Capital Crime
A Brief History of Regulations Regarding Financial Markets in the United States: 1789 to 2009
Alejandro Komai & Gary Richardson
NBER Working Paper, September 2011
Abstract:
In the United States today, the system of financial regulation is complex and fragmented. Responsibility to regulate the financial services industry is split between about a dozen federal agencies, hundreds of state agencies, and numerous industry-sponsored self-governing associations. Regulatory jurisdictions often overlap, so that most financial firms report to multiple regulators, but gaps exist in the supervisory structure, so that some firms report to few, and at times, no regulator. The overlapping jumble of standards, laws, and federal, state, and private jurisdictions can confuse even the most sophisticated student of the system. This article explains how that confusion arose. The story begins with the Constitutional Convention and the foundation of our nation. Our founding fathers fragmented authority over financial markets between federal and state governments. That legacy survives today, complicating efforts to create a financial system that can function effectively during the twenty-first century.
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Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis
Julia Lees Allen
Stanford Law Review, forthcoming
Abstract:
This Note analyzes the effectiveness of derivatives clearinghouses in decreasing systemic risk upon a counterparty default. The analysis first explains how a derivatives clearinghouse can successfully reduce systemic risk by analyzing LCH.Clearnet's management of the Lehman default in 2008. Next, the analysis demonstrates that if a clearinghouse could not manage a default and became insolvent, systemic risk would greatly increase. Rather than containing the impact of a counterparty default, an insolvent clearinghouse would enhance systemic risk because the two existing resolution regimes, including the Bankruptcy Code and Dodd-Frank Orderly Liquidation Authority, could not successfully unwind the institution. The primary contribution of the Note is identifying that an insolvent derivatives clearinghouse creates an unsolvable problem with respect to resolution: untangling the derivatives trades will inevitably take more than a day, but if sorting out the portfolios takes even a few days, clearing members will start a run on the clearinghouse. The resulting enhanced systemic risk would necessitate government intervention. A major derivatives clearinghouse would be too big to fail. Accordingly, this Note proposes two recommendations to ensure that derivatives clearinghouses effectively reduce systemic risk: (1) regulators should minimize the risk of clearinghouse insolvency through strict collateral, capital, and default management requirements, and (2) create an ex ante guarantee fund to serve as a government backstop and provide liquidity to an insolvent derivatives clearinghouse, thereby avoiding enhanced systemic risk.
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Income Dynamics, Economic Rents, and the Financialization of the U.S. Economy
Donald Tomaskovic-Devey & Ken-Hou Lin
American Sociological Review, August 2011, Pages 538-559
Abstract:
The 2008 collapse of the world financial system, while proximately linked to the housing bubble and risk-laden mortgage backed securities, was a consequence of the financialization of the U.S. economy since the 1970s. This article examines the institutional and income dynamics associated with the financialization of the U.S. economy, advancing a sociological explanation of income shifts into the finance sector. Complementary developments include banking deregulation, finance industry concentration, increased size and scope of institutional investors, the shareholder value movement, and dominance of the neoliberal policy model. As a result, we estimate that between 5.8 and 6.6 trillion dollars were transferred to the finance sector since 1980. We conclude that understanding inequality dynamics requires attention to market institutions and politics.
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A New Capital Regulation for Large Financial Institutions
Oliver Hart & Luigi Zingales
American Law and Economics Review, forthcoming
Abstract:
We design a new capital requirement for large financial institutions (LFIs) that are "too big to fail." Our mechanism mimics the operation of margin accounts. To ensure LFIs do not default on systemically relevant obligations, we require that they maintain a cushion of equity and junior long-term debt sufficiently great that the credit default swap (CDS) price on the long-term debt stays below a threshold level. If the CDS price moves above the threshold, either LFIs issue equity to bring it down or the regulator intervenes. This mechanism ensures that LFIs are always solvent, while preserving some of the benefits of debt.
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Government Ownership of Banks, Institutions and Economic Growth
Svetlana Andrianova, Panicos Demetriades & Anja Shortland
Economica, forthcoming
Abstract:
We present new cross-country evidence that reveals that during 1995-2007, government ownership of banks has been robustly associated with higher long-run growth rates. We also show that previous results suggesting that government ownership of banks is associated with lower long-run growth rates are not robust to conditioning on more 'fundamental' determinants of economic growth.
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Steven Davis et al.
NBER Working Paper, September 2011
Abstract:
Private equity critics claim that leveraged buyouts bring huge job losses. To investigate this claim, we construct and analyze a new dataset that covers U.S. private equity transactions from 1980 to 2005. We track 3,200 target firms and their 150,000 establishments before and after acquisition, comparing outcomes to controls similar in terms of industry, size, age, and prior growth. Relative to controls, employment at target establishments declines 3 percent over two years post buyout and 6 percent over five years. The job losses are concentrated among public-to-private buyouts, and transactions involving firms in the service and retail sectors. But target firms also create more new jobs at new establishments, and they acquire and divest establishments more rapidly. When we consider these additional adjustment margins, net relative job losses at target firms are less than 1 percent of initial employment. In contrast, the sum of gross job creation and destruction at target firms exceeds that of controls by 13 percent of employment over two years. In short, private equity buyouts catalyze the creative destruction process in the labor market, with only a modest net impact on employment. The creative destruction response mainly involves a more rapid reallocation of jobs across establishments within target firms.
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Yongjing (Eugene) Zhang
Public Choice, forthcoming
Abstract:
The following study, integrating public choice theory and evolutionary game theory, develops a predator-prey model with intelligent design to explain the "evolutionary-institutional perspective" that is a well-accepted premise in transitional economics. In the model, growth-oriented central government leaders are intelligent designers of institutional change, provincial and local officials are potential predators, and private firms are potential prey. The model finds that reductions in discriminatory policies are the major institutional contributors to China's market miracle, whereas improvements in the rule of law and in the protection of private property rights are not needed for short-run economic growth.
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The Sarbanes-Oxley Act and the Choice of Bond Market by Foreign Firms
Yu Gao
Journal of Accounting Research, September 2011, Pages 933-968
Abstract:
This paper examines the economic impact of the Sarbanes-Oxley Act (SOX) by studying foreign firms' choice of whether to issue bonds in the U.S. public bond market or elsewhere before and after the law's enactment in 2002. After controlling for firm characteristics, bond features, home-country attributes, and market conditions, I find that foreign firms rely less on the U.S. public bond market after SOX. Additionally, some determinants of choosing the U.S. public bond market have changed since the passage of SOX: firms listing equities on U.S. stock exchanges, adopting International Financial Reporting Standards (IFRS), and doing large bond issuances are more likely to choose this market in the post-SOX period than in the pre-SOX period. Overall, these results are consistent with a shift in the expected costs and benefits of choosing the U.S. public bond market following SOX. This paper provides the first evidence about how SOX influences debt financing decisions and alters capital flows across international bond markets.
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Gene Amromin et al.
NBER Working Paper, August 2011
Abstract:
We investigate the characteristics and the default behavior of households who take out complex mortgages. Unlike traditional fixed rate or adjustable rate mortgages, complex mortgages are not fully amortizing and enable households to postpone loan repayment. We find that complex mortgages are used by sophisticated households with high income levels and prime credit scores, in contrast to the low income population targeted by subprime mortgages. Complex mortgage borrowers have significantly higher delinquency rates than traditional mortgage borrowers even after controlling for leverage, payment resets, and other household and loan characteristics. The difference in the delinquency rates between complex and traditional borrowers increases with measures of financial sophistication and leverage, suggesting that complex borrowers are more strategic in their default decisions than traditional borrowers.
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To err is human: US rating agencies and the interwar foreign government debt crisis
Marc Flandreau, Norbert Gaillard & Frank Packer
European Review of Economic History, December 2011, Pages 495-538
Abstract:
This article provides a new perspective on the interwar foreign debt crisis by analysing original data on the credit ratings, market yields and subsequent performance of government borrowers in the New York market. We focus on the four agencies that are known to have been operating at the time (Fitch, Moody's, Poor's and Standard Statistics). We provide a description of the rise of the market for grades and gather information on the products sold, price schedules, etc. We find that rating agencies did exhibit features similar to those that have attracted considerable interest recently: namely, they did not react until the crisis had already begun and then implemented massive downgrades. We conclude by suggesting that, given the less than stellar record of the agencies, their emergence in the 1930s as a regulatory tool will have to be explained in future research.
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Vicarious Liability for Bad Corporate Governance: Are We Wrong about 10b-5?
James Spindler
American Law and Economics Review, forthcoming
Abstract:
I formulate a rational expectations signaling model of vicarious liability for securities fraud, particularly the much criticized "fraud-on-the-market" private class action arising under Rule 10b-5. I show that fraudulent misreporting by managers occurs in the absence of managerial moral hazard - that is, where managers simply maximize shareholder payoffs - and that vicarious liability can serve as an appropriate deterrent, creating separating equilibrium. I then show that the particular remedy under Rule 10b-5 can perfectly deter fraud and perfectly compensate purchasers, and that Rule 10b-5 class actions may function better than critics claim.
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The Bear's Lair: Index Credit Default Swaps and the Subprime Mortgage Crisis
Richard Stanton & Nancy Wallace
Review of Financial Studies, October 2011, Pages 3250-3280
Abstract:
During the recent financial crisis, ABX.HE index credit default swaps (CDS) on baskets of mortgage-backed securities were a benchmark widely used by financial institutions to mark their subprime mortgage portfolios to market. However, we find that prices for the AAA ABX.HE index CDS during the crisis were inconsistent with any reasonable assumption for mortgage default rates, and that these price changes are only weakly correlated with observed changes in the credit performance of the underlying loans in the index, casting serious doubt on the suitability of these CDS as valuation benchmarks. We also find that the AAA ABX.HE index CDS price changes are related to short-sale activity for publicly traded investment banks with significant mortgage market exposure. This suggests that capital constraints, limiting the supply of mortgage-bond insurance, may be playing a role here similar to that identified by Froot (2001) in the market for catastrophe insurance.