But so was six days.

Authors

Pietro S. Nivola

Lessons From the Financial Crisis

Martin Neil Baily — Mon, 06 Oct 2008 12:00:00 -0400

INTRODUCTION

As part of our ongoing series covering the financial crisis, Martin Baily, director of the Initiative on Business Public Policy delivered a presentation at the NABE Meeting on October 6, 2008 on the cause of the current financial crisis and the domino effect that permeated the financial markets, and provided measures to be implemented to prevent another financial institution meltdown.

View Presentation »

Downloads

Download

Authors

Martin Neil Baily

A Brief Guide To Fixing Finance

Martin Neil Baily and Robert E. Litan — Mon, 22 Sep 2008 12:00:00 -0400

Americans reading the newspapers or watching the television coverage of the tumult in our stock markets and financial institutions over the past few weeks rightly wonder: what is going on? How can seemingly once solid rocks of American finance—indeed American capitalism—like Fannie Mae and Freddie Mac (the twin engines of mortgage finance), Merrill Lynch (the original stock market “bull”), and AIG (the nation’s largest insurer)—either be forced to merge with other institutions or be forced into government hands—at least temporarily?

Even more shocking, how could the nation be on the verge of enacting the largest federal bailout in history on such a short time schedule? As we write this, Congress is considering an unprecedented proposal from the Administration to give authority to the Treasury Department, modeled on the Resolution Trust Corporation that disposed of real estate and other assets in the 1990s that the government inherited from failed savings and loans, to remove illiquid mortgage assets that are currently weighing down financial institutions and threatening the economy. The Treasury Department has asked for up to $700 billion to carry out this job, although the ultimate cost to the government will depend on the proceeds from the sale of the securities.

Less noticed, but also dramatic, was the Treasury’s announcement that federal guarantees will be extended for a year to previously uninsured money market funds. This step was designed to prevent a run on the funds after one of the largest such funds “broke the buck” last week because of losses on Lehman Brothers’ securities suffered by the bankruptcy of Lehman earlier last week. And, as if these efforts were not enough, the Treasury announced it was going to expand its program announced earlier this month of purchasing mortgage-backed securities to enable Fannie Mae and Freddie Mac to increase their purchases of these instruments to support the housing market.

As a number of financial experts, including our Brookings colleague Douglas Elmendorf, have noted, the Administration had another alternative way of addressing the financial crisis, which it rejected (though we cannot know how actively it was considered): It could have followed the model of the Reconstruction Finance Corporation established during the Depression (and, more recently, of the Fed’s rescue of AIG) and selectively purchased preferred stock in failing financial institutions, while imposing the kinds of stiff conditions as the Fed imposed on Bear Stearns and AIG (severely haircutting shareholders and firing top managers). This option would have left troubled assets in the private sector, which should be better equipped to deal with them than the government, and probably would have done a better job minimizing moral hazard. The RFC model probably would not be as effective in liquefying the frozen mortgage securities market, however, and it could tempt the government to pour even more money down the road into some losing companies. In addition, the government would be left under the RFC approach with disposing of the assisted firms, or their assets, if they fail.

While we thus generally support the efforts of policy-makers to avoid further chaos in U.S. and global financial markets through some means, it cannot be disputed that all of this financial firefighting may create serious long term problems. When government funds on a large scale are used to support private sector companies, without a clear quid pro quo or price to be paid for that support, there is inevitably the problem of moral hazard and the encouragement of excessive risk taking in the future. Furthermore, the sweeping nature of the proposed rescue—benefiting a broad range of financial institutions holding troubled mortgage securities – will make it difficult for policymakers in the future to resist requests by other types of firms in other industries for similar treatment, and more broadly, may undermine for a lengthy period the public’s faith in markets in a wide range of contexts.

Whatever steps are taken in the short run to address the current financial crisis, there is at least broad consensus that financial regulatory and supervisory reform is needed to dramatically reduce the likelihood that something like the recent set of events never recurs. In May, we joined with Douglas Elmendorf to produce some initial thoughts on this subject, in a document available elsewhere on this website, The Great Credit Squeeze. The financial crisis since then has deepened, and new information continues to come to light. Like many others who are following these unprecedented events, we are being forced to rethink not only what we wrote only a few months ago, but to address a growing list of topics that the unfolding events are bringing to the fore. In the coming weeks and months, therefore, we intend to issue short briefings on selected financial reform topics, as part of our Initiative on Business and Public Policy. We also plan a series of meetings with financial experts to discuss these issues. Ultimately, we will present our collected views either in a revised version of The Great Credit Squeeze or in a separate manuscript.

In the meantime, what follows is our brief guide to interested readers of principles for reform that we believe should guide policy-makers to address financial issues, both in the immediate term and over the longer run.

Prioritize

Whatever one may believe about the specific recommendations in the Treasury Department’s Blueprint for a Modernized Financial Regulatory Structure issued in March 2008, the Department was right to suggest that policy-makers must set priorities. The next Administration and Congress, in particular, should address first those problems that are most pressing, and then tackle those that are less time-sensitive.

Clearly, if Congress enacts the Administration’s massive bailout proposal, the first priority will be setting up the new asset disposal agency, staffing it, and establishing a plan and timetable for selling the assets it acquires. We anticipate that if the proposal is enacted, Treasury will rely heavily on private sector financial advisors to assist with the purchase and sale of the securities, as well as management of the whole portfolio of assets before sale (although the pool of such advisers may be limited, since no adviser should come from an institution that sells its securities to the new agency).

A related priority item, if it is not addressed in a forthcoming mortgage securities bailout bill, is whether and how to shore up residential real estate markets by stemming the tide of future foreclosures. As it is now, analysts generally expect 2 million more homes to enter foreclosure in 2009, which should dampen, if not depress, home prices in many parts of the country. During the summer of 2008, the Administration and Congress enacted legislation to guarantee an estimated 500,000 residential mortgages, if the lenders and borrowers agreed to a write-down of approximately 15 percent below current appraised value. If the economy continues to weaken and housing prices continue to fall, there will be political pressure for another home mortgage relief bill.

A third high priority item on any financial “to do” list is providing more resources for the FDIC, whose Chairman, Sheila Bair, has asked for them. Congress and the Administration (this one, or certainly the next) should enlarge the FDIC’s line of credit with the Treasury. At a later point, the FDIC can repay any borrowings it may require from higher insurance assessments on the banks and thrifts whose deposits it insures.

Policy-makers now have a bit more breathing room to figure out what to do with the two large housing “government-sponsored enterprises” (GSEs), Fannie Mae and Freddie Mac, because both are in “conservatorship” and continue to operate with federal guarantees and a pledge by the federal government to back the roughly $5 trillion in mortgages they hold or that back the mortgage-backed securities (MBS) they guarantee. The broad options include: (1) the return of Fannie and Freddie to the private sector, but much better regulated; (2) privatizing them in some fashion; (3) nationalizing them and having them become arms of a federal agency (as Fannie once was); or (4) gradually liquidating their portfolios. Regardless of which of these options policy makers eventually choose, it makes sense to find other, more direct and transparent ways of assisting home buyers of limited financial means than channeling such aid through the GSEs.

The next Administration, the Congress, and regulators also have more time to enact the necessary reforms for preventing a replay of what we have seen. They must act with deliberate haste—that is, promptly but with enough time to think through both the likely benefits and costs of the steps they consider, and only adopt those measures where the former outweigh the latter. We outline some of the options and our key recommendations, to this point, in the sections that follow.

Know What Went Wrong Before Beginning to Fix Anything

There has been a “domino-like” character to the financial crisis that is now readily apparent to all:

the bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate;
the peaking of residential home prices in 2006, combined with lax lending standards were followed by a very high rate of delinquencies on subprime mortgages in 2007 and a rising rate of delinquencies on prime mortgages;
losses thereafter on the complex “Collateralized Debt Obligations” (CDOs) that were backed by these mortgages;
increased liabilities by the many financial institutions (banks, investment banks, insurance companies, and hedge funds) that issued “credit default swaps” contracts (CDS) that insured the CDOs;
losses suffered by financial institutions that held CDOs and/or that issued CDS’s;
cutbacks in credit extended by highly leveraged lenders that suffered these losses.

These events, individually and in combination, have led to the bear stock market, whose downward slide accelerated Monday September 15 through mid day Thursday the 18, after Lehman Brothers filed for bankruptcy and the Federal Reserve loaned AIG $85 billion to keep it afloat—although the market quickly recovered at the end of the week after the Administration’s massive mortgage securities rescue initiative was announced.

So far, the financial turmoil on Wall Street has had a surprisingly modest impact on Main Street. Despite the crisis and the surge in commodity prices, the non-financial sector of the economy has continued to grow, spurred in significant part by a large growth in exports (fueled, in turn, by a steep decline in the dollar). Whether this pattern will continue—and specifically whether consumer spending will hold up in the face of the recent nerve-racking financial events and the steady climb in the unemployment rate (now over 6 percent)—is one of the large uncertainties confronting us all.

Likewise, in retrospect it is now relatively easy to see that much of this financial carnage, and thus any subsequent economic damage, could have been avoided:

Had policy makers reined in the increasingly irresponsible subprime mortgage lending practices that were apparent earlier this decade—the proliferation of “no-doc” loans, often taken out with little or no equity from subprime borrowers, and frequently on adjustable terms with seductively attractive initial “teaser” interest rates, all on the widely held assumption that home prices would continue to rise—it is likely that this crisis would been largely, if not entirely, avoided. When there is a significant probability that an asset market is in a speculative bubble, it is time to tighten lending standards, not loosen them.
Had Federal policymakers in both the Congress and the Administration not pressed so hard on “affordable housing goals” that encouraged lenders to extend and borrowers to take out loans that could not be reasonably serviced unless home prices continued to rise, and which Fannie and Freddie began to buy in large volumes in the last several years, Fannie and Freddie may have escaped the fate that has befallen them.
Had the credit rating agencies whose stamps of approval were key to the sale of CDOs and other complex securities that later suffered losses been more transparent in how their ratings were provided and in the limited nature of the data on which they were made, it is likely that these securities would have been much more difficult to sell, and thus in turn, that subprime mortgages would not have been so easily originated.
Had regulators done a better job monitoring the risk exposures of commercial banks, especially through their creation of off-balance entities known as “Structured Investment Vehicles” (SIVs), the market for CDOs would not have been so deep (the same is true for the state insurance regulators who oversaw the “monoline” insurers that insured CDOs and AIG, the nation’s largest insurer, that issued them).
Had policy makers not permitted investment banks to vastly increase their leverage so that they were far more exposed to failure when they suffered losses from their various investments, the previously independent investment banks may have been able to avoid their forced alliances with commercial banks (or, in the case, of Lehman, failure).
And had financial institutions followed their own internal risk management guidelines, then it is possible that the current crisis would not be so deep and that the face of both of the commercial and investment banking industries would now not be so radically changed.

Recognizing what went wrong is important in assessing what needs to be changed in the future. We do not plan to get into the blame game, nor is it productive for policy makers to do so (though we expect a certain amount of this during an election campaign). Instead, it is vital that those charged with fixing this mess draw on what is now widely known and agreed upon so as to develop appropriate reforms that would dramatically lower the risks and consequences of future financial crises, without chilling the financial innovation for which America’s highly entrepreneurial financial sector has long been known. That is the approach we will follow in this project, and in the broad suggestions outlined next.

Principles To Guide More Permanent Reforms

The array of things that require fixing over the intermediate to long run can seem so daunting and unique that it can be paralyzing without having a sensible framework to guide the effort. There are two ways to bring structure to this process.

One way is to think of the time-line of events that led to the crisis and address reforms at each stage. This would mean new rules (not necessarily all statutory) for: mortgage origination; mortgage (and perhaps other asset) securitization; better oversight of and/or disclosure by credit ratings agencies; improved oversight of currently regulated financial institutions and possibly new federal safety and soundness and disclosure rules for other financial institutions (such as insurance companies, which are now regulated only at the state level; investment banks, whether standalone or affiliated with commercial banks; and hedge funds) that engaged in securitization and that ended up with the complex securities on their balance sheets.

Separately, policymakers will want to weigh in on how Fannie/Freddie should emerge, if at all, from conservatorship; on whether so-called “mark-to-market” accounting rules (requiring assets to be valued at their market prices even if the “market” for them are thinly or barely traded) that some have argued have aggravated the financial meltdown should be changed at all, and if so, how; and perhaps on the need to keep the SEC’s rules governing short sales, a practice that some critics assert have accelerated the recent stock price declines, or whether stronger enforcement of existing laws against coordinated short selling and spreading false rumors is a more appropriate response.

A second way to structure and think about reform proposals is to ensure that they abide by certain fundamental principles. We suggest three, on which there seem to be a broad consensus (even though differences remain on the way in which these principles should be applied).

First, financial instruments and institutions should be more transparent.

One key problem with financial innovation in recent years has been that many of the securities and the financial institutions that issued or held them have been less than transparent. In addition, many borrowers, it seems, did not understand some of the key terms of the subprime mortgages they signed to finance the purchase of new homes or refinance their existing residences. Transparency was further reduced by arrangements that purported to insulate investors from risk, such as credit default swaps, bond insurance, and shifting liabilities off balance sheets.

As we know from many areas of life, self-interest is a powerful economic force. Good regulation harnesses that force. By increasing transparency—specifically rules improving and simplifying disclosures of financial instruments and by different financial institutions—we can give all parties better tools to monitor financial risk-taking themselves.

As examples, consider the following:

For mortgages: simpler disclosures, counseling in advance for subprime borrowers, and perhaps a default contract from which people could opt out; and further restrictions on the design of high-cost mortgage contracts, along the lines proposed by the Federal Reserve.
For asset-backed securities: public reporting on characteristics of the underlying assets.
For credit ratings agencies: greater clarity in presenting ratings across asset classes, reporting of the ratings agencies’ track records, and disclosure of the limitations of ratings for newer instruments.
For commercial banks: clearer accounting of off-balance-sheet activities.
For derivatives, especially credit default swaps: facilitate the formation of a clearinghouse, which should reduce counter-party risk; and to encourage the standardization of these contracts, impose higher capital requirements on CDS’ that are customized.

Second, financial institutions should be less leveraged and more liquid.

Even if private investors had perfect information, they would tend to take greater financial risks than are optimal from society’s perspective. The reason is that taking risks in a financial transaction can have negative consequences for people not directly involved in that transaction. These spillover effects arise in part because of the risk of contagion in the financial system, and they arise in part because of the government safety net including bank deposit insurance and the role of the Federal Reserve as lender of last resort. The parties to a transaction have no reason to take account of these externalities, as economists label them, and this provides the traditional rationale for government financial regulation and supervision.

In recent years, the lack of transparency and divergent incentives caused a run-up in financial risk-taking, both in the assets purchased and the degree of leverage used to finance those assets. These forces helped to fuel the housing bubble, and it has greatly worsened the consequences when the bubble deflated.

To be sure, the financial system is already moving to reduce leverage and increase liquidity. Those institutions with larger capital cushions are weathering this crisis far better than their less-conservative competitors, and they now find themselves in position to purchase assets at favorable prices. Those institutions with greater amounts of liquid assets have been less subject to “runs” in which their investors scramble to get their money out first. These examples provide strong lessons for future institutional strategies.

Still, these private responses should be accompanied by regulatory changes. We believe the following steps have much to recommend them:

For commercial banks: capital requirements for off-balance-sheet liabilities and required issuance of uninsured subordinated debt.
For investment banks: regulation and supervision of capital, liquidity, and risk management.
For bond insurers: higher capital requirements.
For insurers: an optional system of federal chartering and regulation, aimed primarily at protecting their safety and soundness.

Third, financial institutions should be supervised more effectively, with greater regard for systemic risks.

Government oversight of risk-taking by financial institutions does not take the form solely of laws and regulations. Prudential supervision is another crucial component of public policy. In recent years, supervision did not adequately monitor or constrain mistakes being made by financial institutions, and we must improve supervision going forward.

An immediate priority is for the agencies with current regulatory authority to do a better job of carrying out the responsibilities they already have. In this regard, special attention must be paid to ensuring that financial institutions do not have off-balance sheet entities that, in an emergency, must be pulled back on the balance sheet; to doing a better job of overseeing institutions’ risk management practices; and to more closely supervise underwriting standards for new products.

In addition, when regulators monitored the safety and soundness of individual institutions, they did not take into account adequately the way in which a given institution might be contributing to systemic risk. Looked at in isolation, a financial institution may seem to have adequate reserves, liquidity and solvency. But the assets of this institution may be the liabilities of another, and this pattern may be repeated down the line for several interconnected institutions. In this case, problems in one institution can cause a cascade of problems through the system. As the global capital market has become more integrated this issue has become more important, indeed such interactions were an important ingredient in the current crisis. Under the Treasury Blue Print for regulation, the Federal Reserve has been charged with monitoring systemic risk and it will need to develop powerful new tools to provide this supervision and work with other regulatory agencies.

Act In Our Own Interest, While Consulting with Other Countries

Finally, recent events have dramatically illustrated the extent to which the financial system is now truly global in nature: subprime mortgages originated throughout the United States found their way, through the development and sale of complex mortgage securities, on the balance sheets of financial institutions around the world.

A number of global or multinational bodies – the Basel Committee (for banks), the International Organization of Securities Commissions (IOSCO), the International Association of Insurance Supervisors (IAIS), and the International Accounting Standards Board (for accounting standards) -- are in place to coordinate regulatory oversight of financial markets and institutions for precisely this reason. Markets and institutions are linked across borders, and thus effective regulation requires, at a minimum, cooperation by regulators from different countries. In some areas, such as bank capital regulation, great effort has gone into harmonizing the rules, not only to help ensure safety and soundness but ostensibly to “level the playing field” so that no country’s banks have an “unfair” competitive advantage relative to those from other countries.

It is important going forward to continue working with and consulting these various multinational bodies and the financial experts within their member governments. It is the U.S. financial system, after all, that is now on trial in the eyes of the world, and it is important at least for this reason, and others, for our policy makers to reach out to seek advice from other countries whose financial institutions and economies have suffered on account of the mistakes made here.

That said, waiting to gain international consensus can take time: witness the roughly 10 years it took to gain agreement on a revision to bank capital standards, which by the time that occurred, the current financial crisis was upon us, triggering yet another reexamination of those standards. In addition, international politics have a way of affecting international standards, to the potential detriment of our own interests.

Accordingly, we would counsel policy makers here to proceed expeditiously, but deliberately, to fix the problems with our financial system that are very much home-made. We should continue to take part in the discussions of these issues in the appropriate international forums, but we should not wait for international consensus to develop before we act.

Downloads

Download

Authors

Government Bailout: Changing the Face of Capitalism

Robert E. Litan — Wed, 17 Sep 2008 12:00:00 -0400

In seizing Bear Stearns, then Fannie Mae and Freddie Mac, and now insurance giant AIG, federal policy-makers appropriately used their authority to stabilize the markets and protect the American economy from systemic risk and collapse. However, the government appropriately drew the line at not bailing out Lehman Brothers after concluding its demise did not present a sufficient risk to the system, had it failed.

Recent events have brought to the fore the kinds of financial nightmares policy-makers had hoped they never would have to face: saving very large financial institutions (and their creditors and possibly shareholders indirectly) because those firms’ failures would cause much greater financial and economic damage to the U.S. economy as a whole, as well as economies abroad. In my view, most policy-makers, businesses and experts have always believed that in an emergency the government would be forced to do this, and now they have confirmed those expectations and made the “too big to fail” policy explicit.

What is so shocking to many is that these worst case scenarios—something that few ever expected to play out—have actually materialized. But the good news is that we have learned from the past: while Depression-era policy makers watched idly while events spiraled out of control, today’s policy-makers have recognized the need for swift action to contain the damage. The hope is that it will be enough.

Unfortunately, given the number of unforeseen events we have witnessed so far, it would be surprising if we have reached the end of large firm failures. The mortgage crisis is now spilling over into areas of the credit markets. We simply don't know the extent of additional losses all this will cause, nor who will suffer them. The Fed's balance sheet isn't what it used to be, so there is a limit to its ability to continue coming to the rescue—without printing more money and fueling inflation, or in a last resort, borrowing from central banks elsewhere. If push comes to shove, though, the Fed will likely print what is necessary to finance any rescues it believes are needed to contain risks to the financial system.

Policy-makers have applied tourniquets as needed, but longer-term questions remain about how to preventing future crises. The Treasury Department's Blueprint issued last March provides a good list of the topics—improving the mortgage origination and securitization processes, the regulation of banks and other financial institutions, and a reexamination of accounting rules, for starters. The next Administration, the Congress and regulators clearly will have a full plate of issues to resolve. They won't get much sleep.

Authors

Robert E. Litan

Accounting and Disclosure After Enron

Robert E. Litan — Fri, 15 Mar 2002 00:00:00 -0500

Thank you, Mr. Chairman, for inviting me to appear today to discuss accounting and disclosure issues in the wake of the Enron failure.

I come to you with a somewhat different background than many of those who have appeared before you so far––not as a professional accountant or securities regulator, but as an individual who has spent most of his career in a policy research setting and in government working on a variety of issues, some of which have touched on Enron-related questions. In particular, much of my research has focused on the financial services industry, while in my years in government, I have helped enforce the nation's antitrust laws and have overseen or worked with the budgets with a number of federal agencies, including the SEC. Of perhaps greater relevance to the current hearing, I have coauthored a book with my colleague from AEI here today, Peter Wallison, on what we believe to be some of the cutting edge issues in accounting and disclosure, and am in the process of co-authoring another book on disclosure policy in a world of increasingly global capital markets. I hope that through these various experiences and endeavors I can provide the Committee with some fresh insight into the challenges it and the entire Congress now confront.

Overview

The Enron failure poses some of the toughest policy challenges of any financial collapse in recent memory. The current situation is not comparable to the savings and loan or the banking disasters of the 1980s, which were nearly a decade in the making before Congress finally took action. By comparison, the disclosure problems that have surfaced in Enron have been apparent only over the past several years, especially the growing number of earnings restatements and the rising concern about "earnings management" expressed by the SEC and others. More importantly, whereas in the S&L and banking cases there were clear "solutions" on the "policy shelf", as it were, for Congress to implement (notably, the system of prompt corrective action for enforcing capital standards), only some ideas are on the shelf this time and there appears to be only a limited consensus on which ones ought to be adopted.

Downloads

Download

Authors

Robert E. Litan

Publication: Testimony before the Senate Committee on Banking, Housing, and Urban Affairs