Dr. Sherry Jarrell

Should the Risk of Financial Products be Regulated?

A lively debate from LearningFromDogs blog about the wisdom of regulating the safety of financial products ....  http://learningfromdogs.com/2009/10/30/consumer-financial-product-quality/

Consumer ’safety’ for financial products

with one comment

Are we missing a lesson that has been applied for years?

I have resisted any temptation to comment on the economic situation on Learning from Dogs. The contributions from others are based on far more knowledge and understanding of the subject then I will ever have.

However, I feel obliged to ask humbly for some clarification about something that bothers me. Are we putting the cart before the horse? Are we ignoring the relationship between provider and consumer in finance?

The regulatory regime applied to the vast majority of products which are allowed to be sold to the public is such that there are probably more stringent safety standards for an electric toaster than for most, if not all, financial products!

Much of the talk of regulation and restraint, in the current climate, seems to relate to remuneration of people working for financial organisations. But, why does it matter what they receive? In other fields, success is rewarded and the shareholders, admittedly fairly indirectly, have some say on the policy in that area. Why should they not pay what they wish?

On the other hand (to coin an economic phrase!),  the minimum standards of the products are set by regulators.

In other fields, if a supplier cannot demonstrate, to the satisfaction of the regulators, that its product meets specified safety standards, then that product is not allowed to be offered.

It is very simple! I am not referring to contracts, customer service, compensation and so on; I am referring to a threshold level of safety below which the product is not allowed to be sold or operated. Think: “cars”, “aeroplanes”, “electrical appliances”, “children’s toys”, and … well anything else!

To be even clearer, this is not about “perfect safety” which is, of course, not available at any price. This is not about blame. This is not about guarantees. It IS about inspection, testing, certification, regulation … oh and policing!

Can anyone explain why this approach cannot be applied to financial products? (Sherry attempts to here.)

By John Lewis

p.s. as chance would have it the image of the toaster at the head of this Post was taken from an article talking about a recall of the Viking Toaster – point made rather well, don’t you think?

My first attempt at a reply apparently hit a nerve!  Those comments tomorrow.

Sherry’s reply.

A great question, John: why do we not have a threshold level of safety for financial products, as we do with cars and toys?

Well, for one, if a financial product “fails,” the consequence is purely financial – it is not injury or death.  A financial product simply represents a financial investment today in exchange for financial payoffs tomorrow.

The less certain those payoffs, the higher the minimum required return on that investment. If the returns were certified or regulated in some way, risk would be reduced, and the required return would also fall.  Limiting risk exposure throws out the baby with the bath water:  less risk means lower returns on the investment.  Look at the real returns to U.S. Treasury Bills – they are almost zero!

There is a role for regulation in financial products and that is for disclosure of relevant information.  When we invest in a financial product, we are putting our money at risk in exchange for future expected cash flows.  We forecast those cash flows on the basis of material information about the firm, its products or services, and its management and strategy.

Even here there is a fine line between the right to know and proprietary information that enables a firm to invest its own funds in the hope of generating a large return in exchange for taking risks.

The Securities and Exchange Commission’s requirement for a 20-day window between the time a bidder makes a tender offer for a target and the time the target shareholders must decide whether to accept the offer or not is an example of a regulation that crosses the line, in my view.

In a misguided attempt to protect shareholders from fly-by-night tender offers, the SEC has created an environment where multiple competing bids can arise, driving down the return to the original bidder and limiting the incentives for firms to productively redeploy assets through tender offers.

By Sherry Jarrell

Zombie Stocks: Not for the Faint of Heart

[http://in.sys-con.com/node/1157066#. By Eric Frazier, Advancement: University Relations, Wake Forest University.]

Two weeks before Halloween, the Securities and Exchange Commission again warned investors against buying shares of bankrupt companies, but like those creatures in horror films that rise from the dead, so-called "zombie" stocks--shares of companies that failed during the financial crisis--are still on the march.

Take, for example, Washington Mutual and Lehman Brothers. At the end of last year, their stocks traded at 2 cents and 3 cents per share, respectively. With no future earnings in sight, shares of Washington Mutual recently traded around 20 cents, and Lehman Brothers shares have hovered around 15 cents--spectacular gains fueled by what many consider nothing more than gambling.

Critics have called on the SEC to halt the trading of such stocks to protect unsophisticated investors who might be lured into unwise trades. But Lecturer of Finance Sherry Jarrell, who teaches a graduate-level class on investments and portfolio management in the Wake Forest University Schools of Business, disagrees.

While Jarrell doesn't think investing in zombie stocks is a sure-fire profitable strategy, she doesn't consider it gambling either, because there is an expectation of gain. Jarrell also doesn't believe those who are trading zombie stocks are ignorant or unsophisticated. "To outlaw these stocks means that you've truncated an avenue for people to express their different risk preferences," Jarrell says. "If someone wants to go on that haunted trail, let them. It's not like they're taking advantage of people on the other side of the trade."

Washington Mutual and Lehman Brothers lost their standing to be listed on stock exchanges, so traders have to keep up with prices through a quotation service known as the Over the Counter Bulletin Board, which unsophisticated investors are unlikely to access. Other troubled companies, such as Fannie Mae, Freddie Mac and AIG, whose shares are widely considered to be zombie stocks, are still listed on major exchanges. The federal government's own backing of those companies weakens any argument against allowing individuals to invest in them, if they dare.

One project Jarrell assigns her students is to identify a publicly traded stock they believe the market has significantly mispriced. By definition, she says, the exercise requires the same calculation made by traders of zombie stocks--reaching a different conclusion about a stock's future cash flows and risks than that of the market.

Jarrell points out that all investments carry a degree of risk proportional to potential returns, and investors have varying tolerances for risk. Some hide from risk; others seek it out. She recalls a study some years ago that found striking similarities in the blood chemistry of day traders on Wall Street and jet fighter pilots. "It turns out they need a certain amount of danger to feel normal," Jarrell says. "They seek risk in order to feel comfortable."

Comment on WSJ: Fed and inflationary expectations

Fed Acknowledges Inflation Hawk Concerns

By Jon Hilsenrath

Today’s Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank’s policy making committee who think the Fed is putting too much weight on the argument that the economy’s substantial slack will drive down inflation.

Fed Chairman Ben Bernanke. (Reuters)

Slack is the economy’s productive capacity that doesn’t get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there’s a lot of slack, it puts downward pressure on prices in the short-run. It’s one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.

But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

In previous recent statements, it hasn’t mentioned inflation expectations. It focused mostly on slack. Here’s how the Fed put it in August: “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed’s inflation view could change and tilt it toward a more hawkish stance.http://blogs.wsj.com/economics/2009/09/23/fed-acknowledges-inflation-hawk-concerns/

My comment:  Price levels result from the intersection of demand and supply. Aggregate demand in the U.S. increases with an increase in purchases by consumers, businesses, or government, and with an increase in the money supply (yes, money SUPPLY). The aggregate supply curve is basically the marginal cost curve of the economy, or the sum of the cost curves of all firms in the economy. It is driven by productivity and wage rates; more productivity, lower costs, and a downward shift in supply, pushing GDP up and the price index down. Lower efficiency and/or higher wage rates result in higher costs, a shift up in the supply curve, and a higher price level. Slack refers to "unused capacity," generally unused plant or physical capacity. But slack also results from "unused labor capacity," i.e., unemployment. There is no question that the U.S. economy currently has significant slack in both areas. This basically means that the short run supply curve is relatively flat; that a given increase in demand can be met by an increase in quantity supplied with minimal increase in prices. But that is not the end of the story. There are two additional factors that must be considered. One, the fed reserve is in unchartered territory right now, underwriting record increases in the money supply, which translate into unknown but potentially monstrous increases in aggregate demand. Unless the long run supply curve is flat, which it certainly is not, this is inflationary. Two, there is some evidence, though not entirely convincing, that expectations of inflation lead to increases in wages, but this is generally only after the economy experiences repeated bouts of unanticipated inflation. So, the bottom line is that supply and demand drive equilibrium output and price, as always, and that inflation will in fact result if the increase in demand continues to outstrip the increase in supply in the economy.

The smallest hint of oil surplus leads to a real fall in oil prices!

Today, the mere hint of a fairly insignificant surplus in U,S. oil reserves pushed down current oil prices and energy-related futures and other speculative plays.   Can you imagine the reaction to an announcement of a new source of U.S. oil reserves?  Of renewed off-shore drilling capacity?  Relaxed EPA standards? Additional refinery capacityA?  Our energy prices would be cut in half and we'd be so much less likely to war with oil-rich nations on whom we now depend for the functioning of our economy and who, indirectly or not, limit our economic and personal freedoms. 

The Unemployment Rate hides Dramatic Labor Market Activity

In an earlier post, I explained how the reported U.S. unemployment rate, which was 9.6% in August of 2009, is measured. This post will explore the reported unemployment rate in more depth, distinguishing between the short-term, temporary sources of unemployment and the long-term, more structural, and troubling aspects of the unemployment rate.  

The 9.6% U.S. unemployment rate remains the same next month if no one changes their employment status.  But the rate also remains unchanged if the same number of people hired get fired.  In truth, the U.S. unemployment rate nets out enormous flows of people into and out of the labor force and, for those in the labor force, between being employed and unemployed.   

A representative month in the unemployment statistic tells the story.  In May of 1993, there was no change in the reported U.S. unemployment rate.  And yet, fully 5 million people got jobs that month; 3 million were just entering the labor force; the other 2 million were in the labor force but had been unemployed.  In the same month, 5 million other people left employment:  3.2 million left the labor force, some for good reasons and some for bad, and 1.8 became unemployed.  

The net reported U.S. unemployment rate also hides another very important phenomenon, and that is that there are two distinct types of unemployment:  short-term and long-term unemployment.   The fact is that some short-run unemployment is desirable.  In general, it is better for people to take some time in finding the ideal job, one in which they are productive, happy, and satisfied.  If individuals always take the first job offer that comes along, rather than searching for a good fit, the odds of a bad match and future job separation increase. 

Chronic unemployment is a bad thing, however.  The economic, social, and psychological costs of the chronically unemployed are enormous.  

Policymakers must carefully weigh the costs and benefits to society of the type of unemployment insurance they support:  a little unemployment insurance for a short period helps people to find the right job, which is a good thing.  Too much unemployment insurance over too long a period encourages slack and enables more structural, long-term unemployment, which is a very bad thing for our economy.