Author: Daniel Indiviglio

Troubled U.S. automaker giant General Motors paid back the remainder of the debt it owed the government. In an announcement today, the U.S. Treasury said that it repaid the final $4.7 billion it owed out of the original $6.7 billion the government had lent the company. GM was expected to pay back its debt early, but not this soon. Does that mean taxpayers are off the hook? Hardly.

The Treasury still retains a great deal of GM’s equity. It owns $2.1 billion in preferred shares and 60.8% of common stock. So taxpayers still own GM, they just aren’t owed any debt from the firm. Until the Treasury gets rid of its stake in the company, the bailout could still result in a loss if it fails to recover. If you include equity, the GM received about $50 billion. Taxpayers have a ways to go before they can stop worrying about the automaker.

And there’s still reason for skepticism regarding GM’s ability to survive. The company lost $4.3 billion in the second half of 2009. It forecasts a profit for 2010, but it certainly isn’t minting money yet.

The company also paid back its debt to the Canadian government. Where did GM get the billions to pay all this back? It has been doing better lately and likely utilized a great deal of its revenue to make these payments. This was a priority for the company, as it would have trouble convincing private investors to buy into a new public equity offering with debt to governments still outstanding.

One big fear is that GM rushed this repayment. If the company runs into trouble again, having a few billion dollars in free cash lying around would certainly be helpful. Lower interest payments going forward are a plus, however. The repayment should make for lower net income in the short run, but higher profits in the long run. That is, if the automaker can manage to control its costs and recapture the consumer demand that it has lost over the past few years to bring back sales.

(NAV Image Credit: Mike Licht, NotionsCapital.com/flickr)

Today, Wells Fargo reported a $2.4 billion profit in the first-quarter. That sounds pretty good — the bank’s earnings also beat analyst estimates by 3 cents-per-share, or 7%. Yet, in the context of other banks far exceeding what the market anticipated, 7% isn’t much. Why didn’t Wells surprise analysts?

Part of Wells’ merely adequate performance was its high consumer credit-related charge-offs. The bank set aside $5.3 billion to deal with those losses. But Citigroup’s first quarter losses from bad loans were a whopping $8.4 billion — and the bank still out earned Wells by nearly $2 billion. So credit losses are likely only a small part of the story.

A bigger reason is likely that Wells isn’t much of an investment bank. Other big banks like Goldman Sachs, Morgan Stanely, Citigroup, JPMorgan and Bank of America all have strong investment banking divisions. Much of their success was due to trading profits. All of those listed had at least $4 billion of revenue from this source, but Wells had a paltry $537 million.

The follow chart demonstrates this point:

As you can see, all of these big banks except for Wells had very strong trading profits and soundly beat expectations — by at least 17%. Analysts likely underestimated how much revenue would be generated by trading in the first quarter. For Wells, that wasn’t a very significant factor, so the market’s expectation was pretty close.

Would you have sympathy for a professional auto mechanic who bought a lemon after given the opportunity to examine the car beforehand? Few people probably would, since if anyone should have known better, he should have. Yet, in its case (.pdf – brief synopsis here) against Goldman Sachs, the Securities and Exchange Commission needs the court to develop a very similar sort of sympathy for German IKB bank and other large sophisticated investors who purchased a synthetic collateralized debt obligation (CDO) from Goldman. Even under the circumstances of the case, it’s extremely difficult not to feel that IKB should have known better.

Sophisticated Investor

Not just anyone invests in synthetic CDOs and other asset-backed securities. Buyers are limited to big, sophisticated investors. After all, IKB purchased $150 million worth of the bonds in the deal — only a serious investor has that kind of cash to spend. This wasn’t a case where Goldman cold-called a guy who works at a tire factory to trick him into buying a wacky security. IKB should have had the resources and motivation to understand what it was buying.

The Collateral Wasn’t Misleading

IKB’s sophistication wouldn’t matter if Goldman lied to the German bank about what was in the portfolio that the bonds were based on. The SEC doesn’t allege that. Instead, the complaint says that Goldman didn’t disclose that a hedge fund manager, John Paulson, played a role in creating the pool of securities. While that may or may not be found to be material, it’s hard to imagine how it would have made a difference to IKB. The collateral would have been the same either way, and IKB had the opportunity to perform its own analysis on the pool’s potential performance. There’s no input in a cash flow model for evaluating a CDO that takes into account the parties influencing the collateral pool’s creation.

In a press release, Cornell law associate professor (and former associate at a firm that represented Goldman) Charles K. Whitehead makes this point:

If, instead of creating a synthetic Collateralized Debt Obligation, Paulson decided to sell the identical assets to Goldman Sachs, and Goldman Sachs had then sold the portfolio to the ABACUS investors, would Goldman Sachs have been obligated to disclose that Paulson was the seller? No – in fact, doing so would have been a breach of confidentiality. But that is, in substance, what occurred here.

This sharpens the point: investors should decide whether to buy an asset-backed bond based on how the pool will perform, not based on who put it together.

By Definition, IKB Knew a Short Existed

Finally, most news articles about the SEC case imply that if investors realized a big hedge fund had shorted the portfolio, then they would have thought twice about going long. In the case of a synthetic CDO, that’s a nonsensical claim, because you can’t create a synthetic CDO without also creating a short interest. The security we’re talking about is derivative-like, because it references other securities. So in order to have long invertors profit if the portfolio does well, a short investor must pay up accordingly. The reverse works the same way — so when investors like IKB lost money, Paulson profited. You need the two sides of the equation to balance.

As a result, IKB should have known a short interest existed. If it didn’t, then it didn’t understand a very basic fact about a synthetic CDO and really had no business investing in one. Again, it’s hard to conjure up much sympathy if that’s the case. This fact makes it even harder to believe that who held the short interest matters. Would be mean more if Paulson bought it instead of any of the other dozens of major hedge funds? It’s hard to imagine how.

Ultimately, if Goldman is found to have misled investors, then it doesn’t much matter if those investors should still have known better than to buy the security. But a sympathetic plaintiff is generally an important pre-requisite for a successful lawsuit. IKB is the SEC’s de facto plaintiff here, since it’s the party that lost based on Goldman’s actions.

(The collateral agent, ACA, was also supposedly misled. But there’s a dispute of fact here, so finding the truth regarding what really happened matters more there than what information was material.)

Last Friday, when business journalists everywhere were drooling over the SEC’s announcement of its lawsuit against Goldman Sachs, Senate Agriculture Committee Chair Blanche Lincoln (D-AR) released her aggressive bill (.pdf) to regulate the derivatives market. Leaks advertised the bill as the most serious crackdown to-date on Wall Street’s profit-center for making and trading complex securities. Its actual text includes some very controversial provisions, but the bill isn’t quite as aggressive as some early reports indicated. For example, Lincoln provides regulator flexibility in determining how aggressively to implement some of her changes.

After the Senate Banking Committee passed its financial reform bill, Chairman Dodd (D-CT) indicated that its derivatives section was just a placeholder for a new version some of its members intended to produce. Since those Senators have yet to deliver an amended version of that section, there’s talk that Lincoln’s bill could take its place. Here are some of its more important highlights (.pdf):

Real Time Reporting

One of the most significant changes would require almost all derivatives trades to be reported real-time. Currently, many over-the-counter transactions are not reported to the SEC.

Mandatory Clearing

Lincoln wants virtually all derivative trades to go through a clearinghouse. Right now, some trades are cleared, but many are not. A clearinghouse acts as a third-party that nets trades and minimizes counterparty risk. The trades will also have to go through regulated exchanges.

No Bailouts for Derivatives

In an effort to prevent future bailouts, Lincoln wants to make sure derivatives deals that go bad don’t fall on the shoulders of taxpayers. As a result, she seeks to prohibit federal funds being used to pay off obligations of failed firms arising from derivatives exposures.

Segregates Derivatives

The new bill also seeks to separate a firm’s derivatives activity from its other business. The intention here is to create derivatives dealers who can more easily fail and won’t bring down large institutions with them if their trades go bad.

Enforcement Authority

The legislation would also provide regulators with enhanced enforcement authority to prosecute investors who use derivatives to hide information from the market. It also includes increased bounties paid to whistleblowers.

While these ideas might sound good at first blush, some are very controversial and would radically change the derivatives market Wall Street knows today. More analysis on that tomorrow.

At the heart of the SEC’s lawsuit against Goldman Sachs is the creation of a synthetic collateralized debt obligation (CDO). This type of security is one of the most complex out there. A hybrid of a derivative and asset-backed security, its consists of bonds that are paid cash flows based on the performance of other bonds, loans or securities that they reference, but are not directly backed by. For anyone who hasn’t worked in the securities industry, that’s probably confusing. Some who work in finance even find them strange. They don’t serve any funding purpose, but act more to allow investors to bet for or against some asset or market. Without any clear social purpose, should they be banned?

First, it’s important to understand what drove banks to create these complex securities in the first place. The Goldman fiasco is a perfect example. In that case, a hedge fund manager named John Paulson wanted to short — bet against — the subprime mortgage market in early 2007. Yet it isn’t that easy to short the mortgage market. Mortgage-backed securities aren’t like stocks, where there’s a large supply of put options that allow buying a short interest in a company. So he asked Goldman Sachs to arrange a synthetic CDO. Other investors who wanted to bet on the subprime mortgage market would purchase the long interest and Paulson would buy the short. So the synthetic CDO created an opportunity for some investors to bet on the subprime mortgage market and others to bet against it — without anyone actually investing in a single mortgage.

In his New York Times column today, Andrew Ross Sorkin renews the call to ban seemingly socially useless derivatives like synthetic CDOs. He says:

Why was Goldman, or any regulated bank, allowed to create and sell a product like the synthetic collateralized debt obligation at the center of this case? What purpose does a synthetic C.D.O., which contains no actual mortgage bonds, serve for the capital markets, and for society?

The blaring Goldman Sachs headlines of the last few days have given the public a crash course in synthetic C.D.O.’s. Many more people now know that synthetic C.D.O.’s are a simple wager.

And he quotes a former securities lawyer:

“With a synthetic C.D.O., it’s a pure bet,” said Erik F. Gerding, a former securities lawyer at Cleary Gottlieb Steen & Hamilton who is now a law professor at the University of New Mexico. “It is hard to see what the social value is — it’s hard to see why you’d want to encourage these bets.”

Does the Government Ban Socially Useless Things?

But it’s also hard to see why it matters how socially useful a financial product is. Since when does something have to make the world a better place for people to legally buy or sell it? It isn’t hard to think of a vast number of products out there that have no social value. Remember the Koosh ball? That hardly earned its inventor the Nobel Peace Prize. Some may like the way breast implants look, but surely such purely elective cosmetic surgery serves no tangible benefit to society at large. Even fast sports cars like Ferraris are completely unnecessary to society. Indeed, on almost all roads in the U.S. the speed limit will preclude a Ferrari’s owner from enjoying the vehicle’s full potential.

The government response to a socially useless product isn’t generally to ban it. It’s to make sure it doesn’t result in social harm. Speed limits serve this purpose for the Ferrari, for example. The same could be done with securities that are seen as being speculative and risky. If there’s a significant potential for loss, then require investors to put up significant portion of cash to cover the downside.

Useful After All?

In the case of synthetic CDOs there may even be some socially useful purpose of keeping them around after all.

A Smaller Real Estate Bubble

Some have suggested that the existence of the synthetic CDO market prevented investors from overheating the mortgage market even more. My colleague Megan McArdle brought up this argument earlier while discussing this topic. By investors purchasing the synthetic CDOs instead of MBS, that took funding away from the real estate market, which would have inflated the bubble even further.

Economic Efficiency

And on the other side of the coin, the short interests in synthetic CDOs also helped prevent the bubble from continuing to grow even larger. As the short positions built up, the mortgage market corrected itself more quickly, since investors began to realize their error sooner than they might have otherwise, had shorting been impossible.

So synthetic CDOs may have some positive social benefit after all. But even if they don’t, there doesn’t appear to be a precedent for the government to ban them just because they don’t make the world a better place. Instead, precautions could be taking to ensure they don’t get banks and investors in too much trouble.

When the Group of 20 nations (G-20) meets in Washington this week, it will consider an International Monetary Fund (IMF) proposal to tax financial companies to recoup bailout costs resulting from the crisis. Bloomberg reports that the IMF’s recommendation is for non-deposit liabilities or profits and compensation to be taxed — not financial transactions. How will the nations react?

It’s fairly likely that some will embrace the proposal. Great Britain and France have already adopted such measures. Canada, however, rejected a global bank tax. In the U.S., the fate of such a tax is unclear. President Obama supports a punitive bank tax, but Congress hasn’t been as willing to go along.

In the U.S. it could also depend on the details. Such a tax would likely be less controversial if it took the form of a tax on non-deposit liabilities instead of profits and compensation. That way, it would target risk instead of success. Washington arguing that big banks should pay for the bailout is something of a hard sell, since they have all paid back their bailout money. Any cost related to the bailout will likely result from AIG, the auto companies, smaller banks and the Treasury’s mortgage modification program.

A bank tax should also be considered in the context of financial reform. The Dodd proposal essentially calls for a preemptive bank tax, administered as an assessment to pay for a fund which would be used to resolve large institutions that fail. The proposal, however, is also very controversial and remains one of the major sticking points in the financial reform battle.

The IMF’s suggestion will make for an interesting aspect of the G-20’s meeting to keep an eye on. The nations will likely be divided, given what we know from their previous actions explained above. But the G-20 could still issue some fuzzy language supporting the idea of a bank tax. That’s what it did back in September when it endorsed financial compensation guidelines, but failed to put in place specific rules or an enforcement mechanism.

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Lehman Brothers bankruptcy examiner Anton Valukas blames the Securities and Exchange Commission for not cracking down on the risky behavior that led to the investment bank’s demise in a hearing today on Capital Hill. His investigation will conclude that the regulatory framework was insufficient to keep Lehman’s appetite for risk in check. As its leverage grew, the SEC sat by without forcing the firm the rein in its borrowing. Lehman’s failure followed.

Valukas’s findings can be summed up by the following short paragraph contained within his testimony (.pdf):

So the agencies were concerned. They gathered information. They monitored. But no agency regulated.

The SEC was Lehman’s chief regulator through its Consolidated Supervised Entity (CSE) Program. In her testimony (.pdf), current Chairperson Mary Schapiro admits the program failed:

Under the CSE program, the SEC undertook for the first time the consolidated oversight of the five largest U.S. investment banks, whose operations were global in scope and extended well beyond the types of products and business lines typically found in a registered broker-dealer. Participation by the CSE firms in this regime was voluntary, and the consolidated oversight of these holding companies was more prudential in nature than the SEC’s traditional rule-based approach for broker-dealer regulation. In brief, this program reflected a profoundly different approach to oversight and supervision for the Commission. Properly executing the program called for a correspondingly significant expansion in human, financial, managerial, technological and other resources devoted to the oversight and examination of CSE holding companies and their subsidiaries.

The SEC believed at the time that it was stepping in to address an existing gap in the oversight of these entities. Once, the agency took on that responsibility, however, it had to follow through effectively. Notwithstanding the hard work of its staff, in hindsight it is clear that the program lacked sufficient resources and staffing, was undermanaged, and at least in certain respects lacked a clear vision as to its scope and mandate.

The program was discontinued in 2008. One of the major problems with the program was that the SEC did not actually audit financial firms. Instead, it relied on third-party auditor reports. This is part of the reason why the SEC did not pick up on Lehman’s now famous Repo 105 transactions, which hid some of the firm’s leverage from regulators. Also from Schapiro’s testimony:

As discussed in the Examiner’s Report, regulators (including Commission staff), rating agencies and the Lehman Board, were unaware of Lehman’s use of Repo 105 transactions. For purposes of the CSE program, the Commission did not perform an audit of Lehman’s balance sheet. Instead, the Commission depended on the integrity of the balance sheet information provided by Lehman’s management which was audited or, in the case of quarterly reports, reviewed, by Lehman’s auditors. Lehman did not disclose in its audited financials that it was undertaking repos as sales – on the contrary, Lehman’s disclosure would lead one to believe that it accounted for all of its repos as financings and that the repos were properly reported as such on the balance sheet.

So the problem wasn’t only that the SEC failed to act — the problem was also that the SEC didn’t understand precisely what was going on in Lehman. Yet, Valukas somewhat disputes that. He found that the SEC certainly knew enough to act (his emphasis below):

The SEC knew that Lehman was reporting sums in its reported liquidity pool that the SEC did not believe were in fact liquid; the SEC knew that Lehman was exceeding its risk control limits; and the SEC should have known that Lehman was manipulating its balance sheet to make its leverage appear better than it was. Yet even in the face of actual knowledge of critical shortcomings, and after Bear Stearns’ near collapse in March 2008 following a liquidity crisis, the SEC did not take decisive action.

This represents failures in both supervision and enforcement on the part of the SEC. Presumably, Congress’ new systemic risk regulator to be created from financial reform would hope to do a better job. The Lehman bankruptcy examiner appears to provide evidence that a regulator must have enforcement authority and the will to act. Schapiro’s testimony could be interpreted to assert that audit authority is necessary as well.

A record-setting Fifth Avenue rent this week adds to the narrative that both New York City and luxury are back. Japanese clothier Uniqlo has reportedly signed the fattest retail lease contract Manhattan’s priciest street has ever seen. The company will pay $300 million over 15 years. Is the recession over for Fifth Avenue?

Bloomberg reports:

“It’s just another reinforcement that retailers have to have a Fifth Avenue presence,” said Faith Hope Consolo, chairman of retail leasing, marketing and sales for Manhattan- based Prudential Douglas Elliman Real Estate. “Fifth is going to be their face to the world.”

The deal will be the highest aggregate amount paid to lease retail space in New York City, beating Gucci Group NV’s $16.5 million in annual rent for about 45,000 square feet at Trump Tower three blocks north, Mendelson said.

The Uniqlo contract weighs in at $20 million per year — significantly more than Gucci’s rent. The Japanese retailer has a significant global presence, though is little known in the U.S. To be sure, this Fifth Avenue store hopes to change that.

So why is Uniqlo paying such a high price for a presence in the U.S. just as the nation begins to come out of a deep recession? Because it must believe the recovery is well underway for both Manhattan and luxury. That looks like a smart bet.

Much of New York City’s recent success has to do with the Wall Street bailout, which left its economy in better shape than it would have otherwise been. New York City’s labor market has been improving significantly in 2010. From February through March, the city saw its number of unemployed decline by over 15,000 residents. That might not sound like much, but it’s more than any other major city listed in the Bureau of Labor Statistics’ state report. The city also saw its unemployment rate decline from 10.4% in January to 10.0% in March. That puts its rate lower than that in Chicago, Los Angeles, Detroit, DC, and Miami.

Its residential real estate market has also largely recovered. The Uniqlo contract signals that commercial real estate might be making a comeback as well. Retailers may again be willing to pay up for Manhattan store fronts.

For luxury, the downturn also could be over. Bubble-driven recessions often end with the wealthy recovering first. That’s what we’re seeing here. The millionaire’s club increased its ranks last year. Asset prices, especially the stock market, are improving. That benefits the rich more than the low- and middle-classes. So it should really come as no surprise that luxury retailers are eager to capitalize on the wealthy’s rebound. And where better than the on the U.S.’s best known street for luxury in what may be the nation’s fastest recovering city?

Imagine if, during the climax of the health care reform battle, the much loved-comedic actress Reese Witherspoon was learned to have lost her fortune. And that wasn’t all: she had contracted a rare, aggressive — but curable — illness. She then died, because she didn’t have health insurance. Reform advocates would have seized the moment to declare Witherspoon’s death a travesty of justice. Her death would serve as the perfect example of a good, hardworking American with a family that died due to the U.S. health care system. Public opinion of reform would likely have even ticked up a few points, benefitting from real reminder of the dangers of not passing health care legislation.

SEC v Goldman is financial reform’s Reese Witherspoon.

And that’s suspicious. In the example above, you can almost imagine conspiracy theorists wondering if health care supporters had staged Witherspoon’s death to garner support for reform. So naturally, Republicans have begun suggesting that the White House has something to do with the SEC’s newfound passion for prosecuting the most prominent investment bank. After all, the SEC chairperson does answer to the President. Of course, the White House denied it had any advance knowledge of the complaint.

It’s hard to imagine better timing. The financial reform debate is finally hitting Main Street after brewing in the halls of Congress and the Treasury for months. Democrats and progressive groups are trying to get average Americans riled up about regulating Wall Street. The Senate could begin formal debate on the floor as soon as this week.

And it won’t be an easy battle. While there appears to be some consensus in Congress that reform is necessary, the details are highly controversial. And last week, top Republicans made clear that they were ready for a fight. Then, the SEC accused Goldman of fraud related to selling unsuspecting investors complex securities destined to fail. The case looks pretty strong — if the SEC’s facts are proven accurate.

So perhaps the SEC’s case is entirely legitimate and just happened to bring it now, but the timing is a little hard to believe. The following revealing, and somewhat troubling, paragraph from an article in the Wall Street Journal raises some questions:

Firms typically get a chance to settle such suits, but not in this case, Goldman said. The Wall Street giant said it was alerted to the probe in the summer of 2008 and was warned that it might face a suit in July 2009. It says it then responded in detail to the Securities Exchange Commission’s inquiry in September, but heard nothing back from the government until Friday’s unveiling of the civil suit. The SEC usually notifies firms ahead of a lawsuit as a courtesy to give them a chance for a last-ditch settlement or to prepare for the public fallout.

Why No Opportunity to Settle?

If the SEC often settles such cases with banks and investment firms, why wasn’t Goldman provided the same opportunity? This implies that the SEC had some motivation for treating Goldman differently here than it would most defendants.

Why Now?

The probe started back in 2008. The SEC has had all the information it needed from Goldman since September. Why, seven months later, is Goldman finally being sued? That seems like a long time to formally charge a company after it has responded to an inquiry.

Why Goldman?

Indeed, there’s little doubt that the SEC has been investigating dozens of cases like the one involving Goldman. There are a lot of angry investors out there who claim they were taken advantage of by crafty bankers peddling tricky securities like those involved in this suit. Why not pursue one against Merrill Lynch or Deutsche Bank?

Why a synthetic CDO?

There were a slew of toxic securities released into the market during the housing boom. Subprime mortgage-backed securities are possibly the most famous. Collateralized debt obligations were the bonds of bonds that often depended on those MBS and consequently suffered. But synthetic CDOs are perhaps the kings of complexity. They’re securities created by structuring bonds to pay based on the cash flows of other bonds, loans or securities. That makes them part derivative, part MBS, and all Byzantine.

So it just all seems a little too perfect. Perhaps financial reformers really are just that lucky, and there’s no conspiracy here involving the SEC intentionally releasing its dream case as the financial reform debate was at its boiling point. Or maybe we will learn the real story in the days that follow.

The government’s attempt to boost home purchases through a broadened tax credit hasn’t worked, according to Fannie Mae. In a new report (.pdf), the government-sponsored enterprise says that the housing rebound has been choppy and revised its projection of home sales growth for 2010 downward to 6% from the 9% forecast just last month. Fannie worries that home sales inventory is shrinking too slowly for a strong recovery to take hold.

Here’s a graph the company provides to demonstrate the government credit’s lackluster performance:

The report explains:

Despite the looming deadline of the second tax credit, which requires a signed contract by April 30 and settlement by June 30, builders saw no rush in new home buying. Both components gauging current sales conditions and traffic of prospective buyers fell. The component gauging sales expectations in the next six months also declined, which was to be expected given that the tax credit is scheduled to expire soon. Builders cited the lack of available credit for new projects, tough competition from the continual flow of distressed properties for sale, in some cases below production cost, and concerns over job security as factors weighing on confidence.

Fannie’s 2010 home sales growth revision from 6% to 9% is also quite significant. It essentially cuts the number of additional sales expected compared to 2009 by 50%. That’s a major change. From the narrative above, it sounds like economists underestimated foreclosures and credit difficulties that would persist in 2010, while overestimating the power of the credit.

So that big bump in home sales expected for March and April may not come to be. The home credit is having a weaker impact than anticipated. Fannie says even though homebuilding has been weak since the housing bubble burst, it needs to be even slower to allow the housing inventory to begin to decline to normal levels again. If foreclosures continue to break records as they did in March, then that also won’t help matters.

The report makes pretty clear that the housing recovery will be a slow one.

Would you prefer more choice regarding air travel costs or that Washington dictate what fees are fair? Senator Charles Schumer (D-NY) opts for the latter. He called on airlines to promise not to charge fees for carry-on luggage. American, Delta Air Lines, United Airlines, US Airways and JetBlue did so this week. This move is in response to Spirit announcing that it would begin charging fliers for luggage they store in the overhead compartment earlier this month. While many consumers likely have an adverse gut reaction to such apparent nickel-and-diming, is Schumer really looking to help travelers here or score some political points?

In fact, travelers may be better off through Spirit’s approach. Carry-on fees should result in more discretion on consumer spending for flights, lower fares, and a smoother airport experience. Yet Schumer proposes a tax to punish airlines that charge fliers who bring their luggage into the cabin. It’s hard to understand why this distinction matters.

Currently, many airlines charge fliers to check their baggage, but allow them to carry-on luggage at no additional charge. This results in customers trying to squeeze as much as possible in their suitcases intended for the overhead compartment. Longer security lines, lengthier boarding times, and delays follow. Yet similar treatment for both types of baggage would eliminate the carry-on incentive. So shouldn’t Schumer and others in Washington be indifferent to how luggage is transported? Customers would certainly be better off in such a world.

Instead of just eliminating consumer choice, lawmakers might consider some real reforms to the luggage dilemma — and could still score political points with fliers.

Better Disclosure

A politician should be troubled if constituents are being tricked into paying unanticipated fees by airlines. Reducing choice, by forcing all airlines to include luggage fees in ticket prices, is not the solution. A better alternative would be to require airlines to disclose all fees upfront. For example, for tickets sold online, airlines could be required to allow consumers to view a screen that shows all the fees they could be subject to and ask them to agree to those terms before purchase. That way, if travelers don’t like the fees, they can choose another airline.

Fees by weight

Washington could also require airlines to be indifferent as to how passengers fly with their luggage. Rather than fees distinguish by carry-on versus checking, wouldn’t it be more sensible to discriminate by weight? After all, weight matters most. Heavier suitcases lead to more fuel spent. That leads to higher costs for airlines, additional natural resources consumed and more pollution emitted. Universal weight-based fees would encourage fliers to pack lighter and shield them from any unanticipated fee disparities from airline to airline.

Financial reform advocates were practically shaking with excitement to utter their I-told-you-so’s over the weekend after the SEC filed a lawsuit (.pdf – brief synopsis here) against Goldman Sachs for fraud. One example of a reformer with a triumphant tone came this morning as House Financial Services Chairman Barney Frank (D-MA) said that the case helps reinforce the need for more regulation of financial markets. Should it?

Political Perfection

To be sure, having a major investment bank sued by the SEC strengthens anti-Wall Street rhetoric. In that way, it will enhance public support for measures to crack down on banks and discourage politicians from looking the other way — and the timing couldn’t have been better. So politically, the event is extremely helpful. But that’s different from saying that the content of the SEC complaint assists regulation proponents in defending the more controversial reform proposals.

If the SEC Wins

An SEC win might seem like it would strengthen the case for reform. It shouldn’t. If the SEC succeeds in showing that Goldman committed fraud, then that means current law already forbid Goldman’s alleged bad behavior. In other words, no further regulation would be necessary to right the wrongs committed by the investment bank in this case.

If the SEC Loses

A Goldman win, however, should help reform’s appeal. If it’s widely perceived that the deal at the center of the SEC case was sleazy but Goldman gets away with it, then reforms everywhere will be vindicated in their view of the necessity of changes to the system.

Yet the corrections needed to fix the system according to the Goldman example are relatively benign. The SEC says that Goldman misled investors by not providing all of the relevant information for a security it sold. This is merely a call for greater disclosure. Virtually no one — whether Republican, Democrat, banker, or consumer — has much trouble with additional disclosure requirements. All of the more controversial measures, like the non-bank resolution authority, the consumer financial protection agency and putting derivatives on an exchange, wouldn’t be necessary to have prevented the fraud the SEC believes occurred. Investors would have just needed a little more disclosure.

What Reforms Should Argue

However, this could provide some additional ammo for reformers’ war if they highlight the uniqueness of this case. After a historic financial crisis, this marks the first — and potentially last — legal action related to wrongdoing against a major Wall Street bank the SEC has managed to take. That revelation shows how little regulators could have done to lessen the severity of the crisis in the current framework. Good reform should help to create an environment where investors don’t as easily buy securities that will one day be toxic.

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Goldman Sachs released an expanded response to the SEC’s suit (.pdf) late Friday. A brief synopsis of the situation can be found at the top of this post. Earlier in the day, the bank had released just a one-sentence statement, denying culpability. The additional detail provides a glimpse of how the bank intends to fight the complaint. The response makes four points:

• Goldman Sachs Lost Money On The Transaction.

The bank notes that it was net loser on the transaction. While interesting to note, this assertion has nothing to do with the SEC’s claim that Goldman misled investors. At best, it could cause a court to question if the profit-seeking motive the SEC’s complaint implies makes sense in the context of a money-losing deal.

• Extensive Disclosure Was Provided.

Here, Goldman essentially says that the disclosure it provided was sufficient. The defense would appear to imply that Goldman believes John Paulson’s influence in selecting the portfolio was not material to investors, because they could analyze the investment on its own merits adequately. This will boil down to a question of law in determining whether the disclosure of all influences in choosing a security’s portfolio is necessary.

• ACA, the Largest Investor, Selected The Portfolio.

Goldman says that ACA was ultimately responsible for the portfolio and had an incentive to pick a good one. This is true, but like the first assertion above, this point has nothing to do with the SEC’s complaint that Goldman misled investors. The bank likely hopes a court will question why ACA would assist Goldman in misleading investors through Paulson. Of course, ACA wouldn’t, which is why the SEC believes Goldman misled the firm as well.

• Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor.

This is a hugely important point, because it’s the first time we see Goldman refuting any of the facts of the SEC’s case. The SEC says that Goldman told ACA that Paulson would be a long investor, so ACA believed its interests were aligned with Paulson. Yet, the SEC complaint appears to include some evidence showing that Goldman did, in fact, lead ACA to believe Paulson would be going long. Here’s what the SEC complaint says on this matter:

47. On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% – [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% – [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% – [9]%” first loss equity tranche in this transaction.

48. On January 12, 2007, Tourre spoke by telephone with ACA about the proposed transaction. Following that conversation, on January 14, 2007, ACA sent an email to the GS&Co sales representative raising questions about the proposed transaction and referring to Paulson’s equity interest. The email, which had the subject line “Call with Fabrice [Tourre] on Friday,” read in pertinent part:

“I certainly hope I didn’t come across too antagonistic on the call with Fabrice [Tourre] last week but the structure looks difficult from a debt investor perspective. I can understand Paulson’s equity perspective but for us to put our name on something, we have to be sure it enhances our reputation.”

The Securities and Exchange Commission (SEC) filed an explosive complaint (.pdf) yesterday against investment banking titan Goldman Sachs. The civil lawsuit alleges that the bank defrauded investors who it sold a synthetic collateralized debt obligation (CDO) it created. Naturally, Goldman vehemently denies wrongdoing, having released the follow one-sentence statement:

The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.

Yet, through reading the SEC’s complaint, the case sounds rather strong. So how might Goldman choose to respond?

Brief Synopsis

The SEC lays out the facts (which Goldman may dispute) as follows. A hedge fund manager named John Paulson wanted to short the subprime mortgage market in early 2007. He asked Goldman Sachs to create a short position that he could purchase. In order to do so, Goldman had to create a long position to balance it out. A Goldman banker named Fabrice Tourre took on the deal. He sought to create a synthetic CDO for that long position to sell to investors. To do so, he knew he needed a seemingly neutral 3rd party collateral agent to make investors feel comfortable that the assets selected which the CDO referenced were sound. Goldman hired ACA Management for that job, and informed the company that Paulson would be purchasing the first-loss (long equity) piece of the CDO. As a result, ACA allowed Paulson to play a major role in selecting the assets, since it thought their interests were aligned. Of course, Paulson intentionally picked the assets he thought would do poorly instead, as he wanted to short the bonds. After ACA and Paulson agreed on a pool of assets, Goldman sold the resulting bonds to investors, informing them that ACA had selected the assets, without mentioning Paulson’s major influence.

The SEC says Goldman and Tourre intentionally misled both investors and ACA.

Blame ACA

One tactic Goldman might take is to blame ACA for believing that Paulson’s interests were aligned with its own. The SEC documents e-mails in the complaint showing that Goldman told ACA that Paulson would purchase a portion of the deal’s first-loss equity piece. But the bank could claim that ACA had no way of knowing whether Paulson would ultimately follow through with his agreement. As a result, ACA’s poor assumption was to blame — not Goldman.

The fate of this defense depends whether the court is convinced that ACA acted irresponsibly by allowing Paulson to have an influence on the pool, despite Goldman’s assurances that he would be an equity investor. If the evidence is strong that Goldman intentionally misled ACA — and it appears to be — then this argument might not be very compelling.

Blame Paulson

Goldman could attempt to say that Paulson misled the bank too. Goldman could say that it thought Paulson did want the equity piece, and claim it thought he would go long on the deal. Proving Goldman knew Paulson wanted to short the deal from the start could be challenging — I don’t see any indisputable evidence in the complaint to support this. But it’s extremely implausible that Goldman could have thought Paulson wanted go net-long on the deal. The entire purpose of the transaction was for Paulson to obtain a short position.

A court will probably have trouble finding this argument sound as well. Any reasonable person who understands how markets work would conclude that Goldman must have understood Paulson’s strategy, or else it would never have created the deal in the first place.

Blame Tourre

The bank could claim that Tourre was a sort of rogue banker who was acting improperly without their knowledge or consent. Given that he was only a 28-year-old vice-president, this seems a little far-fetched. Is supervision so lax at Goldman that his managing directors were unaware of the details of how he was doing deals? Bank management must have ultimately signed off on most of this stuff, so his managers couldn’t have been completely oblivious to the transaction they stamped Goldman’s name on.

This defense seems thin. Ultimately, the bank is responsible for the actions of its employees. If Tourre is found to have acted improperly, Goldman should also be held accountable — unless it can be shown that he misled Goldman management as well.

Blame Investors

Finally, Goldman could attempt to fall back on the old “buyer beware” defense. If investors had done sufficient due diligence, they would have discovered that the deal’s bonds were based on bogus collateral. While there’s a kernel of truth in that argument, it only holds up if the seller discloses accurate information. In this case, Goldman may have intentionally misled investors by claiming that the collateral was chosen by an independent third party. In reality, it was heavily influenced — and partially cherry-picked — by Paulson.

The court’s view here will probably hinge on whether it believes Goldman’s disclosure to investors explaining the collateral selection was sufficient. A legal judgment will be needed to determine whether Paulson’s degree of involvement in the collateral picking process was material to investors.

Consumers aren’t feeling better about the economy this month: they’re feeling worse. That’s what the Thomson Reuters/University of Michigan survey of consumer confidence says. Earlier this week, the market cheered better-than-expected sales data for March. This, in conjunction with better consumer confidence levels last month, appeared to indicate that Americans were feeling more optimistic about the economy. The Reuters/U-Michigan survey indicates the positive trend may have reversed this month.

Reuters reports:

The surveys’ overall index on consumer sentiments slipped to 69.5 in early April — the lowest in five months. This was below the 73.6 reading seen at the end of March and the 75.0 median forecast of analysts polled by Reuters.

That’s certainly not good news for the hope that better-than-expected March indicators were forming a new trend signaling economic recovery. In fact, consumers may have taken a step back. Reuters says that this change was driven by Americans hearing more negative information about government programs and perceiving that the recovery is too slow. They also hold negative views of their income and job prospects.

This is a little surprising, since the vast majority of economic reports issued thus far in April have painted a cheerful picture about March. Other than sales and consumer confidence, other positive news included legitimate job growth, a low inventory-to-sales ratio, virtually non-existent inflation, and increased pending home sales. The negative news was mostly limited to foreclosures and the government’s struggle modifying mortgages.

The Reuters/U-Michigan index’s April decline refutes the relatively strong positive sentiment expressed through Rasmussen’s consumer index for this month. We may have to wait for the Conference Board’s reading on consumer confidence at month’s end to settle the dispute.

March’s unemployment report was celebrated by economists as showing the most job growth seen in three years. But not all states were popping the champagne. Some saw their labor markets worsen. In fact, 32 states had more unemployed residents in March than in February, according to the Bureau of Labor Statistics. This may begin to show that the labor market recovery will not be felt equally by all states.

The five worst states were Michigan (14.1%), Nevada, (13.4%), California (12.6%), Rhode Island (12.6%), and Florida (12.3%). Of those five, Michigan and Rhode Island experienced job growth; the other three endured more job losses. North Dakota, South Dakota, and Nebraska remained the only three states with unemployment rates below 5%. North Dakota actually saw its rate decline by 0.1% to 4.1%.

California had the greatest number of additional unemployed residents with 30,500 more in March. It was followed by Virginia and Florida with 9,100 and 8,400 more, respectively. New York showed the most positive change with 12,700 fewer unemployed residents.

In terms of worsening unemployment rates, the most negatively affected states were Colorado, Nevada, Virginia, Montana, and New Mexico. All five saw their rates increase by 0.2%. 19 states had a 0.1% rise. Louisiana saw its rate decline the most, by 0.4%. South Carolina and the District of Columbia each enjoyed a 0.3% decline in their unemployment percentages.

The following chart shows the top-20 states with the highest increase in unemployment rate for March from February (#s in thousands):

That last column is revealing: it shows each state’s ranking in March foreclosure severity (foreclosures per housing unit). Six of the 10 worst states are on this list. The column also shows that only two of the 10-best states in terms of foreclosure severity are listed. If you compare the rankings of all 50 states for foreclosure severity and unemployment rate increase, they have a positive correlation of 0.31. While that’s not terribly compelling at this point, the correlation should be watched over the next few months to see whether ailing local housing markets weigh on states’ job market recovery.

Note: All statistics are seasonally adjusted.

The Securities and Exchange Commission is taking action against Goldman Sachs for misrepresenting securities the bank created and sold to investors. The suit (.pdf) is civil, so you won’t see any bankers in orange jumpsuits here, but it is significant. The action marks the first time the SEC has accused a major Wall Street bank of fraud involving securities related to the housing bubble. Does the SEC have a case or is this just a feel-good political move on the part of the regulator? That depends on the evidence it has accumulated.

Here’s the New York Times’ report of the facts:

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

The idea is that Goldman structured securities that were designed by an interested manager to go bad, but didn’t represent them that way to investors. If the facts of the case are proven to be accurate as depicted above, then it should be very easy for the SEC to prove fraud. Cherry picking bad assets and selling them to investors who thought they were chosen by an “independent manager” is illegal.

Up to now, Goldman has been arguing that it was just making markets in regard to the securities it created and sold that went bad. That isn’t generally fraud. Investment banks are free to unite buyers and sellers of securities — so long as they don’t misrepresent what they’re selling. But if it worked with a hedge fund to intentionally create a garbage fund and misrepresented that to investors, then that is fraud.

Yet suing Goldman is a slam-dunk for headline grabbing. This point raises the question: is it just a lucky coincidence that the SEC chose the investment bank most demonized by the media to finally sue? It’s plausible that many banks engaged in questionable behavior as the housing market began to sink in 2007, so it’s curious that the SEC chose to sue Goldman, and only Goldman. There is some chance that the SEC has a weak case, but looks to enjoy some public praise for finally appearing to crack down on Wall Street’s much-criticized actions during the housing market’s collapse.

So if the evidence described above is there, then the SEC should succeed. But even a win here won’t necessarily open the floodgates to lots more lawsuits. This could be an isolated situation where Goldman misrepresented how the securities were designed. If, in fact, an independent manager had chosen the assets in question, then there would be no case.

(Nav Image Credit: Wikimedia Commons)

The home building market continued to improve in March. Private building permits rose to 685,000 from 637,000 in February, a 7.5% increase, according to today’s Commerce Department report (.pdf). Last month’s number was also 34.1% higher than a year earlier. Private housing starts — indicating new construction begun — were also up in March, rising to 626,000. That beat February’s number by 1.6% and March 2009 by 20.2%. Both of these numbers are the highest seen since 2008.

Here are two charts that provide some historical perspective for both figures:

As these charts show pretty clearly, the new home construction market has improved recently, but still has a very long way to go to approach even pre-bubble levels.

Still, these two measures rising in March would appear to be good news, since they indicate  builders sense increased demand for new homes on the part of Americans. This is particularly positive for the labor market. Construction has lost 2.1 million jobs since the height of the housing boom. More home building means that some of those jobs will return.

Yet new construction doesn’t necessarily stabilize the housing market; in fact, it may weaken it. For home prices to rise, inventory must decline. That will occur as purchases of existing homes exceed those that hit the market. Foreclosures are still a huge problem, as they reached a new high in March.

But new home building increases housing inventory. For every new home bought during a month, one fewer existing home will be purchased. That slows the decline in housing inventory and will prevent housing prices from rising as much, if at all. So while increased building of new homes might be good for the labor market, it’s bad for the housing market in this environment.

Note: All numbers above are seasonally adjusted.

Perhaps nothing angered the average American more during the financial crisis than the idea that they would have to bear the cost of keeping alive giant financial firms that should have failed. Policymakers, including former Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, said that bailouts were undesirable but necessary. They asserted that the entire financial system would collapse if the government did not intervene. It’s impossible to know if that claim was true, but Congress wants to make sure that the question of whether to bail out a firm never has to be asked again.

Yet, Republicans are unconvinced that the financial reform legislation offered by Senate Banking Committee Chairman Christopher Dodd (D-CT) would really end bailouts. In a fiery exchange of floor speeches this week, he and Senate Minority Leader Mitch McConnell (R-KY) debated this point. Dodd asserts that his bill will put an end to bailouts, while McConnell and other Republicans say it leaves the door open for the government to prop up firms in perpetuity. Who’s right? They both are.

The Problem

Dodd’s bill seeks to create a mechanism for winding down firms that are so large or interconnected that their failure could cause the financial system to collapse. The so-called too-big-to-fail problem was the basis for rescuing firms like AIG and Fannie Mae. Such institutions enduring regular bankruptcy proceeds would have taken too long, creating an extended period of uncertainty and market turmoil. The creation of a non-bank resolution authority — with a similar role to that the FDIC plays with troubled depository institutions — could help.

But quickly and cleanly liquidating giant failed firms won’t be easy. So merely providing this authority to a government regulator isn’t enough. What happens if losses to creditors and counterparties threaten to further weaken the financial system? To alleviate this pitfall, Dodd has included a $50 billion liquidation fund to cover those costs, which will be paid for through proactive assessments on the very firms that the fund could be used to wind down.

And therein lies the problem: the liquidation fund would likely provide those firms a distinct advantage. The American Enterprise Institute Financial Policy Scholar Peter Wallison explains this objection in a blog post today. What are these “costs” that the $50 billion fund will be used to cover? He believes it will serve to pay off creditors, “so that the market’s fear of a general collapse will be allayed.” Even if creditors don’t benefit, other vendors or counterparties who do would provide an advantage to firms that are covered by the fund in a failure event.

Wallison has a fair complaint. Even though the resolution authority may, ultimately, wind down these big failed institutions, it may still bail out creditors — and that’s a problem. This will result in the firms on the government’s list of systemically risky firms having cheaper borrowing costs than smaller firms, since their debt will be perceived as safer. Creditors could be fairly certain that they’ll get some of their money back if a big institution fails. Large firms will have a competitive advantage over smaller ones.

Some Solutions

This isn’t an easy problem to fix, but the Senate can take one of several measures to attempt to do so:

Provide Clarity on Costs

Dodd might gain some political points if he explicitly defines the “costs” that the liquidation fund could cover. Then, if any of those costs are objectionable — like using the fund to pay off creditors — they can be crossed off the list. The problem here, however, is that it’s hard to imagine that the resolution authority can accomplish its mission without some flexibility in deciding which costs must be paid to achieve market stability. If you define costs too liberally, then you end up with a bailout-like feel; if you define costs too conservatively, then the resolution authority is ineffective. More on this issue here.

Let All Firms Utilize the Liquidation Fund

Dodd’s bill has a problem because it could provide big firms with an advantage, since only their failures utilize the liquidation fund during wind down. Why not, instead, allow all firms equal access to the fund for whatever costs it would have covered for only the large institutions? Think of depository insurance here. The FDIC does not provide only some banks with a competitive advantage because all participate. All pay assessments, and all get the benefit of depository insurance. Why not do the same for the liquidation fund? More on this solution here and here.

Create Financial Utilities

Another possibility would be to sort of meld together the two options above. Define which kinds of obligations or transactions must be protected to prevent a financial system-wide panic. Then guarantee these aspects of business for all firms. More on this here.

Whatever the Senate decides, the contention that the government should do nothing if a very large or interconnected firm fails is not a legitimate solution. The collapse of Lehman Brothers demonstrated just how ugly things can get — it triggered a financial crisis leading to 20% underemployment. Even if whatever steps taken with financial reform do not result in a perfectly safe financial system — and they likely can’t — they should at least seek to lessen the severity of major market disturbances like those experienced during the recent crisis.

April 15th marks a date most Americans despise: tax day. Naturally, the Atlantic has plenty of tax-related coverage to mark the unhappy occasion. Megan McArdle has a post exploring the difference between tax rates and tax burdens. Chris Good has pieces on the Tax Day Tea Parties and what the first family owed. Max Fisher over at the Wire has a roundup of views on the politics of tax day. Derek Thompson has a several posts as well — one about the coming tax wars, another about a tax day Tea Party poll and one more about a Gallup Poll that found 45% of Americans think their tax obligation is “about right.”

On that last question, we thought it might be nice to give Atlantic readers a voice to respond: did you find your 2009 tax burden fair? Vote in the poll below, and leave a comment as well if you’d like to share some thoughts on paying your 2009 taxes.