The Finance Class That’s ‘Guaranteed’ to Get You a Job on Wall Street

In this Business Insider article by Portia Crowe, we are taken inside the Johns Hopkins University classroom of Professor Steve Hanke.

According to the professor, his applied economics and finance class guarantees its alumni top jobs on the Street. Professor Hanke, who’s been at Hopkins for 45 years, created the course two decades ago. It’s evolved but has always focused on “producing the top people in the country.”

To find out how, see:

Professor Hanke is also Special Counselor at the Center for Financial Stability.

Senator Richard Shelby Releases Draft of Financial Regulatory Reform Bill

Senate Banking Chair Richard C. Shelby (R-AL) released a draft of “The Financial Regulatory Improvement Act of 2015” that is intended to implement a wide variety of financial regulatory reforms and promote greater Congressional oversight of the Board of Governors of the Federal Reserve System (the “FRB”).

The bill is divided into 8 Titles that would implement the following reforms:

  • Title 1 concerns access to consumer credit and would (i) streamline certain bank examination and reporting requirements for community banks and (ii) exempt banks with less than $10 billion in assets from the Volcker Rule;
  • Title 2 concerns systemically important bank holding companies and would provide that only bank holding companies with over $500 billion in assets were designated automatically as systemically important, while bank holding companies with over $50 billion but less than $500 billion in assets would be subject to an individual determination by the FRB and the Financial Stability Oversight Council (“FSOC”) regarding their systemic importance;
  • Title 3 concerns FSOC’s designation process for systemically important non-bank financial companies and would impose detailed procedural requirements thereon;
  • Title 4 concerns insurance and would affirm Congressional intent that insurance activities be regulated primarily by the states under the McCarran-Ferguson Act of 1945;
  • Title 5 concerns the Federal Reserve System and would expand Congressional oversight regarding the activities of the FRB;
  • Title 6 concerns “tailored regulation” and would (i) facilitate the sharing of SEC and CFTC swaps data with foreign regulators and (ii) provide a grace period for any company that is transitioning out of the JOBS Act classification as an “emerging growth company”;
  • Title 7 concerns mortgage finance and would expand the Congressional oversight of securitization activities conducted by the Federal Housing Finance Authority (the “FHFA”); and
  • Title 8 concerns the Dodd-Frank Act and would enact various technical corrections.

The Senate Banking Committee is scheduled to mark up the legislation on May 21, 2015.

Lofchie Comment: Although the bill covers a lot of ground, it takes action in a particular way that we have supported steadily: in the greater formalization of the process by which FSOC is authorized to designate banks and non-banks as systemically significant. We have expressed the view consistently that the discretionary rules and secretive processes by which FSOC is able to designate entities are inconsistent with the rule of law.

ISDA CEO O’Malia Discusses Cross-Border Harmonization Issues

ISDA CEO Scott O’Malia authored the blog post “No Answer Yet to Cross-Border Concerns.” The piece focuses on the long-running negotiations between U.S. and EU regulators regarding mutual recognition of clearinghouses.

According to Mr. O’Malia, while U.S. and European regulators are continuing their efforts to reach agreement on clearing house rules, it seems an agreement is unlikely “before the third quarter at the earliest.” He explained that cross-border issues are of particular concern for ISDA members, since without an effective process for recognizing and deferring to comparable regimes, “globally active derivatives firms face the prospect of having to meet duplicative and potentially contradictory rules.” Mr. O’Malia stated that as a result, many members are opting to trade with counterparties in their own jurisdictions “leading to a fragmentation of liquidity along geographic lines.”

In the meantime, Mr. O’Malia noted that ISDA has been working hard on the harmonization issue, and has published principles in papers on CCP recovery, trade reporting and trade execution. He stated that abiding by these principles when developing rules “will increase the likelihood of substituted compliance/equivalence determinations.”

Lofchie Comment: Under its prior leadership, the CFTC bet heavily that if it rushed to adopt rules, other nations would be forced to follow, even though no consensus had been formed as to the rules adopted by the CFTC. The CFTC lost that bet as European and Asian regulators not only rejected the U.S. rules, but also took out their rejection on U.S. market participants; e.g., the refusal of the European regulators to give the same regulatory recognition to U.S. clearing houses as was given to Asian clearing houses. The consequence has been a diminution of the United States as a center for global finance (instead, the world’s finances are being siloed into the Americas, Europe and Asia as distinct markets). ISDA CEO O’Malia makes plain a number of the particulars.

CFTC Chair Massad has made some progress in healing the rift between U.S. and European regulators, but it does not seem likely that all of the damage can be undone. So long as European firms are likely to gain market share at the expense of U.S. firms if global markets are split, the Europeans are likely to continue to disagree with the imposition of the CFTC rules. At some point, it becomes sensible for U.S. regulators to concede to tolerating the European rules or to acknowledging that the world financial markets are being divided into three, with the consequent damage to our global economic position.

Senators Introduce Legislation Aimed at FRB Accountability

U.S. Senators Elizabeth Warren (D-MA) and David Vitter (R-LA) introduced the Fed Accountability Act (S. 1248), which is intended to increase independence of individual Governors on the Board of Governors of the Federal Reserve System (“FRB”) and to bring transparency by requiring a formal vote on all enforcement actions resulting in fines over $1 million.

According to the sponsors (the text of the bill is not yet posted on the Congressional website), the bill would allow each member of the FRB his or her own staff. Additionally, the bill would require a publicly recorded vote by FRB members on the resolution of any enforcement action that includes $1 million or more in payments.

The bill was introduced on May 7, 2015, and referred to the Committee on Banking, Housing, and Urban Affairs.

Lofchie Comment: What is odd about this bill is that it appears inconsistent with the manner in which Dodd-Frank’s Consumer Financial Protection Board (“CFPB”) was established, largely at the direction of not-yet-Senator Warren. That is, the CFPB was put under the FRB, with the CFPB’s budget and powers insulated from Congressional oversight. Further, because the CFPB was to be run by a single director, and not by a commission, there was no possibility of dissent within the organization, and obviously there was no need for a vote when there was only one vote. (Here is a link to a Huffington Post news story in which Senator Warren argues for keeping the CFPB outside of Congressional control. Here is a link to a Cadwalader Clients & Friends memo that we wrote three years ago raising policy questions as to the structure of the CFPB, particularly concerning the fact that it seemed to be structured as to be largely outside of the control of the three established branches of the government.)

Does Senator Warren’s sponsorship of this bill indicate a change in direction of her thoughts as to how the CFPB should be run or would she have it continue to operate in its current fashion? Furthermore, if one is not concerned about “groupthink,” doesn’t it follow that one should favor multi-member commissions (as we have at the SEC and CFTC), rather than the single-director structure of CFPB?

Senator Proposes Bill to Dissolve ”Too Big to Fail” Financial Institutions

Senator Bernard Sanders (I-VT) and Representative Brad Sherman (D-CA) introduced legislation (S. 1206) that is intended to address the “concept of ‘Too Big to Fail.'” The title of the bill is the “Too Big to Fail, Too Big to Exist Act.”

From the moment of its passage, the bill would give the Financial Stability Oversight Council (“FSOC”) 90 days to compile and submit a list of the entities it deemed “Too Big To Fail” to the Department of the Treasury, Congress and the President. Then, no later than one year after the enactment of the bill, the Secretary of the Treasury would “break up” the entities included in the “Too Big to Fail” list. The bill also would stipulate that any entity included in the “Too Big to Fail” list would be prohibited from using Federal Reserve financing and insured deposits (if the entity were an insured depository institution).

The bill was read twice and referred to the Committee on Banking, Housing and Urban Affairs.

Lofchie Comment: One ironic aspect of this document is that the principal entities that are deemed too big to fail are the swaps clearinghouses that were created by Dodd-Frank. It would be interesting to know whether Senator Sanders acknowledges that the passage of his proposal would unwind Dodd-Frank significantly.

Oddly, the proposed bill does not specify that the required breakup is limited to financial institutions. Although the preamble to the bill refers to “financial entities” (a term that is not defined in the bill), it defines an entity as “too big to fail” if the entity’s failure, “due to its size, exposure to counterparties, liquidity position, interdependencies, role in critical markets, or other characteristics or factors, would have a catastrophic effect on the stability of either the financial system or the United States economy without substantial government assistance.” Read literally, the bill could compel FSOC to lard its list with entities such as General Motors, which received government assistance during the financial crisis to prevent the damage that its complete failure would have done to the economy.

SEC Approves Pilot Program to Assess Tick Size Impact for Smaller Companies

The SEC approved a proposal by FINRA and the national securities exchanges (the “Exchanges”) for a two-year pilot program. The program would widen the minimum quoting and trading increments – or tick sizes – for the stocks of certain smaller companies.

The SEC stated that it plans to use the pilot program to assess whether wider tick sizes enhance the market quality of those stocks to the benefit of issuers and investors.

The pilot program will begin on May 6, 2016. It will include the stocks of companies with (i) $3 billion or less in market capitalization, (ii) an average daily trading volume of one million shares or less, and (iii) a volume weighted average price of at least $2.00 for every trading day.

The pilot program will involve a control group of approximately 1400 securities and three test groups with 400 securities in each selected by a stratified sampling. During the program:

  • pilot securities in the control group will be quoted at the current tick size increment of $0.01 per share and will trade at the currently permitted increments;
  • pilot securities in the first test group will be quoted in $0.05 minimum increments but will continue to trade at any price increment that is currently permitted;
  • pilot securities in the second test group will be quoted in $0.05 minimum increments and will trade at $0.05 minimum increments subject to a midpoint exception, a retail investor exception and a negotiated trade exception; and
  • pilot securities in the third test group will be subject to the same terms as the second test group and also will be subject to the “trade-at” requirement to prevent price matching by a person who is not displaying orders at the price of a trading center’s best “protected” bid or offer, unless an enumerated exception applies.

In addition to the exceptions provided under the second test group, an exception for block size orders and exceptions that mirror those under Rule 611 (“Order Protection Rule”) of Regulation NMS will apply.

The SEC explained that the Exchanges and FINRA will submit their initial assessments of the tick size pilot program’s impact 18 months after the program begins based on data generated during the first 12 months of its operation.

Lofchie Comment: It seems far-fetched to assume that widening tick sizes in small cap securities will result indirectly in an increase in the number of small cap companies that choose to go public. The notion hinges on the theory that if tick sizes increase, then market makers will make more money trading small caps, which will encourage underwriters to take small caps public, which will lead to small caps going public. The problem is that market makers are not the same as underwriters. Even if they are in the same legal entity, they are different profit centers, and there is no reason to believe that underwriters will take a company public because they hope that their firm will make money as a market maker in the issuer’s stock. Ultimately, the decision to go public is made by the issuer and not the underwriter. Despite being able to find an underwriter, many attractive issuers do not go public because the cost of doing so is greater than the amount of money they’re able to raise privately.

If the SEC wishes to create incentives for small companies to go public, then it should (i) reduce the regulatory burdens associated with going public and (ii) create a system in which broker-dealers that do research on small companies have the means to profit from the production of that research. This would encourage the production of information about small companies.

See: SEC Approval Order.

Professor Hanke’s Atelier: Reflections on the “Bullpen” and Raphael’s Workshop

Author Alexis Dawson Gaillard examines the teaching methods of Professor Steve H. Hanke, CFS Special Counselor and Co-Director of the Institute for Applied Economics, Global Heath and the Study of Business Enterprise at The Johns Hopkins University. Professor Hanke’s teaching methods are then compared to  Raphael Sanzio da Urbino’s instruction of his famous atelier.

In Professor Hanke’s experience, he has found that the one thing a professor can do is to introduce a student to the skills required to learn. This is the teaching methodology he implements in training his Bullpen students. Hanke begins a student’s training by stressing the most valuable and basic skills: writing and research methods.

After thorough research, Galliard discovers that Professor Hanke’s method of training clearly does mimic that of Raphael’s. Raphael not only created excellent art, but also prepared his assistants to become individual artists by cultivating their skills and stressing the importance of individuality. In this way, the ‘Bullpen’ is the modern equivalent of Raphael’s workshop. Professor Hanke instills a level of quality and commitment in each of his students that serves them forever. Both Raphael’s workshop and Hanke’s Bullpen result in an interdependent relationship between teacher and student.

The full paper can be found at:



SEC Grants WKSI Waiver

The SEC granted a waiver to a European bank from ineligible issuer status. The bank’s ineligibility was triggered by its criminal conviction for manipulating LIBOR in order to maintain its well-known seasoned issuer (“WKSI”) status.

The SEC explained that under Securities Act Rule 405, a firm’s WKSI status is automatically revoked because of its criminal misconduct absent a waiver from the SEC. In the SEC’s waiver order, the SEC determined that the bank “made a showing of good cause” and so would not be considered an ineligible issuer if it complied with the terms of a plea agreement.

SEC Commissioner Stein issued a dissenting statement regarding the SEC’s decision to grant a WKSI waiver to the bank, and asserted that the waiver “confers on the largest companies certain advantages over smaller companies.”

Lofchie Comment: The regular granting of waivers from statutory disqualification shows that the securities laws should be amended. Instead of being imposed on a WKSI automatically unless a waiver is granted, a disqualification should be imposed only where the SEC finds that it would serve a purpose. If the firm that violated the law has been adequately punished, then it is illogical to pile on an additional penalty for an unrelated activity.

Flawed Math on Student Loans

Aggregate student loan debt surpassed credit card debt in size for the first time in 2010. Since then, the gap has continued to grow and now exceeds $200 billion. Student loans (at over $1 trillion) are now the second-largest category of consumer lending, second only to home mortgage lending.

While the total pool has been growing, the share owned by the Federal government has grown even faster. In 2000, the government’s student loan was valued by the CBO at $149 billion; now, it exceeds $1 trillion. More than 90% of new student loans are being initiated by the government.

The rapid growth in the government’s portfolio can be traced to several policy changes: 

  • The government chose to largely remove banks from the lending process, following the financial crisis.  The commonly stated objective was to save of $60 billion in fees over ten years (though that number has been questioned by the CBO).
  • A decision was also made to expand the type of lending done without screening criteria.  Typically, student lending done by banks had involved application of some basic credit criteria, even if the government would ultimately own the loans.  Now, for the majority of loans, that is no longer the case.

What is the quality of this massive loan book, and what are the implications for both students and taxpayers?  The New York Times, on March 22 of this year, noted that “many” of these loans “appear to be troubled.” 

Unfortunately, it’s difficult to know exactly how bad the problem is.  The Federal government’s own lending is exempt from the stringent loan forecasting, accounting, and reporting requirements that apply to lending by financial institutions.   The March 22nd Times article noted that the Fed has had to resort to purchasing student loan data from credit bureaus in an attempt to get some metrics on this portfolio.  The Education Department does not provide even basic vintage delinquency data to the agencies that oversee the financial system.   This is ironic, given that Federal reporting requirements for banks have grown massively since 2008, and reporting of more than 100 data elements is now required at the individual loan level on a monthly basis.

Another unknown is equally troubling.  It’s really not clear whether the expertise to manage this kind of portfolio exists within the Education Department.  Consumer lending is primarily driven by technology and analytics.  These tools work best when deployed by staff with deep expertise in management of risk assets.  Has the Federal government had the time (or budget) to invest in the massive loan tracking and management systems that underlie the operations of consumer banks?  Constant updating of data (both from the students themselves and external sources) should be taking place, leading to frequent loan-level modeling of default risk.  This type of modeling could drive targeted rollout of both pre-delinquency and early delinquency programs.  Such programs could potentially aid borrowers before it’s too late.  

Proactive management of this $1 trillion portfolio is crucial, both for the borrowers and the lenders (the taxpayers).  It’s important that the implications of this coming wave of defaults for future Federal budgets be clearly understood.  How much of a loss do we expect to take?

It is particularly hard to know the answer to the last question, as the CBO is required to use an unusual method of accounting for these loans.  They have released quite a few reports noting that fair value accounting would yield a much less favorable assessment of the Federal loan book.  A recent report documented a negative swing of over $200 billion.  Crucially, these estimates are being made without the benefit of true credit quality data, which should underlie forecasting on all risk assets.  The real “hole” may be much worse.  And the problem is just kicking in, as the no-payment grace period is just now expiring on many of the loans made in recent years.

Good intentions followed by poor execution can bring damaging results. 

Some years back, the idea of providing a way for most Americans to own homes sounded very appealing.  But the result was a situation in which many lower incomes households became excessively leveraged and terribly illiquid.  Many were badly harmed when housing prices started to drop, and suffered further pain when the job market tanked.   In its execution, these home ownership programs seemed to end up hurting some of the very folks that they had been intended to help.

More recently, the idea of extending a loan to anyone who qualified for college also sounded appealing.  However, not all courses of study will provide sufficient additional income potential to ensure payback.  Both the economic value of the asset (the degree itself) and the available credit data on the borrower should have been considered when lending was expanded.  Finally, and more controversially: interest rates on Federal student loans should have been varied in relation to the risk of the loan.  This is Risk Management 101.  By not doing this, the government is essentially admitting upfront that they plan to subsidize loans to riskier borrowers, or in areas of study that do not typically bring large returns.  Our national policy on this point should have been debated openly.  College tuition grants should be done explicitly, in accordance with a comprehensive policy framework, not through the back door (and not in a way that demeans students by first having them default on obligations).

It’s worth noting that household debt can be discharged in bankruptcy court.  However, Federally-backed student debt cannot.  Many students who were given loans initiated without appropriate risk assessment face a situation in which repayment will be difficult, and legally available opportunities to reset their obligations will be few.  It seems likely that the rules governing discharge will have to be changed.  As noted, loan forgiveness programs will doubtless be greatly expanded, and a sizable portion of this $1 trillion loan book will likely be written off.   The impact to the lives of the graduates in question will be severe, as discharges and forgiveness programs must be reported to the bureaus.  Credit scores will drop hugely as a result.  The graduates in question will therefore find it harder to get jobs, credit cards, car loans, and even apartments.  Credit scores are routinely checked in relation to many transactions these days, including potential offers of employment.

The longer we wait to face this growing problem, the more future graduates (and taxpayers) we will put at risk.  The bell is ringing.  It’s time to get the math right on student loans.

For a pdf version:

FINRA CEO Testifies before House Financial Services Committee

The House Financial Services Committee held a hearing titled, “Oversight of the Financial Industry Regulatory Authority,” which examined FINRA’s oversight of financial markets. FINRA CEO and Chairman Richard Ketchum was the sole witness at the hearing.

During the hearing, Mr. Ketchum stated that FINRA will not move forward with its Comprehensive Automated Risk Data System (“CARDS”) proposal until FINRA has determined that the concerns that have been raised in the comments of market participants have been adequately addressed.

SIFMA’s Executive Vice President and General Counsel, Ira D. Hammerman, issued a statement commending FINRA for “recognizing the industry’s concerns” regarding clients’ sensitive information and the “burden of building yet another reporting system.”

Lofchie Comment: Mr. Ketchum should be commended for taking a go-slow approach to a regulatory initiative (CARDS) that he had previously favored and for being willing to address the reasonable concerns that have been raised with respect to it. There is nothing in the least wrong with regulators proposing rules that meet opposition; the problem is when they don’t listen to those opposing views that legitimately highlight problems. We also believe that Mr. Ketchum’s willingness to slow down on this issue is consistent with FINRA’s ongoing effort of performing more in the way of economic analysis before it adopts new regulations, as discussed in the portion of his testimony titled “Rulemaking, Economic Analysis and Retrospective Rule Review.”

We also note that Mr. Ketchum’s written testimony provides a good overall description of FINRA’s responsibilities.