Senate Judiciary Committee Approves RIAA Bailout Radio Tax

from the and-so-it-goes dept

Because the federal government apparently hasn't helped the RIAA enough in the past century -- despite repeatedly changing copyright laws to favor the industry again and again and again (and again) -- the Senate Judiciary Committee has approved the Performance Rights Act, which effectively serves to tax radio stations for promoting music. It's quite obvious to anyone who actually understands radio economics that this makes no sense. After all, the history of radio has always been about payola -- having the labels pay the radio stations to play certain works. That's because the record labels know quite well that airtime leads to more money in terms of promoting an artist and building a business model around music, concert and merchandise sales. To the labels, airplay has always been the equivalent of advertising. That's why they pay for it.

But now they want the radio stations to pay them to advertise the labels' music? Isn't that getting the equation backwards?

This is nothing more than a federal bailout of the RIAA, who still refuses to embrace new business models. Instead, they have to squeeze others and get the government to force them to hand over money. A real business model doesn't involve changing the law. It involves giving others a reason to buy. Apparently, that's too difficult for the RIAA.

As for the claims that a performance license will somehow help musicians, that's bogus as well. First, ask the RIAA's SoundExchange about all the money it keeps for itself and about all the musicians it "can't find." Besides, all this will do is harm up-and-coming musicians. Because radio stations will now need to pay more for playing music, they'll play less music, and if they're playing less music, they'll focus just on the big name acts. Smaller up-and-coming artists should be furious with the RIAA for giving radio stations less incentive to play their works. Remember, this is the opposite of payola. While payola got new records on the air, this will make sure fewer get on the air. But it will sure put a bunch more money in the pockets of the major record labels. So there's that.

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Pandora Continues To Push Users To Vote For Shameful Radio Performance Tax

from the can't-compete? dept

We mentioned back in July how Pandora was urging its users to support the Performance Rights Act, which is effectively a government bailout for the RIAA by taxing already struggling radio stations for the right to help promote the RIAA's music. It's a travesty. The only reason Pandora supports it is because Pandora was pressured into its own ridiculous webcasting rates and wants to help bring down radio too. While I like Pandora as a service, I think it's shameful that it's now using the political process to burden competitors with a government created tax, that goes straight to the RIAA.

Apparently, Pandora has once again ramped up this effort to have the government tax its competitors. A whole bunch of you have been forwarding these ridiculous emails from Pandora that urge people to contact their elected officials in support of the RIAA Bailout bill. Most of those submitting those emails to us have said that you'll be doing the exact opposite, and are offended that Pandora is pushing you to support such a thing.

Yes, Pandora, it sucks that you got stuck with ridiculous webcasting rates that will make it difficult to remain profitable, but that's no excuse for trying to get the government to dump an unfair tax on your competitors.

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Why Is The FCC Even Giving The Time Of Day To RIAA's Bogus Radio Witchhunt?

from the waste-of-resources dept

Earlier this year, MusicFirst, a lobbying group that is run by the RIAA and pushing for a special tax on radio stations for daring to promote songs, came out with its latest in a long list of bizarre claims, demanding that the FCC investigate the fact that radio stations were supposedly boycotting musicians who supported the Performance Royalty tax. There were numerous problems with this claim. First, we thought it was rather hypocritical of MusicFirst to demand that radio stations play these artists, when it was the very same MusicFirst that was also claiming that radio was "a kind of piracy" for playing the music of these very same artists without paying a performance tax.

So, apparently if a radio station does play these artists, it's piracy. If it doesn't play these artists, it requires an FCC investigation.

Beyond that, MusicFirst failed to note that many of the artists topping the charts (including the Black Eyed Peas, who topped the charts at the time) were some of the most outspoken artists in favor of this tax. If there was some big conspiracy to not play these artists on the radio, someone forgot to tell... well... pretty much every radio station around.

That highlighted the third problem: MusicFirst didn't happen to point to any radio station that actually did this. The only one that could be dug up was a small high school radio station that had publicly boycotted artists supporting such a tax (which would have shut down the radio station), but only did so for one month and that month happened two years ago, and was a clearly supported expression of free speech.

And that brings up the final point. The recording industry has no right to demand that radio stations play certain artists. A radio station is free to play whatever artists they wish and run whatever commercial they wish. This is a pure free speech issue, and it's quite troubling that the recording industry is targeting radio stations when they have no right over this.

Based on all of this, you would hope that the FCC would simply laugh off the petition... but tragically, it's opened up a consultation on the matter and is asking for public input (found via Michael Scott). The article linked here goes through all of the First Amendment questions raised by this, and notes (thankfully) that the FCC seems to recognize those issues as well. But, if that's the case, why even bother holding this investigation in the first place?

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Pandora: If We're Getting Taxed So Heavily By SoundExchange, Radio Should Be Too

from the strange-bedfellows dept

Well, this is rather disappointing. Just days after caving in and agreeing to new webcaster rates that will harm pretty much everyone, Pandora has gotten right into bed with the RIAA/SoundExchange in supporting the Performance Right Act (the RIAA Bailout Act) to extend a similar unnecessary tax on radio. Pandora's reasoning is no surprise: basically it's saying that if it has to pay such a silly tax to help promote musicians, it's unfair that radio stations get away without paying something similar. But, still, it's disappointing. Rather than looking at adding value to the overall market, Pandora has basically decided that it's "enemy's enemy is a friend" and is supporting such a law simply because it will harm radio stations. This makes me think significantly less of Pandora.

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Recording Industry: Radio Is Piracy, But Not Playing Our Music Is A Federal Offense

from the logic-much? dept

It appears that the big record labels and their lobbyists aren't content with just suing and shaking down students across the country -- now they want to threaten them for taking a political stand as well. Earlier this week, musicFIRST, the big time lobbying group put together by the RIAA to push for the highly questionable Performance Rights tax on radio stations, did a neat little publicity stunt where it asked the FCC to investigate radio stations that apparently were "boycotting" musicians who supported the Performance Rights tax, claiming that it was an abuse of the airwaves. Remember, this is the same group that just recently called radio "a kind of piracy."

So, wait, which is it? If it's a kind of piracy to play songs on the radio, shouldn't musicFIRST and the RIAA be thrilled that radio stations aren't playing their music? Or do they recognize the free promotional benefits radio provides for artists? They can't have it both ways, can they? First they're upset that the music is being "pirated" and now they're upset that it's not being "pirated"? Please explain!

Now, as for those nasty nasty radio stations "boycotting" certain artists, well who are they? Turns out one of the main culprits is a tiny 100-watt high school radio station who has explained, in great detail the reasons behind their political stance. They are making a political choice by purposely boycotting musicians who support the view that playing their songs on the radio is "a kind of piracy." You would think that would make musicFIRST, the RIAA and those musicians happy. But, more to the point, that music "boycott" was a temporary thing, and lasted for one month, from mid-June 2007 until mid-July of that same year. Yes. It lasted for one month, to make a political statement, and it happened two years ago. And suddenly the RIAA/musicFIRST wants an FCC investigation? Of a bunch of high schoolers making a political statement against a tax that would harm their educational radio station by not "pirating" materials that the lobbyists claim are pirated?

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Bailing Out The RIAA?

from the there-we-go... dept

At the Tech Policy Summit yesterday, David Carson, the General Counsel of the US Copyright Office spent a bit of time at the beginning of his talk explaining why the Performance Rights Act made sense. This is the bill that would make radio stations pay musicians (rather than just songwriters as it is now) for every song they play on the radio. The recording industry insists that it's somehow unfair that radio stations have been promoting their music for free, and Carson seems to believe their explanation 100% (which is, unfortunately, quite typical of the Copyright Office). He argued, unconvincingly, that while radio used to promote artists (the reason that stations don't need to pay musicians), it no longer does so. That makes no sense. While there are alternatives out there for promoting artists, and radio may not have the impact it once had, that hardly means that the stations aren't promoting the music.

And, of course, the most damning argument against the recording industry's demand for money here is the fact that, for decades, the industry has (illegally) had the money go in the other direction. The system of payola has shown, quite clearly, how much the recording industry values airtime, in that it's willing to pay radio stations to play its music.

So, can anyone explain why it's illegal for record labels to pay radio stations to play music, but it's okay for Congress to force radio stations to pay the record labels for playing their music? It defies common sense.

Yet, with a nice push from the Copyright Office, the bill is moving forward, and will face a full House vote. During the Committee debate over the bill, Rep. Daniel Lungren made a perfectly reasonable suggestion: why not wait until the GAO had a chance to do an economic analysis of how the bill would impact radio stations. Considering that the bill is effectively a tax on those radio stations, this seems like a perfectly reasonable idea... but it resulted in Rep. Howard Berman (who represents Hollywood, always) accusing Lungren of trying to kill the bill. Isn't it great when simply waiting to find out what kind of impact the bill might have gets you accused of trying to kill it. Apparently in Congress, it's all about shooting first and asking questions later.

That said, Peter Kafka, over at AllThingsD, has made the best point: most people don't care about this bill because they don't realize that it's really a bill to bail out the RIAA by creating a radio station tax that goes straight into the recording industry's bank accounts. So, rather than call it the Performance Rights Act, it should more accurately be called the Britney Bailout Bill.

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Making The Tough Choices To Save The Economy?

from the stop-giving-the-banks-everything-they-want dept

With the latest plan laid out last week on how to "save Wall Street" ("the Geithner plan"), there's a lot of back and forth over whether or not this is a good plan or not -- and while Planet Money had a decent "is it good or bad?" show, the folks there didn't get too deep into it (and even claimed that no one really thought the plan was all that dangerous (just that it could slow down the recovery). However, the more I read up on it, the worse and worse it seems. Simon Johnson has a long, but worthwhile writeup at The Atlantic, where he delves into how Wall Street has effectively taken over Washington DC, such that it helped both create the mess, and then set things up so that the "recovery plan" only benefits those who caused the problems in the first place. This echoes a piece by Andy Kessler last week, where he pointed out that we're effectively handing money to those who brought the collapse upon us -- and suggests that the better response is to simply stymie the plans of the hedge funds -- flooding the markets where they're looking to buy, rather than subsidizing them.

Then, there's Umair Haque, who basically makes the same points, but suggests that this is an outright looting of taxpayer money by putting most of the risk on taxpayers, and encouraging the hedge funds to make increasingly risky loans (you know, like the ones that got us into this mess in the first place). The root of all of these stories is that the government seems to think that the only way to fix the problem is to reinflate the bubble, rather than letting the bubble deflate and moving forward from there. The problem with reinflating the bubble isn't just that it puts off the inevitable (though, it does), but that the inevitable is that much worse when it comes.

It's what we've done for the past couple decades -- effectively building an even shakier house of cards, and every time the cards start to fall... we just reinforce it with another layer of shaky cards to prop it up. At some point, the cards do have to fall, and propping it up with more leverage isn't going to help that.

Even if, as Richard Posner suggests, the current plan is about the most politically feasible, it's still problematic. The politics of the situation is troubling. On one side, you have populist anger, making it difficult to do certain necessary things. On the other, you do still have the influence of the bankers, who view the world as being one where we need to keep propping up that house of cards.

Why is it that no one is talking about carefully taking down the house of cards while building a sturdy house next door?

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Why Aren't We Trying To Solve The Too Big To Fail Problem?

from the getting-it-wrong dept

Last year, with all the talk of companies being "too big to fail" and governments bailing out such companies left and right, we had what seemed like a simple suggestion. Recognizing that it is possible for a company to be "too big to fail," in an intertwined economy, because the fallout would create even more problems, we suggested that a requirement for taking government money would be to become small enough to fail. That could mean spinning off parts, selling off parts, shutting down parts, exiting businesses, shrinking businesses -- whatever. There just needed to be some sort of guarantee that within a certain time frame, the company wouldn't be so tied up that if it failed it would bring down the rest of the economy. And, if a company didn't want to deal with those restrictions, then fine, it didn't need to take gov't bailout money.

The idea didn't get much traction (not surprisingly), and now some are pointing out that the opposite seems to be happening. Our solution to dealing with companies that are too big to fail has been to make them bigger and bigger, and pass off the question of "too big to fail" to other politicians in the future -- at which point the problems will likely be even bigger and harder to deal with. Propping up companies that are too big to fail, without a clear path towards making them small enough to fail, is a recipe for a future disaster.

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Throwing Money At Problems Usually Is Not The Solution

from the time-to-work-smarter dept

Thomas Friedman has stirred up some controversy with his suggestion that the government (instead of giving it to dying automakers) should give $20 billion to top venture capital firms and have them invest in new innovation. The initial thought makes sense, and, in fact, we discussed something quite similar a few months ago -- though, concerning a new venture fund in the UK, rather than giving money to existing funds. Indeed, if we must throw money at the economy, it should be to invest in new innovation, rather than throwing good money after bad. However, Fred Wilson points out that the top VC firms don't want or need the cash, and in fact, adding more money to the venture investing pool at this point might cause a lot more harm than good.

And, that brings up an important point, worth discussing, that the government seems to be missing: throwing money at problems is very rarely the best solution. Often the problems are caused by too much money sloshing around (see: Wall Street). Dumping more money into the system just encourages the same inefficiencies and bad decision making. The real fix to problems is to wipe out the broken parts of the system, not fund them further. Yes, letting some of these businesses fail will have rippling effects into other parts of the economy -- but shouldn't the focus be on helping out those aspects, rather than rewarding companies like GM and Chrysler that have screwed up dreadfully?

While there's something to be said for taking money when it's available, plenty of experienced entrepreneurs know that having too much money on hand is almost as bad as not having enough. Having too little money makes you focus and makes you creative out of necessity. Having too much money makes you lazy and puts you in a position to hide or ignore the real issues for way too long. What we should be working on right now is fixing the systemic problems throughout our economy -- not papering them over with cash.

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Government Already Overpaid By $78 Billion In Bailout Money

from the transparency? dept

Well here's a quick, but depressing one. As politicians are still debating the stimulus package, the head of the Congressional Oversight Panel for the TARP bailout funds is admitting that we, the taxpayers, appear to have already paid $254 billion for assets that appear to be worth $176 billion. That's a shortfall of $78 billion that may have just gone up in smoke, effectively. Now, it may eventually happen that the assets we now own appreciate in value, and that money is made back, but this is the key problem with just having the gov't jump into "buying" bad assets. It's almost guaranteed that they're going to overspend. If that doesn't make you uncomfortable about what sort of mess we're going to get with the stimulus package, I don't know what will. The government isn't just throwing money at a problem that might not need money -- it's doing it badly. On a historic level.

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Building Good Banks Instead Of Bad Banks

from the revisiting-the-idea dept

Last year, we had an interesting discussion about using the government's bank bailout money not to bail out banks, but to build an entirely new set of banks that weren't encumbered by the problems of the legacy banks. It seems like that idea is worth revisiting, as there's been plenty of talk about having the existing banks dump a bunch of their "toxic assets" into a so-called "bad bank." The idea is gaining a lot of steam, but definitely worries a lot of people. Willem Buiter, however, has a different suggestion that harkens back to our older discussion: rather than creating a "bad bank" with all the toxic assets, why not create "good banks" instead and turn all of the legacy providers into "bad banks."

This would solve the biggest problem of the bad bank solution: which is that the government would effectively be paying for a ton of assets that no one has any idea how to value -- meaning there's a half decent chance that we (the taxpayers) will overspend on those assets. Instead, the "good bank" idea would be that those banks would then buy up the good assets from legacy banks -- which are good because they can actually be valued. The legacy banks then automatically become "bad banks," but the taxpayers are left with the good assets, rather than the toxic ones. Buiter then suggests that those legacy banks have their banking licenses taken away so that they can't do any new business -- but can only look to wind down or sell whatever remaining assets they have. Effectively, this system would also avoid rewarding the shareholders of those legacy banks (though, they could still receive something from whatever's left over after the sale of the various assets).

In actuality, this is a suggestion for rebuilding the entire banking system, and throwing off the old banks. It's still pretty risky, however, and plenty of folks in the US would be horrified (of course) at the idea of the government effectively owning the entire "good" banking sector. Still, if you could set it up in a way that allows the system to quickly, but safely, transfer over to private ownership, the idea does seem significantly better than the bad bank solution. That said... you have to wonder why the government is needed to fund the banks under this scenario at all. Why aren't private investors putting up the money to buy up the "good" assets of the legacy banks? Are they still just too afraid to spend? Too afraid that "good assets" are really toxic? Or are the banks too afraid to sell any of the good assets?

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Sprint Wants Its Government Handout, Too

from the brother-can-you-spare-$2-billion dept

Sprint has sent a letter to the incoming Obama administration making a pitch for a $2 billion emergency communications network (via Phone Scoop) for first responders. Sprint's plan calls for satellite-equipped trucks (that sound like mobile base stations on wheels) and up to 100,000 handsets and other gear to be stockpiled around the country so that it could be delivered anywhere in the US within four hours. Sprint wants the plan included in the economic stimulus plan working its way through Congress -- and it's just coincidence, of course, that Sprint would be a huge beneficiary of such legislation, and $2 billion would give its struggling business a big boost. Without a doubt, public-safety communications are in need of a serious overhaul, and this is an area that the FCC and other parties have been looking at for some time. It's a complex situation -- one that deserves a more thorough investigation and solution, rather than a piece of government pork.

Carlo Longino is an expert at the Insight Community. To get insight and analysis from Carlo Longino and other experts on challenges your company faces, click here.

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Connecticut Government Bails Out Newspapers

from the will-it-impact-coverage? dept

A few readers have sent in the news that Connecticut lawmakers have stepped in to save two newspapers in the state, that were about to be shut down. This is raising all sorts of questions about the separation of government from the press. What's scary is that just a few years ago, such an idea was used as satire. Then it became a serious suggestion and now it's happening. Of course, the big question is about how this will impact coverage. It is possible for the government to own a newspaper and still have that newspaper report critically on that government... but it's definitely harder, and a lot of people may wonder about how closely the papers will monitor government officials.

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Transparency On The Bailout? Banks: No Thanks!

from the who-needs-transparency? dept

The Associated Press is being a bit unfair with its set of "gotcha questions" it asked a bunch of banks that have received bailout money, suddenly demanding that they all explain how the money is being used and how much is being used, but it is an important issue. In handing over all of this money to banks for a stake in those banks, one would think that we, the taxpayers, deserve at least some transparency into how the money is being spent. Considering the sums handed over, this is hardly an out-of-line question. Yet, we've already seen that the promised transparency surrounding the bailout has hardly been forthcoming. And, the worst part of it is that the thing we need more than anything else right now is significantly more transparency to rebuild the trust in the financial system.

Of course, it's not the banks' fault that they're not detailing what they're doing. There's no reason for them to do so right now. However, we should be asking why the government, which rushed to hand over so much money while promising transparency, didn't require more openness as a part of the deal and hasn't done much to add any transparency to the process since handing over the cash. Sure, everyone's been pretty busy, but transparency shouldn't be an afterthought here, it should be a central piece of any economic recovery package. The fact that the government hasn't done much to increase transparency should be seen as a troubling sign.

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Creative Destruction: Time To Make Companies Small Enough To Fail

from the channeling-schumpeter dept

The news is filled with stories of the latest bailout: this time of the US auto industry, and for some reason it has me thinking about Joseph Schumpeter. Schumpeter, as (hopefully) many of you know, was an economist in the first half of the 20th century, who today is probably most well-known for two things: his championship of the concept of "entrepreneurs" and ongoing innovation as the process of economic growth, and the creation of profits, as well as the idea of "creative destruction" brought about by those entrepreneurs, taking down old industries with new ideas, new products and new processes. There is much that Schumpeter got wrong in his analysis (in general, I'm not a huge fan of much of Schumpeter's work), but throughout it all, there were some very important ideas that have been proven time and time again.

It's important to revisit his work, as we're seeing a sudden influx of economic philosophy "battles" between different schools of economists over how to deal with the financial crisis. The new Keynesians still believe that through government tweaking, we can guide the economy to some sort of "soft landing." The more free market-focused economists fear the end result of such tweaking. The split in schools of thinking has become significantly less pronounced than in the past, and ideas seem to permeate back and forth among these and other economic philosophies, but some core beliefs are common across most economists, and they've been shown to be correct time and time again.

Competition and Innovation

Innovation, driven by competition, is the core of economic growth. Competition drives companies to keep innovating, creating better and better products (often for less and less money). Companies that rest on their laurels get beaten in the marketplace, and that's good for everyone (except, temporarily, employees and shareholders of those companies). It gives the public better products, made more efficiently, and it keeps companies from becoming burdens.

Encouraging competition should be a key goal of government, but in most cases that means staying out of the way. Unfortunately, things don't always work out that way, and the government has often been much more involved than necessary, later causing problems. This is often seen in a rush to send antitrust lawyers after a company for being successful, but not when it's doing any actual harm on the market, or preventing any real competition from happening.

We also see it as a problem in the government's intellectual property policies, which often do little to encourage innovation, and plenty to hinder it by creating defacto monopolies.

If the government should be involved at all, it should be to enable (not create) the infrastructure that's necessary for further innovations. It should be enabling the next generation of entrepreneurs to be creating the next great businesses.

Too Big To Fail

But, rather than doing that, we see the government looking to prop up non-competitive, non-innovative behemoths that are being called "too big to fail." These are companies that, often with the help of government regulations and subsidies, have become so intertwined in the economy, that a failure on their part really would cause significant ripples throughout the rest of the economy. While there are some who suggest they should be allowed to simply fail anyway, the economic risk in doing so is quite large -- in part, as a result of bad gov't policies for many years, abused and exploited by these companies.

Simply giving these companies more money and new regulations isn't going to make a difference. It only puts off the inevitable, and potentially will make things even worse when the problems resurface. The regulations and "oversight" will seem like a good deal at first, but over time the companies will twist the regulations to their advantage. They'll create new and larger loopholes, and the regulations won't do what they're intended to do, but will instead have created massive new problems. It's what almost always happens.

Creative Destruction

So perhaps it's time to go back to Schumpeter, with a big twist. If we grant the premise that some of these companies are too big to fail, and they absolutely need gov't bailouts to make them work, then why not set the terms of the bailout as being that they need to use the money to become small enough to fail? That is, they can get the money, one time only, and then need to look at breaking themselves up into separate pieces (even competitive pieces) that, by themselves, are no longer too big to fail.

The end result is that you aren't left with the same terrible situation, while also creating a new generation of "spinoffs" that can innovate and compete against both older firms in the space, and new upstarts that can more readily enter the market, rather than face a few giants. That way we're enabling more competition and innovation, leading to economic growth, while dismantling the structure of "too big to fail."

It's not quite that simple, of course. But, on the whole, it makes absolutely no sense to be "bailing out" companies that are too big to fail while leaving them as too big to fail. The end result is just going to keep sucking in more bailout money and wasting it, rather than encouraging innovation and competition.

A Cold Douche

This, obviously, is not the "creative destruction" that Schumpeter was talking about at all. In fact, at times he toyed with the idea that companies too big too fail were where the market would eventually end up. But, he also recognized the power of destroying old industries and setting the path for new innovations -- and he knew that the process was often messy, tied to business downturns.

In economist Robert Heilbroner's excellent The Worldly Philosophers, Heilbroner recalls sitting in Schumpeter's class at Harvard during the Great Depression:

When he lectured on the economy at Harvard in the midst of the depression, Joseph Schumpeter would stride into the lecture hall, and divesting himself of his European cloak, announce to the startled class in his Viennese accent, "Chentlemen, you are vorried about the depression. You should not be. For capitalism, a depression is a good cold douche." Having been one of those startled listeners, I can testify that the great majority of us did not know that a douche was a shower, but we did grasp that this was a very strange and certainly un-Keynesian message.

And, indeed, this economic restructuring is a good cold shower (though, some may prefer douche), but we don't get that sort of restructuring when the government is propping up exactly what needs to be restructured.

So, let's repurpose creative destruction with a clear plan: if you accept government bail out money because you're too big to fail, then that money needs to be used to make you small enough to fail.

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Suckers And Transparency: Preventing Another Financial Crisis

from the can-we-outlaw-suckers? dept

In continuing to try to understand the root causes of the financial crisis, we find that the whole story just keeps getting more interesting. While lots of folks are trying to blame one single thing (free markets, regulations, greed, poor people, rich people, bankers, mortgage lenders, hedge funds, short sellers, the President, Congress, etc.), the truth is that almost all of those explanations aren't just wrong, they're highly misleading. The problems involve a whole bunch of different things that combined to create the incentives that resulted in this situation -- and preventing it from happening again is hardly an easy proposition.

Finding the last sucker

Earlier this year, in talking about a highly questionable investment firm that was investing in startups, we wrote about how the venture capital game has always been about finding the last sucker to invest. It used to be the public markets, but when that dried up, apparently some VCs moved on to basically skirting public offerings by getting firms like the one described in the post to effectively trick unsophisticated investors out of their money and put it into a "fund" that then went to startups. It was the same process -- but actually less regulated than the public markets, and much more open to fraud.

The more I read about and understand different aspects of the current financial crisis, the more it becomes clear that basically the same thing happened here, but just on a much, much larger scale. It was a giant game of hot potato, where folks were passing along toxic assets looking for the last sucker to take them -- except the process of finding that last sucker became so valuable, that many of the firms in the business of finding new bigger suckers... found themselves. In many cases, the suckers were, in fact, unsophisticated investors like the school districts we described recently, but the various banks got so tied up in the process that they started betting on these things themselves.

Becoming the last sucker

While we've been trying to avoid the blame game, the more details come out, the more it looks like an awful lot of the trouble actually comes from the ratings agencies, such as S&P and Moody's. As we discussed in the story about the school districts, the ratings agencies screwed up pretty massively, by taking collections of poorly rated loans, and effectively claiming that all together, they suddenly became low risk assets. At some level you can see where they were coming from. If they were basing their decisions on the idea that default rates were independent, then bundling a bunch of questionable assets is a potential diversification strategy. You're assuming that only a small percentage will default, and you can look at historical numbers to figure out the risk. But, the problem is that these aren't independent, and as defaults start happening it leads to more defaults -- and the ratings agencies were simply fooled by their own models.

That's the generous interpretation, at least. The other is that there was outright fraud going on at the ratings agencies, and there's some evidence there was a fair amount of fraud. My guess is there was a little of both. The ratings agencies were pushed to rate these financial products highly, and so they created models that would support a high rating. Basically, rather than creating models that actually judged the risk, they created models that told them what they wanted them to say, because, in part, their business model depended on it. It was, as noted, garbage in, financial crisis out.

A lot of this becomes clear in Michael Lewis' excellent (as usual) discussion with a hedge fund guy who recognized this early (and made quite a bit of money doing so). What's fascinating is how much work even he had to do before he realized how fragile the whole setup was. When the financial crisis first went into full swing, many folks pointed the blame finger at hedge funds that were shorting bank stocks, like this guy. However, as the Lewis profile makes clear, he wasn't to blame. He was accurately telling everyone that the financial system itself had been built on a myth -- and the mythmakers were believing their own myth.

The end result is that the race to find that last sucker resulted in plenty of suckers being taken -- but when there weren't enough of those, the banks basically made themselves the next sucker in line, and convinced themselves that they weren't suckers. While there was almost certainly some amount of fraud involved in all of this, part of the problem was that everyone started believing their own bogus models in order to convince themselves that there would always be a later sucker (or, even worse, that they didn't need a later sucker).

So how do you prevent suckers?

And that leads us to the crux of the problem. How do you prevent suckers? At some point, you can just say, well it should be "buyer beware," and to some extent I agree with that sentiment. But, when all of the other incentives are as screwed up as they were in this situation, then even the "aware" buyer finds that almost every single datapoint he or she is using is wrong. That's what was happening here. You could look pretty deep at many of these assets and everything was saying they were solid, when the reality was they were not. In cases of outright fraud by ratings agencies, you can pull out the blame finger, but in many cases it wasn't so much fraud as it was the "experts" deluding themselves. How do you stop defrauding suckers, when it's the suckers defrauding themselves... and then earnestly convincing everyone else in the process?

Radical transparency

The one thing I keep coming back to as a solution is to put in place some aspect of radical transparency on pretty much all aspects of financial instruments, both on the debt side and the equity side. On the equity side, I'm surprised that more folks haven't picked up on Umair Haque's point that quarterly reports are obsolete and not nearly transparent enough. What if public companies provided ongoing reports that revealed a lot more than they do today. And, similarly, any debt instrument provided much more detail concerning what was actually making up the investment.

The reason school districts got stuck with worthless CDOs was because the information they got wasn't transparent at all. Sure, the prospectus was a book three inches thick, but all that information was actually used to obscure what the product was. Hell, the districts thought they were buying actual bonds, not making a side bet on how those bonds would do (what the CDO actually represented). But if there were real transparency within these instruments, and everyone buying into them could easily understand what was actually at stake, then they wouldn't be so reliant on ratings agencies and their crappy models. They'd be able to build their own models -- or openly share and discuss models with others.

While there will always be some "last sucker" out there, we can limit the risk of such things by limiting the suckers as much as possible -- and the way to do that is to become much more transparent and open with information.

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Instead Of Bailing Out Broken Banks, Why Not Build New Banks?

from the thinking-out-of-the-box dept

Plenty of people are pretty angry about the financial bailout, where it often looks like taxpayers are effectively handing over money to banks who screwed up big time by betting excessively on high risk investments, and borrowing a ton of money in the process. However, the argument from the other side (which does make sense) is that the "alternative" could be the collapse of the global financial system, and that would have such far reaching impacts that it's not at all desirable. But, that assumes the only options are to either bailout the banks or to let them fail entirely. Some are trying to come up with other options. Salman Khan and David Leinweber have come out with a suggestion that instead of bailing out banks, the government should take the $700 billion and use it to fund an entirely new financial sector. Then, as the screwed up banks fail, these new banks can take over their discarded assets.

This certainly has some appeal. The idea is that you wouldn't be rewarding shareholders in the original banks and also wouldn't be allowing the entire capital engine to seize -- and, on the flip side, you also might be rewarding the shareholders of the new banks (the American taxpayer). However, there's also tremendous risk in doing this. In effect, it's something like building a new airplane from within a troubled airplane that's flying at 40,000 feet, getting it to fly from the air, and then moving people from the troubled airplane to the new one. There's an awful lot that can go wrong. Also, in doing this in such a rapid fashion, when it's still not entirely clear what all the root causes of this crisis are, you run the risk of simply transferring the core problems to these new banks (basically taking the problems from the first airplane to the second, if we continue the analogy). Then you end up spending $700 billion to basically create a new set of troubled banks that are even more confusing, because they were put together in a rush. So, while it's an interesting idea, it seems like it would present some significant problems as well.

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Bloomberg Sues The Fed For More Transparency Over $2 Trillion In Emergency Loans

from the that-would-be-useful-info dept

While plenty of people are focused on the $700 billion TARP bailout/rescue plan that Congress gave the Treasury Department, that's not the only cash the government has at its disposal. In fact, the Federal Reserve has apparently handed out $2 trillion in emergency loans, with almost no transparency over who received the loans and what the collateral is or how it's valued. Bloomberg (the company, not the mayor) is now suing to have the Fed reveal that info. The government has been talking up a storm about how all of these bailout efforts would be very transparent with respect to taxpayer money -- but the reality hasn't lived up to the rhetoric.

The article linked above is from Bloomberg (the party suing the gov't), so perhaps it's biased, but it does seem noteworthy how pretty much everyone tried to dodge questions concerning the $2 trillion in loans. The only person who seemed to be willing to say anything was Rep. Barney Frank, who is the House Financial Services Committee Chairman. Yet, his explanation for the secrecy is hardly compelling:

"I talk to [New York Fed CEO Timothy] Geithner and he was pretty sure that they're OK. If the risk is that the Fed takes a little bit of a haircut, well that's regrettable.''

Pretty sure they're OK? That's hardly a ringing endorsement for keeping the details of such loans a secret.

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Transparency Schmancparency: Bailout Payment Details Blacked Out

from the this-will-end-badly dept

With the financial bailout process under way, our main fear was that the government would royally screw up, often by handing out favors to friends, rather than focusing on what actually needs to be done to get the economy moving in the right direction. To counter that possibility, one thing you heard repeatedly was that there would be unprecedented "transparency" in how the government conducted this. Transparency here is important. In fact, a big part of the reason we're in this mess in the first place was that banks consistently obfuscated the details of various deals, in order to hide the risk levels. That caused banks and others to buy hugely risky assets, believing they weren't that risky. So, is the government really being transparent?

Of course not.

The folks over at Planet Money note that the first contract awarded under the bailout, with Bank of New York Mellon Corp. just so happens to have the compensation details to Bank of New York Mellon redacted. If anyone is going to trust the government in handling the $700 billion, how much it spends and how it compensates the various banks that take part in the process clearly need to be open. Otherwise this is a huge opportunity for cronyism and corruption. To start out by blacking out the compensation details is quite troubling, and it doesn't exactly bode well for how transparent the rest of this process is going to be.

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Banks May Say 'Thanks, But No Thanks' To That New $700 Billion

from the hello-adverse-selection... dept

Last week, in that big post about the financial crisis, one thing I mentioned is that despite all the talk of "moral hazard" -- the bigger fear might be moral hazard's sister problem: adverse selection. That is, it would only be those with truly awful assets and no other options that would take the government up on its offer to buy its "toxic" assets. That may be happening. Reports are coming out that some on Wall Street are considering saying "thanks, but no thanks" to the new ~$700 billion that the Treasury Secretary has been given. The article paints the issue as being about the strings that come attached to it, such as limits on executive pay and golden parachutes. That almost certainly could be a part of the reasoning, but a much bigger part may simply be that these banks recognize that the assets they have aren't quite as toxic as they're being made out to be.

Yes, there are bundles of highly questionable mortgages, but contrary to what the media tells you, plenty of the people who possess those mortgages are still paying -- and even if they're not, the property and houses they represent still do have some value on the market -- or will someday. Thus, it may be that the only banks that really take up Paulson on a buyout offer, are those with really toxic assets that aren't likely to appreciate in value. That's not good for anyone. The more you look at this bailout, the worse it seems. It also makes you wonder why there isn't more of a focus on using a so-called "stock injection" plan, whereby the gov't becomes an investor in the banks, rather than just buying out certain questionable assets. That would, in theory, help avoid sticking the taxpayers with only the worst of the worst assets.

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