Category: Finance

Advice to Nasdaq and the NYSE: Cancel Only 90% of the “Erroneous” Trades

Nasdaq and the New York Stock Exchange have both announced that they will cancel many trades made during the temporary market meltdown between 2:40 and 3:00 last Thursday afternoon (see, for example, this story from Reuters). These “erroneous” trades include any that were executed at a price more than 60% away from their last trade as of 2:40.

The motivation for these cancellations is clear: a sudden absence of liquidity meant that many stocks (and exchange-traded funds) temporarily traded at anomalous prices that no rational investor would have accepted.

As several analysts have noted, however, canceling these trades creates perverse incentives. It rewards the careless and stupid, while penalizing the careful and smart. It protects market participants who naively expected that deep liquidity would always be there for them, while eliminating any benefits for the market participants who actually were willing to provide that liquidity in the midst of the turmoil.

Kid Dynamite has helpfully linked to several comments along these lines, as well as providing his own view:

Paul Kedrosky asks aloud: “why are we wiping out all the errant trades by runaway algorithms and market battle bots?”

David Merkel points out, emphasis mine: “NASDAQ should not have canceled the trades.  It ruins the incentives of market actors during a panic.  Set your programs so that they don’t so stupid things.  Don’t give them the idea that if they do something really stupid, there will be a do-over.”

And the Law of Unintended Consequences rears its ugly head again.  Merkel’s point is simple and accurate:  if buyers who step in later see their trades canceled, it removes all incentive for them to step in – and then you don’t get the bounce back that we saw!  Think about how much havoc it causes a trader who astutely bought cheap stock, then sold it out at a profit.  He’s now short!  Or, he spent the entire day wondering if his order would be canceled, in a state of limbo.  What’s the alternative – that traders should just assume that the orders will get canceled, and NOT buy stock?  Guess what – if no one buys, the stock stays cheap! SOMEONE has to buy, and that someone shouldn’t be penalized in favor of remedying the ignorance of the seller who screwed up.

I see merit in both sides of this argument. My economist side thinks people should be responsible for their actions and bear the costs and benefits accordingly. But my, er, human side sees merit in protecting people from trades that seem obviously erroneous.

What’s needed is a compromise–one that maintains good incentives for stock buyers and sellers, but provides protection against truly perverse outcomes.

Happily, the world of insurance has already taught us how to design such compromises: what we need is coinsurance. People have to have some skin in the game, otherwise they become too cavalier about costs and risks. That’s why your health insurance has co-pays and coinsurance. Those payments undermine the risk reduction that insurance provides, but for a very good reason; 100% insurance would make medical care free, and people act really weird when things are free. Even a little skin in the game gets people to pay attention to what they are doing.

So here is my proposal:  NYSE and Nasdaq should cancel only 90% of each erroneous trade. The other 10% should still stand.

If Jack the Algorithmic Trader sold 100,000 shares of Accenture for $1.00 last Thursday, he should be allowed to cancel 90,000 shares of that order. But the other 10,000 shares should stand–as a reminder to Jack (and his boss) of his error and as a reward to Jill the Better Algorithmic Trader who was willing to buy stocks in the midst of the confusion.

The Looming Budget Battle over the Bank Tax

Treasury Secretary Tim Geithner appeared before the Senate Finance Committee today to push the Administration’s proposal for a Financial Crisis Responsibility Fee, more commonly known as the Bank Tax. The purpose of the fee is to

[M]ake sure that the direct costs of TARP are paid for by the major financial institutions, not by the taxpayer.  Assessments on these institutions will be determined by the risks they pose to the financial system.  These risks, the combination of high levels of riskier assets and less stable sources of funding, were key contributors to the financial crisis.

The fee would be applied over a period of at least ten years, and set at a level to ensure that the costs of TARP do not add to our national debt.  One year ago we estimated those costs could exceed half a trillion dollars.  However, we have been successful in repairing the financial system at a fraction of those initial estimates. The estimated impact on the deficit varies from $109 billion according to CBO to $117 billion according to the Administration.  We anticipate that our fee would raise about $90 billion over 10 years, and believe it should stay in place longer, if necessary, to ensure that the cost of TARP is fully recouped.

As noted by other participants in today’s hearing, the bank tax raises a host of questions: Is it possible to design the tax so that it is ultimately paid by major financial institutions (by which I presume Geithner means their shareholders and top management), or will it get passed through to their customers? How much, if at all, would the tax reduce bank lending? Is it fair to target the banks even though the bank part of TARP actually made money for taxpayers? Would the tax reduce risks in the financial system?

Those are all interesting questions, but today I’d like to highlight another one: Can Congress embrace the idea of a bank tax that would be used to “ensure the costs of TARP do not add to our national debt”?

As described by the Administration, the bank tax would be used to reduce the deficit, thus offsetting budget costs of TARP. Congress, however, is hungry for revenues that it can use to offset the budget costs of new legislation, e.g., extending the ever popular research-and-experimentation tax credit or limiting the upcoming increase in dividend taxes. With PAYGO now the law of the land (for many legislative proposals), some members are looking at the $90 billion of potential bank tax revenues as the answer to their PAYGO prayers.

All of which points to a looming budget battle: Will the bank tax be used to pay off the costs of TARP, as the President has proposed, or will it be used to pay for other initiatives?

Greece, the Other PIIGS, and “The Chastening”

Several colleagues recently suggested that now is a propitious time to read (or re-read) Paul Blustein’s “The Chastening.” The book recounts how the International Monetary Fund (IMF) and the G-7 nations struggled to combat the Asian, Russian, and Latin American economic crises of the late 1990s.

Having read the book while flying back and forth across the nation, I heartily agree. The Chastening is a great read if you want to get up to speed on many of the issues now posed by the “PIIGS” (Portugal, Ireland, Italy, Greece, and Spain).

I particularly enjoyed (if that’s the right word) the number of characters, familiar from today’s Greece debacle, that appear in the book. For example:

* The government that used derivatives to hide its perilous financial situation (Thailand)

* The German leaders who denounced the moral hazard created by sovereign bailouts (most notably Hans Tietmeyer)

* The policymakers facing doubts (often well-founded) about whether assistance packages could really help or were just postponing the inevitable (and, in the meantime, bailing out some unsympathetic creditors).

With the benefit of ten years more hindsight, readers can also enjoy a certain “you ain’t seen nothing yet” thrill from passages about how scary the financial world looked during the crises of the late 1990s.

[Alan Greenspan the] Fed chief told the G-7 that in almost 50 years of watching the U.S. economy, he had never witnessed anything like the drying up of markets in the previous days and weeks. (p. 334)

Unfortunately, we were all in for even worse in less than a decade. And now Greece is following in many of the steps of Korea, Thailand, Indonesia, Russia, and Brazil.

A Useful Primer on Derivatives Regulation

Bob Litan of the Brookings Institution recently penned an excellent overview of the issues surrounding derivatives regulation, with a particular focus on credit default swaps (CDS). “The Derivative Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, and Other Interested Parties,” is really two pieces in one: a primer on derivatives policy and a warning about the power that a few firms now exercise over CDS markets.

Bob’s recommendations for reform (which I have numbered for convenience) are:

1. Induce or require “standardized” derivatives to be “cleared” on central clearinghouses rather than handled by dealers, acting on behalf of each of the parties (the buyer and seller) to these contracts.

2. Establish the conditions that will induce derivatives that are centrally cleared to be traded on exchanges or an equivalent transparent platform, as is now the case generally with stocks and futures contracts.

3. Ensure that adequate reserves – in the form of capital or margin – are held against all trades that are not centrally cleared.

4. Require the margin or collateral backing derivatives positions to be held either in segregated accounts or by third parties (such as a central clearinghouse) so that these funds cannot be co-mingled with other assets of dealers.

5. For derivatives that are both centrally cleared and traded on exchanges, regulators should ensure that the transaction prices and volumes of derivatives transactions are posted promptly on the equivalent of a “ticker” (post-trade transparency), while also ensuring that the prices at which buyers are willing to trade (the “bids”) and sellers willing to sell (the “asks”) are made public so that all parties, not just the dealers, know the state of the market at any given time (pre-trade transparency). I believe that a price ticker, or something close to it, should be in place even without central clearing and/or exchange trading.

Of course, much of the heavy lifting will be deciding which derivatives are “standardized.”

Financial Literacy and the Subprime Crisis

A new working paper from the Atlanta Fed identifies a key reason why some subprime mortgage borrowers have defaulted and some haven’t: differences in numerical ability (ht: Torsten S.).

In “Financial Literacy and Subprime Mortgage Delinquency,” Kristopher Gerardi, Lorenz Goette, and Stephan Meier examine how the financial literacy of individual subprime borrowers (as measured through a survey) relates to mortgage outcomes. They find a big effect:

Foreclosure starts are approximately two-thirds lower in the group with the highest measured level of numerical ability compared with the group with the lowest measured level. The result is robust to controlling for a broad set of sociodemographic variables and not driven by other aspects of cognitive ability or the characteristics of the mortgage contracts.

…

20 percent of the borrowers in the bottom quartile of our financial literacy index have experienced foreclosure, compared to only 5 percent of those in the top quartile. Furthermore, borrowers in the bottom quartile of the index are behind on their mortgage payments 25 percent of the time, while those in the top quartile are behind approximately 10 percent of the time.

Interestingly, this effect is not due to differences in the mortgages that borrowers selected (e.g., it’s not that the less-numerically-able chose systematically bad mortgages*) or obvious socioeconomic factors (e.g., it’s not that the less-numerically-able had lower incomes).

Instead it appears that the less-numerically-able are more likely to make financial mistakes once they have their mortgages. As the authors note, this conclusion is consistent with other studies that examine how financial literacy relates to saving and spending choices over time. All of which is further evidence of the potential benefits of better financial (and numerical) education.

* The authors note one caveat on the conclusion about mortgage terms: The survey covered “individuals between 1 and 2 years after their mortgage had been originated,” but many subprime defaults happened more quickly than that. As a result, their results don’t address whether financial literacy played a role in determining which borrowers ended up in mortgages that blew up very rapidly.

How Did Treasury Vote Its Citigroup Shares?

The United States Treasury is Citigroup’s largest common shareholder, owning 7.7 billion shares, or about 27% of the company. Which raised an interesting issue at today’s annual meeting: how should the Treasury vote its shares?

Treasury answered as follows:

As we have previously stated, Treasury is a reluctant shareholder in private companies and intends to dispose of its TARP investments as quickly as practicable.  When it acquired the Citigroup common shares, Treasury announced that it would retain the discretion to vote only on core shareholder issues, including the election of directors;  amendments to corporate charters or bylaws; mergers, liquidations and  substantial asset sales; and significant common stock issuances.  At the time of the exchange, Treasury agreed with Citigroup that it would vote on all other matters proportionately–that is, in the same proportion (for, against or abstain) as all other shares of the company’s stock are voted with respect to each such matter.  Treasury is abiding by the same principles in the few other companies in which it owns common shares, which are very few, as most TARP investments were in the form of nonvoting preferred stock.

Those sound like good principles. So how did Treasury actually vote?

Treasury voted FOR three ballot proposals:

  • 15 Nominees to the Board of Directors
  • To issue $1.7 billion of “common stock equivalents” to workers in lieu of cash incentive compensation (a way to conserve cash that Citi agreed to in a deal to repay some TARP money)
  • Reverse stock split

Treasury voted PROPORTIONALLY on the remaining proposals:

  • Ratify KPMG as the firm’s accountant
  • An increase in shares for a stock incentive plan
  • Executive compensation (nonbinding “say on pay”)
  • A “Tax Benefits Protection Plan” which discourages ownership changes that would reduce the value of Citi’s $46 billion in deferred tax assets
  • Six shareholder proposals covering such issues as corporate governance and political activity.

Treasury emphasizes that its proportional votes don’t mean it lacks an opinion on these proposals. Referring to two corporate governance proposals, for example, Treasury noted that it may have a policy preference but:

Treasury believes that it would be inappropriate to use its power as a shareholder to advance a position on matters of public policy and believes such issues should be decided by Congress, the SEC or through other proper governmental forums in a manner that applies generally to companies.  For this reason, and because voting on such matters was not necessary in order to fulfill its EESA responsibilities, Treasury refrained from exercising a discretionary vote.

Although Treasury expressed that view with respect to the corporate governance provisions, I can’t help but wonder what it felt about the “Tax Benefits Preservation Plan.”

You can see all the proposals in Citigroup’s proxy statement.

Disclosure: I own no Citigroup securities of any kind (see this post for a summary of my previous thoughts about Citi securities).

Microlending Comes to Washington

Banks continue to be reluctant to lend to small businesses. As a result, NPR reports (ht Ray), some small businesses are turning to a form of microlending. A case in point is Ryan Fochler, a pet care entrepreneur:

After being turned down by bank after bank, Fochler came across the Latino Economic Development Corporation, a nonprofit microlender based nearby in Washington, D.C.

Fochler is not Latino, but he was told that was OK. The LEDC works with all kinds of local businesses that have been turned down by traditional banks. Their goal is to help fledgling, independent businesses get on their feet.

They don’t operate exactly like microlenders in the developing world, some of which issue interest-free loans and let recipients repay whatever they can, whenever they can.

In contrast, American microlenders charge competitive interest rates, and the loans must be repaid on time. Defaulting on a microloan has the same consequences as defaulting on a bank loan.

The LEDC issues loans ranging from $500 to $50,000. Often in the past, those who came to the LEDC to apply for a microloan had little or no credit history.

But Rob Vickers, director of lending at the LEDC, says the profile of his average microloan applicant changed dramatically during the credit crisis.

“I was seeing clients that I couldn’t believe weren’t bankable coming in, and thinking, ‘Wow, this person has a credit score in the mid-700s, their business existed for more than two years, and yet, not only are they not able to obtain a bank loan, but they’re having their credit line slashed.'”

As noted, it isn’t exactly the same as the microlending made famous in developing economies. But it has some interesting similarities.

For more, read the transcript on which the NPR article is based.

Tax Loopholes, Wealth Destruction, and Health Reform

AT&T, Caterpillar, Deere, and Verizon garnered headlines last week (and an unwelcome summons to Capitol Hill) for announcing that a provision in the recent health care legislation would result in substantial accounting write downs. AT&T, for example, told the SEC that it expects to take a $1 billion charge in the first quarter because the law eliminates a tax subsidy for providing prescription drug coverage to retirees. According to the Wall Street Journal, Credit Suisse estimates that the total accounting hit for corporate America will total $4.5 billion.

Citing these impacts, a Wall Street Journal editorial denounced the provision as “a wholesale destruction of wealth and capital.” White House Press Secretary Robert Gibbs, in contrast, praised it as “closing a loophole.”

Who’s right?

To figure that out, I spent a lovely Saturday afternoon tracking through the intersection of health policy, tax policy, and financial accounting and emerged with a clear verdict: Gibbs is right. The provision does indeed close a tax loophole.

But the WSJ isn’t completely wrong. The first law of loopholes is that every loophole benefits someone. If you close a loophole, someone will be hurt. That’s what’s happening here. The extra subsidy for retiree prescription drug coverage provided an extra financial boost for AT&T, Caterpillar, et al. Eliminating the loophole will thus reduce the value of the companies and the wealth of their shareholders, just as the WSJ alleges. But it’s hard to get too teary-eyed since that value and wealth were created by the loophole in the first place.

And now to the details:

Continue reading “Tax Loopholes, Wealth Destruction, and Health Reform”

About that Government Takeover of the Student Loan Business …

Health care understandably dominated the headlines leading up to — and beyond — yesterday’s historic House vote. It’s important to remember, however, that the reconciliation legislation also includes major reforms in the way that the government supports student loans.

Under current law, federally supported loans are made both direct from the government and through private lenders. The government loans are direct loans (i.e., the government lends directly to students). The private loans are guaranteed by the government (i.e., private organizations lend to students and the government guarantees the lenders against the risk of default). The health/revenue/education legislation will eliminate the private lending channel. (The market for non-government private loans will continue to exist.)

Opponents have denounced this change as a government takeover of the student loan market. That makes for a great soundbite, but overlooks one key fact: the federal government took over this part of the student loan business a long time ago.

In a private lending market, you would expect lenders to make decisions about whom to lend to and what interest rates to charge. And in return, you would expect those lenders to bear the risks of borrowers defaulting. None of that happens in the market for guaranteed student loans. Instead, the federal government establishes who can qualify for these loans, what interest rates they will pay, and what interest rates the lenders will receive. And the government guarantees the lenders against almost all default risks.

In short, the government already controls all of the most important aspects of this part of the student loan business. The legislation just takes this a step further and cuts back on the role of private firms in the origination of these loans.

That step raises some interesting questions about the costs of the current system (see this post), possible benefits of the current system (some colleges and universities appear to prefer working with private lenders), and the potential budget savings of cutting out the middle man (which appear to be large but somewhat overstated in official budget analyses).

But it hardly constitutes a government takeover.

Good Charts from the ERP

Last week, the Council of Economic Advisers released its 2010 Economic Report of the President (ERP). I haven’t had time to read it yet, but I did take a quick spin through looking at the charts and getting a feel for it.

The first thing I noticed is that the folks at the CEA have made an important innovation: the ERP now includes references to the academic studies, government reports, etc. on which it bases some of its conclusions. That’s a welcome break from a long-standing tradition (which I never really understood) that the ERP didn’t include references.

A second useful innovation is that the ERP is available in eBook formats, including for my beloved Kindle. Not to add to their already enormous workload, but I look forward to the 2011 or 2012 version having dynamic graphics and live links to the references.

Here are some of the charts that I particularly liked:

1. The boom and bust of house prices. By this measure, house prices are still historically high–except for the bubble.

2. The declining role of banks in the financial sector. Note the growth of mutual funds and ABS issuers.

3. How rising health care costs may consume a rising share of employee compensation. (Note, however, that by setting the axis at $30,000 rather $0, the chart visually exaggerates the effect.)

4. How the rate of being uninsured varies with age.