30 September 2008

Landlords Are Crooks

At least an estimated 53% of individual taxpayers with rental real estate misreported their rental real estate activities for tax year 2001, resulting in an estimated $12.4 billion of net misreported income.

From here, citing a recent GAO report.

Also, keep in mind that in Colorado, where Colorado taxable income is a function of federal taxable income, that gaps in federal income tax enforcement cost Colorado money as well.

Your House Is Like A Cat

I posted the Daily Kos diary, "Your House Is Like A Cat: Cramdowns Explained" today. I encourage you to read it.

29 September 2008

Wachovia Buyout Explained

An outline of Citigroup's FDIC assisted buyout of Wachovia's banking operations is explained at the Securities Law Prof Blog.

Citigroup [will] acquire Wachovia's banking operations . . . . The FDIC is providing loss protection to Citi in support of transaction . . . . Wachovia will remain a public company and retain its asset management, retail brokerage, and certain select parts of its wealth management businesses, including the Evergreen and Wachovia Securities franchises. . . . Citi will pay Wachovia approximately $2.16 billion in stock and assume Wachovia senior and subordinated debt, totaling approximately $53 billion.

The transaction still leaves some questions about what "loss protection" for Citi from the FDIC means. How real is the risk of a loss and what is its likely and possible magnitude?

The Citigroup press release helps a little in understanding the isuse:

Citi will acquire more than $700 billion of assets of Wachovia's banking subsidiaries, and related liabilities. The Federal Deposit Insurance Corporation (FDIC) has agreed to provide loss protection in connection with approximately $312 billion of mortgage-related and other Wachovia assets. Citi is responsible for the first $30 billion of losses on this portfolio, and expects to record these expected losses under purchase accounting upon closing of the transaction. Citi is also responsible for the next $12 billion in losses up to a maximum of $4 billion per year for the next three years. Citi has also agreed to issue to the FDIC preferred stock and warrants with a combined value of approximately $12 billion. The FDIC has agreed to be responsible for any further losses on this portfolio.

The scale of this loss protection is breath taking. It rivals the proposed bailout bill in the scale of the assets guaranteed. At 10% loss on the mortgage related assets certainly doesn't seem out of the realm of possibility, so the FDIC may take a real loss on this deal. I certainly hope that the good folks at the FDIC have properly evaluated the risk and determined that they won't get burned too badly.

It also raises questions about what the financial structure of rump Wachovia will look like after the transaction closes. The press release mearly notes that "Going forward, Wachovia expects to have adequate capital to support its remaining businesses, an appropriate allocation of tangible equity, and certain tax assets that will be recognized immediately."

Will Wachovia have no debt at all? Presumably rump Wachovia will still have some publicly held shares. Will current shareholders get some rump Wachovia shares and then cash or will they get Citi shares, or will they have publicly held shares merely in the Wachovia subsidiary? This is quite odd for this type of business, which is usually more leveraged than a commercial bank.

Still, it does prove once again how effective the FDIC has been a dealing with the financial crisis in a way that appears to have the federal government spending little on the deal. The conversion of other big investment banks to the commercial banking regimes presumably allows the FDIC to deal with their failures, if any, as well and to broker similar deals with them.

Other FDIC brokered deals have often swiftly led to the bankruptcy of the rump entity. Is Wachovia's rump operation likely to follow in the same footsteps? The very fact that the FDIC was involved at all suggests that Wachovia's financial situation was perilous before this deal was concluded.

Bailouts And Executive Compensation

Congress votes on the bailout bill today. If I get a chance to review it, I'll update this post and summarize it. (UPDATE: Never mind. The House narrowly voted down the bill on a bipartisan basis, with more Republican opposition than Democratic opposition to the Bush Administration backed compromise plan, 140 Dems for, 95 against, and 65 Rs for, 133 against. One non-voter, Jerry Weller (R-IL).)

A few related notions about shareholder rights and executive compensation in big corporations.

1. The Wall Street rule (i.e. sell stocks of bad companies, rather than holding and making proxy votes) does have a real impact on corporate behavior. While a large negative proxy vote has little impact, has major stock price collapse, as we've seen in the recent financial crisis, can have a dramatic mpact.

2. I've frequently blogged about the notion that the dollar amount of executive compensation, which often remains fairly modest relative to overall shareholder equity, is less important than the incentives it creates for executives who have a heads I win, tails you lose proposition.

There are, at least, three other concerns related to executive compensation.

One is something of a Laffer Curve/diminishing marginal utility concern. Basically, at some point, senior executives get so wealthy that their compensation becomes little more than a way to keep score in a game that doesn't matter much more than a guy's night out poker game. If their company collapses or loses value, they may lose a perk or two, but life will go on even if the executives never make another dollar.

A second concern is that the self-dealing involved in these executive compensation packages builds a culture of corruption that is bad for the integrity of large corporations generally.

Third, there are also a macroeconomic income inequality and social class concern. The CEO and senior executive pay vis-a-vis shareholder wealth fight (and I do believe that the CEO and senior executive pay issue is largely one between shareholders and senior executives), makes almost no difference to the bottom 95% of the wealth distribution who neither work as senior executives, nor have substantial stockholdings. But, there may be a notable impact on the distribution of wealth within the top 5% of the wealth distribution. My intuition is that older pensioners and pre-retirees who have accumulated financial wealth throughout their lives, are taking a modest dent in favor of a new class robber barons who invest substantial portions of their massive compensation packages, and who have disproportionate political economic and social power in our society as a result of this wealth that could be leveraged into a new aristocracy.

26 September 2008

Nacchio in Trouble, New Federal Judges Confirmed

Former Qwest chief executive Joe Nacchio looks likely to have his conviction affirmed in review by the en banc United States Court of Appeals for the 10th Circuit, based upon the questions asked at oral arguments. A three judge panel in the case had ordered a new trial. The principal issue on appeal is whether expert witness testimony from Nacchio was properly excluded.

Meanwhile, two new U.S. District Court for the District of Colorado judges were confirmed by the Senate today. Philip Brimmer and Christine Arguello will join the bench as lifetime appointees, after Senators Salazar and Allard from Colorado, and U.S. Attorney Troy Eid, agreed on the appointments.

25 September 2008

Managing Risk On Wall Street

Wall Street is in the business of breaking up business financing so that those who have a low tolerance for risk face little risk, while those who have a high tolerance risk take greater risk in exchange for the possibilty of greater returns.

This seems to be working as intended, without new federal regulation or any massive bailouts.

Shareholders of collapsed institutions have generally lost 95% or more of their investment valued at the market peak about a year ago. Subordinated bondholders appear to have taken a beating. Ordinary bondholders may see delayed payments and not receive all promised interest, but are unlikely to lose a large percentage of principal in these collapses. Just one small money market fund appears to have fallen below the 100% return of principal mark, even though many have had subpar returns on investment. No FDIC insured deposit has gone unpaid, and the FDIC has not had to seek additional funding despite a large number of bank failures.

Even in the area of mortgage backed securities, the duty of the originating and underwriting parties to compensate buyers for excessive defaults has largely left sloppy underwriting originators bankrupt. The line of business that created the crisis, subprime lending, no longer exists. The investment banks that played a leading role in securing funds to make bad loans with, and AIG that insured man other investors against default, have collapsed as a result of their bad financial judgment. Whole industries which developed reckless practices are gone, while more prudent industries have managed to stay in business.

Certainly, relatively innocent parties have been hurt, particularly non-executive employees laid off through no fault of their own and investors in prudent business who have seen their investments fall in price due to general market panic. Meanwhile, the executives who were behind some of these schemes seem to have gotten fat bonuses while seeming to escape responsibility for business failures for now. Some of those executives may face later investigations, be forced to forfeit or return some or all of their bonuses, and may have been heavily invested in the now worthless securities of their companies. But, one suspects that many will have swiftly diverified money taken out of their companies in good times and will weather the financial crisis well.

Critics of the WaMu buyout rightly note that there doesn't appear to have been competitive bidding, so the FDIC was permitted to play favorites between the remaining fiscally solvent large national banks that were interesting in buying the assets. But, securing justice between big commercial banks for the benefit of shareholders and subordinated bondholders in an investment known to be high risk seems like a low priority relative to stability and certainty for customers and protecting the federal government from having to bail out the FDIC.

By and large, the most culpable financial institutions have been promptly punished financially, and the highest risk investments have suffered most, while financial institutions with less culpability, and investors that chose safer investments, seem to have fared better. Where there have been bailouts, shareholders seem to have salvaged part of an investment that would otherwise have been wiped out, and subordinated bondholders seem to have come out much better than they otherwise would have, but shareholders and the many investors who sold out in the face of impending collapse have still lost much of their investments.

While some of the failures, like Bear Sterns and Lehman Brothers have been rather sudden, others, like Washington Mutual, have been expected for months allowing diligent risk intolerant investors to bail out and preserve some of their investment.

Yes, the stock market generally has slumped. But, so far, we have seen declines in stock prices not atypical of a bear market, and bear markets have happened regularly over the years.

Even at the individual loan level this seems to be the case. Fixed rate conventional loans have continued to have extremely low default rates throughout the financial crisis. Those loans that have gone bad, particularly subprime adjustable rate loan with small downpayments, were clearly the highest risk loans being made in the mortgage market.

Housing prices have slumped, but only after a couple of years of increasingly stark warnings from some participants in the national economic discussion that the housing market was in a bubble at risk of collapsing in some areas.

In short, while clearly Wall Street's existing institutions were broken, it isn't obvious that the overall system of allocating risk, and the basic regulatory structure is as deeply out of whack as it may seem. There may need to be some tweaks, but any reform should build on the current system's tendency to direct financial consequences to the investors who took foreseeable gambles that went bad.

WaMu Seized By FDIC and Sold To JP Morgan

Washington Mutual, known for its aggressively pro-consumer terms in its retail banking and an excessively large mortgage portfolio, has been on a death watch for a long time. Today appears to have been the day. It has apparently been seized by the FDIC and acquired by JP Morgan Chase in a transaction that is the banking equivalent of a pre-packaged Chapter 11 filing that wipes out Washington Mutual's investors.

Washington Mutual is probably the largest banking institution to fail in recent memory, perhaps ever.

UPDATE (9/25/08 later in the day):

It is the largest bank failure in American history.

Shareholders and some bondholders will be wiped out. WaMu deposits are guaranteed by the Federal Deposit Insurance Corporation up to the $100,000 limit for each account. WaMu customers are unlikely to be affected.

It does not appear that the FDIC will have to make any meaningful payouts in this case. While WaMu was insolvent, it does not appear to have insured deposits greater than the sum of the buyout price and its remaining assets.

Shorter Noah Feldman On International Law

Conservatives don't believe in international law, liberals do, and Justice Kennedy is the only swing vote in the court on that issue.

24 September 2008

Colorado Ballot Issue 50 (Gambling)

There is a website out opposing Colorado Ballot Issue 50 that was brought to my attention in the comments. The official state explanation is here.

Colorado Amendment 50 modifies the part of Colorado's state constitution that sets rules for gambling in Central City, Black Hawk and Cripple Creek (and thus could not have been accomplished through a statutory change), and earmarks increased state revenues, if any, for local governments that are home to casinos and to community colleges.

Many of the provisions of Amendment 50 are good:

* Increasing the betting limit from $5 to $100.
* Authorizing the games of Las Vegas-style roulette and craps in Colorado.
* 24/7 gambling for the first time in Colorado.
* Excluding gambling tax revenues from TABOR spending limits, but include them in the requirement that tax rate increases be approved by voters.
* Requires the industry to bear the burden of increased regulatory costs associate with its increased scope.
* Increases tax revenues from gambling due to increased gambling revenues.

The proposal isn't perfect (which is one of the reasons I generally don't favor law making by citizen initiative). The local governments involved probably make out a bit too richly in their share of increased gambling tax revenues. There is no meaningful mandate to keep some gambling taxes targeted at treating problem gamblers in the state in particular, as opposed to local impacts of gambling in general on the community. And, the choice of community colleges as a funding beneficiary is a poor fit, despite the fact that community colleges do need more money.

Still, overall, the monies from additional gambling taxes would reduce pressure on the state budget general fund, which is currently exceedingly tight, by making reasonable modest liberalizations in the scope of casino gambling in the state. So, in the end, I give Amendment 50 a weak thumbs up. Allow me to explain my reasoning in more detail.

The Conduct of Gambling

The whole point of gambling in Colorado is to have a mini-Las Vegas in Colorado and there is absolutely nothing wrong with that, indeed, it is ecologically sound because it reduces carbon emissions from Colorado residents who might otherwise make the long trip to Las Vegas to gamble.

Betting limits protect the casino, not the gambler, because betting limits make the impact of random chance on the percentage of wagers that go to the casino more reliable. Since the odds in any given game at a casino are always designed favor the house, the mathematically optimal approach to betting and coming out ahead by any given amount of money, is to bet as much as possible in as few bets as possible. Still, a $100 betting limit is still so small, that this impact is likely to be minimal.

Betting limits do little to discourage problem gambling, since the cap in on the amount to be spent in a given bet, not the amount to be spent by a given gambler. Also, limits on gambling of one type simply encourage gambling in some other manner. If one can't make big bets at the slots, one will buy lots of lottery instant winner games. Piecemeal approaches to stopping problem gambling are useless. Any industry level regulation of problem gambling needs to be comprehensive to work.

Even banning gambling all together wouldn't stop problem gambling. It is well established that illegal gambling thrives where it is illegal to gamble, with all the attendant criminality that comes with organized crime. The particularly troubling phenomena of problem gambling also appears to be linked more generally to personality and/or mental health traits that predispose a person to addictive behavior anyway. To the extent that problem gamblers would otherwise be doing drugs or becoming alcoholics, problem gambling may actually be a better vice.

Particularly in Colorado, where legal gambling discourages the development of a thriving illegal gambling industry, regulation of gambling is a more promising option, and the number of casino gambling options is small enough to make barring problem gamblers from casinos and other gambling venues a not entirely unworkable proposition. Certainly, nothing prohibits the state from enacting legislation to address problem gambling, like the development of list of persons prohibited from gambling, and developing treatment programs.

Local governments around the casinos should fund treatment programs, but probably won't to a sufficient degree. Funds to address problem gambling in the state should have been better mandated in the gambling tax revenue stream, but given benefits that gambling taxes have on general revenues in Colorado, spending some state general revenues on gambling treatment programs would still probably hurt general revenues less than the additional funding of community colleges would help a program traditionally funded from general revenues.

There is no reason under the sun that roulette and craps are any less desirable for any reason than slot machines, blackjack and poker. Why are roulette and craps any worse than various Colorado Lotto/Powerball games, or betting on horse and dog racing or bingo and raffles, all of which are also legal in Colorado? All gambling in Colorado is tightly regulated anyway.

There is nothing more moral about gambling during the day time or evening, than gambling between the hours of 2 a.m. and 8 a.m. in the morning. Indeed, forcing people out of bars at 2 a.m. in greater Denver, where violent closing time incidents are common, appears to impair public safety. There is no obvious good served by tossing people out of casinos at 2 a.m. in the morning, an hour at which they may be more likely than at other times to drive drunk, at the very least.

Also, like most vices, most negative impact from gambling is local. The biggest real downside to liberalized gambling under Amendment 50 in which the public has an interest is that longer hours may require police to increase staffing at night, and the additional funding provided to these governments is more than enough to address this concern. This is the genius of authorizing vices like gambling only in designated locations that ask to host them, as we have in Colorado, and as Las Vegas did. When negative impacts are balanced by enough positive public impacts, the places impacted welcome them and provide a forum where activity that is considered bad for the neighborhood, even if it doesn't directly hurt anyone else, can do business while keeping almost everyone happy.

In short, those complaining that Colorado Amendment 50 "would bring high-stakes, 24-hour Las Vegas style gambling to the State of Colorado" are mostly raising silly, indeed histrionic points of opposition. Allowing $100 bets is hardly high stakes gambling. In short, the opponents sound like a bunch of ninnies who think we need an ineffectual nanny state to protect us.

TABOR Implications

TABOR spending limitations are wrong in general, and including gambling taxes which are quiet cyclic in the equation simply makes unnecessary work for revenue estimators at the capitol, in the case of a tax that is a pittance compared to the state's overall revenues and can be easily controlled by people subject to the tax by gambling less.

Also, while the TABOR spending limits are dispensed with, the core of TABOR, which is that any tax increase must be approved by voters is retained.

The state Gaming Commission sets the tax rates on casino income within the parameters in the state constitution. Currently, the constitution sets the highest allowable tax rate at 40 percent. On July 1, 2008, the highest tax rate actually imposed was 20 percent. If voters in any of the gaming towns approve new gaming limits, a gaming tax increase above the July 1, 2008, level must be
approved through a statewide vote.

To the extent that the prior law allowed tax rates to be changed without voter approval, this was a quirk, as almost every state and local tax in Colorado requires voter approval before a rate can be increased (in some circumstances, property taxes designed to collect a sum certain can be adjusted after the fact, but in those cases the actual amount collected is fixed).

More revenue for the public good (and whoever gets the money nominally, money is fungible, so increases to a stated purpose may not work out that way in the long run) from people eager to pay more in taxes is also not a problem.

Distribution of Tax Revenues

As the Blue Book explains:

After paying to enforce gaming laws, approximately one-quarter of the gaming money goes back to the gaming cities and counties, about one-quarter goes to historic preservation and restoration projects across the state, and half of the revenue is allocated to the state legislature to spend on programs. These programs currently include assistance to local governments for gaming impacts, tourism promotion, economic development programs, energy efficiency and renewable energy projects, and highway projects.

Amendment 50 distributes new money from increased gaming activity differently than existing law. First, the money is used to pay to enforce gaming laws related to any changes in the limits. Second, some of the new money provides annual increases to the programs and local governments that currently get gaming money. The rest is distributed as follows:

• 78 percent for financial aid and classroom instruction at Colorado community, junior, and district colleges based on each school's number of students;
• 12 percent to Gilpin and Teller Counties, based on the proportion of the new money raised within each county, to help address the impacts of gaming; and
• 10 percent to Central City, Black Hawk, and Cripple Creek, based on the proportion of the new money raised within each town, to help address the impacts of gaming.

The new tax split is the most problematic part of Amendment 50, and is a rather weak part of the status quo.

As explained below, the share of gambling tax revenues allotted to local governments seems high, and their likelihood of using the money responsibly seems rather low, although surely there will be some additional local impact from gambling that will use some portion new tax revenues. The new revenue reduced by new costs, split three ways, aren't so huge relative to existing tax revenues that this is a cost of grave concern. Even with the new gambling tax revenues (which fluctuate quite a bit), these towns won't be a flush as some of Colorado's ski resorts. But, there is no doubt that the three cities most impacted will have a lot to gain from the proposed changes.

Community colleges are also, on the merits, a poor fit for gambling tax revenues, and have been put in the position of advertising for gambling, which, while not evil, they have no business encouraging. Gambling is a tax on people whose emotions are more powerful than their mathematical literacy, while community colleges are in the business of helping people make smarter choices in their lives.

This isn't the only problem with community colleges as a funding target. Community colleges have the lowest per student costs of any form of higher education in the state, which is paid for with a combination of tuition dollars (generally cheaper than any other higher education alternative), general fund appropriations from the state (some directly and some through "scholarships" to in state students who attend college in Colorado), and in a few exceptional cases, local property taxes. They also receive federal and private grants directly, and benefit from federal subsidies (mostly in the tax code and student loans) for students, indirectly.

The cost of funding community colleges overall greatly exceeds the increased revenues contemplated by Amendment 50. So, it is likely that this will play out more like using lottery funds for schools in Ohio, buying extra frills and whistles while not making a very noticeable overall difference, rather than the Colorado example of using lottery funds for Great Outdoors Colorado (GOCO), a small expenditure item that might not happen at all without lottery funding.

Historic preservation was a better fit for gambling revenues in both scope and in having some relation to the historic nature of the towns where there is gambling (and Colorado's history of gambling in the cowboy era). Historic preservation is also, like GOCO, something of a luxury that might not get funding at all without an earmark, and is like GOCO, not dependent on having a particularly steady stream of income, which gambling revenues are not. But, apparently, the backers of Amendment 50 thought that historic preservation didn't have enough clout to encourage marginal voters to support the measure.

Further, because community colleges are funded from always scarce general funds, unlike K-12 education which has a state constitutional minimum funding mandate and also a state constitutional mandate to provide the service, there is a real risk that community college funding will become less of a priority in the annual food fight at the end of every state legislative session over how general fund revenues are spent. Historically, higher education has born the brunt of hard economic times in the general fund budget, and there is no reason to believe that community colleges won't be particular hard hit in another recession on the theory that they have gambling tax funds coming to them.

Now, all things being equal, the state budget is still easier to balance with more money to pay for line items that have historically been paid for out of general funds, than less. And, one doesn't have a great deal of sympathy for a fool parted from his money in casino gambling, a classic "voluntary tax" because no one must spend money on casino gambling.

Fiscal Impact

The estimated increase in casino gambling tax revenues in Colorado, something that is never more than a guess in any case, is about 50%.

Casinos pay taxes on income from gaming and also pay various fees and fines. Last year, the state collected $112 million from gaming. . . .

State revenue and spending resulting from Amendment 50 will depend upon the extent to which the three gaming towns approve new gaming limits. The following estimates of tax revenue and spending are based on the assumption that all three towns approve the maximum gaming limits.

• Tax revenue will increase by about $300 million over the first five years. . . .

• State regulation costs will increase by $461,000 in budget year 2009 and $1.0 million in budget year 2010. These costs will be paid from gaming revenue. The state will also incur a one-time computer programming cost of $21,000 in budget year 2009 to account for both changes in gaming limits and the approval of roulette and craps by any of the gaming towns. This cost will be paid from other state money. . . .

The local governments serving both the gaming communities and surrounding areas could experience increased costs from new gaming limits, such as higher public safety, traffic, and road maintenance costs. The revenue resulting from new gaming limits could help offset any increased costs. Also, the gaming communities could see increased sales tax revenue from an increase in the number of visitors and more property tax revenue if new casinos are built or existing ones are expanded.

Payment of gambling law enforcement out of gambling tax revenues is the status quo, and not uncommon for narrow taxes like these. Indeed, merchants that collect sales taxes in Colorado are actually entitled to a small portion of the revenue collected themselves, to cover their costs of administering that tax.

The overall revenue estimate is probably optimistic, because it doesn't reflect the likely possibility that people who might have chosen to play bingo or bet at the tracks before, might now choose casino gambling instead, increasing one gambling tax revenue source while reducing another. Still, the overall conclusion that liberalizing casino gambling in the state will increase overall gambling revenues is not unreasonable.

On the other hand, the estimate local impact is very vague. As I understand the numbers from the Blue Book, local governments in the vicinity of Central City, Black Hawk and Cripple Creek get about $28 million a year in gambling taxes, plus some addition state appropriations to mitigate local effects of gambling, and increases sales tax revenues and gasoline tax revenues from associated tourism. The gambling industry also undoubtedly boosts the local property tax base.

The $14 million a year that these cities stand to gain, in addition to increased sales tax revenues, from expanded gambling probably exceeds the additional public costs to these localities from having a somewhat increased number of people bet larger amounts of money in the same casinos for a longer time period, even assuming that some state appropriations to these communities end. This is something of a concern, given that rightly or wrongly, these communities have a reputation from gambling money linked corruption already.

Not Very Important

I've argued that the Democratic party should not take a stance on Amendment 50, because many people disagree with me and think that gambling is evil in general. They are welcome to their opinion and the Democratic party shouldn't make them feel unwelcome. Gambling is not a core issue facing this state or this nation right now. If Amendment 50 fails, people can go to Las Vegas and bet in other ways. If it passes, there is one more option.

On balance, I favor Amendment 50. It will make more public funds available for things that are basically good, while dispensing with archaic limitations on the scope of gambling in the state and not doing any serious harm. But, the ill thought out earmarks in that Amendment 50 makes from gambling tax revenues (from a policy as opposed to a political point of view), leave me as an unenthusiastic supporter of the proposal. Amendment 50 will probably get my vote, but won't get my campaign contributions (something that the gambling industry has been more than willing to provide in any case).

Funding the Bailout

Tax blogger and law prof James Edward Maule rants about where the Treasury would find money for the proposed $700 billion financial industry bailout. Mr. Maule is prone to hyperbole when he gets angry, this time proclaiming that "the managers of these institutions have put the financial health, the national security, and perhaps even the continued existence of the nation at risk."

The United States isn't going anywhere soon, and Wall Street isn't going to kill it. But the problem is serious, and the financial sector has to bear a lot of the blame for the predicament it has created. His deeper point, about where the money will come from, moreover, is serious and on target.

In short, the money doesn't come from nowhere. While some of the amount lend may be recovered in whole or in part someday, through the sale of the purchased assets, that is a gamble. If the U.S. is buying assets that no one else on the market will buy, the likelihood is that some taxpayer money will be lost. We could lose everything, we could lose 10%, we could even gain, but like someone who walks into a casino without having research in advance on the probabilities in particular games, all we really know is that the odds are against us. Whether we have lottery odds, or favorite horse odds, or long shot odds, we don't know, because we got to this place as a result of the bookie who sets the odds (credit reporting agencies and key market players) screwing up in the first place.

No one has suggested any taxes to pay for this expenditure. But, simply "printing more money" (it more complicated than that but the equivalent can be done) produces inflation which has consequences. Monetary inflation is an implied tax on everyone whose income does not rise in lockstep with the cost of goods and services. Inflation can also destabilize the economy, although it does have the virtue of reducing the bite of debts denominated in dollar terms, such as fixed rate debts like fixed or rate locked mortgages, for people who have incomes that grow with the cost of living.

Monetary inflation isn't usually as bad as "real inflation" produced by the need to pay more in real terms for imports (like foreign oil) which transfers money out of the domestic economy entirely. Monetary inflation merely transfers wealth from one part of the domestic economy to another in an economically disruptive way. But, there aren't many economists out there who believe that monetary inflation is a good way to finance major government spending. Used in excess, major government spending financed by printing money leads to hyperinflation which is a death knell to a functional economy and often leads to martial law.

Borrowing money from third parties (and much of U.S. Treasury debt is held by foreign sovereigns) both increases the share of tax revenues for which the public gets nothing in return, and imposes a burden that must be paid off by taxes from some future generation.

Even more simply, there is no such thing as a free lunch. Somehow or other, spending money has consequences to the general public that spends it. We may not know exactly who will bear the burden, but some large class of people will bear that burden. All spending ultimately produces an express or implied tax.

23 September 2008

GM Bonds Downgraded

General Motors bonds are now rated CCC by one credit reporting agency. This makes the company one of the least credit worthy publicly held companies still in business, and indicate that its bonds are high risk junk bonds. General Motors bonds had a less severe junk bond rating before the credit rating downgrade. More details are available here.

General Motors spend good money during the Olympics marketing vehicles like the Chevy Volt that it doesn't actually sell yet, but it may not still be in busines by 2010 when it is scheduled to be for sale. Chrysler also has an electric vehicle scheduled to enter production in 2010.

Lehman Brothers bonds were given a similar bond rating on September 18, 2008. No one expects GM to collapse as quickly as Lehman did, but there are real concerns about GM's ability to survive for the next twelve months without filing for bankruptcy.

UPDATE: More current analysis here.

Air Force Argues For AC-27J Stinger II

The AC-130 Spectre/Spooky, a modified C-130 cargo plane with a 105mm howitzer in it, designed for air to ground warfare is getting old and expensive to maintain. The planes were used heavily in Vietnam, and more recently as part of the "War on Terrorism," against suspected terrorists.

The Air Force would like to replace it with the AC-27J Stinger II gunship, a modified C-27 which is an intratheater transport plane similar to, but smaller than a C-130, designed to be operated by the Army. The cargo version, also known as the joint cargo aircraft, has a capacity similar to that of a heavy transport helicopter (about half that of a C-130), but with more fuel efficiency, speed, range and reliability than a helicopter, while still able to operate from short field airstrips. It is also cheaper than the C-130. The primary weapon has not been determined, but a 25mm to 40mm cannon is contemplated, so it would have the ability to destroy a tank or truck. The proposal was previously discussed here.

No other military aircraft in the world has a slug thrower that delivers a shell as large of that of the AC-130. All other aircraft use some combination of "dumb bombs," "smart bombs" and missiles to deliver larger explosive packages.

Like the A-10 Warthog, both the AC-130 and the AC-27J are designed for relatively long, subsonic air to ground combat and patrol missions, at relatively low altitudes. But, the A-10 is primarily envisioned as a tank killer with heavier armament and more allowances for targets that shoot back, while the AC-130 and AC-27J are primarily designed to target a lightly armed enemy encampment or group of soldiers, and to provide fire support during infantry battles or sieges of friendly encampments. The slower speed and smaller armament of these planes suits them for missions where it is important to be able to identify targets up close and to limit collateral damage and friendly fire casualties.

The proposed armament is similar to that of the guns on an A-10, or an Apache AH-64 helicopter, but an AC-27J or AC-130 has more capacity to carry ammunition for a sustained engagement than an A-10, and greater speed and range than an Apache AH-64.

Supersonic fighter aircraft, like the F-15, F-16, F-18, F-22 and three planned version of the F-35 (the Air Force F-35A, the Marine F-35B, and the Navy F-35C), have less of an ability to linger over a small part of a battlefield, are designed to have significant air to air combat capabilities, and are designed to use heavier bombs and missiles that might not be appropriate in close quarters where allied troops are nearby.

Historically, the Air Force has been less than enthusiastic about close air support missions, and has been highly skeptical that it is ever necessary for aircraft to engage opponents at close range, rather than using guided weapons and sophisticated sensors from a greater distance. But, the shift of U.S. military engagements towards counterinsurgency actions in Afghanistan and Iraq has encouraged the Air Force to prioritize this kind of procurement so that it can remain relevant.

Could The Financial Crisis Help The Real Economy?

The Wall Street Journal notes that the financial crisis had weakened the U.S. dollar. Meanwhile, a brief $25 dollar spike in oil prices quickly retreated.

A weak dollar is good for U.S. exports, and hence jobs, while discouraging U.S. imports that contribute to the trade deficit. So, while Wall Street may suffer, the manufacturing sector may actual get a boost.

Undocumented Americans Emigrate

The legal immigration system admits about 1.1 million people a year. Immigration quota backlogs keep this number constant and close to that number every year.

As recently as 2006, about 700,000 undocumented immigrants added to that flow. But, in 2007, there was a dramatic reversal of this trend. According to the census bureau, only about 500,000 people documented and undocumented immigrated to the United States in 2007, compared to 1.8 million in 2006. This means that a net of about 600,000 undocumented Americans left the U.S. in 2007. In Colorado, the total estimated foreign born population declined by 0.9%, which means that more undocumented immigrants left the U.S. than there were legal immigrants who entered the state.

Presumably, this is driven by the decline in the U.S. economy generally, and the undocumented immigrant intensive construction sector in particular. Given the state of the economy so far in 2008 and the prospects for the U.S. economy in 2009, we are likely to see two more years of emigration by undocumented Americans.

This may rob the immigration issue of the pressure that it has seen in recent years. Immigration hasn't been the number one issue for many years. But, an important and vocal minority of voters, who are often disaffected from either major political party, care a great deal about the issue. A talked with one likely Obama voter while canvasing explain his concerns about this issue (and related ones) for about fifteen minutes. I have a politically active neighbor who feels the same way. And, no issue more frequently garners fierce reactions to otherwise routine stories on comment pages of the online Denver Post and Rocky Mountain News.

State and local governments have tried to address the issue. Colorado recently had a special session of the legislature addressing these issues, and Denver voters cast votes on a ballot issue this summer targeted at illegal immigration. But, the President and Congress are the dominant players on this issue.

How will this play out politically?

Tax collection changes are one likely place this could have an impact.

Cheap labor conservatives will lose clout, because their industries, particularly construction, are weak. In these industries, most undocumented immigrants operate as independent contractors, often through corporations, which don't have to be issued a 1099 when they provide services. If these corporations were 1099'd, they would have to report the income on federal tax returns, drying up a big hunk of the small business tax gap, while at the same time reducing the economic incentive to hire undocumented immigrants in these industries.

Also, given that Democrats will control Congress, facially neutral tax gap measures that have an incidental, even if significant impact on immigration, is likely to be more popular than an immigration specific measure.

We also may expect to see legislation requiring subcontractors to certify in detail immigration compliance for the general contractors that hire them.

Bullshit Promises

Bullshit promises are promises that are in a certain sense insincere even though they are not lying promises, at least not in a sense that would be actionable under the tort of promissory fraud. Promissory fraud is available in cases where a party makes a promise that it has no intention to keep, and it does so in order to deceive the promisee about its intentions. But it is quite common today for parties, especially companies dealing with consumers, to make promises that are not lying promises in that the promisor is not concealing an intention not to perform, but that are nevertheless insincere. In such cases a party uses promissory language but elsewhere reserves the right not to perform, or to change the terms of performance unilaterally as it sees fit.

Such promises are not necessarily lying, especially if the promisor does not at the time have a specific plan to change the terms, but they are usually bullshit. By simply leaving its options open a party can help itself to the benefits of promissory language without being subject to the norms associated with promising, in particular some sort of commitment to a particular course of action. The tort of promissory fraud as now applied is not able to address this problem, but we will suggest minor modifications in both contract and tort that should help. At the very least, it is time courts and commentators recognized the phenomenon of bullshit promises and the potential challenges they create.

From here.

The issue is less theoretical than it seems. Not so long ago, I litigated a case where opposing counsel argued strenuously that its client had made a bullshit promise, while I argued on behalf of my client that the promise made had real effect.

Another kindred contract drafting practice is to include a contract term, such as "this contract may only be modified in writing" that has been clearly established under applicable law to be invalid or unenforceable, but which may impact an uncounseled person's evaluation of their rights (or even that of a judge who rarely deals with contract law).

22 September 2008

Link Hunting

A number of the links in my sidebar have gone stale, referencing blogs that have been largely abandoned. While those stale blogs may deserve a parting achival post, I'm looking for likely, thoughtful replacements that don't simply ditto links already in place.

I'm not rigorously ideological in my links, although the quality of the discussion have to be reasonable good for me to link a moderate or conservative leaning blog. Mostly, the driving concern is "more input" that broadens the net.

As much as anything, the mission of this blog is to disseminate information that isn't secret, but also isn't saturating the traditional media.

Please leave suggestions, with links, in the comments, if you have any to make.

I also tinkered with the colors, because the old colors were getting stale.

When Did CNN Get So Awful?

When CNN started out as a network, I watched it a lot. It, like Daily Kos and Drudge Report on the Internet, made its name by scooping everyone else on basic factual, authoritative news coverage.

Since then I have spent more than a decade without cable TV or satellite TV, so my only contact with CNN has been via its website reading stories that I have sought out. But, I spent many hours this past weekend in airports, mostly airports where CNN was playing on the ubiquitous video screens.

The station is now all Presidential race, all the time. And, every issue is debated by bipartisan panels of so called experts who act like and are treated like craven proxies for the Presidential candidate of their choice. CNN has utterly abdicated any notion that there could be factually correct answers to anything, or that it is possible to conduct a discussion of current events, in a non-partisan way, or even at any tone less intense than just short of shouting.

Simply put, the whole network has become unbearable. Have I just had my head in the sand which has allowed me to overlook a fundamental change in our political culture, or has CNN simply lost its self-respect, or both?

No wonder internet analysis of current events, which is time, thoughtful and civil by comparsion, has thrived.

Wrong on the Housing Bubble

Economics of Contempt lists a couple dozen leading economic pundits that who actively denied the existence of a housing bubble, the very bubble that has us in a major economic mess now.

Dean Baker and Paul Krugman got it right. But, notably, the list of those who got it very wrong, not long before the bubble burst, is heavily populated with politically conservative economists (support for the proposition that they got it wrong is in the link above).

1. Alan Reynolds, Cato Institute
2. Kevin Hassett, American Enterprise Institute
3. James K. Glassman, American Enterprise Institute
4. Jude Wanniski, journalist/hack
5. Jerry Bowyer, author of The Bush Boom
6. Nicolas P. Restinas, director, Harvard Joint Center for Housing Studies
7. Jim Cramer, host of CNBC's "Mad Money"
8. Neil Barsky, Alson Capital Partners, LLC
9. Chris Mayer, professor of real estate, Columbia Business School, and Todd Sinai, professor of real estate, Wharton
10. Jonathan McCarthy, senior economist, New York Fed, and Richard W. Peach, vice president, New York Fed
11. David Malpass, chief economist, Bear Stearns
12. Steve Forbes, CEO, Forbes, Inc.:
13. Brian S. Wesbury, chief investment strategist, Claymore Advisors
14. Noel Sheppard, economist, Business & Media Institute
15. Carl Steidtmann, chief economist, Deloitte Research
16. John K. McIlwain, senior resident fellow for housing, Urban Land Institute
17. Margaret Hwang Smith, professor of economics, Pomona College, and Gary Smith, professor of economics, Pomona College
18. Charles Himmelberg, economist, New York Fed
19. Jim Jubak, investing columnist, MSN Money
20. James F. Smith, director, Center for Business Forecasting
21. Kathryn Jean Lopez, editor, National Review Online
22. Samuel Lieber, president, Alpine Woods Capital Investors
23. Mark Vitner, senior economist, Wachovia
24. George Karvel, professor of real estate, St. Thomas University

The list also notably illustrates another important point. A plausible, even compelling economic argument, and the confidence of the people who put you in a good position to expound upon your economic arguments, does not mean that you are right.

In the hard sciences, the guys with the most expertise are right a very large percentage of the time. In economics, this isn't true.

The Case For Trade Creditor Priority

The current financial bailout, which involves having the U.S. government spend up to $700 billion buying distressed financial assets (mostly collateralized mortgage securities) have several possible justifications.

1. The market is undervaluing these assets.

The trouble with this is that we don't usually consider the federal government to be better at valuing sophisticated derivatives than the private sector. If the private sector isn't buying at the price that the government is willing to pay, there may be a good reason for this reluctance.

2. Failure in one institution drags down others.

There are two versions of this argument.

One is that ordinary people will be hurt because pensions and other institutional investments that they benefit from indirectly are hurt by making bad investments, impacting them. This is true, but usually, we don't bailout companies simply because they made bad investments. The whole point of buying stocks and bonds not insured by the government is that you get returns greater than Treasury bonds in exchange for taking the risk that their value may decline. Investors in these kinds of investments are expected to evaluate the creditworthiness of the transaction in advance. Also, the willingness of the government to let many of these investments lose most of their value, suggest that this isn't a real motive.

The other version of this argument is that the failures will bring down the financial system itself. This is essentially an argument about payment systems, short term loans and trade credit. It argues that if day to day business cannot continue, that otherwise only slightly impaired companies will collapse, because these short term transactions can't afford to be delayed by being tied up in the Chapter 11 bankruptcy process.

Most publicly held companies and big financial institutions that deal with them have stockholders, people who have made long term bond and bank loans on an investment basis, and a variety of short term payments that haven't cleared, trade credits and short term loans. In theory, none of these transactions can take place in a Chapter 11 bankruptcy without court permission, because they could dissipate cash stockpiles of a company, although permission to engage in these transactions is usually granted right away. These kinds of creditors such as customers, suppliers, and operations creditors rarely evaluate institutions from a credit perspecitve with care, because individually they have small transactions for short periods of time.

But, even the risk of a bankruptcy can discourage people from doing business on anything but a purely cash basis with a company in financial peril, for fear that they will take a loss if they are unlucky and the company goes under on them. This reluctance to do business, moreover, can cause the very bankruptcy that is feared. This is essentially what forced Frontier Airlines into bankruptcy. A trade creditor, its credit card processor, tightened its trade credit terms for fear that the company would go out of business and leave it burned through customer chargebacks.

Since almost all dealings of financial institutions involve some kind of extension of credit, this is a real concern. From a financial institution's perspective, insurance policies and customer deposits are just one more liability.

The solution to this problem lies in the preferences section of bankruptcy code. In a bankruptcy, secured creditors (mortgage holders in real and personal property) get paid first, then preferred creditors (taxes due, the FDIC, recent wages and costs of conducting the bankruptcy and post-decree operations are important prefered creditors), then general creditors, then subordinated debt, then preferred stock, and lastly (and usually never) common stock. These default rules can only be overriden with the consent of creditors who are impaired by a deviation from the default rules.

Typically, in a successful Chapter 11 bankruptcy (i.e. one that doesn't convert to a liquidation), secured creditors and preferred creditors get paid in full or very nearly so, while subordinated debt and stockholders get nothing. Typically, general creditors get some percentage on the dollar payment, unless the plan specifically provides otherwise. Often, but not always, trade creditors are singled out for special treatment since they can cease to do business with the bankrupt company, and force a liquidation otherwise in many cases. But there is no assurance of this up front, so everyone who deals with a financially troubled company needs to protect themselves somehow, such as requiring payment in cash.

One solution would be to give trade creditors and similar creditor formal preference over long term investment creditors in bankruptcy proceedings. Yes, these short term business creditors could still get burned. But, it is rare for a companies that are still operating to be so deeply insolvent that there is not enough money to pay most of the trade creditors, even if long term investors get nothing.

There would also be less reason to object to allowing business as usual to continue in cases where trade creditors were almost sure to get a 100% payout.

The definition of trade creditor could be tied to a definition already in the bankruptcy code of a "preference" which is a payment to a creditor of more than its fair share on the eve of bankruptcy. If it payment in full of a debt prior to bankruptcy wouldn't constitute a preference (perhaps with a slightly broadened definition of preference), those payments should also be preferred in an ultimate payment. Creditors should'nt be penalized simply for not receiving favored treatment from the managers of a bankrupt company.

This tweak in a fairly obscure part of the bankruptcy code would make the fall of one company far less threatening to the system as a whole, which would allow business as usual to go on with basically viable businesses, while the long term financing of these businesses was rearranged.

With the risk of one company brining down an entire web of related companies greatly reduced, this in turn, would reduce the need for any kind of bailout, and allow the bankruptcy system to do its job of salvaging value while holding investors who made bad decisions accountable.

Ballot Counting Prediction

I predict that Colorado's unofficial ballot counting from the November 4, 2008 eletion will not be done any sooner than the afternoon of November 7, 2008, mostly due to delay in counting the vote in Denver. Colorado may be one of the last jurisdictions in the nation to provide results, and since it could be a swing state, could leave the rest of the country waiting.


The unofficial count for the primary election (admitted done using only partial ballot counting resources) took until 1 a.m. the next day. In this election, the ballot was short, a large proportion of voters voted by mail which can be counted in advance, turnout overall and in particular on election day was very low, and voter error rates were probably low.

While the vote counting capacity will be about 50% higher (or maybe as much as 100% more) on election day on November 4, 2008, numerous challenges will arise. The ballot will be much longer and vote counting speed is more closely related to how many pages of ballots much be counted, than how many ballots must be counted. Turnout is always highest in general election years, and Obama related enthusiasm and voter registration efforts are likely to make turnout particularly high in Denver. The mail in ballot percentage will be lower in Denver than it was in the primary. And, voter error requiring laborious hand counts will be higher than in the primary in an election where many voters are first time voters and the voting methods have changed since the last general election.

Given the fact that Denver leans Democratic, and that Denver is large enough to decisively influence statewide totals, Colorado returns will not be possible in the Presidential, U.S. Senate or ballot issue races without Denver numbers.

LPD 17 San Antonio Procurement Mess

The San Antonio class amphibious ship (LPD 17), which brings Marines and their gear to amphibious assaults, was a procurement disaster. It was more over budget, and more behind schedule than usual, and continued to have problems after all of the problems were supposed to be fixed.

It is particularly notable because despite having a new design, that consolidates more functions into a single larger ship and updates some systems, it wasn't particularly technologically ambitious compared to other major military projects like the F-22, F-35B, Osprey, Future Combat System, DD(X) and the Littoral Combat Ship. In other contracts, over budget and behind schedule problems have been blamed on the fact that the projects were trying to do thing which were previous impossible. In contrast, the San Antonio has basically sought to used well established technologies in a package designed to use them as opposed to a retrofit.

There is nothing inherent to government contracting about this problem. There have been times in U.S. military procurement history, where projects have been completed quickly and swiftly. But, the administration seems to have lost its way, presumably through less competent or political savy personnel, in knowing how to manage these contracts.

$700 Billion Is Too Much, Too Fast

The thrust of the Bush Administration plan for the financial sector is to buy lots of financal investments that are at grave risk of going bad, $700 billion worth, give or take. We've already authorized something like $200 billion for FannieMae and FreddieMac, which were government sponsored but privately owned companies that dominated the secondary market in mortgages, $70 billion in foreign insurer AIG, and something like $30 billion in investment bank Bear Sterns, although only in support of a buyout from J.P. Morgan Chase.

Bailout Alternatives

Other institutional crisis situations have been handled for more conventional and traditional approaches.

About a dozen failed FDIC banks, most notably IndyMac, have been handled through the existing FDIC receivership progress.

Investment bank Lehman Brothers filed for bankruptcy under Chapter 11, which contrary to the folks saying that government bailouts are necessary, is swiftly parceling out the company by auction to private sector investors in a manner that is preserving thousands of jobs, without putting public funds at risk, and may even leave most bondholders

Bank of America bought investment bank Merrill Lynch in an entirely non-governmentally funded transaction.

Goldman Sachs and Morgan Stanley, the remaining big investment banks, have agreed to become traditional commercial banks, primarily at the cost of becoming far less leveraged.

The private sector has already also put together a $70 billion emergency lending fund.

Essentially, the market has shut down the investment banking industry as preciptiously as it previously shut down the subprime mortgage industry.

This isn't a first in the history of the modern economy. The U.S. steel industry, textile industry, and television industry were all wiped out by foreign competition and the U.S. automobile industry looks eager to follow suit.

Better Options

The cycle of overleverage producing excessive risk taking from players who have head I win, tails you lose incentives is a very old one in the American economy. Investment banks are only the latest players. Waves of insurance and banking bankruptcies have characterized panics since well back into the 19th century.

There are essentially two solutions that work. One is to insist as a regulatory matter on reduced debt to equity ratios. This, far more than the insurance product itself, is why FDIC regulated banks have weathered the latest financial crisis so much better than mortgage finance companies and investment banks.

The other is to organize companies on a cooperative or as financial companies prefer to say, "mutual" basis. When your shareholders and your investor/customers are the same, there isn't an incentive to become excessively leveraged. This is why credit unions and mutual insurance companies are not all over the headlines.

Shareholder owned insurance companies are regulated by state governments, most of which have reserve requirements. But, some of the more esoteric players in the market, like AIG which participated in sophisticated small markets like credit enhancement for otherwise weak investments, state regulation is not always enough for thin markets.

Credit rating agencies have also failed to adequately factor in the risks associated with excessive leverage.

Bottom Line

Simply put, the Bush Administration has not made the case to the general public that buying assets, as opposed to increasing regulation and allowing the Chapter 11 bankruptcy process to work, are so inadequate as means of responding to the current financial crisis that we need to socialize the losses of major investment firms at public expense.

When the price for mortgage backed securities gets low enough to reflect the risk, investors will buy them, and that price will be nowhere close to zero. Yes, the stock market will fall. A bubble has punctured, not for the first time. Indeed, this administration started out with the tech bust and let it run its course. But, the bust is mostly a function of unreasonable paper gains.

Rather than spending $700 billion proping up bad business decisions on Wall Street, we should be focusing on a bailout that is almost certain to follow, the huge inadequately declared risk that the Pension Benefit Guarantee Corporation will have when corporations drop their defined benefit pension plans in bankruptcy, a risk the federal goverment insures, but has inadequately guarded against from a regulatory perspective.

By increasing pension regulation, PBGC premiums, and increasing PBGC reserves now, we can minimize that risk while letting risks that government never undertook play out in the market, which isn't nearly as bad at dealing with financial institution collapse as suggested. And, if there are weaknesses in the bankruptcy system (e.g. because it fails to give priority to trade creditors and short term payment system debt needed to maintain market integrity) than we need to fix those problems.

19 September 2008

11th Circuit Sanctions Police Brutality

The United States Court of Appeals for the 11th Circuit has held (in a 2-1 decision) that it does not violate the constitution to taser, three times in a row, an unresisting handcuffed man, who asks to be arrested, simply because he fails to get up on a command and fails to voluntarily sign a traffic ticket. The facts of the videotaped incident are undisputed and the video was posted with the opinion.

It is really a shame to see our constitution so badly shredded. This case screams out for en banc review, or U.S. Supreme Court review. Cops like this one should be fired on the spot. Judges like those in the majority in this case betray their oath.

Mangakas Without Medicine

In Japan, they call a comic book author a Mangaka, and many of the highest income earners in the country write comic books. In the U.S., however, life as a mangaka is tougher. Most are young, often about to get married or just starting families, and cobbling together sufficient health care is a struggle.

The husband wife team that write Misfile, one of the most popular webcomics, have a newborn who recently came home from NICU. Their situation, as husband Chris Hazelton explains, referencing his wife, who goes by Third Child on line, and their daughter Avery:

Health insurance is a pain in the ass. Every since Third lost her job back in May, I’ve been without, and we’ve been paying for hers out of pocket. Now that Avery has been born, the price has doubled and the new payment is killing us. The worst part is after all that extra money I still have no personal health insurance. >_< As I always say, if anything goes wrong with me, throw me in the car and say I was hit, because it’s the only way I’m covered.

Of course, like everyone who has had a major medical event, Chris and Third are also engaged in endless paperwork dickering with their insurance company.

Equally often, they don't have health insurance, leaving folks like musician and comic community member Tom Smith in a bind when an injury sent him to the hospital. One can throw a fundraiser and ask for help, but there are limits to how much that raises.

There isn't actually anything special about comic book writers. Their plight is one shared by a large portion of all people who, like them, are self-employed. A comic book writer is fundamentally a small business person in our economy, and anyone striking out on their own in a small business is at grave risk of losing that safety net. Premiums for small businesses for health insurance are far greater than those for big businesses.

It isn't impossible to get health insurance, but it can be very difficult to get insurance that covers all the risk you have a reasonable likelihood of facing without hitting you very hard financially if you get sick. After seeing a link at Square State, for example, I reviewed the offerings at eHealthInsurance, which markets individual and family health insurance plans, and connects people to brokers for group health insurance plans.

The individual health insurance plans have lower premiums (from $2,000 to $6,600 a year, compared to about $19,600 a year for a family four to COBRA at large employer group rates with a fairly modest plan where there are only small deductibles and are co-payments for most services). They also have big deductibles that you pay before you get any coverage, most in the $2,500 to $7,500 range (often, per person, not per family), often require you to pay 20%-30% of the charges after the deductible, still require you to stay in a network of physicians, and frequently don't cover pregnancies, prescription drugs, mental health care, or pre-existing conditions without a hefty additional premium, if you can get health insurance at all. Some of these plans also have fairly low caps on the maximum payout, so your insurance may end in the midst of a really serious illness or injury when you need it most.

Now, some health insurance is usually better than nothing. If you have some health insurance you usually pay the real price from health care providers, instead of the exaggerated prices charged to the uninsured. Indeed, having health insurance is often necessary to even get an appointment with a health care provider -- many won't take new patients who lack insurance.

Also, if you have a major medical incident, most individual policies can easily put you out of pocket $10,000 or more. But, some of this can be made up for by saving your premium savings to use for out of pocket costs, and it is much easier to pay $10,000 with help from credit cards, home equity loans, friends, family, bake sales, pawn shops, overtime and extra jobs, than it is to pay the $50,000 to $100,000 you might owe otherwise.

While most people contemplating starting a small business may not known the precise numbers involved, most do know in general terms that going into business for yourself means paying more for a weaker safety net. The big price our economy pays as a result is that many people simply don't start that business, even if it would otherwise make economic sense for them to do so. Since small businesses create far more jobs proportionate to their economic size than big businesses, and are far less likely to offshore their labor, this lack of affordable health care for small businesses kills millions of American jobs every year.

18 September 2008

Can Civil Litigation Expenses Be Controlled?

Lawsuits are expensive. The bigger the lawsuit, the more expensive the lawsuit, generally speaking.

Most of the additional cost of a bigger lawsuit comes from the costs of discovery. In really big cases, discovery can easily account for 90% of litigation costs or more. Even in small cases, discovery is an important part of litigation costs, usually involving at least a third to a half of the expenses even in a small case that settles before trial and/or is resolved in motion practice.

Discovery is the gathering of evidence on a compulsory basis, usually with little court supervision, after a lawsuit is filed and before trial. Discovery can be costly, often unnecessarily so, but is also often necessary so that a party to a lawsuit can discover key evidence of the facts in the case that are controlled by someone else. The basic question is how costs can be minimized while not dismissing more lawsuits that have merit.

Closely intertwined with the discovery problem, indeed, really a facet of it, is the question of how specific litigants should be required to be about their claims when they initially bring suit. Suits that can be dismissed on the basis of a pre-discovery motion to dismiss for failure to state a claim quickly dispose of weak cases, so there is a temptation to require a high level of specificity. But, defendants often have control of key information, so setting high standards may through out suits with merit.

Also, closely related is issue of how easily cases should be resolved prior to trial in motions for summary judgment, in which documentary and affidavit evidence not creating square disputes of material facts are considered by a judge. These motions are typically brought part way through or at the end of the discovery stage of a case.

Traditionally, pre-evidentiary motions to dismiss and motions for summary judgment have been disfavored, in order to preserve the role of a jury in resolving cases as often as possible. But, in practice, these standards have grown more liberal over time. The percentage of cases resolved through motions for summary judgment has increased greatly.

The problem is that if a case is cursed with a disputed issue of fact, even if the evidence is very strong for one side or the other, resolution of the case can be delayed, and expenses can multiply, even if the primary dispute between the parties is a dispute over contract interpretation or questions of law, that are the duty of a judge rather than a jury to decide.

Also, while the vast majority of personal injury cases are on track to being decided by juries if they are not settled, most commercial cases will ultimately be resolved in a bench trial, so postponing judicial decision making until trial often has no solid theoretical basis.

It is also worth noting that civil jury trials are becoming increasingly rare due to high settlement rates and due to increased resolution of cases in motion practice, particularly outside the realm of individual personal injury cases, and that the vast majority of civil cases are tried in state courts where there is no federal constitutional right, and often no state state constitutional right, to a trial by jury.

There is essentially no room in the existing legal system for increased settlement rates alone to reduce litigation costs. Mediation and settlement discussions are almost always mandatory before a case goes to trial. And, a very high percentage of cases (in the view of many observers including myself, too many cases) already settle.

Law professor Paul Stancil, in his article about the desired specificity of legal pleadings, linked above, which really goes further and retraces the larger law and economics argument regarding how litigation costs influence settlement to zero in on a particular class of cases where he believes that the current system is most prone to litigation cost driven settlements. In this class of cases:

• The plaintiff’s internal costs of litigation are lowest, as in claims in which the plaintiff has little discoverable information in its possession, custody, or control.

• The plaintiff’s external costs of filing a frivolous suit are lowest, as in claims in which the plaintiff’s attorneys are unlikely to be repeat players in the same court or against the same insurer/payer.

• The defendant’s internal costs of litigation are highest, as in claims in which the defendant’s discovery costs are high and cannot be filtered or sequenced to minimize expenditures.

• The defendant’s external costs of settlement are lowest, as in claims in which there is little risk of reputational harm or copycat litigation and there is no insurance coverage.

. . . there is a relatively low risk of opportunistic pleading in most types of civil claims. Though full empirical analysis is beyond the scope of the current article, there is reason to believe that many of the most common forms of civil litigation – automobile torts, breach of contract cases, intellectual property disputes, etc.—inherently involve or can be made to involve relative parity in pretrial costs, or even disparity in favor of the defendant. Thus, stricter pleading standards across all claim types are unnecessary.

While is is not specific about identifying "high risk cases" he identifies anti-trust, class action securities fraud and class action consumer fraud types of cases against public corporations are examples of the kinds of cases he believes are high risk. He proposes as a solution the requirement that plaintiff's post a bond against defendant's attorneys fees if they wish to proceed with bare bones allegations, rather than a detailed factual description of the basis of their claim when they file suit.

In addition to my natural distrust of any economic theory that encourages a change in the law to favor large public corporations at the expense of a large group of injured ordinary person plaintiffs, I also think that Stancil's analysis understates the extent of the problem in more typical types of litigation.

While litigation costs are bigger in big cases than in small ones, litigation costs are larger relative to the amount in controversy in small cases than in big ones.

Also, Stancil, like many law and economics analysts, overestates the amount of certainty involved in the underlying merits of the case. In practice, predicting the outcome of a case even knowing all of the facts with certainty, is much more difficult than one would expect. Ambiguities of law or contract interpretation make the universe of potentially relevant facts larger, and can leverage modest disputes regarding the facts into big outcome differences.

My own suggestions are largely influenced by European civil law practice, and by criminal practice which conducts trials in very serious cases on a routine basis, with far less pre-trial discovery and motion practice.

So, what could be done procedurally to reduce civil litigation expenses?

1. Civil jury trials should be banned or procedurally discouraged outside the narrow subset of civil cases that account for a large share of cases that actually go to trial before civil juries. Primarily, these should consist of cases in which non-economic damages are available and eminent domain cases, although perhaps there are some exceptions I have failed to consider. The existing distinction between cases that were considered cases "at law" under historical English law, and those that were brought "in equity" under historical English law, has long ago outlived its usefulness. Notably, outside the United States, civil juries are virtually non-existent, even in England.

While the expense of calling a jury and preparing proposed jury instructions itself doesn't add all the much to the costs of litigation, the entire system of civil procedure is designed around the assumption the cases will be resolved by a jury, and this assumption causes the civil litigation to be conducted in a way that is very expensive because so many issues must go unresolved until a jury can hear the entire case. It is also essentially impossible to hear a case tried before a jury piecemeal.

These procedural consequences of a jury system are not necessary in a case headed to a trial before a judge in any case.

Also, the near absolute finality of a civil trial, after which no factual issues can be raised on appeal, encourages litigators to overprepare. Litigators preparing for a civil trial devote considerable expense to preparing to address every issue in the case that is not the subject of a stipulation, no matter how minor or how unlikely it is to be raised at trial, in order to guard against surprise. But, this can greatly drive up the costs associated with pre-trial preparation if the client can afford that level of preparation.

The narrowing of the scope of civil cases eligible for trial by jury in types of cases where this option is used very rarely, it is also possible to make changes as significant as rethinking courthouse architecture by allowing most courtrooms to be built without jury boxes.

2. At least in cases not on track to go to trial before a jury, a preliminary hearing should be held early in the case. This preliminary hearing would be analogous to a preliminary hearing in a criminal case, or to a first hearing in a court of first instance the civil law system, from which a first appeal on both issues of law and issue of fact is available. Each party might be given up to two hours to present preliminary evidence in the case.

At a preliminary hearing, a judge would preliminarily resolve as many issues of law and fact as possible, after receiving offers of proof that are undisputed, stipulations as to facts, key documents disclosed early on, and testimony (possibly by telephone) from a small number of key witnesses. One would have to make a detailed offer of proof in the hearing (or perhaps promptly thereafter) of additional evidence regarding a disputed fact, or show good cause based upon evidence discovered after the preliminary hearing, to have an opportunity to dispute those findings at trial.

While attorneys would have to devote time early on to preparing for a preliminary hearing and knowing their case, there is only so much one can do to prepare for a hearing that will last no more than four hours, and the ability to revisit issues resolved against a client at trial for good cause could help to discourage wasteful over preparation.

The goal of a preliminary hearing would be to resolve early on the kinds of cases that can be resolved in motions for summary judgment, and cases with simple evidentiary disputes that can be resolved with a minimum of evidentiary presentation. Preliminary hearings would also narrow the scope of cases that have some disputed issues of fact that require a great deal of evidence to resolve, to the greatest extent possible. Resolving disputed legal issues up front can also greatly narrow the scope of evidence that is relevant in a case.

The opportunity to resolve all or part of a case early on in a preliminary hearing would take a great deal of pressure to stretch the scope of motion to dismiss and summary judgment practice, because many of the close cases under motion practice could be resolved early on in a preliminary hearing, reducing the stakes in allowing a weak case to go forward.

The presence of a judge is also a factor that is more effective than almost anything else at constraining unreasonable litigation conduct by counsel for the parties. The prospect of an immediate negative judicial ruling or sanction from a judge discourages weak legal arguments or arguments based upon false inferences from the facts.

Another benefit of a preliminary hearing is that it would often give a judge a quick primer on the big picture of the case, which would make it easier for a judge to formulate a sensible case management plan for the case, which would assist in implementation of my next proposal.

Preliminary hearings are not unprecedented in civil litigation. Some version of a preliminary hearing is required under Colorado civil procedure in eviction actions, foreclosure cases, cases where an attachment (i.e. pre-trial asset seizure) is sought, and cases where a preliminary injunction is sought. Pre-trial relief requests that are often outcome determinative in practice, are particularly common in cases involving intellectual property, non-competition agreements, election cases, constitutional challenges to statutes, and publicly prosecuted securities fraud cases.

Cases brought in limited jurisdiction courts (up to $15,000 in Colorado) don't have preliminary hearings, but are resolved without any pre-trial motion practice or discovery unless specifically ordered by a judge which is the exception, and often are resolved in bench trials considerably shorter than a single full day. The judicial system attempt to resolve the vast majority of these cases within six months, and often does so in three or four months. Most are collection and eviction cases arising out of contracts in consumer transactions or transactions with small businesses.

3. At least in cases not on track to go to trial before a jury, it often makes sense to try a case piecemeal, considering issues that could resolve a case with less evidence first, before opening up evidence intensive issues.

For example, in most contract disputes, the cost of the litigation can often be significantly reduced by ruling prior to the conduct of substantial discovery in the case, on the question of whether or not a term of the contract whose meaning is disputed is ambiguous, which is a threshold to permitting additional testimony and evidence concerning its meaning to be considered, or not, which often greatly reduces the amount of evidence that is relevant and either resolves the suit or greatly narrows the issues in the case.

Similarly, in a contract case, if there is a serious dispute over whether a contract was entered into at all, it often makes sense to resolve the issue of the existence of the contract before litigating its meaning and the measure of damages in the case, or and even before allowing discovery on those issues.

Likewise, it often makes sense to resolve statute of limitations disputes, even if they involve greatly disputed issues of fact, before opening up discovery on other issues in the case.

4. Some asset discovery should be allowed in cases that survive a preliminary hearing. The cases that work best in the current litigation regime, individual personal injury cases, also happen to be cases in which the most important piece of asset discovery in those cases -- disclosure of insurance policy limits, takes place early in the case. While ability to pay is sometimes discussed in settlement negotiations, privacy considerations, strategic interests of high asset defendants, and concerns about the extent to which there is any remedy if a representation about assets is inaccurate, mean that asset discovery often takes place rather late in a case if it happens at all. But, realistic information about the ability of a defendant to pay a judgment if a plaintiff prevails not only encourages settlement, but also discourages plaintiffs from pursuing theories of recovery that can complicate a case without adding to a likely recovery. Currently, assets discovery is only allowed as a matter of right only after a judgment enters.

17 September 2008

Dow Down For Bush Presidency

The Dow closed today at 10,609.66. finishing not far off its lows of the session. It has fallen more than 25 percent since reaching a record close of 14,164.53 on Oct. 9 last year.

The Dow when President Bush took office (January 20, 2001) was 10,732.

The Dow has fallen 122.34 points (a bit more than 1%) in the seven years, seven months, and four weeks since President Bush took office.

When Bush took office the exchange rates with the U.S. dollar and the following currencies were (compared to their current values in parenthesis)

Canadian Dollar 1.5072 (1.0788) Down 28%
Euro 0.9374 (1.4215) Down 34%
British Pound 1.465 (1.7855) Down 18%
Yen 116.44 (109.71) Down 6%

Consumer Price Index (CPI-U) January 2001 175.1; August 2008 219.086; Inflation 25.1%

Thus, the inflation adjusted return on the stock market is about -26% during the Bush Presidency. The slide of the U.S. dollar against major foreign currencies confirms the slide in its value during the Bush Presidency.

Dividend yields as a percentage of share price have been in the 1% per annum to 2% per annum rate for the S&P 500 during the Bush Administration. Dividend yield were higher every single year from 1871-1997, although they bottomed out at 1.1% in August 2000, shortly before Bush was elected.

Total dividend yields during the Bush Presidency have been less than the amount that share prices have lost due to inflation, even before accounting for income taxes on dividend income.

Thus, even when considering total real return, rather than merely nominal stock index change, the stock market has been a losing proposition during the Bush Administration.

In State Tuition For Non-Citizens Illegal?

An intermediate appellate court in California ruled yesterday that federal law prohibits public colleges from allowing non-citizens to pay in state tuition, even if they are de facto residents of the state.

Colorado has recently faced similar disputes, which were resolved generally in favor of the students seeking in state tuition.

The California ruling is not directly applicable to Colorado and other states, but is persausive authority as other states interpret federal limitations on grants of in state tuition.

Particularly of concern is what exactly public college and universities must do to determine the state residecy of its students, and where the line between a non-residency related tuition break, and one that simply grants de facto in state status to undocumented resident is drawn.

One response could be to eliminate in state tuition preferences for institutions where this would not make much of an economic impact. Less selective high education institutions typically have very few out of state students. For example, 92% of Metropolitan State College of Denver students are residents of the Denver Metropolitan area, and many of the rest of Colorado residents. Moreover, 90% or more of alums stay in Colorado where they contribute to the economy, which is the point of encouraging in state students for the state.

While out of state tuition may be necessary at flagship institutions, like CU-Boulder, where 41% of students are from out of state, the number of public colleges in Colorado where this is concern is small.

16 September 2008

C-27 JCA Program in Trouble

A Congressional appropriations subcommittee is backing away from support of the C-27 Joint Cargo Aircraft program which the Air Force has always been lukewarm about, despite Army and National Guard insistence that there is a need for an intratheater fixed wing aircraft with a load capacity closer to a heavy lift helicopter than a C-130.

The subtext is this debtate in Congress, like the debate over the next generation air tanker award, is that Congress hates giving military aircraft contracts to firms with a strong foreign connection, like Airbus and the designer of the C-27.

Also, the Air Force fighter mafia, as always, hates the idea that it should have to spend scarce budget resources in a support role for the Army.

On the merits the C-27 is a solid program because it is faster, has a longer range, and is more fuel efficient and reliable than a comparable capacity helicopter. Yet, because the Army lacks fixed wing aircraft, it often uses helicopters in missions where the vertical takeoff and landing capacity of a helicopter isn't necessary because field airstrips are available.

McCain Against Minimum Wage

Last year Senator and GOP Presidential nominee John McCain voted in favor of a proposal by Colorado's own Senator Wayne Allard to end the federal minimum wage.

The Lehman Brothers bankruptcy

The Lehman Brothers bankruptcy filing indicate that as of their May 31, 2008 financial statement that the firm has $639 billion of assets and $613 billion of debt. At that time the firm had about $110 billion in ordinary bonds, and about $17.6 billion in subordinated bonds. The composition of the other debts is hard to determine, in part, because of a bad cross reference in that part of the filing.

As of the last financial statement, accounts payable were about $71 billion, short term debt was $163 billion, other current liabilities were about $29 billion, and long term debt was about $350 billion.

As of the filing date, the listing of the top 30 outsider creditors of the firm mentioned $138 billion of ordinary bonds (managed by two bond trustees), $17 billion of subordinated bonds (managed by one of the two ordinary bond trustees), and about 3 billion in bank loans and letters of credit ranging in size from $463 million to $10 million from 23 different institutions (a few of whom appear to be related entities of each other). This leaves about $485 million of debts owed to creditors in amounts less than $10 million and insider debtors.

This would suggest that $71 billion+ is made up of trade credit in small amounts per creditor, while $414 billion is made up of financial creditors in amounts less than $10 million and insider debt, with insider debt probably making up the bulk of the debts, as investment banks don't generally take deposits from millions of households the way that commercial banks do.

There don't appear to be any significant (i.e. more than $10 million) secured creditors or trade creditors, although this might not include financial rights of setoff.

There are more details (and explanations for why better data isn't provided) in an Affidavit of the CFO, which is honestly rather dubious and unsatisfying. I find it very hard to believe that Lehman Brothers is incapable of providing much, much more information than it has to date with only modest effort. While it might not be able to provide ever single creditor in a matter of weeks (although with the joy of computers it is hard to see why it shouldn't, it has to do so every quarter anyway), it ought to be able to publicly account for more than a third of its outstanding debt. These folks are in the financial analysis business and live and die on their own ability to be highly leveraged without becoming insolvent.


The most recent financial statement listed the aggregate value of preferred stock at $7 billion (and did not include it as a debtor in the petition).

The aggregate redemption value of the preferred stock based upon the rights of each class of preferred stock, the number of preferred shares identified in the petition (presumably the number of authorized preferred shares in each class), and assuming that preferred stock dividends aren't grossly in arrears, is about $237 billion. This is calculated as follows:

C 5 million shares, $500 each, $2.5 billion
D 4 million shares, $5000 each, $2.0 billion
F 12 million shares, $2500 each, $30 billion
G 5.2 million shares, $2500 each, $12.5 billion
J 66 million shares, $2500 each, $165 billlion
K 12 million shares, $25 each, $0.3 billion
L 12 million shares, $25 each, $0.3 billion
M 16 million shares, $25 each, $0.4 billion
N 8 million shares, $25 each, $0.2 billion
P 4 million shares, $1000 each, $4 billion
Q 2 million shares, $1000 each, $2 billion

But, this appears to grossly overstate the amount of preferred stock shares outstanding.

There are 694,401,926 common shares outstanding according to the petition.


The source balance statement listed the company's assets as $314 billion in cash, $42 billion in net receivables, $4.3 billion in fixed assets, and $279 billion in non-current assets.

Presumably, this number is lower now, due to market losses, particularly in mortgage based securities.

Some breakdown on the nature of those assets is available:

Sanford Bernstein analyst Brad Hintz estimates that 55% of Lehman's balance sheet can be quickly liquidated, particularly such assets as receivables and short-term loans known as repurchase agreements. There are about $269 billion in securities that are "another story," Hintz wrote in a report released Monday. He estimates 27% of the $269 billion is in mortgages, 17% in derivatives, and 8% in real estate.


The two primary bond trustees seem likely to be the dominant voice on behalf of creditors in this bankruptcy on the creditor's committee.

This could be a 100% payout liquidity failure bankruptcy, and failing that, could be one in which common stock shareholders, preferred stock shareholders, and perhaps subordinated debtors bear the brunt of the impact, while general creditors are held harmless or nearly so.

Indeed, if the company adopts a plan that holds harmless all preferred and general unsecured creditors, and all secured creditors, then only the holders of subordinated debt would have any right to object. Since all of the subordinated debt appears to be represented by a single bond trustee, this might mean that the plan could be confirmed in a one on one negotiation with the representative of that bank.

Equity and subordinated debt together are capable of absorbing a $43 billion loss between May 31, 2008 and the bankruptcy filing, and pre-bankruptcy loss estimates had been in the vicinity of $7 billion.

Barclays Bank is discussing buying the brokerage and investment banking operations including the headquarters out of bankruptcy for about $8 billion (presumably the usually highly profitable brick and mortar part of the operation which probably also counts for most accounts payable and accounts receivable), and assuming that this is a market value for that operation by some reasonable measure, the market losses that other creditors would have to bear would remain unchanges, but greater liquidity could speed up the payout.

As one source explains:

The bankruptcy filing covers only Lehman’s holding company. Its brokerage and money-management units are not in Chapter 11 – employees still have their jobs, customers still execute transactions on accounts, and portfolio managers still manage mutual funds.

The relative independence of these subsidiaries from the bankruptcy process is what enables Barclays, the U.K.-bank that walked away from a Lehman rescue over the weekend, to consider purchasing part of Lehman.

Another interesting possibility would be a plan that allocated good, short term assets to outsider creditors as payment in full, while allocating securities of uncertain value, like the mortgage backed securities, to the insiders. Outsiders can't object if they get quick cash in exchange of the debts owed to them, so this plan could be imposed on them, leaving insiders with any windfalls resulting from market undervaluation of Lehman Brothers' complex financial assets.

The biggest overall risk is that the derivatives market, and in particular, the credit default market, will be screwed up by the freezing of the positions of a major market player, although recent bankruptcy law reforms are designed to minimize this impact.

Bottom line: Despite the drama, the class of people really taking a hit from this bankruptcy may be quite small.