The political push against private equity

Private equity has taken a bit of a back seat recently to the subprime mess, but an article in the Financial Times today (see "Capital markets face shift to opaque investors") shows that the issue is hardly forgotten. As the hidden assumptions and unquoted opinions in the FT piece show, much of the concern about private equity is not coming from the United States (this time), but from Europe. And, surprisingly, some of the most concerned are not the locust-basing Germans, but the British.

In the US, of course, private equity is also an issue -- albeit for different reasons. US Senators Byron Dorgan (D - North Dakota) and Tim Johnson (D - South Dakota) have asked the General Accounting Office to study the issue of private equity, particularly as it relates to the safety and soundness of the US financial system. European regulators have similar concerns, but, in addition, they have other more "societal" issues. These include concerns that private equity investors do not provide sufficient information to corporate "stakeholders" -- particularly labor unions and government regulators. Citing a new study by a management consulting firm, Joanna Chung's article in the FT highlights these issues by focusing on how "regulators" now have less information about their markets because private equity firms are "opaque":

Global financial markets face a permanent shift in power from traditional money managers to opaque groups such as petro-dollar investors, Asian central banks, hedge funds and private equity groups, according to a study out Thursday.

These power brokers had amassed $8,400bn in assets by the end of 2006, three times what they held in 2000 when they were “little more than fringe players” in the capital markets... . Their holdings now represent 5 per cent of the world’s $167,000bn of financial assets. If current trends continue, they could control assets worth $20,700bn, or nearly three-quarters of the size of global pension funds, by 2012.

However, the study says the four investor groups often lack transparency and are out of the reach of regulators.

“It is true that there is not the kind of light shed on some of these activities in the way we are used to,” said Diana Farrell, director of MGI and one of the authors of the report. “The Anglo-Saxon model of capitalism will be challenged. We need to evolve in terms of regulatory oversight.”

Not stated in the article, however, is the considerable (though subtle) divide that exists between the United States and Europe on the issue of "investor transparency." In the United States, "transparency" is a matter for issuers and financial firms -- a tool to protect investors. Investor disclosure generally only comes into play where a takeover is involved or where an "insider" is purchasing or selling securities. Neither of these issues depend on whether the investor is a regulated investment bank or a private equity firm. In short, US market regulation largely doesn't care about "investor transparency".

In the UK, on the other hand, things are quite different. The United Kingdom's "light touch" oversight, in many ways, works at all because there is an underlying monopsony of large investment firms. These firms, with deep roots in the City of London, act as the primary UK market police. They mandate corporate codes of conduct, punish boards of directors by having the (rarely used) power to vote off recalcitrant board members, and, generally speaking, act like a good old fashioned guild.

Add private equity firms into this City mix, and suddenly the guild system is in danger. Private equity firms are numerous, have different values, with members who didn't all go to the same schools. A lot are not British at all. Suddenly, a market that prides itself on its "light touch" oversight is calling for greater regulation of these outsiders. We shouldn't be surprised.

All of this serves as an interesting case study in how politics and regulation intersect. Over the past year or so, there has been a lot of discussion about the philosophical differences between regulation in the United States and the UK, with the UK often portrayed as more flexible and far less heavy-handed. But the reality is that regulation in the United States and the United Kingdom (and pretty much everywhere else) is designed to benefit a domestic constituency. In the United States, for historical reasons, there are two (often conflicting) constituencies -- issuers and retail investors. Hence, strong shareholder litigation rights, a strong SEC enforcement regime, and almost no other shareholder rights or constraints on management. Contrary to popular opinion, New York's financial industry is not a major political constituency.

In the UK, by contrast, the City's financial industry is a major political power, while retail investors and issuers (comparatively speaking) are not. This latter point may seem odd when you consider that the London Stock Exchange and the UK Financial Services Authority advertises the UK as a "Sarbanes-Oxley-free zone". But, while UK-based issuers do not have to deal with SOX, they do have to deal with a host of other, frankly more nettlesome, regulations regarding labor, advertising, environmental and consumer protection, etc. At the same time, the LSE's SOX-free zone isn't designed to benefit issuers -- at least primarily. By offering London as a low-oversight market, the City attracts foreign issuers, which means money for London's financial firms. Since sophisticated investors in the UK (or in the US, for that matter) do not rely primarily on the regulator for protection from dishonest issuers, potentially greater fraud in the UK retail market is but a small price to pay for the extra fees these firms can draw by attracting foreign issuers.

In other words, there is no "Anglo-Saxon" model of capitalism to be challenged, at least in the financial realm.

All of that said, Chung's article does touch on a separate issue of concern in the United States -- sovereign wealth funds. These foreign government-owned funds do present transparency (and trade, and strategic) issues for the US government. But these concerns are quite different from the purportively non-transparent investor concerns otherwise highlighted in the article.

Avoiding the "lapdog" label

The UK media roundly criticized former Prime Minister Tony Blair for his close association with US President George W. Bush's invasion of Iraq, frequently labeling him a "lapdog." The term has become so devastating that UK politicians will go out of their way to avoid the ruinous epithet. But there is a greater danger to Great Britain today than just a particular alliance with Bush's failed policies, and that is the general risk of allowing your government to be a lapdog to short-term economic interests.

This isn't a risk peculiar to the British, of course. Indeed, it's a general risk for all governments. For some governments, it is the normal course of doing business. However, it wasn't always the case for the UK. Nonetheless, recently the United Kingdom seems to be creating the appearance of subsuming their national interest to short-term economic gain. This came to my mind today when it was announced that British prosecutors were dropping charges against two prostitutes who allegedly (and by "allegedly" I mean "most probably") were beaten to a pulp by the son of Libya's intelligence chief. (See Call girls drop charges against Gadhafi's kin)

I'm not blaming the prosecutors in the case. They can only do so much when the chief witnesses withdraw their complaint. And, of course, this wouldn't be the first case of witness intimidation. However, it does seem strange that the UK police and intelligence services would permit Mohammed al-Sanussi to be in London without being subject to constant surveillance -- or that Libyan intelligence operatives could surrepticiously videotape the two prostitutes in question without themselves being under MI5 surveillance. In other words, it's one thing if you have some neighborhood thug able to intimidate witnesses in some run-of-the-mill criminal case. But having Libyan intelligence do it in your own backyard shows something is wrong. Could they be pussyfooting around the Libyans for fear of botching business negotiations?

If this were a one-off situation, that would be one thing. But coming on the heals of the Alexander Litvinenko assassination and the BAe-Saudi bribery scandal, it's a bit too much.

And another thing...

I want to continue my rant on the New York Times' recent article about how the subprime mess has led some in the "international community" to call for more input into US financial regulation. (See my screed here and the NYT article here.)

Clearly, greater international regulatory cooperation can be a great boon. However, the arguments posited by Peter Bofinger and Professor Dick Bryan in Heather Timmons' and Katrin Bennhold's article are not among the reasons we need this cooperation. International regulatory cooperation exists for two purposes -- so bad guys can't use the international system to undermine national sovereignty (quite the opposite of what Bofinger is suggesting) by permitting regulatory arbitrage; and, second, so the world's regulators don't step on each others' feet so much, to the detriment of global markets.

I'm harping on this point because these academicians really should know better. For example, the article notes:

Their argument is simple: The United States is exporting financial products, but
losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks. “We need an international approach, and the United States needs to be part of it,” said
Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.

While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.

“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

Rather than an argument that the US regulators are asleep on the job, isn't this an argument that the European regulators aren't monitoring the risk management practices of their own firms? Were these firms really snookered into believing that the subprime mortgage securities were safer than they are -- particularly when anyone with half a bucket of sense could tell you otherwise?

Likewise, it is certainly true that US regulators have not been keen on engaging foreign governments in determining what US financial regulations should be. Indeed, I suspect that if the US public knew anyone in the United States was even considering it, they would be hanged from the nearest lamp post (which may explain why Basel II is as complicated as it is -- US banking regulators, after all, have such skinny necks). All of that said, I fail to see why US financial regulators would particularly care if foreign investors, in particular, stopped investing in any specific US security. Regulators might care if investors, writ large, started having a problem, but there is nothing magical about foreign investors.

And this, fundamentally, is why these academics' arguments fail. The Fed, the SEC and most other US financial regulators draw no distinctions between US and foreign investors. This is the strength of the US system and why the United States is able to import capital so cheaply, regardless of how many boneheaded statements Congressional leaders might make about foreign capital. What's good for foreign investors is good for American investors, and vice versa. US regulators are unlikely to take advice from foreign regulators who historically have a problem with attracting even domestic investors to their own market.

NYT: World wants a say in US financial regulation

Yesterday, the New York Times had an article on the subprime mess quoting a number of foreign talking heads demanding more international input into US financial regulation. (See Calls Grow for Foreigners to Have a Say on U.S. Market Rules.)

Yeah, what's new? Actually, that should be the title of the article. What I found most amusing, of course, is the arguments put forward about why there needs to be more of an "international" approach -- whatever that means.

“We need an international approach, and the United States needs to be part of it,” said Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.

While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.

“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

I believe logicians call that the "we're your customers, therefore we should have a say into how you run things" argument. I suggest you try it with your cell phone carrier some time -- it really does work.

(As for the "we're going to stop buying your products" thought, Mr. Bofinger, you'll stop buying when we stop being so damn profitable, and not a day before--or a day later, for that matter. Do I have to explain everything to you European government types?)

Granted, I expect that kind of thinking from European academicians. (Do you ever stop and wonder what happened between Rene Descartes and today? I mean, seriously. The Europeans actually invented deductive reasoning, and today we get this?) However, the Aussies are in on it, too.

As geographical boundaries are broken down, “a problem in one location is a problem everywhere,” said Dick Bryan, a professor of economics at the University of Sydney.

“There is the need to challenge the sovereignty of national regulators,” he said. “Why should the rules of lending in the U.S. be left to U.S. regulators when the consequences go everywhere?”

There's your problem, Professor Bryan. You are following the lending rules of the United States because you are actually lending in the United States. If you were lending in Australia, the rules might be different. If you don't like it, stop lending to damn ferriners. (Oh, I guess I don't mean you, personally. I mean Australian financial institutions, who, as we all know, are demanding significantly more regulation in the United States...)

Please, everyone. The old saying is don't confuse brains with a bull market. On the flip side, don't confuse conspiracy with a bear market.

You investors and borrowers out there want to know who's to blame for the subprime mess? Look in the mirror.

Bernanke's competence on subprime crisis brought into question

After all, nothing will bring into question your competence on an issue than for Sen. Chris Dodd (D-Conn.) to say you "get it." (See Fed ‘Gets It’ on Mortgage Crisis, Senator Dodd Says.)

I'm all for addressing liquidity crises, but there is a very fine line right now between holding off a wider, preventable systemic crisis, and repeating the Fed's past mistakes regarding moral hazards and banking bailouts. (Which, in my opinion, include pretty much every Fed banking crisis intervention in the past.)

Just as an example, has there ever been a more blatant case of begging for corporate welfare than Jim Cramer's beserk attack on Bernanke two weeks ago? (Watch here or here if you're interested).

"Bernanke is being an academic!... [William Poole, St. Louis Fed President] has no idea what its like out there--None! They know nothing! The Fed is asleep! My people have been in this game for 25 years ! They are losing their jobs and these firms are going out business!... This is a different kinda market!"

First, never trust anyone who says this is a different kind of market. For 400 years, it's been the same kind of market.

Second, why should we care if you are losing your jobs over your poor investment decisions? (Some people, particularly those betting against you, have been making a lot of money.)

I could be wrong, but given Congress' involvement in previous market-related matters, I can't help but suspect that Chris Dodd is just a slightly more calm version of Jim Cramer (particularly given the number of hedge funds operating out of Connecticut).

Why the Heritage Foundation is getting its butt kicked by Cato

You don't have to go much farther to understand the ideological break up of the Republican Party than the Heritage Foundation's support for an internal US passport. See Federal ID plan raises privacy concerns. Cato, on the other hand, is right: a national ID card is more about illegal immigration than national security.

And Mr. "Shared Responsibility" Chertoff should be credited for being able to say without smirking that he's part of a Republican administration and that: "This is not a mandate," Chertoff said. "A state doesn't have to do this, but if the state doesn't have -- at the end of the day, at the end of the deadline -- Real ID-compliant licenses then the state cannot expect that those licenses will be accepted for federal purposes." Which, of course, means that those of you living in those 20+ states opposed to this plan will either have to suck it up or start using your US passport to board planes, trains and buses.

Chertoff, of course, assures us that our privacy is guaranteed and that the government would never abuse this information. In other words, he's from the government and he's here to help. (Makes you wonder what Reagan would think of his party these days...)

So I guess this means that if I'm in favor of small government and opposed to unfunded mandates, I'm a Democrat?

Roel Campos to leave SEC

Democratic Commissioner Roel Campos announced today that he will be leaving the Securities and Exchange Commission by the end of September. The media is making a big deal out of the fact that Campos is the SEC's first Hispanic commissioner and a Democrat in a highly divided Commission. However, Campos is also the "international" commissioner--he represents the SEC before a number of international organizations and is currently the Vice Chairman (and prospective chairman) of the developed markets committee of the International Organization of Securities Commissions. With Campos leaving, SEC Chairman Cox will have to nominate someone new to represent the SEC before the world--though, given Cox's own interest in international matters, I wouldn't be surprised if he takes up this job himself. If he does, we can expect a new emphasis placed on IFRS-US GAAP convergence and mutual recognition.

The conspiracy theorist in me expects Paul Atkins to leave soon as well, in a quid pro quo that will reduce the SEC to three commissioners. The Financial Times has reported that Atkins may be heading over to the Commodity Futures Trading Commission. Even if he does not, his term ends in a year and he may be interested in more remunerative work even before then. As it stands, the 5-member Commission will soon be down to 4 members, only one of whom is a Democrat at precisely the time that some very important decisions are coming due and an upcoming election season.

If Atkins leaves for the CFTC, I expect Bush will leave the SEC with three commissioners for the remainder of his term. This is because, despite all the talk about a shift in the balance of power, the current Commission is ideologically dysfunctional. Previous SEC chairmen (particularly Arthur Levitt) ran the SEC as a corporate chairman--i.e., largely by fiat, with the four other commissioners more or less falling in line. However, starting with Harvey Pitt and his battles with fellow intellectual heavy-weight Harvey Goldschmid, individual commissioners started having their own ideas and pursuing their own political agendas. The media story on current SEC chairman Cox's predecessor, William Donaldson, was that he "sided" with the Democrats and chaired a fractious Commission. However, the same fractures are starting to appear with Cox as well. And the source of these cleavages? Atkins.

Atkins, in particular, is a thorn in any Republican SEC chairman's side, basically because he has yet to see a securities regulation he likes. He is an ardent deregulator, and such views can be particularly unhelpful to more "responsible" (i.e., vulnerable) Republicans during an election season. Cox is no investor-hugging hippie, but he does recognize that an SEC that appears to be in the pocket of industry is not something good for his party. (Hence his vote with the Democrats to petition the Solicitor General to file an amicus brief on behalf of the investors in the Stoneridge case.) Atkins, on the other hand, would rather be ideologically pure than in power. Furthermore, he has a tendency to get the other Republican commissioner (whoever that might be) to get onboard with him.

Reducing the Commission to three members might, then, help Cox pursue his own (and his party's) wider agenda. Under a 2-1 Commission, Cox likely could count on support from his remaining fellow Republican commission Kathleen Casey, and Democrat Annette Nazareth likely would go along to get along.

A nice, quiet SEC for the remainder of George W.'s term. What's not to like?

China's "Nuclear" Currency Option

The London Telegraph is reporting that the Chinese government is threatening a massive sell-off of the $1.3 trillion-worth of US dollars it holds if the US Congress passes trade sanctions as a result of China's policy of undervaluing its currency. (See China threatens 'nuclear option' of dollar sales.) What's worse, the Telegraph breathlessly reports this as a threat.

OK, I'm a bit lost here. The US accuses China of hoarding dollars as a way to keep the Chinese yuan artificially low, thereby making Chinese products artificially cheap and flooding the US market with Chinese imports. To protect US consumers from having to pay so little money for these products, Congress is threatening to slap trade sanctions on China if it doesn't stop these currency policies. In response, the Chinese goverment basically says, "Oh, yeah? Well, if you slap sanctions on our companies, you know all those dollars you paid us for everything you buy at Walmart? Well, we're going to give them away for free! That'll show you!"

How am I not exaggerating? The US says stop keeping your currency low or we'll hit you with sanctions, and the Chinese say, if that's how your going to be, then we're going to stop keeping our currency so low! Is that a threat? A negotiating tactic? Who are these people?

The Telegraph goes on to suggest that a massive sell-off of Chinese-held US government debt could "...cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession." Granted, a firesale of US bonds might cause a spike in US bond yields (and an excellent investment opportunity for the rest of us), but even if that caused a recession, which products are these newly impoverished American consumers most likely to forgo most quickly? You think it might be all those Chinese products that suddenly doubled in price?

And all those poor American consumers, suddenly seeing their property values drop. Do you think they might be able recoup some of the loss with a better-paying job at a US exporter? You know, maybe a company like Boeing, since the prices foreigners have to pay for a new Dreamliner just dropped dramatically with a devalued dollar?

All I'm saying is that I wish these Chinese negotiators would come over to my place sometime for a night of poker. I could use the cash...particularly with a recession coming up.

Foreign Policy: Five things my economist told me that I'm too dumb to understand

The web issue of Foreign Policy Magazine (which Kids Prefer Cheese calls the People's Magazine of international affairs) has an article called "Five Lies My Economist Told Me". I don't know why some people say ostensibly respectable journals can let their editorial standards go to hell where an Internet edition is involved. In this case, Foreign Policy hits it on the nose. Speakin' the truth, brotha! For example:

1. High productivity and low unemployment make us all better off: Despite six years of sustained growth, with unemployment averaging around 5 percent, the median U.S. worker is not faring well. Since 2001, middle-class Americans have seen their pay drop by 4 percent, although labor productivity went up by 15 percent during the same period.

Now we know this is a lie! It's low productivity and high unemployment that's the secret to success! Bring back stagflation and 10 percent unemployement. Middle class incomes are sure to rise then. And while you're at it, we need to get rid of Tivo. I don't know about you, but my middle class life hasn't improved one wit by fast-forwarding through 40 minutes of TV ads every day. After all, if it's not salary, I don't care.

2. It’s hard to grow without good banks and private property: One word: China. The gross domestic product of this Asian giant has increased sixfold between 1984 and 2004, with a stunning average growth of roughly 9 percent since 2005. Yet only in 2007 did the protection of private property acquire equal footing in Chinese property law. Moreover, experts still deem China’s banking system to be shaky despite a major overhaul that started in 2002.

Good banks and private property are a lie! It's easy to grow if you don't have banks or private property! Which, of course, is why Mao's China was going gangbusters. In fact, China would be growing much faster now that it was in the past if they had just stuck to Mao's glorious policies. After all, why do you need a bank if you don't own any property? Clearly, economic growth has never been linked to a strong financial system or some kind of assurance that you aren't going to be robbed. And any economist who tells you otherwise is just lying to you.

3. Capital must always be let free to flow: The Asian financial crisis. Starting in 1996, overvalued real estate prices collapsed in Thailand, spurring a devaluation of the Thai currency. Soon enough, the contagion spread to nearby Malaysia, Indonesia, and South Korea. Capital flight triggered painful recessions in most of East Asia. Only China and Taiwan, which had maintained tight capital controls, weathered the crisis unscathed. Malaysia split the difference by introducing capital controls in 1998, a last-minute attempt to avoid the worst.

This is completely a lie! After all, if you keep capital out of your economy, clearly it won't flee when the corrupt underpinnings of your market become apparent. Which, of course, is why Zimbabwe is an economic powerhouse, and Western markets, which got rid of their capital controls in the late 1970s, have been in the economic shitter ever since.

4. The euro will never work: In January 2002, the euro made its entrance on the world stage and into the wallets of the citizens of 13 European countries. Five years later, it is still alive and healthy—stronger than the U.S. dollar, in fact. And despite grumbling from countries like Italy, where policymakers wish they could still boost exports by devaluing the old lira, nobody is seriously considering going back to single national currencies.

That's right, you liars! The Euro is stronger than the US dollar! And the only people complaining about the Euro are little whiners like the Italians and all the lower-wage EU markets getting burned by the strong Euro. Because, you know, a strong currency is a sign of economic strength. Just ask the Chinese, and their pathetically devalued Yuan. Not an economic growth sign in sight there. (By the way, why does the FP then go on to say that the critics are right and the Euro is essentially just a political tool divorced from economics? Why back down when you've got such a compelling argument?)

5. Japan—no wait, China—is going to take over the world economy: As of 2007, the United States is still the greatest capitalist economy in the world, with a gross domestic product roughly three times as big as that of Japan, the world’s second largest economy. True, Japan’s car industry is still a rising star: Toyota briefly overtook General Motors a few months ago as the world’s largest automaker. Yet, as Newsweek columnist Fareed Zakaria put it, the Japanese “ran into a brick wall.” After more than 15 years of economic stagnation, repeated currency deflations, and record-high unemployment, the Japanese economy is just now coming out of the doldrums.

Again with the lies! All those lies in the late 1980s by such reknown economists as Clyde Prestowitz, Chalmers Johnson and Robert Reich. OK, so maybe they weren't "economists" in the U.S.-sense of the word. And by that I mean they didn't know anything about economics. And by that, I mean that Paul Krugman, who actually is an economist and knows something about industrial policy, calls them a bunch of policy poseurs (he's such an asshole like that). But somebody once said "economics" and "the Japanese and Chinese are going to crush us" in the same sentence, and if that's good enough for Foreign Policy, it's good enough for me.

Sub-prime credit rating agencies

Sean Egan, head of boutique rating agency Egan-Jones and co-founder of some lobbying group designed to get his firm recognized by the SEC as a Nationally Recognized Statistical Rating Organization ("NRSROs" as they are known to their friends) wrote an op-ed in last Thursday's Financial Times (see Sobering lessons of the Bear Stearns losses). Given Egan's previous writings to the SEC and other groups, the FT piece is actually pretty good. Which means, of course, that I doubt he really wrote it. (Must have hired a new PR firm recently.) Egan correctly points out that the Basel II accord has basically made the role of credit rating agencies (CRAs) more important than ever, even as recent structured finance deals and the all-to-predictable sub-prime fiasco call into question whether these CRAs really can be trusted to properly rate the component parts that go into a structured finance deal or a collateralized debt obligation (CDO).

Structured financing and CDOs have become an important part of our economy. In "finance for dummies" terms, these are complex arrangements that let banks or others lend money, and then sell off the IOUs from those debts to other investors. Groups of these IOUs are broken into "tranches" according to the risk that the borrowers will default, and then bits of those tranches are sold off as securities. The idea is that the lender can diffuse its risk among a wide range of investors, each with a different risk preference. You want to invest in rock-solid debt? Then you buy securities from the AAA tranche. You want to take your chances, buy low with a very high chance you'll get nothing, but a chance that you'll make a killing? Then you buy into the "junk" (or sub-prime) tranche. You're an idiot and don't want to get paid back at all? I've got securities in the M.D. Fatwa tranche right here!

In an ideal world, this system is great and, according to some economists, is the reason that the last two recessions in the United States were as painless as they were. (You think they weren't? Then you are a punk and obviously can't remember the early 1980s.)

However, in the latest go around, Egan notes:

Investors in two hedge funds managed by US investment bank Bear Stearns were wiped out in June, which was surprising given that the securities in the funds were rated either AAA - the same level of safety as US Treasury bonds - or one notch lower at AA. Within a couple of months, $1.5bn of capital was lost in only two funds. This development is particularly sobering because, from the obvious indicators, the two funds were insubstantially better financial condition than most banks: they had equitymore than twice that of most banks, at 15 per cent of assets compared with only 6 per cent or 7 per cent for the majority of banks. These funds therefore met and exceeded the requirements of debt-to-equity ratios under Basel II. Additionally, the assets of the funds were rated higher than the typical bank's assets.

This event is a reminder of the weak underpinnings of the mortgage financing market. The problem is a shift in the mortgage business to a situation where all the participants have an incentive to complete the transactions; the mortgage brokers, bankers, investment banks and rating firms are paid if and only if a deal is completed.

This structure is significantly different from the markets of yore, in which a local banker would check borrowers' income and grant a loan only if there was an adequate ability to pay. Even if the banker became too aggressive, there were bank regulators to keep the business on the straight and narrow. One could argue that rating firms today are capable of assessing credit quality and halting the flow of garbage by withholding a rating. Unfortunately, in the ratings field, the tough rater is likely to be the underemployed rater. One of the major rating firms, Moody's, announced last week that it lost market share when it became less liberal than its
competitors.

Egan's point about Moody's is very good. Moody's recently noted that ever since it toughened up its standards for reviewing commercial mortgage bonds, it has been shut out of 70 percent of this market. (See Moody's Shut Out of Rating Commercial Mortgage Bonds.) Moody's is one of the biggest CRAs and if it is being ratings-shopped, it's not hard to imagine that CRAs may be becoming subject to the same types of pressures that undermined securities analysts a few years ago.

However, as cogent an argument as Egan makes, he actually undermines his point (and his own firm) in his op-ed. In particular, as Egan has consistently noted, the big CRAs are all paid by the issuers they rate. A clear conflict of interest. The big guys argue that if they didn't charge issuers, then no one would pay them since email and fax machines mean that once they issue a rating to even one person, news of that rating travels fast (and the more respected their ratings, the faster the news travels). However, Egan-Jones and other small CRAs are paid by subscribers and investors, and not by the issuers they rate. No conflict of interest, right?

But then Egan writes:

...regulators must pay better attention to incentives. If a rating firm receives 90 per cent of its compensation for ratings from sellers of securities, it is difficult to envision that the interests of investors are paramount. This issue of incentives is all the more pressing given the great difference ratings make to a bank's capitalisation requirements. Under the Basel II accords, $100 of AAA securitised assets requires a bank to hold 56 cents of equity to back up the debt. However, if the bank or fund holds $100 of BBB assets, it has to hold $4.80 of equity - a far more onerous proposition. (Last week Standard & Poor's cut the ratings of several securities from AAA to BBB in one day.) This greater burden of holding lower-rated assets increases pressure on ratings firms, which depend on issuers of debt for business.

Wait a minute. Sure, I get your first point -- if a CRA receives 90% of its revenue from issuers (sellers) of securities, it's hard to see how the CRA will make the interests of the investors (buyers) of these securities paramount. But then you say that, under Basel II, the greater burden investors face in holding lower-rated assets increases pressure of the CRAs to up the ratings. But aren't the banks getting screwed by a lower rating the investors you were just talking about? So who's putting the pressure on the CRAs? Sure, I can see an issuer not wanting a low rating on a debt offering, but once that debt is out there, the pressure will be coming from the banks and investors. And aren't those guys the ones paying your bills, Mr. Egan?

So who's conflicted here?

99 percent of Chinese exports safe

This according to Chinese Commerce Minister Bo Xilai, as reported in the FT. This makes some sense, when you keep in mind that 1 percent of all Chinese exports these days are for the new Mattel Swishy Switchblade (TM) Vodka Bottle Opener and Child Home Defense Kit (now with more lead flavor!) What can I say. It's not China's fault that kids thing this is the hottest thing since the Bat Masterson Derringer Belt Gun.

Risk, of course, is such a fun topic. Basically, Minister Bo is reassuring us that 99 out of every 100 Chinese products we have in our house or that we use are safe. Personally, I'm completely reassured. After all, it's not like we use a lot of Chinese-made goods every day, is it?

The Clinton Service Academy

OK, I hate Hillary as much as the next guy, which means I fully expect her to win the next election. But her new proposal to have a national service academy for public servants is one of the most boneheaded idea in an election season full of boneheaded ideas. (See Clinton: Create Public Service Academy). Does the United States really need a École Nationale d'Administration? After all, that's proven such a font of ingenuity for all things French and bureaucratic. And, besides, don't we already have Georgetown University?

The UK FSA lapdogs

I know it's been a while since I bitched about the UK Financial Services Authority, but last Monday the Wall Street Journal (of all places!) published an article by Alistair MacDonald titled Assessing U.K. Watchdog -- FSA's Regulatory Model Gets Some Raves in U.S.; A Lapdog at Home? Of course, you have to have a subscription to the WSJ to read it -- a silly policy that's contributing to why Rupert Murdoch is going to buy out their asses and fire a quarter of the staff. Nonetheless, for a newspaper committed to a "principles-based" approach to financial regulation, I found the article both fun and interesting.

The WSJ article describes the FSA as a toothless "lapdog," barely regulating and never enforcing even the rules it has. (You can really get the British goat by calling something a "lapdog" these days. Ah, the effects of Murdoch already...) The WSJ draws on some recent research by Howell Jackson, a Harvard Law School professor currently studying how different countries regulate their securities markets. (One of Jackson's recent preliminary papers on this topic can be read here.) Jackson's research, along with a recent paper by Columbia Law School professor John Coffee (which can be read here), show that the degree of enforcement of securities regulations in the United States is qualitatively different from other countries. When compared to the UK FSA, this is particularly apparent. The US spends considerably more on securities regulation than does the UK, even when accounting for market and economic size. But the area that really stands out is enforcement. Between 2002 and 2004, on average, the US Securities and Exchange Commission took 639 enforcement actions, and levied $2.1 billion in fines. By contrast, the UK FSA took 72 enforcement actions per year, and on average levied $27 million in fines.

And this actually understates the differences, since the FSA combines within it many of the regulatory functions that in the US are divided among the SEC, the self-regulatory organizations (such as the National Association of Securities Dealers), and some state regulators. When all of those are added together, the US brought 2,985 enforcement cases and levied $5.3 billion in fines. Even this, however, understates enforcement activity in the US since, as Coffee shows, US private enforcement activity (i.e., securities class action suits) levies the equivalent of another $2 - $9.7 billion per year.

What this all means is that if you misbehave in the United States, you can expect to be slapped with a market-adjusted fine that is 10 times greater than similar activity might fetch you in the UK. And that's not counting the private lawsuits, which are very rare in the UK. Or the criminal penalties. Did I mention the criminal penalties? Oh, yeah -- Coffee notes that between 1978 and 2004, joint SEC-Department of Justice investigations led to criminal indictments of 755 individuals and 40 companies for various kinds of severe market shenanigans. The indictments led to 1230.7 years of incarceration (or 4.2 years in the hoosegow on average). In the UK, criminal indictments for securities law violations are very rare, and convictions as rare as hens' teeth.

Your chances of getting busted in the US are also much higher, not least because the US devotes considerably more resources towards investigating infractions. Coffee notes that 40 percent of the SEC staff are part of the Division of Enforcement, while only 12 percent of the UK FSA is in enforcement -- and this group splits it time between policing the securities, insurance and banking sectors.

None of this necessarily means anything, of course. It's possible that the US devotes so much of its regulatory resources to enforcement because its market is plagued by crooks. It's also possible that you can over-enforce -- an argument that Coffee also makes, particularly with regard to private lawsuits. In other words, a scourge of scorpions may not be the best thing for market efficiency. However, another recent study -- this by the team of Craig Doidge, George Karolyi, and René Stulz argues that the stronger investor protections and enforcement system in the US provides a markedly lower cost of capital for foreign issuers listing on a US exchange. (See "Has New York Become Less Competitive in Global Markets? Evaluating Foreign Listing Choices over Time" (July 2007)). Doidge, Karolyi and Stulz also show that this US listing premium has not diminished since passage of the Sarbanes-Oxley Act. So take that, all you SOX haters out there. Yeah, I'm talking about you, Bainbridge. You too, Ribstein.

And while I'm at it, you too, Paulson Committee and Chuck Schumer and Michael Bloomberg. One of the interesting points in the Doidge, Karolyi and Stulz paper is that, when you look at the types of foreign companies that have listed with NASDAQ and the New York Stock Exchange in the past, there hasn't actually been a drop-off in IPOs in New York since passage of SOX, contrary to what the Paulson Committee and others claim. Doidge, et al. analyze the types of companies that traditionally have listed in New York in the past and find that these tend to be larger companies with a history of cash flow and high Tobin's q ratios. By contrast, many of the IPOs over the past several years have been smaller companies, with no cash flow, and low Tobin's q ratios. Indeed, these types of companies have become the bread-and-butter of London's Alternative Investment Market (AIM). (I'm not saying these companies suck, but can you say "Russian corporate governance"? I mean, without snickering, ducking, or hiring a food-taster.) In other words, most of the issuers "not going to New York" these days wouldn't have gone to New York even before SOX. Most likely, they would have just borrowed from a bank or had to recapitalize earnings.

None of this is much comfort to the NYSE or NASDAQ. Even if these issuers would never have gone got New York to begin with, slumming is big bucks these days and high US standards and a toothy watchdog preclude them from competing with AIM in attracting mobbed-up Russian issuers and risk-tolerant suckers investors. But, in my opinion, US regulators shouldn't be in the business of improving the NYSE's bottom line. They should be in the business of providing US companies with the lowest cost of capital. That's a key difference between the US and UK market.

New New Name for Consolidated Regulator

Last March, the New York Stock Exchange and the National Association of Securities Dealers announced that they would combine their self-regulatory organizations (SROs) into a single consolidated oversight body. The idea behind this was to end some of the minor differences that crop up over time between the NYSE's rules and the NASD's rules, and also further separate the regulatory side of what the exchanges do from their business side. Originally, this new organization was to be named the Securities Industry Regulatory Authority (SIRA). However, just recently it was discovered that "Sira" in Arabic means a biography of Mohammed. Of course, it doesn't mean that in English--in English, it just means Tom Cruise's artificial child. But, rather than risk offending anyone, Sira's head Mary Schapiro announced a name change, which you can read here. The new name? The Financial Industry Regulatory Authority, or "FINRA". They decided on "FINRA" rather than the more appropriate "FINIRA" because, of course, "Finira" is a goddess in the religion of Poetology, which I invented when writing a science fiction novel. (Tom Cruise, as you might expect, is a charter member.) Since I was potentially so offended, FINIRAwas out.

But that just leaves one question: Didn't Finra fight Godzilla in one of those 1960s Japanese monster flicks? You remember, the guy in the fish suit who twirled around knocking over the little buildings with his radioactive fins? Anybody?? Buddies with Gamera? Hey, you don't believe me, just Tivo it on Nick at Night or Spike or something. I've even got a picture (see right).

U.S. signs on to implementing Basel II

This is one of those really really big deals that practically nobody knows about--a case strong enough to resurrect Mancur Olson just so he can point his finger at all those Public Choice haters out there and say, "See, this is exactly what I meant!"

"Basel II" is the second set of international agreements on banking regulation created by the Basel Committee on Banking Supervision, which is itself a group of central banks from a dozen or so of the world's most developed economies. Unlike securities regulation, which tends to focus on investor protection, and insurance regulation, which tends to focus on the safety and soundness of the institutions, banking regulation is all about systemic risk. (Of course, all financial regulators focus on investor protection, soundness of financial institutions, and systemic risk, but we're talking about emphasis here.) From a banking regulator's perspective, the worst case scenario is not that a bank fails or some customers get ripped off, but that the system itself is brought into question. When that happens, as it did in 1929, you get the proverbial run on the banks, and then the world goes to hell in a handbasket, regardless of how many investor protections you've built into your regulation or how strong the individual institutions are. And, as we all know, the only thing that's going to save your economy's sorry ass when that happens is Jimmy Stewart explaining basic finance to a bunch of town yokels.

The second accord of the Basel Committee on Banking Supervision (or Basel II, as it's known to its friends) is designed to help protect the international financial system against systemic shocks by setting global standards on capital reserves and other aspects of banking regulation. The lessons of banking crises over the past 30 years or so (and particularly the 1997 Asian Crisis) shows that a collapse of the financial system in one country can be contagious and produce risks to the financial systems in other countries as well--even if those other countries have better regulatory oversight. That's because, in today's world, everybody is invested in everybody else, so if everybody in one market defaults at the same time (as happens more often than you might think), it could effect a major international bank invested in that market. And if that major bank goes belly-up, people start wondering about the strength of all those other major banks--and pretty soon you have a run. So, to put a stop to this type of problem, the big country central banks got together to create a uniform world standard on how banks should measure risk and set cash aside for a rainy day. Being a world standard would make it harder for some countries to "cheat" and let their banks set aside less than everyone else.

The first Basel accord, agreed to in 1988, was very basic by today's standards and was soon overtaken by new risk-measurement tools. Hence, Basel II. The fun thing about Basel II is that it is absolutely incomprehensible to everyone other than a handful of banking regulators, who themselves are incomprehensible to all other humans. Nonetheless, like all banking regulation, it involves a whole lot of money. I mean, really really really large sums of money. So, a tweak here or there can mean some bank goes out of business or else the president of that bank gets a $1 billion check in his or her Christmas stocking. Making matters more fun has been the long-standing disagreement between two of the United States' myriad banking regulators--the Federal Reserve and the Federal Deposit Insurance Corporation. I don't really understand the details of this disagreement--and by "details," I mean "anything at all"--except that the large US banks wanted one thing and the small US banks wanted something else, with the result that the European banks were worried that in the end they were going to be really screwed over. Hmmm, so many delicious choices! But all of this led to a very interesting situation where you had Congressmen holding hearings on this issue and reading questions off index cards to the various banking regulators, with neither the questions nor answers being understood by either the Congressmen or their staffs. This, itself, is not that unusual, but what was really interesting was that the industry lobbyists pushing for various concessions often didn't understand what they were pushing for, either. It's just that arcane.

Which gets back to Public Choice theory. Public Choice says that most policy issues are just too complex and tiresome for most people to pay attention to, unless the issue has a very strong impact on them. Hence, we get subsidies for milk producers, even though the average taxpayer and consumer is made worse off by these subsidies--but only a little worse off, while a few milk farmers are made very much better indeed. With Basel II, however, we have a situation were the policy issues may be just too complex and tiresome for anybody. What happens then?

The Financial Times writes about it here.

SEC Terrorist Sponsor List Deep-Sixed

Not the brightest bunch, but at least they have something of a learning curve. By that, I mean the folks in SEC chairman Christopher Cox's office who came up with the "search tool" that was really just a blacklist of US-listed companies that somewhere, somehow, in some connection mentioned Cuba, Iran, North Korea, Sudan and/or Syria in their SEC filings. "Context," unfortunately, wasn't a feature built into this search tool, with the result that a company mentioning that it was completely divesting of all its assets in Iran (for example) joined the blacklist just as readily would "Bombs 'R' Us" when it mentions that North Korea is its brightest future market.

Cox's statement on this about-face is here. Seems the SEC decided to pull this little fiasco after both Barney Frank (D-Mass.) and Spencer Bachus (R-Ala.) publicly said it was a boneheaded idea. (On the bright side, Cox should be congratulated for helping forge a bipartisan consensus here.)

It's hard for me to feel all that worked up on this issue, particularly since some of the biggest whiners about this have been European companies that really are working too closely with some bad people and are worried that European human rights activists might actually call them on it, via the SEC's blacklist. But the SEC's execution was pathetic enough to give these companies enough ammunition to make themselves look like victims. Cox's office initiated this half-assed scheme as a way to keep Congress from enacting even more draconian rules (though why Cox would care if Congress wanted to shoulder the blame is beyond me).

A much better approach would have been to develop a real search tool--perhaps one based on Cox's beloved XBRL. Such a tool would let an investor (or anyone, for that matter) run a search for a specific country (any country) and pull up their own private blacklist of companies mentioning the nasty country in question, with links to the references so they can do their own research on whether Company X deserves to be blackballed for whatever reason your heart fancies. If you care about only the 5 countries that the US State Department lists as state-sponsors of terrorism, then you just punch in Cuba, Iran, North Korea, Sudan and Syria. If you don't like China because of the way they treat Tibetians, then punch in "China." You don't like the Belgians because they share a border with the Dutch, then... you get the point. Some kind of electronic data gathering, analysis and research tool. Just, you know, more so.

Why didn't the SEC do this? Well, probably because this was being driven by politics rather than real concern over investor interests. Bloody shame. But, hey, that's Washington.

I'm not saying W has burned up some of his credibility with me...

But I am saying these guys at Stratfor seem more plausible.

Al Qaeda has reconstituted itself? As strong as they were pre-9/11? Really?? Then what the hell have you been doing for the past six years?

Bush's problem is that the idea that Iraq is linked to al Qaeda rests on
semantic confusion...

Yes, we have a winner! Give Dr. Friedman the "Diplomatic Euphemism of the Month Award"!

Russia and Banana Republics

The news today is that the UK expelled a bunch of Russian diplomats to protest the Russians not extradicting a Soviet Russian spy who probably dropped the polonium sugar cubes in former-Russian spy Alexander Litvinenko's tea. (I once stayed in the London Millenium Hotel. And if there were ever a hotel where you'd expect someone to poison a former Russian spy, that would be it. Also, the breakfast bangers are way overpriced...)

Anyway, Bloomberg had the news, plus this interesting quote from Konstantin Kosachyov, the head of the Russian lower house of parliament:

You can act this way toward a banana republic, but Russia is not a banana
republic.

Two things. Apparently, Russians are generally fine with kicking around banana republics. Not so much news there, but interesting to actually see someone say it. Second, Russians are really really worried that they are getting treated like a banana republic. (Can you imagine the United States or China saying, "You can't treat us like we're a banana republic!")

I'm baaack....

Yeah, it's been a while. I finished some research and got bored a few months ago, so took a hiatus. But I just started thinking bout a new project, which means blogging is back as a way to think out loud or otherwise divert myself. Plus, there's just so much happening to annoy me, so why shouldn't I complain here?

EU wants everyone to do things its way

An amusing article from the FT (EU wants rest of world to adopt its rules). A European Commission paper soon to be released says the European Union should promote “European standards internationally through international organisation and bilateral agreements.” Doing so will give an advantage to European companies since it “works to the advantage of those already geared up to meet these standards”.

Yeah, good luck with that. A word to the wise: if you're trying to slip one over on someone, it's best not to announce that this is what you're trying to do.

The FT adds that the sheer size and wealth of the Union’s single market means that few corporations can afford to ignore it. “By harmonising the rules for a market boasting 500m consumers, the Union has set standards 'which partners then have to meet if they are to benefit from the single market'.”

Except, of course, that the rules for the EU really haven't been harmonized for 500 million consumers. Actual implementation of EU directives varies widely among the different EU countries, and where real harmonization would be too painful, EU directives are nebulous to the point of pointlessness. In other places (such as labor and environmental laws), EU standards place EU member states at a competitive disadvantage vis-a-vis their American, Chinese and Japanese competitors.

Sure, the EU is too big to ignore. But it's not big enough to truly set global standards, and as the size of its economy shrinks relative to the US, China, India and elsewhere, it will eventually be ignorable. That's why its more important to get the standards right, than to try to convince everyone else to go along with them.

Nasdaq and LSE: who lost?

I haven't written in a while because I was busy sabotaging an international stock exchange hostile takeover. Which brings me to this question: now that Nasdaq has admitted defeat on its efforts to take over the London Stock Exchange at £12.43 per share (with the LSE trading well above that over the past few months), who is screwed the most?

First, Nasdaq: it lost on its bid and now faces a transatlantic NYSE/Euronext monster. It still owns nearly 30 percent of the LSE. While it bought most of those shares when the LSE was trading at £11 (LSE shares closed at £12.82 today), it will be hard to unload that position. The LSE has launched a £250 million share buy-back, but this is still small potatoes against Nasdaq's holdings. Nasdaq can hold on to those shares to deter other bidders, but that likely will prevent it from making other link-ups at the same time that the NYSE is looking at markets in India, Japan and elsewhere.

On the plus side, however, Nasdaq has avoided a classic pitfall of many a merger — paying too much. If Nasdaq's board is right and the current price of the LSE is overvalued, then the hedge funds that bought LSE shares after Nasdaq announced its intentions will suffer big time. Despite the LSE's press about how it is stealing market share from New York, there are serious questions about its future profit margins, particularly (if Nasdaq is to be believed) after the EU MiFID (Markets in Financial Instruments Directive) fully comes online.

London will also look to go on the offensive, but the fact that it is a perennial prey rather than a hunter may be telling. While it has a new technology platform coming online, so does everyone else. And the LSE's share buy-back (at £12.70 per share), designed to make future takeover attempts harder, will also chew up cash that the LSE could be using on future technology modernizations. In this sense, while it is in a decent position at the moment, the LSE doesn't have the deep pockets of either the NYSE or Nasdaq when it comes to future development. While the LSE has kept out ahead of the New York exchanges because of quirks in the US system (quirks that essentially let New York operate in a hothouse, sheltered from outside competitive forces), now that New York is facing competition, it seems to be showing itself surprisingly aggressive.

So who's screwed the most? Hard to say at this point, but my guess is the LSE's hedge fund shareholders. They gambled that Nasdaq would raise its price rather than lose, and they lost instead.

"Going private" short-changes shareholders

The FT has an article today by James Politi and Francesco Guerrera (Investors ‘short-changed’ in buy-outs) on a survey showing that private equity groups are buying out public companies at surprisingly low takeover prices. The survey, conducted by Weil Gotshal & Manges (a big NY-based law firm) shows that of 50 private equity takeovers last year, bidders on average paid only 6 percent more than the highest price the target company had been trading over the previous 12 months. In a takeover, a bidder can typically expect to have to pay significantly more than what the target company is trading at on a stock exchange -- after all, when you buy a share on the New York Stock Exchange, you are buying a right to a tiny portion of the company's profits. When you are buying 51 percent of the shares, you are buying not just a right to the company's profits, but also control of the company. (Hence the term "control premium" for the amount a bidder pays above what the company was trading at in order to take control.)

The Weil Gotschal study is interesting because it suggests that corporate boards are quite literally giving away the store in these private equity deals. It's possible, of course, that private equity groups are sniping off companies in a downward spiral, with the hopes of replacing management, restructuring the target company, and improving performance. However, given the amount of equity existing corporate officers and directors are given as part of recent deals, this seems somewhat dubious. The fear is that these equity deals are bribes to corporate officers and directors in exchange for an agreement to sell the company at firesale prices, which will then be sold back to the public at some future date at a much higher price.

The FT quotes Simpson Thacher & Bartlett partner Alan Klein as saying “They are not forcing anyone to sell. For a private equity deal to be attractive they need to put a lot of leverage on the business. A lot of institutional investors and managements can’t live with that.” But that isn't quite the whole story; the target company's board of directors often is forcing shareholders to sell. And leverage is just debt. If a leverage buy-out makes sense to the tune of a 15 percent return on assets per year, why won't institutional investors live with it?

Spitzer and the Schumer/Bloomberg/McKinsey Report: Irony to make your eyebrows bleed

Unfortunately, I haven't yet had the chance to wade through the 141-page McKinsey report on New York's financial competitiveness. (Believe it or not, I have a real job.) However, U of Illinois professor Larry Ribstein, bless his Sarbanes-Oxley-hating heart, notes that NY governor and former attorney general Eliot Spitzer showed up with the report's sponsors, NYC Mayor Michael Bloomberg and U.S. Sen. Chuck Schumer, to help unveil the report:

Bloomberg and Schumer were joined at today's press conference by New York Governor Eliot Spitzer, who said the cost of complying with Sarbanes-Oxley is ``simply too great'' for small companies. ``That is why some reasonable changes there and elsewhere in the statute can and should be embraced,'' he said.

(See Bloomberg, Schumer Warn U.S. May Lose Financial Lead.)

However, Ribstein also quotes a WSJ op-ed that Spitzer made sure that the report didn't recommend anything about constraining states attorneys general from creating their own securities regulation through lawsuits and settlement agreements:

The study, however, didn't support making state attorneys general give up jurisdiction in some financial-services cases, an idea that Mr. Spitzer criticized when it was included in the report by the Committee on Capital Markets Regulation. Mr. Spitzer said he made sure the Bloomberg-Schumer recommendations didn't include such a provision.

Even for a New York politician, this level of hypocrasy is breathtaking. My hat is off to you, sir!

U.S. securities markets and the Maginot Line

Check out the latest speech from SEC chairman Christopher Cox at the 34th Annual Securities Regulation Institute in Coronado, California. (See Re-Thinking Regulation in the Era of Global Securities Markets.) The topic is the cross-border integration of stock markets, and Cox warns that if the U.S. isn't careful, it's securities laws risk becoming like the French Maginot Line. (As you probably know, the Maginot Line was a system of static fortifications that ran along the Franco-German border and built during the 1930s to keep the Germans from invading France. It was premised on the idea that the next war would be like the last -- i.e., a defense-dominated situation like WWI. Instead, technological and tactical innovations allowed the Germans to do an end-run around the Maginot Line and move deep into France before the French -- who actually had more troops and more modern equipment -- were able to respond.)

So, basically, Cox is warning that if the SEC fails to adapt, U.S. securities regulations risk becoming as potent, innovative and competent as the French military. Ouch!

Without a doubt, our regulatory defenses proved very effective in maintaining healthy markets in the 20th century. The world-beating success of America's capital markets is a testament to that. For most of the last 74 years, our ability to police our markets and maintain investor confidence in their integrity has been premised on requiring both domestic and foreign market participants that operate in the U.S. to register with the SEC — and for the most part, to follow the same rules. That approach has followed from our concern that the alternative, permitting foreign market participants to operate in the U.S. without direct SEC oversight, would threaten the integrity of our nation's capital markets.

But while this approach served us well in the past, when the world's capital markets were separated not just by oceans but by the preference and habits of most investors, the world is a far different place today. And so we have to ask ourselves: have the basic assumptions on which we've built these regulations changed?
...
I'm convinced that the way to surmount these new challenges posed by technology is to harness the power of that same technology. We've got to recognize that to catch a global network of market crooks, it will take a global network of securities cops.

That means that our success will be measured not by the degree to which we close off other marketplaces from our own, but rather by the extent to which we more closely integrate our regulatory efforts as our markets themselves become more closely connected.

Every regulator has an obligation to the investors and issuers within its borders to protect them from fraud perpetrated within those borders. For the SEC, therefore, every other like-minded regulator is our natural ally. We've made great strides in recent years in building ways to share enforcement information with our counterparts in other countries, and to cooperate in doing every other part of our jobs. And as the story of this success has spread, we have found new friends and allies sharing the same concerns and devoted to the same cause of protecting investors and promoting capital formation.

This process of discovering our mutual interests has led us to realize that some of the old ways of doing things are obsolete. For example, while our historical justification for having issuers, broker-dealers and exchanges to register with the SEC is sound, it may be that by working with like-minded foreign counterparts we can find ways to lower costs and increase opportunities for investors while still maintaining the highest standards of investor protection. In this regard, the Memorandum of Understanding we recently concluded with the College of Euronext Regulators should be an excellent start.

And this brings us to an interesting question. Just what is "like-mindedness"? Will we know it when we see it? I believe the answer to this question is not wholly subjective. In my discussions with our counterpart regulators in other countries, I have found one touchstone in particular that is of overarching importance. It is an acceptance by the regulator that the genius of the market is that individuals are free to investigate their options and make their own decisions. It is an appreciation for the "wisdom of the crowd" that is ultimately the consensus of that market — representing the solution of many minds working on a common problem.

Working with all of the world's regulators who share this belief in the power of markets, we can tap that same principle, so that a multiplicity of jurisdictions — each seeking to develop the best regulatory framework — can likewise investigate their options and make their own decisions about ways to handle regulatory issues within their borders. This is something from which we all can benefit: observing what works, and how the market responds, and learning from what doesn't work.

To give you just one example of what the "wisdom of the crowd" means for securities regulators, consider the global reaction to the Sarbanes-Oxley Act. There has been loud complaint about its costs, even by some in other jurisdictions to whom it does not apply. But one interesting effect of these reforms has been the degree to which they have been copied, in one form or another, in many other major markets.

A lot of interesting ideas here. My question is, is Cox really signally support for radical change to how the SEC operates internationally? Some of the ideas in this speech (regulatory competition, working with "like-minded" foreign regulators, etc.) clearly echo ideas in a recent Harvard International Law Journal article by SEC staffers proposing a "substituted compliance" approach. (See here.)

My second question is, what effect would such a radical change have for the U.S. market? The FT on Friday led with an article on comments by Lehmean Brothers vice-chairman Thomas Russo at the World Economic Forum in Davos, Switzerland where Russo basically said that despite all the sturm-und-drang over New York's falling position in world finance, it is unlikely to ever recover no matter what policies the U.S. enacts. (See NY unable to regain lost business, says top banker.) Russo, however, doesn't seem to be imagining that truly radical change is possible. To carry the Maginot Line analogy even farther (by the way, the guy who thought up that analogy -- brilliant!), in 1940 even the German Army High Command believed the invasion of France would break down into a static war of attrition. Only a radical change in tactics, envisioned by Heinz Guderian and Erich von Manstein, allowed Germany to march into Paris only 6 weeks after the invasion began. If the SEC were to adopt a radical change -- made all the more relevant by the cross-border consolidation of stock exchanges -- New York may still have its day in the sun.

More than half of all S&P500 firms move away from staggered boards

Alex Simpson catches an interesting article in the WSJ about how 55 percent of all S&P500 firms have ditched the anti-takeover practice of having "classified" or "staggered" boards of directors. (Alex links to the article here.) A staggered board of directors is a board whose members are like members of the U.S. Senate -- only a third are up for reelection every year, making it impossible for any shareholder or group of shareholders to take control of the company quickly (or, for practical purposes, at all). The explanations by Carol Bowie, vice president of research at Institutional Shareholder Services (a research and ratings firm that advices institutional investors on how to vote on shareholder proxies), seem plausible, but unsatisfying. Just because Enron has put S&P500 companies under a spotlight doesn't seem to me to be enough to make these companies' boards "unentrench" themselves. It seems more likely that this is some kind of signally mechanism to the market to allow these companies to lower their cost of capital. For example, the article quotes Staples proxy materials proposing to have shareholders vote to get rid of its classified board structure as necessary to "maintain and enhance the accountability" of its board members. Whenever someone votes to "enhance" their own accountability, it means something is up.

Interestingly, this trend is in line with proposals Harvard professor Allen Ferrell makes in the recently issued report of the Committee on Capital Markets Regulation. (Page 93-199, if you want to read the report itself.)

Bloomberg and Schumer publish McKinsey report on how global finance doesn't heart NY anymore

David Wighton of the Financial Times writes about it here. Apparently the report (which you can read all 130+ pages here on Chuck Schumer's website) says that New York could lose up to 7 per cent of its market share, equivalent to 60,000 jobs, over the next five years if current trends continue. As remedies, it proposes "clearer guidance on the Sarbanes-Oxley corporate governance rules, securities litigation reform, promoting the convergence of accounting standards, and easing visa restrictions on foreign professionals."

The Problem in Islamic Finance

Today's fake fatwa actually deals with real fatwas. If that doesn't make you head hurt, nothing will.

Anyway, Islamic finance is a topic I've been thinking about a bit for some time. However, since I'm not a Muslim or Shariah scholar, I've always felt like this was one of those things where you run the risk of being an outsider offering unwanted opinions on something you know nothing about. (Does Arabic have a word for "kibitz"?) Nonetheless, I'm heartened by an article in last week's Financial Times by Muhammad Saleem, an investment banker and author of Islamic Banking: A $300 billion Deception. (See Islamic finance has much to learn from the west).

When most Americans think of Islamic finance or Islamic banking, they probably think of terrorist financing. This is wrong, of course. Terrorist financing has as much in common with Islamic finance as money laundering has in common with "traditional" banking. Though, as a general matter, any time you mix religion and finance, the results usually do not have pleasant connotations. For example, even today "Jewish banking" brings to mind conspiracy theories and pograms. How about "Catholic banking" -- indulgences and albino monks, anyone? Or "Evangelical Christian finance." Can't you just see Tammy Faye's mascara-running tears and Jim crying about hookers? Let's just say there's probably a reason Jesus drove the money-changers from the Temple.

But Islamic finance actually is something that is different from the type of financing that has developed in the West over the past 500 years -- at least in theory. And it is beginning to be big business. There are two reasons for this, I believe. The first is oil money, of course. With the price of oil being what it is, many Muslim countries are flush with cash, and it's hardly surprising that they have put a great deal of this cash into Islamic financial institutions. But this isn't the whole story. After all, these countries were flush with cash in the 1970s as well, but Islamic banking really didn't take off in any real sense until the 1990s. So some of the growth of Islamic finance, I believe, might be fallout related to Samuel Huntington's "clash of civilizations" idea. At a time of great uncertainty and conflict, when Muslims and Westerners think of each other as "us versus them," we humans have a tendency to seek solace with tradition. One way to do that is to seek out new "old ways" of doing things that allow us to reinforce our cultural and religious identities while offering alternatives to the very things that seem most foreign, uncertain and hostile. And I think, for some Muslims, Islamic banking might fall into this category.

Islamic finance has several characteristics that make it quite different -- at least on the surface -- from "traditional" Western finance. The most obvious is the prohibition on earning interest. But there are others as well. The Koranic injunction against gambling has been interpreted as a prohibition on contracts where the final terms of the contract (the thing to be delivered, how much is to be paid, etc.) cannot be determined until some future event. This interpretation effectively prohibits most Western commodities and futures contracts and insurance. There is also a third prong to Islamic finance that goes to what you can invest in, rather than the form the investment may take. This, however, is relatively straight-forward and very similar to Western concepts of "ethical investing." For example, following Islamic investing principles, because Shariah prohibits eating pork, drinking alcohol, gambling and watching pornography, investing in Hormel, Seagrams, PartyGaming and Playboy would be no-no's.

The first point -- the prohibition on earning interest -- is not unique to Islam, of course. The Old Testament (particularly Exodus 22:25-27, Leviticus 25:35-37, Deuteronomy 23:19-20, Psalm 15:5, et al.) all prohibit charging interest, in one form or fashion. (Exodus and Leviticus seem to prohibit it only if one is lending to the poor; Deuteronomy prohibits it in loans given out to fellow Jews/Israelites, but allows it when lending to foreigners.) Throughout most of Christian history, the Old Testament prohibition was adopted in canonical law, with charging interest to fellow Christians considered a sin and "usurers" ineligible to partake in the Eucharist.

This historic distaste for charging interest was not limited to the religious. Aristotle, in both the Politics and the Ethics argues that charging interest is wrong. In the Politics, Aristotle describes usury as:

The most hated sort (of wealth generation) and with the greatest reason, is usury, which makes a gain out of money itself and not from the natural object of it. For money was intended to be used in exchange but not to increase at interest. And this term interest, which means the birth of money from money is applied to the breeding of money because the offspring resembles the parent. Wherefore of all modes of getting wealth, this is the most unnatural.

It wasn't until the Protestant reformer John Calvin came along that the West rejected this view (though even Calvin thought charging interest was wrong if the borrower was poor). (By the way, I'm not a particularly big fan of Calvin, but I am very thankful it was his economic views, and not Martin Luther's, that came to dominate post-Reformation Europe.)

Islam, however, has yet to have its John Calvin. The result is that much of modern interpretation of the Koran runs directly contrary to modern financial concepts -- particularly the concepts of the time value of money and risk. For example, most Shariah scholars argue that interest is impermissible, while profit-sharing is acceptable. The idea is that a guaranteed return on an investment is wrong because the risk is not shared equally between the lender and borrower if misfortune should occur; however, if the risk is shared equally, the "lender" and "borrower" are partners and the arrangement is just. Put simply, equity investments are fine, but bonds are not.

For this reason, much of Islamic finance involves creating mechanisms that replicate the benefits of bank lending, but have the appearance of profit-sharing or buying and selling. For example, with a typical "traditional" car loan, the bank lends you money, at a certain interest rate, for you to purchase your car. If you default on the loan, the bank takes your car, sells it, and collects what it is owed and gives you whatever may be left. With an Islamic "loan," the bank buys the car and then sells it to you at a mark-up, to be paid in installments over time. You end up paying the same amount under both scenarios. However, Shariah scholars believe the Islamic loan is more just because, if you default, the bank simply takes back the car and has no further claim on you. With a traditional loan, the bank may still pursue you for any remaining principal if the repo doesn't provide enough.

(As an aside, there was a case a few years ago where a woman unknowingly bought a stolen car using an Islamic bank. She lost the car after a fender-bender brought to light that the car was stolen, after which she refused to repay the loan, saying that the bank had sold her a stolen car. Much to the bank's chagrin, the Shariah scholar charged with adjudicating the case sided with the woman. The bank's representatives complained that they specialized in making loans, not buying cars and running title searches. The scholar replied that you are either lending at interest or selling at a mark-up -- you can't have it both ways.)

However, modern finance recognizes that debt and equity are just two ends of a very smooth risk continuum. This is particularly the case in the modern world were bankruptcy laws exist. As a practical matter, car loans are secured with little more than the car itself, whether the bank is Islamic or "traditional." One corrollary of Merton Miller's and Franco Modigliani's work is that the difference between debt and equity is risk, and in an efficient market, the risk-return ratio of debt and equity are the same. In other words, if the market is efficient (and things like taxes and subsidies of various sorts factored out), the less risk I take as a lender, the less return I can expect. Or, if I'm a borrower, the more risk I expose my lender to, the more I'm going to have to pay to get the lender to part with his or her money. The calculus is as close to an iron-clad law as you can get in economics. Consequently, if I'm an Islamic bank and I'm on the hook if your car ends up being stolen goods, or if the only thing that can secure the "loan" is the car itself, the borrower is going to end up paying more at the end of the day. Whether we call it interest or profit, paying more is paying more.

The car loan example described above (called a "murabahah" or "cost plus" transaction) is relatively simple. Other types of financial transactions designed to replicate insurance products, futures contracts, and various financial hedging strategies are considerably more complicated and far less transparent. Indeed, many Islamic bond structures (sukuk), Islamic insurance (takaful), and Islamic futures contracts involve a degree of complexity and opacity that rivals those used by Enron. (Islamic insurance can even involve a certain degree of willful fiction: when a policyholder suffers a loss, the insurance fund doesn't contractually compensate the policyholder; rather, the other policyholders "donate" to help the misfortunate. Presumably, reneging on this "donation" is frowned upon.)

This, fundamentally, is the problem I have with Islamic finance as it is most commonly used. It uses very complicated structures to accomplish the exact same goal as Western finance, but with added cost and opacity. It is, as Rice University professor Mahmoud Amin El-Gamal has called it, a case of Muslim customers "paying more for less." In this sense, I believe Islamic finance today shares much in common with Christian finance of the Middle Ages, particularly after the traditional Jewish financiers were exiled. (Following the Deuteronomy passage noted above, many Jews at that time believed lending at interest was permissible, provided the borrower was not Jewish. Since Christians had the same prohibition where the borrower was Christian, Jews often became the preferred financiers for Christian enterprises, up to and including lending money to finance the construction of Christian monasteries and the First Crusade.) When Edward I in 1275 banished 15,000 Jews from England, lending money at interest did not disappear -- it merely went underground, to the detriment of borrower and lender alike. David Hume, in his second volume of the History of England writes:

...as it is impossible for a nation to subsist without lenders of money, and none will lend without a compensation, the practise of usury, as it was then called, was thenceforth exercised by the English themselves upon their fellow citizens, or by Lombards [Medieval Italian pawnbrokers] and other foreigners. It is very much to be questioned whether the dealings of these new usurers were equally open and unexceptionable with those of the old. By a law of Richard it was enacted that three copies should be made of every bond given to a Jew; one to be put into the hands of a public magistrate, another into those of a man of credit, and a third to remain with the Jew himself.

But as the canon law, seconded by the municipal, permitted no Christian to take interest, all transactions of this kind must, after the banishment of the Jews, have become more secret and clandestine; and the lender, of consequence, be paid both for the use of his money and for the infamy and danger which he incurred by lending it.

Hume wrote this in the mid-1700s, and while the situation today is somewhat different with Islamic finance, the end result is the same. In short, the predominant interpretation of the Koran today makes it more expensive for poor and middle-class Muslims to borrow money and buy insurance. It makes them less secure in their retirement, because it increases the transaction costs and lowers the returns on their pension funds. And I believe that this is fundamentally opposed to the objective of the original Koranic injunction.

This, of course, is where I am on a bit of thin ice. I have had Muslim colleagues quite logically argue that human reason is limited and if God comes up to you and tells you not to do something, you don't ask for an explanation for His reasons. However, I still believe context is important. (Ironically, for this I must thank my Muslim colleagues' predecessors. If it weren't for Averroës and other Muslim scholars, the West would have never rediscovered Aristotle. And without Aristotle, there would have been no Thomas Aquinas and the philosophy that the will of God can be deduced from both Scripture and reason.)

For example, Sura 2:275 of the Koran (using the Penguin Classics translation -- unfortunately, I cannot read Arabic) states:

Those that live on usury shall rise up before God like men whom Satan has demented by his touch; for they claim that trading is no different from usury. But God has permitted trading and made usury unlawful.

This is as pretty clear a prohibition as you can get. But if you read the immediately preceeding passages, you see the context:

To be charitable in public is good, but to give alms to the poor in private is better and will atone for some of your sins. God has knowledge of your actions...Those that give alms by day and by night, in private and in public, shall be rewarded by their Lord. They shall have nothing to fear or regret. (Sura 2:271, 274)

Likewise, Sura 3:130 states:

Believers, do not live on usury, doubling your wealth many times over. Have fear of God, that you may prosper.

But following this passage, the Koran says:

Obey God and the Apostle that you may find mercy. Vie with each other to earn the forgiveness of your Lord and a Paradise as vast as heaven and earth, prepared for the righteous: those who give alms alike in prosperity and in adversity; who curb their anger and forgive their fellow men (God loves the charitable); ... (Sura 3:132-133)

Viewed this way, it appears that the prohibition against interest is closely tied to protecting the poor from abuse. In this sense, these Suras are very similar to several of the Old Testament passages noted above:

If you lend money to one of my people among you who is needy, do not be like a moneylender; charge him no interest. (Exodus 22:24)

If one of your countrymen becomes poor and is unable to support himself among you, help him as you would an alien or a temporary resident, so he can continue to live among you. Do not take interest of any kind from him, but fear your God so that your countryman may continue to live among you. You must not lend him money at interest or sell him food at a profit. (Leviticus 25:35-37)

In each of these cases, the prohibition on charging interest is couched in the language of charity and protecting the poor. When we consider that the bankruptcy protection -- the idea that debts can be discharged by a court if the debtor is impoverished and unable to repay the debt -- is a relatively new idea, the prohibition on usury where the poor are concerned makes sense. After all, the historical fate of a defaulting borrower was debtors' prison or worse. But bankruptcy laws change the risk calculus. All lenders today are "partners" in the sense that repayment is never guaranteed. What varies is the risk the lender takes, and the return the borrower offers. Where a free, liquid market exists, risk correlates with return, to the benefit of both borrower and lender.

The same situation exists with regard to Islamic insurance and futures contracts. Shariah law prohibits gambling, and while the Koran does not spell out the reasons for this prohibition, the moral issues that attach to gambling are well known. Gambling does not create wealth, but merely moves it from one person's pocket to another's, based on chance. It can be addictive, and a gambler's losses can not only affect the gambler, but also that gambler's family and others for whom he or she is responsible.

But chance and risk are two entirely different things. While it is certainly true that some financial speculators might as well be gambling, insurance products and futures contracts inherently are the opposite of gambling. They are about controlling and limiting risk, not profiting from chance. Consequently, Shariah scholars who interpret the Koran as equating most traditional insurance products, futures contracts, and hedging transactions with gambling are missing the point of the original Koranic injunction. If the objective is to protect the poor and generate social good, few things have contributed more to this over the past 300 years than our understanding of risk. (By the way, a really good book on this subject is Peter L. Bernstein's Against the Gods: The Remarkable Story of Risk.) The complex and opaque mechanisms used by Islamic finance to achieve precisely the same risk management that is provided by cheaper and more transparent traditional methods is a disservice to those Muslims most in need. It is hard to imagine that this was the Prophet Muhammad's objective.

There are other problematic issues with Islamic finance that Muhammad Saleem and Professor Gamal discuss, particularly those relating to the Shariah scholars hired by Islamic financial institutions to opine on whether a given investment or financial product is permissible. These scholars are hired and paid by the financial institutions themselves and, absent some kind of branding mechanism, it is easy to see that this presents a classic conflict of interest. (You can be sure that Islamic financial institutions know which Shariah scholars are sticklers, and which take a more laid-back approach to interpreting Shariah; and I imagine the latter tend to have a better employment record.) But this problem is one that can probably be addressed through regulation and market mechanisms (i.e., disclosure and branding). The bigger issues relating to the interpretation of what constitutes "usury" and "gambling" may not.

So what are the alternatives? I think the first is to return to first principles. In this regard, I believe Professor Gamal's mutualization ideas may be very valuable. Gamal argues that it is not the form of financing that is problematic under Shariah principles, but the profit motive. Therefore, financing organizations such as mutual savings and loans and mutual insurance companies, where borrowers are also shareholders in the bank or insurance company, may still be perfectly acceptable even if they charge fixed interest or use traditional insurance contracts, because they are non-profits and the benefits are shared by all members. Personally, I suspect that such banks will be less economically efficient than for-profit banks, but they likely will still be an improvement over existing Islamic financial institutions and mutualization will address certain social justice concerns. Such institutions will also be far more transparent, given that they will operate under existing banking and insurance regulatory systems.

Another approach might be for Shariah scholars (and Muslims generally) to focus on those financial activities that are similar to the types of abuses that the Prophet Muhammad was concerned about. This would be a true social justice approach to Islamic finance. For example, does the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 unduly harm the poor? Does the U.S. student loan system, which features government-backed loans, the near impossibility of discharging the loans regardless of economic circumstance, and high fees charged by the private institutions that provide these loans at no risk to themselves, have elements of the usury that the Koran decries? Or so-called "payday loans," often used by the poor despite exceedingly high interest rates and very low risk to lenders? Do these practices harm the poor to the benefit of the powerful? If so, Shariah scholars (and all Muslims, and Jews and Christians) all have a role in pointing this out. However, the current approach of most Islamic finance that focuses on mere form rather than substance does not provide a viable alternative to these abuses, and adds to the problems that the Prophet Muhammad sought to alleviate.