Author Archives: James Kwak

Rumsfeldian Journalism

By James Kwak

I still have Nate Silver in my Twitter feed, and I used to be a pretty avid basketball fan, so when I saw this I had to click through:

In the article, Benjamin Morris tries to analyze how “bad”* the Detroit Pistons of the late 1980s and early 1990s (Bill Laimbeer, Rick Mahorn, Dennis Rodman, etc.) were, with full 538 gusto: “That seems like just the kind of thing a data-driven operation might want to quantify.” But the attempt falls short in some telling ways.

Continue reading

Defending Kickbacks

By James Kwak

The Wall Street Journal reports that the SEC will soon decide (well, sometime this year) whether brokers should be subject to a fiduciary standard in their dealings with clients, as registered financial advisers are today. At present, brokers only need to show that investments they recognize are “suitable” for their clients—roughly speaking, that they are in an appropriate asset class.

Not surprisingly, the brokerage industry is up in arms. They want to be able to push clients into the products for which they receive the highest commissions—a practice that (they say) could be more difficult under a fiduciary standard. According to one lobbyist,

a universal fiduciary standard could end up hurting many investors. Lower- and middle-income investors often turn to brokers who are compensated through product commissions, he says, because such clients are less attractive to financial advisers who are compensated based on a percentage of assets under management. Higher costs could prompt some brokers to drop commission-based accounts in favor of more-lucrative accounts that charge a percentage of assets under management, leaving many lower- and middle-income investors without anyone to turn to for investment advice.”

(That’s a paraphrase by the Journal writer, not a direct quotation.)

Continue reading

What Might Have Been . . .

By James Kwak

I was reading the plea deal in the SAC case, which was approved by the judge yesterday, and then I started reading the criminal indictment filed by the U.S. Attorney’s Office. What I noticed was how relatively simple it was for the prosecutors to convict SAC Capital for the insider trading committed by its employees. In short, because the firm enabled and benefited from the employees’ crimes, the firm was itself criminally liable.

Looking back at the enormous amount of effort the Southern District has put into Preet Bharara’s crusade against insider trading, you have to wonder what they might have accomplished had they instead targeted, say, fraud committed by Wall Street banks that contributed to the financial crisis. That’s the topic of my new column in The Atlantic. One of the frustrations of post-crisis legal proceedings is that it’s so hard to show that any senior executives themselves committed fraud, since they can usually plead some combination of ignorance and incompetence instead. Failing that, though, the government could have put more resources into flipping lower-level employees and then filing criminal indictments against their banks. Yesterday Bharara claimed, “when institutions flout the law in such a colossal way, they will pay a heavy price.” But only if the Department of Justice chooses to go after them.

The Absurdity of Fifth Third

By James Kwak

No, I’m not talking about the fact that a major bank is named Fifth Third Bank. (As a friend said, why would you trust your money to a bank that seems not to understand fractions?) I’m talking about Fifth Third Bancorp. v. Dudenhoeffer, which was heard by the Supreme Court last week.

The plaintiffs in Fifth Third were former employees who were participants in the company’s defined contribution retirement plan. One of the plan’s investment options was company stock, and the employees put some of their money in company stock. (Most important lesson here: don’t invest a significant portion of your retirement assets in your company’s stock. Remember Enron? Anyway, back to our story.) As you probably guessed, Fifth Third’s stock price fell by 74% from 2007 to 2009—this is a bank, you know—so the plaintiffs lost money in their retirement accounts.

The claim (I’m looking at the 6th Circuit opinion)  is that the people running the retirement plan knew or should have known that Fifth Third stock was overvalued in 2007, and they breached their fiduciary duty to plan participants by continuing to offer company stock as an investment option and by failing to sell the company stock that was owned by the plan. The suit was dismissed in the district court for failure to state a claim, so on review the courts are supposed to accept all the plaintiffs’ allegations as correct.

Continue reading

Disability Insurance Basics

By James Kwak

A while back I wrote a post critical of a Planet Money/This American Life episode on disability insurance. Among other things, I thought that the episode made too much of the fact that the number of people on federal disability insurance (SSDI or SSI) has gone up since the financial crisis.

The book I’m currently reading with my daughter at family reading time (she just finished a fictional book about a Polish immigrant girl in a mining community in the late nineteenth century) is Social Insurance: America’s Neglected Heritage and Contested Future, by Theodore Marmor, Jerry Mashaw, and John Pakutka. It’s a pretty good overview of the programs that are typically thought of (at least by the left and center-left) as social insurance in this country. Here’s what they say about recent trends in disability insurance (pp. 166–67):

“It has long been understood by those who study disability insurance that during times of economic distress, the incidence of claimed disability increases. Impairments that might have been overcome during times of economic growth and high rates of employment become the basis for claims of disability. . . . As a recession drags on and jobs are not plentiful, many no doubt make the choice to see if a musculoskeletal malady or a mood disorder qualifies them for disability insurance benefits.”

In the longer term—meaning before the financial crisis—disability rates have been creeping upward. The main reasons are: (1) an aging population; (2) the slow increase in the full retirement age for Social Security, which keeps people on SSDI (as opposed to OASI) longer; and (3) the increasing frequency of musculoskeletal and mood disorder claims (e.g., depression). These are all completely normal things, unless you want to go back to the bad old days when mental illnesses like depression were not considered on pair with physical illnesses. At the margin, there is certainly fraud in the system, but in fact it’s quite hard to get disability benefits, and the standards aren’t getting any more lenient.

Sometimes the real story isn’t all that mysterious.

More Pseudo-Contrarianism

By James Kwak

I accidentally glanced at the link to David Brooks’s recent column and—oh my god, is it stupid. You may want to stop reading right here to avoid being exposed to it.

Continue reading

Incidence

By James Kwak

One of the criticism’s of Michael Lewis’s book is that he gets his moral wrong. High-frequency trading doesn’t hurt the little guy, as Lewis claims; instead, it hurts the big guy. The explanation is this: people sitting at their desks buying 100 shares of Apple are getting the current ask, so mainly they care about volume and tight bid-ask spreads. Institutional investors, buy contrast, want to buy and sell huge blocks of shares, and they don’t want the price to move in the process; they are the ones being front-run by the HFTs. Felix Salmon pointed this out, and it’s the subject of an op-ed by Philip Delves Broughton today.

What this leaves out is the question of who ends up being harmed. To figure that out, you have to ask whose money we’re talking about when we say “institutional investor.” If it’s SAC Capital, meaning Steven Cohen’s money, then who cares? But most ordinary people invest—if they are lucky enough to have money to invest—through mutual funds (401(k) plans, for example, are largely invested in mutual funds), and those funds are among the “institutional investors” losing money to HFTs. Another big chunk of institutional money belongs to pension funds. In this case, if the pension fund does poorly, the money may come out of its corporate sponsor in the form of increased contributions—or it may come out of beneficiaries and taxpayers in the form of a bankrupt plan shifting its obligations to the PBGC. Then there are insurance companies: in that case, losses from trading affect shareholders, but if they are systemic across the industry they end up as higher premiums for consumers.

This is not to say that the institutional investors are warm and cuddly and are just passive victims in all of this. I’ve spilled enough ink inveighing against active asset managers, and Salmon points out that the buy side bears its share of blame for being careless with other people’s money. At the end of the day, if HFT harms other people in the markets, it’s just a fraternal spat among capital, and doesn’t affect the fundamental divide in the post-Piketty world. Until a poorly-tested algorithm goes berserk and freezes the financial system, that is.

The Desperation of the Vanishing Middle Class

By James Kwak

I recently finished reading Pound Foolish, by Helaine Olen, which I discussed earlier (while one-third of the way through). The book is a condemnation of just almost every form of personal financial advice out there, from the personal finance gurus (Suze Orman, Dave Ramsey) to the variable annuity salespeople to the peddlers of real estate get-rich-quick schemes to Sesame Street‘s corporate-sponsored financial education programs. (Of them all, Jane Bryant Quinn is one of the few who generally come off as more good than evil.)

A lot of what’s going on is just semi-sleazy entrepreneurs trying to make a buck, taking “advice” that is equal parts routine, wrong, and contradictory and packaging it into attractive-looking books, TV shows, and in-person events. A lot of the rest is marketing by the real financial industry, which either (a) wants to make a show of promoting financial education so people will think they are good or (b) wants to teach people that they need their products. (You pick.)

Continue reading

Stress Tests, Lending, and Capital Requirements

By James Kwak

Despite the much-publicized black eye to Citigroup’s management, the bottom line of the Federal Reserve’s stress tests is that every other large U.S. bank will be allowed to pay out more cash to its shareholders, either as increased dividends or stock buybacks. And pay out more cash they will: at least $22 billion in increased dividends (that includes all the banks subject to stress tests), plus increased buyback plans.

Those cash payouts come straight out of the banks’ capital, since they reduce assets without reducing liabilities. Alternatively, the banks could have chosen to keep the cash and increase their balance sheets—that is, by lending more to companies and households. The fact that they choose to distribute the cash to shareholders indicates that they cannot find additional, profitable lending opportunities.

This puts the lie to the banks’ mantra that capital requirements will constrain lending and therefore reduce growth (made most famously in the Institute of International Finance’s amateurish report claiming that increased regulation would make the world’s advanced economies 3 percent smaller). Capital isn’t the constraint on bank lending: it’s their willingness to lend.

Continue reading

A Book That Needed To Be Written

By James Kwak

I have previously written about (here, for example) what I call economism, or excessive belief in the little bit that you remember from Economics 101. The problem is twofold. First, Economics 101 usually paints a highly stylized, unrealistic view of the world in which free markets always produce optimal outcomes. Second, most people in the world who have taken any economics have only taken first-year economics, and so they never learned that, from a practical perspective, just about everything in Economics 101 is wrong. (Complete information? Rational actors? Perfectly competitive markets?) This produces a nation of people like Paul Ryan, who repeats reflexively that free market solutions are always good, journalists who repeat what Paul Ryan says, and ordinary people who nod their heads in agreement.

The problem is not the economics profession per se. These days, to make your mark as an economist, it helps to be arguing (or, better yet, proving) that the free market caricature of Economics 101 is wrong. The problem is the way it is taught to first-year students, which pretty much assumes that Joseph Stiglitz, Daniel Kahnemann, Elinor Ostrom, and many others had never existed.

What we need, I have often thought, is a companion book for students in Economics 101, one that points out the problems with the standard material that is covered in the textbook. For a while I was thinking of writing such a book, but I decided against it for a number of reasons, one of them being that I am not actually an economist. Fortunately, John Komlos, who really is an economist, has written a book along these lines, titled What Every Economics Student Needs to Know and Doesn’t Get in the Usual Principles Text.

Continue reading

More on Wasting Shareholders’ Money

By James Kwak

A few weeks ago I wrote a post about my most recent “academic” paper, on the issue of whether corporate political contributions might constitute a breach of insiders’ fiduciary duty toward shareholders. The thrust of that paper was that some political contributions could be contested as breaches of the duty of loyalty—for example, if a CEO causes the corporation to give money to a candidate who promises to lower the CEO’s individual income taxes—which would result in the courts applying a higher standard of review.

Joseph Leahy, another law professor, recently directed me to a paper that he wrote last year (but is still being edited for publication in the Missouri Law Review) on basically the same topic. He argues first that corporate political contributions do not qualify as “waste” (which has a precise legal definition), barring the kind of extreme facts that you only see in law school hypotheticals. I agree with that, although my only discussion of the point was in a footnote (79).

Continue reading

Skew

By James Kwak

There is a common phenomenon in legal disputes over the value of something, be it a company, a piece of land, or a person’s expected lifetime earnings. Each side hires an “expert” who produces an estimate based on some kind of model. And miraculously, every single time, the expert for the party that wants a higher number comes up with a high number, while the expert for the party that wants a lower number comes up with a low number. No one is surprised by this.

Yesterday, the Federal Reserve posted the results of the latest periodic bank stress tests mandated by the Dodd-Frank Act. For these tests, the Fed comes up with various scenarios of how things could go badly in the economy, and the goal is to see how banks’ income statements and balance sheets would respond. The key metrics are the banks’ capital ratios; the goal is to identify if, in bad states of the world, the banks would still remain solvent. If not, the banks won’t be allowed to do things that reduce their capital ratios today, like paying dividends or buying back stock.

For the most part, the results look pretty good: capital levels even under the severely adverse scenario should remain above the levels reached during the 2008–2009 crisis. (Of course, there are several huge caveats here. You have to believe: first, that the scenarios are sufficiently pessimistic; second, that the banks’ current financials are accurately represented; third, that the model is sensible; and fourth, that the capital levels set by current law are high enough.)

But there’s something else going on here. As part of the stress testing routine, each bank is supposed to do its own simulation of how it would respond to the scenarios specified by the Fed, using its own internal model. And—surprise, surprise!—the banks virtually uniformly predict that they will do better than the Fed.

Continue reading

Whiskey Costs Money

By James Kwak

A few days ago I wrote a post that began with New York Fed President William Dudley talking tough about banks: “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” The thrust of that post was that I’m not very encouraged when regulators talk about culture and the “trust issue” but don’t indicate how they are going to actually affect industry behavior.

As they say, talk is cheap, whiskey costs money. What’s more important than what regulators say is what they do—and don’t talk about. Peter Eavis (who wrote the earlier story about bank regulators that my previous post was responding to) wrote a new article detailing how that same William Dudley has delayed the finalization of the supplementary leverage ratio: the backup capital standard that requires banks to maintain capital based on their total assets, not using risk weighting.

Dudley has said, “I do not feel that I in any way hold any allegiance or loyalty to the financial industry whatsoever.” That may be true; he certainly made enough at Goldman that he has no real financial incentive to continue to make nice with Wall Street.* Yet at the same time he appears to be parroting concerns raised by some of the big banks, raising a concern about the leverage rule that Felix Salmon calls “very silly” and that, according to Eavis, the Federal Reserve mother ship in Washington didn’t consider significant.

In the grand scheme of banks and their allies weakening and slowing down new regulation, this is probably not a particularly momentous battle. But it does put things in perspective.

* Of course, we know that among some people (many of whom live in New York and work in finance), no amount of money is ever enough.

There’s No Substitute for the Government

By James Kwak

Mike Konczal wrote an excellent article for Democracy about the problems with a voluntary safety net and the superiority of government social insurance. The article draws on serious historical research (by other people) to prove two main points: first, there never was a Golden Age of purely voluntary charity; second, and more important, what charitable support mechanisms existed were not up to the challenges of the Second Industrial Revolution of the late nineteenth century and completely collapsed with the onset of the Great Depression.

This shouldn’t come as a surprise. There are basic economic reasons why public social insurance is superior to voluntary charity. The goal here is to protect people against risk: of unemployment, of health emergency, of outliving one’s savings, and so on. For a risk-mitigation scheme to work, there are a few things that are necessary. One is that people actually be covered. This is something you can never have with a private system (unless it’s regulated to the point of being essentially public), since charities get to pick and choose whom they want to help. As Konczal says of private agencies before the Depression,

“They were also concerned they’d lose their ability to stigmatize—or to protect—various populations; by playing a role in determining who wasn’t deserving of assistance, they could shield those they felt worthy of their support.”

Continue reading

You Don’t Say

By James Kwak

Last week Peter Eavis of DealBook highlighted a statement made last year by New York Fed President William Dudley (formerly of Goldman Sachs, then a top lieutenant to Tim Geithner): “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” There was a point, say in 2008, when many people probably thought that our largest banks were just guilty of shoddy risk management, dubious sales practices, and excessive risk-taking. Since then, we’ve had to add price fixing, money laundering, bribery,  and systematic fraud on the judicial system, among other things. 

Eavis also tried to make something positive out of a couple of other recent comments. Dudley said, “I think that trust issue is of their own doing—they have done it to themselves,” while OCC head Thomas Curry said, “It is not going to work if we approach it from a lawyerly standpoint. It is more like a priest-penitent relationship.”

Continue reading