Mortgage Bonds and Stock Blockchains
A mortgage case.
Well here's a blast from the past: The U.S. Department of Justice brought a civil case against Paul Mangione, the former head of subprime mortgage trading at Deutsche Bank AG, for an alleged "fraudulent scheme to misrepresent the characteristics of loans backing two residential mortgage-backed securities (RMBS) that Deutsche Bank sold to investors that resulted in hundreds of millions of dollars in losses." In April and June 2007. Surely we are very near the end of financial-crisis enforcement cases: The longest statute of limitations you can get for this sort of thing is 10 years, and all the big crisis mortgage securitizations are now more than 10 years old. I don't quite know how they snuck in this case, really, but there can't be many more.
Reading the Justice Department's complaint gives you a sense of why bringing cases against individuals over mortgage fraud has generally been difficult. Mangione was a trader, not a structurer. His job was to buy mortgages for Deutsche Bank from originators, and then to sell them to investors at a profit. ("We gotta sell the stuff. That's the problem," Mangione allegedly told his boss in February 2007, after taking a $30 million markdown in one day on some of the $5.9 billion in subprime loans he was carrying on his book.) Other people were, in the most direct sense, responsible for building the securitizations (the "Securitization Group"), writing the contracts (the "Mortgage Finance Group") and doing due diligence on the mortgages (the "Diligence Group"). As the trader actually responsible for the risk, Mangione had a lot of say over what all those people got up to, and he was certainly interested in moving the mortgages off his book and selling them to customers, but he wasn't the guy writing all the allegedly false statements about the quality of the mortgages Deutsche Bank was securitizing. (He was sometimes the guy signing them.) "He had substantial input (or at least the opportunity to provide input) into each" prospectus, says the government, but that parenthetical makes me think he didn't spend a lot of time giving feedback on prospectuses.
The most damaging quotes in the complaint come from Mangione's calls with his colleagues in which they complained about a mortgage originator called Chapel Funding LLC that Deutsche Bank had bought to be (in Mangione's words) "an origination engine to feed the different DB trading desks." "Chapel, these guys ... they should ... fire all those guys at Chapel," Mangione told one person, using an extra word that I have not repeated here. "I'll say one word to you ... Chapel. That's the ... that deal's all Chapel loans. ... Those guys -- the guys at ... -- the guys at Chapel should be arrested [for] the [stuff] they were doing," Mangione told another trader, using quite a few extra words that I have not repeated here. At one point a director in the Diligence Group told Mangione some more bad stuff about Chapel's origination process. "Mangione responded 'I kind of knew all that,' to which the Diligence Director stated, 'I know, nobody wanted to admit it.'"
Meanwhile of course Deutsche Bank was putting out RMBS prospectuses representing that Chapel was following its underwriting standards and making good loans and so forth. Obviously the contrast between what Deutsche Bank was saying to investors and what Mangione was saying internally does not look great. (Deutsche Bank itself agreed to pay $7.2 billion earlier this year to settle charges over these and other loans.) But Mangione's quotes don't sound gleeful, or even strategic. They are not the cackling boasts of the man in charge of the process, but the rueful shrugs of a man caught up in a process beyond his control. But of course everyone on these calls sounds like that. No one was the prime mover, the evil genius who came up with the idea of securitizing bad loans and lying about them to investors. They just sort of did it, and they were all sad about it, but it happened anyway.
A stock blockchain.
Companies issue stock, and people buy the stock, and then someone needs to keep a list of who owns the stock. This is a difficult problem, though not that difficult. Humanity has traveled to the moon and plumbed the mysteries of the universe. You'd think we could keep a list of who owns a company's stock. And in fact we can. In the United States, the lists are kept by Depository Trust & Clearing Corp., and they run on essentially 1960s-era legal technology in which almost all stocks are technically owned by DTCC nominee Cede & Co. (which keeps the list short!), brokerage firms own their stocks through Cede, and investors own their stocks through their brokerages. This is a somewhat silly way to keep the list, but it mostly works, though sometimes it breaks down in hilarious ways.
The last time we talked about one of those breakdowns, I said "It's enough to make you wish for a blockchain," and in 2017 merely wishing for a blockchain -- merely uttering the word "blockchain" -- is enough to make one come into being, so of course now there's a blockchain:
Finally an answer is near, thanks to Delaware. Last month, the home state for most incorporated companies in the U.S. made it legal for corporations to offer digital shares that would be recorded and tracked on a blockchain, the ledger that powers cryptocurrencies like bitcoin. Delaware officials hope the move will increase ownership accountability and clarity. The new law, more than a year in the making, is also a shot across the bow for the Depository Trust & Clearing Corp. and its little-known partner Cede & Co., the legal holder of the vast majority of U.S. stocks.
I mean, like most blockchains, this one is more at the theoretically-viable-proof-of-concept stage than the actually-conducting-meaningful-economic-transactions stage, but still: stock blockchain! The old-timey technology that U.S. companies currently use to keep lists of stockholders might soon be replaced by newfangled blockchain technology.
That's good! It's good. I have no serious objections. My only tiny quibble is, you know, there are other ways to keep a list? You could just write it down, or keep it in Excel. A lot of the encrusted weirdness of the DTCC/Cede system comes from its development in the 1960s, when keeping a long list and updating it frequently was a genuine technological problem, and so the list had to essentially be divided up and farmed out to brokerage firms to keep track of. I am not a computer scientist but I believe that that problem was more or less solved in the intervening decades. Now you could just have a trusted central party -- a transfer agent, or a state agency, or even DTCC -- keep a list of who owns stock, without the decentralization and cryptography of blockchain. But perhaps we are too late for that.
The best thing to read about socially responsible investing remains this piece by Cliff Asness from May. Asness explains:
- The point of not investing in evil companies is to increase those companies' cost of capital.
- This makes it harder for them to fund projects, so they will do less evil stuff.
- But it also means that the people who are still providing them capital should expect a higher return.
As Asness puts it:
Put simply, if the virtuous are not raising the cost of capital to sinful projects, what are they doing? How are they actually affecting the world as they wish to? If the cost of capital isn’t also an expected return, what is it? This might be a painful reality to swallow for the virtuous. To get precisely what they want, which is less of the bad stuff occurring, they have to pay the sinful investors in the form of a higher expected return. Importantly, this isn’t an accidental byproduct of ESG investing. It’s the only way all this really matters one drop to the central issue – how much bad stuff happens. If the discount rate used by sinful companies isn’t higher as a result of constraints on holding sinful stocks than there was no impact. And, if the discount rate on sin is now higher, the sinful investors make more going forward than otherwise.
Anyway here is a story about how "Investors Can Be Ethical and Still Beat the Market, Study Says." Here is the study, "finding that the performance of sin stocks can be fully explained by the two new quality factors in the recently introduced Fama-French 5-factor model, profitability and investment": "Sin stocks" don't actually outperform other stocks, once you control for those quality factors. The good news is, you know, "you can be ethical and still beat the market." The bad news would appear to be that the cost of capital for vice is no higher than the cost of capital for virtue, meaning that the capital markets, at least, aren't doing much to cut down on sin. Not that you'd really expect them to.
The quiet life.
The fundamental idea of academic corporate finance is that if shareholders aren't constantly monitoring the managers they hire, the managers will get up to terrible things. (Or as Jean Tirole puts it: "The essence of corporate finance is that investors cannot appropriate the full benefit attached to the investments they enable.") There are, in the literature, various flavors of terrible things. Maybe the managers will steal all the shareholders' money. Maybe they will embark on ambitious empire-building projects that aggrandize themselves without providing positive returns for the shareholders. Maybe they will do stuff that optimizes their own compensation rather than shareholder return.
But my favorite flavor of terrible thing is: nothing. This is called the "quiet life hypothesis," and it hypothesizes that, if shareholders do not constantly monitor their managers, the managers will just take a long nap, or maybe play Angry Birds or whatever. I find it congenial because I am pretty sure that if anyone put me in charge of a public company and didn't check up on me, I would pursue a quiet life more than I would empire-building or embezzlement, and it is pleasing to find my own preferences represented in the corporate-finance literature. Anyway here's an empirical paper from Naoshi Ikeda, Kotaro Inoue and Sho Watanabe:
In this study, we empirically test “quiet life hypothesis,” which predicts that managers who are subject to weak monitoring from the shareholders avoid making difficult decisions such as risky investment and business restructuring with Japanese firm data. We employ cross-shareholder and stable shareholder ownership as the proxy variables of the strength of a manager’s defense against market disciplinary power. We examine the effect of the proxy variables on manager-enacted corporate behaviors and the results indicate that entrenched managers who are insulated from disciplinary power of stock market avoid making difficult decisions such as large investments and business restructures. However, when managers are closely monitored by institutional investors and independent directors, they tend to be active in making difficult decisions. Taken together, our results are consistent with managerial quiet life hypothesis.
"Cross-shareholder" ownership, here, means ownership of shares of one public company by another public company, a practice more common in Japan than in the United States, and one that tends to entrench managers because cross-owners tend to vote against hostile takeovers. It is not the thing sometimes called "cross-ownership" (or "common ownership") in the U.S., in which one big institutional index or quasi-index investor owns big chunks of multiple firms in the same industry. But if the rise of indexing does lead to more companies being owned by long-term stable shareholder bases who are not particularly discriminating about what companies they invest in and are not particularly active in monitoring their managers, then you might expect similar results: managers who are insulated from shareholder pressures and who therefore try to avoid sharp competition and difficult decisions.
Friends of the court.
One thing that I often find puzzling in the fight over the fate of Fannie Mae and Freddie Mac is why so many otherwise populist people and groups are such ardent supporters of the small group of hedge funds who want the government to give them billions of dollars' worth of value for their Fannie and Freddie stock. Bloomberg's Zach Mider has a partial answer, which is that sometimes the hedge funds' lawyers write briefs for ostensibly unaffiliated outside groups:
Last year, an impending ruling in a separate case presented a threat to the Fairholme suit. Judges in the U.S. Court of Appeals for the Federal Circuit were weighing the case of Anthony “Buddy” Piszel, a former Freddie Mac chief financial officer fired after the 2008 government rescue. Piszel didn’t receive a promised $7 million severance and sued, arguing that denying him the money amounted to an illegal taking. But at oral arguments, the appellate judges were openly skeptical.
A few weeks later, the judges got an eight-page amicus brief from the National Black Chamber of Commerce. On the face of it, the Piszel case had nothing to do with the group’s stated mission of promoting black entrepreneurship. In its brief, the Washington-based nonprofit says “a strong interest in the protection of property rights” prompted it to intervene.
That brief was written by Cooper & Kirk PLLC, the law firm that represents Bruce Berkowitz's Fairholme Funds in their lawsuit against the government, but their name didn't appear on the brief. Instead it was signed by Washington lawyer (and my law school classmate) Rebecca LeGrand. "'I don’t know anything about this case,' said LeGrand, who’s now in a solo practice. 'I was involved for five minutes.'"
Some legal realism.
I enjoyed this interview with retiring Judge Richard Posner:
“I pay very little attention to legal rules, statutes, constitutional provisions,” Judge Posner said. “A case is just a dispute. The first thing you do is ask yourself — forget about the law — what is a sensible resolution of this dispute?”
The next thing, he said, was to see if a recent Supreme Court precedent or some other legal obstacle stood in the way of ruling in favor of that sensible resolution. “And the answer is that’s actually rarely the case,” he said. “When you have a Supreme Court case or something similar, they’re often extremely easy to get around.”
You can imagine ranking judges on two axes: legal skills, and sensibility. A judge who is a good lawyer, as Posner is, will in fact find it "extremely easy to get around" Supreme Court precedents. A judge who is sensible will resolve disputes sensibly. If you have a sensible judge who is a good lawyer, you will get pretty good results, though against a backdrop of sort of random lawlessness. If you have a nonsensible judge who is a good lawyer, you will get bad results and lawlessness. If you have a sensible judge who is a mediocre lawyer, you will get reasonable obedience to precedent. If you have a nonsensible judge who is a mediocre lawyer, you will get unreasonable obedience to precedent. If your legal system depends too much on how subjectively sensible your judges are, it will occasionally feel like something less than a legal system. If your famous retiring federal judges say things like "I pay very little attention to legal rules," it will feel like quite a bit less than a legal system.
People are worried about unicorns.
Here is Om Malik worrying that if you're too big a unicorn you should probably stop calling yourself a startup:
They have thousands of employees and many have billions in revenue. What they are not is liquid on public markets. They have not IPO’d. In a different Silicon Valley, they will all be public companies and they won’t be deemed startups. Revenue, growth, relative size, market share – pick a metric (except for lack of profits in many cases) and you know they aren’t really startups.
"My Lyft driver said that his first month driving in SF he thought there was a large company called Startup and everyone worked there," Austin Smith once tweeted: If you work in the Bay Area, you're supposed to work for a startup, and if that startup has billions of dollars in revenue and thousands of employees, well, you're still supposed to call it a startup. It's like "tech": If you work in the Bay Area, you're supposed to work for a tech company, and if that tech company happens to be in the business of grocery delivery, well, you're still supposed to call it "tech."
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