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.

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.

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.

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:

1) Forced, unpaid prison labor contracted out to third parties was a very common element of the 19th century penal system. It was thought to be good for workers, and it allowed the prison industry to grow as the profits made by contracting out production of goods inside the prison to third parties, where businesses paid the state for use of the labor, almost paid for the prison itself.

It’s something whose footprint shows up in a lot of places I didn’t expect. Take The 13th Amendment: “Section 1. Neither slavery nor involuntary servitude, except as a punishment for crime whereof the party shall have been duly convicted, shall exist within the United States, or any place subject to their jurisdiction.” Note the exception that had to be made in 1865 that would still allow involuntary servitude for prisoners – I never caught that before!

2) It’s a book of history, but there are points where the late 19th century prison looks to be the forming ground for the ideal of the 20th century firm. One problem proto-industrialists in the 19th century had to deal with was that it was difficult to keep workers in place, consistently productive, on a timed schedule. They were always wanting more money or else they’d leave for other jobs! The prison certainly took care of that:

Under the conditions of labor scarcity and mobility that characterized Gilded Age economies, the industrialist worked his free laborers harder and longer, and disciplined them more stringently, at his own peril: His workers might simply move on. That dilemma was significantly relieved [in the prison] where the labor force was composed of a mass of perpetually confined, rightless, convicts. As John Sherwood Perry put it, in his typically direct manner, “(t)here is no intemperance, a minimum amount of sickness; there are no ‘Blue Mondays’, and no strikes.”

By extension, prison industries promised contractors a much higher degree of control over the pace and general process of production than was the case with waged workers in free industry. Wholly dependent upon the state for the bare necessities of life, and socially and physically confined, prisoners were not merely a steady source of cheap labor, but also an unorganized and highly exploitable body of workers – unlike their increasingly assertive counterparts in the free world. (p. 111)

Any theory of the firm that isn’t just about reducing transaction costs but is also about organizing the body through disciplinary mechanisms makes my eyes light up. How much is firm organization about creating a docile mass of bodies to manipulate, particularly when it comes to using an option of exit?

3) Torture was routinely used in these 19th century prisons to keep disorganization low and prison labor productivity high. Because of the specific times I live in, I always pay close attention to when an agent of the U.S. government drowns someone under his control in order to convince him to do something. Sometimes that thing is signing a confession or revealing information. Sometimes it is something else:

The keeper swiftly administered a massive shock to the victim’s central nervous system by plunging him into a large vat of ice-cold water…in the earliest days of its use, the prison physician reported that the victim was fastened into the stocks, which forced his head back, and then the keeper would “douche” him with ice-cold water….

Such extreme forms of chastisement were not as commonly resorted to as others; they appeared to have been reserved for prisoners who repeatedly, and flat-out, refused to work. One witness of a “bathing” in an Ohio prison noted that the prisoner was held down for some time, then allowed to breathe, and finally asked “whether he will consent to make bolts.” (p. 130)

The waterboard is deployable In Defense of Country, and In Defense of Industry as well.

4) Enter the progressives. One thing about this prison labor is that the prison wage rate is being set well below the standard free labor rate in local areas. The progressives complained. This is my new favorite thing:

In 1879, Massachusetts’ State Chief of Labor Statistics, Carroll D. Wright, submitted an exhaustive study not only of his own state’s prison labor practices, but those of the nation as a whole….[He] derided as “socialist” the demand of Massachusetts workingmen that the state fix the price of prison labor at the same level as that of free workers.

Woah! Did some proto-economist call out people complaining about the wages of prison labor not being set competitively as “socialist”? Is this the 19th century version of our time’s: “I’m not saying you are a socialist, I’m just saying that the suggestion that people who are waterboarded if they don’t make bolts aren’t getting a competitive bolt-making wage is the kind of suggestion a socialist would make”?

I almost didn’t believe it. Here’s something fantastic: we can actually pull that 1879 study up on google books. Here’s the Annual report of the Commissioner of Labor, Volume 1, 1879 (should go to page 329):

II. The prohibition by law of any contract for convict labor at lower rates per day than the average paid for outside labor of the same kind.

To secure legislation to this end petitions have been extensively circulated and signed…The socialist would hail such legislation with delight; for it would be in the direction of his demands that the state shall establish prices of labor and goods.

How wonderful is that “government takeover” scare quote? It’s just so wrong in this context it is amazing. It’s actually the opposite of what he means it to be – the government is establishing the price of labor by using force to undercut local markets, presumably making little bureaucrats running prisons a healthy kickback.

(Yes I can hear the first comment that is going to say that prison labor isn’t as marginally productive so the wage should be less. Luckily the 1879 document has an insane amount of statistics – here’s a snippet showing that prison labor was around 40% less productive, and here’s a snippet showing the wages being set at 60%+ lower rates. Seems like a sweet deal for businesses.)

All in all, a highly recommended book.

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?

Some excellent additional thoughts on the Dodd plan from Felix Salmon, Kevin Drum, and Ezra Klein.

Also – Daniel Indiviglio has been taking apart the bill piece by piece in several blog entries; he did a similar eight part series on the Frank bill – indexed here – that is worth the 10 minute read if you want to know the details at a fine level.

I don’t know if it’s practical for the Federal Reserve to not be involved in regulating Wall Street. I suppose you could end up with a situation where the single ““Financial Institutions Regulatory Administration” regulator works closely but separately with the New York Fed, but that seems unlikely to work in practice. The call for the banks not to pick the regulators of the regional Federal Reserve branches strikes me as a massive improvement though.

Yglesias had a post a while ago about crude measures with regulation:

But I think this is an important point — in just the areas where we’d most like effective regulation, we’re sort of unlikely to get it. If traders are likely to overestimate the effectiveness of their risk models, then regulators are prone to those exact same errors. Where does this leave us?

Brooks, I think, thinks it leaves us just as skeptical of regulation as we were before we took the behavioral turn. I think it arguably leaves us somewhere else. It leaves us with an appreciation of crude measures rather than hubristic efforts to get the regulations precisely right….

At the same time, this rule, for all its arbitrariness, has the virtues of being clear and largely self-implementing. It doesn’t depend on anyone’s discretion being used wisely or honestly, and it doesn’t depend on anyone’s calculations being right…The best you can hope from a regulatory regime is that it will be a satisficing solution wherein some fairly crude rule will improve on the outcomes generated by the unfettered market. When that’s not the case, we may as well let the market go unfettered even though that, too, will be somewhat sub-optimal. But at the same time when we’re looking at a regulatory regime that seems to be working okay, and the regulated parties start saying we need tweaks x and y and z and oh there’s no danger there we should be very suspicious. We shouldn’t count on being to fine-tune our results to perfection, we should either lean in with a heavy hand or else stay away.

Decisions are about tradeoffs, and I always watch for the tradeoff between satisficing solutions, hard rules that will be clear and harder to game but presumably sub-optimal, and solutions that allow for greater flexibility but require greater discretion and wise judgement on the part of regulators, and I tend to side with the first.

Once banks make it onto the To Big To Fail list in Frank’s plan, the Federal Reserve will handle them on a case-by-case basis, shifting them across a series of four ratings. It’s possible that they will use satisficing solutions in these cases; it is also possible that they will not. The FIRA will (from the document): “prescribe such regulations and guidelines, and issue such orders, as FIRA determines to be appropriate to carry out this title, and the powers, authorities, rights, and duties transferred to FIRA under this title”, so not much help there.

But if the rationale for the FIRA is to have a super-FDIC, or an FDIC with a larger charter, the regulation may fall on the clear rule side of the regulatory burden. Hopefully in the next week we’ll learn more about how the FIRA will be run.

[Just added: One UPDATE near end.]

Senate Banking Chairman Chris Dodd released his own financial reform legislation today (discussion draft here). It is similar to the House effort lead by Barney Frank and the White House’s own plan; where are the places to watch to see how they conflict, which is where a lot of the debate going forward will be?

How Many Regulators?

Under Barney Frank’s plan the Office of Thrift Supervision (OTS) will be taken apart, but the rest of the regulatory infrastructure will be kept in place. New powers to designate Too Big To Fail firms will be handled by a Financial Oversight Council, which is a group of all the leading regulators, and once designated, extra scrutiny and oversight of these firms will be handled by the Federal Reserve. How public this list of firms will be, and whether a firm on the list will likely be rewarded or penalized by the market, is up for a lot of debate.

Under Dodd’s plan, he would take all of the bank regulators and merge them into one single regulator called the “Financial Institutions Regulatory Administration.” There are roughly 4 regulatory agencies overseeing Federal banking currently, and this would reduce it to one. This is a development that seemed very unlikely 5 months ago – here’s Tyler Cowen thinking of reasons against consolidation (after the Obama administration signaled it wasn’t going to go down this route), and me arguing for consolidation.

As for Too Big To Fail: Dodd would create a “Agency for Financial Stability”, similar in some ways to Frank’s Financial Oversight Council. Some details:

b. This agency would identify systemic risks to the economy, promote market discipline, and respond to emerging risks.
c. It will have the power to require companies to face enhanced supervision.
d. It will also be able to write regulations setting risk-based capital, leverage, and liquidity requirements for larger companies.

When it comes to deciding who poses systemic risks the bills are similar; the big difference is in who enacts the increased supervision. Let’s say, as a hypothetical, that a large financial firm has piled into short tenor debt in such a way to leave them vulnerable to a bank run. In Frank’s plan, the Federal Reserve handles increasing capital reserves and other regulatory burdens; in Dodd’s plan the Agency itself handles it. So it is a shift away from giving the Federal Reserve more powers.

CFPA

The Consumer Financial Protection Agency goes through in a similar fashion to Frank’s plan. It’s worth noting that, as far as I read reports from DC, Senator Richard Shelby, the banking committee’s top Republican, and Dodd failed to reach a consensus over the CFPA and this is what is the major hurdle. It’s possible that they disagreed on a whole variety of items, but to hold up reform of the financial sector on this one point strikes me a necessitating a better rationale than what I’ve heard from the anti-CFPA side.

It is encouraging that this is here. Stopping this has been a rallying point for financial interests; it’s their version of a “public option” rallying point in co-ordinating a lot of different financial service industry interests. The U.S. Chamber of Commerce dumped $2 million+ dollars with a large campaign to kill this proposal – complete with a webpage with the subtle address of stopthecfpa.com, in case you didn’t know what their opinion was. Blue Dog Democrats, led by Melissa Bean and the New Democrat Coalition, tried to give this a serious run by weakening and watering down the language, but have been largely ineffectual. So some kudos are deserved to Frank and Dodd for keeping this alive as best they can, even if we are losing ideas like the vanilla option.

Funding Resolution

It appears that the costs of resolving large institutions will go to the surviving firms. From what I understand, like the original Frank plan, firms with over $10bn in assets will have to pay to clean up the costs of a failed TBTF bank after the fact. This is designed to encourage moral hazard; someone else has to clean up after you. Frank’s plan has changed to create a FDIC like fund for firms to pay into up front; it is likely that the Dodd plan, or whatever final version, will go a similar way.

This funding part is likely to be a central point of controversy. Here’s Adam Levitin (h/t):

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.

And this regularization problem scales terribly as the size of the institutions themselves grow, and any returns-to-scale numbers that can be found from the banking sector needs to be resolved against this.

Wider Net

The Dodd bill is strong in a lot of areas that the Frank bill doesn’t go. [UPDATE: The Frank Bill does include a version of each other these; Hedge Funds, Ratings Agencies and Compensation Reform. I'm curious about the differentials in the ratings agencies approach - Will the Dodd plan cement in the situation we have?]

- Hedge Funds worth over $100m will be required to register with the SEC.
- Creates an Office of Credit Ratings at the SEC, which will be tasked with enforcing higher levels of disclosure, and will maintain a right to deregister an agency. I haven’t heard many really great ideas for how to solve the problems with the credit rating agencies; there may not be a ‘there’ here in this bill, but hopefully this will allow a better solution down the road.
- Strengthening shareholder rights through requiring an independent compensation committee as a prerequisite for listing on an exchange. Requires polices for public companies that allow the clawback of executive pay if financial statements turn out to be inaccurate.

I’ll update this if it turns out my reading of the bill is incorrect, but I believe this is an accurate summary. It’s possible that this plan is purposefully strong up front so layers of it can be sliced off as the bill goes forward. Let’s hope it keeps the best parts. More as the week goes on and I get a better read.

Good news: It looks like a trial version of Dean Baker’s Right to Rent will be a go, carried out by Fannie Mae and called Deed for Lease. Daniel Indiviglio offers an overview and critique.

I wrote about this program back here. A few additional thoughts.

- There’s a question as to why are we setting this up? The CEPR put out a statement with one compelling example:

“This policy takes advantage of the fact that in many former bubble markets, ownership costs are likely to be far higher than the cost of renting an equivalent unit, if the homeowner purchased their home near the peak of the market. In many cases this gap can be dramatic. For example, the savings on a moderate-priced home purchased near the peak of the market in the Washington, DC area could more than $1,300 a month. The gap between ownership costs and renting in the Los Angeles area could be almost $2,000 a month.”

- There’s pretty robust empirical evidence that a foreclosure eats up ~28% of a house’s value in resale, and growing evidence that there is a significant, though relatively small, externality effect on neighbor’s houses. I don’t know the extent to which this externality would grow in a housing bubble crisis, though my suspicion is that it would bias towards a larger effect.

- Foreclosures are expected to to peak in late 2010. As such, this is a problem that will be growing for another year; new policy moves aren’t chasing the last problem.

- To whatever extent you can characterize a neighborhood by the amount of ‘order’ and ‘disorder’ it has, a worry for people moved by “broken-window” theories of crime, it is obvious that a massive wave of foreclosures would increase the amount of disorder a neighborhood has. If we are ok jailing a generation to save a window, why wouldn’t we ask some bond holders and property developers to take a haircut to save the whole house?

Though this predominately effects poor neighborhoods, this vacant, not maintained and otherwise abandoned property is everywhere, and will get worse next year. Here’s Noompa worrying that this winter will be particularly bad for this issue. Here’s a major piece on the abandonment in Cleveland. There’s a large amount of human devastation that will be coming with this wave; letting people stay in their homes with a decline in rental rates while keeping their communities intact will take some of this pressure off in the middle of a crisis.

- Daniel catches a problem: “The occupant agrees to be responsible for regular maintenance, to keep the property in good condition, and to permit marketing of the property for sale.” The obvious problem example is: Let’s assume that this winter, a Deed For Lease property has the heater break. Who fixes it? Presumably not the tenant, since he or she doesn’t want to invest in a home she doesn’t own. There’s also the reasonable assumption that the tenant is struggling financially, so the the person with the deed (Fannie in this case) will be responsible. Ideally, rolling this program out targeted at communities as opposed to random draws from the nation can overcome this; local groups can maintain these condos subject to competition for this service. We’ll see if that manages to work or not.

I hope a lot of eyes are watching this. Realizing the strengths and weaknesses of this program, tweaking where necessary, will hopefully lead to moving it forward into a larger framework.

I have some commentary on the new Too Big To Fail resolution bill going through the Financial Services up here at The Nation, you should check it out.

A few things I didn’t get the chance to bring up.

1) Steve Waldman has an overview of financial bloggers that met with the Treasury earlier in the week. It would have been interesting to see Steve tell Treasury officials “”I’ve read your bill, and it’s terrible – no offense…too big to fail is too stupid a criteria.” Heh.

2) I’m really encouraged by this:

Representative Paul Kanjorski said today regulators should get authority to dismantle firms, preventing them from getting so big their collapse would harm the financial system. He said he is coordinating with the European Union, which is forcing asset sales by state-aided banks to limit their advantage…

Senator Richard Shelby, the top Republican on the Senate Banking Committee, said today he liked the idea.

“I don’t think anything is too-big-to-fail,” said Shelby, of Alabama. “We ought to be looking at legislation to deal with a bank beforehand if we can, or an institution that would cause systemic risk, to make it stronger, or make it smaller.”

Like most, I’m conditioned to think that bills start off great and then it’s a matter of holding on against all hope that it doesn’t get too corrupted in the political process by the time it gets to be signed. Could it be that this part of the bill might do the opposite; starting off weak and getting stronger the more people add amendments to it? I wouldn’t even know how to process that.

3) I don’t address the the capital markets shadow banking system since that’s a headache to try and shoe-horn into a paragraph, but it’s important to watch where and how a liquidity backstop for this system will be created. I worry this ‘fund’ that the bill is trying to fund through fees on the largest banks will evolve into such a backstop, at least implicitly. And the only person credible enough to do that is ultimately the taxpayer.

4) I get the impression that, in realizing “Too Interconnected To Fail” isn’t necessarily the same as “Too Big To Fail”, some people are going too far in thinking that the first is the only problem, rather than them being two problems that amplify each other.

Check out Felix’s review of a Taleb paper, in which risks grow exponentially with size. I’ll unpack this more critically next week when we talk about the debate on ‘returns to scale’ in the financial sector, but step back for a second: How much would you trust a “living will” for an entity with $100 billion in assets? $1,000 billion? For the risk quants and/or financial lawyers out there, am I wrong to be skeptical that this “living will” for large institutions will look more like a Jackson Pollock painting than a coherent roadmap of how to unwind an institution when the time comes, especially in the middle of a crisis?

(cross posted. Check out the interesting comments there. I’m still curious as how differential fees could come about in terms of costs; anyone involved with mutual funds is welcome to comment or contact me off the record. I also just realized that my WRDS contract doesn’t include their awesome mutual fund database anymore; lame. Now that we are at the non-profit rortybomb blog I was going to smack you up with all kinds of conditional expense ratio graphs, but you get off lucky this Friday.)

On Monday, the Supreme Court heard arguments on the case of Harris Associates v. Jones. The plaintiffs are three shareholders in the Oakmark mutual fund family, while the defendant is Harris Associates LP, which manages the funds. The claim is that Oakmark charges excessive fees for its mutual fund — individual investors are charged roughly twice as much as institutional investors — and has violated the “fiduciary responsibility” set out for it by Congress.

As Simon Johnson and James Kwak point out, as the trial was working its way through the lower courts, a surprising argument broke out. Chief Judge Frank Easterbrook, siding with the mutual fund noted:

“Mutual funds come much closer to the model of atomistic competition than do most other markets…It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest…Harris Associates charges a lower percentage of assets to other clients, but this does not imply that it must be charging too much to the Oakmark funds. Different clients call for different commitments of time. Pension funds have low (and predictable) turnover of assets…In competition those joint costs are apportioned among paying customers according to their elasticity of demand, not according to any rule of equal treatment.”

An interesting dissent came from law and economics guru Judge Richard Posner:

“The panel bases its [decision] mainly on an economic analysis that is ripe for reexamination on the basis of growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation. . . . Competition in product and capital markets can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds. Mutual funds are a component of the financial services industry, where abuses have been rampant.”

So again, institutional investors investing in a mutual fund, say a pension fund bringing $50,000,000, secures a percentage fee rate half that of an individual bringing $25,000 to the fund. These fees are taken out of the amount invested every year regardless of performance. Let’s imagine a rate at 1.4% for the individual and a rate of 0.7% for the pension fund. They each put a $1 into the fund, and after 10 years of 8% returns (before fees), the individual has $1.87, and the pension fund has $2.01. After 30 years, the individual has $6.59, and the pension fund has $8.15. They were each in the same fund, facing the same market risks, but they have much different returns years later — so the stakes are high.

Judge Easterbrook takes an efficient market stance, and says since markets are working any differential has to be the result of characteristics of the individuals. It’s equally easy to conclude that someone who is bringing more money and more sophistication to the table, as the institutional investor does, can say “charge me the marginal cost of providing this service or I won’t buy” more credibly. Now that rate cascading down to the regular folks with $25,000 is what the efficient markets are supposed to do; that’s how a rising tide of informed investors raises the boats of all us regular noise traders who can’t dedicate our full time and our full knowledge to finance.

This is how it is supposed to happen in financial markets — smart investors bring the price of a financial instrument to its ‘true’ value, making a tidy profit, and then regular people can buy it at the correct value, increasing value for all. The disturbing implication is we have a situation where there are multiple equilibria; one for savvy insiders, and a worse one for people who aren’t finance professionals. Why aren’t these converging at mutual funds?

There’s a lot of talk about how competitive the mutual funds market is with its 8,000 funds — it is worth noting statistics from this abstraction of “How Does Size Affect Mutual Fund Behavior?” (Pollet/Wilson) “the largest quintile [20%] at the start of the decade controlled over 86% of all mutual fund assets…In comparison, the smallest quintile [controlled] only 0.27% of all mutual fund assets.” I’m not sure if this is a worrisome number, but it is worth noting that it is a top-heavy industry.

Now should the funds charge less for larger clients? There are fixed costs to adding a client: they have to mail you a summary, and the stamp costs the same for both. This is why for even straightforward index funds there are still minimums requirements to opening and maintaining an account. There’s a headache for people who flip funds quickly with hot money, which is why many funds charge a fee for those who withdraw money in a short term timeframe. So these don’t strike me as relevant reasons.

All the money should go to the same pool, but perhaps individual investors need to have greater liquidity, as they are more likely to leave the fund. I wonder how this actually plays out: the expectation from a 10% chance of the $25,000 client leaving a fund would be the same as a 0.005% chance of the $50m client leaving that same fund, so the liquidity arguments would strike me as more dangerous for the largest clients. Liquidity arguments are incredibly important for hedge funds and other leveraged strategy vehicles that involve pair-trading, less so for mutual funds.

There’s a vein in the mutual fund research that argues that funds have severe mean-regression as they get larger. It’s easier to make a higher profit with a clever idea with $25K than with $50m; you move the market too much with $50m and people take notice of the clever thing you are doing and replicate it, weakening it. Also see the Pollet/Wilson piece for another argument (changing strategies mid-stream to accommodate larger pools of money has its costs).

But perhaps there are internal numbers that work out that justify this differential of fees. If so, why aren’t the funds shouting them from the rooftops? In an age when individuals have had a lot of their financial risks shifted to them from institutions, where every single individual is expected to be a financial entrepreneur of his or her own future, the idea that individuals are getting hit with much larger fees than larger agents should worry all of us for our financial futures. Making sure that informed traders at the largest institutions are negotiating the price to its optimal setting for all of us, instead of for their insider status, is the definition of how the price mechanism is supposed to work, and can work if fiduciaries are allowed to take these differentials into account.