There's a lot that I thought was objectionable or questionable in Evans and Wrights study, but most of it was well within the bounds of reasonable argument.  I have no problem intellectually with arguments that any particular regulation could impose costs that outweigh its benefits.  Instead, I was was moved to write because Evans and Wright were making precise numerical claims about the cost impact of the CFPA, and that these claims were based on either (1) a highly questionable comparison to dissimilar regulation or (2) pure conjecture.  

In their reply, Evans and Wright spend a good deal of time arguing about things that are really beside the point to my critique.  For example, Evans and Wright emphasize that I have not proved the affirmative case for the CFPA's positive impact (a passing point I made to show that the economic impact of regulation is susceptible to multiple predictions) and that I have "disputed virtually none of [their] findings that the CFPA Act would impose high costs on lenders and ultimately result in denying borrowers choice."  Let's be clear.  My critique was about three spurious numbers.  I didn't set out to prove a positive case in the critique and don't need to do so to make my central point.  And to imply a concession from silence about other issues is ridiculous in this context.  This sort of logical move is, however, consistent with the problems with Evans and Wright's statistical claims.  

But let's get to the heart of the matter.  My issue with Evans and Wright is about the numbers, not about their priors regarding regulation.  There are three numerical claims in Evans and Wright's piece with which I took issue. First, Evans and Wright claim that a CFPA would result in a 160 basis point increase in the cost of credit and a derivative 2.1% decrease in credit demand.  These assertions were based on a comparison with a study of non-analogous regulations that have been found to have an 80 basis point impact.  Evans and Wright argue that even though the regulations are different, they are less invasive, so therefore at least twice the impact would be the lower bound. Why twice?  Just because.  Evans and Wright still have no justifiable basis for doubling, as opposed to tripling the number, etc.  It is not as if 160 basis points is within some statistical confidence interval or the like.  While a 160 basis point number appears to have the imprimatur of social science, it is just conjecture, or, to be charitable, a very rough guesstimate.  

In a cost-benefit analysis, however, precision matters.  A CFPA might be worthwhile at 120 basis points, but not at 160 basis points, for example.  The problem with Evans and Wright's methodology is that they can no better defend a 160 basis point number than a 120 basis point number or a 700 basis point number.  Evans and Wright emphasize that there were merely setting a lower bound, but that hardly makes their number more defensible.  Evans and Wright simply do not and cannot know the impact, including what the lower bound would be.  Of course, precision is beside the point if the goal is to produce a scare statistic, rather than a rigorous cost-benefit analysis.  

The third spurious statistic in Evans and Wright is a claim that a CFPA would result in 4.3% slower job creation.  They achieved this number by taking a statistic about the role of small startups in job creation and then "supposing" that a CFPA would inhibit five percent of this.  I noted there were problems with their job creation statistic (namely that it failed to account for the spectacular failure rate of small startups after their first year, when they result in net job loss, not creation).  But that was a side point.  The critical problem was that they "supposed" a impact number without any basis whatsoever for their supposition. 

Evans and Wright take issue with my statement that "The key point here, however, is the impact of the legislation is speculative and certainly not susceptible to precise statistical predictions.”   They state, "That is a nihilistic approach."  Actually, it is an intellectually honest approach.  A debate that is poisoned by spurious statistical claims, rather than their debunking, are what will engender nihilism.  It'd be great to have an empirically informed policy debate.  But that's not license to make up numbers.  Policy debates have to function within our epistemological limitations.  There's a constructive debate to be had about the CFPA.  But constructive doesn't mean making things up.  

I think it is important, however, to draw attention to a serious defect in proposals for a special resolution system for large systemically important firms.  There is simply no way to regularize a resolution system for too-big-to-fail institutions because they cannot be resolved without the commitment of government funds, and provision of government funds is a political decision that cannot be decided ex ante.  The nature of too-big-to-fail resolution is inherently political and locked into a preexisting system. 

Resolution of financially distressed firms is at core a distributive exercise.  There isn’t enough money to pay everyone on time.  Therefore, some creditors won’t get paid according to the original terms of their obligations.  Some won’t get paid in full and some won’t get paid on time and some won’t get either.  Deciding who has to take their lumps is a distributive decision, and that sort of decision is inherently political. 

For regular firms or non-systemically important financial institutions, we avoid having to deal with the politics of distribution on a case-by-case basis through a statutory system that allocates risk in advance.  Parties largely know where they will stand in the event of bankruptcy or bank insolvency and can deal accordingly ex ante.  This is one of the great strengths of regular insolvency systems. 

It cannot work, however, for too-big-to-fail institutions because resolution of a too-big-to-fail institution requires government funds, and provision of government funds is a political decision that cannot be decided ex ante both because of the way appropriations work and because the distributional questions are likely to be particularly sharp and nasty with systemically important institutions. 

The problem with too-big-to-fail institutions is not the institution itself—no one really cares about the distressed firm qua firm.  Instead, the concern is about the distressed firms’ counterparties and the impact its failure will have on them.  Sometimes the problem is from the ubiquity of counterparties and sometimes it is from the particular identity of counterparties.  In either case, the goal in resolving a systemically important institution is to protect a particular set of counterparties.  Who those counterparties will be, however, will vary by systemically important institution.  In one case it might be payment system creditors, in another it might be brokerage creditors, in another it might be bondholders, in another it might be secured lenders, and in another it might be unionized employees or retirees.  The unpredictable nature of the counterparties we want to protect means that distributional questions cannot be pre-set, and that makes them political issues, especially when the government has to provide active funding for the resolution.

Resolving a financially distressed firm of any sort requires funding, whether a bridge loan to a sale or liquidation or financing for a reorganization.  There are many financially distressed firms that are able to get private bridge loans until they can sell themselves or otherwise work out their problems.  To the extent that a financial firm, however large, can obtain such private funding, there is no need for a special legal resolution procedure.   A special resolution procedure might provide buyers of the firms’ assets with special protections, like a 363(f) sale in bankruptcy, but if I had to guess, lack of a free and clear sale order from a court or agency probably wouldn’t be the dealbreaker. 

Thus, a special resolution procedure is only really needed when a private resolution is not possible either because of (1) the lack of assets available as collateral for new loans, (2) the scale of the failed enterprise, or (3) the speed of the enterprise’s collapse, which makes due diligence for lending impossible.  A formal resolution procedure alone can only help with situation (1).  It is of no help in situations (2) or (3).

In situation (1) a priming lien procedure, such as in 364(d)(2) of the Bankruptcy Code, would allow for new money to be injected even if all assets were already committed as collateral.  To be sure, there very few contested priming liens granted in bankruptcy, and in bankruptcy, at least, existing secured creditors still have to get adequate protection, which might not be possible in all cases.  Moreover, a priming lien is only possible when there is collateral value left.  If the firm’s assets are worthless, they will not support a secured loan. 

A formal resolution procedure is of no help in situation (2) because the sheer size of the failed firm is so large that sufficient private funding is not available.  Is there enough private capital that could be readily assembled to provide a bridge loan to JPMorgan Chase, for example?  If not, then there is only one choice—the lender of last resort—the government.  Likewise, in situation (3), private capital might be available, but not on such short notice.  There are too many questions about the failed firm’s finances for lenders to commit.  The solution to this is to provide some sort of a third-party guaranty for the new financing, but where would this come from except the government. 

Thus in most failures of too-big-to-fail institutions, the government will have to provide funding for the resolution, and this makes the resolution a political issue.  For this reason alone, I think we are kidding ourselves if we believe that we can regularize the resolution of systemically important institutions.  It would be great if we could regularize too-big-to-fail resolution, but I don’t think it is possible to come up with any set of rules that we won’t break at the first sign of them creating distributional results that we do not like. 

So where does this leave us?  We could avoid the too-big-to-fail problem to some degree by splitting off riskier business lines (investment banking) from the systemically important ones (commercial banking--payments and deposits).  There isn't a lot of political appetite for this fight, however; the administration has made clear it isn't going to get into this mother-of-all-banking-regulation-battles.  So that means we're are going to have to learn to live with too-big-to-fail.  The administration believes it can regulate its way to safety.  I hope so, but worry that the nature of regulation in most cases is to play catch-up and it is often politically influenced.  Moreover, I'm not sure that all of the implications of too-big-to-fail have been thought through.  Allowing too-big-to-fail institutions has profound consequences on housing finance for example (good-bye GSE funding advantage...).  And having too-big-to-fail institutions means, at core, that the credit of these institutions is the credit of the national government.  Thus BoA, Chase, Citi, and Wells will be extensions of the US government.  UBS will be an extension of the Swiss government, Deutsche Bank of the German government, etc.  I wonder if this points toward some sort of neo-mercantilism....  

In 2005, there was the phantom $400 bankruptcy tax used to push through the BAPCPA.  Then there was the Mortgage Bankers Association's 200 basis point interest rate increase claim about cramdown.  For credit cards, there was no fake statistic, but a pseudo-academic study funded by the American Bankers Association.  (In retrospect, lack of a scare number was a major strategic mistake for the industry.) 

Now we have the latest installment in the parade of phony numbers:  an American Bankers Association-funded study about the likely impact of the Consumer Financial Protection Agency (CFPA) on consumer credit cost and availability and economic growth.  The study is by David Evans of LECG and Joshua Wright of George Mason Law School (Wright may be familiar to some Credit Slips readers from his blog comments in the past). 

There's a lot of tendentious claims in Evans and Wright's study, but the heart of it are some very precise claims as to the impact of the CFPA on the cost of consumer credit (160 basis points), the demand for consumer credit (2.1% decrease), and the net job creation (4.3% slower).

How, you might ask, did anyone possibly arrive at such precise predictions based on legislation that does not create any substantive regulation of the credit industry, but would merely transfer largely existing powers to a new agency? 

The short answer:  just make up the numbers.  I kid you not.  Evans and Wright selectively chose a study on the impact of a different regulation (interstate banking restrictions) on credit cost.  They briefly argue it is analogous to the CFPA Act, which they claim will have double the impact.  (Why double?  Why not?)   Then they take that number and multiply it by an elasticity metric for the demand impact.  And for the coup-de-grace, they take a misleading number on net job creation and conjecture with no basis that it would be reduced by 5%.  These numbers are presented as "plausible, yet conservative" assumptions. 

There's a lot of room for good faith disagreement about methodology, but Evans and Wright's numbers don't come close to passing the straight-faced test.  (Even the Mortgage Bankers Association had some facially plausible basis for their cramdown claim.)  I am still shocked that two serious scholars would attach their names to this study. My short critique of their study is here. 

I figure that the Cubs reached a deal with the Player's Union that they would not reject any executory player contracts in bankruptcy, but there are certainly some contracts that should be rejected on an economic basis in terms of underperforming players, such as  Fukudome or Zambrano... 

[Comments are closed.]

"Bankers were excluded from communion by an ordinance of 1581, joining a list of other shady occupations---pawnbrokers, actors, jugglers, acrobats, quacks, and brothel keepers---that were disqualified from receiving God's grace.  Their wives were permitted to join the Lord's Supper, but only on condition that they publicly declared their repugnance for their husband's profession!  Their families shared the taint and were only permitted to join communion after a public profession of distaste for dealing in money.  It was not until 1658 that the States of Holland [the representatives of the estates of nobles and commoners to the court of Holland] persuaded the church to withdraw this humiliating prohibition on "lombards."

That's a remarkable shunning of those in finance by a culture that was absolutely obsessed with material goods of every sort (tulips, satin, brocade, damasks, gold, silver, pearls, etc.).  There's a long history of religious discomfort with finance, but to see this in as commercial of an early modern culture as there was surprised me. 

Whatever one thinks of the quality of the work of law professors on financial regulation and the crisis, its existence cannot be denied, as Kenneth Anderson notes on Volokh Conspiracy.  Off the top of my head, I can count at least three dozen law professors who are active in this area, and can think of at least half-dozen symposia that have already occurred and a few crisis-themed law review volumes.  We have been writing articles and policy papers, speaking at legal and non-legal conferences, testifying for years on Capitol Hill, drafting legislation (if only the good judge knew just how many pieces of legislation had drafting input from authors of this blog alone...), and actively serving in government:  Daniel Tarullo as Fed governor, Michael Barr as Assistant Treasury Secretary for Financial Institutions, Peter Swire with the NEC, Cass Sunstein at OIRA, and Elizabeth Warren as Congressional Oversight Panel Chair.  Posner might not be bothered to read our work, but we exist.

[9.4.09--comments are now open]

"training and research of academic lawyers have not been oriented toward macroeconomic issues or even issues of financial structure. There are many able professors of bankruptcy law, secured transactions law, and the legal regulation of securities (including futures contracts and other derivatives), but very few who study financial intermediation as a whole, and almost none who combine a deep knowledge of the financial system with an understanding of the economics of the business cycle, important as the financial system is to the cycle, as we now know."

Again, it just seems that Posner hasn't bothered to read the literature.

So what are we to make then of Posner's Complaint?  To borrow from the title of his latest book, it's simply "A Failure of Research."

Quick version:  the ruling went against Countrywide, but it was a procedurally based ruling about whether the case belongs in Federal District Court or state court at this point, not on the merits.  (As an aside, I think the reason this case wasn't removed to the Federal District Court on diversity jurisdiction grounds is because Countrywide is a "citizen" of New York, so under the Class Action Fairness Act removal isn't possible.  28 U.S.C. 1441(b).)

What I find most fascinating about this case is that it is the only investor lawsuit related to modifications about which I know.  (But please post in the comments if I'm wrong on this.)  For a while the story we heard from servicers was one of avoiding loan mods due to the fear of litigation (of course, there could just have easily been litigation for not doing mods).  Interesting how that litigation never materialized. 

Many of the issues discussed in the research brief will be familiar to Credit Slips readers, but one thing that I believe is unique to the brief is a detailed examination of the supposed conflicts between safety-and-soundness and consumer protection.  While this has been raised as a general specter or with an analogy to the conflict between affordable housing regulation and safety-and-soundness in the case of Fannie Mae and Freddie Mac (more on that specific case in another post), precious few examples of potential conflicts have been put forth.  The research brief considers the specific examples that have been raised and demonstrates through examination of the proposed statutory languag they are for non-issues either because of the careful way in which the CFPA delegates authority. 

I've previously written a short piece (here) about RDC that covers it more detail, but until I read about USAA's RDC iPhone app, I don't think I appreciated degree to which RDC could shake up retail banking.  We're just at the beginning of RDC (which has been growing like mad), but it is going to rapidly antiquate the retail bank branch, create truly nation competition for deposits (beyond brokered deposits and CDs), and help even the competitive playing field between large and small banks.  

RDC has the potential to seriously shake up retail banking.  Most people have little physical interaction with their bank beyond deposit checks and withdrawing cash funds.  These are important banking activities, however, so most people and small businesses choose their banking relationship based on the availability of local branches and ATMs.  That means that in any particular market, there are only a limited number of competitors.  It also means that large banks benefit from a type of network effect--the more branches and ATM the bank has in an area, the more valuable it is to consumers.   And the national scope of some banks' operations (BoA, Chase, Citi, Wells, in particular) only increases their value for consumers.  Smaller banks, which already have trouble competing on costs because of economies of scale are further disadvantaged, and have to emphasize service, rather than cost. 

RDC, combined with ATM fees waivers and e-banking (for transfers and payments) has the potential to make physical branch banking largely irrelevant.  This won't happen immediately--there are plenty of Americans (especially older ones), who will not quickly transition to doing everything electronically, and the fraud risk issues will have to be better addressed.  And branches won't entirely disappear (not least because of CRA pressures).

But if the bank branch becomes an outdated and expensive method of deposit collection due to RDC, small banks with lower overhead and employee costs will have a leg up on the behemoths with thousands of branches.  This isn't to say that the behemoths won't have plenty of offsetting advantages, but RDC will start to level the competitive playing field.  It will also create a national market for deposits--this is good, both in terms of ensuring the best deployment of capital nationwide--and in encouraging more competition. 

So RDC means better bank competition for deposits, but also fewer bank branches, which means fewer teller jobs and a bunch of commercial RE vacancies down the road. RDC poses some major fraud risks, not least the risk of multiple presentment:  a check can be deposited multiple times electronically at different institutions and the physical check can also subsequently be deposited.  For this reason, banks have rolled out RDC cautiously, starting with trusted business customers with whom they have multi-service relationships (and ample opportunity for set-off).  (I wonder what the bank regulators say about the safety-and-soundness of RDC and what acceptable levels of fraud loss are with it...)

Banks have been very hesitant to use RDC for consumers.  To my knowledge, USAA FSB has been the only major financial institution that has done a major roll out of consumer RDC, but it's clearly popular (and why wouldn't it be?)--a quarter of their deposits are now done remotely.  And now the USAA RDC iPhone app.  This is a major step forward in RDC and m-commerce in general, and it's a glimpse of the future of banking:  money will be electronic.  In 50 years, will we still have cash?  And do we care? 

Finally, the study has a very strange observation that there is a moral hazard problem in principal balance reductions, but apparently not for interest rate reductions:  "Balance reductions are appealing to both borrowers in danger of default and those who are not."  Therefore, borrowers might default to get principal reductions.  Sure, that's right, but everyone would also like a lower interest rate too.  I don't see why a principal reduction presents a different level of moral hazard from an interest rate reduction.  In terms of net present value, principal and interest rate are interchangeable (yes, there's an interest deduction, and a principal reduction changes the ability to refinance, but that's not the distinction at issue).  The bigger factor pushing against principal reductions (other than servicer compensation) is an accounting issue.  A principal reduction shows up on the balance sheet immediately.  A reduction of interest just reduces future income.

[Value if modified, but would have self-cured] + [value if performs as modified] + [foreclosure value if redefault]≥ [value if self-cured without mod] + [value if foreclosed without mod] 

In this post I want to underscore why we need a CFPA.  In future blog posts, I hope to come back to what a CFPA will and won’t do.

Simply put, we need a CFPA because the current regulatory structure doesn’t work and it will almost inevitably cause future crises, if not of the scale of the current one, then still too serious to countenance. 

The economic disaster of 2008 is the chief exhibit in showing that the current system doesn't work.  There were many factors behind the economic disaster, but bad consumer credit products were an important factor.  A major lesson from this crisis is that consumer debt can affect global economic stability (no surprise as consumer spending is something like 70% of GDP). 

Unfortunately, the market drives the introduction of bad consumer credit products.  Credit is at core a commodity.  A dollar from Chase is no different than a dollar from Bank of America.  The only way high-cost products that skim consumer surplus are able to compete in the credit market is through price obfuscation.  Some of this obfuscation is through fine-print.  Some is through product design, as complexity and exploitation of consumers’ cognitive biases can mask pricing.  Credit cards have led the way with price obfuscation, but mortgages made up the gap, and other products are not far behind.  Basically, the consumer credit market is a market in which competition often encourages bad products, and this calls for regulatory intervention. 

We have a regulatory system for consumer financial products in place, but the current regulatory structure doesn’t work for three reasons.  First, it fractures consumer protection in financial services over multiple agencies.  Second, it couples consumer protection with an incompatible mission, bank safety-and-soundness regulation.  And third, there is a lack of centralized expertise on consumer financial products in the federal government. 

In the current regulatory structure, consumer protection is an orphan.  Consumer protection in financial services is divided among five federal banking regulatory agencies, the FTC, the Department of Justice, and 50 states (with banking regulators and attorneys general).  And that’s just for banking services (credit, deposit-taking, and payments).  It doesn’t count the additional regulators for securities, commodities, and insurance. 

This fractured system is rife with opportunities for regulatory arbitration by financial institutions, and makes coordination between agencies a major challenge.  The essential nature of the consumer financial services market is hydraulic—regulating one sort of institution or product will merely shift business to another sort of institution or product.  For example, stricter limits on payday loans could well result in a boom in auto title loans.  When agencies have authority over only a part of the consumer financial services market, they are often loathe to regulate lest they just push the problem—and the business—into another agency’s bailiwick. 

Among the alphabet soup of agencies that have consumer protection duties in financial services, there is only one whose primary mission is consumer protection:  the FTC.  The FTC, however, only has jurisdiction over fringe players in financial services; it has almost no authority over banks or thrifts or credit unions.  For the other regulators, consumer protection is thrown in with other missions, and it has often been an afterthought.  The key problem for federal banking regulators (Fed, OCC, OTS, FDIC, NCUA) is that they are charged with ensuring bank safety and soundness.  A bank cannot be safe and sound without being profitable, and abusive and exploitative lending practices are frequently quite profitable (there’s no other reason to engage in them).  If a regulator cracks down on an abusive lending practice, it might endanger its regulatory charge’s safety and soundness.  The result has been that consumer protection almost inevitably takes a back seat to safety and soundness. 

The fracturing of consumer protection in financial services has also inhibited the federal government from building up expertise in the area.  There are many able staffers at various federal agencies who study consumer finance, but their dispersion limits their effectiveness.  It also limits their ability to collect data.  Data is the lifeblood of consumer finance regulation, but the federal government knows shockingly little about mortgages or credit cards or payday loans, for example.  To provide a simple example, the federal government does not know with any precision the volume of credit card debt outstanding.  The Fed tracks revolving debt, but that includes bank account overdrafts and other revolving lines.  Likewise, the federal government lacks detailed knowledge about credit card terms and pricing.  In order to gauge the impact of regulations, that sort of knowledge is essential, and a major reason the federal government doesn’t have the sort of knowledge is that there is no single regulator with a field-wide purview. 

Creating a CFPA would solve the fractured authority problem, would solve the conflicting missions (a/k/a motivation) problem, and would become a locus of knowledge and expertise on consumer credit that would allow for better and more efficient regulation.  It would provide an important bulwark against abusive consumer finance products and practices not just for the next few years while the memory of the current crisis is still fresh, but well beyond the memory horizon.  It might not be failsafe (no regulatory regime is), but the current regulatory system can also be guaranteed to keep producing bad consumer financial products, and that’s something America can’t afford. 

I've encountered only a limited number of publication contracts, but it is already apparent to me that there is major variation among these contracts, some of which are drafted well, and some of which are rank amateur works.  Some are conscience of the need to address author's desire to post works to electronic distribution sites like SSRN and BePress, others are not.  Some transfer the copyright to the law review, others are merely a publication license, exclusive for some period of time (or not).  My sense is that some of the agreements were simply drafted by law students (who have little-to-no experience in contract drafting), while others went through a university's general counsel's office and conform with a university-wide standard. 

Now in 99% of cases, the contents of the law review publication contract don't matter--they will simply never come up, and when issues do arise (I had to deal with this problem this year), the langauge of the contract is irrelevant, as no one is going to sue.  Instead, the issue is all about relative bargaining power between the journal and the author.  Indeed, this raises the question of why a formal written publication agreement is necessary at all; two journals I've dealt with have not had a formal written agreement. 

Still, the law review publication contract strikes me as a case where there should be a standard form contract, maybe with some check-the-box options.  It's hard to imagine that either law reviews or authors want tremendous variation in the contract. 

Maybe some enterprising law professor (not me) will draft such a contract for the good of the profession.  Consider this a call for an open-source standard law-review publication contract.

Sorry, but that's just not credible.  The Obama financial reorganization blueprint basically says that there are Tier 1 FHCs financial institutions that get special regulation) that are too-big-to-fail (TBTF).  For these (today 19?) companies that the administration has decided are guaranteed a bailout.  The blueprint refers to a guarantee of liabilities only passingly in its section on special resolution powers for Tier 1 FHCs, but given how we've handled the GSEs, AIG, Bear Stearns, etc., its hard to believe that we wouldn't guarantee the debts of a failed Tier 1 FHC--the whole nature of being a Tier 1 FHC is that there is systemic risk from its failure to honor debt obligations. 

This means that for Tier 1 FHCs, their debt is as good as guaranteed by the U.S. government.  The implications of this are far-ranging and serious; I haven't worked through all of them, but here's what jumps out at me:

(1)  This implicit (or almost explicit) guarantee will give these financial institutions a huge advantage in the market--they will enjoy a cheaper cost of capital  than any of their rivals (the same that the GSEs enjoyed).  That means all smaller banks, broker-dealers, and insurance companies will get crushed.  It also means that foreign financial institutions will be competing against the US government in essence.  I hate to think of the trade law implications. 

(2) This funding advantage for Tier 1 institutions will come at taxpayer expense--the result of guaranteeing the debt of large financial institutions is to balloon the federal balance sheet and raise the cost of Treasuries, which means raising the cost of borrowing for everybody (except maybe its offset by the cheaper cost of funds for borrowers from the TBTF institutions).

My intital thought is that this implicit guarantee would be very disruptive to the economy--possibly more so than the failure of any of these Tier 1 FHCs.  If that's the case, it's a bad trade-off. 

The blueprint's goal seems to be to regulate these TBTF institutions so carefully that they won't need a bailout (and maybe the regulation will be so onerous that companies will voluntarily shrink to avoid Tier 1 status or the regulatory costs will offset the funding advantage).  Methinks there's a bit of Master-of-the-Universe-as-regulator hubris there.  I don't trust the smartest guys in the room to get it 100% right, whether they're on Wall Street or Treasury.  We should know better now.  No regulatory scheme is failsafe, just as no investment scheme is guaranteed.  Even if it works now, what works today will be dated in 5, 10 or 20 years.  We shouldn't kid ourselves that a bailout will never be necessary with a revamped regulatory system and that we aren't therefore guarnateeing anything. 

The Obama plan is an implicit guarantee of JPMorgan, Bank of America, Citi, Goldman, Amex, Morgan Stanley, CapOne, and the rest of the Stress Test 19 institutions.  Do we really want the US government implicitly guaranteeing Goldman Sachs or CapOne's debt?  Is that what this world has come to?  Did we really cross the Rubicon in September 2008 without realizing it?  I recognize that the alternative is trust-busting, and shrinking financial institutions until they are no longer systemic risks, and that isn't very palatable, but it strikes me as possibly the less bitter gall.  

The conference features appearances by numerous current and former FTC and state officials--including a greeting by the incoming head of the Consumer Protection bureau, my GULC colleague David Vladeck--as well as prominent private practitioners. Sessions cover issues including internet issues (with special attention to the perhaps surprising scope of Section 230 of the CDA), privacy, the use of empirical evidence, and the different standards applied by different regulators, including the FTC, NAD, and courts applying the Lanham Act.

Just to play with acronyms for proposed Consumer Financial Protection Agency: CoFiPro=Coffee Pro? or CoFinPro=Coffin Pro?

The skin in the game requirement is being driven by the experience in mortgage securitization, not other types of securitization, and imposing a skin in the game requirement probably won't do much to non-mortgage securitization, where there might already be more than 5% retained interest. But for housing finance, skin in the game is really counter productive.

If we want to do long-term fixed-rate mortgages (and we should, as consumers are not well equipped to handle interest rate risk), we need to match long-term funders (insurance companies, pension plans, etc.) with long-term borrowers. The long-term funders don't do mortgage origination (insurance companies used to, but they got out of the market for reasons I don't understand), so we need the secondary market (securitization) to match them with the long-term borrowers. Making depositary institutions sit on a chunk of the loan is just counterproductive--it places interest rate risk on institutions that we know can't handle it--rather than placing it with institutions that are happy to take the risk in exchange for a locked-in, long-term fixed-rate of return.

The problems that arose with private-label securitization were primarily from information asymmetries between MBS purchasers and originators. The ratings agencies were supposed to bridge that divide, but the nature of private-label MBS was that they were heterogenous products, and the whole ratings system is based on past performance, which requires homogenous products with known track records. Not possible for new niche products. (fwiw, the niche products were only able to gain market share because of information asymmetries between originators and consumers. If the full cost of the niche products was clear up-front, they could not compete against the 30-year fixed, which benefitted from the implicit government guarantee of the GSEs; the only way private-label products could compete was through cost obfuscation via complexity.) Private-label MBS can work, but product standardization both of the mortgages and the MBS are essential for correcting the information asymmetries that originators exploiting during the bubble. Skin in the game is just an awkward and counterproductive way of dealing with the information asymmetries that could be more easily corrected through policies that favor the 30-year fixed as the standard product for securitization.

Where skin in the game actually make sense is not with originators, but with servicers. This crisis has taught us about the importance of servicers in loan performance, and servicer compensation needs to be revised so that servicers have incentives that match all investors' (something like a vertical slice). Watch for more on this later this summer.

According to Bankrate.com, credit card interest rates stayed steady for low-rate cards and dropped for some high-rate cards.  So what this means that the Credit CARD Act has resulted in lower interest rates, right? 

Of course not.  That's a pretty obvious ex-post ergo propter hoc argument that doesn't proove anything.  But you can bet we'd see exactly the same sort of argument being made if rates had gone up (and we assuredly will the next time rates do go up).  No conclusive evidence need apply.  Never mind that the legislation hasn't even gone into effect yet.  Flipping through the cable stations, I saw no less a luminary than Mike Huckabee on Fox saying that one of his interviewees was having trouble getting credit because of the legislation.  I believe in anticipatory effects, but really, what issuer would shift away from a juicy business model a minute sooner than required? 

Currently there are four key federal banking regulators:  Office of Comptroller of the Currency (national banks), Office of Thrift Supervision (federal savings banks), Federal Reserve Board (all bank holding companies and also state-chartered Federal Reserve member banks), Federal Deposit Insurance Corporation (state-chartered insured banks that are not Federal Reserve members).  There's also the National Credit Union Administration (federal credit unions).  There are some further twists to this mess, enough so that a good chunk of a banking regulation class is spent just on figuring out who regulates what entity within a bank holding company structure.  This piecemeal structure is a regulatory system that developed out of peculiar historic circumstances; increasingly there is less and less difference in the types of financial intermediation offered by different types of financial institutions. 

 I've blogged far too much about interchange over the last couple years (see here, here, here, here, here, here, here, here, here, here and here). It's important as an antitrust issue between merchants and banks, as a consumer protection issue because of the regressive cross subsidy it creates among consumers and because it encourages greater consumer card use and thus leverage, and as a bank safety-and-soundness issue because it encourages weaker underwriting.  The last point is not something I've blogged much about, but it's pretty simple:  guaranteed interchange revenue enables weaker underwriting standards the same way as points and closing costs on mortgages; when some revenue is guaranteed up front, greater risk can be assumed on the back end of the deal.

H.R. 2382 (Welch's bill).  The Welch bill takes a very different tack than the Conyers or Durbin bills.  Whereas Conyers and Durbin aim to solve the interchange problem by opening interchange up to negotiation on a leveled playing field, the Welch bill instead focuses on the credit card network rules that restrict merchants' ability to select which cards they wish to select and on what terms.  The Welch bill would prohibit card networks from restricting merchants from steering consumers to particular payment methods, from limiting how merchants can price for payment methods, and from limiting merchants in their ability to choose whether they will take certain payment methods for certain transactions or at certain locations.  It also provides that card networks can't charge merchants more for taking rewards cards than non-rewards cards.  

In other words, a fair conclusion is that even without the legislation, we'd be seeing credit lines cut and eliminated right and left.  That means it just won't do to rest on priors and fall back on the syllogism of more regulation means more costs means less credit available.  To be fair, there could be an anticipatory effect showing up in the account attrition data.  But the legislation doesn't start to go into effect until late August, and a lot of it doesn't go into effect until 2010.  So a profit maximizing issuer would probably want to close the accounts that are profitable under current law, but not under the new law on the day before the legislation goes into effect, rather than a few months ahead.

The card industry does do some ersatz income verification, however, using credit reports,but this might only exacerbate underwriting problems.  Credit reports only list debts, not income, but card issuers are able to piggyback off the underwriting of lenders that do income verification.  Thus card lenders will look at mortgage debt on credit reports to gauge income levels.  If you have/had a large mortgage, that implies a large income. 

The problem with this style of underwriting is that it relied on mortgages being thoroughly underwritten both in terms of income verification and in terms of mortgage-debt-to-income ratios.  As mortgage lending standards went out the door, so too did card lending standards.  Card issuers ceased to get the benefit of mortgage lenders' income verification and got squeezed as mortgage debt gobbled up an increasing share of borrowers' income. 

To be sure, there are other factors now pushing up credit card defaults to historic levels, unemployment being chief among them and the inability to refinance credit card debt by using home equity, but what amazes me is that even now that we know that mortgages size is a completely unreliable indicator of repayment ability, leading card issuers are still piggybacking off of mortgage underwriting.

(As an aside, there has long been internal card industry piggybacking, such as Neiman Marcus issuing cards to anyone with an Amex card on the theory that if you could get an Amex--in the good old days--you were a good credit risk.) 

GM wants to separate its productive assets from its liabilities. The basic way to do this is to sell the assets (piecemeal or as a going concern). The assets can then be deployed without the debt overhang and the creditors can look to the sale proceeds, which should be what they'd get if the company liquidated or they foreclosed.

This is the strategy that Chrysler has pursued with its sale to Fiat. The problem for GM is that there's nobody interested and capable of buying its assets (maybe some piecemeal sales around the edges, but not enough to matter). Anyone want 5.5 million square feet of prime Detroit office space?

GM has a pretty nifty idea, though. If it can't find an existing buyer, why not create on? It looks like GM will create a special purpose entity (New GM) to purchase its assets. How will this entity pay for the assets? A combination of cash, notes (IOUs), and its own stock. The notes and stock are easy enough to issue; the cash will be raised through a public offering of its stock, bond issuance, and loans from the US government.

So to put the numbers on this: (Old) GM's bankruptcy petition listed $82bn in assets and $173bn in debt. Old GM will sell most of its assets to New GM. Let's hypothesize that the sale is for $82bn present value. New GM will have to raise $82bn between debt and equity. Old GM will then take that $82bn (in a combo of cash, notes, and stock in New GM) and divvy it up amongst its creditors. Any remaining assets in Old GM will be liquidated catch as catch can.

Sure, there will be some fighting about exactly what gets sold and at what price, but the sale to New GM is really the only option on the table. There will also be intercreditor fights about distribution of the sale assets, but the net result will be that Old GM's creditors (including the UAW and US government) will end up holding a sizable part of New GM's equity, as well as its debt.

The use of a sale/liquidation as a type of sub rosa plan of reorganization isn't a novel idea (and this one's a steamroller), but GM's use of a specially-created, publicly traded New GM buyer strikes me as novel. To be sure, acquisition vehicles are often special purpose entities, but they are always subsidiaries of the true purchaser. Here the purchaser will be a real stand-alone company. Anyone know of other cases where this has been done? Comments are open.

Also a couple random observations:

1) Notice how GM piggybacked into SDNY jurisdiction through the filing of its affiliate Chevrolet-Saturn of Harlem, Inc., which appears to be a subsidiary of a subsidiary of a subsidiary (it appears that Saturn LLC owns Saturn Distribution, which owns Chevy-Saturn of Harlem) I wonder what the case caption will be... Will this be another Ionosphere Club? And will anyone challenge venue?

2) The rental car companies have an awful lot of exposure. ;I'm guessing this is from GM's buyback obligations. On the other hand, if there is lots of surplus GM inventory, the rental car companies might net out OK.

It's worthwhile stepping back for a second to gain some perspective on this bill.  Since 1968 there has been only minimal regulation or legislation relating to credit cards.  Four years ago, the card industry pushed through the BAPCPA and then poured money into defeating Tom Daschle's reelection bid.  The industry looked invincible.  The banking industry showed that it still has significant political muscle when it defeated cramdown legislation last month. 

That there would be any regulation of the card industry today is quite remarkable.  Some of the credit goes to the card industry's greed---for all that the industry knows about consumer behavior, it didn't realize that when consumers are squeezed too hard for too long, there will be legislative pushback.  But a lot of the credit for the legislation goes to the Congressmen and their staffs that really pushed the issue, especially Representative Maloney and Senator Dodd, as well as to advocates and academics who worked very hard for the legislation.  From the consumer groups, Travis Plunkett and Ed Mierzywinski deserve particular plaudits.  And some of Credit Slips' Finest had a hand in the legislation:  Robert Lawless, Katie Porter, and Elizabeth Warren, and non-Slipster Lawrence Ausubel.  Congratulations!

The news reporting on the legislation has been rather mixed.  Andrew Martin wrote an odd story in the New York Times that bit hook line and sinker into the card industry's spin.  Other commentary, such as Ron Lieber's analysis in the Times has been more critical.  So, let's pause for a second and take stock of what the legislation accomplishes and what it does not. 

(1)  The legislation addresses many of the current abusive credit card practices toward consumers.  The Senate version is more comprehensive, but both versions address a lot (but not quite all) of the bad practices:  double-cycle billing, automatic overlimit, application of payments to lowest APR balances, aggressive marketing to college students, etc..  I've detailed some of these practices in past blog posts here, here, and here (addressed only in the Senate bill). 

(2) The legislation isn't going to cause credit costs to skyrocket or credit availability to dry up.  There will be some effect on credit card pricing.  But let's be really careful in evaluating it.  There is an unfortunate tendency to equate the cost of credit cards with the purchase APR.  But that's just part of the cost of using cards.  To really know if there's been a price increase, we'd need to examine all the price points and factor in things like cost of funds and cost of operations.  The truth is that it's near impossible to do, which is why we fall back on a very misleading metric like purchase APR.  But any claim about card pricing that doesn't address the total cost, not just APRs isn't telling the full story.  

It will be very difficult, if not impossible, to sort out the legislation's effects on card pricing and credit availability.  Not only will there be anticipation effects to address, but there is the financial crisis and issuers' existing cutbacks on credit lines plus a frozen securitization market, but cheap funds directly from the Fed.

While we might not be able to sort out the pricing impact neatly, I think it's safe to say this much: the card industry's story of inevitable price increases and credit scalebacks is overblown.  First, over 85% of the cost of cards is a function of the cost of funds and cost of operations.  These aren't affected by the legislation.  The remaining 15% or so accounts for risk as well as for opportunistic pricing. It's just not realistic to think that card rates will go through the roof as a result of the legislation.  The worst case scenario, then, would be a 15% impact on card pricing.  To put that just in APR terms, it's like a 14% APR going up to 16.1%.  Not a huge deal. 

(3) Congress isn't taking away issuers' ability to price for risk.  Issuers still get to do the initial underwriting  and are able to cut off credit lines or adjust for risk prospectively with reasonable notice.  Congress is taking away issuers' ability to engage in opportunistic pricing in time period 2 to compensate for riskier behavior in time period 1.  The simple solution to this is for issuers to just do a better job pricing credit up front. 

(4)  The legislation has its limits:  this legislation addresses the problems of today, but it doesn't solve the problems of tomorrow.  The card industry has shown that it is quite skilled at adaptation, and economic theory tells us that regulation has a hydraulic effect--if practice A is banned, the market will simply move to practice B.  This is just plain vanilla term substitution.  If there is an interest rate cap, the cost is shifted to annual fees and the like.  The same can and will happen with other billing practices. 

Thus, I worry that within the next year we will see a host of new, creative fees:  unused limit fees, high-risk transaction fees, account review fees, line increase fees, etc.  If card industry executives are doing their job, they have already deployed lots of lawyers and economists and pyschologists to come up with new product features and have already been doing market tests.  I fear that the consumer victory from this legislation will be very short-lived. 

(5) So what do we do?  The answer is that we have to embrace a new model of regulation.  We have to recognize the hydraulic effects of regulation and use that to channel market forces to help consumers.  As long as credit product structure remains in the control of the card industry, regulation will always be met with term substitution.  A better route would be to restrict product structure:  limit card issuers to a few price points (availability fee, transaction fee, single interest rate) and mandate standardized terms for the entire industry.  This would leave issuers free to compete on price (and product structure within these limits) and service, and prevent them from playing the three-(credit)-card monte game of "hide the cost".

The risk here is that it makes it harder to bring innovation to market.  But it doesn't make innovation impossible.  Rather it merely shifts the burden of innovation to industry.  Instead of lawmakers having to play catch-up, what's the harm in making the industry seek regulatory approval of innovation?  An agency like a federal consumer financial product safety commission would be able to perform that very task. 

The key thing to remember in credit card regulation is that we are regulating a commodity.  BoA's credit is just as good as Citi's (and not just because they are both taxpayer-brand credit...)  Commodities should be all about price competition and standardization.  Credit is simply the flip-side of insurance, and standardized contracts are a hallmark of insurance regulation (and one of the things insurance regulation does right.)  The card industry does everything it can to avoid commodization--lots of bundling and not-very-meaningful add-on features--but in the end let's recognize that cards are just an access device to the ultimate commodity--credit--and regulate on those grounds with an eye to making an ultra-efficient commodity market.  

I’ve previously argued that making interchange rates competitive would result in savings for consumers.  But as The Home Depot pointed out, reduced interchange rates could benefit consumers in other ways:  cutting interchange costs in half (as happened in Australia after the Reserve Bank of Australia mandated at-cost weighted average and allowed surcharging), would put another 5 full-time employees on the floor of every Home Depot store.  Not only would that make customers’ shopping experience a lot better (and faster), but it would also generate an awful lot of jobs.

Just to play this out on the back of the envelope:  $48 billion in interchange last year, according to the Merchants' Payments Coalition.  If interchange dropped from around 1.8% to .5% on average (.5% is what it is in Australia; MasterCard recently agreed to .3% for cross-border interchange in Europe), that's around a 70% drop.  That'd translate into roughly $34 billion in savings.  Bureau of Labor Statistics estimates that average total cost of employment for an employer of an employee working 50 weeks a year, 40 hours a week at roughly $60,000.  So the cost savings would be equivalent to about 560,000 average jobs.  That's nothing to sniff at, especially these days. 

I don’t want to harp too much on interchange as an employment issue.  If businesses paid lower taxes, they could hire more employees too.  But it is worth underscoring that interchange is a lot like a tax, just not one subject to political control or which is for the public benefit.  And lowering interchange could have the same stimulus effect of a tax break, but without an impact on the federal budget.  Dealing with the interchange issue would be a nice economic stimulus package. 

The bankruptcy filing of General Growth, the second largest mall operator and the largest CMBS sponsor in the US is putting bankruptcy remoteness into question.

 General Growth owns 166 over 200 mall properties.  It seems that the revenue stream from most has been separately securitized.  This means that the revenue stream has been sold to an independent entity that paid for the revenue stream by issuing securities (CMBS) to be paid from the revenue stream.  The result is that General Growth got cash now for future revenue.  The CMBS investors, of course, assumed that they were taking on the credit risk from a particular mall, not the overall credit risk of General Growth. 

Imagine their shock when 166 SPVs filed for bankruptcy along with General Growth.  How did this happen?  Many of the malls are doing just fine.  The trick was that General Growth replaced enough directors on the SPVs' boards to get a filing authorized.  Most of the directors seem to have been from a rent-a-board operation.  The boards were overlapping, so replacing a few board members was sufficient to ensure a compliant board.  (Can you guess what sort of covenants will be in the next round of CMBS deals?) 

The investors and servicers of these SPVs are objecting, and to be sure there are some legal arguments, like the good faith filing doctrine, that might still save them.  But General Growth stands as a reminder that credit risk can be reduced and difused and hedged, but not ever completely eliminated. 

[As an aside:  check out the terms of the General Growth DIP:  LIBOR+1200!  Ouch.]

To understand rate-jacking, you have to understand two factors about credit cards:  lock-in and the incentive to increase account volatility created by card securitization.

(2)  Securitization Encourages Rate-Jacking. Credit card securitization is key to rate-jacking. Credit card securitization is different from mortgage securitization in three important ways.

MasterCard's MIF was always much lower than US interchange, which is somewhere upwards of 2.0% (and that's not the full merchant discount fee, just the interchange component). But now we see that MasterCard has decided that it can survive by charging just .3% interchange on credit cards in Europe. So why are American merchants going to pay seven times as much in interchange for credit card transactions? Are American banks or merchants seven times riskier? Or is US antitrust law just seven times weaker?

Technically it is jail time for failure to comply with a court order (much like failure to comply with a domestic support obligation); in that sense it's just plain old civil contempt.  But the wide-scale use of civil contempt to force payment for court fees strikes me as novel.  It's certainly been used before to effectuate things like turnover orders, but there's something very awkward about the courts in the role of creditor.

Every state in the union has a fraudulent transfer law.  But there is also a special (and virtually unknown) federal fraudulent transfer statute just for the United States government, as creditor.  The federal government could, of course, proceed under a state fraudulent transfer law (I’m not sure which state’s law would apply to AIG), but why bother when it could proceed under its own law?

So would the government be able to clawback AIG’s bonuses with a fraudulent transfer action? 

Maybe.  As far as I know AIG has received loans from the Federal Reserve Bank of New York and the US Treasury has purchased preferred shares in AIG, but not made any loans directly.  The government’s argument would be that AIG made the transfers when it was thinly capitalized and/or insolvent or likely to become so and that AIG did not receive “reasonably equivalent value.”  Discretionary bonuses are also per se not reasonably equivalent value. 

But there are some potential problems for the federal government.  First, the federal fraudulent transfer statute only applies to the United States as a “creditor.”  Creditor is defined to include the holder of contingent claims, so to the extent the US is a guarantor, it should have standing to bring an action.  I’m less certain that this would hold for being a second-tier guarantor, e.g., Treasury guarantees the Fed, which guarantees AIG, much less if the guarantee of the Fed is implicit.

If the United States is not a guarantor, what about bringing an action as a preferred shareholder? Preferred stock is a hybrid debt-equity security.  It has some characteristics of debt and some of equity.  While preferred shares are nominally equity, there are many circumstances (tax, bankruptcy, corporate governance) in which courts have recharacterized preferred shares as debt, including cases in which preferred shareholders have been successful in bringing fraudulent transfer actions.  (If preferred stock is equity, there is still a state corporate law claim for “waste.”) 

It is difficult to generalize about preferred stock because there are many possible variations, including whether it is perpetual, cumulative, voting, convertible, redeemable at will or on or after date certain, whether dividends are automatic or must be declared, and whether a dividend has in fact been declared and come due.  There is no case law directly on point regarding the federal fraudulent transfer statute. 

There is, however, case law on whether preferred shareholders have standing to bring fraudulent transfer actions under various state statutes. The case law is mixed.  While most decisions indicate that preferred shareholders lack standing, the decisions are highly dependent on the particular characteristics of the preferred stock.  So it’s uncertain whether the federal government as preferred shareholder could bring a fraudulent transfer action.

It is important to note that while the standing question is unresolved for preferred stock, the Treasury Department’s March 2, 2009 stock exchange agreement with AIG likely weakened any argument the federal government had for standing to bring fraudulent transfer litigation under 28 U.S.C. § 3304 as a preferred shareholder.  The agreement provided for Treasury to exchange cumulative, quarterly compounding, automatic dividend Series D AIG preferred stock for non-cumulative Series E AIG preferred stock on which a dividend must be declared.  Non-cumulative preferred shares without an automatic dividend are more like equity than cumulative, compounding, automatic dividend shares.  This makes standing as a creditor less likely.

AIG is clearly a debtor to the Federal Reserve Bank of New York. (Let's put aside the part of the deal in which AIG “lent” the NY Fed a bunch of toxic assets, presumably on a non-recourse basis, and the Fed posted good “cash” collateral).  The Federal Reserve Bank of New York is not part of the federal government.  Although authorized under federal law, it is a privately-owned institution, owned by its member banks.  So the FRBNY can't use the federal fraudulent transfer statute, but it should be able to bring a fraudulent transfer action against AIG under state law, and surely Treasury could persuade the FRBNY to do so.  (I’m uncertain where the Federal Reserve Board fits in here, either in terms of AIG transactions or government/private classification, but the Board might also be able to bring an action.) 

There’s also a question about whether the transfer was made by the relevant debtor.  I am not sure how AIG is structured, but the bonuses might have been paid by a subsidiary of the debtor holding company, which is not itself a co-debtor.  For example, if the United States or FRBNY is a creditor solely of AIG’s holding company, AIG’s Financial Products Division is a separately incorporated subsidiary of the AIG holding company, and the transfer being challenged was made by the Financial Products Division, the United States might not be able to challenge the transfer on the basis of insolvency and lack of reasonably equivalent value because it lacks a creditor relationship with the entity actually making the transfer.  Lastly, as Angie Littwin has noted, the bailout of financial institutions might save AIG from having committed a fraudulent transfer because the bailout arguably rectified the institutions’ insolvency

The FRBNY could almost certainly bring a fraudulent transfer action against AIG and maybe the US government could as well.  Whether the action would ultimately be successful is uncertain, but there’s certainly a colorable litigation route to take with AIG, and I’d bet there are lots of law firms that would gladly take this on on a contingency fee basis. 

What about the potential double damages issue that Chairman Bernanke suggested scared off the Fed?  My understanding is that is a matter of Connecticut state employment law and is triggered if an employer wrongfully withholds wages.  Even if it covered bonuses, it just doesn't come up as an issue with fraudulent transfer actions, regardless of whether state or federal fraudulent transfer law applies. With fraudulent transfer actions, the bonuses are paid, and then clawed back.  There's no withholding whatsoever, so the double damages issue for an unsuccessful suit doesn't arise.  Instead just the traditional rule that parties bear their own costs. 

We’re seeing a lot of interesting twists as the federal government becomes a market participant in distressed investment and lending situations.  From questions of priority in the GM and Chrysler credit agreements to fraudulent transfers with AIG, the government’s market activities are really a primer in the risks involved in distressed situations.  The government's position is complicated because it has political, as well as economic considerations, and those often argue for taking actions that if unsuccessful leave the government poorly protected down the road. There is a real tension between the attempts to avoid economic failure and the attempts to shield the taxpayers from the impact of such failure.  If the government aims for the former and is unsuccessful, public funds are much more exposed as a result.