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WSJ: Americans Stumble on Math of Big Issues

WSJ: Americans Stumble on Math of Big Issues

http://online.wsj.com/article/SB10001424052970203471004577144632919979666.html

Many Americans have strong opinions about policy issues shaping the presidential campaign, from immigration to Social Security. But their grasp of numbers that underlie those issues can be tenuous.

Americans vastly overestimate the percentage of fellow residents who are foreign-born, by more than a factor of two, and the percentage who are in the country illegally, by a factor of six or seven. They overestimate spending on foreign aid by a factor of 25, according to a 2010 survey. And more than two-thirds of those who responded to a 2010 Zogby online poll underestimated the part of the federal budget that goes to Social Security or Medicare and Medicaid.

"It's pretty apparent that Americans routinely don't know objective facts about the government," says Joshua Clinton, a political scientist at Vanderbilt University.

Americans' numerical misapprehension can be traced to a range of factors, including where they live, the news they consume, the political rhetoric they hear and even the challenges of numbers themselves. And it isn't even clear how much this matters: Telling people the right numbers often doesn't change their views.

This isn't exclusively an American problem. Estimates by people in the U.K., Italy and France of immigrant populations in their nation miss by a bigger percentage than do Americans' estimates, and Britons overstated the magnitude of U.K. net contributions to the European Union by more than 100 times in a 2010 survey.

Some of these findings may show simply that people don't have a good grasp on very small or large numbers. Take a poll last year that found Americans overestimated federal spending on the Corporation for Public Broadcasting by a factor of at least 100. Arthur Lupia, a political scientist at the University of Michigan, says while Americans were far off the mark, the average response of 1% to 5% signals "that lots of people know that the amount spent is a small number." CPB was budgeted $430 million last year, 0.01% of federal outlays.

"Numbers are hard," says Ellen Peters, a psychologist at Ohio State University. "They're difficult to evaluate and remember because they're abstract symbols," and their meaning shifts depending on the context. And absorbing policy numbers may not be worth the effort: "People are more likely to remember numbers accurately when that information is more valuable to them," Ms. Peters says.

Pollsters and political scientists say people, when asked to estimate national figures, can place undue weight on their immediate surroundings. Someone who lives near many foreign-born people might exaggerate the national foreign-born population.

Even when polls have a narrower scope, respondents aren't necessarily on firmer ground. A telephone poll last year of 2,004 Californians by the Public Policy Institute of California found that they didn't know much about how their state government was spending its money.

Nearly half of respondents named prisons and corrections as the top state expenditure among four available choices, while just 16% named education. In fact, education was the leading state expenditure, with prisons getting about a quarter the funds that education does.

Correcting misconceptions may not change peoples' beliefs about the underlying issues, according to several studies for which researchers tested the effect of supplying the right numbers. That finding is corroborated by psychological research suggesting that people struggle to identify their reasons for forming opinions, instead supplying ex post facto rationalizations—such as faulty numbers.

This undermines the notion of rational choice, but also weakens any case these findings might support for a poll quiz or mandatory civics education: The truth may not change the outcome.

"People recall facts that support their beliefs, and don't recall facts that contradict beliefs," says Leo Simonetta, a social psychologist and director of analytics for the Art & Science Group, a Baltimore-based education consultancy.

When researchers provide study respondents with corrected figures and ask them to re-evaluate their opinion on issues, there generally isn't a big shift. And any lasting effects—when study participants returned to their usual media diet and peer group—likely would be even slighter.

"We found that people resisted any attempts to give them accurate information," says James Kuklinski, a political scientist at the University of Illinois.

He and colleagues asked Illinois residents for their opinions and factual beliefs on welfare. More than 60% supplied an estimate of the percentage of U.S. families on welfare that was more than double the correct proportion, among other misfires. Those most misinformed were most confident in their estimates, according to the 2000 paper. And a subgroup supplied with the right numbers didn't change their views in a meaningful way.

A recent immigration study confirmed the finding. Political scientists John Sides of George Washington University and Jack Citrin of the University of California, Berkeley, hypothesized in a working paper that supplying Americans, who typically overestimate the number of immigrants and illegal immigrants among them, with correct numbers would reduce the perceived threat of immigration and change their views. Instead, getting the right number reinforced their views, and even increased their support for letting fewer immigrants into the U.S

NYT: Harder for Americans to Rise From Lower Rungs

http://www.nytimes.com/2012/01/05/us/harder-for-americans-to-rise-from-lower-rungs.html?_r=1&pagewanted=print

Harder for Americans to Rise From Lower Rungs

By JASON DePARLE

WASHINGTON — Benjamin Franklin did it. Henry Ford did it. And American life is built on the faith that others can do it, too: rise from humble origins to economic heights. “Movin’ on up,” George Jefferson-style, is not only a sitcom song but a civil religion.

But many researchers have reached a conclusion that turns conventional wisdom on its head: Americans enjoy less economic mobility than their peers in Canada and much of Western Europe. The mobility gap has been widely discussed in academic circles, but a sour season of mass unemployment and street protests has moved the discussion toward center stage.

Former Senator Rick Santorum of Pennsylvania, a Republican candidate for president, warned this fall that movement “up into the middle income is actually greater, the mobility in Europe, than it is in America.” National Review, a conservative thought leader, wrote that “most Western European and English-speaking nations have higher rates of mobility.” Even Representative Paul D. Ryan, a Wisconsin Republican who argues that overall mobility remains high, recently wrote that “mobility from the very bottom up” is “where the United States lags behind.”

Liberal commentators have long emphasized class, but the attention on the right is largely new.

“It’s becoming conventional wisdom that the U.S. does not have as much mobility as most other advanced countries,” said Isabel V. Sawhill, an economist at the Brookings Institution. “I don’t think you’ll find too many people who will argue with that.”

One reason for the mobility gap may be the depth of American poverty, which leaves poor children starting especially far behind. Another may be the unusually large premiums that American employers pay for college degrees. Since children generally follow their parents’ educational trajectory, that premium increases the importance of family background and stymies people with less schooling.

At least five large studies in recent years have found the United States to be less mobile than comparable nations. A project led by Markus Jantti, an economist at a Swedish university, found that 42 percent of American men raised in the bottom fifth of incomes stay there as adults. That shows a level of persistent disadvantage much higher than in Denmark (25 percent) and Britain (30 percent) — a country famous for its class constraints.

Meanwhile, just 8 percent of American men at the bottom rose to the top fifth. That compares with 12 percent of the British and 14 percent of the Danes.

Despite frequent references to the United States as a classless society, about 62 percent of Americans (male and female) raised in the top fifth of incomes stay in the top two-fifths, according to research by the Economic Mobility Project of the Pew Charitable Trusts. Similarly, 65 percent born in the bottom fifth stay in the bottom two-fifths.

By emphasizing the influence of family background, the studies not only challenge American identity but speak to the debate about inequality. While liberals often complain that the United States has unusually large income gaps, many conservatives have argued that the system is fair because mobility is especially high, too: everyone can climb the ladder. Now the evidence suggests that America is not only less equal, but also less mobile.

John Bridgeland, a former aide to President George W. Bush who helped start Opportunity Nation, an effort to seek policy solutions, said he was “shocked” by the international comparisons. “Republicans will not feel compelled to talk about income inequality,” Mr. Bridgeland said. “But they will feel a need to talk about a lack of mobility — a lack of access to the American Dream.”

While Europe differs from the United States in culture and demographics, a more telling comparison may be with Canada, a neighbor with significant ethnic diversity. Miles Corak, an economist at the University of Ottawa, found that just 16 percent of Canadian men raised in the bottom tenth of incomes stayed there as adults, compared with 22 percent of Americans. Similarly, 26 percent of American men raised at the top tenth stayed there, but just 18 percent of Canadians.

“Family background plays more of a role in the U.S. than in most comparable countries,” Professor Corak said in an interview.

Skeptics caution that the studies measure “relative mobility” — how likely children are to move from their parents’ place in the income distribution. That is different from asking whether they have more money. Most Americans have higher incomes than their parents because the country has grown richer.

Some conservatives say this measure, called absolute mobility, is a better gauge of opportunity. A Pew study found that 81 percent of Americans have higher incomes than their parents (after accounting for family size). There is no comparable data on other countries.

Since they require two generations of data, the studies also omit immigrants, whose upward movement has long been considered an American strength. “If America is so poor in economic mobility, maybe someone should tell all these people who still want to come to the U.S.,” said Stuart M. Butler, an analyst at the Heritage Foundation.

The income compression in rival countries may also make them seem more mobile. Reihan Salam, a writer for The Daily and National Review Online, has calculated that a Danish family can move from the 10th percentile to the 90th percentile with $45,000 of additional earnings, while an American family would need an additional $93,000.

Even by measures of relative mobility, Middle America remains fluid. About 36 percent of Americans raised in the middle fifth move up as adults, while 23 percent stay on the same rung and 41 percent move down, according to Pew research. The “stickiness” appears at the top and bottom, as affluent families transmit their advantages and poor families stay trapped.

While Americans have boasted of casting off class since Poor Richard’s Almanac, until recently there has been little data.

Pioneering work in the early 1980s by Gary S. Becker, a Nobel laureate in economics, found only a mild relationship between fathers’ earnings and those of their sons. But when better data became available a decade later, another prominent economist, Gary Solon, found the bond twice as strong. Most researchers now estimate the “elasticity” of father-son earnings at 0.5, which means if one man earns $100,000 more than another, his sons would earn $50,000 more on average than the sons of the poorer man.

In 2006 Professor Corak reviewed more than 50 studies of nine countries. He ranked Canada, Norway, Finland and Denmark as the most mobile, with the United States and Britain roughly tied at the other extreme. Sweden, Germany, and France were scattered across the middle.

The causes of America’s mobility problem are a topic of dispute — starting with the debates over poverty. The United States maintains a thinner safety net than other rich countries, leaving more children vulnerable to debilitating hardships.

Poor Americans are also more likely than foreign peers to grow up with single mothers. That places them at an elevated risk of experiencing poverty and related problems, a point frequently made by Mr. Santorum, who surged into contention in the Iowa caucuses. The United States also has uniquely high incarceration rates, and a longer history of racial stratification than its peers.

“The bottom fifth in the U.S. looks very different from the bottom fifth in other countries,” said Scott Winship, a researcher at the Brookings Institution, who wrote the article for National Review. “Poor Americans have to work their way up from a lower floor.”

A second distinguishing American trait is the pay tilt toward educated workers. While in theory that could help poor children rise — good learners can become high earners — more often it favors the children of the educated and affluent, who have access to better schools and arrive in them more prepared to learn.

“Upper-income families can invest more in their children’s education and they may have a better understanding of what it takes to get a good education,” said Eric Wanner, president of the Russell Sage Foundation, which gives grants to social scientists.

The United States is also less unionized than many of its peers, which may lower wages among the least skilled, and has public health problems, like obesity and diabetes, which can limit education and employment.

Perhaps another brake on American mobility is the sheer magnitude of the gaps between rich and the rest — the theme of the Occupy Wall Street protests, which emphasize the power of the privileged to protect their interests. Countries with less equality generally have less mobility.

Mr. Salam recently wrote that relative mobility “is overrated as a social policy goal” compared with raising incomes across the board. Parents naturally try to help their children, and a completely mobile society would mean complete insecurity: anyone could tumble any time.

But he finds the stagnation at the bottom alarming and warns that it will worsen. Most of the studies end with people born before 1970, while wage gaps, single motherhood and incarceration increased later. Until more recent data arrives, he said, “we don’t know the half of it.”

Article: MF Global and the great Wall St re-hypothecation scandal

MF Global and the great Wall St re-hypothecation scandal
http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12_-_December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/

Featured Content from WESTLAW

MF Global and the great Wall St re-hypothecation scandal

By Christopher Elias (UK) 

(Business Law Currents) A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients. 

MF Global’s bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet. 

If anyone thought that you couldn’t have your cake and eat it too in the world of finance, MF Global shows how you can have your cake, eat it, eat someone else’s cake and then let your clients pick up the bill. Hard cheese for many as their dough goes missing. 

FINDING FUNDS 

Current estimates for the shortfall in MF Global customer funds have now reached $1.2 billion as revelations break that the use of client money appears widespread. Up until now the assumption has been that the funds missing had been misappropriated by MF Global as it desperately sought to avoid bankruptcy. 

Sadly, the truth is likely to be that MF Global took advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name - a legal loophole that may mean that MF Global clients never get their money back. 

REPO RECAP 

First a quick recap. By now the story of MF Global’s demise is strikingly familiar. MF plowed money into an off-balance-sheet maneuver known as a repo, or sale and repurchase agreement. A repo involves a firm borrowing money and putting up assets as collateral, assets it promises to repurchase later. Repos are a common way for firms to generate money but are not normally off-balance sheet and are instead treated as “financing” under accountancy rules. 

MF Global used a version of an off-balance-sheet repo called a “repo-to-maturity.” The repo-to-maturity involved borrowing billions of dollars backed by huge sums of sovereign debt, all of which was due to expire at the same time as the loan itself. With the collateral and the loans becoming due simultaneously, MF Global was entitled to treat the transaction as a “sale” under U.S. GAAP. This allowed the firm to move $16.5 billion off its balance sheet, most of it debt from Italy, Spain, Belgium, Portugal and Ireland. 

Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow. Ultimately, however, it proved to be MF Global’s downfall as margin calls and its high level of leverage sucked out capital from the firm. For more information on the repo used by MF Global please see Business Law Currents MF Global – Slayed by the Grim Repo? 

Puzzling many, though, were the huge sums involved. How was MF Global able to “lose” $1.2 billion of its clients’ money and acquire a sovereign debt position of $6.3 billion – a position more than five times the firm’s book value, or net worth? The answer it seems lies in its exploitation of a loophole between UK and U.S. brokerage rules on the use of clients funds known as “re-hypothecation”. 

RE-HYPOTHECATION 

By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults. 

In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default. 

In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital). 

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds. 

U.S. RULES 

Under the U.S. Federal Reserve Board’s Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client’s liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets. 

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500). 

This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions. 

In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation. 

BEWARE THE BRITS: CIRCUMVENTING U.S. RULES 

Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules. 

Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation. 

Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules. 

LEHMAN LESSONS 

In fact this is exactly what Lehman Brothers did through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished. 

A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK (normally conducted under a Global Master Securities Lending Agreement). 

These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE. 

MF RE-HYPOTHECATION PROVISION 

A similar re-hypothecation provision can be seen in MF Global’s U.S. client agreements. MF Global’s Customer Agreement for trading in cash commodities, commodity futures, security futures, options, and forward contracts, securities, foreign futures and options and currencies includes the following clause: 

 “7. Consent To Loan Or PledgeYou hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate,loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.” 

In its quarterly report, MF Global disclosed that by June 2011 it had repledged (re-hypothecated) $70 million, including securities received under resale agreements. With these transactions taking place off-balance sheet it is difficult to pin down the exact entity which was used to re-hypothecate such large sums of money but regulatory filings and letters from MF Global’s administrators contain some clues. 

According to a letter from KPMG to MF Global clients, when MF Global collapsed, its UK subsidiary MF Global UK Limited had over 10,000 accounts. MF Global disclosed in March 2011 that it had significant credit risk from its European subsidiary from “counterparties with whom we place both our own funds or securities and those of our clients”. 

CAUSTIC COLLATERAL 

Matters get even worse when we consider what has for the last 6 years counted as collateral under re-hypothecation rules. 

Despite the fact that there may only be a quarter of the collateral in the world to back these transactions, successive U.S. governments have softened the requirements for what can back a re-hypothecation transaction. 

Beginning with Clinton-era liberalisation, rules were eased that had until 2000 limited the use of re-hypothecated funds to U.S. Treasury, state and municipal obligations. These rules were slowly cut away (from 2000-2005) so that customer money could be used to enter into repurchase agreements (repos), buy foreign bonds, money market funds and other assorted securities. 

Hence, when MF Global conceived of its Eurozone repo ruse, client funds were waiting to be plundered for investment in AA rated European sovereign debt, despite the fact that many of its hedge fund clients may have been betting against the performance of those very same bonds. 

OFF BALANCE SHEET 

As well as collateral risk, re-hypothecation creates significant counterparty risk and its off-balance sheet treatment contains many hidden nasties. Even without circumventing U.S. limits on re-hypothecation, the off-balance sheet treatment means that the amount of leverage (gearing) and systemic risk created in the system by re-hypothecation is staggering. 

Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again. Essentially, it is a chain of debt obligations that is only as strong as its weakest link. 

With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing. 

The lack of balance sheet recognition of re-hypothecation was noted in Jefferies’ recent 10Q (emphasis added): 

 “Note 7. Collateralized Transactions
We pledge securities in connection with repurchase agreements, securities lending agreements and other secured arrangements, including clearing arrangements. The pledge of our securities is in connection with our mortgage−backed securities, corporate bond, government and agency securities and equities businesses. Counterparties generally have the right to sell or repledge the collateral.Pledged securities that can be sold or repledged by the counterparty are included within Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. We receive securities as collateral in connection with resale agreements, securities borrowings and customer margin loans. In many instances, we are permitted by contract or custom to rehypothecate securities received as collateral. These securities maybe used to secure repurchase agreements, enter into security lending or derivative transactions or cover short positions. At August 31, 2011 and November 30, 2010, the approximate fair value of securities received as collateral by us that may be sold or repledged was approximately $25.9 billion and $22.3 billion, respectively. At August 31, 2011 and November 30, 2010, a substantial portion of the securities received by us had been sold or repledged. 

We engage in securities for securities transactions in which we are the borrower of securities and provide other securities as collateral rather than cash. As no cash is provided under these types of transactions, we, as borrower, treat these as noncash transactions and do not recognize assets or liabilities on the Consolidated Statements of Financial Condition. The securities pledged as collateral under these transactions are included within the total amount of Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. 

According to Jefferies’ most recent Annual Report it had re-hypothecated $22.3 billion (in fair value) of assets in 2011 including government debt, asset backed securities, derivatives and corporate equity- that’s just $15 billion shy of Jefferies total on balance sheet assets of $37 billion. 

HYPER-HYPOTHECATION 

With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble. 

Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion),Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion). 

Nor is lending confined to between banks. Intra-bank re-hypothecation is also possible as evidenced by filings from Wells Fargo. According to disclosures from Wachovia Preferred Funding Corp, its parent, Wells Fargo, acts as collateral custodian and has the right to re-hypothecate and use around $170 million of assets posted as collateral. 

LIQUIDITY CRISIS 

The volume and level of re-hypothecation suggests a frightening alternative hypothesis for the current liquidity crisis being experienced by banks and for why regulators around the world decided to step in to prop up the markets recently. To date, reports have been focused on how Eurozone default concerns were provoking fear in the markets and causing liquidity to dry up. 

Most have been focused on how a Eurozone default would result in huge losses in Eurozone bonds being felt across the world’s banks. However, re-hypothecation suggests an even greater fear. Considering that re-hypothecation may have increased the financial footprint of Eurozone bonds by at least four fold then a Eurozone sovereign default could be apocalyptic. 

U.S. banks direct holding of sovereign debt is hardly negligible. According to the Bank for International Settlements (BIS), U.S. banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal and Spain. If we factor in off-balance sheet transactions such as re-hypothecations and repos, then the picture becomes frightening. 

As for MF Global’s clients, the recent adoption of an “MF Global rule” by the Commodity Futures Trading Commission to ban using client funds to purchase foreign sovereign debt, would seem to suggest that it was indeed client money behind its leveraged repo-to-maturity deal - a fact that will likely mean that very few MF Global clients few get their money back. 

Written with contributions from Jack Bunker and Nanette Byrnes. 

 

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com. )   

© 2011 Thomson Reuters

Article: Taxing the 1%: Why the top tax rate could be over 80% | vox - Research-based policy analysis and commentary from leading economists

Taxing the 1%: Why the top tax rate could be over 80% | vox - Research-based policy analysis and commentary from leading economists
http://www.VoxEU.org/index.php?q=node/7402

Thomas Piketty   Emmanuel Saez   Stefanie Stantcheva
8 December 2011

The top 1% of US earners now command a far higher share of the country’s income than they did 40 years ago. This column looks at 18 OECD countries and disputes the claim that low taxes on the rich raise productivity and economic growth. It says the optimal top tax rate could be over 80% and no one but the mega rich would lose out.


In the United States, the share of total pre-tax income accruing to the top 1% has more than doubled from less than 10% in the 1970s to over 20% today (CBO 2011 and Piketty and Saez 2003). A similar pattern is true of other English-speaking countries. Contrary to the widely held view, however, globalisation and new technologies are not to blame. Other OECD countries such as those in continental Europe or Japan have seen far less concentration of income among the mega rich (World Top Incomes Database 2011).

At the same time, top income tax rates on upper income earners have declined significantly since the 1970s in many OECD countries, again particularly in English-speaking ones. For example, top marginal income tax rates in the United States or the United Kingdom were above 70% in the 1970s before the Reagan and Thatcher revolutions drastically cut them by 40 percentage points within a decade.

At a time when most OECD countries face large deficits and debt burdens, a crucial public policy question is whether governments should tax high earners more. The potential tax revenue at stake is now very large. For example, doubling the average US individual income tax rate on the top 1% income earners from the current 22.5% level to 45% would increase tax revenue by 2.7% of GDP per year, as much as letting all of the Bush tax cuts expire. But, of course, this simple calculation is static and such a large increase in taxes may well affect the economic behaviour of the rich and the income they report pre-tax, the broader economy, and ultimately the tax revenue generated. In recent research (Piketty et al 2011), we analyse this issue both conceptually and empirically using international evidence on top incomes and top tax rates since the 1970s.

Figure 1 shows that there is indeed a strong correlation between the reductions in top tax rates and the increases in top 1% pre-tax income shares from 1975–79 to 2004–08 across 18 OECD countries for which top income share information is available. For example, the United States experienced a 35 percentage point reduction in its top income tax rate and a very large ten percentage point increase in its top 1% pre-tax income share. By contrast, France or Germany saw very little change in their top tax rates and their top 1% income shares during the same period. Hence, the evolution of top tax rates is a good predictor of changes in pre-tax income concentration. There are three scenarios to explain the strong response of top pre-tax incomes to top tax rates. They have very different policy implications and can be tested in the data.

First, higher top tax rates may discourage work effort and business creation among the most talented – the so-called supply-side effect. In this scenario, lower top tax rates would lead to more economic activity by the rich and hence more economic growth. If all the correlation of top income shares and top tax rates documented on Figure 1 were due to such supply-side effects, the revenue-maximising top tax rate would be 57%. This would still imply that the United States still has some leeway to increase taxes on the rich, but that the upper limit has already been reached in many European countries.

Second, higher top tax rates can increase tax avoidance. In that scenario, increasing top rates in a tax system riddled with loopholes and tax avoidance opportunities is not productive either. However, a better policy would be to first close loopholes so as to eliminate most tax avoidance opportunities and only then increase top tax rates. With sufficient political will and international cooperation to enforce taxes, it is possible to eliminate most tax avoidance opportunities, which are well known and documented. With a broad tax base offering no significant avoidance opportunities, only real supply-side responses would limit how high top tax rate can be set before becoming counter-productive.

Third, while standard economic models assume that pay reflects productivity, there are strong reasons to be sceptical, especially at the top of the income distribution where the actual economic contribution of managers working in complex organisations is particularly difficult to measure. In this scenario, top earners might be able to partly set their own pay by bargaining harder or influencing compensation committees. Naturally, the incentives for such ‘rent-seeking’ are much stronger when top tax rates are low. In this scenario, cuts in top tax rates can still increase top income shares – consistent with the observed trend in Figure 1 – but the increases in top 1% incomes now come at the expense of the remaining 99%. In other words, top rate cuts stimulate rent-seeking at the top but not overall economic growth – the key difference with the first, supply-side, scenario.

To tell these various scenarios apart, we need to analyse to what extent top tax rate cuts lead to higher economic growth. Figure 2 shows that there is no correlation between cuts in top tax rates and average annual real GDP-per-capita growth since the 1970s. For example, countries that made large cuts in top tax rates such as the United Kingdom or the United States have not grown significantly faster than countries that did not, such as Germany or Denmark. Hence, a substantial fraction of the response of pre-tax top incomes to top tax rates documented in Figure 1 may be due to increased rent-seeking at the top rather than increased productive effort.

Naturally, cross-country comparisons are bound to be fragile, and the exact results vary with the specification, years, and countries. But by and large, the bottom line is that rich countries have all grown at roughly the same rate over the past 30 years – in spite of huge variations in tax policies. Using our model and mid-range parameter values where the response of top earners to top tax rate cuts is due in part to increased rent-seeking behaviour and in part to increased productive work, we find that the top tax rate could potentially be set as high as 83% – as opposed to 57% in the pure supply-side model.

Up until the 1970s, policymakers and public opinion probably considered – rightly or wrongly – that at the very top of the income ladder, pay increases reflected mostly greed or other socially wasteful activities rather than productive work effort. This is why they were able to set marginal tax rates as high as 80% in the US and the UK. The Reagan/Thatcher revolution has succeeded in making such top tax rate levels unthinkable since then. But after decades of increasing income concentration that has brought about mediocre growth since the 1970s and a Great Recession triggered by financial sector excesses, a rethinking of the Reagan and Thatcher revolutions is perhaps underway. The United Kingdom has increased its top income tax rate from 40% to 50% in 2010 in part to curb top pay excesses. In the United States, the Occupy Wall Street movement and its famous “We are the 99%” slogan also reflects the view that the top 1% may have gained at the expense of the 99%.

In the end, the future of top tax rates depends on the public’s beliefs of whether top pay fairly reflects productivity or whether top pay, rather unfairly, arises from rent-seeking. With higher income concentration, top earners have more economic resources to influence social beliefs (through think tanks and media) and policies (through lobbying), thereby creating some reverse causality between income inequality, perceptions, and policies. We hope economists can shed light on these beliefs with compelling theoretical and empirical analysis.

Figure 1. Changes in top 1% pre-tax income shares and top marginal tax rates since the 1970s


Note: The Figure depicts the change in top 1% pre-tax income shares against the change in top marginal income tax rates from 1975-9 to 2004-8 for 18 OECD countries (top tax rates include both central and local individual income tax rates, exact years vary slightly by countries depending on data availability in the World Top Income Database). Source: Piketty et al (2011), Figure 4A.

Figure 2. GDP-per-capita growth rates and top marginal tax rates since the 1970s

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FT - Fund industry ‘overpaid by $1,300bn’

FT.com / FTfm / Regulation and governance - Fund industry ‘overpaid by $1,300bn’
http://www.ft.com/intl/cms/s/0/3adcb3e6-5c9c-11e0-ab7c-00144feab49a.html#axzz1fb8R4MOz

The “overpaid” fund management industry is destroying $1,300bn of value annually, according to an unpublished draft report conducted by IBM.

The document, seen by FTfm, claims the industry is “paid too much for the value it delivers” and that “destroying value for clients and shareholders is unsustainable”.

It also carries a prediction of swingeing job cuts in parts of the industry, such as sell side research, credit rating agencies and funds of hedge funds.

The wide-ranging report, Financial Markets 2020, is based on a survey of more than 2,600 industry participants and government officials across 84 countries by the IBM Institute for Business Value.

The bulk of the value destruction, almost $1,100bn a year, equivalent to 1.9 per cent of global gross domestic product, is seen as impacting on clients. This includes $300bn in excess fees for actively managed long-only funds that fail to beat their benchmark (this figure is quoted as $834bn in the draft report but it is believed IBM has since revised it lower), $250bn spent in fees for wealth management and advisory services that fail to deliver promised above-benchmark returns, and $51bn in fees for hedge funds that also fail to deliver their targeted returns.

Credit rating agencies, sell side research and trading are seen as destroying a further $459bn, largely due to the perceived inaccuracy of much of the analysis these sectors deliver.

Across the financial sector as a whole, IBM said “alpha generation” or the ability to deliver index-beating returns, was “pitiful”, despite the huge sums paid in pursuit of this. Perhaps unsurprisingly, it found 87 per cent of investors expressed no loyalty to their “primary investment provider”.

The report argues the industry is destroying a further $213bn a year for shareholders due to organisational complexity, largely as a result of inefficiencies.

This value destruction is “unsustainable” in a world where, according to respondents to the report, regulation is likely to become tighter in the wake of the financial crisis and investors are becoming more financially sophisticated, more price sensitive and increasingly keen to measure the “value-add” of their investment managers.

“Government influence and client behavioural shifts over the next decade will destroy the majority of today’s revenue base,” the report states.

Against this backdrop, the survey respondents indicate that significant job losses are inevitable. In particular, clients forecast a 45 per cent headcount reduction in sell side research and 42 per cent reduction at credit rating agencies in the next decade, as the buyside takes more of this activity in-house.

Funds of hedge fund staff are seen as most vulnerable on the buyside, with headcount cuts of 37 per cent forecast.

Liz Rae, senior adviser, investment and markets at the UK Investment Management Association, said fund houses were already bringing more research activities in-house, partly driven by a view that sell side was irredeemably conflicted.

Sell-side research “probably is overstaffed and there is probably too much of it”, she said. However, Amin Rajan, chief executive of Create Research, a consultancy, argued that the bulk of the industry’s post-crisis job losses were now behind it. He said much of the value destruction was caused by the “behavioural biases” of investors.

Shiller: The Neuroeconomics Revolution

http://www.project-syndicate.org/commentary/shiller80/English

The Neuroeconomics Revolution

2011-11-21

The Neuroeconomics Revolution

NEW HAVEN – Economics is at the start of a revolution that is traceable to an unexpected source: medical schools and their research facilities. Neuroscience – the science of how the brain, that physical organ inside one’s head, really works – is beginning to change the way we think about how people make decisions. These findings will inevitably change the way we think about how economies function. In short, we are at the dawn of “neuroeconomics.”

Efforts to link neuroscience to economics have occurred mostly in just the last few years, and the growth of neuroeconomics is still in its early stages. But its nascence follows a pattern: revolutions in science tend to come from completely unexpected places. A field of science can turn barren if no fundamentally new approaches to research are on the horizon. Scholars can become so trapped in their methods – in the language and assumptions of the accepted approach to their discipline – that their research becomes repetitive or trivial.

Then something exciting comes along from someone who was never involved with these methods – some new idea that attracts young scholars and a few iconoclastic old scholars, who are willing to learn a different science and its different research methods. At a certain moment in this process, a scientific revolution is born.

The neuroeconomic revolution has passed some key milestones quite recently, notably the publication last year of neuroscientist Paul Glimcher’s bookFoundations of Neuroeconomic Analysis – a pointed variation on the title of Paul Samuelson’s 1947 classic work, Foundations of Economic Analysis, which helped to launch an earlier revolution in economic theory. And Glimcher himself now holds an appointment at New York University’s economics department (he also works at NYU’s Center for Neural Science).

To most economists, however, Glimcher might as well have come from outer space. After all, his doctorate is from the University of Pennsylvania School of Medicine’s neuroscience department. Moreover, neuroeconomists like him conduct research that is well beyond their conventional colleagues’ intellectual comfort zone, for they seek to advance some of the core concepts of economics by linking them to specific brain structures.

Much of modern economic and financial theory is based on the assumption that people are rational, and thus that they systematically maximize their own happiness, or as economists call it, their “utility.” When Samuelson took on the subject in his 1947 book, he did not look into the brain, but relied instead on “revealed preference.” People’s objectives are revealed only by observing their economic activities. Under Samuelson’s guidance, generations of economists have based their research not on any physical structure underlying thought and behavior, but only on the assumption of rationality.

As a result, Glimcher is skeptical of prevailing economic theory, and is seeking a physical basis for it in the brain. He wants to transform “soft” utility theory into “hard” utility theory by discovering the brain mechanisms that underlie it.

In particular, Glimcher wants to identify brain structures that process key elements of utility theory when people face uncertainty: “(1) subjective value, (2) probability, (3) the product of subjective value and probability (expected subjective value), and (4) a neuro-computational mechanism that selects the element from the choice set that has the highest ‘expected subjective value’…”

While Glimcher and his colleagues have uncovered tantalizing evidence, they have yet to find most of the fundamental brain structures. Maybe that is because such structures simply do not exist, and the whole utility-maximization theory is wrong, or at least in need of fundamental revision. If so, that finding alone would shake economics to its foundations.

Another direction that excites neuroscientists is how the brain deals with ambiguous situations, when probabilities are not known, and when other highly relevant information is not available. It has already been discovered that the brain regions used to deal with problems when probabilities are clear are different from those used when probabilities are unknown. This research might help us to understand how people handle uncertainty and risk in, say, financial markets at a time of crisis.

John Maynard Keynes thought that most economic decision-making occurs in ambiguous situations in which probabilities are not known. He concluded that much of our business cycle is driven by fluctuations in “animal spirits,” something in the mind – and not understood by economists.

Of course, the problem with economics is that there are often as many interpretations of any crisis as there are economists. An economy is a remarkably complex structure, and fathoming it depends on understanding its laws, regulations, business practices and customs, and balance sheets, among many other details.

Yet it is likely that one day we will know much more about how economies work – or fail to work – by understanding better the physical structures that underlie brain functioning. Those structures – networks of neurons that communicate with each other via axons and dendrites – underlie the familiar analogy of the brain to a computer – networks of transistors that communicate with each other via electric wires. The economy is the next analogy: a network of people who communicate with each other via electronic and other connections.

The brain, the computer, and the economy: all three are devices whose purpose is to solve fundamental information problems in coordinating the activities of individual units – the neurons, the transistors, or individual people. As we improve our understanding of the problems that any one of these devices solves – and how it overcomes obstacles in doing so – we learn something valuable about all three.

FT Where bonds beat equities long term

http://www.ft.com/intl/cms/s/0/80b88c60-de0a-11e0-a115-00144feabdc0.html#axzz1eJfA9WnI

Where bonds beat equities long term

By Steve Johnson

Received wisdom tells us that equities are more volatile than bonds, and that investors are compensated for this greater risk with higher returns. This excess return even has a name, the equity risk premium.

Of course, no one expects this neat and tidy relationship to hold true every year, but for those able and willing to invest for the long term, the efficient market hypothesis suggests equity investors should reap greater returns.

One might think a half century or so should comfortably qualify for the tag “long term”. Yet figures released last week by Deutsche Bank suggest that for three members of the G7 group of leading industrialised nations, Italy, Germany and Japan, returns from equities have been worse than those of government bonds since 1962.

Indeed, the Italian stock market has even managed to deliver a negative real return over the past half-century, -0.38 per cent on an annualised basis versus +2.64 per cent for bonds, “a remarkable statistic in a world where we are all used to seeing equity outperformance increase the longer you expand the time horizon”, wrote Jim Reid, strategist at Deutsche.

In Japan, government bonds have delivered a real return of 4.17 per cent a year, beating the 2.72 per cent of equities, while in Germany bonds have won by 4.28 per cent versus 3.46 per cent for equities. In France, a fourth member of the G7, equities have performed better, but only by 45 basis points a year, a meagre excess return for the higher volatility.

The data have led to a degree of head scratching.

“It’s very curious. [Bonds outperforming equities] certainly has been the case over a shorter period of 10 or maybe even 15 years in many economies, I think that would be the case in the US and UK. But I’m very surprised that that would be the case over 50 years,” says Tom Stevenson, investment director at Fidelity International.

Bill O’Neill, chief investment officer, Emea at Merrill Lynch Wealth Management, adds: “In an efficient market equities should pay more than bonds, assuming you start from an equilibrium level in terms of valuation. Efficient markets should suggest that the equity risk premium is positive. Over time we require to be compensated for the higher volatility of the asset class over bonds.”

Even Deutsche muses whether the figures “reflect a developed world financial system that hasn’t been working efficiently”.

An alternative thesis would be that there is something specific about Italy, Germany, Japan, and the time period involved, that makes them unusual.

“All three lost wars quite disastrously and had to rebuild their economies and it wouldn’t surprise me if some of the early year figures reflected that development. I think there may be country-specific reasons,” says Ewen Cameron Watt, chief investment strategist at the BlackRock Investment Institute.

Mr Stevenson speculates that the seeming anomaly could be “a response to that period after the second world war and the inflation that accompanied that”.

Similarly Deutsche points out that the trio all experienced hyper or severe inflation in the 50 years preceding 1962. However, the idea of the data being distorted by a strong rally for bonds at the start of the last half century as inflation and interest rates normalised is not borne out: in both Germany and Japan equities outperformed bonds in the 1960s, while even in Italy the differential in favour of bonds was only 1.3 percentage points a year.

Longer-term data collated by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, suggest Deutsche’s findings may just be a statistical quirk, albeit an unusually long-running one.

The LBS analysis shows that if the dataset is extended back to 1950, equities have beaten bonds in each of the 19 developed countries it covers, including Italy, Germany and Japan. While some may argue this in turn merely introduces another anomalous period – the 1950s, which were a golden decade for equity investors – the same pattern holds for the 110-year period from 1900.

There is, however, wider agreement as to how investors should react to the Deutsche figures – buy equities.

“The key point when it comes to investment returns is valuations at the starting point,” says Mr Stevenson. “Ten-year benchmark yields in Germany and the US are under 2 per cent and in Britain not much more than 2 per cent. We are at the end of an extended bull market for government securities, and if not at the end, we are at least 11 years into a bear market for equities which has brought valuations down to a historically low level. Valuations look better for equities than bonds.”

Mr Dimson concurs, saying: “We’ve had over a decade in which equities became relatively cheaper, and non-defaultable bonds more expensive. Why do so many people reckon that the forward-looking return on cheaper assets is now lower? And the forward-looking return on more expensive assets is now higher?”

This ties in with a view that equities will outperform bonds by more than the trend equity risk premium (which Mr O’Neill puts at 3-4 per cent) in the coming period, as the
anomalous returns of the past 50 years are unwound.

“After a period of poor returns we should get a period of good returns,” argues Mr Cameron Watt.

Deutsche’s Mr Reid also “wouldn’t give up on equities”, arguing we are in for a period of higher inflation, which will be worse for bonds than equities.

One even clearer message would appear to shine out of this analysis, however. The figures for the US (and UK), the most widely cited in investment circles, show equities beating bonds over the past 50 years, leading Deutsche to warn “caution needs to be applied when using US data to try to predict markets elsewhere in the developed world”.

Article: Economics focus: Exports to Mars | The Economist

Economics focus: Exports to Mars | The Economist
http://www.economist.com/node/21538100

ECONOMISTS are constantly urging governments to adopt policies that would reduce global imbalances—which, in crude terms, means that China should slash its current-account surplus and America its deficit. Yet they ignore the biggest imbalance of all: the current-account surplus that planet Earth appears to run with extraterrestrials. In theory, countries’ current-account balances should all sum to zero because one country’s export is another’s import. However, if you add up all countries’ reported current-account transactions (exports minus imports of goods and services, net investment income, workers’ remittances and other transfers), the world exported $331 billion more than it imported in 2010, according to the IMF’s World Economic Outlook. The fund forecasts that the global current-account surplus will rise to almost $700 billion by 2014.

Are aliens buying Louis Vuitton handbags? Are little green men bagging the best sunbeds by the hotel pool? The more down-to-earth explanation is that the global surplus reflects statistical errors. Either the current-account deficits of countries such as America are being understated or the surpluses of countries like China are being overstated, and by a rising amount.

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