A Little More on Consumer Finances

As a last followup before vacation to the previous post.

Financial Literacy

Do check out John Carney’s Sorry America: You’re Probably Doomed To Financial Illiteracy. He links to an older post by Matthew Yglesias pointing out that one problem with financial illiteracy is illiteracy – if people have terrible reading comprehension and can’t do basic math, we can’t expect them to navigate a mortgage.

This is incredibly important, but we can over read this. I am terrible at science, having never excelled at biology or chemistry. So I outsource my medical needs to a doctor. I’m terrible at confrontation and reading long legal documents, so I have a lawyer who can represent my legal needs. I’m not a dumb person, I’m just not smart at those things. And right now it is very difficult to get conflict-of-interest free financial advice, so it is worth looking further into Shiller’s idea of subsidizing conflict-free financial advice.

Subprime Student Loan Racket

Richard Serlin convinced me some time ago that private student loans are one of the most dangerous things for anyone to be around, especially our young people, and the more I read about the subject the more depressed I get.

So the story from The Washington Monthly, The Subprime Student Loan Racket, is heartbreaking. Whenever we talk about education, there’s always talk about abstractions: is it just signaling, a negative thing that should be taxed? is it ‘keeping up the race with technology’? etc.

The Washington Monthly story is a real example of educational failure: A 43 year old woman wants to career transition to become a nurse. We need nurses in this country. Maybe Martine Leveque would have made a good one. Maybe not. But regardless she ends up in a type of debt servitude having nothing to show for it, and with loans that can’t be discharged and that she can barely pay the interest for.

Lucky Ducky, Buyer Beware

I mentioned the idea that the Right might try to pin the blame on the subprime crisis on non-recourse loans in the previous entry – “AEI’s Peter Wallison has discussed preempting nonrecourse mortgages…” I haven’t mentioned it before because I was really hoping it would become a talking point for the Right. I still do! If it does, I’m going to commission another Lucky Ducky cartoon from the guy who does Tom The Dancing Bug (if you are unfamiliar with the meme, take the minute to click on that link; here’s one of the comics), where the dog sees Lucky Ducky and his family getting evicted and throws a fit that Lucky Ducky gets to enjoy not being in debt peonage for years after the eviction for defaulting on a NINJA 2/28 subprime loan that someone gave him for no money down.

Yes, yes, I know in Europe the mortgages are all recourse, but they have a radically different system from front-to-back. Here’s Soros on the Danish Model. But that’s much more in the Public Utility model of a financial system. Good or bad, it’s not what we’ve been doing.

I’m of the idea that this scenario should be “Let The Buyer Beware” – in this case the buyer is the buyer of credit risk – no person “buys” a mortgage, the bank buys your risk. That’s how the rate is set. There’s some risk here that can’t be diversified away; the question is who is better at identifying and holding this risk. Many states have decided that the lender is better off holding it than the seller, who is terribly bad at identifying it.

As Mark Gimein put it: “The loss was something that lenders could have anticipated at least as easily as borrowers…The reason that the [non-recourse] act rule exists is that lenders and developers have through the years shown a great deal of ability to maneuver unsophisticated buyers into crummy real estate deals. The reason that the [non-recourse] rule exists is to put the risk of these deals on the lender, not the buyer. The purpose is to discourage bad underwriting, dishonest marketing, and unjustified price inflation by making it very, very hard for a lender to get back the money if they lent more on a mortgage than a house was worth.”

That strikes me as perfectly reasonable. I’m not a homeowner, but then again, I’m not currently spending the rest of my life paying off the bondholders of all the stocks in my 401(k) that have gone bankrupt. And I love incentives for good underwriting. So take it for what it is worth.

Regardless, if you want to know why progressives are fighting so hard to prevent federal law from preempting state laws when it comes to the CFPA, maybe this will explain why. As I think through the agency, I seriously consider it coming into being January 2013, just in time for President Sarah Palin to announce Peter Wallison as the first Director of the Consumer Financial Protection Agency. And I can only assume the Agency’s motto will be “It’s Lucky Ducky Hunting Season.”

Aspen Conference on Financial Reform

If you are interested in killing some time on the internet today before Thanksgiving, check out this Aspen Institute event, Financial Reform for America: Strengthening Our Economy and Our Communities. It’s a moderated debate between Edward Yingling, President & CEO of the American Bankers Association, and Damon Silvers, Director of Policy and Special Counsel for the AFL-CIO.

I was asked to submit a question on Consumer Financial Protection. I wrote this long question and told them they were free to use whatever parts they’d like:

Several approaches to the concept of consumer financial protection have been proposed and discussed in the recent past.

1) Around 2006 Congress passed a series of laws, recommended by the Department of Defense, that created rules for offering financial products to service members. These rules instituted usury caps and limited certain features thought to be predatory. (link)

2) Economist Robert Shiller has proposed independent government sponsored advisors who would advise through contract details with consumers. (link)

3) Law Professor Elizabeth Warren has suggested creating a government agency that would take the regulatory regime, currently split among many different agencies, and consolidate it. (link)

4) AEI’s Peter Wallison has discussed preempting nonrecourse mortgages which would have borrowers be liable for the full difference between the loan value and the house value after foreclosure – switching the narrative to protecting lenders from consumers. (link)

5) Still others have considered forcing the standardization of financial contracts to make comparisons shopping between institutions easier – the so-called ‘vanilla contract.’ (link)

Is there a government role in providing consumer financial protection, and if so, what are the strengths and weaknesses of these various approach?

They ended up asking about approach #1 as a question. What approaches did I miss, and which ones do you like?

Frontline’s The Card Game

I wrote a quick review at The Atlantic Business of Frontline’s “The Card Game”, available for viewing online at this page.

If you’ve followed the debate closely, it’s probably a narrative you’ve heard before. What surprised me is how explicit CEOs of credit card companies were in stating things about the relationship between poor and rich borrowers. Former Providian CEO Shailesh Mehta, and pioneer of the new credit card marketing techniques, says directly that the most affluent consumers pay the least, while the poorest pay the most. It’s not exactly the same as when a risk quant reader of Felix’s said: “The industry is just a giant wealth transfer mechanism from poor people to wealthly people. The profits from below (subprime) serve to subsidize the interest rate and rewards cost of people in the ’super prime’ category”, or some of the emails I got after I went digging into what is going on with credit card interest rates. But it also points in the same direction.

The review is titled “How Credit Cards Rob the Poor to Spoil the Rich” and the comments are worth reading. They include my new favorite comment ever: “Seems more a transfer from the ignorant and foolish to the informed and prudent – certainly something I feel should be incouraged [sic].” Indeed. As you can imagine, several readers thought this was grossly inaccurate. Well, Shailesh Mehta said it, not me, and that dude knows a hella ton more than me about hidden fees, so take it up with him. From supplemental pbs material:

Mehta: Now, if somebody pays their monthly bill in full, and zero interest income, and if you don’t charge annual fee, zero fee income. So you have to make up everything from the merchant side, which you cannot. So what banks ended up doing is therefore they were subsidizing this whole group, because still two-thirds of the people were not making full payment. And that interest income covered the losses of the people who were paying in full.

So overall, the business looked profitable. But … in a strange way, the banks were charging borrowers higher interest rates in order to give the wealthy people a break — in a strange way, if you look at it, because the people who have money were paying in full, and they were getting the break at the expense of the people who couldn’t pay in full.

PBS: So it was sort of an unintended transfer of wealth.

Mehta: It’s unintended, exactly. I don’t think anybody thought through that. But correct.

I see the transfer in two dimensions. First: Picture 100 consumers, and it costs a firm $1 to give them each a credit card. Now instead of charging $1 to each person, you give the card to everyone ‘free’, but charge 10 people $10 at random. That’s the movement that is made here. If you speak micro, there’s some fantastic theory work being done on why, even in perfect markets, “It is also not possible to profitably lure either myopes or sophisticates to non-exploitative firms. We show that informational shrouding flourishes even in highly competitive markets, even in markets with costless advertising, and even when the shrouding generates allocational inefficiencies.”

Now all I’m pointing out is that the 10 people here aren’t entirely randomly chosen. Some are chosen because they aren’t as sophisticated as others. Some are chosen because they have health problems, or were in an accident, or have had a spell of unexpected chronic unemployment. But no matter what the story of how they are chosen, they tend to be chosen from the bottom end of the distribution.

The other dimension, less interesting from a distributional point of view but interesting in the dynamics between payment types, is that there tends to be only one price charged regardless of whether or not you use a credit card. If your card gives you some sort of reward that is paid for by the merchant, which the merchant has to take from you in increased prices, even if you would rather pay cash it’s a nash equilibrium for you to have to use your credit card. We looked at this back here:

Let’s assume that the interchange fee is 2% to the business. If I buy a $100 stereo from a store, they only make ~$98 if you pay with a credit card, but they make $100 if you pay with cash. Now if I pay with a credit card, I get about 1/3rd of that interchange fee in some sort of credit card payment reward. Frequent flyer miles, an inflatable grill, whatever. Let’s say that I end up with a $1 if I use my credit card in this case.

Now I have to decide whether or not to use my credit card, and the business has to decide whether or not to charge $100 or $102, the $102 reflecting a break-even from a customer using their credit card. The stereo costs the business $100 and is worth $100 to me. What’s the payouts?

…This isn’t an academic exercise. A small business I was at had a sign noting that they get charged over 2% every time a customer used a credit card, so why don’t you pay cash or with a check? But as I was about to pay cash, I wondered: “Don’t the prices already reflect that I will use a credit card? I might as well get points towards my plane ticket or whatever comes with the card.”

Note that if you don’t have access to a credit card, you pay that price regardless.

Why You Should Support The Lynch Amendment

The OTC derivative market is one of the crucial points of reform. Noam Scheiber has good news, Could Wall Street Actually Lose in Congress?

The proposal the Obama administration unveiled this summer would have forced banks and hedge funds to trade derivatives on exchanges and “centrally clear” them. Clearing means inserting a well-capitalized middleman between two parties on either side of a trade….In order to ensure [OTC regulation] eventual passage, Frank found himself having to strike a deal with a group of moderate New Democrats on his committee…

But independent experts who studied the measure came to a different conclusion: that it could exempt between 60 and 80 percent of the standardized market because of its vague wording, including many firms who were speculating rather than simply hedging risk…

But a funny thing happened on the way to securing the loophole: A confederation of consumer and investor groups, labor unions, environmental activists and a progressive organization called Americans for Financial Reform (AFR) started raising hackles of their own….By early this month, the pressure from Gensler and the progressive groups had the desired effect. Though Frank believed their concerns were somewhat overblown, he pronounced himself open to tightening the language to make sure the bill didn’t give speculators a pass.

This is good news. But just because we made first down on 4th and 10 doesn’t mean we are done driving the ball. I want to discuss my new favorite financial reform amendment. This one is pretty awesome: Amendment by Mr. Lynch, no. 7, H.R. 3795, Over-the-Counter Derivatives Markets Act of 2009.

The Problem

Background: There is a move to have OTC derivatives brought to exchanges. This will allow for a more even playing field, removing opacity and information problems inherit in the market. Smaller firms will be able to compete on prices, adding liquidity and decentralizing the risks of our financial markets. To the extent that private contracts need to be made, the exchange can set extra rules for those trades to make them available but discouraged.

So pretend you are the CEO of a large financial firm, who wants to manipulate this situation. What’s the obvious move?

Think of it yet?

Why not just buy the exchange?

It’s a private entity, not a government agency. And the owners get to set all the margins and all the rules which will make this competitive (or not). Right now the OTC derivative market is heavily dominated by a few financial firms, with 5 firms (1. JPMorgan Chase, 2. Goldman Sachs, 3. Bank of America, 4. Citibank, 5. HSBC.) accounting for 97% of the notional amount of all derivative contracts. And four out of five of those banks are TARP recipients, so they have gotten some cheap capital that they could be looking to invest.

So here’s a simple amendment, by Stephen Lynch (D. Mass). Here’s the crucial part of it:

(B) BENEFICIAL OWNERSHIP BY A RESTRICTED OWNER – The rules of a clearing agency that clears security-based swaps shall provide that a restricted owner shall not be permitted directly or indirectly to acquire beneficial ownership of interest in the agency or in persons with a controlling interest in the agency, to the extent that such an acquisition would result in restricted owners controlling more than 20 percent of the votes entitled to be cast on any matter by the holders of the ownership interests.

Financial firms can’t own more than 20% of the exchanges. That’s it. No Exchange Czars. No additional government regulator to fall asleep at the wheel. No complicated Rube Goldberg device with a “let’s nudge someone to do something with taxpayer money” payoff structure. Competition. People looking out for their own money. Level playing field. Simple, good ideas. Let’s have a large number of market participants, looking out for their own interests, owning these things, instead of a subsidiary of the largest banks. Because in that case, we don’t need to invoke a metaphor for regulatory capture, say ‘cognitive capture’ or ’social capital’; it wouldn’t be a metaphor – they’d actually own the mechanism we expect to regulate them.

Breaking this amendment on the floor is going to be a rallying point for the largest business interests. The Securities Industry Financial Markets Association (SIFMA) and International Swaps and Derivatives Association (ISDA) are already opposed, saying, of all the wonderful things, that it is “anti-competitive.” And the fighting and lobbying is going to get more intense for Lynch and those who want to support this amendment.

Competition

This amendment should move you if you believe (a) the largest banks have a concentration of political power and need to be curbed and (b) the government should be in the business of defending markets, not big businesses. Left or right doesn’t matter much here since they have the same concerns. Here’s Luigi Zingales’ An Economic Agenda for the GOP (h/t Reihan Salam):

A pro-market strategy aims to encourage the best conditions for doing business, for everyone. Large banks, for instance, benefit from trading derivatives (such as credit default swaps) over the counter, rather than in an organized exchange: they can charge wider spreads that way, and they can afford to post less collateral by using their credit ratings. For this reason, they oppose moving such trades to organized exchanges, where transactions would be conducted with greater transparency, liquidity, and collateralization—and so with greater financial stability. This is where a pro-market party needs the courage to take on the financial industry on behalf of everyone else….For every “zombie” firm that survives because of government assistance, several innovative start-ups don’t get the chance to be born. Subsidies, then, hurt taxpayers twice.

People think of finance as a single thing, but there are small firms, innovators, people looking to pick up the slack somewhere and make some money in the process. Read those last two line from Zingales, and then re-read the email from my friend at the end of my post on liquidity and TBTF: “We know that the banks make huge spreads in trading OTC products and we were looking forward to performing our patriotic duty of competing these spreads away [in a small new firm]. It looks like it will never be.” The market can handle this, as long as it is able to function as an actual market. And that means the biggest firms don’t buy the exchanges with TARP money and set the rules.

Anyone, progressive or conservative, who supports the idea of free and more equitable financial markets should take a minute out of their next few weeks and show support for this amendment. Blog about it. Write and call your representative when it gets into a fight on the floor. Write and call them now. Maybe 10,000 people will read this post over its life. The Financial Services Industry will spend well over $200 million dollars this year lobbying. That’s $20,000 per person that reads this, or about half the median income. I sadly can’t ask you to donate that much – I can ask you to get involved however.

Religion and Our Economic Times

There are two articles about religion and the financialization of regular life in the latest Atlantic Monthly, and both are worth your time. The first to check out is about financial guru Dave Ramsey by Megan Mcardle:

How, searching for help in his hour of need, he turned to the Bible and discovered Proverbs 22:7: “The rich rule over the poor, and the borrower is slave of the lender.” At that moment, he told an audience so hushed that we could hear the ice squeak, Ramsey decided to never borrow another dollar again….

Ramsey offers some investment advice (much of which would have struck horror in my business-school professors), but for most of his followers, the main attraction is a simple program: give 10 percent of your income to charity, save 15 percent for retirement, build up a sizable emergency stash and a college fund for your kids, and above all, stop borrowing money. Ramsey devotees pay cash for everything they can. They are allowed only one exception to the no-more-debt rule: a 15-year fixed-rate mortgage. He is so serious about shunning debt that his Web site takes only debit cards; try to pay with a Capital One Visa, and the system rejects the card, then tut-tuts at you. These simple, austere, unbreakable rules are, as Ramsey likes to say, “the advice that God and Grandma gave you.”

The second is about the Prosperity Gospel by Hanna Rosin:

That Sunday, Garay was preaching a variation on his usual theme, about how prosperity and abundance unerringly find true believers. “It doesn’t matter what country you’re from, what degree you have, or what money you have in the bank,” Garay said. “You don’t have to say, ‘God, bless my business. Bless my bank account.’ The blessings will come! The blessings are looking for you! God will take care of you. God will not let you be without a house!”

Pastor Garay, 48, is short and stocky, with thick black hair combed back. In his off hours, he looks like a contented tourist, in his printed Hawaiian shirts or bright guayaberas. But he preaches with a ferocity that taps into his youth as a cocaine dealer with a knife in his back pocket. “Fight the attack of the devil on my finances! Fight him! We declare financial blessings! Financial miracles this week, NOW NOW NOW!” he preached that Sunday. “More work! Better work! The best finances!” Gonzales shook and paced as the pastor spoke, eventually leaving his wife and three kids in the family section to join the single men toward the front, many of whom were jumping, raising their Bibles, and weeping. On the altar sat some anointing oils, alongside the keys to the Mercedes Benz.

I would have like to see a little bit more as to how these are similar but inverted reactions to the same phenomenon; a messianic evangelicalism, composed of equal parts ecstasy and terror, that helps navigate and construe a new world of economic instability, risk transfers, and the financial narcotic of winner-take-all inequality capitalism.

Place plays a crucial role in the Rosin piece. She focuses on hispanic immigrants in Virginia, and the implication is that coming to America has opened the door to a type of success they could never have dreamt of before, but it’s a highly leveraged, highly risky type of American Dream. She mentions that the prosperity gospel takes a center role in the subdivisions of the exurbs as well. Connecting the two, and noting that the idea that success in the exurbs also involves thriving in a Brave New World of financialized capitalism, alien to their senses inherited from the generation before them, isn’t approached – we never look inside the exurban Prosperity Church. It’s worrisome that the techniques most available to citizens navigating this world seem to be either shunning or whole-heartedly embracing the capitalism of the 00s, especially worrisome for those who try to think through what it would mean to rebuild a social contract under these new conditions that can salvage the good parts from the wreckage.

UC Fee Hike and Berkeley Strike

Caught between state funding cuts and rowdy student protests, a key committee of the University of California’s Board of Regents on Wednesday reluctantly approved a two-step student fee increase that would raise undergraduate education costs more than $2,500, or 32%, by next fall.

If you are interested in an on the ground perspective of the strike and building occupation that occured at UC Berkeley, as well as being a graduate student at a public university at this particular moment of public sphere dismantling, I’d recommend this series of posts over at zunguzungu: (in chronological order) On Being a Graduate Student (sort of) On Strike, Wheeler Hall Occupation, Wheeler Hall Occupied by the Police, Security Doors.

Two additional things. One, from Kevin Drum, shows the relationship between prison spending and student tuition:

Also the chart here at Edge Of The American West, about the changing priorities of the university by employment categories.

Two. Wendy Brown’s “Why Privatization Is About More Than Who Pays”, from a UC Berkeley event “Save the University” (all of which is on youtube, and features Robert Reich, Ananya Roy and others). For work that is theory driven, the speech is incredibly accessible, and walks through the larger implications of the move to make public higher education more market driven in 10 easy steps.

Liquidity, OTC Market and TBTF Banks

I’ve been thinking a lot about what kinds of benefits we enjoy from having large banks. Economics of Contempt has a post arguing that the benefit comes from big banks being able to keep big books, and thus increase liquidity:

You need a very large and diverse balance sheet to be a market-maker in fixed-income products—government securities, investment grade corporate bonds, high-yield bonds, mortgage-backed securities, bank and secured loans, consumer ABS, distressed debt, emerging market bonds, etc. Dealers hold inventories of all these securities because they need to remain “ready and willing” to sell, and because when they buy a security from a client, they need to hold it in inventory until a buyer for the security appears. Dealers are exposed to price movements for the period they hold the security in inventory, and because inventories can grow large in a short amount of time, sharp price movements can result in substantial losses for dealers.

So dealers hedge. Constantly. The cheapest way for dealers to hedge is internally

A few points:

1. This is exactly the argument you would make defending Fannie Mae and the rest of the GSEs during the early and mid parts of the 2000s. I’m trying to find a good statement of this; here is Fannie critic Peter Wallison talking about arguments the GSE have made:

What, then, are the arguments advanced by the GSEs? Freddie Mac has been circulating on Capitol Hill a lobbying document that one should assume contains the best case the GSEs can make for retaining large portfolios of mortgages and MBS….1. The accumulation of large portfolios adds liquidity and stability to the secondary mortgage market.

2. As far as I understand it, and if I’m wrong I’ll take back the point, but the largest banks don’t provide much liquidity in terms of NASDAQ stocks. There’s not much profit in it, and the market does a great jobs of handling those liquidity needs itself.

One reason is that it’s a market with easy access, allowing those with market power to be dwindled away by market competition. Electronic access has helped, but so has applied finance research (that Christie/Schultz is one of my top 5 desert island empirical finance papers, fyi) and arguments arguing where market power exists, and pressures that immediately followed in making those markets more competitive.

3. What kind of market making structure should we have? Market making by its very nature should be a transitory business. As a product’s liquidity improves, the need to a third party to act as an intermediary should diminish. Natural buyers will interact with natural sellers and the market maker role is obviated. And in transparent markets with unrestricted access, you see the profitability of market making vanish. The NASDAQ market mentioned above is one case; listed options is another.

To use an analogy that EoC uses as well, these banks were supposed to be in the moving business but they ended up in the storage business. The only reason Goldman came out relatively unscathed is because they identified the crisis earlier than the others and hedged their “storage” book. This is well played on their part, but it is something that by definition not everyone can do. Every one of the biggest banks with large storage books can’t all hedge, it goes against the very idea of liquidity. There’s only so many chairs in this game of musical chairs.

4. How deep is the liquidity actually provided by big banks? I’m under the impression, through friends and friends-of-friends, that only time banks take down trades that have negative expectancy is when they know with a high degree of certainty that they are going to get paid back soon by the same client. They look at this is an “expense” to be recouped. A trading desk’s will have a “customer facilitation” book where these negatively expectancy trades get dumped, but it is segregated and rigorously monitored. When a particular firm ends up on the winning side of too many trades in this book, the bank stops trading with that client, end of story. Maybe that’s just talk, but it seems reasonable to me given what I know of the specific area.

5. So where does the big banks make their profit and provide liquidity no one else can? In the OTC market. The TBTF banks don’t want (and given the times we live in, I might even say “allow”) these products to trade openly because they make excess rents by keeping the market opaque for competitors. I would love to see a study about transaction costs of trading a US convertible issue – you can’t get a bid and offer without calling a dealer, and even these prices are not even firm, you can try to lift or hit but the dealer can fade – versus a comparable European warrant issue that is listed on an exchange (as many warrants are in Europe). Are there any?

I think all this talk about improved and graduated capital ratios is going to be nonsense when it comes to shrinking the largest banks. I don’t expect a ‘living will’ to be credible, even in the good times. The latest fad that is sweeping risk management circles is talk about Basel having risk quants “leaning against the risk curve” during cycles, being harder in good times and easier in bad times to try and counteract the dynamics described so perfectly in the first two large paragraphs by this excellent interfludity post. Good luck.

Here is probably where EoC and I are going to disagree. I think one concrete thing to do to take care of this problem is to push for the OTC market to be brought onto exchanges. This is a big source of profits for big banks, hedging and providing liquidity for this market. EoC might think it’s largely driven by returns to scale; I think it’s largely driven by market power and the drive to keep the market opaque. Let’s see if the small players can actually provide this liquidity for the market.

Here’s a recent email from a friend at a small trading firm:

About a year ago, several of my ex-[trading firm] colleagues and I had a conference call to discuss the likely future market structure when all the dust settled. We were all a bit excited because we assumed (spectacularly incorrectly as it turned out) that one of the earliest reforms would be to put many of these OTC products on an exchange, and then firms like [trading firm]–or in our case, a group of [trading firm] refugees–would be able to compete on an equal trading field. We know that the banks make huge spreads in trading OTC products and we were looking forward to performing our patriotic duty of competing these spreads away. It looks like it will never be. These products are intentionally structured to keep them off exchanges, and the TBTF firms lobby continuously to limit competition in what is a very profitably arena.

This blog is probably read as anti-finance too often, but I seriously love the field and the work that is done. And you might read the line “performing our patriotic duty of competing these spreads away” as a bit of an ironic wink, but I take it seriously. It’s a really great thing to do, and it should be very well compensated to those who can do it. But the way to do it best is to level the playing field; standardize the OTC already, and all liquidity to come from diverse corners of the world, small firms, and those that want to keep them in check, as opposed to a super-secret list of the largest few banks. Allow the small firms of finance to actually be competitive in a real manner with the largest firms, who, as basic Ronald Coase would tell us, have a lot of internal noise and transaction costs to deal with; this is how markets are supposed to work, and this is the way competition leads us to a better place by solving problems regulators can’t.

Junior Tranches First in Line

It’s not just random Americans getting hit with gotcha fees and term changes that could use a “vanilla contract”, check out this amazing story:

Goldman Sachs Group Inc. paid off at face value some junior-ranking slices of two collateralized debt obligations at the potential expense of more-senior classes that now are likely to default, according to Fitch Ratings.

Goldman Sachs, the most-profitable securities firm, applied its “sole discretion” to ignore standard payment priority and use cash in reserve accounts for the Abacus 2006-13 and Abacus 2006-17 CDOs to retire lower-ranked notes, Fitch said yesterday in separate statements.

The moves are unusual in that the most senior creditors are typically the first in line to get paid. Fitch analyst Karen Trebach said the use of reserve funds may help cause or add to losses for holders of the CDO’s remaining classes.

“We are not aware of the use of this feature in other transactions we rate,” Trebach said in a telephone interview.

Here’s FT Alphaville:

In short, Goldman Sachs paid off (at face value) some junior tranches of two CDOs — Abacus 2006-13 and Abacus 2006-17 — at the expense of senior tranches.

That’s a practice virtually unheard of in CDO circles — and is extremely surprising given that one of the basic ideas of structured finance is to have clear and legally-binding payment waterfall structures. Holders of the A tranche get paid first out of available CDO cashflows, followed by the B tranche and then the equity tranche, etc. But the documentation for the two Abacus deals seems to have allowed the issuer (Goldman) to use its “sole discretion” to redeem the notes without regard to seniority.

The FT Alphaville article has a lot more in it. Keep an eye on this story, it’s fascinating. If only there was more financial literacy available to these people, perhaps they would have understood what they were signing. Or perhaps these contracts are in such a state that they are virtual handshakes and a wink, things that could read 12 different ways depending on how useful it is to cooperate at any moment.

The Crisis of Imprisonment

I don’t read anywhere near as much history as I’d like, and I realize that when I read something that is excellent. If the topic interests you, I’d highly recommend The Crisis of Imprisonment: Protest, Politics, and the Making of the American Penal State, 1776-1941.

The recent book, by Berkeley historian Rebecca McLennan, is a walk through the creation and evolution of the distinctly American penal state. It’s primary focus is on the massive, brutal yet profitable, prison labor industry that existed for much of the 19th century, and the struggle to reform it.

A few additional things:

Who Owns Financial Literacy?

I’m going to start blogging out a longer project I’m working on, one I really want your input for. One thing that I always hear from people across a wide range of the political spectrum is that we need more ‘financial literacy.’ In so much as there are products or practices out there that may be harming consumers, the best way to fight them is to make sure consumers are ‘financially literate.’ This is always something that is easy and good to say. Did you know that since 2003, when the subprime market really took off, April has been Financial Literacy Month? Now you do. But in an age where financial expertise seems so discredited what qualifies someone to be financially literate?

(I’m going to table the serious debate about whether financial literacy is a bad thing, and whether or not we should be, in law professor’s Lauren Willis provocatively titled paper, Against Financial Literacy Education. If we can’t even put our finger on what it is, it doesn’t make sense to be for or against it, much less to give it a lot of agency.)

Gatekeepers

One way to investigate this is to see who the academic gatekeepers are on this body of knowledge and see what they say. If you want to think critically about any subject, one looks for the departments where people with expertise study it, and see where the debates are. And one thing I notice about ‘financial literacy’ is that it doesn’t exist in economics. Or anywhere else.

California has been considering taking its one-semester required course in economics for high school graduation and splitting it with a personal finance class. A panicked high school economics teacher wrote to Greg Mankiw, and he responded on his blog:

I agree with this teacher that this law would be a step in the wrong direction. The legislation is akin to requiring high school biology teachers to spend half their class time on issues of personal health and nutrition. Personal finance is a useful life skill, but students need a more thorough grounding in other basic economic principles than what can be learned in the other half of a single semester course. They need a framework to think about such as topics as market outcomes, price controls, taxes, international trade, environmental regulation, monetary and fiscal policy, and so on. The goal of high school economics should be to produce not just smarter decision makers at a personal level but better informed voters on election day.

(For the David Harvey fans in the audience, please do note that the last sentence makes clear how much of a specific political project Mankiw considers this, akin to hypothetical Marxist English professors talking about “consciousness raising” their students.)

Time students spend in class is a scarce resource, and I’ll leave it up to you to decide whether or not it is a better idea to beat kids over the head with the idea of compounding interest versus getting them to mimic just enough calculus to reproduce the Slutsky equation on a test. But do note that an economist studying ‘personal finance’ is a subject akin to a biologist studying something that is not biology; it’s not within the discipline. I hear this from people within finance and economics PhD programs; one really can’t publish in this topic on personal finance, and since one can’t publish in it is doesn’t get researched. Given we are in an age where everything from voting to marriage to criminology has an economist doing a PhD in it, why is there little to no research in this realm? Some thoughts:

- Economics is more interested in representative households, households that can be aggregated to a macro level. Financial literacy involves dealing too much with heterogenous households to be modeled.
- There’s a normative part of this – how should a person manage their finances? – that the methodology, which studies actions and choices as given and reflecting deep preferences, can’t handle.
- There’s something that reeks of terrible remedial education in the subject, long boring lectures about how to read a paystub, or the gendered “home economics.”
- This isn’t just to single out economics; sociologists are much more likely to be concerned with the way consumption and financing gets embedded and performed within a fields and networks. A lot of that sadly ends up as a kind of David Brooks level of analysis in the broader culture (and I encourage Andrew Seal to continue his project of saving Bourdieu’s Distinction from glib readings!).

Who Fills The Gap?

I want to point out this excellent Mary Kane article in TWI, in which she talked about financial literacy groups and their connections to subprime lenders. What I want to note is the two professors quoted as experts who study consumer finance are professors in Family Studies and Consumer Affairs. They are doing excellent work in the field of financial literacy: but, and this is my high-level read on it that may be wrong, it seems to be something they do in addition to their proper studies and duties in their fields.

As there’s little academic backing, there’s no money for journals, research grants, conferences, the development of theory and expertise that is deployable into policy. That leaves the field wide open to be funded by credit card companies, subprime lenders, and others with a vested interest in certain modes of thought becoming the norm. And for expertise to be filled by people who come from motivational speaking backgrounds, and theory to end up as a mess of common-sense adages and low-level morality plays. The theme of Financial Literacy Month for 2008 was “Financial Responsibility Begins with Me”; why didn’t they call it “caveat emptor”?

Realizing this, Robert Shiller’s call for subsidized financial advice for the working and middle class seems like a good way to go, but the question remains: what would they advise?