10.27.10
Posted in Blog at 2:14 pm by Andrew Clearfield
On October 26th, 2010, a piece written by John Carney of CNBC was published and spread around the internet, claiming that the proxy advisors were similar to the credit ratings agencies in that their judgments were similarly biased (in the case of the proxy advisors “by a small clique . . . whose interest may conflict with clients”) and that the only reason these existed at all was because of a regulatory mandate, which required institutional investors to protect themselves by voting in accord with the advisors’ recommendations. Larry Ribstein of the U. of Illinois College of Law, in his regular blog, “Truth on the Market,” noted the article with approval: http://truthonthemarket.com/2010/10/26/proxy-advisors-as-regulatory-spawn/. I felt that the analogy was not only misplaced, but particularly insidious, because it denied the potential utility of both, and because it deliberately confused the very different business models of the two industries. I responded:
Larry,
Of course, we never had abuses of power by directors and chief executives before the regulators started empowering shareholders, did we?
The problem of the power of the proxy advisors is analogous to that of the credit rating agencies for only one reason: most institutional investors refuse to dedicate any resources to dealing with these issues, so they outsource it. If instead of regarding governance issues as a nuisance artificially created by regulators, they attempted to integrate consideration of them into their investment process, they would (a) be capable of making independent judgments rather than merely trying to cover their rear ends by relying solely on someone else’s opinion, and (b) they would then be in a position to make a fuss only about governance issues they themselves deemed substantive—but they would really make a fuss about those.
There is another important analogy with credit rating: as we saw in 2007 – 2008, it wasn’t that the debt ratings were unimportant, it was that they had been corrupted. And they were corrupted because bond investors relied upon somebody’s measure of risk, but refused to pay anything for it themselves. So the issuers paid instead. Similarly, one may argue that the voting recommendations can be important (yes, most of them are routine, but in that case, there’s no controversy), and that they key issue is only whether the system has been corrupted or not. The analogy to the credit rating system would only hold if the companies themselves were paying for the governance advisors’ recommendations. There have been accusations that ISS has some conflicts of interest due to the fact that they also have a consulting service for issuers, but they claim to be careful to avoid those conflicts, and the complaint Mr. Carney is making is that on the contrary, the recommendations are anti-management. (The other major proxy advisors have no such conflicts in any case.) For the analogy to hold, one must argue that the credit ratings agencies were an unnecessary nuisance because ratings they had issued on a lot of paper were too low, not that they were in fact far too high.
I agree that it would be better if more investors did some research on these issues and thought for themselves, rather than relying entirely upon third-party recommendations. But they would have to be prepared to spend a bit more on staff dedicated to considering these issues from an investment point of view. As it is, there is an almost total lack of coordination between corporate governance and investing at most institutions in the U.S. Then, when something that has been flagged for years goes very wrong, the portfolio managers who had ignored the risk run screaming to their lawyers, and a raft of after-the-fact litigation results. In such cases, any recoveries are paid for by the other shareholders. Is this really the better way to run this particular railroad?
Another contributor, Douglas Levene, responded to my post by arguing that I had avoided the central issue, that there was no economic incentive for institutions to pay attention to agency costs anyway, and they were only doing a minimal job of it because it had been mandated by regulators. Again, I think this is a dangerous misconception that needed to be met head on:
Douglas,
You’re assuming that they are correct in believing (if they really believe) that there is no economic incentive for monitoring agency costs. Actually, there are two: one, that more and more of their clients are demanding it; two, that poor governance is a risk factor, and correlates over the longer term with poor (often spectacularly poor) performance.
I know, there are some studies that claim to demonstrate otherwise, but they were, I believe, poorly constructed in two respects. First, they almost always looked for positive correlations between high governance scores and outperformance; governance is not a positive performance factor for the same reason that being law-abiding is not a sufficient reason in itself to hire someone—it’s an important requirement, not a sign of growth or performance potential. Second, most of the studies were event-driven. As with most risk factors, the event does not occur when the risks are first taken, and certainly not when they are ameliorated—they will occur somewhere down the road. As a veteran portfolio manager, I can assure you that plenty of investors who were told they might be supping with the devil, but thought they would have time to get out safely, ended up losing barrelfuls of money.
Meanwhile, there are plenty of other long-term studies which indicate the opposite, beginning with the landmark study of Gompers, Ishii, and Metrick (2003) which demonstrated an 8.5% annual performance spread from S&P constituents over the 1990s between the highest quintile on IRRC ratings, and the lowest. The sample was re-balanced each year, so that survivor bias should not have been a major factor. My own examination of the data indicated that about two-thirds of this return came from avoiding the low-rated components, which confirms my view that much of the benefit from governance monitoring is in minimizing risk.
There is another issue: many institutions do not pay for an in-house governance program primarily because their directors or trustees passionately hate the idea. They hate the idea because they are also CEOs and directors of other companies which may at some point be the object of governance concerns. It’s a conflict of interest problem as much as it is a problem of demonstrating and quantifying the economic incentives.
Yes: in an ideal efficient market, higher agency costs will translate rapidly into a higher cost of capital and underperformance. The problem is that this assumes (a) that the market is monitoring those agency costs itself, and (b) that real-life capital markets are efficient. I think we have had enough practical experience with the algorithms of efficient-market theorists in recent years to demonstrate that markets are far from perfect, or at least that when they do return to equilibrium it is sometimes with a very long lag and often a violent over-correction. As for the market being potentially a sufficient monitor of agency costs, this is contrary to the author’s hypothesis that monitoring these factors is a waste of time. If everyone is ignoring them, the invisible hand of the market will have no effect. It is true that the market could serve this function in theory, (which would create a free-rider problem), but this issue would not be solved by abolishing (or crippling) proxy advisors, nor by recommending that all investors vote blindly with management.
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10.25.10
Posted in Blog at 6:47 pm by Andrew Clearfield
The Wall Street Journal ran a piece on Friday, October 22nd, stating and appearing to give support for a proposed rules change that proxy voting by retail shareholders should be encouraged by permitting shareholders to leave standing instructions with their brokers or custodians to vote their shares in a particular way—e.g., always in support of management recommendations, or always in support of all resolutions, rather than requiring them to return a proxy card with their decisions regarding that particular election indicated on it. This proposition is favored by many issuers and by the U.S. Chamber of Commerce as a way to “level the playing field,” i.e., to restore the situation that prevailed before the broker vote of unvoted shares for directors was abolished, and before the proposed reforms of the proxy process come into effect. This blatant attempt to restore ballot stuffing in behalf of incumbent boards has reminded me of nothing so much as election procedures in totalitarian states (e.g., the former Soviet Union), and I was moved to write the author of the article:
Dear Ms. Holzer:
If you agree with the U.S. Chamber of Commerce that business needs a “level playing field” to offset the ‘case-by-case approach’ of the institutions, I have another wonderful proposition for you:
-
- a law that guarantees high voter turnout in U.S. elections by allowing registered voters to have ‘standing instructions’ that their vote should be automatically cast for their affiliated party’s candidate or for the incumbent official. They could always change their standing instructions to a different set of standing instructions if they bother to, remember to, or are allowed to by the authorities (who, after all, should have the last word).
It is an absolute scandal that voter participation in U.S. elections is so low—bordering on 50%—when it is so much higher in other countries such as North Korea, Iran, or Zimbabwe. We need to get out more voters to create a level playing field so that our elections cannot be dominated by malcontents and special-interest voters who seek to overturn the established order and create chaos throughout the legislatures and cabinet rooms of our country!
Similarly, If you agree with IBM that ISS and other third-party proxy advisors who have such tremendous influence, but no economic interest in a company should be stopped, I’m sure you would be in favor of a law preventing third parties such as the Wall Street Journal from airing their influential opinions on matters in which they have no direct interest, such as tax policy, monetary policy, and the attitudes towards private property of various foreign powers. Just think of how much easier it would be for policy makers to operate effectively without all these noisome distractions from uninvolved parties!
Sincerely,
Dr. Andrew Clearfield
President
Investment Initiatives LLC
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10.06.10
Posted in Blog at 2:20 pm by Andrew Clearfield
Patience Wheatcroft, one of the Wall St. Journal Europe’s regular contributors, had a piece on a U.K. regulator’s seeming willingness to add corporate culture to the list of things for financial regulators to attempt to control. The occasion was a speech by Hector Sants, who was until recently head of the British Financial Services Authority, at the Mansion House on the subject, “Should a regulator seek to regulate culture?” I had known Hector well in his earlier life as an analyst and stockbroker, and regard him as a thoughtful and intelligent commentator on the scene as well as a regulator. While I understand that anyone with the slightest belief in free markets finds points where it makes sense to say, ‘enough already!’ I have long believed that the problem of contemporary investment banking culture needs to be addressed in some form. This was my response to her article, on October 5th, 2010:
The problem is, that as trite as it might sound, it is the radical changes in corporate culture at the major financial institutions that created the environment for 2008′s crash. The changes in corporate culture at the investment banks in the late ’80s and early ’90s were palpable. There were always unscrupulous players before, of course, but even before these were caught out, they were usually mistrusted by most of the rest of the industry. Suddenly, over a period of less than 20 years (my impression was that it never took more than about 10 in any given country, with the U.S. leading the way) the ethos became, “Anything goes, if it makes enough money.” The question is, how do you get the genie back in the bottle?
It may be that the only way to stop individuals from reckless behavior, once the psychological barrier against unethical behavior has been broken, is to police them much more closely. This puts an intolerable burden on markets, and on regulators as well. An alternative is to consider a world in which, unlike that of our present financial markets, everyone at a firm knows what everyone else does for a living. This implies smaller, more specialized firms, and partnership-like arrangements. If someone is cutting ethical corners with what is partly your own money, you will try to rein in the behavior, or see that someone else reins it in. As long as it’s someone else’s money, you are far more likely to say, ‘What the hell,’ and let it go.
Such a radical change in market structures and financing may have all sorts of negative implications for growth, which should be studied carefully, before any such radical a reform is contemplated. But it should be considered seriously, because, as behavior within large bureaucracies has always shown (consider government agencies, police states, and the rest), individual responsibility declines in inverse proportion to the size of the organization. If there is only a limited degree of personal (read, ‘economic’) identification with it, then the process accelerates.
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06.11.10
Posted in Blog at 3:06 pm by Andrew Clearfield
In an exchange on the role and importance of corporate governance as a driver for business performance, a respondent seemed to feel that I was making governance out to be a compliance issue, rather than, as he saw it, a strategic issue for companies. I thought that this mistook my position, and felt the need to respond. Although I do not consider corporate governance a strategic matter per se, but rather a question of risk management, good governance is essential in order to execute a strategy properly over time. In fact, it is frequently an important element in enabling that the best strategy is chosen. However, recent history is full of examples of companies which seemed to have winning business models, but which nevertheless blew up because of weak governance, leaving many investors who’d been convinced by the company’s strategy holding the bag:
WHERE did you get the idea that I see governance as mere compliance??? Compliance is making sure that the laws and regulations have been complied with; by definition, that is backward-looking. Governance is an aspect of risk management, which is inherently forward-looking. Good management manages its risks well; it produces the highest possible returns commensurate with an acceptable level of risk. Bad management is hyper-cautious, or bets the farm on a risky strategy (sometimes both in alternation!)
I think people get hung up on seeing this as a negative, merely because it will only manifest itself to outsiders if the roof falls in. Rather it is, if you will, the exercise of foresight that allows a good strategy to shine through. But governance is not itself the strategy, it is not the growth factor. And you need growth factors as well if the company is to do well.
The issue for investors is that there will be plenty of successful growth strategies that succeed over the short-to-medium term because the company got lucky: if you bought WorldCom in 1994 and sold it in 1999, you did well. AIG shareholders were lucky for years. Their luck ran out because of defects in governance which were visible if one paid attention to them. Spotting AIG early as a high risk saved my clients a lot of money, and I believe that’s where the most demonstrable value-added in governance activity is situated.
Sure, if anybody could have convinced Hank Greenberg twenty years ago to break down the silo structure he had created, and to allow his board to have a succession plan (among other things) you would have saved everyone a lot of money, a lot of jobs, a lot of financial stability. But that wasn’t easy, and Greenberg probably wouldn’t have listened to anyone who tried. So the next best thing is the scolds, who point out the shortcomings, and (mostly) persuade a minority that is willing to listen to stay away from risky practices. Yes, you want the best board possible, but you can’t guarantee that they will all do their jobs properly, so you monitor, and you try to assure that all the structures are working, and to make sure than no one is asleep at their post.
Those who oppose the rights of shareholders to monitor and speak out on governance issues seem to believe that human nature changes when people walk into a boardroom. It doesn’t.
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05.30.10
Posted in Blog at 2:40 pm by Andrew Clearfield
A consultant raised the question on the LinkedIn network, “Are Corporate Governance Ratings more like Religion than Science?” He linked to a number of studies which purported to indicate that governance ratings can be capricious or arbitrary, and I had the impression that the goal of the exercise was to debunk the role of governance rating services. The methodology of many of the studies cited was somewhat suspect, and while I have never doubted that there is a great deal of arbitrary judgment involved in arriving at a particular rating, in my experience the services have been good at identifying lists of companies whose governance required further attention: among those companies have been a high percentage of truly dangerous situations, and many of the catastrophes of recent years among them. Obviously, we are dealing with small numbers here and granular statistics; fortunately, companies don’t blow up every day, and one would need to have forty or fifty years of evaluations before one would have enough data points to come up with incontrovertible evidence of clear correlations between governance screening and corporate failure. Instead of tackling the ratings question (which should really be worded, ‘Is Trust in Particular Corporate Governance Ratings more like Religion than Science?’), I responded to the underlying issue, which I believed to be whether corporate governance had become a religion for those active in the field.
Corporate governance may be like religion for some, but it needn’t be. Most of the studies attempting to discredit governance have two fundamental flaws: first, they assume that there should be evidence of governance “events” affecting price performance in the short- to medium-term, and second, they always look for evidence that higher governance standards have a positive effect upon the economic performance of companies adopting them.
WEAK GOVERNANCE IS A RISK FACTOR. It primarily manifests itself in corporate catastrophes, and secondarily in secular declines of companies. As one of the best early studies of governance and performance ever done, the Gompers, Ishii, and Metrick study of 2003, clearly showed, the principal driver of outperformance was avoidance of companies headed for disaster. As more recent studies, as well as the ongoing outperformance of The Governance Fund indicates, excess returns can also be made from improvements in the standards of companies which had been hampered by poor governance, BUT ONLY WHEN THERE ARE OTHER PERFORMANCE DRIVERS AS WELL.
No one is going to buy a company merely because it is well-governed any more than they will entrust their wealth to an investment advisor or their bodies to a physician merely because he is law-abiding. The point is that if he is known not to be, they would be taking foolish risks by trusting him, and the same thing is true of corporations. Companies with substandard governance (assuming it IS substandard, and not merely at some variance from a compliance-defined norm) are at risk of nasty things happening to them. They may also be at risk of long-term decline, due to poor internal policies, and a corporate culture that makes appropriate response to problems difficult or impossible.
To the extent that the market becomes aware of governance risk (evidence is that most investors could not care less, because no one on the sell side tells them to) weak governance could conceivably become a drag on performance, but being innately long-term, it would seldom dominate over a sexy growth story or an exciting new product. It does mean that there might be a time bomb ticking inside the company, and wise investors would do well to keep this in mind in determining how much of their wealth they want to risk that the bomb does not explode while they are involved.
To look for other sorts of correlations and performance links is probably futile, because that is not how risk management works. I would suspect many of these studies come from a pre-determined desire to debunk the whole enterprise. I would turn the proposition around, and ask “Is disbelief that corporate governance may be an important factor a religion?”
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04.30.10
Posted in Blog at 11:48 am by Andrew Clearfield
The following exchange on the website LinkedIn was stimulated by a question posed by the sales manager for an Indian securities firm, “What are the three most essential skills of an equity sales person?” The question was posted on April 28, 2010, at the time of the acrimonious Congressional hearings on Goldman, Sachs’ alleged misbehavior in marketing a CDO that was deliberately designed, at the request of a Goldman client, as a shorting vehicle, without telling purchasers of the security that this was the case. Goldman’s defense was that this was industry practice, and not illegal. Perhaps not, but as a portfolio manager for many years, I found this defense alarming, and therefore felt it incumbent to put unwillingness to do this to one’s clients as my top criterion for a good salesman.
After reading the testimony of all those Goldman people, I think I’ll put Honesty at the top of the list. Two, Ability to Listen to What the Client is Saying. Three, Independent Analytical Intelligence. To expand upon these:
(1) I don’t want to have to worry about being nailed by my brokers. They can make mistakes, they don’t have to be perfect forecasters, but I don’t want them to shaft me (even by just withholding a key bit of information) in order to help out their own trading operation, or their own corporate finance group.
(2) Brokers who give you the same spiel whether you are looking for something totally different, are in a hurry, or obviously have your mind on something else, are useless. If they think the story is good, they should come back with it when they have your attention. If you don’t like it, and tell them why, they should note for future reference that this is something you don’t buy, period.
(3) I can read the research myself. The broker should be able to analyze it, and he should also be able to tell you how good he thinks it is, and not just parrot back the house line.
Anything else I would consider extraordinary, and not to be demanded, although I will pay more when I find it. For example, having a strategic thinker is a real asset. But you can’t expect this from most salesmen. Exceptional service—as opposed to merely very good service—is a plus, but I don’t kid myself into thinking I’m the only client the salesman has, even if I’m one of the biggest.
This prompted another member of this LinkedIn group to question my analysis:
Question for you Andrew regarding your above Gman comment about honesty. In the case of CDS (which as we know is a zero sum game). Is it common that in the various covenants of a “brokered” CDS contract, there is an exposure of the party on the other side of the trade? I think not? OK, if it’s between XYC and ABC they obviously know, but as Gman is acting as a “broker”, or market maker between two traders, the broker typically doesn’t reveal to each side the other trader’s identity. From what I know, that’s the case..but I may be wrong? Let us know if that’s been your experience.
Sir,
That depends upon whether I am talking to an institutional salesman or to the trading desk. I don’t necessarily have a client relationship with another organization’s trading desk; I know they are a counterparty, pursuing only their own interest. If I am talking to a broker, however, who claims to be a middleman, and especially to its institutional salesman, who claims to be my representative at that broker’s firm, I expect him not to deliberately try to screw me. Otherwise, what is he for? I can trade directly with a market-maker on the screen or over the telephone, and would have no expectations that this was anything other than an arm’s length transaction.
The broker/salesman tries to develop a personal relationship with the portfolio managers who are potential buyers and sellers of securities. He offers them advice on what he is seeing and hearing from his colleagues and from the marketplace. The PM, even if he works for the most savvy hedge fund in the world (and that is not the sort of buyer we are talking about in the Goldman case), is not in the same middle-of-the-marketplace situation, must necessarily talk to other PMs as competitors, and cannot have access to the same information, which is why he depends upon brokers for some assistance and advice. If his broker fails to tell him that he is knowingly marketing a security that he and his colleagues expect will fall sharply in price, the customer has every reason to feel betrayed. This is doubly true, when, as here, we are talking about equity sales, where there are so many more variables hidden behind the security.
Traders may be in the game only to maximize the results from their own book, but the reason they are nowadays under the umbrella of investment banks is because it gives them access to more order flow, on more advantageous terms, because the bankers can gain marketing muscle, and because the broker can offer better execution. But the quid pro quo is that the traders shouldn’t try to happily screw anyone who comes near them with the same abandon they could when they worked for specialized firms that offered no other service than bids and offers. Just as their corporate finance people should recognize they are under an obligation not to offer clients deceptive advice so that they are left exposed to a hit on their treasury, a bankruptcy, or a hostile bid.
If all Goldie and its peers can offer today are bids and offers, they should (a) fire all those expensive salesmen and bankers, (b) stop hawking research, and (c) stop pretending they are an investment bank, or anything other than a used car lot for securities. It is the development of amicable business relationships under the guise of offering advice that creates a moral obligation towards your client. Whatever Darwinian universe the traders want to inhabit is their own business, but it should not be allowed to infect the whole firm.
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04.21.10
Posted in Blog at 1:23 pm by Andrew Clearfield
In most conservative circles, the current push by the Democrats to pass more financial services regulation has been received with skepticism fading over into outright hostility at yet-another power grab by Washington. The piece in the National Review’s online Corner column to which I was responding here was no exception. I was becoming concerned that too many believers in free markets were convincing themselves that just because there was a lot of dirty bathwater, there was no baby in it.
Editor:
As Frank Luntz was recently quoted in The Corner:
By the way, it’s time to hold Wall Street equally accountable, but there are better ways than creating yet another Washington bureaucracy. It requires better enforcement, not new laws.
This has been the mantra of almost all those who oppose the latest regulatory bill in the Senate. In principle, they are right. The problem is, that existing laws don’t cover many of the problems that were exposed in the 2007 – 08 financial crisis.
Far be it for me to recommend that the bloated bureaucracy in Washington be made still bigger, or the federal government be allowed to become even more intrusive than it already is, but we have a problem that contains the seeds of the next financial catastrophe, and it is no good pretending that it isn’t there simply because its existence inconveniently contradicts the principles of free-market capitalism or libertarianism: under the present laws, the big banks have license to run amok.
Without constraints on their size, we now live in a world where five or seven so-called “investment banks” (most are really ‘universal’ banks) completely dominate the capital markets. All are “too big to fail.” Given that there exists no authority to demand otherwise, there is no reason why mergers could not reduce their number still further. If there is a bid, institutional shareholders must accept a higher offer for their shares; even if they wanted to reject a deal as being economically inadvisable, they have no choice. Thirty years ago there were over a hundred significant players in the financial markets, fifteen years ago, there were still several dozen. With so many players, the opportunity for systemic risk was greatly reduced. Today, mistakes by just a couple of the survivors could bring down the system. The process of consolidation has gone too far.
Conflicts of interest are now hard-wired into the system. When I began my career as an institutional portfolio manager (for TIAA-CREF, let me add, not some small player), there was a great deal of worthwhile research available, and thus a proper range of opinions, from bullish to bearish, on any stock, new tactic, or market trend. In some countries (e.g., the U.K. and France) the brokers who talked to investors were not allowed to have any position in a security, either long or short. Since (aside from encouraging activity of course), their only interest was in keeping their investor clients satisfied, their opinions could be trusted not to be deliberately deceptive. Similarly, investment bankers (the real ones, those engaged in corporate finance) had as their only interest making sure that their corporate clients got the best price at the best time for their securities issues. They were not allowed to sell securities directly to the investing public, not even to the most sophisticated institutions. Market makers were not allowed to deal directly either with investors or with issuers. Other traders—those who worked for their own account—were by definition investors, and as competitors to the traditional long-only funds, insurers, and private individuals, occupied no privileged position within the system.
In the United States, where the only legal barrier was between deposit-taking banks and all others, the division of function tended to be maintained by tradition, by client concerns about conflict of interest, and by the requirement that stock exchange members, at least, had to be unlimited partnerships. We had wire houses and institutional brokers, investment banks specialized in corporate finance only, and there were research boutiques as well. There were separate firms that specialized in risk arbitrage. Critics—mostly the commercial banks which wanted to use their market capitalization to buy their way into the sexier business of the capital markets—complained of its inefficiency. Everyone, naturally, wanted to game the system to his own advantage, and there were fads. But by virtue of its fragmentation, the system worked as a free market, with sufficient numbers of participants to insure that the invisible hand could have an effect before total disaster set in. There was euphoria at times, of course, and there were some nasty bear markets, but for fifty-four years, from the end of the Great Crash of 1929 – 32, to the ‘portfolio insurance’ crash of 1987, despite World War II, several sterling crises, the collapse of the ‘nifty Fifty,’ Silver Monday, Franklin National, and Continental Illinois, etc. etc., there were no full-blown financial panics: the survival of the system never was in doubt.
But major forces in the U.S. began chipping away at this system. Stock exchange members were allowed to incorporate, then to issue shares to the public. The blue-ribbon investment banks merged with institutional brokers, then with the wire houses, to obtain “distribution,” i.e., to have a sales force to push their issues upon the investing public. Trading for the firm’s own account became accepted, then de rigueur, despite the fact that investors no longer knew whether they were being advised to take a good bet, or being sold a bill of goods by someone who knew more than they. In self-defense, American institutions began to build up their research staffs (which was very expensive), but they could never command the kind of resources that market intermediaries could. Issuers liked being able to call up ‘their’ banker, and tell it to silence any analyst who had unkind things to say about their share price, or their financial situation. Armed by their wealth and huge market caps, the American houses began to take over brokers in other parts of the world. Since then, we have had financial crises in 1987, in 1991, in 1997, in 2000, and most recently, in 2007 – 08.
The problem isn’t just that the principle of caveat emptor has been reaffirmed. Any participant in the financial system, as in any market, should always be careful to look after his own interests. It is that this is no longer enough. Financial intermediaries have been allowed to become so big, and so riven with conflicts of interest, that there is no longer a true free market in securities, and since everything is now securitized, the free market in financial services can no longer be self-correcting. The invisible hand only manifests itself when the situation has gotten so out of hand that catastrophe is already upon it. And of course, big government would then be there to bail out too-big-to-fail banking, but not market investors, who would have lost (a third? a half? three-fourths?) of their wealth.
Therefore, I’m afraid some sort of new regulation is required. Hand-wringing on behalf of the poor boys at Goldman Sachs doesn’t help either: they may or may not have broken the law, but there is no way I would continue to deal with any broker who had sold me such a deal, if I had any choice. Sadly, no one has such a choice today. The Dodd bill may have many lousy features, and one must be careful of anything from the people who gave us Fanny Mae and Freddie Mac, but just enforcing existing law is no longer enough. Somehow, the financial system must be brought back within the realm of free markets. Just relying upon the bid-and-offer mechanism of the stock market won’t do it under present conditions.
It should be incumbent upon conservatives to push for the right kind of regulation, even if this gives Washington some new powers. The worst financial power the Government has right now is their ability to get in bed with a handful of giant banks in a corporatist muddle of interests, as one set of barons might deal with another. Only by modifying the system can we reduce the risk of that.
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04.20.10
Posted in Blog at 5:31 pm by Andrew Clearfield
Toyota’s recent public relations disasters involving the recall of their Prius hybrid because of sticking accelerators, and then of one of their SUVs because it rolled over too easily, prompted a great deal of reflection in the business press wondering what had gone wrong with a one-time champion of quality control? Observers pinned much of the blame on an inbred corporate culture that could not admit to the rest of the world that the company was capable of making a mistake. Corporate governance professionals noted that the denial of responsibility had run right up to the boardroom. In response to a discussion which opened on the Society of Corporate Secretaries and Governance Professionals’ page, I was prompted to revisit observations I had originally made when I began to look at Japanese corporate governance nine years ago. At the time, the accepted wisdom was that it was useless to engage Japanese companies, because the Japanese culture would never allow criticism of any sort from outside a company. I was intrigued to discover that this wasn’t necessarily the case.
At the 2001 ICGN Conference in Tokyo, the CEOs of about eight leading Japanese companies addressed the conference. Toyota stood out as the only company adamantly opposed to any Western-style reforms of their corporate governance régime whatsoever. They were successful, they said, and they argued that therefore everyone else must be wrong. . .
This ignored the fundamental fact that corporate governance is a risk factor, folks, not a profit factor. It doesn’t do anyone much good to defend one’s governance practices by pointing to the track record. The point is to protect your company against what might go wrong in the future, both foreseeable risks, such as management succession issues and yes, product recalls, and the ‘Black Swans’ you can’t even envision. Toyota wasn’t doing that, couldn’t respond properly when such an issue arose, and a major marketing disaster was the result.
Japanese companies almost all have boards that are much, much too large, composed entirely or almost entirely of employees. No one is ever going to even question a management decision. That’s not a board; at best, it might be a council of elder statesmen within the company, which can be used to sound out opinions when the CEO is genuinely uncertain what to do. But as soon as a decision has been made, or a consensus has emerged, such a group would be useless, even in a culture less-consensus-driven and anti-confrontational than Japan’s.
Of course, no Japanese director, no matter how independent, is going to get into a direct confrontation with the CEO, but the Japanese do have more subtle ways of indicating concern and even direct disagreement. Opposition can be expressed successfully, so long as it comes from respected counsellors, who understand and live within the Japanese culture. The problem is that rarely are directors with any real standing chosen from outside the company; in most cases, if there are token outside directors, they are both affiliated with the company, and chosen because they are not likely to make waves in the boardroom.
‘Twas not always thus. Before World War II, many companies had strong outside directors who represented major investors in the company. But MacArthur’s imposed destruction of the supposedly “fascist” concentration of capital and ownership after the war, and the fact that Japan was impoverished by her defeat, made the conquest of companies by managerialism very easy. The incredible expansion of the Japanese economy, and then of her neighbors, for forty years after the Occupation masked the problems that were accumulating, and allowed everyone to forget that there was nothing inherently ‘Japanese’ about their governance arrangements, that other approaches had once worked well in Japan.
Somehow, the Japanese have to be convinced that for their own good, they need to roll back some of this managerial power, and allow a little bit of old-fashioned financial capitalism back into their system. Perhaps experiences such as this will help that message get through to those who can effect such changes: the CEOs of the major institutional shareholders and the mandarins at METI and the Ministries of Law and Finance. But it won’t be easy, because the primary impetus is going to have to come from inside.
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04.01.10
Posted in Blog at 1:28 pm by Andrew Clearfield
An article in the Wall Street Journal on March 31, 2010 cited a senior regulator at the Bank of England on the very high social costs imposed by every banking bailout, and supported the notion that banks should not be allowed to grow “too big to fail,” because of the vast total cost of a banking crisis. One reader replied that our former Glass-Steagall Act had put American banks at a disadvantage with respect to their foreign counterparts, and stated that “the move to repeal Glass-Steagall began fifty years ago.” I can seldom resist the opportunity to reply to an historical misconception, and I wanted to clarify the record on U.S. banking deregulation.
The move to repeal Glass-Steagall began the day after it was passed. There are some who can’t stand any sort of regulation, and some who resent not being able to place the whole world under their own flag or logo. The fact that both U.S. commercial banks and U.S. investment banks remained very profitable despite these restrictions was irrelevant.
The big European banks were the envy of the U.S. money center banks in the 1970s because of their broader deposit base, and especially because some savers, e.g., the Germans, were so risk-averse they were happy to leave billions in low-interest bearing deposits just to avoid the terrifying market risk posed by—bonds, for example. The fact that U.S. savers were unwilling to live with such low returns was disregarded. The dreaded code-word of the day was ‘disintermediation’ [of the banking system] and we were supposed to avoid it by allowing state-wide and then interstate banking. If we’d had it sooner, it would have permitted our money-center banks to buy more market share in sovereign loans to Paraguay, for example.
After the survivors recovered from that one, and the geographical limitations upon our banks began to be erased, they turned their envy upon the universal banking franchise of the foreign banks. Calls for the abolition of Glass-Steagall became louder. Having the same freedom as the foreign banks would let them wheel and deal like the J.P. Morgans and National City Banks of the ‘twenties. Except that the foreign banks were mostly risk-averse, and avoided the kind of aggressive dealmaking that characterized our investment banks. They also maintained huge inner reserves that made their results less exciting, but made the banks safer. (Funny: I never heard an American banker lobby for that particular freedom!)
Still, our libertarian regulators broke down the Glass-Steagall barriers so that our banks, with bigger equity bases than the Europeans and Asians, could buy up the investment banking world, and even corrupt some of their foreign counterparts. With the results we’ve seen, which were pretty much those feared by the architects of Glass-Steagall. The commercial banks wanted the much higher return on assets of the investment banks, and the investment banks wanted to leverage up a larger capital base. The investment banks did not want to submit to the regulatory burden of the commercial banks, and the commercial banks did not want to suffer the extreme volatility of return of the investment banks. In the end, we got the leverage and the volatility—much more volatility than anyone had expected. Anyone want to break down any more regulatory barriers?
Through most of the history of this saga of burdensome regulation and artificial barriers, the American banks remained some of the most highly-rated and most profitable in the world, with higher returns on assets and larger market capitalizations than most of their foreign counterparts. One question still troubles me: What were they all whining about, and why should we have broken our system in order to accommodate them?
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03.01.10
Posted in Blog at 1:35 pm by Andrew Clearfield
An essay appeared in the Wall Street Journal on March 1st, 2010, entitled “Why Financial Reform is Stalled,” by Peter J. Wallison, a Senior Fellow at the American Enterprise Institute. The article blames all of the financial failure of 2007 – 2010 upon moral hazard, and argues that the government never should have bailed out the crumbling banks, because this only furthered moral hazard. A very neat analysis that ignored the fact that something had to be wrong in the first place for the moral hazard to have been created, and also that the consequences of this particular cure might have killed the patient.
Uh, Mr. Wallison, you forgot to tell us why the crisis happened. I agree that the crew in the White House and most of Washington are statists, and that their cures are often worse than the disease. But how do you expect us to believe that wrong-headed solutions caused a crisis that had already occurred months before? And do you really think that the crisis would have been averted if we simply had less regulation of the banking sector?
Contrary to your assertion, life would not have returned to normal if the Fed and Treasury had done nothing when Lehman failed. The chain reaction was already in progress: Morgan Stanley and Merrill were both on the brink. The whole banking sector seized up—as it would have done if Bear Stearns had simply been allowed to go bankrupt back in March. Statism is a huge problem, but that doesn’t mean that pure laissez-faire will cure all problems. To make such a bald assertion risks impugning the whole cause of conservatism in the United States.
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Several readers responded to my entry by simply denying that there ever was a crisis, that the Lehman bankruptcy did not cause counterparty failure, and that if the Federal Government had not intervened, everything would be back to normal. Several likened their idea of an appropriate response to ripping off a Band-Aid quickly, rather than trying to lessen the pain by pulling it off one hair at a time. A more dangerous misconception than this, I could scarcely imagine, and after reading about fifty more responses to the thread, most of which said in essence, “just get the Government off our backs,” I couldn’t stand this mindlessness any longer:
You radical libertarians are the mirror image of the true-believer Communists, who all swore that if Marxian socialism were just given ONE more chance—one REAL chance—without the corruptions of [insert the name of the latest loused-up social disaster here] it would all be shown to work, and to be the best political system ever devised. . . . Give us a break! The mirror image of chaos isn’t perfection, it’s rearranged chaos. A ‘perfect’ free market is not going to work any better than a ‘perfect’ centrally-planned economy will work. You all think that if we had just been wiling to rip the Band-Aid off a little faster, life would be hunky-dory by now. It wouldn’t, and you’d be out of work, too. And you and you and you and you and you . . .
Until you realize that there is no lower limit to the misery into which an economy can sink, until you realize that if you want to play roulette with someone else’s life, they are just as happy to play roulette with yours, until you realize that failed banks, repossessed homes, and crushed pension accounts are not statistical abstractions but real lives, ruined possibly forever, you will continue to prescribe this eighteenth-century snake oil that kills otherwise potentially save-able patients. Any such deaths should be on your heads.
The financial system failed because too much of it was dedicated to making speculative returns for its own practitioners. It was no longer producing a good product for those who needed it, but was dedicating more and more of its resources to enriching itself through dealings only with itself. Yes, federal insistence upon making mortgages available to anyone, no matter how impoverished or otherwise unfit, provided the basis upon which the actual disaster was jerry-rigged and that was unbelievably stupid. It provided the proximate stimulus for the disaster this time. But it was the go-go financial services industry that gleefully provided the means by which the scaffolding was piled so high; otherwise the real-estate bubble never could have been funded. And the engine that made the financial services industry so self-serving and risk-seeking was not stoked from outside; it was stoked by the pure, simple, very human greed of those within the industry. The same greed that rabid Ayn Randians exalt as the best human motivator. Greed of which any of us and all of us are capable. You put a money machine in any of our hands, and it will rapidly go to our heads, destroy our judgment, and lead to the next economic bubble. That is human nature, and we are stuck with it.
The solution to the abdication of regulatory responsibility that made this crash inevitable sooner or later is not to further reduce regulation, it is to make it better and where it is needed, stronger. Not necessarily more of it, because much of the current regulation is useless and ill-designed, and adds unnecessary costs. But better regulation, specifically designed to re-focus this service industry (for that is all it is) upon the services it provides to its ultimate clients: corporate borrowers, issuers, and savers. Big financial conglomerates will not of themselves do what is right; they will do whatever maximizes their returns within their existing framework, and over a relatively short time frame. The free market, which depends upon constant feedback from all of its participants, will not naturally foresee and correct what lies beyond its time horizon. Yet most of us involved in the industry knew instinctively that the colossal framework that had developed in and because of derivatives was mostly artificial, economically unproductive, made too many disparate financial entities too interconnected, and was ultimately balanced on the head of a pin. It took naive belief in the perpetual rightness of free markets to let it go its merry way, happily growing of its own accord, until something underneath it was yanked away and the whole edifice started to collapse.
Now you are telling us that no one should have tried to catch any of the pieces, to prop up what was still wavering, not even to pull any survivors out of the wreckage. Let the chips fall where they may, and keep the government out of the business of backstopping financial losers, even those central to the financial system. Just as, I suppose, the “solution” to the earthquake disasters in Haiti and Chile would be to let the victims there die, and eventually any survivors will move somewhere where there are no earthquakes—yet. (But not the U.S., of course, because we will protect our borders. Of course, so will everyone else.) This is what Social Darwinism would require.
Has anyone out there ever heard of the Golden Mean? The possibility of steering between two excesses? That without creating a ‘nanny state’ we just might want to have some prudential regulation, to keep card sharps from stealing too much from the naive and unwary, and to keep a fad from diverting so many resources that there is nothing left for the necessary functions of life? Just a thought you might want to ponder before you pick up your copy of Atlas Shrugged to look for the old answers to new problems.
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