Opinion

Felix Salmon

Counterparties: Happy Tax Day! You’re not done paying

Apr 17, 2012 21:32 UTC

It’s Tax Day. You’ve just signed, sealed and mailed your least favorite civic duty. Now get ready to pay more.

If Congress doesn’t act, David Leonhardt notes, on Jan. 1, 2013 we get “taxmageddon”: The average tax bill for a family making roughly $50,000 will jump by about $1,750, and nasty spending cuts kick in. The CBO’s analysis says total individual income tax revenue is set to nearly double by 2017. This is the “fiscal cliff” we’ve been hearing smart people warn about for months.

Yesterday, Congress shot down the “Buffett Rule,” which would have raised rates on America’s highest earners, the demographic that can best afford a tax hike. And to stave off Pentagon cuts, House Republicans are proposing some steep cuts to food stamps. So, we’ve got tax hikes for the wealthy being shot down, tax hikes for everyone else set to kick in during 2013 – and cuts to a safety net that more than 1 in 7 Americans rely on.

But whether we’re cutting services or paying higher taxes, we’re going to pay in some fashion. Ezra Klein spells out the dilemma:

In the coming years, the alternative to higher taxes is savage cuts to the Pentagon, and to food stamps, and to Medicaid, and to Medicare. Indeed, the reality is that even with higher taxes, all those programs are going to come in for cuts. Without taxes, the required cuts to government services will be far beyond anything either party has dared to specifically propose.

Before we start severely cutting social programs, should Americans even worry about their tax levels? Americans rarely cite taxes as the reason they’re not doing well financially, and when they do, it spikes in tax-filing season. Overall, fewer than half of Americans think their tax bill is too high (though 68 percent of Americans think the tax code favors the wealthy). Total government tax receipts, as Jonathan Cohn notes, are lower as a percentage of GDP in America than in any other country in the OECD other than Australia.

Even better than raising taxes would be fixing the way taxes actually work. Mitt Romney’s reported suggestion that he’d consider eliminating tax deductions for some mortgages was a good place to start (it’s too bad he backtracked). Tax expenditures like those, Betsey Stevenson and Justin Wolfers smartly point out, cost taxpayers $1.3 trillion per year. This is just spending by another name.

And on to today’s links:

Visible Hands
“We’re all in the same boat and the captain is a government bureaucrat” – WSJ

Tax Arcana
Obama called “politically astute” for not taking advantage of perfectly legal tax codes – Fortune
Meet the lauded income-inequality scholars who want to raise top tax rates up to 90% – NYT
The tax code is “America’s biggest spender” – Bloomberg
The world’s top incomes database – Piketty and Saez
Three good first steps to reversing the falling tax rates for the wealthy – Off The Charts
Why the VAT in the U.S. is like MacArthur in the Pacific – NYT
Florida’s rent-a-cow tax break – The Atlantic
Trying (and failing) to add up the numbers in Romney’s budget – Econbrowser
The 6 principles of fair taxes – Jared Bernstein

Alpha
John Paulson is short your euro zone – Bloomberg

EU Mess
“Full crisis mode”: Spain may take control over at least one of its regional governments – Guardian
World Bank chief: “The survival of the eurozone now depends on Italy and Spain” – World Bank
China’s view of the European crisis – Chicago Review

Remuneration
1 Jamie Dimon is equal to 67 average JPMorgan I-bankers – Bloomberg
Citigroup shareholders decide not to pay Vikram Pandit $15 million – Dealbook

Reuters Opinion
The rise of lovely and lousy jobs – Chrystia Freeland
Let’s stop talking about a “double-dip recession” – James Ledbetter
The immigration-averse U.S. – Felix
Can the euro omelette be unscrambled? – Hugo Dixon
The lobbying group behind “Stand Your Ground” laws – Joanne Doroshow
Stop conflating microfinance and entrepreneurship – Elmira Bayrasli

Crisis Retro
What five years of crisis history tells us – FT Alphaville

Regulations
The SEC has no hope of monitoring high-frequency trading, ex-agency lawyers say – HuffPo

Shocker
Fed officials leave for the private sector, surprising exactly no one – HuffPo

 

COMMENT

With so much dread surrounding this big day, many businesses are attempting to lighten the mood around the country with discounts and deals. So when you’re done filing, be sure to check out this year’s tax day freebies.

Mission Viejo IRS settlement

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Bruno Iksil and the CHIPS trade

Felix Salmon
Apr 17, 2012 17:43 UTC

John Carney has been plugging away at what on earth Bruno Iskil, the so-called London Whale, might be doing with his reported $100 billion bet on an obscure off-the-run CDX index. Carney’s idea is that this is all part of some kind of inflation-protection trade, but as Ben Walsh says, if you want to protect against inflation, you just buy TIPS. Corporate credit default swaps aren’t going to help you out much on that front.

But thinking about it a bit more, Carney’s CHIPS theory (for Corporate Hedging Inflation-Protected Securities) makes a certain amount of sense. Let’s say that Iksil, with his $360 billion portfolio, wants to make money in the fixed-income markets even as he sees inflation appearing over the next 5 years. It’s never easy for bond investors to make money in the face of inflation, since they’re receiving a fixed income, and that fixed income is effectively being eroded by inflation. And with rates as low as they are today, investors aren’t being paid for the inflation risk they’re taking.

Most normal investors are faced with a choice: they can either get insanely low yields on TIPS, and protect themselves from inflation, or else they can get slightly higher yields on corporate bonds, but leave themselves open to having their money eroded by inflation.

Iksil, however, might have found a way of managing to have his cake and eat it. He buys TIPS — say the 10-year series issued in January 2007, which matures in January 2017. Because those TIPS are now off the run, he gets a slightly higher yield on them.

At the same time, Iksil wants exposure to investment-grade corporate credit risk. If you or I had put our money in TIPS, we couldn’t do that, because, well, our money would be tied up in TIPS. But Iksil works for JP Morgan, so he can get credit risk without having to tie up any money at all. All he needs to do is sell protection on a CDX index which matures at roughly the same time — in this case, Series 9 of the Markit CDX North America Investment Grade Index, which matures in September 2017.

Now the great thing about selling protection, rather than buying bonds, is that it costs you nothing up-front. Quite the opposite, in fact: you get paid for doing it. Iksil is cashing insurance premiums on a basket of corporate debt every six months, and he can add that cashflow to the much more modest cashflow he’s getting on his TIPS. And because he’s JP Morgan, even if the market moves against him, he’s unlikely to have to put up much if any margin.

Put the TIPS and the CDX trade together into a package, and you get what Carney calls CHIPS, or what Pimco managing director Mihir Worah cals CIPS: Corporate Inflation-Linked Securities. (Yeah, I know, that looks more like CILS to me.)

What happens now if inflation picks up before 2017? For one thing, Iksil will make money on his TIPS, which go up in value when inflation rises. But Iksil will also make money on his CDX trade. The yield on a corporate bond is basically made up of two elements, called credit and rates. The rates part is the bit which goes up when inflation appears. But when you’re selling credit protection, you’re stripping out the rates part, and you’re exposing yourself only to the credit part of the equation.

And when inflation appears, corporate credit risk actually goes down, not up. Inflation is bad for lenders; it’s good for borrowers. And it means, generally speaking, that companies are raising their prices and bringing in more money, in nominal terms. Which means they have a higher income with which to pay off their fixed debts. Which means that they’re more likely to be able to pay those debts off in full.

Indeed, if you look at the rate sensitivity of the index that Iksil is buying, his mark-to-market P&L goes up when rates go up. For every basis point that rates rise, Iksil makes a profit, if he has $100 billion of exposure, of roughly $650,000. If yields go up by one percentage point, Iksil has made himself $65 million, just on the CDX part of the trade. Which is quite an achievement for a fixed-income investor in a rising-rates environment. Add in the profit on his TIPS, and he’s making even more.

It’s a big and risky trade — but it’s not one which he’s ever necessarily going to have to unwind. It has a maturity of about 5 years, and JP Morgan is more than big enough to hold a 5-year trade to maturity.

But is that really what he’s doing? There’s one very good reason to believe it’s much more complicated than I’ve laid out: if you look at those TIPS maturing in 2017, there were only $9 billion of them issued in total. And more generally, what Iksil is doing here is basically replicating the kind of corporate credit exposure that JP Morgan has lots of already. This isn’t in any way a hedge of JP Morgan’s existing portfolio; it’s more of a doubling-down on it.

Still, looked at one way, Iksil’s job is to take the assets that JP Morgan hasn’t been able to loan out, and get the kind of return on those assets that JP Morgan would be seeing if it had been able to loan them out. So maybe it makes sense that he’s making a big bet on corporate credit. I just wonder where on earth he could possibly find $100 billion of inflation protection.

COMMENT

Whoops.

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Why Richard Koo’s idea won’t save the Eurozone

Felix Salmon
Apr 16, 2012 23:13 UTC

A lot of people were looking forward to Richard Koo deliver his paper at INET last week; it comes with associated slides, here. Koo is the intellectual father of the idea of the balance-sheet recession — an idea which was born in Japan, has increasingly been adopted in the US and the UK, and which is now gaining traction in the Eurozone.

Koo’s diagnosis that Europe is in a balance-sheet recession, which he defines as a post-bubble-bursting state of affairs where individuals and companies choose to pay down their debts rather than borrow money, even when interest rates are at zero. That certainly seems to be the problem in Spain; Koo’s charts can be hard to read, but what you’re seeing here is a massive borrowing binge by the Spanish corporate sector — the dark-blue line — suddenly turning into net savings after the crisis hits. And to make matters worse, Spanish households — the red line — did exactly the same thing. As a result, the government had to run a massive deficit after the crisis; the four lines always have to sum to zero.

spain.tiff

In this kind of a recession, monetary policy — reducing rates to zero — doesn’t work. And tax cuts don’t work either: they just increase household savings. You need government spending, at least until the economy has warmed up to the point at which companies and individuals start borrowing again. And the good news is that in a balance sheet recession, government spending is pretty much cost-free, since interest rates are at zero.

That’s the good news in Japan and the US and the UK, anyway. But it’s not the case in Spain. This is a big problem with the single currency, as Koo explains: it encourages capital to flow in exactly the wrong direction.

When presented with a deleveraging private sector, fund managers in non- eurozone countries can place their money only in their own government’s bonds if constraints prevent them from taking on more currency risk or principle risk.

In contrast, eurozone fund managers who are not allowed to take on more principle risk or currency risk are not required to buy their own country’s bonds: they can also buy bonds issued by other eurozone governments because they all share the same currency. Thus, fund managers at French and German banks were busily moving funds into Spanish and Greek bonds a number of years ago in search of higher yields, and Spanish and Portuguese fund managers are now buying German and Dutch government bonds for added safety, all without incurring foreign exchange risk.

The former capital flow aggravated real estate bubbles in many peripheral countries prior to 2008, while the latter flow triggered a sovereign debt crisis in the same countries after 2008. Indeed, the excess domestic savings of Spain and Portugal fled to Germany and Holland just when the Spanish and Portuguese governments needed them to fight balance sheet recessions. That capital flight pushed bond yields higher in peripheral countries and forced their governments into austerity when their private sectors were also deleveraging. With both public and private sectors saving money, the economies fell into deflationary spirals which took the unemployment rate to 23 percent in Spain and to nearly 15 percent in Ireland and Portugal.

With the recipients, Germany and Holland, also aiming for fiscal austerity, the savings that flowed into these countries remained unborrowed and became a deflationary gap for the entire eurozone. It will be difficult to expect stable economic growth until something is done about these highly pro-cyclical and destabilizing capital flows unique to the eurozone.

The solution to this problem is eurobonds. If all the eurozone countries funded themselves jointly and severally, then the yields on European government debt would be very low, and there would be no fiscal crisis in Spain.

But that’s not the solution that Koo provides to the problem that he quite correctly diagnoses. Instead, he said at the INET conference that the way to bring Spanish government bond yields down would be to massively decrease the number of people allowed to buy Spanish bonds.

This doesn’t make any sense to me at all. After all, in any market, the greater the number of potential buyers, the higher the price. But I’ll let Koo try to explain:

Eurozone governments should limit the sale of their government bonds to their own citizens. In other words, only German citizens should be allowed to purchase Bunds, and only Spanish citizens should be able to buy Spanish government bonds. If this rule had been in place from the outset of the euro, none of the problems affecting the single currency today would have happened.

The Greek government could not have pursued a profligate fiscal policy for so long if only Greeks had been allowed to buy its bonds, since private-sector savings in the country was nowhere near enough to finance the government’s spending spree…

The new rule will also resolve the capital flight problem by preventing Spanish savings from flowing into German Bunds. This will prompt Spanish fund managers facing private sector deleveraging to invest in Spanish government bonds, just as their counterparts in the US, UK or Japan must buy bonds issued by their own governments. That would allow Spanish government bond yields to come down to UK—if not to US—levels. With low bond yields and high bond prices, talk of a sovereign debt crisis would also disappear.

It’s absolutely true that a lot of Spanish fund managers, in a flight-to-quality trade, are buying up German and Dutch government bonds. It’s also true that Koo’s proposed rule would prevent them from doing that. But it’s emphatically not true that if they couldn’t buy German or Dutch government bonds, they would buy Spanish government bonds instead.

I asked Koo about this, in Berlin, and the conceptual problem quickly emerged. On the one hand, Koo is careful not to say that he wants fully-fledged capital controls preventing Spanish fund managers from investing abroad at all. He’s confining his proposal just to government bonds, and is not including corporate bonds, equities, structured credit, or anything else that Spaniards can currently invest in. But, he still thinks that this one rule would, single-handedly, take the 6% of GDP that the Spanish private sector is currently saving, and divert it directly into the Spanish government bond market, sending yields there plunging.

It wouldn’t.

The fact is that when money flows into US Treasuries or JGBs or Gilts during a balance-sheet recession, that has absolutely nothing to do with the fact that they’re government bonds, and absolutely everything to do with the fact that they’re the dollar- or yen- or pound-based securities with the lowest perceived credit risk. If you ban Spanish institutional investors from investing in Bunds, then they’ll just buy something else with extremely low credit risk instead — AAA-rated corporate bonds, perhaps, or covered mortgage bonds from somewhere in the north, or some other kind of highly collateralized structured credit instrument. None of those things might have quite the degree of liquidity that Bunds can offer, but they’re still safer than Spanish government debt right now.

Koo is absolutely right that the flow of savings out of Spain is doing absolutely gruesome things to the Spanish economy: you can’t possibly grow when your companies and households are paying down debt, and all your national savings are fleeing the country. So maybe there’s a case for fully-fledged capital controls. But Koo’s weak-tea version would only serve to decrease, rather than increase, demand for Spanish government bonds. Their price would go down, their yields would go up, and Spain would be in an even worse position than it’s in now.

COMMENT

Euro or dollar system doesn’t require the four figures to add up to zero. Under these currencies new money is created when new credit is created. This is called credit expansion. Conversely, under credit contraction the total amount of credit and therefore the total amount of money in the currency system decreases.

Therefore, when private sector chooses to pay back their debt ie. deleverage, there is no need for Gvt to step in and start to borrow. Unless of cource the policy makers don’t want the credit contraction to happen.

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Counterparties: The bailout according to Treasury

Apr 16, 2012 21:20 UTC

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

The Treasury Department is out with a new presentation on the bailout, which attempts to calculate the combined costs of the crisis-era bailouts, including TARP and actions by the FDIC and the Fed. If you think Treasury’s accounting is even directionally correct, the presentation has some very good news: The bailout cost less than expected, averted a deeper crisis and may even turn a net profit.

It’s a convincing case that rescuing the financial markets was necessary. But that’s much different from saying the bailouts were perfectly executed.

This is a document about a messy collection of programs. Which is why we get things like this convoluted slide intended to illustrate how the government’s myriad financial arcana helped individual Americans.

 

This chart is the crux of Treasury’s problem: If you’re trying to convince Americans that things could be much worse than our 8.2 percent unemployment, protracted foreclosure crisis and fragile recovery, it helps if you can tell a simple story. And this is not a simple matter.

Contrast Treasury’s take with another regulator’s. Sheila Bair, who was head of the FDIC until last year, has criticized the Fed’s zero interest rates as a huge subsidy for financial companies but not for average Americans, and has slammed what she sees as a growing “too big to fail” problem – which explains her reported refusal to agree to Geithner’s 2008 request that the FDIC guarantee literally all debt issued by bank holding companies.

It’s telling, then, that the gray line labeled “Financial markets” in Treasury’s chart reaches into each and every aspect of “crisis response that helped support families and business.” More than three years on, Treasury still can’t shake the perception that this was a bailout that focused too heavily on the financial markets.

Treasury’s slides suggest a host of markets – including commercial and industrial lending, bank capital and credit cards – are higher or nearly back to pre-crisis levels; the middle class hasn’t been so lucky.

And on to today’s links:

Shocking
British businessman reportedly poisoned after threatening to expose Chinese leader’s wife – Reuters

Confessions
How to tell your son that you’re a short seller – Bronte Capital

Legalese
Income inequality is growing – even for lawyers – WSJ

Inertia
Why Kodak could never invent Instagram – NYT

Primary Sources
World Bank selects Jim Yong Kim as new president – World Bank

Wonks
Ezra: eliminating a few tax deductions does not add up to a real deficit reduction plan – WashPo

Rhetoric Meets Reality
Too-big-to-fail banks are larger now than before the credit crisis – Bloomberg

Modest Proposals
Sheila Bair: $10 million loans for every American – WashPo

Taxmageddon
“The end of 2012 will be unlike any other time in memory for the federal government” – NYT

Competition
7-Eleven targets New York’s bodegas – Daily News

Compelling
Americans sought homeownership but got debt ownership – Math Babe

Cephalopods
Goldman sells $2.5 billion stake in ICBC to Temasek – Dealbook

Transparency
It is private equity, but the public has a right to know – WashPo

EU Mess
Top European banks expecting ratings cuts – WSJ

Yield on Spanish bonds rises above 6 percent – WSJ

Mas Kapital
Biggest European banks would need to hold 17 percent core capital under EU plan – Bloomberg

Housing
Banks are worried FHFA may finally consider principal reductions – The Hill

Big Numbers
Facebook controls 28 percent of the display ad market – Mashable

COMMENT

Yes, with the support of the FDIC, JPM acquired the deposits, assets, and contracts of WaMu, but left the stockholders and bondholders to the mercy of the bankruptcy courts.

It was an odd transaction — in theory, the bondholders should have been senior to the counterparties of the swap contracts.

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The immigration-averse USA

Felix Salmon
Apr 16, 2012 16:53 UTC

Ann Lee’s op-ed on the EB-5 visa program, which is designed to give visas to people who invest at least $500,000 in the country and create at least ten jobs, is worth reading in conjunction with the WSJ excerpt from Kip Hawley’s new book, explaining why and how TSA airport security is so broken.

As Reuters showed in an excellent report as long ago as December 2010, the EB-5 program is horribly broken, with the brunt of the pain being borne by people who have really done nothing wrong at all — immigrants who invested a lot of money in US businesses, and who created jobs, but who were then rejected by Customs when they applied for their green card. In our 2010 report, Reuters worked out that of 13,719 immigrant investors who tried to take part in the EB-5 program since 1990, just 3,127 ended up with green cards.

Anybody who’s ever applied for a US visa or green card will not be surprised, but at the same time it’s easy to see how the EB-5 program is never going to generate all that much investment in the US so long as stories like this continue.

Dozens of EB-5 immigrants have had their final residency applications denied because the businesses they invested in deviated from the plans filed with USCIS. These are the plans the immigrants must cite when they first apply for their conditional green card, using a form known as an I-526.

And it isn’t just businesses new to the program that are making mistakes, the analysis shows.

In a case earlier this year, an immigrant had invested in a partnership run by the Philadelphia Industrial Development Corporation and CanAm Enterprises, one of the biggest and oldest EB-5 companies. The partnership originally loaned money to a building materials company, which planned to use the funds to expand its warehouse and hire new workers.

But the downturn in the U.S. housing market stopped that expansion in its tracks, and the building materials company returned the loan. So the partnership, by unanimous resolution, decided to loan the money to a developer building an upscale steakhouse, which opened a few months later.

From a business perspective, it was a perfectly reasonable change of tack. But the switch jeopardized the applications of the immigrants who invested in the partnership. When one of them applied to get his permanent green card in 2008, USCIS denied the petition. When he appealed, USCIS’s administrative appeals office ruled against him.

Over the past year and a half, there has been a raft of such adverse “material change” rulings against immigrants. In some cases, the businesses insist they informally communicated the changes to USCIS personnel, who told them not to worry about them. The USCIS has rejected their appeals, saying: “the opinion of a single USCIS official is not binding and no USCIS officer has the authority to pre-adjudicate an immigrant-investor petition.”

It’s worth underlining that these rejections come after the investor has moved to the US and set up a new life here with their family. And once rejected, the investor has no choice but to leave the country.

The USCIS responded to the broken EB-5 system by announcing in May 2011 that it would be streamlined, including “the creation of new specialized intake teams with expertise in economic analysis”, as well as the ability to email the immigrant investors.

But here we are, a year later, and Lee is still saying that the government needs to “hire more business-savvy administrators and make the entire process more transparent” — essentially exactly what Secretary Napolitano has already announced. Lee’s also asking for penalties to be levied when brokers lie to would-be immigrant investors — something else which should be happening but isn’t.

Which is where Hawley comes in. He headed the Transportation Security Administration from July 2005 to January 2009, and has a pretty sophisticated view of what the agency should be doing.

The TSA’s job is to manage risk, not to enforce regulations. Terrorists are adaptive, and we need to be adaptive, too. Regulations are always playing catch-up, because terrorists design their plots around the loopholes.

I tried to follow these principles as the head of the TSA, and I believe that the agency made strides during my tenure. But I readily acknowledge my share of failures as well. I arrived in 2005 with naive notions of wrangling the organization into shape, only to discover the power of the TSA’s bureaucratic momentum…

By the time of my arrival, the agency was focused almost entirely on finding prohibited items. Constant positive reinforcement on finding items like lighters had turned our checkpoint operations into an Easter-egg hunt. When we ran a test, putting dummy bomb components near lighters in bags at checkpoints, officers caught the lighters, not the bomb parts.

I wanted to reduce the amount of time that officers spent searching for low-risk objects, but politics intervened at every turn. Lighters were untouchable, having been banned by an act of Congress. And despite the radically reduced risk that knives and box cutters presented in the post-9/11 world, allowing them back on board was considered too emotionally charged for the American public.

The passive voice here (“was considered”) is telling: even the head of the TSA can’t tell the TSA what to do. Instead, as in all large bureaucracies, there’s a way that things get done, and changing it is all but impossible.

Which says to me that for all the efforts by people like Napolitano and Lee to revamp the EB-5 system, they’re going to find doing so extremely difficult. Reuters found what immigration attorney Ira Kurzban calls “a basic hostility to the EB-5 program inside USCIS”, which is at heart a reflexive opposition to the idea that anybody can buy their way into the country. Despite the fact, of course, that the whole point of the EB-5 program is to enable exactly that.

Those of us who have had dealings with USCIS know that it is always looking for an excuse to say no: even people like me who get our green cards the “easy” way, by marrying a US citizen, find the process extremely fraught. No matter how much money I was earning, for instance, the USCIS would not let me have a green card unless my wife could demonstrate that she was earning enough, on her own, to support me. And a friend of mine, after marrying a US citizen and having two US children with her, actually got a notice of deportation at one point in his green card application saga, on the grounds that a certain piece of paperwork had been filed, years previously, a few days too late.

The TSA and the USCIS have grown, over the years, into agencies devoted to saying no. There’s very little downside, for these agencies, when they deport someone applying for a green card, or cause a mother to miss her flight because of a fight over breast milk. And it’s almost impossible to change that big-picture dynamic, no matter what Congress mandates, and no matter what the senior leadership in these organizations might want.

Which is why it makes sense to make skilled immigration as easy as possible. Resuscitate the Schumer-Lee bill giving a residency visa to anybody who spends at least $500,000 on a house here, except lower that number to $250,000, and make sure that the visa allows the homeowner to actually work and create jobs in this country. The less room there is for USCIS agents to say no, the more smoothly the program will run.

Will making immigration easier allow a few people into the country who weren’t the intended recipients of the bill’s generosity? Yes, of course. But all immigration is good for America. And with net migration from Mexico now down to zero, and the US economy desperately in need of entrepreneurial investment, now’s exactly the time to start opening our doors much wider.

COMMENT

matthewslyman, thanks for the story!

Whatever the policies, it is healthy for all if they are transparent, consistent, and efficiently implemented. The INS is **THE WORST** bureaucracy in the US in this regard. Byzantine and arbitrary. Doesn’t sound like the UKBA is much better?

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Do Jubilee shares make any sense?

Felix Salmon
Apr 16, 2012 00:38 UTC

One of the more intriguing concepts to come out of the INET conference was Steve Keen’s idea for what he calls “Jubilee shares”. It’s not exactly new — he’s been writing about the concept since October 2010 — but he refined the concept for INET, and it has a bizarre kernel of genius to it, for all its flaws.

Here’s how it works. Right now, shares issued by a company represent the permanent equity capital of that company. If a company raises new equity capital, then the people buying that stock will have an ownership interest in that company in perpetuity. Under Keen’s proposal, none of that changes. But when those shares get sold, things start getting interesting.

At companies like Google, one class of shares automatically converts to another class when they’re sold. In Keen’s world, all companies would be a bit like Google. Not in terms of voting rights: each share would still carry the same voting weight. But there would be different share classes, all the same. Eight of them, to be precise.

As a rule, when companies issue Jubilee shares, they issue Class A shares — the highest class. And the way that Jubilee shares work, Class A shares would automatically convert to Class B shares when they were sold.

Now that wouldn’t be much of a change. Class B shares have all the same ownership and voting rights of Class A shares; the only difference between Class A shares and Class B shares is that when Class A shares are sold they become Class B shares, while Class B shares convert to Class C shares when they’re sold.

You can guess what Class C shares are like: they’re exactly the same as Class A shares and Class B shares, except that they convert to Class D shares when they’re sold. And so on and so forth, until you reach Class G shares. They convert to Class H shares when they’re sold, and Class H shares are actually very different indeed from all the others. Because Class H shares are not permanent equity capital at all: instead, they expire, worthless, on their 50th birthday.

If you hold Class H shares, you can trade in and out of them as much as you like: there’s no Class I. And you get full dividend payments and voting rights. But you also hold a piece of paper with an expiry date. As far as the cashflows from Class H shares are concerned, it’s basically just 50 years’ worth of dividends, and that’s it. (Although, if the company is sold, you get full participation rights.)

For a company like Berkshire Hathaway, which has little prospect of being taken over and which doesn’t pay a dividend, Class H shares would be close to worthless. On the other hand, for a company which is in clear decline and which is probably going to fail or get taken over in the next decade or two, Class H shares — at least the ones still far from expiry — would trade at only a very modest discount to Class A.

For companies going public, issuing Jubilee shares would be quite attractive, in some ways. The founders of Google and Facebook would feel much less need to give themselves super-voting rights, or to worry that IPO allocations are silly because they just end up getting flipped on day one, because the structure of the Jubilee shares would encourage shareholders to act like long-term owners rather than short-term traders.

For investors, Jubilee shares would also be attractive. Any company with Jubilee shares would have a very low stock-price correlation with the market as a whole — and investors like low correlations nearly as much as they like liquidity. And besides, Jubilee shares would be cheaper than normal shares, and it’s always nice to be able to buy equity in a company at a discount.

As for traders, Jubilee shares would be a very mixed bag. On the one hand, volumes would plunge. But on the other hand, bid-offer spreads would rise, and there would be a lot more opportunity to generate alpha and outperform the market by smartly navigating the various classes of stock.

Jubilee shares would work like a financial-transactions tax: on a mark-to-market basis, you’d take a loss every time you bought a stock. Shares would trade in seven main classes: A/B, B/C, C/D, and so on, with the first letter representing what the seller is selling, and the second letter representing what the buyer is buying. Since each class would trade at a lower price than the one before, the cost of doing a round-trip trade — of buying a stock and then selling it immediately — would be substantial. And I haven’t really thought through what might need to be done in the area of shorting and securities lending.

Still, there would surely be active trading, and the biggest profit opportunities, in Class H shares. Those shares would be highly specialized financial instruments, not least because they wouldn’t be fungible: each one would have a unique expiry date, and would be priced accordingly. Broker-dealers would trade them on the OTC market — it would be incredibly difficult to trade them on an exchange — and would tempt merger arbs and anybody else in the special-situations space with the promise of enormous profits. Dividend-related announcements would take on huge market importance, much more than they do now, and the difference between dividends and stock buybacks would go from being negligible to being enormous.

For all the active trading in such instruments, however, what you would not get would be a speculative bubble. The price of Class H shares would always be capped at the price of Class A/B shares, and Class A/B shares would be almost impossible to speculate in because volumes in that market would perforce be extremely low.

And so I think that Jubilee shares would indeed achieve what Keen intends them to achieve — the end of stock-market bubbles. They would also make investing in the stock market extremely difficult — something which can probably be considered a feature rather than a bug. Most investors would be forced to do their homework and really understand what they were buying; you wouldn’t get people logging on to E-Trade and buying thousands of dollars of a stock just because of something they saw on CNBC. And the huge current volume in ETFs — most of which is accounted for by speculative day-traders — would disappear overnight.

There are two ways that Jubilee shares might be introduced, neither of which is going to happen. One option would be for them to simply be imposed on the market by legislative fiat; that seems to be what Keen has in mind. That wouldn’t just be bad politics, it would be bad policy, since stock-market bubbles aren’t actually all that much of a problem. As we saw in 2000, they can wipe out enormous amounts of wealth when they burst, with surprisingly modest macroeconomic consequences, thanks to the fact that most stock-market investments are unlevered.

More to the point, legislating Jubilee shares would only make debt even more attractive than equity, as a funding source for companies — and that’s exactly what we don’t want to achieve. Unless and until Congress first abolished the tax-deductibility of corporate interest payments, the introduction of Jubilee shares would cause more harm than good in the markets as a whole, giving companies even more incentive to borrow money rather than to fund themselves with equity.

There is another way for Jubilee shares to arrive, however, and that’s for companies to issue them voluntarily. As far as I can tell, there’s no reason why a company couldn’t issue Jubilee shares rather than common stock tomorrow, were it so inclined. The market capitalization of any such company would certainly suffer: a founder wanting to maximize the mark-to-market valuation of her own stake in a company would never opt for such a structure. But for CEOs who prefer long-term control to paper wealth, Jubilee shares could be an attractive alternative to the current modish option — dual classes of shares with the founders’ shares having many more votes than everybody else’s.

But founders don’t need to issue Jubilee shares, now, thanks to the passage of the JOBS act. It’s now much easier for founders to retain control: with the 500-shareholder rule no longer in effect, founders can simply elect to stay private indefinitely, with a right of first refusal on any share sales and essentially complete control over where, how, and even whether their stock is traded. Given the attractions of private markets and the new powerlessness of the SEC when it comes to requiring companies to go public, it seems like Jubilee shares are to a large degree a solution to a problem which no longer exists.

Still, I’d love to see just one company try them out, if only to see what happens. Existing corporate stock can remain untouched, but new shares, be they sold directly to the public or given out to employees or used to buy some other company, could still be issued in Jubilee form. It would be fascinating to see where and how they traded.

COMMENT

I think you have missed the game theoretic implications. Take a company like Birkshire Hathaway, for example. You mentioned that with no dividends or possibility that the company will be sold, class H stocks would be worthless. But that means class G shares are also worthless, because you would only be able to sell them at whatever price someone is willing to buy H class shares, which is $0. That means that class F is worthless, and so one all the way to A. It is not enough for the class A through G stocks to be non-expiring, but they also have to be fully transferable, because the value of Birkshire Hathaway stocks really only in the limit–the value comes from the amount that liquidation of the company will yield shareholders, but if that liquidation won’t come in our lifetime, and we can’t transfer stocks without them becoming perishable, then none of the stocks have value. This means that the firm would bleed equity until it is forced to offer regular dividends, which in turn reduces the profitability of the firm.

This backward’s recursion principle would apply to all classes of stocks: a class H stock would be priced at the discounted sum of 50 years worth of dividends, and a class G stock would be worth that plus the discounted sum of dividends expected before selling it, and so on. But ultimately, all of these classes of stocks have value if and only if the firm pays regular dividends. At this point, we have to call into question whether these should be called “dividends” at all–since it is now an obligatory payment needed to maintain the company’s capital valuation, it should be called “interest” not dividends, and recorded as an operating expense, not profits.

My point is what you have described is just an incredibly complicated reformulation of a financial instrument already available to corporations: a bond. Essentially, Keen wants to turn stocks into bonds, so that a stock is really a debt issued by the company that has to be repaid in 50+some odd number of years with interest. We could simplify the whole thing if we eliminated all 8 classes of stocks and simply specify that bondholders have voting rights.

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Counterparties – Jamie Dimon and JPMorgan’s risk question

Ben Walsh
Apr 13, 2012 21:01 UTC

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

This morning, JPMorgan reported $5.4 billion in earnings, or $83 million per weekday. While management trumpeted the increased strength of the company’s “fortress balance sheet” (trademark pending), they also pushed back on a Bloomberg report that a bank division called the Chief Investment Office had shifted from risk management toward large-scale speculation.

The CIO division, of course, is where the now infamous trader known as “Voldemort” works, and Bloomberg has compiled more evidence that the bank could have trouble with the Volcker Rule. Bloomberg’s reporting contradicts JPMorgan’s description of the CIO as a division that uses approximately $360 billion in excess deposits to manage risk, not to make bets for its own account:

JPMorgan Chase & Co. (JPM) Chief Executive Officer Jamie Dimon has transformed the bank’s chief investment office in the past five years, increasing the size and risk of its speculative bets, according to five former executives with direct knowledge of the changes.

Achilles Macris, hired in 2006 as the CIO’s top executive in London, led an expansion into corporate and mortgage-debt investments with a mandate to generate profits for the New York- based bank, three of the former employees said. Dimon, 56, closely supervised the shift from the CIO’s previous focus on protecting JPMorgan from risks inherent in its banking business, such as interest-rate and currency movements, they said.

On today’s earnings call, Dimon called the story a “tempest in a teapot.”

Dimon’s comments are hard to square with one of the CIO division’s traders writing a reported $100 billion in protection on a single CDS index. Similarly perplexing was Dimon’s statement that, because of CIO investments, JPMorgan would profit from rising rates.

Given Dimon’s tone this morning – “It’s like having mozzarella for pizza, when it goes up a little your margins go down a little bit … that was a dumb analogy,” he said at one point – it’s unlikely we’ll get much more information about the bank’s risk-taking.

Dimon joked: “I constantly read about counterparties.” While we’re secretly hoping he’s talking about us, the bank’s actual counterparties are likely still waiting for answers.

And on to today’s links:

Must Read
JPMorgan division is ramping up speculative bets in “an unprecedented build-up of credit risk” – Bloomberg
Full text: The JPM Q1 earnings release – JPM
Full text: The Wells Fargo Q1 earnings release – Wells Fargo

Modest Proposals
Sheila Bair: $10 million loans for every American – WashPost

Charts
The geography of America’s job market recovery – The Economist
The 1% and the 99% – The political economy in 4 charts – The New Yorker
“A debate on inequality, opportunity and politics” – Jared Bernstein

EU Mess
A disturbing look at extreme right-wing, anti-immigrant movements growing in Greece – NYT
Amartya Sen: “There is a democratic failure in Europe” – Economics Intelligence
Europe has a “recession strategy that makes austerity and reform self-defeating” – Roubini

Reversals
Goldman Sachs tries a new approach: Engaging with pissed-off shareholders – WSJ

Euphemisms
Your illustrated guide to “pink slime”, “white slime” and “advanced meat recovery” – ProPublica
How a “meat innovator” has been nearly destroyed by the “pink slime” scandal – Bloomberg

Defenestrations
Best Buy looking into whether former CEO had an inappropriate relationship with an employee – Star Tribune
It could take 6-9 months for Best Buy to name a new CEO – Reuters

Worrisome
China’s GDP falls to a 3-year low in Q1 – Reuters

Rational Markets
AOL’s patents and the case against the efficient markets theory – Bloomberg Businessweek

Oxpeckers
How 25 National Magazine Awards went to 25 male writers – The Awl

Regulations
Two companies have already filed confidential IPO plans under the JOBS Act – WSJ

Big Numbers
Instagram added 10 million users in just 10 days – TechCrunch

Remuneration
Lloyd Blankfein’s $12 million pay package – NYT

Awesome
18th century shipping mapped using 21st century technology – The Guardian

COMMENT

I was looking at Chart 16 here (the “real output gap”):
http://www.treasury.gov/resource-center/ data-chart-center/Documents/20120413_Fin ancialCrisisResponse.pdf

Am I the only one seeing a trend line that fits both 2000-2003 and 2009-2011 quite nicely? We know there was some crazy stuff going on between 2004-2008. Why is that presumed to be “normal” output? Is there some longer-term rationale for placing the trend line that high? (How can there possibly be, when the economy has changed so much in the last 30 years?)

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Is the World Bank board sure what Jim Kim thinks?

Felix Salmon
Apr 13, 2012 19:22 UTC

William Easterly is uncharacteristically credulous today. He spoke to one of those Senior Administration Officials on Wednesday, and the Official gave Easterly the official explanation for why Jim Yong Kim has failed to RSVP for the CGD/Washington Post forum or for any other public appearance.

The official said it was purely logistical: Kim has been constantly on the road meeting member governments, and would continue to be on the road right up until the vote.

Moreover, Kim’s nomination happened at the last possible moment, and the nominations of Okonjo-Iweala and Ocampo were also late. The official said this was a global appointment and not a Washington one, so member governments have a higher claim on Kim’s very limited time than development experts.

I confess this argument (almost) convinces me.

Easterly goes on to say that because there needs to be some kind of public debate about Kim’s views on development, the World Bank’s board should delay its choice in the matter until after that debate has happened.

That’s not going to happen: by all accounts we’re well into the end of the process already. The board has interviewed all three candidates, and today is taking a straw poll — a process designed to build consensus (if you’re being charitable) or make it obvious that no non-U.S. candidate has any chance of winning (if you’re not). Jose Antonio Ocampo has officially withdrawn his candidacy in favor of Ngozi Okonjo-Iweala; it’s a noble move, but it’s unlikely to have much practical effect. By Monday, barring some divine intervention, Kim will have been officially awarded the job, in a process characterized by extreme opacity — especially now that a key BRIC nation, Russia, is officially supporting Kim.

I do appreciate that Kim’s constituency, both now and for however long he holds his new job, is the Bank’s shareholders, rather than the broader public. And so, like any good politician, he’s concentrating on buttering up his constituents.

But when most politicians butter up their constituents, they do so in public, and the news media is there to report on what they’re saying. Kim’s meetings, in contrast, have all taken place behind closed doors.

Daniel Altman thinks it’s a “canard” that the next president of the Bank should be asked to make his case to the public, on the grounds that hey, the Bank doesn’t actually cost taxpayers that much. But this isn’t about money, it’s about transparency. And specifically, if all of Kim’s meetings are being held behind closed doors, no one knows what horses are being traded, what the countries with the most votes are asking of Kim, and what he’s promising them in return for their vote.

If a candidate appears in public and says quite clearly what his vision for the bank is and what he intends to do about certain matters, then at least there’s something to hold him to once he’s in office. Kim, by contrast, has said essentially nothing about what he wants to do at the Bank; everybody supporting him is essentially projecting their own hopes for what they would like him to do.

And so while I wouldn’t go so far as Michael Clemens, who suggests that Kim’s nomination could be a violation of the Bank’s articles of agreement, if I were on the board I’d be a bit worried about what Kim had told all the other countries while he was on his “listening tour”, and I’d welcome a public position statement from him just to make sure that he’s saying the same thing to everybody.

COMMENT

The choice of Kim is a good one for the reason that he is a practitioner of development. Anyone who has followed the Bank’s failed policies especially in Africa – SAP’s, Education, etc will tell you that the theorists can’t to the job. Okonjo is not a success by any measure when it comes to seeking such a top job. If is a fantasy or is it a fairy tale, that a Nigerian would seek such a job. Her career in Nigeria did not turn that nation around. Being from a country or continent in which they cannot manage their money, seek debt forgiveness yet come for more and do not ever show signs of improved governance of their monetary and corruption ridden structures raises an eyebrow. Asia is the direction of the next few years and Kim is well placed to take that on. It matters that you are from a country that is not known as the corrupt Mecca of the world.

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Google’s evil stock split

Felix Salmon
Apr 13, 2012 07:56 UTC

Count me in with Robert Cyran: there’s something a little evil about the way that Google is splitting its stock, and in so doing creating a whole new class of non-voting shares.

There’s a long history of such things: they were outlawed in the 1920s, when they were commonly used by unscrupulous managers. The New York World even wrote a poem on the subject:

Then you who drive the fractious nail,
And you who lay the heavy rail,
And all who bear the dinner pail
And daily punch the clock—
Shall it be said your hearts are stone?
They are your brethren and they groan!
Oh, drop a tear for those who own Nonvoting corporate stock.

Dual-class voting shares were illegal for most of the 20th Century, but came back in 1986. James Sterngold’s NYT story on their reintroduction is well worth a read, featuring as it does comments against the new rules from both Felix Rohatyn (”The one-share, one-vote rule is pretty fundamental to the market”) and T Boone Pickens (”Let’s face it, managements want this because they want to entrench themselves. They went to Congress to get protection and they didn’t get it. So they went to the exchange to get protection, and they got it.”)

Even then, however, there were safeguards, including the crucial one that a majority of independent shareholders — excluding management and some directors — had to approve the move. The basic idea was explained ten years later:

The defining principle of current American corporate law seems to be, if the existing shareholders agree to the creation of a new type of shares with no voting rights, why should we object?

Google has, now, clearly violated the spirit of the NYSE rules, if not their letter. It took 15 months for the independent directors on the board to be persuaded of this, in long and secret deliberations:

In January 2011, the board established a special committee, comprised of independent, non-management board members to consider a new class of stock, or other alternatives. This committee retained its own financial and legal advisers to assist with its deliberations, and met on numerous occasions over the 15 months that the special committee considered the proposal separately from the board. The committee recommended, and the board unanimously approved, today’s proposal.

The proposal is subject to the approval of a majority of the voting power of Google’s common stock, voting together as a single class, at our annual meeting on June 21, 2012. Given that Larry, Sergey, and Eric control the majority of voting power and support this proposal, we expect it to pass.

My key problem with the proposal is that it’s being pushed through without common shareholders being given the opportunity to object. I would be OK with it if it was being voted on a one-share, one-vote basis. But instead, Google’s Troika has decided that having ten times the votes of any other shareholder isn’t good enough for them, and that what they really want is a whole new class of shareholders — including new employees — who have no votes in the company at all.

Given the way that this is being done, I’m with Cyran that we can place no store whatsoever in the “stapling” provision which says that as the Troika sells their stock, they will be forced to sell down their super-voting stock commensurately. Such provisions tend to last until they’re needed, at which point the controlling shareholders simply use their control to get rid of them.

Non-voting shares are rare things, and Google’s news comes not long after Telus decided to move the other way, giving votes to all the holders of its non-voting stock. There’s no need for this to happen now — or ever, for that matter — and the letter from Larry and Sergei is pretty unconvincing on the subject of why they’re doing it.

We have a structure that prevents outside parties from taking over or unduly influencing our management decisions. However, day-to-day dilution from routine equity-based employee compensation and other possible dilution, such as stock-based acquisitions, will likely undermine this dual-class structure and our aspirations for Google over the very long term. We have put our hearts into Google and hope to do so for many more years to come. So we want to ensure that our corporate structure can sustain these efforts and our desire to improve the world.

It’s worth putting this theoretical fear in perspective. Common shareholders currently have just 32.6% of the voting stock at Google, with Larry and Sergei Sergey between them controlling 57.7%. If Google doubled the number of common shares outstanding, the Troika still wouldn’t lose control. And in any case, as Steve Jobs has shown, you don’t need control of the stock to have complete control of the company.

This move, then, is basically a way for Google to try to retreat back into its pre-IPO shell as much as possible. It never really wanted to go public in the first place — it was forced into that by the 500-shareholder rule — but at this point, Google is far too entrenched in the corporate landscape to be able to turn back the clock. It’s too big, and too important, and has been public for too long. That’s the thing about going public: it might suck, but once you’ve done it, you’ve done it. And at that point, if you try to pull a stunt like this, you risk looking all too much like Rupert Murdoch.

That said, however, I can’t say I’m wholly surprised by this development. Google hasn’t always been evil, but it has been evil since January: this news just confirms what many of us suspected when they closed down the Kaffee Klatsch in Davos. Which just goes to prove, I suppose, that the World Economic Forum really does give you advance notification of important corporate developments.

COMMENT

For a great read on GOOG and to understand it properly, visit, vippennys tocksite . com

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