Game On: The First Presidential Debate

[Xantar]

Sorry Strangler, I'll have to disappoint you. My feeling on the debate is more or less the same as yours: most of us here have already made up our minds and it's just a question of who appeals most to "undecided" voters with this debate.

According to the polls, most of the "undecided" voters thought Obama won the debate and they ended up liking him more than McCain. I honestly don't understand why because I think if this had been judged point by point like in a college debate club, it would have been basically even (I agree with Obama's positions, but that doesn't mean I think he argued for them more effectively than McCain).

From all the various polls I've seen, it appears that undecided voters basically made their decision at an emotional level. In other words, Obama won because he smiled more while McCain refused to even look at him. It's an utterly stupid way to evaluate a political candidate, but that's the American electorate for you.

It's also worth noting that the CNN audience reaction gauge dipped for whichever candidate went on the attack at that particular moment regardless of which one it was. When McCain went on the attack, viewers thought less favorably of him while still maintaining a favorable view of Obama. When Obama went on the attack, he experienced a similar dip in favorability. So maybe they think Obama won just because he attacked less.

Not that any of it matters. Historically, debates have done nothing to affect presidential races except solidify support. They do nothing to sway swing voters more than one or two percent in either direction.

[Professor S]

Xantar, while we have you: What are your thoughts on the "bailout" plan. Myself, I'm torn about it, and the more a look into it, the more torn I become.

To keep it from happening again, my thoughts were to go back to separating the Mortgage industry from Investment/Securities and installing a government committee to oversee the Federal Reserve, and not a single Fed czar, so that we can better manage the cost of money and not have runs on bad debt.

Am I completely nuts on that? Thoughts?

[Xantar]

I haven't looked into the bailout plan. I understand it only just now got worked out, and I haven't had time to read up about it. The idea that some companies are "too big to fail" is an old classic from economics, and nobody has yet worked out a way to deal with the problem.

As a general idea, I hate the bailout. I understand it's sort of necessary, but it still stinks (it's kind of extraordinary that both liberals and conservatives hate it). My understanding is that the current deal will give $700 billion to Secretary Paulson in installments and it will require that we (i.e. the taxpayers) recoup as much of that investment back as possible. That's probably about the best we can hope for, and I've heard that when we nationalized a whole bunch of companies back in the Great Depression, we actually ended up with a net profit.

The problem: it took about a decade for the profit to show.

As to your idea about the Federal Reserve: I wouldn't mind having several Fed Chairmen instead of just one. However, I don't necessarily support making it into a government oversight committee. The Fed has some problems, but one of the good things about it is that it is that the Fed chairman is largely shielded from political whims. Putting a committee to oversee the Fed would destroy that independence, and neither you nor I want economic policies to be decided by people with a political agenda.

Besides, I don't think it was the Fed's fault. The problem is the Investment/Securities market came up with all these new financial products which people didn't fully understand. The Fed has no role in regulating that -- that's the SEC's job, and for whatever reason, they fell behind.

If I understand you correctly, you're proposing to separate mortgages from other investments and securities. That seems like a good idea to me, and I don't think you're crazy for believing that. I'm not sure if it's possible to really do that, though. All the same, it does seem like a good idea to make Freddie and Fannie either fully private or fully public companies. The fact that people could buy stock in them was just not good.

I think that at a fundamental level, we need to re-examine the issue of executive compensation in the financial system.

Hold on a second! Hear me out. I'm not saying we need to stop paying executives so much. I know some Goldman Sachs employees. They work very hard, and they deserve their high salaries. The problem as I see it is that a lot of them are rewarded for taking risks but they are not punished when those risks. Most of these investment bankers are paid with stock options which means the more they can increase the price of their stock, the more money they personally receive. There's nothing wrong with that except if they screw up, that just means they don't get as much extra bonus money. I think if someone in the financial industry screws up, they should lose money in proportion to the amount that they've cost their company. I don't know exactly how this would be done, but I think it would have prevented a lot of the problems we have now.

[Professor S]

I agree with pretty much everything you wrote. Onlya few corrections/ disagreements

Originally Posted by Xantar

As to your idea about the Federal Reserve: I wouldn't mind having several Fed Chairmen instead of just one. However, I don't necessarily support making it into a government oversight committee.

Neither do I. I meant that the government should appoint the committee of chairmen, like you said, and not a Fed "King on High". I certainly don't believe that politicians should be in control of the Fed. We'd all be broke.

Besides, I don't think it was the Fed's fault. The problem is the Investment/Securities market came up with all these new financial products which people didn't fully understand. The Fed has no role in regulating that -- that's the SEC's job, and for whatever reason, they fell behind.

I agree and disagree. The SEC should have regulted the products better, but I also feel that the Fed should have raised interest rates to stem the flow of loans based on the availability of cheap money. Money was cheap, mortgages were plentiful, and there was a run on those securities and everyone was too busy gobbling them up to check whether or not those mortgages were solid. A higher interest rate would have raised the risk of borrowing to buy.

If I understand you correctly, you're proposing to separate mortgages from other investments and securities. That seems like a good idea to me, and I don't think you're crazy for believing that. I'm not sure if it's possible to really do that, though. All the same, it does seem like a good idea to make Freddie and Fannie either fully private or fully public companies. The fact that people could buy stock in them was just not good.

They were separate for a long time. I believe the deregulation of the two happened in the 70's after the regulation was put in place after the Great Depression. In my opinion, those that originate the mortages should eb made to hold those mortgages. That way they will be MUCH more careful in who gets one. Also, I am not a fan of the CRA (Community Reinvestment Act) and I believe that had a hand in originating some bad mortgages.

I think that at a fundamental level, we need to re-examine the issue of executive compensation in the financial system.

Hold on a second! Hear me out. I'm not saying we need to stop paying executives so much. I know some Goldman Sachs employees. They work very hard, and they deserve their high salaries. The problem as I see it is that a lot of them are rewarded for taking risks but they are not punished when those risks. Most of these investment bankers are paid with stock options which means the more they can increase the price of their stock, the more money they personally receive. There's nothing wrong with that except if they screw up, that just means they don't get as much extra bonus money. I think if someone in the financial industry screws up, they should lose money in proportion to the amount that they've cost their company. I don't know exactly how this would be done, but I think it would have prevented a lot of the problems we have now.

The problem is that most of these CEO's compensations are derived exactly as you said: They come from the bottom-line, and thats how the books get cooked so that they can get their bonuses while the company slowly slides into bankruptcy so the CEO can keep their job and walk away with a ton of cash.

I have the solution, and I'd LOVE to get your feedback on it:

Force the financial industry, specifically securities, credit and banking, to form a national self-regulating association with ethics standards, like in Real Estate, Medical and Law. Right now financial ethics are determined by the institution and there is no reprocussion for their violation.

Hear me out, because the key to this is the transfer of legal action from governmental law, to civil law. The burden of proof when deciding whether or not someone broke the law is all or nothing, and exceedingly difficult when you are dealing with very intelligent businessmen with the means to get the best legal council available. By installing the code of ethics and a self-regulatory association, you open these men up to more civil actions with a burden of proof that goes beyond "a shadow of a doubt" and has degrees of guilt determined by a jury of your peers.

The determination of an ethics board as to the nature of the offense could then be used as evidence in a civil, or even state and federal, trial and would greatly increase the chances of a conviction or settlement. Over time, this would help to stem the tide of white collar shenanigans, because the plaintiffs would be represented top-notch private lawyers who want a piece of the pie and convictions/massive settlements would increase greatly.

[Xantar]

The problem is that most of these CEO's compensations are derived exactly as you said: They come from the bottom-line, and thats how the books get cooked so that they can get their bonuses while the company slowly slides into bankruptcy so the CEO can keep their job and walk away with a ton of cash.

Right, but the thing about financial malfeasance is it's always discovered, and investigators are pretty good about figuring out who's at fault in the end. My proposal (which does not necessarily conflict with yours, but we'll get to that) is that stock options issued to company employees should be able to have negative value. We'd also probably have to mandate that people hold their stock for a year after leaving the company. Anyway, I'm just throwing it out as an idea.

Force the financial industry, specifically securities, credit and banking, to form a national self-regulating association with ethics standards, like in Real Estate, Medical and Law. Right now financial ethics are determined by the institution and there is no reprocussion for their violation.

I think it's important to think through all the implications of what you're saying here, so I'm going to lay them out as I understand them. You tell me if you disagree with any of it.

What you are proposing is that financial professionals be licensed by some voluntary, non-profit group just like like the medical board for doctors or the bar association for lawyers or the board of accountants for CPAs. People working in those professions are required to possess and maintain a license to practice for two reasons:

1. Their work is so complicated that only people who have been competently trained can do it, and

2. Their job is considered an essential service to the public.

Point #2 is especially important because that's why the profession has mandatory regulation for itself. A computer programmer can be certified to a certain level, but it's not actually illegal for him to work without certification. The idea is that if he screws up, his work can be fixed easily and in any case, the computer programming profession isn't about saving the world (most of the time). But a doctor or a lawyer or many other kinds of professionals have such great responsibility on their hands that they must be restrained by a code of ethics to prevent them from doing great harm to the public interest.

I certainly agree that financial professionals wield a great deal of power and should probably have some voluntary industry standards at the very least. But as I see it, for ethical standards to be set and enforced, there has to be licensure by a professional association, and for such an association to exist, there must be some mandate that this profession exists to serve the public which is why there are those ethical standards.

I'm not saying I think that's a bad idea. I just think it's kind of an interesting way to look at investors. They usually think of themselves as serving their own interests and it just so happens that the byproduct of their collective action benefits the public.

Now maybe you didn't mean for this association to set ethical standards so much as professional standards. In other words, the Association of Financial Professionals wouldn't set rules like "You must withdraw in cases of conflict of interest" and would set rules more like, "You must adequately investigate your investments" or "You shall not mix mortgages with other types of investments." This makes financial professionals into something more like a computer programmer who is supposed to adhere to published guidelines but can't be banned from working if he fails to do so. The problem with that is, as I said before, if there's no ethics mandate, then you can't justifiably ban someone from the profession.

Anyway, however we decide to structure it, the main concern I have about your proposal is the part about using the courts. I think courts have a role to play, but I would be much more careful for a few reasons. Firstly, a court case is long, costly, and almost never leaves anyone satisfied with the result. I worked for the Superior Court of Delaware for two years, so believe me when I say that's the reality.

The second problem is that a case of financial wrongdoing could be pretty complicated — way too complicated for a jury to understand. I saw eight medical malpractice cases brought to trial in my time, and I honestly don't believe a single one of them was decided justly. Some of them had results I agreed with, but it was clear to me that the jury was basing their decision on the likability of the doctor rather than the facts. I have no faith in a jury's ability to do any better when deciding a "financial malpractice" case. Yes, you could just have the case decided by a judge or an arbitrator, but the Constitution says that if a defendant wants a case brought to trial before a jury of 12 people, we have to let him do it.

The compromise in Delaware was that cases worth less than $100,000 are required to go through an arbitration hearing first before they can be allowed to go to jury trial. That sort of has its own problems, though. Arbitrators are lawyers themselves, and they all feel a certain solidarity with fellow lawyers. It's just human nature. The result is any case that makes it to arbitration is almost always awarded at least a little money. Likewise, my instinct is that if a case is brought up before a panel of investment bankers, stock traders and other such financial professionals, they will not be able to avoid being influenced by their common backgrounds. One way or another, the interest of the public will not be totally served.

A set of ethical rules set by a professional association seems like a good idea to me, but I think we have to also somehow change the balance of incentives. If we don't do that by altering stock options, then maybe we should mandate that certain clauses be written into executive employment contracts. Or maybe we should require that 25% of a company's voting stock should be owned by the public (boy, good luck getting that one passed). Or maybe something else. I think you and I agree that market-based incentives are the most efficient ways to alter human behavior, and I think there must be some way of changing the incentives around in the financial markets.

[Professor S]

You might be thinking too much about this and not seeing the forest, just the treees. A jury doesn't have to understand the nature of a case. If an ethical board finds against the actions of a professional, that can be used as evidence in the case and replace the need for true understanding. A jury will see that and it will become evidence for the case, simplifying the process greatly.

In the end, it is the threat of action and increase in potential menetary accountability that will pull everyone in line at the top, plus the threat of losing your license to practice will hold everyone in the middle.

Working in real estate, I've seen this up close and personal, it works for licensed Realtors (not Mortgage professionals, obviously). I would use the National Association of Realtors Code of Ethics as the framework for a financial code of ethics.

http://www.realtor.org/MemPolWeb.nsf/pages/COde

You could roll this into MBA programs, for instance, that way it reached those in positions who would require the license but not inhibit the multitide of lower level employees who are not in decision making positions.

In the end, could this have a negative impact on the industry? Maybe for a short while, but would be as negative as not addressing the myria ethical problems with finances? Well, I think the answer to that is in front of us now.

[Xantar]

Originally Posted by Professor S

You might be thinking too much about this and not seeing the forest, just the treees. A jury doesn't have to understand the nature of a case. If an ethical board finds against the actions of a professional, that can be used as evidence in the case and replace the need for true understanding. A jury will see that and it will become evidence for the case, simplifying the process greatly.

But see, I'm not convinced that a jury decides these cases based on the evidence. From what I've seen, it's more of a gut reaction. If the defendant "looks like a nice man," they will give him a little more benefit of the doubt despite what the objective evidence says.

Don't get me wrong. I'm not saying the ethics board is a bad idea. And I certainly agree that it could be a useful piece of evidence. I'm just cautioning you that I don't think it will be a cure to the financial system if the only thing the board can do is provide a piece of evidence at trial. Juries are simply not reliable, consistent enforcers of the rules. As you know, that's part of the reason why medical malpractice in this country is such a mess. This is why I'm trying to think of ways for the ethics board to influence the profession besides just giving a report at trial.

[Professor S]

You make a good point with malpractice in medical law, but I think that could be avoided by having the civil penalties for financial judgements relegated to dollar for dollar. Meaning that the cap of the judgement could not go past the amount of money the accused misappropriated. If you eliminate financial "pain and suffering" from the equation and "statement verdics", I think it becomes more manageable.

Wow.. we're realy kind of working this out, aren't we? I'm impressed and it takes a lot for me to impress myself.

[Xantar]

Well, I do have some technical quibbles, but let's not get bogged down while we have a good thing going. I think we've agreed on some broad principals. Let's say for the sake of discussion that we have some kind of ethics board and that we've defined exactly how to decide monetary awards. I think it would be a good idea to eliminate "pain and suffering" from jury verdicts and simply render it down to a punitive 1.5 multiplier. In other words, if my stock broker does something unethical and it costs me $20,000, the jury would be allowed to award me no more than $30,000 ($20k plus $10k as a punitive award).

I want to raise an entirely separate issue now. I think at its core, we still have a bit of a moral hazard problem. In the above example, my stock broker will get stung pretty badly and he will have a strong incentive not to do it again. But what do you do about the guy is responsible for managing $8 billion worth of assets and who screws up? He knows at this point that there's no way anybody is going to get their money back. To him, $1 billion worth of damage is the same as $5 billion.

When I think of it this way, I confess that my earlier proposal with stocks getting a negative value isn't going to help at all either because the punishment only kicks in after the malfeasance is discovered by which time the problem may have blown up beyond anybody's ability to compensate. People in the financial industry by definition are not putting their own money at risk with their work. I don't have a moral problem with that, but it does mean that the system is vulnerable to people who let greed get the better of them. After all, the fact of the financial system is everybody gets caught sooner or later, and if everyone were acting in their rational self-interest, absurd risks like the sub-prime mortgage meltdown wouldn't happen. But the fact is some people do let greed get the better of their good sense, and so we need to figure out a way to safeguard the public from the consequences of those actions. An ethics board is a good start, but I'm not sure it's enough.

Great. Now I've just gone and convinced myself that the problem is a fundamental flaw of human nature that we will never fix and that nothing the government or private associations come up with will fix it. Help me out here, Strangler.