You might think that an agency that missed the Madoff fraud for years even after being told about it would have some sympathy for people who are, not bad guys necessarily, just a little sloppy on the whole looking-out-for-investors front. But you would be wrong:
Securities and Exchange Commission officials are trying to make it easier on themselves to hold more individuals responsible for wrongdoing during the financial crisis.
The good news, though, is that the way they’re going to make life easier for them is by reducing the stakes, pursuing negligence cases where they only have to show that someone acted “without reasonable care, even if there was no intent to harm investors.” The tradeoff for the SEC is:
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Federal prosecutors are preparing to file criminal charges against managers of two Bear Stearns hedge funds that collapsed at the dawn of the credit crisis last year. Although it’s being described as the conclusion of a year long investigation, it seems very likely that Ralph Cioffi and Matthew Tannin there wouldn’t be facing criminal charges if Bear Stearns hadn’t collapsed.
“Of course what’s really happening here is that the hedge fund managers are taking the fall for the collapse of Bear, and the even broader reverberations from that, including the controversial merger, the bailout and the credit markets’ woe,” law professor Larry Ribstein writes. “As with Enron, the public is screaming for action. When in doubt, throw somebody in jail. The public will eventually calm down, by which time the now impoverished defendants will be in jail or being exonerated on appeal.”
We wonder if the urge to prosecute doesn’t arise from an unrealistic confidence in markets. Regulators and prosecutors believe that preserving investor confidence is their mandate. Massive losses due to innocent if colossal errors about market directions undermine market confidence but there’s little a government official can do about that. If your goal is restoring investor confidence, you’re extra-motivated to find criminal wrong-doing and fraud because you can reassure investors that their losses are do to bad apples rather than risk inherent in the markets.
The Enronization of Bear [Ideoblog]
You’d think that if we’ve learned anything from the past few waves of financial crisis, we’d have learned that shorts sellers play an important role in financial markets.
Shorts can check otherwise unbridled financial enthusiasm, improve price discovery and have often pointed out accounting chicanery at powerful public companies. Shareholders and management are incentivized to overlook or cover-up problems. They want stocks to go up. Regulators often lack institutional incentives to investigate wrong-doing.
But shorts, like John Paulson of Paulson & Company or Jim Chanos of Kynikos Associates, can make fortunes by uncovering hidden problems. In short (sorry), they are providing the market with a valuable service–let’s call them positive externalities–all while pursuing profit.
Nonetheless, we haven’t learned this lesson at all. Today the Financial Times reported that the UK securities regulator, the FSA, is going to impose new disclosure rules on short sellers who take positions on the shares of companies undertaking new share issuances.
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Carl Icahn got the go ahead from the Federal Trade Commission to scoop up huge amounts of Yahoo stock. Icahn owns around 10 million Yahoo shares now, and has options to acquire another 49 million. He said he’s seeking clearance from the FTC to buy up to $2.5 billion of the stock.
In our not-so-free market, you need the FTC’s approval to make stock purchases worth $63 million or more.
In other news, we just noticed that Jerry Yang and Steve Ballmer apparently played golf together last weekend. They may or may not have chatted about a deal but probably not the straight-up acquisition that Icahn wants. Icahn, of course, hates executives who play golf. Is there any chance that Ballmer and Yang arranged the meeting over golf to piss off Icahn?
Icahn gets antitrust go-ahead for Yahoo stock buy [Yahoo--heh]
Opponents of hedge fund regulation scored a win yesterday when California backed away from its plans to regulate hedge funds. Since the registration of hedge funds with the Securities and Exchange Commission was over-turned by the federal courts, several states have considered enacting their own regulatory schemes. Such moves have typically been opposed by the hedge fund industry, which has recently become active in federal and state lobbying efforts.
“California withdrew its proposal this month after many hedge fund industry officials suggested the lightly regulated investment funds could move to another state if California started regulating them,” DealBook reported this morning.
California is thought to have the largest concentration of hedge funds outside of New York, Connecticut and the Dallas area. California’s high-concentration of wealth and agreeable climate make the state very attractive to fund managers. But faced with the threat of extensive regulation, many could choose to relocate to states less prone to regulation.
“Yes, and they would take with them all those huge houses, big cars and taxes paid by hedge fund managers,” law professor Larry Ribstein explains. “California is used to having its regulatory way because many firms can’t avoid its market. But hedge funds can operate just fine without California.”
California’s surrender on hedge fund regulation nicely illustrates how federalism forces states to compete with each other, and can check excessive regulation. This is sometimes decried by critics of federalism as a “race to the bottom” but there’s little evidence to suggest that states are forced to lower regulatory levels on investment managers to below optimum levels. If investors desired more hedge fund regulation, hedge funds would have financial incentives to locate in states with greater regulations. Hedge fund investors, however, seem to doubt that they would benefit from new regulations that go beyond traditional legal strictures against things like theft and fraud.
California Drops Hedge Fund Proposal [DealBook]
Hedge funds and jurisdictional competition [Ideoblog]
Yesterday a cameraman for the Free Press caught two members of the audience napping during an FCC hearing on net neutrality at Harvard Law School. Now we don’t blame them for snoozing through a meeting about net neutrality–our eyes glaze over just thinking about it–but it does raise the question: why would you go to an FCC hearing if you are bored by that type of thing?
Portfolio’s Sam Gustin has answered the question: they were there because cable giant Comcast paid them to be there. Comcast had planned to pack the meeting with its local employees, and had paid some people off the street to show-up early and hold places in the line for the employees.
“Some of those placeholders, however, did more than wait in line: they filled many of the seats at the meeting, according to eyewitnesses,” Gustin reports. “As a result, scores of Comcast critics and other members of the public were denied entry because the room filled up well before the beginning of the hearing.”
Money can’t buy you love, but it can buy you napping bodies to keep your critics at bay.
Comcast Astroturfs the Old-Fashioned Way [Portfolio.com]
We’ve been on a bit of a tear today about the politics of regulation. So why quit when we’re having so much fun with it? As we noted today, calls for additional regulation often depend on a double standard under which market process are characterized by imperfect information and dominated by self-interest while regulatory processes are somehow viewed as well-informed and public-minded. Why are people so attracted to regulatory solutions when despite the lack of evidence for concrete benefits?
David Hirshleifer has a delightful paper that sees through one prominent anti-market double standard and suggests an answer—several in fact—about why regulation is unduly attractive. His approach is simple. He points out that the findings of behavioral psychology—that people are often irrational, biased and ill-informed—apply to regulators as well as investors and consumers.
“The psychological attraction theory of regulation holds that regulation is the result of psychological biases on the part of political participants and regulators, and the evolution of regulatory ideologies that exploit these biases,” he writes.
The cumulative effect of these biases is overregulation. “[Since the universe of possible tempting regulations is unlimited, the theory predicts a general tendency for overregulation, and for rules to accrete over time like barnacles, impeding economic progress. The theory also predicts occasional drastic increases in regulation in response to market downturns or disruption.”
You can download the paper here. (Hat tip to Ribstein.)
The first time we heard the term market failure we assumed the term referred to the occasional inability of market processes to withstand government interference. Later a good friend who was majoring in economics explained to us that this was not the standard understanding of the term. It was another case of our own conceptual dyslexia, where we learn last the simple things and never quite grasp by instinct what strikes everyone as obvious. But we’re stubborn and our initial impression has always colored the way we look at these things.
So the same thing happened later when someone used the term “systemic risk” in a discussion of hedge funds. We assumed they were talking about the risk posed to alternative investments by busybody regulators hungry for campaign donations. It turns out that the systemic risk wasn’t to hedge funds at all—it was a risk allegedly created by hedge funds to everyone else. Who would have thunk it?
We’re still not sure we had it wrong. With many hedge funds having been brutalized by the credit markets in recent months, it does seem that we were at least half right. The systemic risk in the financial system wasn’t being created by hedge funds, it was being absorbed by them. Without a doubt, their appetite for risk may have added to overall risk in the market. The appetite for mortgage backed derivatives, for instance, surely contributed to the mortgage bubble.
[More after the jump.]
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To their credit, lawmakers, regulators and the media have not yet begun to frame the story of the subprime mortgage mess in criminal terms. Forget Ben Stein because his antics have now made him forgettable. Even Gretchen Morgenson had to note in her Sunday column that the story of subprime profiteering was one of greed and not criminality. (Strangely, the entire Sunday Business section of the Times wasn’t available online this morning.)
But the call for criminalization has already begun on the fringes and we wouldn’t be surprised if before long we start hearing this from more mainstream publications. And if not criminalization, we expect the call for regulation to grow louder with each pasing day. It’s a familiar dynamic, where market failure is addressed with regulation.
We’re sometimes accused to have a knee-jerk reaction against regulation. This is unfair. Our problem seems to be a stubborn refusal to subscribe to the double standard that sees market failures and assumes available government solutions. But unless a plan for regulation addresses why the mechanisms and incentives proposed will result in effective regulation at acceptable costs, we think it best to avoid handing power over to government clerks.
Take the proposals to further regulate the ratings agencies. Sure they seem to have catastrophically failed to assess the risk in many credit products tied to mortgages. And, yes, they are rife with conflicts of interest. But we’ve heard precious little by way of practical solutions to these problems more detailed than abstract calls for “oversight” and “transparency.” If wishing were a strategy, this would be enough. But the good intentions of those who see the market as an imperfect process is unlikely to transform the government into an effective institution.
There’s a specter haunting these discussions, the specter of Sarbanes-Oxley. Our last round of financial scandal produced a clumsy and costly regulatory structure of unproven effectiveness. It would be a shame to repeat that mistake after this round of market failure.
One thing you can always count on is that as geographic scope of businesses and finance grow, someone will call for the harmonization of the relevant legal and regulatory structures. Roger Ehrenberg blasts that familiar horn today, calling for “common regulatory frameworks” in order to minimize regulatory arbitrage and cut down on the “immense friction [involved in] operating regulated businesses across markets due to different rules and standards.” Felix Salmon applauds him, and calls for even more of the same. Somehow this is meant to be a lesson from our current credit crisis.
This is a terrible idea. Competing, conflicting regulatory frameworks may not be as efficient as an ideally-designed comprehensive system but it avoids many of the mistakes and oversights of the kind of harmonized regulatory framework we are ever likely to get. The availability of exit and avoidance, experimentation and local checks on corruption and capture are under-rated sources of regulatory strength. A harmonized system with do away with the nimbleness we praised earlier, and there’s little reason to suspect we’d get a system better able to catch abuses, fraud, waste and errors than that we have now. Less abstractly, if none of the regulators saw our current credit crisis coming, how would having a common framework have helped them avoid it?
We wrote about this ages ago in the context of European takeover law, and what we said still applies: let a thousand regulatory regimes bloom.
What has the Credit Crisis Taught Us? [Information Arbitrage]
Dreaming of Regulatory Cooperation [Portfolio]
In the demonological pantheon of the subprime crisis orthodoxy, the deepest level of hell are reserved for unscrupulous lenders. Uncreditworthy borrowers live at a slightly higher plane, nearby unvigiliant regulators. But the cant and caterwauling of the orthodox overlooks that much of the world was focused on quite different concerns before the mortgage bills for the ownership society came due.
Despite our best efforts, we’re still cursed with a memory that reaches past this morning’s headlines. We cannot forget that the problem with the CDO market was supposed to be insider trading instead of the weakness of the underlying financial assets. And it was meant to be hedge funds that posed a systemic risk to the financial system rather than our venerable investment banks, money centers, trading houses and brokerages. The great accounting scandal was backdated stock options rather than marked-to-model financial products. In short, all the heat and light generated by our various guardians was aimed in the wrong direction.
Yet so strongly held was the belief in the old orthodoxy that, if you listen closely or read the New York Times business section on Sunday, you can still hear those who wonder whether or not insider trading or hedge fund manipulation is somehow behind our current troubles. There is not much evidence of this, as SEC Commissioner Paul Atkins pointed out recently.
“Although we and our counterparts in government are monitoring and looking into the origins of the events of the last year, it does not seem that hedge funds were the origin of the subprime problems,” Atkins said. If anything, some hedge funds and their investors seem to have been the first casualties of the current debacle rather than the causes.
We don’t mean this as a criticism of those guardians. Rather, it seems to us an indication that the actual risks in our innovative financial world are difficult to detect and that none of our journalistic and political institutions are particularly well-adapted to early detection. What we need is modesty in forward looking, crisis-avoiding regulations—often we may be aiming our resources where they are not needed, and diverting our attention from where they are. As the fellows at Goldman used to say, since we can’t tell where things are going, we’d best stay nimble. There’s a very good chance that once again the orthodoxy is hunting down imaginary demons.