The baseball antitrust exemption has turned out to be one of the great anomalies of American law.  First recognized in the Supreme Court’s Federal Baseball decision in 1922 at a time when “commerce” was understood much more narrowly than it would be in the post-New Deal world, the exemption took on a life of its own in the 1953 Toolson decision when the Supreme Court acknowledged that professional baseball was commerce after all but that it was leaving the matter of invalidating the exemption to Congress.  In 1972, the Court reasserted the exemption in Flood v. Kuhn, and Congress reaffirmed it in 1999 in the Curt Flood Act in regard to all matters covered by the exemption except major league labor relations.

While there is no question that the Major League Baseball antitrust exemption still exists, it is not at all clear what aspects of the baseball business are protected by the exemption.  Does it apply to any undertaking by Major League Baseball, or is it limited to certain baseball-specific activities? Comments made by my colleague Matt Mitten in an interview presented elsewhere suggest that Matt believes that the exemption applies to all aspects of the professional baseball business.

I am not sure that this is true.  A quarter of a century ago the federal district court for the Southern District of Texas ruled that the baseball antitrust exemption did not extend to restrictions on broadcasting.  (Henderson Broadcasting Corp. v. Houston Sports Ass’n, Inc, 541 F. Supp. 263, 265-72 (S.D. Tex. 1982))  So far as I can tell this decision has never been overruled or even directly contradicted by a decision of a different court. Although the Supreme Court has provided no definitive answer, the conventional wisdom appears to be that the exemption applies only to matters central to the “business of baseball.”  This was the standard adopted in the relatively recent case, Major League Baseball v. Crist, 331 F.3d 1177, 1183 (11th Cir. 2003).

Of course this interpretation just replaces one question with another.  We still have to ask what aspects of the baseball business are “central” to its operation, and as of yet, we have no definitive answer.  Clearly territorial monopolies, minor league salary caps; and restrictions of minor league player mobility are central to the operation of baseball, but what else falls into this category?

Now Major League Baseball has gone and entered into a contract with Topps, Inc., giving that company the exclusive right to use Major League team names and logos with in the production of baseball cards. Topps’ primary competitor in the baseball card market, Upper Deck, can still issue baseball cards of players under its non-exclusive license with the Major League Baseball Players Association, but it will not be permitted to use team names or symbols on its cards.  As a practical matter, this will probably force the company out of the baseball card business, at least until Topps’ exclusive license expires.

It is hard for me to see how the production of baseball cards by an independent company could constitute an activity “central to the business of baseball.”  There was a time when baseball cards were a primary way that fans, particularly young fans, learned about the teams and players of Major League Baseball, but in the age of the Internet, it is hard to believe that baseball cards are in anyway a necessary component of marketing Major League Baseball to the public (if they ever were).  Consequently, the new Topps monopoly will likely to be found to be subject to antitrust challenge.  Whether or not the challenge will succeed is a topic for a different post.

On an entirely personal note, I have extremely fond memories of the old Topps baseball card monopoly that existed from 1956 to 1980.  In that period, only Topps produced baseball cards, and the cards were printed on cheap cardboard, packed to the gills with information about the pictured player not otherwise readily available, and packaged with super sweet sticks of bubble gum.  Even with the gum, they were incredibly inexpensive—a penny a card until the late 1960’s, and less than two-cents a card until the late 1970’s.

There were almost no baseball card shops in that era, so cards had to be purchased by the pack in regular stores that sold candy.  If you were missing a player’s card that you felt you needed, you had to buy more packs or else figure out a way to trade with a friend who had a card of the player you wanted. Many kids learned the rudiments of negotiation from such exchanges.

In fact, the only problem with the old Topps monopoly was that it wasn’t a true monopoly.  Fleer, which competed with Topps in the larger bubble gum market managed to sign a few well-known players including a handful of stars—Ted Williams, Maury Wills, and Wilmer “Vinegar Bend” Mizell (who was later a congressman from North Carolina) for example—but the company never had enough players under contract to produce its own bubblegum based player set.  In 1962, the year he was the National League’s Most Valuable Player, the only way to get a Maury Wills baseball card was to find one on the back of a Post Cereal box.

Because the Topps monopoly only applied to cards packaged with bubblegum or its equivalents cards could be marketed with other products, although that rarely happened.  (The Post experiment of putting baseball cards on cereal boxes only lasted for three years.).  In that era, no one thought of simply marketing the cards alone.

If the new Topps monopoly can somehow bring back the magic to baseball card collecting, then it will be a restraint of trade that we should gladly accept.

 However, in my mind both men are associated with the Second Law of Thermodynamics.  This law of physics states that the entropy of an isolated system always increases over time.  Stephen Hawking described it in more comprehensible terms in A Brief History of Time:

It is a common experience that disorder will increase if things are left to themselves.  . . .  In any closed system disorder, or entropy, always increases with time.

 Therefore, when I think of Hawking, I think of someone who can explain the Second Law of Thermodynamics.  When I think of Barney Frank, I think of someone who is desperately trying to avoid its operation.

I would contend that all forms of market regulation follow the Second Law of Thermodynamics.  In each case, a comprehensive statutory scheme is enacted as law, it imposes a closed system of rules on market actors, and over time the scheme inexorably breaks down.  Federal securities regulation, which began with the Securities Act of 1933 and the Securities Exchange Act of 1934, provides the perfect case history of this principle in action.

The federal securities laws were designed to force companies selling their securities to the public to make certain basic disclosures about their finances and business prospects to the potential purchasers of these securities.  The policy goal was to even the playing field so that the buyers of the securities had at least some of the information that the sellers possessed, and the buyers could then make an informed purchase decision.  Federal law therefore created a system of regulation to ensure that specific documents were prepared, and disclosed to the public, before securities transactions were allowed to take place.

This regulatory scheme was imposed on the world as it existed in 1933.  This was a world where the fastest form of communication for a written text was the United States mail.  It was also a world where all information was compiled and stored in a document-centric format: if you sought a particular piece of information you had to search for it by reading through an entire book or a report.  This was also a world where the types of securities sold to the public were comprised mostly of the vanilla variety of stocks and bonds that buyers (and sellers) knew and understood.

 We live today in a very different world.  Technology has changed.  A written text can be sent anywhere in the world instantaneously via the internet.  In addition, information is stored very differently in the digital age.  We enter search terms into Google and Lexis, thereby allowing us to extract specific nuggets of information directly, without having to read through an entire book or document to find them.

 The markets where securities are bought and sold have also changed dramatically.  Virtually anything can be “securitized” and turned into a product that can be traded over the market – from the right to receive future mortgage payments to the risk that the same mortgage holders will default on those payments.   Financial institutions were initially forced to confine their trading to a single line of business: whether securities trading, banking, or insurance.  Over time, however, these rules were relaxed and firms became “financial supermarkets” that were allowed to take on multiple market risks at the same time.  The same company can now take the simultaneous risk that the securities it underwrites will not sell, that the loans it makes will not be repaid, and that its cash flow will not be sufficient to meet its obligations to policyholders.  A single company can survive one bad bet; it cannot survive losing all three.

 These changes in information technology and market behavior all occurred at the same time that economists were radically changing their theories about the way that prices for securities are determined by the market.  The SEC has long embraced the Efficient Capital Markets Hypothesis, which holds that the price of a financial asset reflects all available information that is relevant to its value.  If this theory holds true, then it is proper for regulators to focus their attention on ensuring that companies quickly and accurately disclose new information relevant to their future prospects.  However, behavioral economists have come to the conclusion that investors are often swayed by irrational factors unconnected to objective data about the company, such as an unjustified optimism that a past price rise will continue into the future (the “bubble” effect).  New theories of evolutionary economics posit that investors adopt trading practices in a process of trial and error, keeping strategies that work and dropping strategies that cease to create profit.  The implication is that investment decisions are neither purely rational nor purely irrational, and that the SEC’s single-minded pursuit of information disclosure can never foreclose the possibility of future market bubbles and meltdowns.

It has become plain that the original regulatory scheme of 1933 is beyond the point where minor patching will work anymore, and is probably beyond the point where even serious repair can rescue the original model.  Entropy has overtaken federal securities regulation.  Some might argue that this fact demonstrates that any attempt to regulate the financial markets is ultimately futile.  However, I believe that our experience with securities regulation merely proves that every regulatory scheme has a natural lifespan.

 Our current model for the regulation of financial markets has reached the end of its useful life.  The world we live in has changed to such an extent that the original model should be discarded and a new regulatory scheme embraced.  While it may not be feasible to replace all of our current market regulators, at a minimum those regulatory bodies should be consolidated and given a new mission.

 If financial institutions are going to be allowed to operate in multiple market sectors, then the focus of our financial regulation should be on systemic risk (the risk that conditions across several different market sectors will lead large financial institutions to fail).  In addition, the content of financial regulation should be determined less by the characteristics of the financial product being sold (securities for the SEC, commodities futures for the CFTC, loans for the Treasury Department and the Federal Reserve) and more on the financial stability of companies that sell financial products.  This would entail the enforcement of minimum capital requirements and prohibitions on excessive leverage so that the managers of large financial institutions do not bet the company’s very existence on risky trading strategies.  Finally, the mission of our financial regulators needs to shift away from policing whether sellers have disclosed information and focus on the needs of the public as the consumers of a product.  Are buyers being given a variety of choices?  Does the information being made available allow consumers to make meaningful comparisons between products?  A new Consumer Financial Protection Agency could be created to undertake this last task.

 What I have described are the very premises that underlie the Obama Administration’s proposals to reform financial regulation.  Barney Frank and the House Financial Services Committee have been holding hearings on these ideas.  You can read more about the Administration’s proposals in this report from the Brookings Institution.  I agree with the report’s author that these measures are sensible and overdue.

However, politics always gets in the way.  Each existing financial regulator is jealously guarding its own turf, to ensure that a new system of market regulation does not diminish its authority.  Powerful congressmen, who possess their power due to their seniority on the committees that oversee different segments of the market, do not want to see the old system of regulation abolished.  And financial institutions that have learned how to operate around and between the interstices of multiple regulatory bodies do not want a comprehensive reform that eliminates or even blurs these lines of demarcation.

As a result, any legislation enacting these reform proposals will probably be significantly watered down and the original 1933 model of securities regulation is likely to persist.  According to the Second Law of Thermodynamics, leaving the original model of regulation to itself will result in increasing disorder in the financial markets.  Someone once said that “you can’t fight the laws of physics.”  I think it was either Stephen Hawking or Barney Frank.

Lawyers in Howrey’s apprenticeship program will be paid significantly less than the going rate for first year associates at other large law firms.  During their first year, the new associates will take firm sponsored classes on legal writing and gain practical experience by working on pro bono matters.  During their second year, the associates in the program will spend several months “embedded” at client sites where their work will be charged at a reduced billing rate.  The law firm’s managing partner compared the apprenticeship program to the training programs typically employed in the medical and accounting professions.

 The Howrey program provides an opportunity to reconsider the entire continuum of legal education: a process that begins with undergraduate instruction, continues through law school, and is perpetuated by continuing legal education requirements.  From time to time, each stage in the continuum comes under scrutiny, as Rick Esenberg’s post on Reengineering Law School illustrates.  In my opinion, the continuum should be viewed holistically when we evaluate whether we are succeeding at training competent and ethical members of the legal profession.  Law schools, law firms and the state bar all need to cooperate in order to ensure that there are no gaps in the preparation that new lawyers receive as they start their careers.  As a member of the Wisconsin Legal Education Commission in 1996, I argued in favor of a program of mandatory skills-based CLE instruction for recent bar admittees.  Many of our students are undoubtedly pleased that the State Bar chose not to implement this particular Commission recommendation.

 Given my predisposition in favor of practical training, I should be supportive of the Howrey apprenticeship model.  Instead, I find myself troubled.  In particular, I am wary of the idea of embedding future corporate lawyers within a client’s legal department for any significant period of time.

 Corporate lawyers play a vital role as “gatekeepers” in the area of economic regulation.  The role of outside legal counsel is not just to provide the advice necessary to implement the client’s business plan, but also to guide the client (sometimes gently and sometimes more forcefully) away from tactics that stray too far into the “grey areas” of  prohibited conduct under securities or antitrust law.  Lawyers who fail to take this gatekeeper role seriously, and who unquestioningly advance the client’s interests, risk possible disciplinary action or even criminal charges.

It is worth recalling that, during the 1990s, accounting firms evolved away from their traditional role as financial monitors and towards more lucrative “client consulting” practices.  This inattention to the gatekeeper responsibilities of their own profession led to several high-profile corporate meltdowns.  Today the accounting profession is subjected to unprecedented regulation via the Sarbanes-Oxley Act.  Among other things, Sarbanes-Oxley forces accounting firms to rotate the lead auditors that they assign to their clients.  The purpose of this provision is to reduce the risk that a long time relationship between a particular auditor and a particular client might eventually jeopardize the auditor’s objectivity.

 My concern is that Howrey’s embedded lawyers may be tempted to internalize the client’s perspective, in a way that hampers the future objectivity of these young professionals.  While the details of the law firm’s program are unclear, it would make sense for Howrey to try and perpetuate the relationships that are formed between its apprentices and its clients when it assigns future legal work to associates.  This could lead to a close and career long association between an apprentice and a particular client.  It seems odd to me in this post-Sarbanes-Oxley world that a law firm would seek to mimic the very lack of separation that accounting firms previously fostered between individual accountants and particular clients.

It was this close association that created a culture where auditors acquiesced in the client’s view of how the company’s financial results should be presented, rather than pushing the client to adopt a more defensible presentation.  Outside legal counsel face pressures from clients as well, in this case to rubber stamp the non-financial disclosures in a company’s annual reports and other securities filings.  Will former apprentices prove too pliable when pushed to sign off on the preferred disclosure language of companies where they were once embedded, and with whom they have a career-long association?  If so, our profession should not be surprised if Congress someday mandates that law firms rotate billing partners among their clients required to file public reports, much as accountants must now rotate lead auditors. 

 There are many ways in which the objectivity of corporate lawyers can be compromised.  Outside counsel is often asked to serve on the board of directors of the client corporation.  In some cases, law firms receive the client’s stock as compensation rather than cash.  Engaging in such practices does not necessarily compromise the objectivity of the lawyer, and neither of these examples directly contravenes the ethical rules for lawyers.  Nonetheless, many observers argue that these practices should be avoided because they tempt lawyers to too closely associate their client’s interests with their own, thereby abandoning their gatekeeper role.  It is interesting to consider whether the use of embedded apprenticeships as a training mechanism for corporate lawyers engenders a similar risk.

Examples of these significant developments include: 

• The very rapid economic recovery of the Chinese economy as against those of the U.S. and the E.U. in the wake of the world-wide economic crisis;
• China’s institution of a broad and deep “Buy China” program despite China’s protests of American congressional consideration of an expansion of its “Buy America” program three months ago (because China’s economy includes many state- or military-owned industries, a “Buy China” program that is facilitated by the top-down structure of Chinese law and government can have a much greater disruptive impact on world trade than a “Buy America” program);
• A complaint filed by the U.S. and the E.U. with the World Trade Organization addressing China’s blocking the export of essential raw materials that would be used by competitive industries in the U.S. and E.U. (China has pointed out that it did not agree to the system of world export trade);
• An effort by China (and Russia) to move away from a U.S. dollar-based world trade system to a broader market basket of currencies.

For Americans these issues are quite important.  The ability to obtain raw materials that will be used in creating the products of American labor and the opportunity to export American-made goods on a level playing field  is essential. One does not need to be an economist to understand that it will be very difficult to rescue the American economy if American industry cannot produce goods or cannot sell goods in foreign markets. Indeed, the Chinese remember very well the nineteenth- and twentieth-century imperialism that undermined Chinese society and its economy by draining natural resources and causing the Chinese to have to buy imported finished goods at high prices. With the hollowing out of American manufacturing during the past quarter of a century, the great costs of war, and the recent undermining of the American banking system leading to the current debtor-nation role of the U.S., we can ill afford to endure trade barriers.

The importance of these economic issues transcends mere American business and financial concerns. At their root is a very different outlook as to the role of government in transnational trade, and different approaches to foreign policy and world environmental, labor, and human rights issues.  This is not to say that Chinese self-interest, however it is defined by its government, is inherently antithetical to American interests. Rather, if the U.S. and the E.U. are going to deal effectively in an open world trade environment, they must have citizens who are familiar with the trade issues and actively involved in supporting a policy that provides growth for all. This is especially true at a time of great world economic vulnerability and a very real potential that the kind of protectionism that undermined world trade in the 1930’s may be revived and threaten to lead us into the kind of world economic depression that was a significant factor behind World War II.

Of considerably broader importance, the Communications Act created the Federal Communications Commission (FCC), which has had an extraordinary effect over the decades on the American economy and society. Not so long ago there were calls to abolish the FCC, but they have not achieved success.

This is not to suggest that the FCC is riding high in all respects. 

The FCC’s rulings are, of course, frequently challenged in court. I have a recollection of a brief that derided the FCC’s approach to some issue (a refusal to rule on a particular matter, I believe) as analogous to what Lewis Carroll set forth in Through the Looking Glass:

“The rule is, jam to-morrow and jam yesterday — but never jam to-day.”
“It MUST come sometimes to ‘jam to-day,’” Alice objected.
“No, it can’t,” said the Queen. “It’s jam every OTHER day: to-day isn’t any OTHER day, you know.”

As I recall the matter, counsel for the FCC made the mistake of lamenting in oral argument before the D.C. Circuit that surely the court was tired of reading in briefs references to Alice in Wonderland and the like. One judge leaned forward and said something along the lines of, “You know, we only read them in cases involving the FCC.”

In any event, whatever its recent track record of success before the D.C. Circuit, the FCC plugs along. Time will tell whether it will surpass in longevity its progenitor, the Interstate Commerce Commission. The ICC endured from 1887 to 1995. I am tempted to say that that is another story; but in certain key respects it is the same story, and aspects of it are told here.

Senator Schumer’s bill is best understood as embodying the principle that, when it comes to corporate governance, more democracy is always better.  The assumption is that corporate governance will improve in tandem with increased shareholder voting power.  I question that assumption.

First, more democracy might actually lead to worse directors. 

The transformation of director elections into real voting battles, with the attendant risk that a management-backed candidate might face serious opposition and possible defeat, could very well deter desirable candidates from subjecting themselves to the process.  A director position already entails a risk of legal liability, and the days of “figure-head” directors who have modest demands placed on their time are long gone.  The risk of an embarrassing election defeat only adds to the long list of reasons that well qualified candidates already have for declining a nomination to the board.

Second, contested board elections assume that shareholders can cast an informed vote.  In the past, the cost of gathering and disseminating information to the voters deterred all but the largest shareholder activists from mounting a challenge to board nominees put forth by management.  This ensured that the voters heard only the pro-management side of the story prior to an election, unless activist shareholders succeeded in a time-consuming and expensive effort to include their views in the company’s proxy materials.  The Internet has changed this equation by making information-gathering and communication on behalf of opposition candidates more cost-effective.  But it is not clear that an explosion of information both in favor and against a particular board candidate will result in a better-informed shareholder electorate.  Our experience under the political model suggests that multiple sources of contradictory information can lead to voter confusion or even apathy.

Finally, and most significantly, the time when reforms to the shareholder voting process could make a meaningful difference to corporate governance has already passed.  The direct ownership of stock by American households has declined from 91 percent in 1950 to just 32 percent in 2007.  In contrast, in 1950, financial institutions such as mutual funds and retirement plans owned only nine percent of all stock, while in 2007 that figure was 68 percent.

Today, the majority of votes in a corporate election are cast not by millions of individual shareholders, but rather by a small class of professional money mangers.  These managers of large financial institutions do not behave like the prototypical private individual shareholders.  In particular, the short investment horizon of these money managers makes them less motivated than private individuals to use their voting rights to demand improved corporate governance. 

My colleague Nadelle Grossman has recently written about the problem of “short-termism” among institutional investors and its impact on the structure of corporate governance.  I recommend her piece, which can be found here.  I merely would add a couple of points.

As mutual fund pioneer John Bogle has pointed out, money managers have little or no incentive to support board candidates put forth by activist shareholders against candidates backed by management.  From 1950 until 1965 the average portfolio turnover rate at a mutual fund was 17 percent per year.  From 1990 through 2005, the turnover rate averaged 91 percent per year.  When you replace virtually your entire investment portfolio each year, aggressive participation in proxy contests and director elections concerning the individual companies in your portfolio is a pointless exercise.  What good does it do to improve the machinery of shareholder democracy if fewer shareholders see any connection between their own long-term interest and the outcome of a particular board election?

Moreover, so long as they generate acceptable investment returns for the beneficiaries of their pension funds and mutual funds, the managers of these financial institutions are free to ignore the interests of the broader universe of shareholders.  Financial institutions can and often do contact management directly when they have concerns about the governance of a particular company in their portfolio, bypassing other shareholders, and they may negotiate side deals with management that address the financial institution’s interests without considering the interests of other shareholders. The law leaves largely undefined the legal duties that mangers of financial institutions might owe to their fellow shareholders.         

Given the dominance of institutional investors among today’s electorate, and the ability of institutional investors to bypass the electoral process in favor of other means of influencing corporate policy, Senator Schumer’s bill may be arriving about six decades too late.

Rejecting the “laissez-faire” views that the Antitrust Division had practiced over the past eight years and attempted to enshrine in a policy statement in 2008, Ms. Varney declared that small- and medium-sized competitors, suppliers, and distributors are encouraged to whistle-blow on any anticompetitive practices. Indeed, she stated the government would welcome hearing from those who were suffering at the hands of dominant entities. Although Ms. Varney did not go so far as to adopt the European Union view of dominance as against the evolved modern American view that monopoly in itself is legal and that the burden is on the plaintiff to show that the defendant had attempted to further its monopoly position through anticompetitive practices, she hinted that challenges based on dominance will be given a much more welcome hearing. Moreover, Ms. Varney indicated that mergers will be scrutinized very carefully, especially in certain sectors of the economy. 

Although the new Antitrust Division policy will place the DOJ more in line with the views of the FTC (healing a rift between the two agencies that became an open conflict after the 2007 DOJ policy statement), Ms. Varney was also announcing a legal stand that will at least put parties and courts on notice that the 2008 policy statement does not reflect the views of the DOJ. Considering the predominant Chicago School bias that has been reflected in recent Supreme Court decisions, such as Leegin Creative Leather Products, Inc. v. PSKS, Inc., 127 S. Ct. 2705 (2007), and Bell Atlantic Corp. v. Twombly, 127 S. Ct. 1955 (2007), the new policy statement could play a significant role in shifting the nature of case selection and legal arguments by the government. But the effect of the new policy statement may go much further. In light of the appointment of a generation of federal judges raised on the dogma of the Chicago School theories, the Antitrust Division announcement could deny the opportunity to use government guidelines as a crutch for decisions that reflect theories over realities in private litigation. Of course, there are many benefits from the economic analyses that inform reasoned decision-making. But, much like the philosophies that dominated banking and securities regulation over the past decade, the Chicago School antitrust doctrines need to be reined in to meet the realities of the marketplace. Hopefully, the courts will treat the Antitrust Division’s policy analysis and guidelines with the same deference as they did those established in the past, and not just ignore them by continuing with their judicial activism in setting economic and legal policy for the country.

The 21^st Century Disclosure Initiative finished its Report in January 2009.  You can read the Report here: www.sec.gov/spotlight/disclosureinitiative/report.shtml.  The recommendations in the Report are both modest and potentially revolutionary.  Today the SEC continues to operate under the same system of preparing and filing specific disclosure documents such as annual reports and quarterly reports that was instituted in 1934.  In the 1990s, the Commission adopted EDGAR, a system for filing and viewing each individual report electronically.  However, the “document centric” format remains and anyone searching for specific items of company data today on EDGAR still has to typically scroll through hundreds of pages to find what they are looking for.

The Report by the Initiative proposes the adoption of company-specific databases for each company required to file reports with the SEC. 

Each database would contain all of the information about that company using XBRL (eXtensible Business Reporting Language) tags attached to each specific item of data.  The use of tags will allow users to search for specific data contained in a filing (i.e., earnings per share) without having to scroll through lots of text.  The use of tags will also allow for quick comparative searches across different companies.  All of this can be implemented using readily available computer software that has been used in private industry for years.  In some respects, therefore, this is a fairly modest reform that should be easy to enact, assuming that budgetary constraints and the demands of other agency priorities don’t get in the way.

What could be revolutionary about the Initiative, however, is that it lays the groundwork for the SEC to undergo a metamorphosis.  Instead of a paper tiger that has to pick and choose its enforcement priorities, the SEC could become a much more proactive and efficient market regulator.  The existence of a constantly updated searchable database will allow the Commission to apply forensic algorithms to company data in order to flag questionable financial disclosures.  It will allow the Commission to audit many more filings than is currently possible.  It will also allow the Commission to aggregate comparable data across multiple companies in order to identify areas of systemic risk in the markets.  In other words, by changing the way in which the SEC collects and manages financial information, the Initiative could actually give the Commission the technological tools that it needs to deter financial fraud and abuse before it happens, rather than being limited to its traditional role of cleaning up after the fraud has already occurred.

“A beggar’s mistake harms no one but the beggar. A king’s mistake, however, harms everyone but the king. Too often, the measure of power lies not in the number who obey your will, but in the number who will suffer your stupidity,” writes R. Scott Bakker in his latest novel, The Judging Eye. 

Bakker’s proverb seems to apply to the current economic situation (climate, recession, downturn, depression, hiccup, what are we calling it again?) and especially the continuing outcry over AIG’s payment of $160 million in bonuses after accepting more than $170 billion in bailout money.

The king’s (AIG) mistake (insuring subprime mortgages) has harmed everyone (taxpayers) but the king. AIG is still in business, still handing out large bonuses, still muddling along without having to worry about bankruptcy because of what has so far been readily available bailout money from the federal government. AIG has suffered some harm, but its position as a “king” in the financial world enabled it to divert a good chunk of the harm from itself to “everyone”—the taxpayers.

In the terms of Bakker’s proverb, AIG’s power is measured in the number of people willing to suffer its stupidity. Recently, and especially this week, the number of people willing to suffer AIG’s stupidity appears to be rapidly decreasing, along with AIG’s power.

When members of the financial industry first turned to the federal government—the Federal Reserve and then Congress—for bailouts, one of their arguments was that the worldwide financial markets were too complex for laymen to understand and that the bailout money should be handed to the experts (the members of the financial industry) without restrictions or further delay. And seemingly, the government and the public were willing to suffer the stupidity inherent in the argument—we made the mess, but trust us, we know how to clean it up. After all, who does understand banks, insuring banks, subprime mortgages, securitizing mortgages, or the financial markets? The financial industry argued that it served a crucial role in the national economy and without the bailout, the financial industry would collapse with uncertain results. Certainly the experts on Wall Street must know better than the public and the government how to fix the problem, right? 

Well, maybe not. More and more it appears that the experts didn’t really understand what was going on either, and maybe didn’t even really know what the bailout money could accomplish. But when your business is losing money, more money is always a good thing, and the experts were sure of that.

Compare the government and public response to the auto industry’s financial troubles with their response to the financial industry’s troubles. From the beginning, the government and the public were much less open to bailing out the domestic auto industry. Why? Don’t the domestic automakers serve an important role in the national economy? The auto industry employs tens of thousands at high wages, provides health care for even more, and actually makes something tangible that people use everyday. 

And that was the problem for the auto industry—the public and the government understand the auto industry, or at least think they do, in a way that is completely different from their understanding of the financial industry. 

The auto industry wasn’t mysterious. If the auto industry was in trouble, they just needed to make better cars, more hybrids, fewer gas guzzlers, be more like Toyota and Honda. Because the government and the public believed they understand the auto industry, they weren’t willing to suffer the stupidity of the auto industry that led to its economic woes. Accordingly, the auto industry didn’t have much power when it went in front of Congress asking for a bailout.

On the other hand, the financial industry was mysterious. No one really understood how it worked or what would happen if companies like AIG went under, so the government and the public were more willing to suffer the stupidity of the financial industry that led to its economic woes. Accordingly, the financial industry had more power than the auto industry and used that power to get more money with fewer restrictions when it went asking for a bailout.

Now, however, the government and the public are finally catching up to the financial industry. They may not understand how the entirety of the financial industry works. But they do know that performance bonuses should reward actual performance, as opposed to rewarding failure. And they know that the argument that the bonuses are needed to retain top talent doesn’t really work when the talent may or may not have left the company—without even getting to the question of should the company even want to retain the people that led it into this mess in the first place. 

In short, the public and the government are less willing to suffer the stupidity of the financial industry than they were just a few months ago. Which I think is a good thing. This new willingness of the public and the government to ask questions and not suffer the stupidity of major industries—be it the financial industry, the auto industry, or others—moves major industries from their positions as “kings” who can redirect harm from themselves to everyone else to positions as “beggars” who must suffer the harm of their own mistakes.

*I worked for General Motors at the Janesville, Wisconsin assembly plant as a summer intern and as a maintenance engineer from 1999-2006.

What is the chance that any given home will decline in value? You can look at the past history of housing prices to give you an idea, but surely the nation’s macroeconomic situation also plays an important role. And what is the chance that if a home in one state falls in value, a similar home in another state will fall in value as well?

Enter [David X.] Li…. Using some relatively simple math—by Wall Street standards, anyway—Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps. . . . It was a brilliant simplification of an intractable problem. . . .

The effect on the securitization market was electric. Armed with Li’s formula, Wall Street’s quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li’s copula approach meant that ratings agencies like Moody’s — or anybody wanting to model the risk of a tranche — no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.

As a result, just about anything could be bundled and turned into a triple-A bond — corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them — an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn’t matter. All you needed was Li’s copula function.

The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

The problem was that the model was only as good as its inputs, and the data being input was all drawn from a bad sample: the short period of time when the market for credit default swaps actually existed, which just happened to be a time when housing prices were rising. The risk of correlated mortgage defaults in a housing downturn therefore wasn’t priced, it was excluded. A fact, it seems, which almost everyone ignored, no doubt entranced by the millions, or billions, everyone else was making. At least the tulip mania generated a lot of pretty flowers.

Jessica cites to a post on Concurring Opinions which relies, to some extent, on a comment in response to a post that I wrote on Prawfs. It’s a small blogosphere after all.

There is much to be said in response to the Pasquale post (which I agree is provocative), but I want to focus on one part that Jessica highlights:

Can anyone doubt that our economy is exposed (with each passing day) as more Sicilian in its “winners’” casual acceptance of fraud, more Russian in its oligarchic tendencies, more Brazilian in its inequality?

Well, I think I can.

It is a natural human tendency to overemphasize whatever happened yesterday. But let’s take the financial meltdown as somehow emblematic of “our economy.” Over the past few months, I yet to read a convincing argument (as opposed to an assertions) that the problem was a result of fraud (although there certainly was some, as there will always be) or deregualtion.

One can always imagine regulation along the lines of “don’t do that again,” which will seem wise in hindsight. The one bit of proposed regulation that might have helped (reining in Freddy and Fannie) was opposed by the Democrats, who, in the words of Barney Frank, did not want “to raise safety and soundness as a kind of general type of shibboleth.” Another type – tightening lending standards – would have been dead on arrival.

Pasquale wants to say that a market economy does not recognize the ways in which wealth is commonly created. That’s not true. Markets (which are always a product of some form of regulation – they require rules) permit interaction for the creation of wealth by voluntary exchanges between participants.

The results may not always be what we would like them to be, and they are influenced by the existing distribution of wealth and talent. But, in the American context, no one really suggests that market forces should determine everything. Even over the last thirty years, government’s share of GDP has continued to rise, albeit only slightly.

Inequality is, I think, a problem, but lack of wealth can be a larger one. Pasquale quotes Patrick S. O’Donnell’s recitation of a a number of tenets of Catholic social teaching in response to a post of mine over at Prawfsblawg.

I disagree with none of them, although I think Patrick’s restatement of the idea of subsidiarity is incomplete; it is not simply about which level of government should do some thing. 

But to accept these aspirations is not to accept any particular way of accomplishing them. Nor does it imply any particular tradeoff between conflicting goals. To move substantially in the direction of a more statist society (at least as concerns the economy) would, I think, be a mistake that would disserve these principles.

Cross posted (with modifications) at PrawfsBlawg.

The current crisis exposes the fragility of markets generally. They are built on mutual reciprocity, and as more opportunism from trusted intermediaries is exposed, the weaker our faith in other market actors becomes. Both Francis Fukuyama’s work on trust and Robert Putnam’s on the “social capital” it reflects bode ill for our economy. Putnam describes a southern Italy mired in corruption and fraud, and a northern Italy whose economic success is built on its long history of civic associations and mutual endeavor. Can anyone doubt that our economy is exposed (with each passing day) as more Sicilian in its “winners’” casual acceptance of fraud, more Russian in its oligarchic tendencies, more Brazilian in its inequality? After the Madoff scandal, what are investors to do–personally spot-check their broker’s office and assure that trades are actually being made?

There is a bunch of other interesting stuff in this post, but I think I’ll just end with my favorite part.  In discussing the “worship of wealth,” Pasquale quotes from the blog of former fund manager John Bogle:

At a party given by a billionaire on Shelter Island, the late Kurt Vonnegut informs his pal, the author Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch 22 over its whole history. Heller responds, “Yes, but I have something he will never have . . . Enough.”

According to the Risk and Governance Blog:

The Laborers’ International Union of North America and the International Brotherhood of Teamsters are filing new proposals that seek compensation reforms at companies that participate in the U.S. Treasury Department’s bailout program.

In the supporting statement for these 2009 resolutions, the labor funds argue that the pay restrictions in the Treasury’s Troubled Asset Relief Program (TARP) “fail to adequately address the serious shortcomings of many executive compensation plans.” Instead, the unions urge directors to adopt “more rigorous executive compensation reforms that we believe will significantly improve the pay-for-performance features of the Company’s plan and help restore investor confidence.”

According to the Associated Press, more than 110 financial firms have indicated that they likely will participate in the TARP’s Capital Purchase Program, under which the government has so far committed up to $250 billion to buy preferred stock. The labor funds have filed this resolution at JPMorgan Chase, KeyCorp, Bank of America, American Express, and SunTrust Banks, and plan to submit the proposal at more than 45 other firms.

The proposal calls for directors to adopt the following reforms:

* Limit annual incentive compensation to an amount not exceeding one times the senior executive’s annual salary;

* Require that a majority of long-term compensation be awarded in the form of performance-vested equity instruments;

* Freeze new stock option awards to senior executives, unless the options are indexed to peer group performance so that relative, not absolute, future stock price improvements are rewarded;

* Require senior executives to hold for the full term of their employment at least 75 percent of the shares of stock obtained through equity awards;

* Prohibit accelerated vesting for all unvested equity awards held by senior executives;

* Limit all senior executive severance payments to an amount no greater than one times the executive’s annual salary; and

* Freeze the accrual of retirement benefits under any supplemental executive retirement plan (SERP) for senior executives.

The labor unions urge directors to adopt all of these reforms unless barred by existing executive employment agreements.

In short, the bailout has presented an opportunity for unions to actively challenge excessive executive compensation. This is an example of how unions through their roles as shareholders are seeking to influence executive pay, voting for boards of directors, and other corporate governance issues.

Cross posted at Workplace Prof Blog.

The current neoconservative majority of the United States Supreme Court and the lesser appellate courts will make it difficult for a new presidential administration to bring the change needed to correct the imbalances fostered by the Bush Administration. Because the development of antitrust law is driven more by the courts than by the executive branch (especially when one is trying to open the spigot to allow application of antitrust law to police the marketplace, as against using the government as a bottleneck), the new administration may have little effect in its efforts to rein in the excesses wrought by the Chicago School theorists. Still, like the Bush Administration, the new administration can use its executive branch powers to foster practical doctrines. By challenging the unsupported parts of the Chicago School doctrine (e.g., fear of free riders where none seem to appear) and showing respect for administrative agency determinations, the new administration may enable a revival of antitrust law protection against the abuses in vertical distribution and elsewhere that have been sheltered by the Bush Administration.  A healing of the open rift between the Antitrust Division of the Department of Justice and the Federal Trade Commission that has simmered for many years and finally erupted over the past year may foster more effective cooperation and thereby better protection of the marketplace. 

Still, whenever the Antitrust Division, the FTC, or private parties bring antitrust actions, the judicial theorists are very likely to apply standards set by the Chicago School dogmatists.  Consider the willingness of the neoconservative members of the Supreme Court last year (in Leegin Creative Leather Products, an antitrust case, when addressing a substantive standard of proof that had been actively upheld for almost a century) to abandon the stare decisis standards that had been endorsed by some of the same neoconservative jurists a year earlier in Wisconsin Right to Life.  This augurs poorly for the prospects that their judicial activism will be stilled by a new administration. Indeed, even the ability of the FTC to bring reasoned application of the antitrust laws administratively has been undermined by the neoconservative jurists, who have not avoided treading on the historic fact-finding role of administrative agencies. Although a new presidential administration may change the focus of enforcement by the Department of Justice, it may take many years to undo the actions of the neoconservative majority of the current Supreme Court and of the Bush appointees in the lower-level United States courts.