The SEC has filed a civil complaint against Goldman Sachs alleging fraud (yes, the f-word) for synthesizing an asset backed security related to residential mortgage loans in 2007. It was done for one of Goldman’s prize clients — John Paulson’s hedge fund, which returned billions of dollars to partners as the wave of mortgages security downgrades and defaults broke (and according to some authors, alerted Goldman to looming problems in mortgage markets) – so that he could take a large short position in (i.e., sell) U.S. mortgage securities.
The rub is that every short seller requires a buyer. And the SEC complaint alleges that Goldman’s and others’ disclosures to buyers were not above board.
There are many, many angles to this story — reputational risk, the firm’s culture and political capital, effects on pending financial regulation, implications for other investment banks and certain hedge funds — the list goes on. We think there are two quick takeaways worth thinking about:
First, the episode illuminates the dark side of financial innovation. There are actually grounds in financial theory for defending creation of this type of product. But it’s apparent that such innovations create serious agency risks for the parties involved. And the SEC is alleging that Goldman did not manage those risks effectively.
Second, we can use the event to cast a different light on the idea of “too big to fail.” At least in this case, the problem appears to have been that Goldman was too big to conduct itself ethically. We’ll leave it to readers to debate whether “greedy” should be substituted for “big”. In the meantime, the market has been vomiting Goldman shares since the news broke.
IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. At the time of this writing, neither the firm nor its clients own shares of stock or any securities issued by Goldman Sachs. One of the firm’s principals owns shares of Goldman Sachs common stock.
Good column by Ron Rhoades on RIABiz.com, in which he predicts what types of financial reforms might come out of Congress in the current session. He echoes some concerns we’ve raised (emphasis added):
There are many parts of the overall financial services reform legislation that are incremental improvements over what we have today, and which should be supported. I hope the upcoming amendments will address “too big to fail” and reduce the perverse compensation incentives which tend to drive improper risk-taking activities.
I am deeply troubled, however, by the lack of oversight of all credit default swaps and other forms of derivatives. There are likely to remain many gaps in regulation which can continue to be exploited.
Additionally, much of the bill appears to fragment, rather than to consolidate, banking regulation. Regulation needs to be robust – to paraphrase James Madison, if securities industry participants were all angels, regulation would not be needed. But regulation also needs to be efficient. Our country cannot afford inefficient regulation of the same functional areas through duplicative, often over-lapping agencies.
This point, on disclosure as panacea, was particularly interesting, and lends some support to our call (and others’) for bringing basic financial education (legal might be a good idea too) into primary education:
The fundamental problem is that the SEC continues to emphasize disclosure above all else. While I support better disclosures of compensation practices and conflicts of interest, we must be realistic in what disclosure can accomplish. Disclosures are usually ineffective, as research into behavioral biases has demonstrated.
Today the financial world is far more complex for consumers than it was in 1940. Hence, disclosures utterly fail to overcome the huge “knowledge gap” between financial advisors and their clients.
A cynical take on Sen. Dodd’s financial regulatory reform bill by Matt Koppenheffer for Motley Fool:
We can probably point to plenty of regulatory failures in the lead-up to the financial crisis. But I hardly think that they’re regulatory failures stemming from lack of regulators. As Valukas noted in his report, regulators were swarming on Lehman well before its collapse…
It seems to me that the issue never was whether there were people trying to address the problem, but rather that they were trying to regulate on a fuzzy mandate of not letting something bad happen within the bounds of a very permissive system. For the same reason that we have speed limit signs posted in our residential neighborhoods, we need to give regulators a clearer, tougher set of standards that they can impose on financial companies.
First and foremost, those standards need to address the lunatic business model that Lehman Brothers — and, really, most of the big financial companies — was operating on at the time of its demise.
Specifically, Lehman was increasingly building up large, illiquid, proprietary investments while primarily financing itself through very short-term agreements. What it became was a massive, teetering Jenga game right smack in the middle of our financial system that could be toppled in the blink of an eye if it lost the confidence of major counterparties…
That last paragraph echoes a beautiful turn of phrase by Bill Bernstein in the most recent Financial Analysts Journal, in which he refers to ”leveraging so unstable that it could not survive the slightest of economic breezes, let alone a 100-year storm.”
Koppenheffer continues:
…the bill includes the Volcker Rule the way Cocoa Puffs include well-balanced nutrition. Little actually gets implemented in the text of the bill. Rather, specific regulations are supposed to come from a study on the rule’s potential impact. Not only is this likely to maximize the squishiness of the eventual rules, but it also gives lobbyists plenty of time to work their magic.
In the end, I don’t see the Fed folks as a bunch of incompetent bumblers. But when it comes to smothering the next Lehman, Fannie Mae…or AIG…I do think they’ll fail miserably because they’re being given a butter knife to regulate with when what they need is a buzzsaw.
A tangential riff: If we aren’t going to impose a hard, fast cap on leverage and other risky behaviors, then perhaps the power of network effects and private sector vigilance (vigilantism?) can help fill the gaps in our financial regulatory structure. For example, it seems reasonable to expect (OK, hope) that the next Harry Markopolos will be taken more seriously.
But when the issue is not fraud by a single market participant, but rather systemic levels of leverage and risk, then it seems unlikely that any kind of enforcement powers could be brought to bear if regulatory bodies haven’t purposefully enlisted private sector assistance beforehand.
As most of the country knows, the House of Representatives passed its latest version of healthcare reform yesterday, and emotions are running high on all sides as a result. Rep. Paul Ryan, a Republican from Wisconsin whom we sincerely admire, seemed to best embody his party’s core philosophical objections to the bill. Unfortunately, too many of the GOP’s arguments are stubbornly anachronistic and overly narrow. They don’t fully reflect the realities of healthcare, and they conveniently overlook the fact that we have had ‘socialized’ medicine in this country for quite some time – since Medicare and Medicaid became laws, and since the tax code and other regulations began to favor group insurance plans.
Our intent isn’t to cheer or take shots at either side. Instead, it’s to raise the level of discourse, something that neither party nor the press has done very well. With an issue as complicated and important as this one, political maturity is a must, and truth telling from leadership is absolutely vital. Unfortunately, Ryan’s speech was riddled with shallow thinking and empty slogans. Perhaps that suited its purpose, but it does little to move the debate or the electorate in constructive directions.
At 1:45 of the video:“Our founders got it right, when they wrote in the Declaration of Independence that our rights come from nature and nature’s God, not from government.”
For tens, perhaps hundreds of thousands of years, and in almost every part of the world, invoking divinity is how the powerful have justified their position (they still do in some parts of the world). So Jefferson may simply have been speaking the English monarchy’s language when he wrote that in the DOI.
More seriously, in today’s world, rational people ought to be able to agree that political rights are absolutely defined and managed by governments. The classical liberal principle of doing no harm to others is a great starting point, but the philosophical or religious beliefs that inform one’s political philosophy are not in and of themselves “rights”.
In fact, in a society of diverse religious and philosophical views, it’s absolutely vital that a government does just that.
1:57“Should we now subscribe to an ideology where government creates rights, is solely responsible for delivering these artificial rights, and then systematically rations these rights?”
Government does indeed create rights. It defined and allocated them in the Constitution without any mention of God as a source. And it has amended and reallocated them many times since. Calling them “artificial”, as in man made, is no more meaningful than the typical PETA slogan, or the idea that human creations, good and bad, are somehow ‘unnatural’.
And political institutions absolutely ration individual rights. They always have, all the way back to our hunting and gathering days, so it’s an idea that we really ought to be used to by now. The challenge is to hold governments accountable for doing it in a way that approaches some social optimum. That’s what the Constitution has done rather well over two centuries, and it’s something that modern political institutions have tended to become more adept at over time.
2:09 “Do we believe that the goal of government is to promote equal opportunity for all Americans to make the most of their lives? Or do we now believe that government’s role is to equalize the results of people’s lives?”
Long ago, the federal government enacted some stupid ideas on how to finance health care coverage. For generations, those ideas have benefitted employees of large corporations, unions, and public sector employees. They have been subsidized, either through higher premiums, greater personal risk, or less health care, by the self-employed and entrepreneurs (which may be why politicians always try to kiss their rear ends), as well as those who do not qualify for private insurance coverage, Medicare, or Medicaid. From the get go, these ideas have promoted INEQUALITY.
Healthcare reform is aimed, in part, at finally addressing this situation, a situation that has stood in stark contrast to the principle of equal opportunity. Over the years, the GOP has developed some good ideas on this issue, but in session after session, they utterly failed to do anything about it. They punted repeatedly until the situation got bad enough that the Dems were finally able to run the ball down their throat. Tua culpa, GOP.
Furthermore, this legislation can’t be said to seek equal outcomes, and Ryan surely most know that. It does seek to extend the social safety net, i.e., to redefine the acceptable minimum outcome in personal health care coverage. It also seeks to impose responsibility, in that everyone must chip in in some way. Personally, I don’t care for that kind of thing, and I know I’m not alone in that. Compulsory anything tends to rub Americans the wrong way.
Unfortunately, as long as there is Medicaid, and as long as health care costs of the uninsured are borne socially (via welfare or higher costs for others), it doesn’t make any sense to avoid a minimum level of buy in. It’s similar to having to carry liability coverage on your automobile, except that we are all physical bodies, and thus all have to participate.
If that really rubs you the wrong way, you have a few options:
Start working on the technology that will provide the bodily equivalent of mass transit and other alternative modes of transport.
Work to repeal Medicaid (why not Medicare while you’re at it?).
Move.
2:24“The philosophy advanced on this floor by this majority today is so paternalistic, and so arrogant. It’s condescending. And it tramples upon the principles that have made America so exceptional.”
Both parties have been guilty of arrogant, condescending paternalism throughout their history. I’m not sure what makes this bill so special. And if we look at the trajectory of American greatness, it’s hard to say that it’s based solely on founding principles (though they’ve certainly made it possible, along with plenty of luck).
Did the U.S. become more exceptional or less after the Progressive movement, the New Deal, and the Great Society? My point is not to sing the usual lefty praises for those episodes, but to point out that they do not seem to have undermined American exceptionalism at all.
3:18 “As we march towards this tipping point of dependency, we are also accelerating toward a debt crisis, a debt crisis that is the result of politicians of the past making promises we simply cannot afford to keep. Deja vu all over again…It’s unconscionable what we are leaving the next generation.”
First I’ll note my love for Yogi Berra quotes. Then I’ll reiterate that there is no U.S. debt crisis.
We do have entitlement and dependency issues to face as a society. But the federal budget is unlike any other budget in our country. It’s not like personal, household, business, or state and local government budgets. In the world, the only budgets that operate in a truly similar fashion are Japan’s and the United Kingdom’s (and in a far more constrained fashion, the European Monetary Union’s). Japan is about ten years ahead of us on the demographic curve, and its net public debt has reached levels that all the deficit hawks in the U.S. now shudder about. What happened? Nothing – no debt crisis, no threat of default, no crowding out. Nothing but a handful of downgrades from the credit rating agencies, and trading floors littered with the bodies of almost two decades worth of misguided hedge fund managers.
And the worst debt to GDP projections, even if we overlook the uncertainty involved in forecasting a decade or more, don’t reach any kind of level that justifies the prevailing deficit anxieties — not for a large modern economy with monopoly power over issuance of the currency used to pay interest on and retire its debts. Until people no longer want to accept dollars (and it’s easy enough for anyone to test out that hypothesis), the government can create more of them. In other words, unlike the rest of us, the only budget constraint faced by the federal government is the socially acceptable level of inflation.
Finally, without proper context, the ‘debt on the backs of our grandchildren’ meme is so much claptrap. If more debt now means better economic outcomes overall, then we are imposing severe opportunity costs on future generations if we do not run larger deficits.
That said, it may be true that health care reform does not represent a social investment with positive ROI. It may also be true that simply rectifying distortions and making the system fairer could have been accomplished with far less than what this bill contains. The electorate has a little over seven months to reflect on it before rendering its judgement in November, and as we’ve noted here and here, this issue deserves a lot more philosophical honesty than it’s been getting. It’s difficult, complicated stuff, with no right or wrong answers – only some as-yet-unknown social optimum, which our sometimes messy political processes are helping us grope our way towards.
A Georgia mother and her two daughters logged onto Facebook from mobile phones last weekend and wound up in a startling place: strangers’ accounts with full access to troves of private information.The glitch — the result of a routing problem at the family’s wireless carrier… — revealed a little known security flaw with far reaching implications for everyone on the Internet, not just Facebook users.
In each case, the Internet lost track of who was who, putting the women into the wrong accounts. It doesn’t appear the users could have done anything to stop it. The problem adds a dimension to researchers’ warnings that there are many ways online information — from mundane data to dark secrets — can go awry.
Several security experts said they had not heard of a case like this, in which the wrong person was shown a Web page whose user name and password had been entered by someone else. It’s not clear whether such episodes are rare or simply not reported. But experts said such flaws could occur on e-mail services, for instance, and that something similar could happen on a PC, not just a phone.
“The fact that it did happen is proof that it could potentially happen again and with something a lot more important than Facebook,” said Nathan Hamiel, founder of the Hexagon Security Group, a research organization.
In Newsweek, former Goldman Sachs CEO, Clinton Treasury Secretary, and Citigroup bigwig Robert Rubin offers his analysis of the Great Recession and proposed nostrums for preventing another:
Given my views as to the causes of the crisis, I would recommend the following:
There should be greatly increased capital and margin requirements for derivatives and other instruments of financial engineering to create a greater cushion when trouble develops and to reduce risk exposure. I developed this view during my many years of working with derivatives before entering government, as described in my 2003 book, In an Uncertain World.
Standard derivative contracts should trade on an exchange to increase transparency. Transactions that are custom designed would not be exchange traded but would be subject to the same capital and margin requirements as listed transactions. Disclosure requirements could be considered for customized transactions, to provide private counterparties and regulators with the transparency to understand the risks.
There should be two sets of more stringent leverage limitations for systemically significant institutions, one defined by risk-based models and the second by much simpler measures, since mathematical models can’t capture the full range of real-world possibilities.
There should be significant constraints on off-balance-sheet financing; for example, institutions must retain ownership of a portion of off-balance-sheet assets.
We need a change in accounting systems to avoid the artificial effects of mark-to-market accounting for illiquid assets on balance sheets and on markets. There are other accounting approaches that would better reflect long-run values for these assets.
We should also provide effective mechanisms for dealing with systemically important nonbank financial institutions—including bank holding companies—that get into trouble, to mitigate “too big to fail” concerns, but practical ways to do this need to be developed.
There should be greatly increased protections, both to safeguard consumers and to reduce systemic risk. The elements should include readily understandable disclosure, suitability requirements, prohibition of practices or instruments inherently susceptible to abuse, and, if some practical way can be found, personalized advice for the most vulnerable consumers.
Fair enough, mostly no brainers, but is Rubin being disingenuous? As we’ve previously written, there seem to be growing threats to to the man’s political capital, particularly within the Democratic party. And judging by this piece from Marshall Auerback, those threats still exist, and have intensified since 2006:
As one of the people whose policies threw the global economy off the rails, Rubin may be uniquely qualified to provide solutions as to how to get the economy back on track. But that would presuppose that the man actually acknowledged mistakes (as some of his other Goldman Sachs/Clinton Administration colleagues, such as Gary Gensler, have done) and displayed at least a marginal understanding of where he went wrong.
No such luck. We get the usual self-serving “nobody could have possibly predicted a crisis of this magnitude” right at the start…
Auerback cites a damning interview with the former head of the CFTC, Brooksley Born (a position now held by the aforementioned Gary Gensler):
…as analysts sort out the origins of what has become the worst financial crisis since the Great Depression, Born has emerged as a sort of modern-day Cassandra. Some people believe the debacle could have been averted or muted had Greenspan and others followed her advice.As chairperson of the CFTC, Born advocated reining in the huge and growing market for financial derivatives.
According to Auerback:
Rubin now suggests that Born’s problem was one of style, rather than substance: she, being “too confrontational”, risked aborting any politically feasible reform of OTC derivatives. That’s certainly an interesting reinterpretation of Rubin’s actual role as Treasury Secretary, during which he laid the groundwork for today’s crisis through an aggressive championing of financial deregulation. It’s hard to think of one instance where the former Goldman Sachs CEO actually came down hard on his former Wall Street colleagues. Had he at least acknowledged some remorse or recognition of error, he would be more appropriately suited for an advisory role on how to fix the global economy, much as a reformed criminal often has useful insights on penal reform.No such luck here. If being one of the worst Treasury Secretaries ever wasn’t enough, Rubin left another unfortunate legacy at Citigroup, where he was a senior advisor after he quit the Treasury. He left Citi just before its near collapse amidst criticism of his performance. A distinguishing moment of his tenure was when Rubin got hold of Peter Fisher in the US Treasury Department to try to put pressure on the bond-rating agencies to avoid downgrading Enron’ debt which was a debtor of Citigroup…
Letting him publicly expound on getting the global economy back on track is akin to providing Kim Il Jong-il a public platform on human rights. Unlike Greenspan, who at least admitted mistakes, Rubin expects to be taken seriously as a policy maker despite acknowledging zero responsibility for the debacle that threw millions of Americans into unemployment. People around the world have lost their jobs, savings, and more largely thanks to the policies championed by this misguided deficit warrior.
Ouch.
We’ll pile on by reminding people that as Treasury Secretary, Rubin presided over implementation of the “strong dollar” policy designed by his predecessor, Lloyd Bentsen, which had damaging effects on many developing nations’ economies. He’s also featured prominently in a recent list at Motley Fool of “The 10 Dumbest Banker Quotes of All Time”. And we agree with Auerback that a sincere mea culpa for past errors, whether at Treasury or Citigroup, would buy the man some badly needed goodwill. We think he should also expand his bullet points to include the following:
Let’s not repeat the mistake of believing that experts always know best.
Let’s agree that optimal outcomes often require more than just unbridled private actors.
Let’s resolve not to get caught up in any more cults of personality, whether adorer or adoree.
Update 01/07/2010 (via Mark Thoma) – Larry Summers, who is currently President Obama’s National Economic Council chief, and was Robert Rubin’s protege and eventual successor at the Clinton Treasury, also finds his political capital under attack from both the left and the right.
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I was quoted in an article about penny stock investing that our friend Jon Heller wrote for Bankrate.com back in August (I’m putting the link up now because we’ve resolved an editorial tussle with Bankrate’s staff over one of my quotes). You may remember that Jon interviewed us back in May regarding our investment philosophy and our active investment strategy, Symmetry Capital’s Opportunistic Portfolio.
Jon asked us to participate because we often purchase low priced shares of companies in the Opportunistic Portfolio. We do this because there are multiple structural and institutional inefficiencies that sometimes create attractive risk-reward situations among low priced securities. However, as all of the experts in Jon’s article point out, there’s a lot of risk and hard work involved in finding the handful of gems among the slag pile of penny stocks, as well as a number of con artists willing to prey upon people’s desire to get rich quick.
It’s a well written article with some good insights – highly recommended.
There’s a governance revolution afoot in the world. Beltway and other capital denizens should be careful to take notice.
We posted that claim in January 2007, and 2009 has provided some interesting evidence in support. Furor over lawmakers’ fringe benefits in the U.S. and the U.K. has been a recurring theme, and now we’ve learned of a story that flew below our radar until a segment on CNBC’s “Street Signs” today. Apparently, a bill has been proposed that would subject legislative activities to insider trading rules. The following description is from the website of co-author Rep. Brian Baird, D-WA (emphasis added):
Insider trading should be illegal on Capitol Hill. While that might seem like common sense to some, there is currently no legislation that prohibits Members of Congress or their staffs from enriching their portfolios with the nonpublic information they are able to glean from their day to day jobs.[On July 13, 2009] Congresswoman Louise M. Slaughter (D-NY-28) and Congressman Brian Baird (D-WA-03) took an important step to closing this loophole by testifying before the House Financial Services Committee about their legislation: the Stop Trading on Congressional Knowledge (STOCK) Act.When passed, the bill will make Members of Congress and their staffs subject to the same regulations that the general public is subject to.
“Members of Congress and their staffs should not be above the law when it comes to profiting from sensitive information.The American people expect their public servants to represent their interests, not fatten theair stock portfolios,” said Congressman Baird.“The STOCK Act is an important step to restore integrity and public trust in two institutions that badly need it: the financial industry and Congress.”
“This bill is about transparency and fairness,” Slaughter said. “As it stands today, neither Members of Congress nor their staff can be held legally accountable for making personal investment decisions based on non-public information.This bill changes that by opening those individuals up to be included under insider trading rules.”
This is fascinating stuff, and near and dear to our hearts — it captures the importance of legislative activities and the significance of agency risk in the political domain. As we’ve argued elsewhere, actions and expected actions in the public sphere — legislative changes regarding taxes, regulations, etc — can have powerful effects on asset values, and this idea is a key part of our investment process. There is also a novel but growing body of research regarding the the performance impact of privileged legislative information, and it was reported during the CNBC segment that sizable fees are paid to lobbyists and public sector employees by private investors (alleged to be primarily hedge funds) in order to obtain access to it. However, one thing that we really like about the Slaughter-Baird bill is that it focuses directly on the conduct of members of Congress, and does not try to lay most of the blame on private parties extending fistfuls of dollars.
Our philosophical position is that an investor can benefit by (1) understanding how significant a role government plays in investment returns and (2) making well grounded assessments regarding the course and consequences of public actions. But despite what we wrote in 2007, we did not hold out much hope that the outsized investment returns accruing to political insiders and/or their private sector contacts would become the focus of regulatory or legislative scrutiny this soon. We tended to agree with the pessimistic view expressed by James Surowiecki in 2005:
[The American people] don’t seem all that interested in doing much about it…Perhaps we want to keep the insider’s advantage intact because we all want to be inside. The choice is between a system in which people get rewarded for the work they do and a system in which people get rewarded for who they know or for what they’re lucky enough to stumble into. And in Washington today that’s no choice at all.
Thus, Reps. Slaughter and Baird’s bill is a welcome and courageous initiative, even if execution would involve some degree of wind mill tilting (more detail regarding the bill is available on Rep. Baird’s website). Of course, at this point it’s just a bill, and it was also reported on CNBC that there is little likelihood of it coming up for a vote any time soon. However, where Surowiecki’s quote would seem to direct most of the blame towards the American electorate, we wonder if legislators simply enjoy too great of an asymmetry in power and information at present — in which case, while we stand by our opening quote, we don’t think that substantive reforms are likely to arrive any time soon — unfortunately.
In the meantime, if this topic is of interest to you, here are some interesting reads:
An interesting op-ed ran in the WSJ last week. Authors Tom Hayes and Michael S. Malone argued that in a world of rapid and persistent change, time moves so fast that trust becomes ever more crucial:
Changes that used to take generations—economic cycles, cultural shifts, mass migrations, changes in the structures of families and institutions—now unfurl in a span of years…
Call it the advent of “the 10-year century”: a fast shuffle that stacks events which once took place in the course of a lifetime compressed into the duration of a childhood…
…when a computer chip goes through as many computations in a single second as there are human heartbeats in 10 lifetimes, a 10-year year century seems positively pokey. But we humans have a slower metabolism, which will make this rapid fire of events ever more difficult to comprehend, much less manage.
More disturbing, we have few safeguards—software shut-off switches, virus protections, firewalls, etc.—in place to check or repair our new global über-system when it misfires or goes completely off the rails…
So how do we control this increasingly out-of-control, interlinked world? Venture capitalist Bill Davidow has proposed the equivalent of online “surge protectors” to stop run-ups and panics on the Internet, the same way stock markets stop runaway trading. At the least we need better analytics to predict where change is taking us next.
Most importantly, trust will become the critical factor. Without the luxury of time, trust will be the new currency of our times, whether in news sources, economic systems, political figures, even spiritual leaders. As change accelerates, it will remain one true constant.
The authors are clearly on to something, and it’s an important dimension of the ‘Schumpeterian destruction’ of our age, an immensely powerful force that’s having significant and ongoing economic and social impacts.
One of our favorite books on the subject at hand is Building Trust: In Business, Politics, Relationships, and Life by Robert Solomon and Fernando Flores. Solomon and Flores have a strong grasp of the importance and potential value of trust, or more specifically, of the act and skill of trusting. It’s more of philosophical discourse than a how-to book — though the thinking they offer should increase one’s capacity to trust skillfully (which includes knowing when to mistrust!).
Extending from our post on Arthur Levitt’s non-binding vote of shareholders, we stumbled across three issues today from which we can draw some interesting parallels between corporations, financial services, and governments.
Levitt’s preferred method of dealing with executive compensation–through direct, non-binding shareholder approval–raised the issues of governance and agency risk, a topic that is close to our hearts. It is possible in corporations for executives and directors (agents) to enrich themselves at the expense of shareholders (principals), and it can be very difficult to detect this kind of malfeasance. Our qualified objection to Levitt’s recommendation was based on a recognition that non-binding shareholder votes and tightly controlled director elections do not provide shareholders with adequate control over their agents. It’s clear that much of the principal-agency risk in publicly traded firms arises from the fact that shareholder’s assets are almost continuously at the disposal of executives and directors. It’s also clear that a relatively closed network of executives and directors–ie, a network where shareholders are largely absent from the relevant conversations–amplifies the risk of misconduct.
An announcement that Vanguard was issuing some new exchange traded funds with an annual expense ratio of .11% reminded us that in the realm of financial services, many investors incur ongoing costs that they may not understand or be aware of. Vanguard has played a key role in creating awareness around this issue and forcing the industry to improve its overall value proposition. Nonetheless, in segments of the financial industry where the value proposition is still tilted away from the customer, it seems clear to us that much of the principal-agency risk in these segments arises from the fact that customer/investor assets are continuously under the control (to varying degrees) of brokers, advisors, money managers, etc., and that a relatively closed and traditional culture–where customers/investors have little or no control over price setting and are not typically involved in relevant conversations around value–lessens the impetus for adding greater value relative to costs incurred.
Finally, this Sen. Tom Coburn interview in the current issue of GQ (which we learned of from Don Luskin) inspired the observation at hand. Quoting from the article:
[Senator Coburn] wants you to know how it works in Washington, how the machine keeps itself running, and the favors get traded, and the deals get struck, and the bridges to nowhere are going up every day. He wants you to know that the United States Congress simply cannot stop itself—that both parties are in on the fix, backing each other and looking the other way, and that in the spirit of bipartisan waste, they manage to blow $500 billion more than they collect in taxes every single year. He wants you to see where that money is going: the 10,000 personal projects and earmarks that senators and congressmen are sneaking into the federal budget every year…
To put it in terms of the two examples above, the federal government is a hotbed of principal-agent risk because of its near continuous control over public assets*, a culture where agents enable mutual self-dealing, and the exclusion of taxpayers/voters from the most relevant conversations around policy and appropriations.
[Two side notes to the Coburn article: (1) We are skeptical of those who decry our public debt based solely on its level--it's very difficult, perhaps impossible, to quantify, but U.S. debt must be assessed like any other--how does it compare to total U.S. assets, some measure of equity, or expected cash flows? And is said debt invested productively, that is, in ways that will add marginally to U.S. assets, equity, and cash flows in the future? (2) We disagree that the USD's position on forex markets is a de facto measure of overextension of federal budget deficits; Senator Coburn would have to reconcile the USD slide with current long term interest rates to make his case; in our view, the exchange value of the USD is driven primarily by Federal Reserve behavior.]
Getting back to the thrust of this post, we have illustrated two key factors that indicate the level of risk in any principal-agent relationship: the degree of agent control over principal assets, and the degree of self-reinforcing behavior among agents. That said, we have to wonder which of the three examples cited above poses the highest level and degree of agency risk overall, and how the three compare at present. Private actors like Vanguard have done wonders for improving the ‘terms of trade’ in the financial services industry; activist investors are increasingly flexing their muscle in publicly held corporations, and executives are subject to rules and penalties imposed by Sarbanes-Oxley; meanwhile, Senator Coburn considers himself something of a lone voice in the wilderness.
There’s a governance revolution afoot in the world. Beltway and other capital denizens should be careful to take notice.
*Imagine if, instead of having access to the cash flowing through the Treasury from debt issuance, payroll tax withholding, quarterly tax filings, and other sources, our Congressional representatives had to present their constitutents with strategic investment plans, detailed budgets, and compensation and benefit plans for approval, and then request the required tax contributions.
News and Views | art April 16, 2010 | 
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