Intellectual Property

• “Make the Patent ‘Polluters’ Pay: Using Pigovian Fees to Curb Patent Abuse,” by James Bessen and Brian J. Love. June 2013. SSRN #2277692.
• “Missing the Forest for the Trolls,” by Mark A. Lemley and A. Douglas Melamed. May 2013. SSRN #2269087.

James Bessen is one of the leading critics of nonpracticing entities (NPEs)—firms that purchase and hold patent rights but neither innovate themselves nor use the patents in the production of goods. At best, NPEs look to wring licensing fees from productive companies; at worst, they are opportunistic plaintiffs who seek to profit from unsuspecting innovators who unknowingly infringe on a patent. (See “The Private and Social Costs of Patent Trolls,” Winter 2011–2012.)

In their new working paper, Bessen and Brian Love propose a remedy for this problem based on two stylized facts about patent lawsuits:

• Two-thirds of lawsuits brought in the last five years of a patent’s life come from NPEs.
• Actual production companies usually finish enforcing their patents within nine years of issuance, long before the patent expires.

These facts lead Bessen and Love to recommend altering the timing of the current patent fee structure to discourage the mischief that occurs late in patent life. That is, lower the fees for patent renewal early in a patent’s life, and increase those fees near the end. Bessen and Love argue that large fees payable late in the term of a patent would affect only patent-holders acting opportunistically and not affect legitimate innovators who act early or, in the case of many high-tech companies, have no patents at all.

In contrast, Mark Lemley and A. Douglas Melamed argue that “patent trolls” (a pejorative term for NPEs) are a symptom of specific problems with the patent system rather than a direct cause. They agree with the characterization of trolls given by the critics. Normal production companies with patent portfolios rarely sue each other because a court loss would devastate their production. In contrast, patent trolls don’t produce anything and thus face fewer costs from losing in court. They would rather sue for infringement instead of licensing their patents. Troll suits do not represent a working market for ideas so much as a government-sanctioned game to control and tax independently developed technologies.

But Lemley and Melamed argue that the patent system itself is the problem, not patent trolls per se. And not all patents are the problem. The problems are found mostly in the information technology (IT) sector. There are too many patents in IT (for example, smart phones use technology covered by 250,000 patents) and they are overly broad because they cover the goal achieved (e.g., an app that matches passengers to transportation providers) rather than the particular technique used to achieve the goal (the app’s actual computer code). Trolls are opportunists that exploit and illuminate flaws in IT patents. The authors propose fee-shifting (imposing court costs on plaintiffs that lose) and reductions in the cost of defending oneself in litigation to reduce incentives for patent-trolling.

Commodity Price Speculation

• “The Simple Economics of Commodity Price Speculation,” by Christopher R. Knittel and Robert S. Pindyck. April 2013. NBER #18951.

Whenever oil prices increase dramatically, elected officials and the media always focus their attention on the role of speculators and “hoarding” through the use of futures contracts as the cause of the price increase, rather than fundamental changes in supply or demand. Christopher Knittel and Robert Pindyck’s paper carefully provides an analytic framework to distinguish oil price increases that result from changes in fundamentals from oil price changes that result from the actions of speculators.

The authors used their economic model to determine how much inventories would have increased in 2007–2008 in order to cause the price of oil to increase from $60 to $130 if there were no fundamental shifts in demand or supply. They concluded that inventories would have had to increase by 168 million barrels per month. But actual U.S. inventories fell by 28 million barrels in 2007. In addition, drilling rig utilization was constant and then increasing—facts that are not consistent with hoarding reserves underground in wells. And actual domestic production, which had been falling for decades, actually stopped decreasing from 2006 to 2008, and then increased in 2009, which is also not consistent with speculation through withholding of production.

The authors then used their model to estimate what oil prices would have been if there were no speculation in 2007–2008. Their estimates mimic actual prices and at the peak are actually slightly more than actual prices. That is, speculation reduced rather than increased prices at the peak.

Short Selling

• “Naked Short Selling: Is it Information-Based Trading?” by Harrison Liu, Sean T. McGuire, and Edward P. Swanson. June 2013. SSRN #2288187.

Short sellers borrow stock that they then sell. They act in the belief that the price of the stock will fall in the near future, before they have to purchase shares in order to return them to the lenders. Short sellers thus profit from the difference between the price they sell at now and the price they buy at in the future—assuming their belief about the stock’s price movement is correct.

Short sellers are controversial because they bet against companies rather than for them, and are often seen as insufficiently positive about the prospects of businesses. But economists typically see shorters’ role as essential in financial markets because they introduce often-needed skepticism about a stock’s price—that is, they counteract irrational exuberance. Regulation has discussed this function before; see “MOME in Hindsight” (Winter 2004–2005) and “Everything Old Is New Again” (Summer 2011).

One type of shorting is “naked” short selling, which means the seller sells a stock that he hasn’t yet borrowed. This is legal because the buyer agrees to wait to take possession of the stock—in essence the seller “borrows” the stock from the buyer. Again, the naked shorter profits if the stock’s price falls before the shorter purchases the shares. Naked shorting is even more controversial than regular shorting because it seems so improper to sell something that the seller doesn’t possess, but again, many academics argue that naked shorting helps to reduce irrational exuberance. Regulation has also discussed naked shorting before; see “The Economics of Naked Short Selling” and “The Phantom Shares Menace” (Spring 2008).

The financial crisis and the subsequent plunge in stock values intensified the cultural and regulatory attack on short sellers. The Securities and Exchange Commission implemented Rule 201 in May 2010, prohibiting the shorting of stocks that suffer an intraday price decline of at least 10 percent from the previous closing price.

In the “Everything Old Is New Again” article mentioned above, authors Pankaj Jain and Thomas McInish describe the rule’s effects. The article documents that before the existence of Rule 201, short selling declined for stocks that experienced a 10 percent intraday decline, apparently because prospective shorters decided that the stocks had “bottomed out.” That means that Rule 201 is a solution for a problem that doesn’t exist—there isn’t much shorting of the stocks that the rule protects. Short sellers were more active before price declines than after. In contrast, short selling increased for stocks that had experienced positive returns. That is, short sellers leaned against excessive increases in price rather than causing severe decreases. These results held true for all general market conditions, whether the market was up, down, or neutral.

In their working paper “Naked Short Selling: Is it Information-Based Trading?” authors Harrison Liu, Sean T. McGuire, and Edward Swanson examined stock trade data from 2005–2008 to determine what sorts of firms are the subject of naked shorting. The authors regressed naked short interest on the firms’ financial statement fundamentals and a set of control variables. They found that naked short sellers took smaller positions in firms with strong accounting fundamentals, but they took larger positions in companies with high levels of capital expenditures and sales growth, recognizing that those firms will have lower abnormal returns in the future just from regression to the mean.

Those findings indicate that both naked and covered short sales are based on financial statement accounting fundamentals and thus consistent with information-based trading. This result contradicts the belief of the SEC and others that naked shorting is not information-based and does not contribute to stock market informational efficiency.

Consumer Financial Protection

• “The Consumer Financial Protection Bureau: Savior or Menace?” by Todd J. Zywicki. August 2012. SSRN #2130942.

Why was the confirmation of Richard Cordray as the first director of the Consumer Financial Protection Bureau (CFPB) such a gargantuan struggle? Todd Zywicki of George Mason University Law School reviews the history of consumer credit regulation and places the CFPB in that history in this comprehensive working paper.

Consumer credit arose in the late 1800s to help urban workers with uncertain incomes smooth their consumption. One theory of the Great Depression is that too much consumer credit led to heavy debt that borrowers couldn’t repay, crippling creditors. In response, consumer credit regulation occurred with a vengeance. By the late 1960s, loan sharking had arisen to fill the gap in consumer credit—so much so that Paul Samuelson testified before the Massachusetts legislature to eliminate usury ceilings and reduce loan sharks.

In 1978 the U.S. Supreme Court ruled that interest rates on consumer credit would be regulated by the state in which the lending bank was based, not where the consumer lived. South Dakota had deregulated consumer interest rates to attract financial institutions. Accordingly, all banks moved their credit card operations there and consumer debt flourished at unregulated rates.

The 2008 financial crisis led to a repeat of the credit cycle observed after the Depression, with strong demands by many for paternalistic regulation. The CFPB is the result. It has a director and its own source of money, not dependent on appropriations from Congress. The director sets a budget subject to a cap of 12 percent of the Federal Reserve’s operating budget. The only check on the director’s decision is the possibility of veto by a two-thirds vote of the Financial Stability Oversight Council, which consists of other federal financial officials, including the secretary of the Treasury, chairman of the Federal Reserve, and the head of the Federal Deposit Insurance Corporation.

Zywicki argues that the CFPB is the most powerful and publicly unaccountable agency in history. The single-mission, single-director model will “protect” consumers and stifle innovation, overlooking the benefits of competition and lower prices for consumers. It operates under the belief that the complexity of consumer credit was invented by banks in order to mislead consumers. In fact, complexity allows different people with different risks to be served at different price points.

It is ironic that the CFPB is supposed to usher in an era of simple mortgages with disclosure when the current complicated one is the product of the previous attempt to simplify: the truth-in-lending era. CFPB advocates don’t seem to understand that much of the complexity and lack of transparency of lending stems from truth-in-lending regulation.

Elizabeth Warren and Oren Barr-Gill believe that the financial crisis is the result of complex, misunderstood, and faulty financial products analogous to an exploding toaster. The problem with this theory, as I have stated in a previous “Working Papers” column (Spring 2011), is that the main users of sophisticated products were sophisticated investors who then rationally decided to default when circumstances changed.

Bankruptcy

• “Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain,” by Mark J. Roe and Frederick Tung. February 2013. SSRN #2224035.

I have discussed Mark Roe’s work on the role of bankruptcy rules in the financial crisis in previous “Working Papers” columns (Summer 2010, Winter 2010–2011, and Fall 2012). He argues that the spectacular rise in the use of short-term repurchase (“repo”) agreements collateralized by securitized loans was the result of special advantages given to such agreements in bankruptcy reforms in 1978 and 2005. Those advantages put repurchase agreements ahead of all other liabilities in bankruptcy proceedings. Thus, “deposits” in the shadow banking system were bankruptcy-remote, which lowered risk for investors and lowered the cost of capital. The bankruptcy of an investment bank would not tie up investors’ cash because they would take possession of the collateral (rather than give it back to the bank to be part of the pool of assets divided among all investors through bankruptcy) and liquidate it outside of the bankruptcy process.

The downside of the bankruptcy provisions, however, is that if investors ever lost confidence in the collateral used to “guarantee” their deposits, they would flee the shadow banking system just like ordinary retail depositors fled the banks during the Depression. And that is exactly what happened in the last quarter of 2008.

In response, Roe has argued that all creditors should be treated identically in bankruptcy. He thus proposes eliminating the special bankruptcy provisions for repurchase agreements. This would increase market monitoring by the suppliers of deposits on investment and decrease the use of short-term funds to back longer-term investment.

In this new working paper, Roe and coauthor Frederick Tung generalize from the financial crises cases to conclude that the bankruptcy priority rule is not a fixed, immutable rule. It changes over time and is properly thought of as a rent-seeking game. Parties are always seeking to innovate and gain advantage through court rulings and congressional changes.

Short-term asset-repurchase agreements (“repo debt”) at the heart of the financial crisis were just bankruptcy arbitrage devices, in the authors’ view. Debtor-In-Possession (DIP) financing (the interim loans provided to a bankrupt firm for ongoing operations) is often provided by a lender that also provided lending to the bankrupt firm prior to bankruptcy. The DIP financing arrangements often involved repayment of earlier loans in the bankrupt company (“DIP roll-up”). This, of course allowed one creditor, the DIP finance provider, to jump the queue and partially nullify the purpose of bankruptcy: the equal treatment of all creditors. The development of the arm’s-length, bankruptcy-remote special purpose vehicles (SPVs) that owned the loans against which the short-term repurchase agreements were written was an arms-race backlash in response to DIP roll-up.

SPVs and repo started in the 1980s. Their transactions were declared by the participants to be sales and repurchases rather than secured loans, to avoid bankruptcy priority rules. The courts did not agree and so the financial community went to Congress for an exemption and received it.

The bottom line from this paper is that bankruptcy’s priority structure is never definitive. In a world where the Modigliani-Miller Theorem applies (the value of a firm is unaffected by how that firm is financed), less risk and return for one creditor means more risk and return for other creditors. Priority-jumping alters the distribution of resources but not the efficiency of capital markets. But in the real world, efficiency may be affected if creditors cannot adjust quickly enough. In addition, the historical role played by banks in monitoring the creditworthiness of borrowers is severely reduced if more and more borrowing takes place outside traditional banking through bankruptcy-remote institutions.