Economics of Contempt

Earlier this week, Joe Nocera wrote a puff piece on Karen Petrou of Federal Financial Analytics. In the piece, Nocera and Petrou repeat a frequently-heard — but nevertheless exceedingly superficial — argument that has always bothered me. From Nocera’s NYT column:

[Petrou] also points to a contradiction in the way the Too Big to Fail institutions are being dealt with. On the one hand, Dodd-Frank is very clear that if a big bank becomes insolvent, there can be no taxpayer bailout. It must be wound down, just like any other bank. Yet, at the same time, she says, the federal and international regulators are adding a host of special Too Big to Fail capital requirements and rules. “They are acting as if these institutions are still too big to fail. The two thrusts are incompatible.”

Oy. This is not a contradiction. Applying additional capital requirements and more stringent regulations to certain large financial institutions is absolutely not incompatible with ending Too Big to Fail — or with Dodd-Frank’s new resolution authority for large financial institutions.

The new resolution authority makes is easier for large financial institutions (known as SIFIs) to fail, which is the exact opposite of “acting as if these institutions are still too big to fail.” Moreover, the additional capital requirements and regulations for SIFIs in no way contradict the resolution authority. The purpose of the additional capital requirements and enhanced prudential regulations for SIFIs is to make it less likely that a SIFI will fail. The purpose of the resolution authority is to make sure that when a SIFI fails, it can do so without bringing down the entire financial system. These are not contradictory — they’re complementary.

These are pretty basic concepts of financial reform — I wrote a post way back in October 2009, before Congress even took up the financial reform bill, explaining how a SIFI regime and a new resolution authority would fit together. The fact that so many financially-focused pundits have yet to move beyond the “hey, if they’re ‘systemically important’ they must be TBTF!”-level of analysis is just sad.

Last night, Bloomberg reported that the Basel Committee was considering revising Basel III's new Liquidity Coverage Ratio (LCR) to allow banks to use equities in their liquidity pools. This would be a relatively major change, and one which I consider ill-advised. (For background, I've written about the LCR several times before.) From Bloomberg:

"The Basel Committee on Banking Supervision, which coordinates regulations for 27 countries, may let banks use equities and more corporate debt, in addition to cash and sovereign bonds, to satisfy new short-term liquidity standards, said two people with direct knowledge of the plans who requested anonymity because the talks are private."

At a Senate Banking hearing today, Fed Governor Dan Tarullo confirmed this report. He also indicated that the Fed would support expanding the list of assets that are eligible for the LCR's liquidity pool. Here's Tarullo after being asked about the Bloomberg report (from the CQ transcript of the hearing):

We — which is to say the Federal Reserve — was one of the entities which asked internationally to take another look at liquidity coverage ratio.
...
And one of the — one of the precepts, I think, for the — for the renewed look was just the point that you were making, that if you're worried about the liquidity of a firm, what you're really asking is, how well is the liabilities and the assets of that firm matched so that in a period of stress it can cover its needs in a — over some period of time so that it has a plan for — it can develop a plan for longer run survival.

And what I have thought was that the 2008 period gave us a very good real life experiment to test what kinds of instruments actually do remain liquid even during a period of stress like that. For example, highly traded equities of large companies.

So that is in fact one of the motivations for the rethink, and I believe that once the international group at the Basel Committee that's looking at the LCR has finished its evaluation next year, that you will see some changes in things like what qualifies in assumed run rates and the like, to try to conform the requirements somewhat more closely to the experience we actually had in late [2008].

Tarullo, therefore, seems to be willing to allow banks to use certain large-cap equities in their liquidity pools. (Basel III's LCR requires banks to maintain large liquidity pools, which must be made up of "high quality liquid assets," so technically what Tarullo is saying is that certain large-cap equities should be included in the definition of "high quality liquid assets.")

Two points here. First, there's a reason that most banks don't currently include equities in their liquidity pools, and that the Fed applies higher haircuts to equities in its emergency lending operations. The reason is that equities are typically more volatile than other instruments (e.g., fixed-income). Allowing banks to use equities in their liquidity pools increases the risk that a bank will have a large shortfall in its liquidity pool on a given day. Presumably, if the Basel Committee makes this change, equities would be categorized as "Level 2" high quality liquid assets (which I explained here), which means a 15% haircut would be applied. But does anyone honestly believe that a 15% haircut is enough for equities — especially given the wild swings in the equity markets that we witnessed even in 2008? I'm not at all convinced that there's a large class of equities that would be truly liquid in a crisis, and certainly not a large enough class to justify the inclusion of equities in banks' liquidity pools.

Second, I'm disappointed to see Tarullo endorse the argument that we can determine which assets are truly liquid by looking at how they fared in the 2008 crisis. As I've noted before, this is a really stupid argument. It may be true that certain large-cap equities maintained their liquidity throughout the 2008 crisis, but there were also massive government bailouts in 2008 — not to mention the extraordinary amounts of liquidity that the Fed pumped into the financial system.

How much did those large-cap equities that Tarullo refers to rely on the Fed's extraordinary lending programs (directly and indirectly) to maintain their liquidity? The point of the LCR is to ensure that banks can survive a funding crisis without massive government bailouts. Contra Tarullo, 2008 is NOT a very good — or even an appropriate — guide. Regulators will simply have to accept that determining which assets are likely to remain liquid in a TARP-free crisis will require the application of judgment on their part.

This is a development worth watching.

The American Banker leaked part of a draft of the regulators’ proposed Volcker Rule (pdf) last week, which has caused quite a stir. The first thing to note is that the American Banker did not leak the most important part: the text of the proposed rule. Instead, they leaked the “Supplementary Information” (which I call just the “Supplement”), the core of which is a lengthy, section-by-section analysis of the proposed rule. In addition, the leaked portion does not include the Appendices to the proposed rule, which, from reading the Supplement, appear to be very important — Appendix B, for example, contains a “detailed commentary regarding how the Agencies propose to identify permitted market making-related activities,” which is a core issue.

First I’ll give some general thoughts on the proposed Volcker Rule, and then, because I’m such a generous guy, I’ll go ahead and highlight some of the most important pressure points in the proposed rule.

General Thoughts on the Proposed Volcker Rule

In general, the proposed Volcker Rule appears to be very good: it’s a serious effort by a group of smart, market-savvy people to draw a workable distinction between market-making and proprietary trading. The regulators recognize the importance of both market-making and hedging, but they also recognize (most of) the places where market-making and hedging can bleed into proprietary trading. And in those situations, the regulators realize that any effort to distinguish impermissible prop trading from permissible market-making or hedging will — quite appropriately — require a very fact-intensive inquiry. That said, I’m still going to have to withhold my final judgment until I see the actual text of the proposed rule.

Also, even though the WSJ keeps trying to gin up controversy over the proposed Volcker Rule allowing hedging on a portfolio basis, the regulators note in the Supplement that allowing hedging on a portfolio basis is “consistent with the statutory reference to mitigating risks of individual or aggregated positions” (emphasis in original). I explained this a couple of weeks ago; it is a faux-controversy. Moreover, prohibiting banks from hedging on a portfolio basis is a monumentally stupid idea in the first place — it would make risk managers’ jobs 100 times harder, introduce all sorts of new risks into banks’ books (counterparty risk would skyrocket), and dramatically raise hedging costs. This is one thing that the statutory text of the Volcker Rule actually got right.

Some Pressure Points in the Proposed Volcker Rule

Now, to the nitty-gritty of the proposed rule. Here some of the major pressure points in the proposed Volcker Rule that I see:

1. Hedges must be “reasonably correlated” to the underlying risk: In defining “risk-mitigating hedging activity,” the rule requires that the hedge be “reasonably correlated” to the underlying risk(s). The Supplement implies that the correlation must be reasonable at the outset of the hedging transaction, which is absolutely appropriate — a lot of times, you think a trade will be a good hedge when you put the trade on, but because of circumstances beyond your control, it turns out not to be a very good hedge (e.g., liquidity may unexpectedly dry up in either the underlying or the hedge, screwing up the normal correlation).

The real question here is: in normal market conditions, when does the correlation between the hedge and the underlying become “unreasonable”? In other words, how much leeway will banks have in determining how to hedge their books? Say a bank enters into a swap that only hedges 50% of the DV01 of the underlying bond. Would that be considered “reasonably correlated” to the underlying risk? (Obviously, I’m simplifying my examples for illustrative purposes.) After reading the Supplement, I strongly suspect that I know what the regulators’ answer would be: it depends on the particular facts and circumstances. If, for example, the swap was coupled with another transaction that hedged the remainder of the DV01 of the underlying bond, then both transactions would be permitted, because when viewed together, they were both part of a legitimate hedging strategy.

The Supplement also hints at what regulators would NOT consider to be “reasonably correlated” — it states that “[a] transaction that is only tangentially related to the risks that it purportedly mitigates would appear to be indicative of prohibited proprietary trading” (emphasis mine). I think it would be a stretch to say that regulators intend to consider any transaction that’s more than “tangentially related” to be a “reasonably correlated” hedge. But this at least indicates that regulators won’t simply accept a hand-waving, “trust me, they’re related” response to inquiries about the appropriateness of a hedge.

In the end, what we know is that a permissible hedge must be less than “fully correlated” but more than “tangentially related” to the underlying risk, and that if the appropriateness of a hedge is questioned, it will be a very fact-intensive inquiry. Which, by the way, is the way it should be.

2. “Additional significant exposures”: The proposed rule prohibits hedges that themselves introduce significant, unhedged exposures. However, the Supplement also states that:

“[T]he proposal also recognizes that any hedging transaction will inevitably give rise to certain types of new risk, such as counterparty credit risk or basis risk reflecting the differences between the hedge position and the related position; the proposed criterion only prohibits the introduction of additional significant exposures through the hedging transaction.”

There are actually three potential flashpoints in this prong. The first flashpoint is what constitutes “additional significant exposures.” How significant does the new risk that the hedging transaction is introducing have to be before regulators will require it to be hedged as well?

The second flashpoint is what constitutes mere “basis risk,” and what constitutes an impermissible residual risk. The Supplement says that a hedge that merely introduces counterparty or basis risk is permissible. Here’s what I would tell our trading desks if I were still working at an investment bank: start calling every residual risk a “basis risk.” Basis risk evidently doesn’t need to be hedged under the proposed Volcker Rule, regardless of how significant the exposure is. So if you want to profit from the price movement in a certain risk, then just partially hedge the risk with another transaction and call the residual risk “basis risk.”

The third flashpoint has to do with when the “additional significant exposure” must be hedged. The Supplement states that if a hedge introduces a significant new exposure, then the exposure must be hedged “in a contemporaneous transaction.” Assuming that regulators will allow banks some time to hedge the new exposure, the question becomes how much time will they have to hedge the new exposure? An hour? A day? A week? I strongly suspect that the regulators’ answer will be that banks will have to hedge the new exposure “as fast as humanly possible” (not in those words, obviously — the legislative language will probably be something like “as quickly as technologically practicable.”)

3. “Bona fide liquidity management”: This is where I would go first if I was trying to circumvent the Volcker Rule. The statutory text of the Volcker Rule defines proprietary trading in a very roundabout way, such that the real definition of proprietary trading is in the definition of a “trading account.” However, the proposed rule provides an exclusion from the definition of a “trading account” for accounts that are use “to acquire or take a position for the purpose of bona fide liquidity management, so long as [five] important criteria are met.”

The reason I would go here first if I was trying to circumvent the Volcker Rule is that if a trade could fit under the “bona fide liquidity management” exclusion, there would be no need to bother with any of the more complicated “permitted activities” exceptions, and evidently, no need to report nearly as much, if any, quantitative trading data to regulators.

The proposed rule requires that trades done under the liquidity management exclusion be done according to a “documented liquidity management plan” that meets five criteria. But none of the five criteria in the proposed rule appear to me to be prohibitive if a bank wanted to use the liquidity management exclusion for prop trades. The plan has to “specifically contemplate and authorize any particular instrument used for liquidity management purposes” — fine, just write a liquidity management plan that contemplates the use of a (very) wide range of instruments (a lot of instruments have reasonably liquid markets in normal times). The second criterion basically requires that an instrument used for liquidity management not be used “principally” for prop trading purposes, which is easy, since prop trading is prohibited regardless of whether it’s the “principal” purpose of the instrument.

The third criterion requires the liquidity management plan to be “limited to financial instruments the market, credit and other risks of which are not expected to give rise to appreciable profits or losses as a result of short-term price movements.” This criterion simply can’t be enforced terribly stringently — even Treasuries, which are the core of any serious liquidity pool, often experience significant short-term price movements. Fourth, the plan would have to limit liquidity management positions to “an amount that is consistent with the banking entity’s near-term funding needs.” This also can’t be seriously enforced, because it would directly conflict with Basel III’s new Liquidity Coverage Ratio (LCR), and cautious liquidity management in general. Finally, the plan would have to be “consistent with the relevant Agency’s supervisory requirements ... regarding liquidity management.” Seeing as the new liquidity rules set a floor on a bank’s liquidity management, and not a ceiling, using instruments that don’t qualify for the LCR in a broader liquidity management plan would certainly still be “consistent with” the regulators’ liquidity requirements.

4. “Near term” / “Short term”: The statutory text of the Volcker Rule effectively defines a proprietary trade as any trade done “principally for the purpose of selling in the near term.” While the Supplement doesn’t provide much detail on what constitutes “near term,” it does hint at an answer: 60 days or less. The proposed rule will apparently include a rebuttable presumption that any account used to take a position that is held for less than 60 days will be considered a “trading account.” Therefore, it stands to reason that accounts which are used (exclusively) to take positions that are held for longer than 60 days will not normally be considered “trading accounts,” and thus not subject to the Volcker Rule. But, of course, I strongly suspect that the regulators will say that this determination is ultimately going to be based on the particular facts and circumstances of the trade.

Anyway, there are a few more pressure points like this in the Supplement, but that’s all I have time for right now.

No need to beat around the bush here: Ron Suskind’s “Confidence Men” is a terrible book. It’s not even remotely accurate, and contains surprisingly little new, original information.

The fundamental problem is that Suskind is stunningly ignorant of basic macroeconomics, financial markets, the financial crisis, and financial regulations — basically, all the subjects you’d need to understand in order to write a competent book about the Obama administration’s economic team. It also contains so many patently absurd, completely unsourced assertions that it’s really not a question of whether Suskind makes up some of his material, but rather how much of his material is made up.

Curiously, the articles slamming Suskind’s book almost all cite a series of minor errors (e.g., saying Tim Geithner was the “chairman” of the NY Fed rather than the “president”) in order to demonstrate Suskind’s incompetence. The book is riddled with much more major errors — errors which provide the foundation for his cooked-up narrative. To give you a flavor of what I’m talking about, here are a few representative examples.

Suskind’s Ignorance of Basic Macroeconomics/Monetary Policy

On page 22, Suskind claims that the idea of making interest rate cuts the primary tool of monetary policy was “an innovation of previous Fed chairman Alan Greenspan.” Yep, no central banker had ever thought to make interest rate cuts their primary policy tool before Greenspan. It gets worse though. Suskind then claims that Fed interest rate cuts only stimulate the economy because they “prompt everyone, everywhere, to roll over debts of all kinds by replacing whatever is on their balance sheet with its equivalent.” That’s it. Interest rates are cut, everyone refinances all their loans, and that’s it. No new loans being made, no inflation, nothing. This is what he thinks monetary policy is (and he repeats this several more times in the book, so it’s clearly how he thinks monetary policy works). This is not some trivial detail, either — how can Suskind be expected to understand the decisions that were being made if he can’t even understand how the Fed works on the most basic level?

Suskind’s Ignorance of the Repo Market

On pages 72–73, Suskind’s complete ignorance of the repo market causes him to badly misinterpret something Tim Geithner said to him — an interpretation which he then uses to further his very unflattering portrait of Geithner.

First of all, Suskind simply asserts, without any sourcing at all, that in August 2007, Geithner had only a “passing familiarity” with the repo market. The idea that the president of the NY Fed had only a “passing familiarity” with repos is absurd on its face. One of the NY Fed’s primary functions is implementing monetary policy, and one of the main ways it does this is by entering into — you guessed it! — repos. Did someone tell Suskind that Geithner only had a “passing familiarity” with repos? Clearly not, or else he would have sourced it, even anonymously. No, it’s clear that Suskind simply made it up in order to further his fictitious unflattering portrait of Geithner.

Ironically, Suskind then proceeds to demonstrate his own ignorance of the repo market, in a discussion of Countrywide’s difficulties securing repo financing in August 2007. From the book (emphasis on the comically wrong parts added):

“That was really interesting,” Geithner later reflected, “because Countrywide had no idea what its exposure was, no understanding of what it had gotten into. And the fact that the market was unwilling to fund Treasuries if Countrywide was a counterparty was the best example of how fragile confidence was and how quickly it turned.”

Translation: the market would not even lend Countrywide cash to buy Treasury bonds, the safest investment in the firmament. CDOs, MBSs, or similar types of mortgage-based collateral that Countrywide was using to roll over its repo loans were suddenly seen as impossible to value or sell in August 2007, meaning that it was illiquid. The whole point of collateral is that it can be taken — the way the repo man repossesses your car after too many missed payments — and sold in liquid markets for cash. Collateral that is illiquid is no collateral at all. Countrywide’s intended use for the borrowed funds — to go out, like Sal Naro, and buy Treasuries and shore up its balance sheet or to use them as collateral for emergency bank loans — was irrelevant. Its collateral was no good.

Geithner, at the time and looking back, saw this strictly in terms of confidence.

No, no, a thousand times no! Suskind completely misinterpreted what Geithner was saying. Countrywide wasn’t trying to use CDOs and MBSs to fund its repo book — it was trying to use Treasuries as collateral on repos, and counterparties were still refusing to roll over Countrywide’s repos. That’s why Geithner said it was “really interesting” — because market participants had become so scared of counterparty risk that they wouldn’t even lend against Treasuries (which in theory shouldn’t happen). Suskind evidently doesn’t know that Countrywide originated the subprime mortgages that went into the MBSs and CBOs; it wasn’t the end investor in the CDOs. But Suskind uses his horrible misinterpretation to paint Geithner as naïve and in denial about the depth of the problems in subprime MBSs and CDOs. (“Silly Geithner, he thought it was just a confidence problem!”) There’s a mistake like this on practically every page of the book (his misinterpretation of a memo by UBS’s Robert Wolf is classic in its utter wrongness too), and it all contributes to a narrative that, at the end of the day, is simply false.

Suskind’s Ignorance of the Difference Between Creditors and Equity Holders

Finally, in the chapter on Geithner’s alleged refusal to resolve Citigroup (which very clearly never happened) Suskind writes:

Geithner, on this point, would not budge. Debt was sacrosanct. No creditor would suffer. Bair was equally intransigent. Secured creditors, such as equity holders, of course, wouldn’t be wiped out, but they had to face consequences for lending money to an institution whose recklessness had led to its demise. They must, she said, “face some discipline.”

Yes, you read that right: Suskind does not know the difference between secured creditors and equity holders. He apparently thinks that in a resolution of Citi, equity holders “wouldn’t be wiped out” (“of course,” he says). Again, this is not a trivial mistake — this is enormously important, because the entire debate over what to do with Citi revolved around the distinction between creditors and equity holders. The FDIC was (allegedly) advocating putting Citi’s commercial bank subsidiary into receivership, which would haircut creditors, whereas Geithner was advocating the stress tests, which in a worst-case scenario would lead to the government diluting equity holders, but not haircutting creditors.

This demonstrates quite clearly that Suskind lacked the knowledge or ability to understand the central dispute in his own book — the dispute that made headlines all over the country. How can Suskind be expected to understand what happened in this dispute if he couldn’t even understand what the dispute was about in the first place?

The answer, obviously, is that Suskind’s account of the dispute is not credible. (Bolstering that conclusion is the fact that the meeting in which Obama allegedly ordered the resolution of Citi has been reported on several times before, and every other journalist reported that Obama decided against resolving Citi.)

Anyone who is even remotely familiar with the financial crisis, or financial markets in general, would be able to catch 90% of Suskind’s mistakes/fabrications, so I don’t know how anyone who knows this material could possibly consider Suskind’s book credible. His account of the financial reform debate was, if possible, even more riddled with fundamental misunderstandings and mistakes, which renders his telling largely false. I was as close to the financial reform debate as anyone, and Suskind’s account is simply not what happened.

In any event, don’t waste your money.

I want to smack down this particular bit of misinformation before the regulators release their proposed Volcker Rule, so that they don’t get hammered for absolutely no reason.

Last week, the WSJ ran a story claiming that a draft version of the regulators’ proposed Volcker Rule would substantially weaken the original law, because the draft rule defines “hedging” on a “portfolio basis.” The problem with this story is that it’s 100% wrong. From the article (emphasis mine):

At issue is how regulators and banks define “hedging,” or trades designed to offset risk taken by a bank, usually on behalf of customers.

The law originally defined hedging narrowly as trades tied to specific bets.

Actually, no. The law did NOT originally define hedging narrowly as trades tied to specific bets. Here’s how the law defined “risk-mitigating hedging activities,” which are exempt from the prop trading ban (emphasis mine):

“(C) Risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.” (Dodd-Frank § 619(d)(1)(C))

As you can see, it was the original law that defined hedging on a portfolio basis. This means that the regulators had no choice but to define hedging on a portfolio basis — the regulators are simply interpreting and fleshing out the original law, and the original law said that banks can permissibly hedge on a portfolio basis.

The law said that the hedges have to be “designed to reduce specific risks,” but risks can be — and, in fact, almost always are — faced on a portfolio basis. Interest-rate risk, for example, is typically measured and hedged on a portfolio basis — banks don’t hedge the interest rate risk on each Agency MBS they hold in inventory individually, because that would be horribly inefficient; instead, they measure the interest-rate risk of their entire Agency MBS portfolio, and hedge that. (And in reality, this “specific risks” limitation is meaningless anyway, because if a transaction wasn’t designed to reduce a specific risk, then it wouldn’t be a “hedge” in the first place, now would it?)

So, clearly, the original law explicitly stated that banks are allowed to hedge on a portoflio basis. The fact that the regulators’ draft rule allows banks to hedge on a portfolio basis does not weaken, dilute, or otherwise change the scope of the Volcker Rule one bit.

Since everyone is telling their 9/11 stories today, I guess I'll share mine. Having experienced the terrorist attacks on 9/11 up close, this day always bring back terrible memories.

My wife and I were both working in the Financial District, and my wife's office was very, very close to the Twin Towers. I had walked over to my wife's office to drop something off that she had forgotten at home, and I was standing in her office waiting for her to finish a call when we heard the first plane hit the North Tower. Most people on her floor went outside to see what was going on / get a better look, because none of us had any idea what had happened. We were standing outside when the second plane hit the South Tower, although I didn't actually see the impact; it was, however, the loudest noise I've heard in my life. I thought there had been a massive explosion in the North Tower at first. Even at that point, we weren't really sure it was an attack, because we still didn't know for sure what had happened to the North Tower. People had been speculating that a plane had hit the North Tower, but no one we talked to had actually seen the plane go into the tower. All you could see was a giant hole in the side of the building with smoke pouring out.

After the second plane hit, people naturally started to panic. My wife always kept a near-lifetime-supply of bottled water in her office, so we went back inside to get them to hand out to people who were coming down the street from the WTC. Handing out bottled water seemed like a very good idea at the time; we hadn't yet realized how dangerous it was to be so close to the WTC. Partly that's because, despite what everyone says in hindsight, a lot of people still weren't sure that we were under attack even after the second plane hit, and so were just standing around staring at the towers rather than fleeing. I wasn't 100% convinced myself, because some people were still claiming that the explosion in the North Tower had been a massive pipe explosion. Anyway, after we handed out the bottled waters and made a few calls on our cell phones to check on friends who worked in the WTC, police officers started telling everyone to clear the entire area immediately. So we started moving down Liberty Street (toward the bridge).

We had only been walking away for about 60 seconds when the South Tower collapsed. I had my back turned initially, but I remember turning around when the rumbling started and seeing the massive cloud of dust and debris rushing toward us. Everyone turned and ran, and I was shocked at how quickly the cloud of dust/debris was on top of us. We barely made it half a block before the cloud effectively engulfed us. (It was very hot.) Once the dust/debris started to clear, it was just pure chaos. There's no other way to describe it. We moved as fast as we could toward the bridge, but everyone seemed to be running in different directions. (No one really knew where we were supposed to run to; "away from here" was the only real consensus.) Eventually we made it to the bridge, where, like everyone else, we remained for basically the rest of the day.

It was, obviously, the most harrowing experience of my life.

As you’ve probably heard, the DC Circuit struck down the SEC’s proxy access rule last month, in Business Roundtable and Chamber of Commerce v. SEC. The three-judge panel held that the SEC’s proxy access rule was “arbitrary and capricious” because the SEC failed “adequately to assess the economic effects of a new rule.” Unlike most securities lawyers, to whom proxy access is a huge deal, I personally don’t find proxy access terribly interesting. But the Business Roundtable decision will affect many future SEC rules required under Dodd-Frank, so it’s important to consider the decision, and how the SEC should proceed in light of the decision.

For a variety of reasons, I think the DC Circuit’s decision was terrible — hilariously biased, and generally not worth the paper it was written on. (Not surprisingly, the opinion was written by failed Reagan Supreme Court nominee Douglas Ginsburg, who also wrote the 2005 opinion striking down another SEC rule.)

In the court’s words:

[T]he Commission has a unique obligation to consider the effect of a new rule upon “efficiency, competition, and capital formation,” 15 U.S.C. §§ 78c(f), 78w(a)(2), 80a-2(c), and its failure to “apprise itself — and hence the public and the Congress — of the economic consequences of a proposed regulation” makes promulgation of the rule arbitrary and capricious and not in accordance with law.

The SEC did, in fact, engage in an unusually lengthy cost-benefit analysis in its proposed rule and its final rule. But the court, clearly determined to find some reason to strike down the proxy access rule, found a few arguments raised by commenters that the SEC didn’t completely and definitively rebut, and used that to conclude that the SEC had failed to adequately consider the effect of the new rule on “efficiency, competition, and capital formation.”

As a preliminary matter, I think the court’s reasoning was comically weak. On one issue, the court conceded that the empirical evidence was “mixed,” but then bizarrely refused to allow the SEC any deference whatsoever in arbitrating between competing empirical studies. In other words, the SEC chose to believe the empirical studies that went against the court’s policy preferences. Awesome. On another issue, the court faulted the SEC for not irrationally assuming that “union and government pension funds” would use the proxy access rule to harm “shareholder value.” (Remember when conservatives used to argue that employee ownership schemes would promote glorious efficiency by aligning the interests of labor and management? I miss those days.)

So what should the SEC — which has to write a slew of regulations implementing Dodd-Frank in the next few years — do in light of the Business Roundtable decision? First, where it’s able to, the SEC should certainly humor the DC Circuit and engage in a (very) detailed cost-benefit analysis.

Second, and more importantly, the SEC shouldn’t be afraid to admit that a proposed rule won’t necessarily maximize “efficiency, competition, and capital formation.” The DC Circuit can’t strike down an SEC rule on the grounds that it doesn’t promote “efficiency, competition, and capital formation.” Let’s look at the statute, 15 U.S.C. § 78c(f):

Whenever pursuant to this chapter the Commission is engaged in rulemaking, or in the review of a rule of a self-regulatory organization, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation. (emphasis mine)

The SEC isn’t required to only promulgate rules that will promote efficiency, competition, and capital formation — it’s only required to consider those factors. And that’s in addition to another, separate, factor — the protection of investors. So if the SEC can’t prove that one of its proposed rules will promote efficiency, competition, and capital formation, the agency can still issue the rule on the grounds that it protects investors. The other relevant statute, 15 U.S.C. § 78w(a)(2), simply requires the SEC to determine that any harm to competition caused by a proposed rule is “appropriate in furtherance of the purposes of” the ’34 Act — which includes investor protection. The Business Roundtable decision just means that the SEC has to lay out its efficiency analysis in detail, even if the conclusion is that the rule won’t promote efficiency.

Essentially, the SEC shouldn’t be afraid to tell the DC Circuit to take its “efficiency, competition, and capital formation” analysis and shove it, and that investor protection is still paramount, thank you very much. Not in those words, of course. But you get the idea.

This is not going to be one of those posts that laments S&P’s decision to downgrade the US, but then says that S&P was probably right about our oh-so-dysfunctional political system.

No, S&P was flat-out wrong — no caveats. They are, to put it very bluntly, idiots, and they deserve every bit of opprobrium coming their way. They were embarrassingly wrong on the basic budget numbers, as everyone knows now, so they were forced to remove that section from their report, and change their rationale for the downgrade. (Always a sign that you’re dealing with hacks.)

S&P’s rationale for the downgrade now is based entirely on their subjective political judgement — and their political judgement is wrong. The brilliant political minds over at S&P said that “the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.”

That sounds like a Very Serious and Sober assessment, but it’s really not. It’s true that the debt limit debate was ridiculous, and that a large contingent of Tea Party freshmen in the House were threatening to not raise the debt ceiling. But here’s the thing: we still raised the debt ceiling, and in such a way that this Congress won’t have the opportunity to use the debt ceiling as a political bargaining chip again.

S&P’s assessment is only remotely serious if you assume that this particular Congress, with its huge contingent of crazy Tea Partiers, is going to serve in perpetuity. But this Congress isn’t going to serve in perpetuity — there are elections next year, and many of the Tea Party freshmen are likely to lose. They won in 2010 because it was a “wave election” in the middle of a very severe economic slump. But 2012 is a presidential election cycle with an incumbent Democratic president. A lot of these Tea Partiers who won in traditionally Democratic districts (and swing districts) are going to lose. In fact, it’s probably even odds that the Dems take back the House.

The simple fact is that the Tea Partiers are almost certainly at the height of their power in this Congress. And no, the debt ceiling debate doesn’t reflect some sort of secular change in US policymaking — the next time there’s a Republican president, House Republicans will be all about raising the debt ceiling, and Democrats won’t engage in the same kind of political brinksmanship. You’d have to be stunningly naïve not to believe this.

There have also been plenty of political de-escalations over the years — Republicans didn’t shut down the government every year after 1995, for instance. After Tom DeLay won the Medicare Part D vote by holding the vote open for 3 hours, everyone claimed that this would be the new normal on all controversial votes. Didn’t happen. There are plenty of one-off political confrontations. Simply assuming that every political confrontation represents a secular change in US politics and policymaking is ridiculous.

(S&P tries to side-step this obvious weakness in their so-called “argument” by claiming that by the time the 2012 elections roll around, it will be too late. Please. The idea that we have to act in the next 18 months in order to meaningfully affect our long-term solvency is patently absurd.)

Look, I know these S&P guys. Not these particular guys — I don’t know John Chambers or David Beers personally. But I know the rating agencies intimately. Back when I was an in-house lawyer for an investment bank, I had extensive interactions with all three rating agencies. We needed to get a lot of deals rated, and I was almost always involved in that process in the deals I worked on. To say that S&P analysts aren’t the sharpest tools in the drawer is a massive understatement.

Naturally, before meeting with a rating agency, we would plan out our arguments — you want to make sure you’re making your strongest arguments, that everyone is on the same page about the deal’s positive attributes, etc. With S&P, it got to the point where we were constantly saying, “that’s a good point, but is S&P smart enough to understand that argument?” I kid you not, that was a hard-constraint in our game-plan. With Moody’s and Fitch, we at least were able to assume that the analysts on our deals would have a minimum level of financial competence.

I’ve seen S&P make far more basic mistakes than the one they made in miscalculating the US’s debt-to-GDP ratio. I’ve seen an S&P managing director who didn’t know the order of operations, and when we pointed it out to him, stopped taking our calls. Despite impressive-sounding titles, these guys personify “amateur hour.” (And my opinion of S&P isn’t just based on a few deals; it’s based on countless deals, meetings, and phone calls over 20 years. It’s also the opinion of practically everyone else who deals with the rating agencies on a semi-regular basis.)

Treasury has every right to be outraged. S&P mangled the economic argument so badly that they had to abandon it entirely, and then fell back on a political argument which they are in no position to make, and which isn’t even correct.

So to S&P, I say: you should be ashamed of yourselves, and I truly hope this is your downfall.