Topic: Finance, Banking & Monetary Policy

Sarbanes-Oxley’s Harms Are Magnified by the PCAOB’s Unconstitutional Structure

Passed with scant deliberation amid a stock market panic, the Sarbanes-Oxley Act of 2002 vastly expanded the federal government’s role in regulating corporate governance and the accounting industry. As part of that effort, Congress created a new agency to “audit the auditors.” Known as the Public Company Accounting Oversight Board, the agency has broad rulemaking and enforcement powers to set accounting standards, investigate accounting firms, punish criminal violations, and make whatever rules “may be necessary or appropriate in the public interest or for the protection of investors.”

Remarkably, the PCAOB (pronounced “peek-a-boo”) also has the power to fund its own budget by levying taxes on publicly traded companies. Despite giving the PCAOB all this power, however, Congress insulated it entirely from presidential oversight. Unlike with an ordinary “independent agency,” the president has no power whatsoever to appoint or remove PCAOB officials. Those officials may be removed only “for cause” by the SEC, not the president; and SEC officials may themselves be removed only for cause.

The Free Enterprise Fund challenged the constitutionality of the PCAOB and appealed to the Supreme Court. Cato’s supporting brief focuses on the PCAOB’s practical policy consequences, illustrating how the PCAOB’s unconstitutional structure has created incentives for out-of-control spending, agency aggrandizement, and lack of coordination between regulators. Our brief also highlights the PCAOB’s efforts to impose American accounting standards abroad, which has caused confusion and invited retaliation from foreign regulators.

I previously blogged about this case here and here.

A Deregulation That Could Reduce Foreclosures

One of the obstacles to reducing mortgage foreclosures is that so many of the homes being foreclosured upon are not occupied by their owners.  Approximately 20 percent of homes are vacant investor-held properties, while according to the National Low Income Housing Coalition another 20 percent are occupied by renters.

Addressing the issue of renter occupied foreclosures has been one of the harder nuts to crack.  We should have no sympathy for vacant homes purchased purely for speculative gain - the best course of action for those homes is foreclosure, or even better, speculators should be expected to continue paying those mortgages even in the face of losses.   Where homes are currently rented however, it may be in the interest of both the bank and the renter to continue that relationship.  Unfortunately, there is one larger barrier:  the very same bank regulators who are pushing lenders not to foreclose.

As banks are not in the business of property management, their regulators strongly discourage banks from keeping foreclosured properties on their books.  In fact bank regulations generally prohibit lenders from entering into long-term leases with tenants.  Legislation (HR 2529) introduced by Republican Gary Miller and Democrat Joe Donnelly would allow banks to do so for up to five years.  While the bill is sure to have some flaws - it merits a closer look.

Although most banks are unlikely to want to become property managers, allowing some to do so, even on an interim basis could reduce both the unnecessary eviction of renters and foreclosures on rental properties.   And unlike proposals that would force banks to make uneconomical modifications, or prohibit lenders from taking ownership of a renter-occupied home, relaxing regulations governing bank management of foreclosured properties could keep some families in their homes without having to violate contracts or re-distribute wealth.

Administration’s Fiscal Muddle

Recent comments by Treasury Secretary Tim Geithner and National Economic Council Director Larry Summers illustrate the incoherence of the administration’s fiscal policy. Previously, they were against raising taxes in the short-run because that would damage the economic recovery. Now they are hinting or suggesting that recovery depends on raising taxes to reduce the deficit.

Previously, they supported rising levels of spending and deficits to supposedly grow the economy, but now they are saying that deficits need to be cut for the economy to grow. Geithner and Summers seem to be repeatedly changing their message depending on the political requirements of the news cycle, rather than providing a consistent program based on economic theory.

The reality is that rising taxes and spending suck resources out of the private sector economy, which damages growth whether we are in an expansion or a contraction. That’s because governments in America already consume more than one-third of everything produced in the nation, and so further resources added to the government sector produce very little or negative returns.

Geithner and Summers ought to stop trying to manipulate the short-term macroeconomy, and instead focus on economic reforms to remove obstacles to private sector growth over the long-term.

The Benefits of Going Naked…Swaps and Derivatives

Key House Democrats have just proposed a new plan for regulating our Nation’s derivatives’ markets.  While the heart of the plan mirrors the Obama Administration’s proposal to require standardized derivatives, such as credit default swaps (CDS), to be traded over a centralized exchange, the House proposal also goes further, raising the possibility of banning “naked” positions in the derivatives, equities and debt markets.

Taking a naked position, where one hedges or bets on a specific risk without actually holding the underlying asset or liability, has been widely blamed for bringing down our financial system.  This blame is misplaced.  For instance, credit default swaps betting that companies such as Fannie Mae, Bear Stearns or AIG would fail did not bring down those companies - bad management practices and excessive risk-taking did.  Of course when those companies were on the way down, their management wanted to blame everyone but themselves; short-sellers and speculators were just the messenger of a truth that management wanted to hide.

At heart, our markets, particularly our capital markets, serve as valuable aggregators of information, generally via the price mechanism.  Speculators, including those holding a naked position, help bring new and valuable information to the market place.  Recall it was the short-sellers who discovered Enron’s frauds, not the regulators or the rating agencies.   Banning naked positions will only serve to reduce the information content of market prices, and also further entrench incompetent management.

In addition to the aid in price discovery, speculators also provide much needed liquidity to other holders of the same instruments.   For instance if you purchase a GM bond and also a credit default swap on GM to hedge the credit risk in that bond, you would prefer to be able to see that CDS contract in as broad a market as possible.  If you were limited to selling that contract only to another holder of that same bond, you will likely have both a harder time selling that contract and will receive a lower price for it.  One of the hardest parts of resolving AIG has been finding buyers for its derivatives contracts.  A deeper market in derivatives would lessen the potential “fire sales” that can occur when a large financial firm fails. 

Of course how one treats derivatives in the case of an issuer failure can greatly impact the stability of the financial system.  By removing derivatives and CDS from the automatic stay provisions of the bankruptcy code in 2005, Congress guaranteed that when a large issuer of CDS got into any trouble, there would be a run on its collateral.  The solution is not to ban naked positions, but to reduce the potential for collateral runs by treating CDS counter-parties like any other creditor.

Who are Entrepreneurs?

The Kauffman Foundation has produced an interesting study about the background of entrepreneurs.  They create businesses for many reasons, including to make money and work for themselves, and play a major role in generating the economic growth that benefits the rest of us.  Too bad politicians, who create so little of value, so often stand in the way of productive entrepreneurs.

Mortgage Mods: Congressman Prefers Coercion over Cooperation

The recent focus in Washington on mortgage modifications once again illustrates one of the most fundamental flaws in current political debate:  the notion of using government to threaten or force the “voluntary” transfer of wealth from one group of citizens to another.

Just this week Rep. Barney Frank warned the banking industry if they don’t “voluntarily” do more to reduce foreclosures, Congress will step in and make them do so, by allowing bankruptcy judges to re-write mortgage contracts.  This proposal is really nothing more an ex poste transfer of wealth from investors in mortgage backed assets to borrowers.

Of course, Rep. Frank and others respond that they are only trying to “bring lenders to the table” in order to keep negotiations going.  In the words of many “consumer” advocates, this is just a “stick” to the motivate the lenders.  I could think of few things more offensive to a free society.  In a government truly constituted on the notion of the common good or general welfare, it would be no more appropriate to use the stick of the state on lenders than it would be on borrowers.  Government quite simply should not take sides in purely private disputes. 

One would think that if anyone could understand the principle that government should not interfere in the private, voluntarily entered relationships of consenting adults, it should be Mr. Frank.

Out of the TARP, But Still on the Dole

While banks such as Goldman and J.P. Morgan have managed to find a way to re-pay the capital injections made under the TARP bailout, their reliance on public subsidies is far from over. The federal government, via a debt guarantee program run by the FDIC, is still putting considerable taxpayer funds at risk on behalf of the banking industry.  The Wall Street Journal estimates that banks participating in the FDIC debt guarantee program will save about $24 billion in reduced borrowing costs of the next three years. The Journal estimates that Goldman alone will save over $2 billion on its borrowing costs due to the FDIC’s guarantees.

One of the conditions imposed by the Treasury department for allowing banks to leave the TARP was that such banks be able to issue debt not guaranteed by the government.  Apparently this requirement did not apply to all of a firm’s debt issues.  These banks should be expected to issue all their debt without a government guarantee and be required to pay back any currently outstanding government guaranteed debt.

To add insult to injury, not only are banks reaping huge subsidies from the FDIC debt guarantee program, but the program itself is likely illegal.  The FDIC’s authority to take special actions on behalf of a failing ”systemically” important bank is limited to a bank-by-bank review.  The FDIC’s actions over the last several months to declare the entire banking system as systemically important is at best a fanciful reading of the law. 

The FDIC should immediately terminate this illegal program and end the continuing string of subsidies going to Wall Street banks, many of which are reporting enormous profits.