Category Archives: Guest Post

Why Section 716 is the Indispensable Reform

By Jane D’Arista

This guest post is contributed by Jane D’Arista, a research associate at the Political Economy Research Institute at the University of Massachusetts, Amherst, and co-coordinator of its Economists’ Committee for Stable, Accountable, Fair, and Efficient Financial Reform (SAFER).  She has taught in graduate economics programs at several universities and served on committee staffs of the U.S. House of Representatives.

Dominated by the world’s largest banks, the over-the-counter (OTC) derivatives market has been expanding since the break-down of the Bretton Woods Agreement in the early 1970s privatized the international monetary system by shifting the payments process from central banks to commercial banks. The proliferation of foreign exchange forwards and swaps that followed set in motion an ever-expanding menu of exotic instruments that reached a nominal value of over $600 trillion by the middle of the current decade. Central banks and financial regulators ignored the implications of the growth of this market and ignored warnings from the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) from 2002 forward that OTC derivatives were at the center of what had become a global casino in which the largest international institutions were the biggest speculators.

The large, international institutions that created the OTC market for foreign exchange forwards and swaps were commercial banks. Following established banking practice, they conducted their derivatives business like portfolio lenders rather than broker/dealers, buying and selling forwards and swaps outside of established markets. But OTC derivatives contracts can’t be classified as assets or liabilities until they are settled and can’t be held on banks’ balance sheets the way loans and deposits are held. Instead, they were booked off balance sheet as contingent liabilities. The market structure that emerged in what came to be the largest market in the global economy was one in which non-tradable contracts were bought by and sold to customers without real time information on volume or pricing or the aggregate positions of the dealers themselves. Moreover, the fact that the contracts were illiquid required constant hedging by dealers that expanded their positions and inflated the size of the market relative to all other national and international financial markets. Meanwhile, the commercial bank dealers’ derivatives business was operating with all the implicit guarantees and subsidies that governments put in place to protect this core financial sector. In 2008, those guarantees became explicit and were exercised.

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Good Government vs. Less Government

Or: Why the Heritage Freedom Index is a Damned Statistical Lie

This guest post was contributed by StatsGuy, a frequent commenter and occasional guest on this blog. It shows how quickly the headline interpretation of statistical measures breaks down once you start peeking under the covers.

Recently, a controversy raged in the blogosphere about whether neo-liberalism has been a bane or a boon for the world economy. The argument is rather coarse, in that it fails to distinguish between the various elements of neo-liberalism, or moderate deregulation vs. extreme deregulation. But if we take the argument at face value, one of the major claims of neoliberals is that countries in the world which are more neoliberal are more successful (because they are more neoliberal). I disagree.

My disagreement is not with the raw correlation between the Heritage Index and Per Capita GDP. A number is a number. My disagreement is with the composition of the index itself, and interpreting this correlation as causation between neo-liberalism and ‘good things.’

My primary contention below is that many of these measures used in the composite Heritage Index have nothing to do with less government, and a lot more to do with good government. It is these measures of good government that correlate to economic growth and drive the overall correlation between the “Freedom Index” and positive outcomes. Secondarily, I will argue that many of the other items in the index (like investment freedom) are not causes of growth, but rather outcomes of growth.

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Reforming Credit Rating Agencies

This guest post was contributed by Gary Witt, an assistant professor in statistics and finance at the Fox Business School at Temple University. He was previously an analyst and then a managing director at Moody’s Investors Service rating CDOs from September 2000 until September 2005. Witt also caught one error in 13 Bankers, which I explain here.

Many readers will think that the last person whose opinion should be consulted on the issue of rating agency reform is a former rating agency employee. Maybe they’re right, but I did learn one thing from rating hundreds of complex securities. Contrary to what some may think, there are no easy solutions here. Unintended consequences are guaranteed. So here’s my humble take on the current CRA reform proposals.

What should be the goal of rating agency reform?

In 2007, as S&P and Moody’s were trying to decide how to rerate the entire structured finance debt market, I asked a shrewd fund manager what advice he would give to the management of a rating agency. He said they have to get the ratings right. No matter how hard it is, they have to focus on getting the ratings right.

There is an alternative school of thought. Instead of improving ratings, the reform agenda should be to be to eliminate their use. Since the rating agencies are hopelessly stupid or corrupt or both, just say no. End the market’s addiction to credit ratings by eliminating the SEC designation Nationally Recognized Statistical Rating Organization (NRSRO). Go cold turkey and end the practice of using ratings to assess credit risk by governmental or regulatory entities.

These two competing goals, improve credit ratings and eliminate credit ratings, can be viewed from a larger perspective, a Minsky mindset. If stability breeds instability, then trust breeds disappointment; the greater the trust, the bigger the disappointment. The rating agencies were over-trusted until 2007.

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Financial Safety and Fire Safety

This guest post was contributed by engineer27, a longtime reader of and frequent commenter on this blog. (I had exams this past week, which is why I haven’t posted in a while.)

This Thursday, the Senate added two amendments to the Financial Regulation in process that deal with Nationally Recognized Statistical Rating Agencies (NRSROs), which are blamed for being a factor in the financial crisis of 2008. The most widely cited problem with the NRSROs is the inherent conflict of interest which resides in the “issuer pays” model currently in use. However, even supporters of doing something are stymied when trying to envision a workable solution. The two (perhaps contradictory) amendments each try to implement a proposed solution that runs into some of the critiques. The Franken amendment has rating agencies assigned to debt issues by a neutral arbiter; critics maintain that lack of competition may reduce the quality of analysis. The LeMieux amendment removes legal mandates to obtain a NRSRO rating and the preferential treatment those issues currently receive. However, it leaves out details about whose advice agencies and public trusts should seek out instead.

This is not such a difficult problem. We already have an example of a successful private rating agency, whose imprimatur is desired or in some cases required by law, that is paid for by fees on the seller, and has been operating since 1894: Underwriters Laboratory. The UL publishes safety standards for almost 20,000 different types of products, many of which are adopted by other standard-setting organizations like ANSI (American National Standards Institute) and Canada’s IRC (Institute for Research In Construction). Although generally not actually required by federal law, the sale of many types of products in the US would be difficult without UL listing. Also, many local jurisdictions responsible for building and fire codes mandate the use of UL approved products. In all cases, the manufacturer must submit samples and pay fees to UL in order to win approval.

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Rewarding Teacher Performance? Resist the Temptation to “Race to Nowhere”

This guest post is contributed by Kathryn McDermott and Lisa Keller. McDermott is Associate Professor of Education and Public Policy and Keller is Assistant Professor in the Research and Evaluation Methods Program, both at the University of Massachusetts, Amherst.

On March 29, the U.S. Department of Education announced that Delaware and Tennessee were the first two states to win funding in the “Race to the Top” grant competition.  A key part of the reason why these two states won was their experience with “growth modeling” of student progress measured by standardized test scores, and their plans for incorporating the growth data into evaluation of teachers.  The Department of Education has $3.4 billion remaining in the Race to the Top fund, and other states are now scrutinizing reviewer feedback on their applications and trying to learn from Delaware’s and Tennessee’s successful applications as they strive to win funds in the next round.

One of the Department’s priorities is to link teachers’ pay to their students’ performance; indeed, states with laws that forbid using student test scores in this way lost points in the Race to the Top competition.  A few months ago, James pointed out some of the general flaws in the pay-for-performance logic; here, our goal is to raise general awareness of some statistical issues that are specific to using test scores to evaluate teachers’ performance.

Using students’ test scores to evaluate their teachers’ performance is a core component of both Delaware’s and Tennessee’s Race to the Top applications.  The logic seems unassailable: everybody knows that some teachers are more effective than others, and there should be some way of rewarding this effectiveness.  Because students take many more state-mandated tests now than they used to, it seems logical that there should be some way of using those test scores to make the kind of effectiveness judgments that currently get made informally, on less scientific grounds.

The problem is that even if you accept the assumption that standardized tests convey useful information about what students have learned (which we both do, in general), measuring the performance gains (or losses) of students in a particular classroom is far more complicated than subtracting the students’ September test scores from their June test scores and averaging out the gains.  We’re concentrating on the statistical issues here; there are other obvious challenges in test-based evaluation, such as what to do for teachers who teach grade levels where students do not take tests and/or subjects without standardized tests.

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Clinton Confesses: Rubin and Summers Gave Bad (strike that) Excellent Advice on Derivatives

The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here).  Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.

Considering that much of the disastrous deregulation of the U.S. financial system occurred on President Bill Clinton’s watch, I was encouraged by his televised confessional Sunday. He admitted to Jake Tapper that he was led astray by two of his secretaries of the treasury, Robert Rubin and Lawrence Summers.

What an important and timely revelation. Admitting we have a problem is the first step to recovery. With financial rehab next up on the Senate’s agenda, it’s useful that someone is discrediting those who persist in promoting failed ideas. What to do about the $450 trillion (notional) over-the-counter (OTC) derivatives market will be at the top of the agenda. This is about big money. Really big. Industry began lobbying last year to protect the annual $35 billion haul that just five US banks bring in trading derivative contracts.

Reform ideas range from the most sensible recommendation by Professor Lynn Stout (return to a regime where naked credit default swaps are not enforceable), to Senator Blanche Lincoln’s very strong amendment (prohibiting the banks that have access to the Fed’s discount window from trading derivatives), to the necessary but insufficient (mandating all standard derivatives be cleared on exchanges and requiring collateral to be posted), to the weak (the current Senate bill, rife with exceptions).

Remember, this market includes potent credit default swaps, a key ingredient to the crisis. The existence of this $60 trillion (now $45 trillion) notional value market, protecting and connecting counterparties across the system, led to a $180 billion taxpapayer-funded bailout of AIG. And, as we have just learned, CDS played a central role inside the synthetic Abacus 2007-AC1 vehicle, a device that helped Goldman Sachs rob purchasers to pay Paulson.

Yet, in spite of the power of Clinton’s admission, or perhaps because of it, just after the interview with Tapper, Clinton counselor Doug Band swiftly dispatched a disclaimer. In a moment of blatant grade inflation, Band said that Clinton believed Rubin and Summers provided “excellent advice on the economy and the financial system.”

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The Discount Rate Mismatch

. . . or, how finance is like quantum mechanics.

This guest post is contributed by StatsGuy, an occasional commenter and contributor to this blog.

Many pundits like to discuss the issue of Maturities Mismatch – that banks borrow short (at low interest), lend long (at higher interest), take the profit and (allegedly) absorb the risk.  We often hear talk about how the Maturities Mismatch is integrally linked to liquidity risk – the sometimes self-fulfilling threat of bank runs – which the FDIC is designed to fight.  Rarely if ever do we see anyone making the connection to the Discount Rate Mismatch . . .  In fact you’ve probably never even heard of it, and neither have I.

What is the Discount Rate Mismatch?

It is the difference between the risk-free return on investment that investors demand, and the risk-free return on investment that can be generated by real world investments.  And by investors, I do not just mean individual retail investors or hedge funds.  I also mean retirement accounts and state pension funds as well, which rely on massive 8% projected returns in order to avoid officially recognizing massive fiscal gaps between their obligations and funding requirements.

It has been well documented that the existence of these gaps implicitly forces state and municipal retirement agencies to engage in risky investments to hit target asset appreciation goals.  This strategy sometimes works.  And, sometimes, it does not – as Orange County well remembers.

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