July 22, 2008 11:31

President Bush says Wall Street got drunk. Anyone care to disagree?

Wall Street got drunk, it got drunk (it’s one of the reasons I asked you to turn off your tv cameras.) It got drunk and now it’s got a hangover. The question is how long will it sober up, and not try to do all these fancy financial instruments.

And now we got a housing issue, not in Houston, and evidently, not in Dallas, because Laura was over there trying to buy a house today.

Can't really quibble with any of that. Not everyone turned off their video cameras, of course. So you can watch it here.

July 22, 2008 2:37

The social responsibility of business is ... what again?

I wrote this for the Creative Capitalism project that Conor Clarke and Michael Kinsley are organizing. And I'm reposting it here because recycling is a really important aspect of creative capitalism:

There's already been ample discussion here of Milton Friedman's famous argument that "The Social Responsibility of Business is to Increase Its Profits." But I haven't seen any explicit mention of the possibly even more influential academic paper inspired by Friedman's essay: Jensen's and Meckling's 1976 "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure."

I'm guessing that's because Jensen-Meckling is mostly a business-school phenomenon, and there don't seem to be a lot of business-school types involved in this effort just yet. I'm not a business-school type, but I am working on a book in which Jensen plays a major role. So here's a quick history: Michael Jensen was a young finance professor at the University of Rochester's business school, William Meckling was the dean. Jensen had recently earned a doctorate at Chicago's business school, where he'd been a core member of the group of students and faculty who formulated and amassed evidence to support the efficient market hypothesis, the theory that stock prices "fully reflect available information"--or, as one of Jensen's Rochester colleagues liked to put it, "the price is right." Meckling was a former Chicago economics graduate student of Friedman's (he never got around to getting his Ph.D, but seemed to do just fine without it).

Jensen and Meckling read Friedman's piece in the New York Times Magazine in 1970, thought it was swell, and decided to translate it into the mathematical language of economics. In doing so they quickly realized that while Friedman had written of corporate executives as "agents" who were supposed to look out for the interests of their "principals," the owners, those agents faced all sorts of economic incentives to behave otherwise. To put it most simply, if it was in the interest of the owners for the CEO to shut down the company and put himself out of a job, what CEO in his right mind would do that?

It wasn't enough just to argue, as Friedman had, that it was executives' job to maximize profits. You had to address the reality that they might not want to do so. Or that, even if they did, there remained the question of which profits: This year's? Next year's? Those 15 years down the road?

Jensen and Meckling looked to the efficient market for help. Weighing future vs. present profits was one of the main things the stock market did. And by monitoring the behavior of agents, and punishing value destroyers with lower share prices, financial markets provided an element of discipline that was otherwise lacking.

Figuring out how to get executives to pay attention to this verdict of the market became the focus of Jensen's career. He moved on to Harvard Business School, where he became the most prominent academic advocate of leveraged buyouts (what we now call private equity), because high indebtedness was supposed to force executives to focus on what mattered. And a few years later he became the most prominent advocate of linking executive pay to stock performance, because that was supposed to incent executives to focus on what mattered.

Without this kind of single-minded focus, the argument went, executives would be tempted to steer resources in directions that chiefly benefited themselves. You don't have to share Jensen's enthusiasm for financial markets to acknowledge that there's at least something to this: As Larry Summers wrote here the other day, "Inherent in the multiple objectives urged for creative capitalists is a loss of accountability with respect to performance."

But as Jensen's approach rose to dominance in the 1990s under the slogan "shareholder value," it became clear that relying on the stock market to enforce accountability wasn't the complete answer either. Stock prices are subject to mood swings and occasional manipulation, rendering them a less than perfect measure of corporate success. Executives out to maximize their stock price can and have destroyed their companies in the process.

Jensen now acknowledges this, and is trying to incorporate what he calls integrity into his concept of how organizations ought to work. Other people have different ideas. But it seems to me that any discussion of the purpose of corporations needs to address the vexing dilemma that:

1) Having multiple organizational goals can be a recipe for underperformance and waste,

but

2) Focusing exclusively on a single, simple goal like profit maximization or shareholder value can lead an organization terribly astray.

July 22, 2008 11:25

Can Paulson really do anything about 'too big to fail'?

Hank Paulson's Build-Confidence-Without-Saying-Anything-That-Will-Sound-Dimwittedly-Pollyannaish-a-Year-From-Now Tour continued with a speech in New York this morning. It's actually pretty good, as these things go. But this paragraph struck me as problematic:

Looking beyond today's market challenges, we need to get to the point where large, complex financial institutions are not perceived to be too big or too interconnected to fail. Essential to this objective is improved market infrastructure and operating practices to increase transparency and efficiency, especially in the OTC derivatives market and the tri-party repo system. Improved infrastructure will add to market stability and mitigate the likelihood that a failing institution can spur a systemic event. We also need additional powers to manage the resolution, or wind-down, of large non-depository financial institutions, such as larger hedge funds, so as to limit the impact of a failure on the broader financial system.

Great, in theory. But the reality in a downturn like this is that big financial institutions get bigger as they, with encouragement from regulators, acquire troubled competitors (as JP Morgan Chase and Bank of America have done this year). Meaning that they're even more likely to be "perceived to be too big or too interconnected to fail" in the future, right?

July 22, 2008 10:12

The CBO estimates the cost of the Fannie-Freddie backstop: Only $25 billion, but ...

The Congressional Budget Office has just issued its estimate of the likely cost of Hank Paulson's plan to let troubled mortgage giants Fannie Mae and Freddie Mac draw on a Treasury credit line (that is, borrow money from taxpayers). The verdict: $25 billion.

This is what the CBO calls "probability-weighted average" of the different potential outcomes. Its economists estimate that there's more than a 50% chance that Fannie and Freddie will be fine and won't need a cent, and almost a 5% chance that losses would total more than $100 billion. It should be added that don't really know that this is the probability distribution. Rating agencies and others thinking they knew the probability of mortgage defaults when they didn't are a large part of what got us into this problem. But you've got to make some sort of estimate or you're completely groping in the dark.

Finally, CBO director Peter Orszag notes that:

a strong argument can be made that if the Treasury used the proposed authority, the GSEs’ operations should be incorporated directly into the federal budget.

Fannie's and Freddie's "book of business"--that is, their assets plus the mortgage securities they've guaranteed--adds up to about $5.2 trillion. The U.S. government's current external debt is $5.3 trillion. Incorporate the GSEs into the budget, and you double of the debt.

Except that it's not quite the same kind of debt. The Fanniefreddieplex's $5.2 trillion is backed by lots of valuable collateral; the government's $5.3 billion is a direct claim on future tax revenue (I mean, I guess we could sell the Capitol or Fort Knox to raise money, too, but that's not really the plan). That mortgage collateral may be worth slightly less than $5.2 trillion at the moment. But it's never going to zero, or anywhere near.