Look Out Below

The Wall Street Journal wrote a story today on the signs that deflation might be on the horizon for Spain and other Euro Zone countries:

Spain became the first country using the euro to post an annual decline in consumer prices in the current slowdown, underlining concerns about the potential for deflation in parts of Europe, as an important research institution reported that the entire euro zone has been in recession since January 2008 -- just a month after the U.S.

You might wonder why people worry about deflation. Lower prices seem pretty good, right? Not quite.

A deflationary economy contains too many goods and too little money. To adjust, prices fall, meaning every dollar you have can buy more stuff. In other words, in Year X $1=1 apple, but in Year Y, with deflation, $1=1.1 apples.

Although this seems good, it can be disastrous for an economy. If you know that your money will have more purchasing power in the future, you will have an incentive to hold onto it instead of spending. When everyone in an economy does hoards cash instead of spending, its contracts the overall demand for goods, which leads firms to fire workers, which further contracts demand for goods, which leads more firms to fire workers, and so on. A classic deflationary spiral.

Deflation also increases the burden on people with outstanding debt, because if you have a fixed-rate interest payment, it remains the same, while the money you use to pay it is worth more. Let's say you have a 7% car lease that costs you $500/month Year X. Even with deflation, it will cost you $500/month in Year Y. But, whereas that $500 was only worth 500 apples in Year X, it's worth 550 apples in Year Y. The actual dollar amount of the payment remains the same, but it's really costing you more*.

So although falling prices might seem good for your pocketbook, somewhat counter-intuitively, they would actually be terrible for this economy.

* If you want to know the math behind this, just take a look at Fischer's equation, which tells us that the Nominal Interest Rate = Real Interest Rate+Inflation Rate. Using algebra, we can show that the Nominal Interest Rate-Inflation Rate=Real Rate of Interest. Therefore when the the inflation rate is negative (which it is under deflation), we will actually get a higher real interest rate.

Blaming BSchools

As a graduate of a business school myself, I've taken great interest in reading about the current crisis will shape how these educational institutions operate. However, I've had some problems with how I've seen the story approached.

First, I'm pretty sure I remember seeing a few of stories that imply that focusing on shareholder value encourages managers to make immoral decisions that harm society. To most people, I'm sure, that vague concept of shareholder value does conjure images of a company fattening its profit margins by destroying rainforests and exploiting foreign workers. But the situation is really much more complex.

Let's take, for instance, the case of a company that wants to tear down an historic building for a new factory. Management expects the plant will be wildly profitable, but locals have been protesting the demolition of the existing structure. Manager A might indeed forge ahead, salivating at the double-digit profit margins he expects the factory will produce. But Manager B might not, realizing that the bad press, boycotts and lawsuit that will no doubt ensue will cut into those profits and lead to a loss. Contrary to the typical characterization of the term, the company would actually maximize shareholder value by NOT building the factory.

I argue that part of the crisis is actually attributable to the fact that management didn't focus enough on maximizing long-term shareholder value. Instead, as has been well documented, bankers and traders at Wall Street banks enriched themselves at the expense of shareholders thanks to a bonus system that encouraged short-terms gains. They reaped rewards creating and investing in products that have led to billions in shareholders losses in the long-term. A quick look at the stock charts tells you that, if anything, these people have minimized shareholder value.

And I'm not sure there is an easy fix to that selfish behavior. Business schools are obviously going to attract people that want to make money. Not all these people are bad people, but for the ones that are, taking an ethics class or two, as some have suggested, isn't going to stop them from making self-serving decisions in the future.

That said, there are parts of the business school curriculum that must be reassessed. Schools continue to teach the financial theories responsible for the Crash of 1987, the downfall of Long-Term Capital Management and the current crisis. As Nassim Taleb -- one of the most vocal critics of business schools* -- points out, for some reason, people still take the word of people like Nobel Prize winner Myron Scholes as gospel despite his role developing the theories that have gotten us into the mess we're in:

First, [Taleb] says, we have to unmask the charlatans of risk like Myron Scholes. To Taleb, Scholes is the Great Oz in this Emerald City because his work on options and derivatives allowed the whole of the financial system to adopt poorly understood products-like the ones that brought AIG down-that hide risk. To Taleb, Scholes' academic work, which enabled the widespread use of complex derivatives, was like "giving children dynamite."
"This guy should be in a retirement home doing Sudoku," Taleb says. "His funds have blown up twice. He shouldn't be allowed in Washington to lecture anyone on risk."

To me, schools continuing to teach these theories seem like a much bigger issue.

* Here's a sample from Fortune:

I worked on Wall Street for close to two decades in trading and risk management of derivatives. I noticed that while portfolio models got worse and worse in tracking reality, their use kept increasing as if nothing was happening. Why? Because in the past 15 years business schools accelerated their teaching of portfolio theory as a replacement for our experiences. It looks like science, and they have been brainwashing more than 100,000 students a year. There is no way my experiences can be transmitted to the next generation because of these schools. We've had fiascoes in finance that they need to neglect because they contradict their models. The problem may also be the Nobel in economics that gave a stamp to these junky theories. Someone needs to make the Nobel committee account for this, for the damage to society - and I hope to do so.

Also see this interview from Bloomberg.

Worth Reading 3/27

• Those Persistent Anonymous Sources (The New York Times): "The Times has a tough policy on anonymous sources, but continues to fall down in living up to it."
  


• Goodbye, Homo Economicus (The Prospect): "What the “madmen in authority” heard this time was the distant echo of a debate among academic economists begun in the 1970s about “rational” investors and “efficient” markets. This debate began against the backdrop of the oil shock and stagflation and was, in its time, a step forward in our understanding of the control of inflation. But, ultimately, it was a debate won by the side that happened to be wrong. And on those two reassuring adjectives, rational and efficient, the victorious academic economists erected an enormous scaffolding of theoretical models, regulatory prescriptions and computer simulations which allowed the practical bankers and politicians to build the towers of bad debt and bad policy."
  


• Richard Rorty and the efficient markets debate (TheMoneyIllusion): "It is widely assumed that the 2006 housing bubble was irrational, and perhaps in part it was. But again, let’s not get too overconfident. In fact irrational overconfidence—the same psychological trait that may generate bubbles, also generates an excessive level of confidence that we can spot bubbles. We all tend to remember when we make a correct prediction, or even have a correct hunch. But how often do we remember our failures? And if we forget the failures, do we grossly overestimate our batting average?"
  

Whither the BSDs?

Wall Street honchos like to fancy themselves as Masters of the Universe. As Michael Lewis hilarious chronicled in Liar's Poker, traders and salesmen, in particular, like to roam the floor considering themselves BSDs. Which is why I always find it funny when these business big shots are too cowardly to go on the record for stories, such as John Heilemann's anonymous source-filled piece in this week's New York on Obama's economic team.

Check out all these at least somewhat-critical quotes:

On Wall Street, meanwhile, where Geithner’s stock has been falling precipitously for weeks, a prominent Democratic banker (and Obama backer) told me, “It’s not that everyone here thinks he should be fired. It’s just that there’s no one who would stand up right now and publicly throw their support behind him.”

“Tim and Barack might have been able to get away with ‘Trust me on the details’—except that they were following Paulson, who asked to be trusted so many times and then changed directions that no one was going to trust any Treasury secretary on the details,” remarks a senior executive at one of Wall Street’s biggest banks. “And then here comes Tim and says, ‘Trust me on the details.’ Oy vey.”

The situation was exacerbated by the paucity of senior staff at Treasury, which has made it nearly impossible for Wall Street to talk to Geithner’s shop: “There is no one there to answer the phone,” says one executive. “Literally.”

To some in the White House, the sight of the financial world turning hard against Geithner is curious, even baffling. What the Obamans thought they were getting in him was Wall Street’s guy. “They don’t get it,” says one name-brand Democratic banker. “Geithner was a $500,000-a-year guy. He was the regulator. People knew him, liked him fine, but he was never a member of the club.”

Back in New York the following day, I related that story to a CEO pal of mine who is a big Obama backer. “What are they, smoking crack down there?” he replied. “Find me one CEO who likes what they’re doing. Seriously, find me one!”

“I heard [Obama budget director] Peter Orszag on TV saying health care is the biggest problem affecting the economy,” says one Democratic CEO. “No, it’s not. Right now, of the top ten things they should be focused on, it’s like, No. 11; the first ten are the banks.”

Obama has made this argument on several occasions now, but it made its debut when he addressed the Business Roundtable earlier this month. It was one of those occasions where the venue for the message mattered nearly as much as the message itself. “What it said to me was, they know they have a problem with business, that they’re not in la-la land about that any more,” explained another Obama-friendly executive in the city. “But unless they fix the banks, nothing else matters. That’s what everyone is waiting for.”

I don't believe in the old saying that if you don't have anything nice to say, you shouldn't say it all. But if you're going to say it, at least have a big enough SD* to put your name behind it**.

*Yes, I realize some of these could be women, but the blog works better this way.

** To be fair, the political types quoted were just as bad in hiding behind anonymity (although not all the quotes were critical).

When the financial crisis hit in September, Furman put Summers in charge of doing the opening presentation on Obama’s economic conference calls, which took place daily (at least) during that pivotal time. “Larry was just brilliant on those calls,” recalls one regular participant. “And not just brilliant but inclusive and generous—he was very rarely as assholic as he had a reputation for being.”

Obama also heard from many Summers opponents. “The problem was, 50 percent of the people Obama asked about Summers said no fucking way—between the confirmation hurdles and the arrogance problem,” says this person, who was asked. “But everyone said he had to have Larry at the table. And Obama had really come to respect him. The funny thing is, Barack barely knew Tim; they’d only met a couple times, there was no relationship there.”

“I went through battle after battle with Tim, and he’s quite remarkable,” says a former Treasury official from the Paulson era. “He’s a very strong leader. He’s smart, he’s tenacious, he works harder than anyone. There were countless times when Paulson and Ben Bernanke were focused on academic discussions and Tim was the one who brought things back to reality.”

(Some suggested putting former Fed chairman Paul Volcker in the job for a year, with Geithner as his deputy and successor in waiting.) “I have great respect for Tim,” says one of them. “But I thought he lacked the gravitas for the job, the ability to be a commanding figure, to get on TV and have people take one look at him and say, ‘Yeah, he’s the man.’ ”

A longtime Geithner ally in Washington comes to a different conclusion. “A lot of the pushback he’s getting from Wall Street is about their lack of self-awareness about how the world has changed, how they’re not the Masters of the Universe anymore,” this person argues. “They feel marginalized and put-upon by the administration’s rhetoric about the greedy bankers. They are way behind the curve about where the public is and how much pressure the administration is feeling. They don’t like what the new environment means for how they run their business. They see their taxes going up and their compensation going down. And what they don’t do is go to the New York Times and say, ‘My feelings are hurt. I don’t like what the new president is saying about our character and our competence.’ What they say is, ‘These guys are incompetent, we need a real policy, the Treasury secretary has got an unsteady hand—he’s not up to the job.’ They’re thinking one thing and saying something quite different.”

When I was at the White House recently, I jokingly asked a senior Obama official if the team was having fun turning the country into a socialist state. “What are you talking about?” this official replied. “Business loves what we’re doing!”

Was Volcker placated? Maybe only momentarily. “He wants to have a real role,” says someone who knows him. “If they’re gonna call him an Obama adviser, he wants to really advise. He has no interest in just being window dressing.”

“All I can tell you,” says one administration official, “is that Larry seems quite happy with this part of the policy portfolio being known as the Geithner Plan.”

The truth, in the end, is that whatever emerges will be perceived as the Obama plan. And the president is apparently deeply uncomfortable with nationalization. “Barack’s perspective is, if you do one bank, what happens to the next weaker one and the next one and the next one?” explains someone with his ear on economics. “Where do you draw the line? How far do you end up going? What are the repercussions?” Obama, notes this person, is risk-averse in his decision-making. “He wants to know in advance the likely outcome. So he’s saying to Tim and Larry, let’s play it out—and there is no solid answer. If you do Citi, you can’t be sure what that means for B of A. You’re not sure whether Goldman and Morgan can survive as just investment banks. That level of uncertainty is something that, for them, is really hard to swallow.”

If you have about 40 free minutes ...

It's worth watching the following video of Larry Lessig speaking at Google. Lessig, the Stanford Law School professor that founded Creative Commons, has decided to return to Harvard Law School to work on his newest project Change Congress, which is pushing to reform the political system by supporting "a hybrid of small-dollar donations and public financing, to keep big money out of politics". I found the speech below thanks to a link on the blog of Northwestern b-school professor Sandeep Baliga, who attended a similar Lessig presentation that he called the "best talk I have ever witnessed in person".

Check it out for yourself:

I Like It, But Will They?

As a reader, I really like what I think is a new feature Esquire magazine has added to its front cover: The page number for the table of contents. It's a minor issue, but I always found it a bit frustrating to have to flip through a bunch ads the magazine has packed up front to get to what I'm looking for. Really, I wish more magazines would do this.


That said, I'd be pretty upset if I were an advertiser. Isn't this basically just inviting readers to skip through ads*? The only reason I could even see the magazine deciding to do this is if there were a bunch of people like me complaining about all the ads that stood in the way of the table of contents. I know there's a wall separating editorial content and ad sales, but given this is magazine that sold an ad on its front cover, that's not quite as clear as it's been in the past. I'm surprised, then, they'd let this sort of a thing happen.

* The cover has page numbers for many feature stories, too, but they've done that in the past.

A few thoughts...

At this point, pretty much everything that one can say about the bonus bill has been said. It's way too broad a piece of legislation, doesn't actually fix the problems underlying the compensation models at these firms, will only encourage firms to shift a bigger portion of pay to salary (if it actually gets passed), etc. That said, there are a few things I did want to point out:

• A number of people have suggested that part of the reason people are upset about the bonuses* is that they simply don't understand how salaries and bonuses work on Wall Street. The "public", the argument goes, equates a bonus with a reward for good work, so it's easy to see why they're upset. But surely, if the public knew that a majority of a banker's pay came from his bonus and not his salary (therefore making a bonus like a de facto salary), people would be more sympethic, the people sticking up for bankers say.
  

  I'm going to go out on a limb and say people would be just as upset if the banks were spending millions to pay salaries instead of bonuses. Average people are pretty shocked to learn you can make so much money simply moving pieces of paper round-and-round.

• There are also a number of people (such as Nate Silver, for instance) who have pointed to examples where bankers/traders might actually deserve the money they make, especially in cases where they better the public good. I'm fairly certain these are the exceptions rather than the rules. Certainly -- like all professions -- there are people that are very good bankers, but most are mediorce or just plain bad. Remember their motivations for getting into the business -- to make a lot of money, not to save the world. My sense is that if you could really rank most Wall Street banker's priorities when doing a deal, they'd go something like this:

1.) Banker
2.) Banker's friends at his firm
3.) Banker's firm
4.) Banker's friends at other firms
5.) Other Wall Street firms
455.) Banker's neighbor
956.) Banker's pizza delivery guy
1875.) Banker's client

* When at Yale for a quiz bowl tournament in high school, a Yale quiz bowl team member made a big point about saying the plural of bonus was boni. Apparently, that is incorrect.

What'd I tell you...

Goldman tries to play the "How were we supposed to know defense?" on AIG:

David Viniar, CFO of Goldman Sachs, basically suggested that since nobody knew that AIG was a house of cards, nobody had any reason to suspect anything. “AIG was a triple-A rated company, one of the largest and considered one of the most sophisticated in the world,” he said. And in a response to a question on how Goldman allowed its exposure to AIG to get as large as it did, Mr. Viniar describes positions made in 2006 and early 2007 as if it was a different age, a more innocent time, when magical dwarves ruled the land, before the ring of power had been forged.
“It was a very long time ago,” Mr. Viniar says. “AIG at the time was one of the largest, strongest companies in the entire world, and they were very sophisticated, or appeared to be, a very sophisticated counterparty.” The firm later scaled back trades — by the end of 2007, according to Mr. Viniar.

As I said, you don't need to look to far back to determine that a "Triple-A" rating has never been that safe:

In 1989, Moody's rated 24 banks Aaa, according to a study by Bankim Chadha and David Folkerts-Landau I found in Martin S. Feldstein's International Capital Flows. By 1996, just three banks retained that top rating. Just one -- Rabobank of the Netherlands -- had triple-A marks from all three agencies.

Worth Reading: 3/20 Edition

As the title probably gives away, I'm starting a new Friday feature on the blog*. I plan to pick out a manageable number of stories to read each week. Since I'm pretty sure the limited readership of this blog mostly overlaps with my Google Reader friends, I will try not to list stories I have already shared during the week.

* Yes, I'm assuming you actually care about what about I think is worth reading, which is probably not the case.

Anyway, here's the list for this weekend:

• Free Larry Summers: Why the White House needs to unshackle its economic oracle. (The New Republic): " 'What does a bad theoretical physicist do for a living? He walks into an office, sits at a desk, and stares at a plain white sheet of paper." "But," Summers added, "there's a lot of work in the world for a bad economist.' "
• Rated F for Failure (The New York Times): "Over time, ratings became valuable not because of their accuracy but because they “unlock” markets; that is, they are a sort of regulatory license that allows money to flow.
• Economists Suggest Fix to Bonus Problems (WSJ Blogs): "One of the main causes of the financial crisis stemmed from the way that top workers at financial firms got compensated, and some economists are proposing a new system to correct the problem."
• UBS: A Swiss Banks Shadowy Operations (Newsweek): "Translation: the Swiss bank was running a shadowy operation to help rich Americans get their money out of the country, and sometimes back in, without the Feds finding out."
  

Perhaps Bill Simmons Should Read Greg Mankiw

I refrained from poking fun of Bill Simmons after he embarrassed himself in a recent podcast with Chuck Klosterman. But when I heard the Sports Guy make an elementary economics mistake during his podcast with National Football Post's Mike Lombardi, I knew I had to call him out.

The error occurred during a discussion on Cleveland Browns QB Brady Quinn, who the Browns traded up* to pick in 2007. Lombardi suggested the Browns might think about drafting a new QB this year.

*It cost them a 2007 second-rounder and 2008 first-rounder.

Simmons--interjecting that the VP of Common Sense had to step in--said that he didn't think that would be a good idea:

I think it's too early to give up on Brady Quinn. I just don't think he played enough. And I still like him, I like the way he carries himself. I'm not willing to write him off yet, especially after all they gave up for him.

That may be the "common sense" decision, but it's not the economically smart one.

The investment to draft Quinn, as anyone who has taken Econ 101 can tell you, is a sunk cost. You've already traded the picks and can't recoup them, so they should not weigh on how you make any decisions. It makes no sense to keep playing Quinn in the future just because you paid a lot to get him in the past.

Simmons comments, though, highlight one of the problems with basic economic models -- they assume people are rational. In this case, there are plenty of people that, just like Simmons, would have too much pride or emotional attachment in a past decision to recognize these investments are sunk costs and that it makes economic sense to move on. In economic theory, this sounds stupid, but in practice, it happens all the time. For instance, haven't you ever sat through a movie you hated just because you bought a ticket to it?

Maybe this needs to be required reading.

Glad to Hear It

From the New York Times:

A New York state judge ruled Wednesday afternoon that New York’s attorney general could disclose the names of executives at Merrill Lynch who received 2008 bonuses ahead of Bank of America’s acquisition of the brokerage firm, rejecting arguments that the information was a trade secret.

“The record does not support the intervenors’ claim that the employee compensation information is a trade secret,” Justice Bernard J. Fried of New York State Supreme Court wrote, referring to Merrill and Bank of America. He ordered them to turn over the list of names.

Attorney General Andrew M. Cuomo has been demanding the names of Merrill’s 200 most highly paid employees as part of his investigation of the firm’s acquisition. The names could be released as early as Thursday.

I covered this earlier this month.

Adventures in Flackery: Dell Edition

When Dell Inc. recently laid off workers at plant in Forsyth County, North Carolina, reporters at the local paper had a "simple question": How many people worked there? Seeing as how the local government had provided about $305 million in incentives related to the $115 million plant, the request would seem reasonable to most. Unless, of course, you work in PR.

We only wanted a straight answer to a simple question -- How many people work at the plant? -- for one simple reason: The number of employees is linked to the payment of incentives.
In the days after the announcement of layoffs, finding out how many people worked at Dell was nearly impossible. Media outlets reported that the plant employed 1,150. Mayor Allen Joines, the head cheerleader for the Dell deal, said that 1,400 people worked there. So which is it?
Ask a simple question, and sometimes you get an idiotic answer.
"Which is the correct number for Dell employees at the Forsyth plant?" Richard Craver, a business reporter for the Winston-Salem Journal, asked a corporate spokesmen in an e-mail Friday.
"We are no longer providing specific site-employment totals," replied Dell flack David Frink.
Pressed a second time, Frink shot this back: "We are not engaging in additional dialogue on this subject."

I give the reporter credit for actually naming the useless flack, unlike some other newspapers I know.

If Dell is really looking to save money, I have a suggestion: Fire the PR department. An automated e-mail response system could easily take over the work they appear to do. Since I'm a nice guy, I have even take the time to draw up a boilerplate e-mail that I think sums up Dell's respect for its stakeholders:

Dear journalist/shareholder/concerned citizen:

Thank you for taking the time to contact us. Whatever stake you may have in our company, we hold ourselves accountable to neither investors nor the public. We will therefore disregard this and all future inquiries.

Go [expletive deleted]* yourself,
Dell

*This is a family blog after all

[H/T: Talking Business News]

I Wouldn't Want These People Teaching My Kids

From the Star-Ledger:

In a move that could turn unemployed Wall Street traders or pharmaceutical workers into classroom instructors, the Legislature unanimously approved a pilot program yesterday to fast-track public school certification in the areas of math and science.

Shocking Even By NJ's Standards

It's not exactly surprising to open the Star-Ledger and find a story about a politician in New Jersey breaking the law. Rarely, though, do they go about it as openly as Jon Corzine did in putting together his budget.

Several years ago, the Legislature decided the arts, history and good beaches were so essential to New Jersey that it passed laws setting a guaranteed level of funding for those entities and others.

As it looks for ways to save money in a recession budget, the Corzine administration has formulated a new approach to those laws: ignore them.

Since taking office, Corzine has never fully funded the cultural offices, but this week he proposed cutting their budgets below the minimum limits required by law. He also cut the Shore Protection Fund below legal prescribed limits.

State treasurer David Rousseau made it clear how the administration feels about those laws. They just don't apply anymore.

"We will be setting aside those laws," said Rousseau. "We didn't want to be bound by laws that were created that say shore protection has to be this amount.

At least they're being transparent...

Isn't that the point?

eBay recently said it will ask shareholders to approve a plan that would allow it to swap employees' underwater stock options for restricted stock. Essentially, eBay granted the employees stock options on the assumption the stock would go up and they would benefit. The stock has fallen -- leaving the options worthless -- and eBay now wants to make for it.

“Like many companies, we have experienced a significant decline in our stock price over the last year in light of the current global financial and economic crisis,” states the board in its extensive argument in favor of the plans.

However, while eBay shares have indeed fallen over the last year, hitting a 52-week low of $9.91 on Friday, the company’s stock price has been under pressure for years now since peaking at $58.17 at the end of 2004. They lost 26 percent in 2005, 30 percent in 2006, gained gained 10 percent in 2007, and fell 58 percent in 2008. So far this year they are down another 26 percent.

This may explain the shaken belief in the stock option as a reliable instrument of compensation, and why the board has opted to replace stock options with restricted stock, which, “provides value to our employees even if current economic conditions continue and our stock price fails to increase further.”

Hogwash.

Stock options aren't meant to be a "reliable" form of compensation. Employers grant stock options to align the long-term interests of employees and shareholders. If the stock rises, they all gain. If the stock falls, they all lose. In fact, the entire point of stock options is exactly the opposite of what eBay suggests in that last quote. Employees shouldn't benefit if the stock continues to drop. They already get salaries, cash bonuses and other benefits upfront. If employees know that they will be rewarded again years later no matter the price of the stock, they won't have the same incentive
to make decisions that will benefit shareholders in the long-term.

Although I'm beating up on eBay, they're certainly not alone in this. That's why I'm glad to see at least some people are fighting this practice at other companies, according to the Associated Press.

"We don't get to trade in our stock so why should they?" said Richard Ferlauto, director of pension and benefits policy for the American Federation of State, County and Municipal Employees, a Washington-based labor group representing government workers.
Investors like Ferlauto plan to fight companies taking such action during this spring's proxy season. As he points out, shareholders have to approve such changes, and many investors this year aren't likely to turn a blind eye to that fact.

The Bigger the Better?

Much has already been said about the role that a skewed compensation model for bankers and traders played in the current crisis. But a recent story on fees related to the proposed Merck-Schering Plough merger reminded me of another issue that's also troubling: The way the banks themselves get paid for advisory work.

Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley may split as much as $146 million advising on Merck & Co.’s $41.1 billion purchase of Schering- Plough Corp., as health-care takeovers dominate the slowest merger market in five years.

The story doesn't actually mention this, but among other fees, banks receive a large portion of their compensation from clients based on the size of the transaction that gets done. Obviously, this encourages them to promote big deals regardless of whether it's good for either company (And executives with huge egos and a thirst for more power are more than willing to buy the bankers' pitches). Companies often tout vague benefits such as "synergies" and "efficiencies" when they announce their mergers, but shareholders are soon hurt when these mega-deals turn into mega-disasters (See Time Warner-AOL*, DaimlerBenz-Chrysler**, RBS-ABN Amro***, etc.).

*A debacle that led to the largest loss ever reported by any company at that time -- $99 billion in 2002. (Although, to be fair, this deal probably made sense from AOL's perspective, since its stock was wildly overvalued.)
** THE case study for how a clash of cultures can doom a merger.
*** Advice given by Andrea Orcel, the Merrill banker that took home a $33.8 million bonus last year. I'll leave this one to Paul Volcker:

“ABN Amro and Royal Bank of Scotland are both bankrupt and their leaders are disgraced, but the investment banker who put it together walks off with $30 million,” Paul Volcker, a former chairman of the Federal Reserve and now head of President Barack Obama’s Economic Recovery Advisory Board, said at a conference at New York University’s Stern School of Business last week. “There’s something the matter with that system.”

Lawyers take a lot of flak for their practice of billable hours. But no one ever complains about the conflict of interest here. Despite it's role as an "impartial" advisor, the bank's incentive is to sell its client on a deal no matter the circumstances -- the bigger the better****. Again, I imagine the difference is while people know how lawyers bill their clients, people never realized how investment bankers did.

**** And don't forget the investment bankers try to sell a bunch of other products produced by the rest of the bank, such as financing, whether or not it's in the best interest of clients.

I really have no opinion on the Merck-Schering-Plough merger. Maybe it will work out great, just as they say. But if it doesn't, I won't be surprised.

Jon Corzine=Robin Hood?

Like most states, New Jersey is facing big drops in revenue that will require some belt-tigthtening. So it came as no surprise when Gov. Jon Corzine announced his "draconian" budget:

Gov. Jon Corzine wants New Jersey taxpayers to shell out more to support a $29.8 billion budget that will "put our state on a stronger footing for tomorrow" while shielding the most vulnerable from the troubled economy.

Seems like a noble goal. Let's see how it plans to do it.

The governor wants to eliminate property tax rebates for all but the elderly and those making less than $75,000 per year.

Fair enough.

He wants to raises taxes on the rich and on employers.

OK, these people can probably afford it.

And he wants more from people who play the lottery, drink alcohol and smoke cigarettes.

Hmmm, not sure this one fits.

It seems to me as though this would disproportionately impact lower-income households -- those "most vulnerable" in the current economy -- making it a regressive tax. One might argue that the tax will discourage people from continuing these bad habits, but I would guess demand for these goods is rather price inelastic, and a increase in price will not deter most people from buying them. In fact, the current economic climate might make them more likely to smoke to kill stress or play the lottery* in hopes of hitting it big.

I understand "sin" taxes are probably much more politically palatable than others. And, depending on your philosophy, you might see value in using a tax to discourage certain behavior. But given the unrealistic nature of that goal, these types of taxes strike me as quite unfair and not in the spirit of what Corzine has proposed.

But don't worry, Corzine feels your pain:

"Just like the choices that a family makes around the kitchen table about its spending, the decisions I have made in laying out this budget reflect a clear ranking of my priorities and core values," Corzine said in an address interrupted 17 times for applause.

For the Corzine -- sitting around a very large kitchen table, no doubt -- it must be agonizing to make choices such as 'Should I buy that chain of private islands or spend another $62 million of my own money on a campaign?'

* I have to mention another gem from Jimmy Breslin's The Good Rat:

I do know that illegal gambling, which once was a glorius fountain of cash for the outfit, now is a government-owned lotter machine that buzzes in every newsstand and deli in the city. Years ago te state looked upon gambling as a low vice, a depravity; and those who profited from it were no better than cheap pimps and deserved years behind bars. That opinion held right up until the government took it over, at which it becaome a civic virtue to lose the rent and all other money you didn't have on rigged games of chance.

You're Cheaper Off

Listening to CBS 101.1 FM the other day, I was struck when one of the station's DJs said "frugal" will be the sexiest word of 2009. As I've said before, this lack of confidence is not a good sign for the economy. As much as many people irrationally spent too much in the years leading up to the current crisis, many of them are now irrationally spending too little. Warren Buffett said today on CNBC that "fear is very contagious and I've never seen the consumer, or the Americans just generally, more fearful than this." Makes you a tad bit nervous, no?

It makes me wonder, though, if this current crisis will actually have a long-term impact on people's spending habits. The Great Depression, of course, led to a generation's worth of people that knew the value of every penny, but that was obviously an extreme case. As legendary New York newspaper columnist Jimmy Breslin* once wrote of his mother-in-law's penny-pinching ways:

The depression arranged all of her life. Since the Depression, she always has regarded any other problem as a bothersome dwarf. When the last Depression ended, she immediately began to prepare, financially and mentally, for the next. Once, she only suspected it would come. Now, reading the headlines, seeing the prices, she is certain that everything will snap.

And German's are apparently still "traumatised" by the hyperinflation in the Weimar Republic.

But other than that, people tend to have short memories. Americans moved to more fuel-efficient vehicles following the oil crisis in 1970s, but eventually found their way to gas guzzling SUVs. And we all know investors are prone to jump from one asset bubble to the next. So, it will be interesting to see what attitudes -- if any -- stick from this crisis.


* I give the Jack Seal of Approval to Breslin's most recent book, The Good Rat , which just got released in paperback. In it, Breslin intertwines Mafia associate Burt Kaplan's testimony against Louis Eppolito and Stephen Caracappa -- two disgraced New York cops now sentenced life in prison for carrying out mob hits -- with his own recollections of the mob. Aside from many of the tremendous stories Breslin tells, the book is filled with gems like this.

The Mafia no longer sends great chords crashing down from the heavens. As it dissolves, you inspect it for what it actually was, grammar-school dropouts who kill each other and purport to live by codes from the hills of Sicily that are either unintelligible or ignored.
It lasted longest in film and print, through the false drama of victims' being shot gloriously with machine guns but without the usual exit wounds the size of a soup plate.

And this:

As gangsters did not have the legs to remain standing on street corners all day, and most certainly could not sit at home or their families would flee, they opened their own social clubs. There these men could sit and do nothing, at which they were excellent.

And perhaps my favorite, this:

He was the Teflon Don. You put me on trial, I fix your fucking jury and walk out in your face.

Making It Worse?

The big news of the day is that the U.S. unemployment rate rose to 8.1% in February. Obviously not a great help to the confidence of the economy itself, but I wonder how much bigger of a blow the ultra-specific information we can now get on layoffs strikes. Even if the unemployment rate was widely disseminated during past recessions, people didn't have the chance to read about all day on the Internet or watch talking heads rant about it all day on a 24-hour cable TV channel. Not to mention the impact the Internet has had in giving us details about layoffs in every niche, whether its Above the Law reporting about job cuts at law firms before they happen or someone on sportsjournalists.com starting a thread about the latest newspaper to trim its staff. These sorts of layoffs certainly happened during past economic downturns, but I have to imagine the fact people can actually read about them is only helping to make things worse.

The Benefits of a Recession?

Phish's members have decided its their duty as good citizens to reunite. From the New York Times:

As a longtime fan of Depression-era swing bands, he has been thinking about Phish’s role in the current recession. “For people in hard times, we can play long shows of pure physical pleasure,” he said. “They come to dance and forget their troubles. It’s like a service commitment.”

Hey, who knows, maybe this will help the economy out. Demand for tickets is high (Being resold for $1000+). And they've put some lawyers to work. I'm sure this will also increase sales of tie-dyed shirts, hackysacks, and acid*.

* I kid. I actually kind of like Phish.

Fight For Your Share(holders') Rights

The Wall Street Journal wrote a great story yesterday detailing the compensation Merrill Lynch handed some of its employees ahead of its merger with Bank of America. All together, 160 employees made more than $3 million -- 11 of those over $10 million -- despite Merrill losing $27.6 billion for shareholders. Given Merrill’s performance last year, I found most of these payments rephrehensible. But the stonewalling Bank of America has done refusing to reveal the compensation levels is equally outrageous.

Mr. Cuomo is examining the Merrill bonuses to determine whether the firm violated any securities laws related to public disclosure. Bank of America is expected to file a motion on Wednesday in New York State Supreme Court to keep the compensation data from becoming public. Next week, Mr. Cuomo intends to make his case that the data shouldn't be kept confidential. A judge is expected to rule on March 13.

"Merrill Lynch was an independent company for the three-year period covered, and made the decisions on compensation," said a spokesman for Bank of America. "Bank of America continues to be concerned about the right of privacy of any employee."

 (Also take note of the cowardly BoA spokesman who likely told the reporter not to use his name.)

As a taxpayer, I’m entitled to know what my town and state pay their employees. Through a simple database search, I can find out the salary of every Verona employee, from our town manager (who makes $164,008) to a new teacher at my elementary school (who makes $46,245 ). As a shareholder of a company*, why shouldn’t I be given these same privileges? After all, as an owner of a company, these people are my employees. They work for me. Don't I deserve to know how much I'm paying them? 

The board of directors at these firms failed during the last crisis. Shareholders must stand up for their own rights to help us prevent the next one.

*I don't actually own any Bank of America stock, I'm just speaking generally

The Gordon Shumway (aka TALF)

If hadn't seen it, the U.S. government has taken extra steps to help out the market for asset-backed securities through its Term Asset-Backed Securities Loan Facility, or TALF. From the WSJ today:

The U.S. launched a program to finance up to $1 trillion in new lending to consumers and businesses, in an ambitious attempt to jump-start credit for everything from car loans to equipment leases.

The Federal Reserve and the Treasury Department hope to revive the moribund market for so-called securitized lending, which until last year was central to providing consumer and business loans. Starting March 17, large investors -- including hedge funds and private-equity firms -- can obtain cheap credit from the Fed and use the money to buy newly issued securities backed by such loans.


The Fed, which announced the program's outlines in November in tandem with the Treasury, had already expanded the size of the program and on Tuesday further expanded its targets. Originally limited to backing securities for consumer and small-business loans, it now will also target securitized loans for heavy industrial equipment, agricultural-equipment leases and rental-car fleets. And the central bank sweetened some terms to draw investors and debt issuers. For instance, participants won't have to adhere to limits on executive compensation that apply to banks that accept bailout government money. Such restrictions were originally planned for some participants.

A few thoughts:

• Despite their role in the current crisis, asset-backed securities are not, in and of themselves, a horrible financial instrument. They, in theory, should allow borrowers to take advantage of lower interest rates by efficiently distributing the risks of the loans. But because they allow the originator of the loan to sell off the risk of holding it, they create an incentive for lenders to lower their underwriting standards. Only triple-A securities will be eligible for Fed funding, but given the rating agencies' recent performance in this area, I'd want a some more restrictions in place if I were the government.
  
• Unfortunately, I'm not sure how much this will actually help the economy. Is lack of available credit really the reason people aren't spending money? People are petrified about the economy right now. I don't think they're as worried about being able to make a 3% car payment instead of a 4% car payment as they are about losing their job and not being able to make any car payment at all. But maybe the extension beyond consumers will help.
  
• A side benefit to this is it could help out some investment bankers and lawyers that don't have much to do these days. As the chart below shows, issuance fell dramatically last year. That's a lot of lost fees.
  

What a Lame Bunch of (Counter)parties

The U.S. government earlier this week injected another $30 billion into American International Group as part of its ongoing bailout of the firm. As people many people have said, this is more a bailout of AIG's counterparties than AIG. I'm sure if you asked many of those counterparties why they were willing to buy so many credit-default swaps from AIG in the first place, they would tell you that AIG was triple-A, no one could have expected the credit crisis, and so on. I'm not buying it as a good excuse.

As Joe Norcera pointed out in a great column Saturday, AIG essentially sold its triple-A rating to others. But even before the credit crisis, how safe was that triple-A rating anyway? If the study I found is any indication, not very.

In 1989, Moody's rated 24 banks* Aaa, according to a study by Bankim Chadha and David Folkerts-Landau I found in Martin S. Feldstein's International Capital Flows. By 1996, just three banks retained that top rating. Just one -- Rabobank of the Netherlands -- had triple-A marks from all three agencies.

I actually heard a person I considered a fairly astute observer of the financial markets say a few weeks ago that one of the lessons of the current crisis is that counterparty risks actually exist. It seems to me, though, that in some ways, this data would suggest we already had proof that it did.

*Not a perfect substitute for AIG, but as large financial institutions close enough if you ask me.

Dow Jones-ing For Some Good News

Source: Bloomberg

Watching the Dow Jones Industrial Average index move and up and down minute-by-minute in such volatile times is no doubt a good way to make your head explode. Trying to peg every twist and turn to some bit of news, such as a every time a deputy Treasury Secretary (if we even have any of those) picks his nose, is pretty silly if you ask me. After all, it's just an index of 30 stocks that has become even more distorted in the current crisis.

Unfortunately, though, as a Wall Street Journal story today points out, the stock market don't just reflect the economy -- it can actually impact it.

Even for families who don't have any skin in the stock market -- that's about half of the country -- stocks matter. A 1999 paper by Federal Reserve economist Maria Ward Otoo found that changes in stock prices affected the confidence of households surveyed for the University of Michigan's consumer-sentiment index whether or not they owned stocks. She concluded that consumers use the stock market as an indicator of where their wages are headed.

The stock market also influences corporate behavior. In a speech last month, former Fed Chairman Alan Greenspan related how in the late 1950s he found that changes in stock prices led to changes in companies' machinery orders. He recently updated the analysis and found that the relationship between stocks and corporate spending on equipment continues to hold.

"A recovery of the equity market driven largely by a receding of fear may well be a seminal turning point of the current crisis," he said. "The key issue, of course, is when."

As I said the other day, it's important that people regain confidence to get us out of this mess. Bad days in the stock market help perpuatate a negative feedback loop, in which people get even more nervous, spend less, leading to more layoffs, which makes people even more nervous, and so on. So on that note, seeing today's DJIA down 300.11 points sure doesn't help us.

A New Cash Crop?

As economic conditions worsen, California State assemblyman Tom Ammiano, among others, has suggested his state could raise as much as $1.3 billion if it legalizes marijuana and taxes it. This, of course, is not a new argument. Unfortunately, no matter your views on drug legalization, it's still a silly one.

Taxes don't magically create wealth for the government, they just transfer it from consumers and producers.* There's not no benefit to society from a tax. If the government's goal is revenue generation, there's no better reason to legalize drugs to tax them than there is to just tax things people can already do, such as buying bubble gum or potato chips. For that matter, there are plenty of other currently illegal things you could justify legalizing by using the the rationale that we could raise money by taxing people that want to do them. So, while we certainly could raise money by legalizing drugs, it's not really a reason in and of itself -- economically speaking, at least -- we should do it.**


*And leads to deadweight losses.
** If you're interested in reading more, Steven Landsburg goes over a comphrensive cost-benefit analysis of legalizing drugs in his book Armchair Economist: Economics of Everyday Life.