GREEK PROBLEMS AND THE WAY FORWARD

 

By Benoît Cœuré

As you know, in recent weeks the Greek authorities have made significant progress in adopting measures to finalize the second review of the ESM program. Discussions on medium-term debt measures and a new IMF program are ongoing and expected to be concluded in the weeks ahead.

I will explain why timely clarity on debt measures and debt sustainability is important – not only to restore trust in public finances but also to help rebuild confidence in the Greek economy more generally, and the financial sector in particular.

But I would first like to focus on one element of the Greek adjustment programme where I believe the ECB’s advice is of particular relevance – the financial sector strategy.

Financial sector reforms are a key element of macroeconomic adjustment programmes, for one simple reason: any sustainable economic recovery needs to be supported by an adequate supply of credit. Without credit, firms may not be able to invest in productive capital, create new employment or cover ongoing expenses.

A healthy credit supply is also important for our monetary policy to filter through to households and firms: it is one of the main ways in which we can affect bank lending conditions and, ultimately, price developments. Indeed, the broad-based and solid recovery we are currently observing in the euro area economy owes much to our policy measures having been effective in repairing the bank lending channel – that is, in overcoming credit supply restrictions and in bringing bank lending rates down to levels consistent with our monetary policy stance.

Greece is a sad exception, unfortunately. Bank loans to the domestic non-financial private sector have contracted in every quarter since end-2008 and by a cumulative 28% up until the end of last year. And although the level of loans to the private sector has stabilised recently, rates on loans to firms are still some 250 basis points above the current euro area average.

This means, of course, that there is still important work to do to allow credit to become a net contributor – rather than an impediment – to growth in Greece and to allow the Greek economy to reap the full benefits of the firming and broadening euro area recovery. But still, we have seen progress.

The situation of Greek banks has improved in several ways since the summer of 2015 when the third programme was negotiated. Capital adequacy, for example, has been strengthened from CET1 ratios of around 11% in the third quarter of 2015 to around 16-17% at the end of last year, following the successful recapitalisation of the four main banks in late 2015. Bank governance has also improved, as shown by the significant changes in the composition of Greek bank boards over the past year. And, importantly, bank profitability recovered in 2016 after years of substantial losses. The average return on assets improved from -1.9% in 2015 to 0.1% in 2016, based on continued operations.

What, then, are the main obstacles that still need to be overcome?

I would argue that they are mainly related to the fragile state of banks’ balance sheets – on both the asset and liability sides.

Let me start with the asset side.

As you know, non-performing loans (NPLs) are a problem in many euro area countries. But in Greece 45% of all bank loans are non-performing. They severely depress the profitability of banks and their ability to extend new, productive loans to firms and households.

Decisive and rapid action is therefore needed. The roadmap was drawn up last year when ECB Banking Supervision agreed with the four main Greek banks on a 50% reduction in their NPL stock by the end of 2019.

Progress so far has been broadly in line with agreed targets, but NPL objectives for this year and the next two years are ambitious. A step change in NPL resolution activities will be needed – in particular after the weak performance in the first months of 2017 that was, in part, also due to the uncertainties related to the delay in the second review.

But I am happy to see that the Greek authorities recently passed several important pieces of legislation to support NPL resolution. Full and timely implementation of these reforms in the months ahead will be crucial to support the required step change in NPL resolution efforts.

Let me highlight three elements that are of particular importance:

First, the overhaul of the out-of-court workout framework. This element is of particular importance in Greece, where many firms are heavily indebted both to banks and the state.
Second, legal provisions to facilitate debt restructuring agreements by reducing the liability of the individuals involved.
And third, after many delays, a framework for electronic auctions for the recovery of claims. An electronic auction platform has become increasingly important as physical auctions have essentially come to a standstill, which has caused significant losses for creditors, debtors and the economy as a whole.

Let me now briefly turn to the liability side of banks’ balance sheets.

Deposits are the cornerstone of any sound banking system. A stable deposit base allows banks to engage in maturity transformation and to extend credit to the real economy.

So far, however, there is no evidence of a sustained return of private deposits in Greece. Since the summer of 2015, when capital controls were imposed, private sector deposits have only recorded a modest 2.5% increase. They remain some 25% below their levels at the end of 2014 before deposit outflows accelerated noticeably.

The upshot is that Greek banks still rely to a significant extent on central bank funding. Although recourse to our facilities, including emergency liquidity assistance, has fallen from 41% of total assets in June 2015 to around 21% of assets today, total central bank funding still amounts to more than 35% of Greek GDP.

Part of the reduction in central bank funding is attributable to improved access to wholesale financing. This is certainly good news. Greek banks have gradually returned to the interbank market and were able to perform repo transactions with a wide range of mostly international counterparties – also thanks to the ECB, in June last year, reinstating the waiver affecting the eligibility of Greek government-related assets for Eurosystem monetary policy operations.

But for credit to become a vital source of economic growth in Greece again, a lot will depend on banks being able to regain the trust of private depositors and rebuild stable funding lines in wholesale funding markets.

Of course, this is not only in the hands of banks. Broader macroeconomic stabilisation is essential, as I will explain in a second. But banks need to contribute actively to this process by making further progress in repairing the asset side of their balance sheets – that is, by reducing the amount of non-performing loans.
Debt sustainability and the public sector purchase programme

Restoring confidence, of course, also means dispelling uncertainty about the sustainability of Greek government debt – and this brings me back to my opening remarks. I think we all agree that uncertainty about high public debt levels has undermined confidence in the Greek economy in general, and the financial system in particular.

In this respect, we regret that no clear definition of debt relief measures was reached at the last Eurogroup meeting. Discussions are ongoing, but in my view it is important that an agreement is reached at the Eurogroup meeting on 15 June.

According to the framework agreed in May last year, debt measures would be implemented in mid-2018, at the end of the programme. But being sufficiently clear on the measures today would help frontload many of the beneficial effects, in particular the rebuilding of confidence of both the international and domestic community in the ability of the Greek economy to return to a path of normality and stability.

Clarity about debt measures is also a necessary condition for Greek government bonds to be potentially eligible under the ECB’s public sector purchase programme (PSPP).

In June last year, the Governing Council clarified that it would examine possible purchases of Greek government bonds under the PSPP, taking into account the progress made in the analysis and reinforcement of Greece’s debt sustainability, as well as other risk management considerations. Any decision by the Eurosystem will be taken independently and autonomously.

This means that one important element in our deliberations is our assessment of the sustainability of Greece’s public debt. But we can only make an informed assessment if we have a clear view of the nature and extent of the envisaged debt measures. Then we can assess how much they would contribute to the sustainability of Greek debt. In other words, we need a sufficient degree of specificity. And as for any other decisions, we will look at all the relevant information. The IMF’s debt sustainability analysis will be an important input in this respect.

To bring the Greek program to a successful conclusion it is essential that the Greek authorities continue to show a serious commitment to the goals set and measures taken in the context of the programme. Only with such a commitment can all stakeholders be confident that reforms will be strengthened in the aftermath of the programme and not reversed.

At the same time, other stakeholders have to do their part to put in place the conditions that will ultimately allow the Greek banking system to fully recover and to enable the country to return to the financial market.

These efforts are not only about Greece – they are also about the euro area as a whole. Based on currently available information, Greece is the only euro area country whose economy contracted, albeit marginally, at the start of this year, despite the cyclical recovery becoming increasingly solid and broad-based – thanks in large part to our monetary policy measures, which have led to a pronounced easing of financing conditions and a convergence of funding costs across countries. But convergence will only be achieved if all euro area countries are involved.

I therefore encourage all parties to continue working hard on making the program a complete success.

MOON HISTORY

 

By Lucas Laursen

As new moon-going efforts ramp up, space explorers must remember to safeguard what humans left there previously — and also study it before it’s too late.

The next several years are shaping up to be busy ones for the moon, with no fewer than 15 landings in the works. That includes the robotic missions soon to be undertaken by five privately funded teams vying for the $20 million Google Lunar XPRIZE, in which the contestants must land a rover on a pre-planned spot, move it at least 500 meters “along an interesting path in a deliberate manner,” and transmit video and other data back to Earth. In fact, tracks from the Google Lunar XPRIZE (GLXP) rovers could be the next intentional tracks to be made by humans on the moon’s surface.

But amid the excitement of exploring the moon, we can’t overlook our lunar heritage, says Derek Webber, a commercial space exploration consultant and former satellite engineer. After all, humanity’s past isn’t just what has been left here on Earth — it’s in space, too. “Lunar heritage is the record of when we first reached the moon, and it captures the epoch-making reality of what happened back then,” he says. The US alone has 58 years’ worth of human-created artifacts on the moon, including flags and footprints (America’s last human-led trip there was the Apollo 17 mission in 1972). Here’s why we should be thoughtful about what we do with them.

Don’t worry. NASA’s got a (tentative) plan. The basis of international space law is the 1967 Outer Space Treaty, which has been signed by 106 nations and states that while the planets and celestial bodies belong to all countries, artifacts in space are owned by the governments that launched them. In 2011, NASA issued an initial set of recommendations on best practices for America’s moon heritage sites, which include the locations where the Apollo missions landed. The guidelines address such questions as how far a rocket should stay away from heritage sites during its landing approach (two kilometers) and how far a rover on the ground should stay from objects to minimize the odds of an accident (one to three meters, depending on the item). However, these aren’t formal rules, and they pertain only to US equipment. So it will take cross-border cooperation and goodwill to ensure that the next wave of explorers act responsibly.

There’s tons of stuff on the moon — and a ton of valuable information. It’s estimated that up to 400,000 pounds of human-made debris have been deposited on that celestial body. The American stuff includes five national flags, a gold olive branch (which was left by the Apollo 11 crew in 1969 as a gesture of peace), discarded packaging from meals, used wet wipes, and dozens of spacecraft, both intentionally and accidentally crashed. And, of course, there are the other less visible but no less important souvenirs of America’s impact on the moon, such as the footsteps of Neil Armstrong, Buzz Aldrin and the 10 other US astronauts who have walked on the moon. “There’s a whole lot of data to get from those sites and objects,” says University of South Florida planetary physicist Phil Metzger, who was involved in writing the NASA guidelines. Researchers could study crashed spacecraft to determine why they stopped working, and the successfully landed vehicles could yield information about space weathering under temperatures that veer from +200 to -200 Celsius. “We want to know how different materials have held up in the space environment,” says Metzger. Even assessing the amount of dust collected on items can tell us about the flux of micrometeorites, which will shed light on how the lunar surface was formed and how the solar system works.

Space heritage won’t last forever. If lunar heritage sites attract robotic or human pilgrims, they’re likely to degrade faster. Since the GLXP competition is aimed at developing low-cost methods of space exploration, “my biggest concern is that [the GLXP missions are] being done on a shoestring, says Roger Launius, former senior curator at the Smithsonian National Air and Space Museum in Washington DC, and the author or editor of 26 books on space. He believes the less money the teams have to spend, the less likely the guidance technology for their landers and rovers is to work. One important question to consider is whether NASA can realistically protect the sites while at the same time being able to conduct any necessary science experiments and make them accessible to future space tourists.

Moon visitors could help provide answers. GLXP teams have been asked to follow NASA’s guidelines, so its recommendations will undergo real-life testing. Teams can win bonus prizes of up to $4 million for producing high-quality video and photographic documentation of heritage sites, so competitors will be motivated to come up with ways to approach the areas without harming them. After the upcoming missions by GLXP teams and by other governments and entities, NASA can “review their work and add aspects to take care of omissions as future knowledge emerges,” says Webber. Flexibility is essential — since so much of the moon has not been very well-explored, “there’s no possible way we could be smart enough to write really good guidelines at this point,” adds Metzger.

Space conservation efforts must strike a balance between past, present and future. Since outer-space spots are not yet tourist destinations, people with the moon bug must settle for digital substitutes now and in the near future — Google offers 3D tours of the Moon through Google Earth and the Smithsonian is planning to incorporate virtual reality into its future Apollo exhibits. At the same time, though, governments must prepare for the inevitable reality of space travel and make plans to protect their country’s artifacts on the moon. A goal should be “to tell that story in the best possible way with the best preserved site possible,” says Launius.

In terms of models, at one extreme are the Churchill War Rooms — the London space where Winston Churchill and the British Cabinet did their plotting during World War II and which is open to the public as a museum. The Rooms are “a good example of halting time, as it were, and preserving a moment and place of history,” Webber says. At the other extreme is Stonehenge, where ongoing attempts to provide access to visitors have created new layers of changes to the site. Regardless of what decisions the next visitors to space heritage sites make, one thing is certain — they probably won’t please everyone. “There will always be a tension between those wanting to protect the past, and those wanting to keep moving forward,” Webber says.

QUASI-APPRAISAL REMEDY AND POST-CLOSING CLAIMS

By Ignacio E. Salceda

On May 11, 2017, Chancellor Andre G. Bouchard of the Delaware Court of Chancery issued another noteworthy opinion, dismissing with prejudice post-closing merger claims in In re Cyan, Inc. Stockholders Litigation.  The case arose out of the August 2015 acquisition of Cyan, Inc., a networking solutions company, by Ciena Corporation through a mostly stock-for-stock transaction, consisting of 89 percent stock and 11 percent cash. Before the deal closed, shareholder plaintiffs filed five lawsuits in the Court of Chancery, which were later consolidated. The plaintiffs did not seek expedited injunctive relief; rather, they elected to pursue damages for their process and disclosure claims post-closing. Specifically, the plaintiffs’ amended complaint asserted two counts for: (1) breach of fiduciary duty against Cyan’s seven-member board in connection with approval of the merger; and (2) equitable relief in the form of “quasi-appraisal.”

There are three main takeaways from the decision. First, this decision is yet another example of the Court of Chancery’s application of the rule announced by the Delaware Supreme Court in Corwin v. KKR Financial Holdings LLC,  which held that the business judgment rule is the standard of review when a fully-informed, uncoerced vote of disinterested stockholders approves a transaction. Second, the decision demonstrates that if plaintiffs wish to bring disclosure claims post-closing, they will have to be able to identify actual material omissions, and not merely plead laundry lists of disclosure violations that are not material or that are of the “tell me more” variety. And finally, the Court of Chancery made clear that “quasi-appraisal” is a remedy for a breach of fiduciary duty and that “artful pleading” is not a viable path to circumvent exculpation from monetary liability provided to directors by 8 Del. C. § 102(b)(7).

The court dismissed Count One on two alternative grounds. First, the court held that the plaintiffs failed to plead a non-exculpated breach of fiduciary duty. Observing that enhanced scrutiny under Revlon did not apply to the mostly stock-for-stock transaction, the court’s analysis turned on whether the plaintiffs pled that a majority of the board was interested or acted in bad faith. The court rejected the plaintiffs’ argument that the directors were conflicted because they allegedly harbored a desire to find a buyer with “deep pockets” to ensure they would not be personally liable in the event of an adverse judgment in an unrelated pending securities class action. The court concluded this theory was doomed because it was based on the factually erroneous premise that, among other things, the directors faced significant exposure in the securities action and were not adequately protected by existing indemnification obligations and D&O insurance. The court also rejected the argument that three of the directors were motivated by a desire to receive make-whole payments triggered by the merger from certain convertible notes they held, because these same directors also had significant Cyan stock holdings, and in any event, were not a majority of the seven-member board. Finally, the court held that it was not bad faith to have rejected a demand from the plaintiffs to supplement the proxy in July 2015, shortly before the scheduled stockholder vote where that letter alleged disclosure deficiencies that were not material.

The Court of Chancery also dismissed Count One on the alternate ground that the fully informed, uncoerced vote of 98 percent of voting Cyan stockholders in favor of the merger invoked the protection of the business judgment rule, citing Corwin. In doing so, the court examined the plaintiffs’ “three strongest disclosure claims”—which the court requested plaintiffs’ counsel identify shortly before oral argument on the motion to dismiss—and found none to have been material. The court rejected the plaintiffs’ claim that the proxy failed to disclose adequately Cyan’s dependence on its largest customer because the proxy did disclose this fact in detail, including by incorporating by reference extensive prior disclosures concerning that customer in Cyan’s SEC filings. Recognizing that documents incorporated by reference can be part of the “total mix of information available to stockholders,” the court held that this was a case where such incorporation was appropriate, as “the language incorporating the Form 10-K and Form 10-Q appears in a section of the Proxy where stockholders reasonably could expect to find the relevant information, and … the information was conspicuously laid out in the incorporated documents so that a reasonable stockholder reading the Proxy could find it without difficulty.” 

Finally, the Court of Chancery dismissed the plaintiffs’ “claim for equitable relief” seeking the “remedy of quasi-appraisal” based on the disclosure allegations in the complaint. Citing In re Orchard Enterprises, Inc. Stockholder Litigation,  the court first reiterated that “quasi-appraisal” is a remedy that may be appropriate when a fiduciary duty breach is based on disclosure violations. Further, despite the plaintiffs’ characterization of the cause of action as “frustration of the statutory right of appraisal,” the court observed that the underlying cause of action was, in substance, breach of the fiduciary duty of disclosure. Because the court had already rejected the plaintiffs’ disclosure claims and concluded that the plaintiffs failed to allege a non-exculpated breach of fiduciary duty, Count Two was barred by Cyan’s exculpatory charter provision adopted pursuant to Section 102(b)(7). The court held, “When the cause of action supporting plaintiffs’ request for a quasi-appraisal remedy is for breach of a fiduciary duty, plaintiffs cannot circumvent the protection afforded in Cyan’s certificate of incorporation through artful pleading.”

PROXY SEASON HALF-TIME

By John Roe

With peak meeting day in the rear-view window and wrapping up the last of the four busiest meeting days of the year today, more and more issuers are reporting their meeting results—and it’s time to take stock of what the numbers are telling us. Through today and among Russell 3000 companies, ISS has issued recommendations on more than 22,000 ballot items at 2,244 companies. And voting results are coming in quickly—we’re calling this proxy season “half-time” because, as of today, just over half—52.4% – of the Russell 3000 has disclosed 2017 shareholder vote results.

Director elections top-of-mind, with thirteen nominees failing to receive majority support

Overall, director election results through mid-season have been strong. The median director across all 10,400 director elections where results are available has enjoyed 98.5% shareholder support. To date, 140 directors have received less than 70% shareholder support, with a total of 375 directors receiving less than 80%—potentially indicating broad dissent.

A total of eleven directors at eight companies have received less than majority support year-to-date. Two S&P 500 firms—AvalonBay Communities and Scripps Networks Interactive—are among those with directors receiving less than majority support. At AvalonBay Communities, the affected director has offered to resign, but the board is not obligated to accept the resignation. According to a company filing, “the Board of Director’s [sic] decision as to whether to accept his offer to resign and the basis for the Boards’ [sic] decision will be disclosed no later than August 16, 2017.” Scripps Networks, on the other hand, has no such policy, and disclosed that the minority-supported director has been elected to serve through next year’s annual meeting.

Say-on-pay off to a strong start, though eight companies have failed to receive majority support

Shareholder support levels for say-on-pay continue to be strong, as more issuers focus on increased shareholder engagement, better disclosure, and improved performance-oriented pay programs. The median support rate across the full Russell 3000 stands at 96.1% so far this year, virtually unchanged from 2016.

However, the news at eight companies’ meetings was not as favorable. These firms failed to reach majority support for their say-on-pay proposal:

  • American Axle & Manufacturing Holdings, Inc.
  • ConocoPhillips
  • Immunomedics, Inc.
  • Microsemi Corporation
  • Nuance Communications, Inc.
  • Senior Housing Properties Trust
  • Sprouts Farmers Market, Inc.
  • Whitestone REIT

A total of 75 Russell 3000 constituents have failed to reach the critical 70% level of support, indicating a broad degree of dissent for executive pay among the shareholder base.

Shareholders strongly favoring annual say-on-pay frequency

Say-on-pay frequency votes, appearing again on ballots in bulk after a 6-year hiatus, are heavily favoring annual votes (as reported in the April 27 edition of Governance Insights). Among the 1,121 say-on-pay frequency vote results cataloged thus far, 1,033—more than 92%—have reflected shareholders’ preference for annual votes.

Thirty-two Shareholder Proposals Received Majority Support

Proxy access continues to show its popularity with shareholders, with 13 majority-supported proposals in the books so far this year. Perennial topics such as requiring a simple majority vote standard, adopting favorable special meeting rights, and enabling shareholders to act by written consent remain popular—but the real change we’re seeing so far this year is in the support level for environmental and social issues.

So far in 2017, majority support was reached for two climate change-related proposals, at Occidental Petroleum and PPL Corporation, and a gender diversity proposal at Cognex Corporation. And, shareholders at Pioneer Natural Resources approved a proposal asking the company to provide an annual sustainability report. These vote results may signal a more active stance among large investors towards environmental and social issues.

Another 800 meeting results likely coming soon

Although more than half of proxy season vote results are now disclosed, quite a few remain. Over the next seven weeks, we expect more than eight hundred more meeting vote results to be published. Stay tuned for ISS’ post-season reports, where the remainder of proxy season results will be analyzed.

WHAT’S WRONG WITH CREDIT RATINGS

Frank Partnoy headshot

By Frank Partnoy

Scholars and regulators generally agree that credit rating agency failures were at the center of the 2007-08 global financial crisis. Government investigations found that the credit rating agencies, particularly Moody’s and S&P, were central villains and that the crisis could not have happened without their misconduct. The Financial Crisis Inquiry Commission called the ratings agencies “key enablers of the financial meltdown.” The U.S. Senate Permanent Subcommittee on Investigations concluded: “Inaccurate AAA credit ratings introduced risk into the U.S. financial system and constituted a key cause of the financial crisis.” The Securities and Exchange Commission and the President’s Working Group on Financial Markets reached similar conclusions.

In 2010, Congress passed the Dodd-Frank Act, which required federal agencies to replace regulatory references to credit ratings with “appropriate” substitutes. Dodd-Frank amended the securities laws to enhance the accountability and transparency of credit rating agencies and to create a new Office of Credit Ratings within the SEC to oversee them. In addition, federal and state prosecutors settled cases against S&P and Moody’s, and there were a handful of private investor lawsuits.

My overarching point in What’s (Still) Wrong with Credit Rating Agencies is that these reforms have had little or no impact, and that therefore the same credit rating-related dangers, market distortions, and inefficient allocations of capital that led to the crisis potentially remain. The major credit rating agencies are still among the most powerful and profitable institutions in the world. The market for credit ratings continues to be a large and impenetrable oligopoly dominated by two firms: Moody’s and S&P. And yet credit ratings are still as uninformative as they were before the financial crisis. Simply put, credit ratings remain enormously important but have little or no informational value.

In this article, I document four main points. First, although Congress attempted to remove credit rating agency “regulatory licenses,” the references to ratings in various statutes and rules, regulatory reliance on ratings remains pervasive. Regulated institutions continue to rely mechanistically on ratings, and regulations continue to reference ratings, notwithstanding the Congressional mandate to remove such references.

Second, although Congress authorized new oversight measures in Dodd-Frank, that oversight has been ineffective. Annual investigations by the Office of Credit Ratings have uncovered numerous failures, many in the same mortgage-related areas that precipitated the financial crisis, but regulators have imposed minimal discipline on violators. Moreover, because regulators refuse to identify particular rating agencies in their reports, wrongdoers do not suffer reputational costs.

Third, although Congress authorized new accountability measures, particularly removing rating agencies’ exemptions from Section 11 liability and Regulation FD, the Securities and Exchange Commission has gutted both of those provisions. The SEC performed an end-run around Dodd-Frank’s explicit requirements, reversing the express will of Congress. Litigation has not been effective as an accountability measure, either, in part because rating agencies continue to assert the dubious argument that ratings are protected speech. I argue that the SEC should reverse course and implement Congress’s intent, including encouraging private litigation.

Fourth, given the ongoing problems in these three areas, it is no surprise that credit rating agency methodologies remain unreliable. I show in detail how current methodologies are weak and nonsensical, particular in the treatment of diversification and investment holding companies. Neither regulators nor investors should rely on such crude and uninformative methodologies.

In sum, both regulators and investors should reduce reliance on credit ratings, and regulators should implement Congress’s will with respect to rating agency oversight and accountability. Credit rating agencies are a cautionary example of regulatory stickiness: reliance on ratings has proven difficult to undo. More generally, the stickiness of regulatory licenses is a warning for policymakers who are considering deferring to private entities for regulatory purposes in other areas.

Leading institutional investors and analysts of corporate bond credit risk have long employed far more subtle and sophisticated methods than those reflected in the credit rating agencies’ methodologies. A modern sophisticated assessment of corporate bond credit risk could include not only analysis of market prices and related variables, but also option-adjusted valuation and risk assessment, simulations of income statement variables, stress tests of risk factors, and detailed consideration of recovery rates. Market participants should rely less on credit ratings and more on fundamental factors, such as market measures of credit risk, financial measures of leverage and profitability, accounting measures of earnings and cash flow, and worst-case scenario analysis with respect to both individual credits and portfolios.

Letter ratings are a crude mechanism for information intermediation. Letter ratings obscure the analysis of the key variables that matter in the analysis of credit: probability of default, expected recovery in the event of default, and the correlation of defaults. The methodologies I critique in this article are disconnected from that analysis. If the markets experience another crisis related to credit ratings, and ratings prove again to have been “garbage out,” then during the next regulatory response it will be important to understand more clearly the role of the “garbage in” (i.e., rating agency methodology).

Enough time has passed since the financial crisis and the resulting legal reforms to assess how much the credit rating industry has changed. The answer: not much. The major credit rating agencies continue to generate little informational value, and yet be rewarded handsomely for their ratings. They continue to operate as an oligopoly with special regulatory treatment. Congress should not permit the rating agencies—and the SEC—to flout Dodd-Frank. But even if Congress remains silent, investors should respond by reducing their reliance on credit ratings.

PAY-TO-PLAY BRIBERY SCHEMES

Joon H. Kim, the Acting United States Attorney for the Southern District of New York, announced today that DEBORAH KELLEY, a former managing director of institutional fixed income sales at a New York-based broker-dealer (the “Broker-Dealer”), pled guilty today before U.S. District Judge J. Paul Oetken for participating in a “pay-to-play” bribery scheme involving the New York State Common Retirement Fund (“NYSCRF”), the nation’s third largest public pension fund. 

Kim said:  “As she admitted today, Deborah Kelley bribed Navnoor Kang to steer state pension business to her brokerage firm, reaping hundreds of thousands of dollars in additional commissions for the firm.  In the process, she was complicit in defrauding New York pensioners and depriving them of Kang’s honest services.  The hard-earned retirement savings of New Yorkers should not be a vehicle for corrupt pension administrators and securities brokers to profit.”

According to allegations contained in the Indictment charging KELLEY and statements made during her plea proceeding:

The NYSCRF is a pension fund administered for the benefit of public employees of the State of New York.  From January 2014 through February 2016, Navnoor Kang served as Director of Fixed Income and Head of Portfolio Strategy for the NYSCRF.  In that capacity, Kang was responsible for investing more than $53 billion in fixed-income securities on behalf of the NYSCRF.  Kang owed a fiduciary duty to the NYSCRF and its members and beneficiaries, and was required to make investment decisions in their best interests and free of any conflict of interest.  New York State law and NYSCRF policies prohibited Kang and other NYSCRF employees from receiving any bribes, gifts, benefits, or consideration of any kind, as KELLEY well knew.

The Scheme to Steer NYSCRF Fixed-Income Business in Exchange for Secret Bribes

From 2014 through 2016, Kang, KELLEY, and others participated in a scheme to defraud the NYSCRF and its members and beneficiaries, and to deprive the NYSCRF of its intangible right to Kang’s honest services.  The scheme involved, among other things, an agreement among Kang, KELLEY, and others to pay Kang bribes – in the form of entertainment, travel, and lavish meals, among other things – in exchange for fixed-income business from the NYSCRF.  Such bribes were strictly forbidden by the NYSCRF, and were paid secretly and without any disclosure to the NYSCRF and its members and beneficiaries concerning the conflicts of interests inherent therein. 

In exchange for the bribes paid by KELLEY, Kang used his position as Director of Fixed Income and Head of Portfolio Strategy at the NYSCRF to promote the interests of KELLEY and her brokerage firm.  Kang, in exchange for the bribes he received, agreed to steer fixed-income business to the Broker-Dealer.  In so doing, Kang, with KELLEY’s knowledge and approval, breached his fiduciary duty to make investment decisions in the best interest of the NYSCRF and its members and beneficiaries, and free of conflict, and deprived the NYSCRF of its intangible right to Kang’s honest services.  

As KELLEY paid bribes to KANG, the Broker-Dealer’s fixed-income business with the NYSCRF skyrocketed.  The value of NYSCRF’s domestic bond transactions with the Broker-Dealer increased from zero in the fiscal year ending March 1, 2014, to approximately $156 million in the fiscal year ending March 1, 2015, and to approximately $179 million in the fiscal year ending March 1, 2016.  Kang’s trades resulted in the payment of hundreds of thousands of dollars in commissions to the Broker-Dealer, of which KELLEY personally earned approximately 35 to 40 percent.

In recent years, citizens’ concerns about corruption in the public sector have become more visible and widespread. From São Paulo to Johannesburg, citizens have taken to the streets against graft. In countries like Greece, Pseudo-Macedonia, Romania, Chile, Brazil, Guatemala, India, Iraq, Malaysia and Ukraine, they are sending a clear and loud message to their leaders: Address corruption!

Policymakers are paying attention too. Discussing the “C word” has long been a sensitive topic at inter-governmental organizations. Defining corruption may seem easy. Most people will have the sense that they know it when they see it. For example, a public official takes a bribe in exchange for providing a financial or political gain.

However, experts increasingly consider corruption to be much broader. Rather than merely being a transaction between two parties, corruption can be viewed as the privatization of public policy. Powerful elites in business and politics collude to control public institutions, capture the policy-making process, and monopolize government contracting and procurement. Defined corruption even more broadly is the lack of impartiality in government, where public money and authority are used in ways that impact negatively on human well-being.

The direct economic costs are obvious to most people. Demand for bribes by providers of services affects achievement of social outcomes. The bribe to the taxman that reduces public revenues, and lowers government’s provision of public services. A school that is not built because the allocated funds have been misappropriated. Yet, the indirect costs are likely to be economically far-reaching. Corruption has a negative impact on economic growth through, for example, the over-investment in rent seeking, the underinvestment in productive activities, and the perpetuation of inefficient policies, among other things. The economic costs of corruption, which by the way afflicts countries at all stages of development, are substantial. The global cost of bribery alone is three trillion euros, in the order of four percent of the world’s current GDP. There is a strong correlation between lower levels of corruption and long-term improvements in GDP per capita and in human development indices. In sum, corruption is a tax on growth and investment.

Moreover, the costs are not only economic in nature. Corruption also contributes to the loss of public trust in government, higher levels of inequality in political influence, the deterioration of public values and, ultimately, to the diminution of citizens’ well-being or quality of life. These non-economic costs create a vicious cycle of under-performance of the public sector that is harmful to the economy in the long-term.

Given how broadly corruption and its consequences are now viewed, addressing it also requires a broad and multifaceted approach. Such a holistic approach requires leadership, changing incentives and building values, which are all mutually-reinforcing.

First, leaders must be willing to bring to account powerful vested interests—the big fish rather than the small fish, the tigers rather than the flies. They must also set the example by being above reproach. Lee Kuan Yew of Singapore is a prime example of a leader who successfully fought corruption through his own personal example and the political will that he engendered.

Second, strong incentives. Leadership must be complemented by a strong system of carrots and sticks—positive reinforcement and accountability. There needs to be a clear framework to combat corruption that is enforced. At the same time, governments need to ensure that public officials earn a living wage. Openness of the economy through deregulation and liberalization will also help since overly-regulated economies create strong incentives to maintain corrupt practices. Poland is a good example of quick and effective liberalization measures. Transparency of government operations and transactions is also important as a disincentive.

Three, building values of integrity. Countries need to promote a culture that values clean government. Building such a culture requires education of citizens. Formal training can help, but ultimately values must be learned through the education system, peer pressure and the day-to-day work experiences and practices of institutions. In most cases, corruption starts long before it becomes critical to the economy.

Fiscal transparency – the comprehensiveness, clarity, reliability, timeliness, and relevance of public reporting on the past, present, and future state of public finances – is critical for effective fiscal management and accountability. It helps ensure that governments have an accurate picture of their finances when making economic decisions, including of the costs and benefits of policy changes and potential risks to public finances. It also provides legislatures, markets, and citizens with the information they need to hold governments accountable.

The Fiscal Transparency Code is the international standard for disclosure of information about public finances. The Code comprises a set of principles built around four pillars: (i) fiscal reporting; (ii) fiscal forecasting and budgeting; (iii) fiscal risk analysis and management; and (iv) resource revenue management. For each transparency principle, the Code differentiates between basic, good, and advanced practices to provide countries with clear milestones toward full compliance with the Code and ensure its applicability to the broad range of countries.

Fiscal Transparency Evaluations (FTEs) are the fiscal transparency diagnostic. FTEs provide countries with:

a comprehensive assessment of their fiscal transparency practices against the differentiated standards set by the Code;

rigorous analysis of the scale and sources of fiscal vulnerability based on a set of fiscal transparency indicators;

a visual account of their fiscal transparency strengths and reform priorities through summary heat maps;

a sequenced fiscal transparency action plan to help them address those reform priorities; and

the option of undertaking a modular assessment focused on just one Pillar of the Code.

FTEs are carried out at the request of countries. They also support capacity building, including the prioritization and delivery of technical assistance. A number of FTEs have been conducted to date in countries across a wide range of regions and income levels and additional FTEs are underway.

One way to end the problem of political corruption is to establish a new branch of government that serves as an umpire. Due to the growth of government, systemic political corruption jeopardizes the equity and well-being of the people. Reforms and remedies to deal with corruption that are under consideration would be ineffective and undermine basic constitutional rights.

Democracy is founded on Madisonian principles, which are based on elections and the rivalry among the existing three branches of American government – the legislative, executive and judicial branches. So the solution is to establish a fourth branch of government of umpires. It would be an improvement to rely on disinterested professional umpires to decide which legislative plays are welfare-enhancing and which are not, particularly if the umpires themselves could be insulated from the political processes that lead to corrupt laws and policies.

Nominations for the umpire seats would come from the president, chief justice, and parliament leaders. After confirmation by a two-thirds majority of the parliament, each umpire would serve a term of 15 years.

Presidential vetoes and judicial review do not stem corruption, as they do not reflect the public well-being objective. The Supreme Court also focuses largely on precedent and procedure, overlooking practical effects on the public welfare.

Even elections prove ineffective, given that all political representatives are themselves unreliable to some degree because of self-interest and voters are woefully bad judges of the performance of these officials.

The best way to overturn corrupt laws is to assign a new branch of government – the umpires – who hold the power to assess and veto legislation that fails to embody the goals expressed in the Constitution’s preamble.

The framers asserted in the preamble that the welfare of the people – their capacity to pursue happiness – should be a primary objective of government, no less fundamental than protection of life and liberty. Umpires would chiefly improve aggregate welfare by restricting rent-seeking, or the advancement of elite interests without concern for other interests or for the economy as a whole.

The output of law will not be perfected by welfare-oriented umpires, but at least welfare and equity issues will have a place, and an institutional advocate, in the debate. As for legitimacy, what matters in the end is whether people trust the government to act in their interests. Despite being thoroughly undemocratic, the judiciary is seen as far more trustworthy than parliament.

Corruption prevents the efficient production and distribution of goods and services throughout the economy. For example, this occurs when resources are denied to the poor and redirected to the rich because elites spend billions of dollars lobbying for their interests. Elite interests that succeed through corruption each have narrow objectives, and they each only marginally reduce citizen well-being. But the overall effect is cumulative.

Even though each successful interest increases its share of the pie at the expense of other interests, the political process as a whole may result in every interest, strong and weak alike, ending up worse off in absolute terms. The accompanying distribution of well-being may be one that even the winners find unattractive.

Umpires would be more effective than other suggested reforms of the political process – such as political expenditure limits, constraints on lobbying, and reforms of the administrative process and congressional procedures.

The umpires would be far more protective of the general welfare of the people, while no more difficult to implement than other reforms. This is a logical extension of the already-existing Madisonian competition between branches of government, otherwise known as the system of checks and balances. It would still likely require a constitutional amendment. But at least the remedy would be effective.

Congresspeople in both political parties have substantial holdings in firms their legislative actions affect — and this number has grown substantially in recent years. While roughly 20% of lawmakers owned stock in 2001, that number had more than tripled today. Most Congress owns stock, many with holdings in excess of $200,000 in stocks alone, not to mention mutual funds and other forms of investments. In addition, most lawmakers are millionaires.

These financial ties to firms can be problematic. For example, Reps. Chris Collins (R-N.Y.) and Tom Price (R-Ga.) received private placement offers for discounted stock in Australian biotech firm Innate Immunotherapeutics. Both Collins and Price sit on House committees with potential to advance the firm’s interests and, at the same time, in theory, their own pocketbooks. Similarly, STAT reports conflicts with Rep. Scott Peters (D-CA). Not only did his wife invest between $610,000 and $1.5 million for stock in drug device companies in 2015 alone (the numbers are estimates, which is all that is legally required), but Peters is a three-time winner of the Biotechnology Innovation Organization legislator of the year award, the only lawmaker so honored, and is noted for leading opposition to the Innovation Act, legislation that pharmaceutical companies opposed because it imposed new restrictions on patent-infringement lawsuits.

Many other examples exist, spanning decades. But there’s still a lot we don’t know about what actually happens at a company level when members of Congress own stock. The average S&P 500 firm has about seven members of Congress holding its stock. Some companies have closer to 100 members holding stock, and many firms have 50 or more in a given year. In addition, firms where a greater percentage of lawmakers invest have significantly higher performance in the subsequent year — with each percentage of congressional membership owning stock worth about a 1% improvement in ROA or Tobin’s Q — suggesting that politicians may be privy to nonpublic information about future regulatory or legislative actions that may prove helpful to these companies. Members of Congress use their influence to benefit the firms in which they invest.

Members of the House and Senate generate abnormally higher returns on their investments. This occurs because members of Congress have a variety of tools at their disposal — from pushing or stalling legislation and regulation to awarding contracts, subsidies, and tax abatements — any of which can aid the firms in their investment portfolios. For example, the financial institutions in which key committee members owned stock received favorable bailouts in the Emergency Economic Stabilization Act, in 2008.

Firms are taking note of congressional investments in a couple of ways. It is not surprising that they’re paying close attention to public disclosure laws that require members of Congress to report their stock holdings annually. But they’re also hiring private companies that specialize in a unique business: identifying who owns firms’ stock (among other political intelligence activities). Firms can use information about which members of Congress own their stock to minimize the intensity of their lobbying activity, as in the case of Apple. Three-quarter increase in members of Congress who held Apple stock from 2007 (22 people) to 2008 (38) was followed by a nearly 50% reduction in lobbying intensity the following year (2009).

Why? Because owning stock aligns the interests of the firms with those of their stock-holding lawmakers. Both the firm and the stockholder benefit when politicians act in ways that benefit their investment portfolio. Thus, companies that have congressional stockholders no longer need to spend as much money on lobbying to influence opinion. Instead, they can cut their lobbying expenses while getting the same general benefit through legislative support or disapproval, among other actions. And, once lobbying is cut, they have more resources to allocate elsewhere, including donating to additional election campaigns and hiring individuals with relationships to current lawmakers.

Even when lobbying has been cut, there has been no change in how much firms donate to election and reelection campaigns. Such donations are still largely seen as quid pro quo, where firms supply members of Congress with cash in their campaign war chests to curry favor later. Unlike lobbying, they affect Congresspeople’s personal interests directly. Reducing those donations would end the quid pro quo arrangement and would generate congressional ill will toward those companies.

Congresspersons intersecting with legislation are profiting at the expense of their constituents and society. For example, one industry that has a direct impact on Americans — and gives a lot of money to elected officials — is big pharma. Prices for prescription drugs have skyrocketed, and researchers argue that this partially stems from the actions of lawmakers. The Senate recently voted on proposed legislation that would allow the importing of prescription medication from Canada, to trim costs. Although it would have benefited Americans struggling to pay for medication, the legislation didn’t pass — and those who voted no received significantly more in contributions from big pharma than those who voted yes. This was true on both sides of the aisle.

Such conflicts undermine public trust. Members of Congress don’t get it, but they need to. If there is an appearance of an impropriety, there just might be an impropriety. Members need to bend over backwards to show people they are there for the good of the country, not their own pocketbooks.

Another problem is that it’s extremely difficult to prove conclusively that a congressperson’s actions are guided by their investment portfolio. Bills can be complex, often hundreds of pages in length, and small changes that may not garner much attention can have substantial effects for firms. Holding up a bill in committee or working with others to stall legislation may be difficult to tie to any single person, while other actions can be defended on alternative premises, like coincidence or even that they are based on a stockbroker’s advice.

The latter claim was given in defense of Tom Price and for similar conflicts involving the portfolio, and voting, of Rep. Joseph Kennedy III (D-Mass). In another example, Nancy Pelosi (D-Calif.) did not allow a vote to come up that, if passed, would have materially affected her stock in Visa, not to mention that she and her husband participated in an IPO around the same time the legislation was moving through the House. Given that there are many reasons why a bill might fail — and many people who might be able to prevent it from coming to a vote — it is hard to prove that a particular lawmaker is motivated by their investment holdings. You can’t get into their heads to know what is motivating them. Companies are good at influencing lawmakers, and they are getting more strategic about it. Such conflicts extend to state and local politics. The effects of corporate money in politics are only going to become more pronounced, and more complex.

FACTORS THAT ALL INVESTORS SHOULD MONITOR CLOSELY

 

Factor investing and smart beta strategies increasingly are in vogue, according to Elroy Dimson. These strategies seek to benefit from long-run premiums highlighted by academic researchers that look beyond traditional asset classes or indices, in order to select a portfolio based on more specific or granular factors. Almost three-quarters of asset owners are using or actively evaluating smart beta strategies, and the use of smart beta indexes is rising quickly.

“The only sure way of making money is through insider trading!  That’s why most traders are insider traders, real or imagined.  The trick of the game is to differentiate an insider tip from a malevolent rumor and from a stupid rumor.  That’s where experience comes in.  I have been trading the markets for forty years, and I can smell the bullshit instantly.” Basil Venitis, venitis@gmail.com, https://venitism.wordpress.com

While researchers have identified more than 300 factors that may fit into such strategies (though most would not survive independent testing of their long-term effectiveness), there are five key factors that all investors are exposed to – whether knowingly or unknowingly: size, value, yield, momentum, and risk.

Dimson discusses the research history surrounding five smart beta factors that investors should monitor closely:

1. Size

Research spanning over six decades in the United Kingdom (and even longer in the United States) has found evidence that smaller quoted companies have provided the best long-term returns. Though the advantage of small-capitalisation companies has been uneven and inconsistent, there has been a general outperformance by small caps over the long term.

With dividends reinvested, £1 invested in UK large caps at the start of 1955 would have grown to £1,087 by the end of 2016, or an annualised return of 12 per cent. The same investment over the same period would have yielded £3,220 for mid caps, £6,861 for small caps, and £27,256 for micro caps.

2. Value

Investing in value stocks has paid off handsomely in markets like the US and UK over the long-term. Value stocks sell for low multiples of earnings or book value, and such stocks may have suffered setbacks or be mature and unexciting businesses – but extensive research in many countries shows that the long-term performance of such stocks has been far superior to growth stocks. In the UK, a £1 investment in the growth index in 1955 would have seen an annualised return of 10.3 per cent to £419 by the end of 2016, while the same £1 invested in the value index would have generated £9,173 or more than 21 times as much.

That said, there have been some relatively disappointing periods for value stocks, including much of the 1990s and again after 2007 – and there is continuing debate over whether the historical overall superiority of value investing over recent decades can be expected to persist.

3. Yield

Above-average dividend yield has been linked to a historical return premium in a series of papers since the 1970s. The evidence provided by Dimson, Marsh and Staunton, spanning 117 years of UK equity market returns, is the longest such study of the yield factor. An investment of £1 in a low-yielding stocks in 1900 would have provided £6,810 by the end of 2016, for an annualised return of 7.8 per cent – while the same investment in high-yield stocks would have generated a 10.8 per cent annualised return, or £158,727.

There are four possible reasons why high yielders have outperformed: mere chance that is unlikely to persist (the authors consider this to be doubtful); national tax policies that have caused growth stocks to sell at a premium by favouring capital gains; investor enthusiasm for growth stocks that bid prices to unrealistic levels; and as a return for risk (the professors find this explanation hard to accept because high-yielding stocks had lower historical volatility).

4. Momentum

From 2000 through the end of last year, winners outperformed losers by 10.2 per cent each year among the 100 largest UK stocks – providing some long-term backing for momentum strategy. But it’s important to mention two key caveats about momentum strategies: they’re costly to implement due to frequent rebalancing, and there are risks of volatility and even whiplash when markets sharply reverse direction — as seen in 2009. Globally, the three researchers found that momentum investment has been profitable in 21 of 23 studied markets since 2000, with the important exceptions being Japan and the US.

5. Volatility

Several researchers have shown the historical superiority of low-risk investing compared with higher-risk strategies – although other studies report that excess returns accrue disproportionately in the first month after a portfolio is assembled, and that this largely evaporates when low-priced stocks (less than $5) are removed from the mix. Dimson, Marsh and Staunton examine risk estimates based on both short term (60 day) and long term (60 month) windows. When they switch to long-term risk estimates, they find similar performance from three different risk-based portfolios until the technology bubble burst in 2000 – with high-risk stocks performing disastrously from 2000 to 2003 but outperforming since then. Although low-risk stocks beat high-risk stocks over the full period 1960 to 2016, this is entirely due to the 2000 to 2003 tech bust. The authors express caution about extrapolating the past performance of low-volatility strategies into the future.

Mass-market products such as exchange-traded funds are being concocted using the same flawed statistical techniques you find in scholarly journals. Most of the empirical research in finance is likely false. This implies that half the financial products promising outperformance that companies are selling to clients are false. Investors are being ripped off by investment firms that charge hefty fees while producing results that are no better than you’d get throwing darts at a page of stock listings.

The core of the problem is that it’s hard to beat the market, but people keep trying anyway. An abundance of computing power makes it possible to test thousands, even millions, of trading strategies. The standard method is to see how the strategy would have done if it had been used during the ups and downs of the market over, say, the past 20 years. This is called backtesting. As a quality check, the technique is then tested on a separate set of out-of-sample data, i.e., market history that wasn’t used to create the technique.

Torturing the data until it confesses is p-hacking, a reference to the p-value, a measure of statistical significance. P-hacking is also known as overfitting, data-mining—or data-snooping. The more you search over the past, the more likely it is you are going to find exotic patterns that you happen to like or focus on. Those patterns are least likely to repeat.

Index funds are cheap because their sponsors don’t need to hire expensive stockpickers. The old adage applies: If asset managers and finance professors are super-smart, why ain’t they super-rich? The big money is being made by firms that ignore finance theory. 

The only sure way of making money is through insider trading!  That’s why most traders are insider traders, real or imagined.  The trick of the game is to differentiate an insider tip from a malevolent rumor and from a stupid rumor.  That’s where experience comes in.  I have been trading the markets for forty years, and I can smell the bullshit instantly. Insider trading is very healthy, because it helps the markets reach the equilibrium point soon.  All insider trading legislation is stupid.  You just cannot put all people in jail!

The permanent political class enriches itself at the expense of the rest of us. Insider trading is illegal, yet it is routine among kleptocrats. Normal individuals cannot get in on IPOs at the asking price, but kleptocrats do so routinely. Kleptocrats also get many hot issues, bypassing all fair procedures of distribution.  By funneling hundreds of millions of dollars or euros to supporters, even more campaign donations are ensured. An entire class of investors now makes all of its profits based on influence and access to kleptocrats.

Kleptocrats have transformed politics to trade. They are traders who use their power, access, and privileged information to generate wealth. And at the same time well-connected financiers and corporate leaders have made a business of politics. They come together to form a kleptocratic caste.

Political intelligence consultants are hired guns who dig for closely held information to be used to trade stocks. Many work for hedge funds and securities firms, who just happen to be some of the biggest political campaign contributors.

While everyone has the same right to be a constituent and the same right to be part of a political discussion, the opportunity just isn’t always there. There’s limited time and resources for everyone to be involved in every discussion. This incentivizes brokerages to cultivate or simply purchase political connections in order to preserve privileged access to profitable information. This flow of information is more difficult to regulate than lobbying, which is regulated, because it is traveling in the opposite direction, that is, from politicians to their constituents.

Trading without inside information is a handicap!  Inside trading is the normal thing to do. Otherwise, the odds are stack against you, as almost everybody else is insider trader. Handicapped traders eventually lose all their money, throwing it in the black hole of ignorance.  Be an insider trader, or do not trade at all.  Technical analysis is ridiculous, and fundamental analysis is yesterday’s news.  Inside trading is the only way to trade!

Insider traders can escape prosecution by publishing a sponsored post with the inside information before they trade it.   If the trade ticket shows a time stamp after the publication of a sponsored post, nobody can touch them, because it’s considered public information, not insider information anymore! 

Legislators do not understand that the objective of insider trading laws is counter-intuitive, to prevent people from using and markets from adjusting to the most accurate and timely information. The rules target non-public information, a legal, not economic concept. As a result, we are supposed to make today’s trades based on yesterday’s information. Unfortunately, keeping people ignorant is economic folly. We make more bad decisions, and markets take longer to adjust.

Insider trading laws imbalance markets by regulating only one-half of the trading equation. A good investor makes money by knowing when not to buy or sell as well as when to buy or sell. Many insider tips alert owners to hold their shares or not to buy other ones. The sooner people act on accurate information the sooner the market will reach the equilibrium price. Interfering with the adjustment process by prosecuting people for insider trading will take the market longer to adjust.

Individuals and companies are entitled to keep proprietary information and punish those who violate that trust. But the offense should be civil, not criminal. And the punishment should fit the charge. In no case is the government justified in using intrusive enforcement measures developed to combat violent crime. The government should stop punishing investors seeking to act on the most accurate and timely information. After all, that’s what the financial markets are all about.

Insider trading creates an arcane distinction between non-public and public information.  It presumes that investors should possess equal information and never know more than anyone else. It punishes traders for seeking to gain information known to some people but not to everyone.  It inhibits people from acting on and markets from reacting to the latest information. Enforcing insider trading laws does more to advance prosecutors’ careers than protect investors’ portfolios.  Information will never be perfect or equal.

Warren Buffett borrows to finance stocks that have low volatility, low price-to-book ratios, high profits, and high dividends. Donald Trump might have been even richer if, instead of dabbling in skyscrapers and casinos, he’d simply taken his eight-figure inheritance and sunk it into the stock market.

Fundamentally, stock markets are driven by popular narratives, which don’t need basis in solid fact. Such stories are thought viruses. They spread by contagion. Theories that seem to explain the stock market’s direction often work like this: First, they cause investors to take action that propels prices even further in the same direction. These narratives can affect people’s spending behavior, too, in turn affecting corporate profit margins, and so on. Sometimes such feedback loops continue for years.

The most prominent story seems to be one of a global slowdown with associated deflation. Underlying this tale are deeper, longer-term fears. There is a name for these concerns too. It is secular stagnation—the idea that there is disturbing evidence that the world economy may languish for a very long time, even for generations.

The current secular-stagnation story is less dramatic than that of the debt crisis. But because it’s so vague, the negative feedback loop can’t be resolved as neatly. The question may be whether this thought virus mutates into a more psychologically powerful version, one with enough narrative force to create a major bear market.

The main legal theory behind insider trading prosecutions is that corporate information belongs to the corporation, so employees shouldn’t be allowed to go around selling it. That makes some sense. It also makes one wonder why it isn’t left up to the corporation to discipline leakers and decide whether to press charges, but you could argue that most corporations would opt just to cover up the wrongdoing and move on.

When it comes to those who receive this information, though, it gets a lot harder to understand what public purpose is served by aggressively prosecuting them. This isn’t hubcaps or Old Master paintings, it’s information. And in general, the more information that gets out about a corporation, the better a job financial markets can do in pricing its securities.

There shouldn’t be any prohibitions on insider trading at all. Insider trading, it’s against the law, but not because the U.S. Congress ever explicitly set out to ban it. Today’s prosecutions are based on an ambitious 1961 Securities and Exchange Commission administrative order and a lot of federal court rulings since. Now the courts may have begun to turn back the tide. That seems like a positive development — especially if it causes smart, ambitious prosecutors to begin looking elsewhere for cases to win.

My financial strategies are based on inside information, libertarian economics, and chaos theory. My objective is to identify the significant undiscounted aspects of economy and industries. This is where the true opportunities for investors lie and where business can get the jump on competitors. My approach is top down, emphasizing the major themes, which will influence business and financial markets.

Financial traders are better at reading their ‘gut feelings’ than the general population – and the better they are at this ability, the more successful they are as traders. Gut feelings, known technically as interoceptive sensations, are sensations that carry information to the brain from many tissues of the body, including the heart and lungs, as well as the gut. They can report anything from body temperature to breathlessness, racing heart, fullness from the gut, bladder and bowel, and they underpin states such as hunger, thirst, pain, and anxiety.
We are often not conscious – or at least barely aware – of this information, but it provides valuable inputs in risky decision making. High-risk choices are accompanied by rapid and subtle physiological changes that feed back to the brain, affecting our decisions, and steering us away from gambles that are likely to lead to loss and towards those that are likely to lead to profit. This can enable people to make important decisions even before they are able to articulate the reasons for their choices.

High frequency trading involves buying and selling futures contracts for only a short period of time – seconds or minutes, a few hours at the most. This form of trading requires an ability to assimilate large amounts of information flowing through news feeds, to rapidly recognize price patterns, and to make large and risky decisions with split-second timing. This niche of the financial markets is particularly unforgiving: while successful traders may earn in excess of £10 million per year, unprofitable ones do not survive for long.

Traders in the financial world often speak of the importance of gut feelings for choosing profitable trades, they select from a range of possible trades the one that just feels right. They manage to read real and valuable physiological trading signals, even if they are unaware they are doing so.

These traders contradict the influential Efficient Markets Hypothesis of economic theory, which argues that the market is random, meaning that no trait or skill of an investor or trader – not their IQ, education, nor training – can improve their performance, any more than these traits and skills could improve their performance at flipping coins.

A large part of a trader’s success and survival seems to be linked to their physiology. Such a finding has profound implications for how we understand financial markets. In economics and finance most models analyze conscious reasoning and are based on psychology. We’re looking instead at risk takers’ physiology, how good are they at sensing signals from their viscera. We should refocus on the body, or more exactly the interaction between body and brain. Medics find this obvious, economists don’t.

New tech-heavy financial firms are helping millennials invest, but with a twist. They are swapping out investment advisers for financial robots, and passing along the savings.

Robotadvisors make wealth advice and services feasible to a greater number of investors. They make it easy to open an account, they limit fees through the use of low-load investments and exchange-traded funds, and instead of time-intensive face-to-face consultations, they have user-friendly digital platforms that use simple questionnaires to identify investing goals and algorithms to determine things like risk profiling and optimal asset allocation.

Robotadvisor features such as portfolio rebalancing and tax-loss harvesting can translate into higher returns for investors. In USA, robotadvisor assets under management have grown threefold from around $60 billion in 2015 to $200 billion this year. And by 2020, that figure could top $500 billion. 

Millennials are disruptive bunch. The first generation to grow up with the internet, consumers born after 1980 are used to relying on technology and engineering to do almost everything—including shopping (Amazon), listening to music (Spotify), communicating with friends (social media), and hailing a cab (Uber).

It seems as if millennials would prefer to avoid face-to-face business interactions when there exists a more efficient way of getting what they want accomplished.

A new breed of financial technology companies, known collectively as fintech, has taken advantage of these traits to disrupt an unexpected industry: personal investing. Just as manufacturing companies have replaced assembly line workers with robots, these companies have replaced financial advisors with robo-advisors, which use big data and algorithms to determine the best places to put clients’ money—and appeal to a whole new generation of investors.
Millennials have a firm belief that the insights of modern technology can be competitive with someone who is personally advising you, and at a fraction of the cost. Traditional financial advisors cater to baby boomers with substantial savings, requiring minimum amounts for investment upwards of $100,000 to access their services. By contrast, industry-leading Wealthfront and similar firms such as Betterment, Vanguard Personal Advisor, and Acorns have tapped into an underserved market by allowing clients to invest as little as $5,000. Wealthfront doesn’t even charge a fee for assets of less than $10,000—and even after that charges a 0.25 percent fee, as opposed to fees of 2 to 3 percent by traditional firms.

The reason Wealthfront is able to do that is by keeping costs low. Traditional financial advisors are all about establishing a personal relationship with their clients, understanding their financial situation and walking them through their options. By pursuing a one-size-fits-all approach to investing, robo-advisors can eliminate a huge amount of operating costs. They have a phone number and an email for customer service, and that’s about it. The main way they communicate with customers is through a blog.

Secondly, much of the cost for traditional financial advisors comes from client acquisition—chasing down leads and making personal visits with potential clients. They also spend considerable resources in traditional marketing, especially the large firms. Those setup costs must be recovered over time through fees. Wealthfront keeps those costs low by finding clients through social media—either through direct ads or referrals by early adopters who post about their services. Their way to capture clients is through viral acquisition.

Lastly, fintech firms save costs by outsourcing money management expertise to technology rather than to experienced money managers. They come from the culture of the Silicon Valley, which is a culture of believing in engineering as a way of solving consumer problems.

That’s where millennials come in. This cohort is ideal for a robo-advisor firm in many ways—first and foremost, because they have faith in the power of technology to solve their problems. In fact, the Occupy Wall Street generation may be more likely to trust a fintech company than a big New York banking firm. Moreover, millennials are heavy users of social media, and apt to recommend services they enjoy to their contacts.

Studies also show millennials are financially responsible, with two-thirds of them putting more than 5 percent of their paychecks into savings, the highest rate of savings of any current generation. Having gone through the Great Recession, they tend to be more conservative with their money. That means that they have been accumulating savings, even if they are not yet large enough to be served by traditional brokers. They are going to be the asset accumulators of the future.

Lastly, millennials show a set it and forget it attitude towards money management, desiring to delegate the responsibility elsewhere so they have more time for their passions, whether that’s their careers, hobbies, or travel.

Despite the big differences in operations, the investment strategy Wealthfront pursues is not dissimilar from a mainstream financial investor. Its portfolio emphasizes a diversification of assets, managed through a portfolio of exchange-traded funds (ETF’s) that track market indexes. It’s a great way to invest cheaply in a diversified basket of stocks, bonds, and other securities.

If anything, Wealthfront’s offering is more diversified than typical balanced mutual funds, with 11 categories of investments, including global stocks, corporate and municipal bonds, real estate, natural resources, and treasury bonds. The fund also automatically rebalances itself over time just as mainstream financial advisors and brokers do for their clients—if for example, stocks do very well over a period of time relative to other asset classes and become too large a percentage of the portfolio, the robo-advisor automatically reinvests in the other asset classes to control investment risk, frequently through the reinvestment of stock dividends or the investment of new contributions.
Most of the strategy Wealthfront pursues is identical for each client; however, it does provide some amount of individual customization through a process known as tax-loss harvesting and asset allocations tailored to the tax status of the client. For example, tax-loss harvesting aims at realizing capital losses that help offset realized capital gains to reduce the amount of capital gains tax paid. Capital gains are computed based on when each individual made contributions to her account and in this sense efficient tax loss harvesting requires customization.

The strategy Wealthfront has pursued has resulted in growth of assets under management from $100 million to over $3.7 billion by September 2016, placing it in the top 100 independent registered investment advisors in the United States. Their diversified portfolios have outperformed the S&P 500 by 40 percent on a risk-adjusted basis. There have been challenges, too. CEO Adam Nash stepped down in October of 2016, replaced by founder Andy Rachleff returning as CEO. Nash retained his seat on the board of directors.

But regardless of their growth, the biggest indication of the success of these firms is the fact that mainstream investment firms have decreased their fees and added their own robo-funds with lower minimum asset amounts in an effort to compete directly with Wealthfront and its ilk.

They have been clearly disruptive. Most of the big brokers, such as Vanguard and Schwab, have seen that there is a way to address this segment of the market, and developed similar offerings. That’s brought this to the attention of not just millennials who have thousands of dollars to invest, but also Gen-Xers who have tens of thousands.

The bigger issue is whether, as millennials get older and develop more sophisticated investing, tax and estate planning needs, firms like Wealthfront will continue to keep them as customers, or lose them to more traditional firms. They are hoping that as millennials grow, the technology will grow with them to continue to offer sophisticated portfolio advice with technological solutions. Whether that will happen or not is an open question. If it does, then expect more disruption in the financial advising industry in the next generation.

We visited Bernie Madoff in prison. Madoff, a renowned stockbroker turned fraudster, lives in FCI Butner, a medium-security federal correctional institution in North Carolina. Madoff is serving a 150-year prison sentence for orchestrating the biggest Ponzi scheme in history.

Madoff told us: In hindsight, when I look back, it wasn’t as if I couldn’t have said no. It wasn’t like I was being blackmailed into doing something, or that I was afraid of getting caught doing it. I, sort of, you know, I sort of rationalized that what I was doing was OK, that it wasn’t going to hurt anybody.

Madoff exhibits several all-too-familiar cognitive biases, psychological tendencies that can lead to irrational behavior. We hear Madoff describe a multitude of common biases. They’re amplified—biases on steroids, in Madoff’s case. But they’re biases that we all have, that we all experience.

Ambition: Madoff describes his ambition, which is something that every person aspiring to be successful in business—can relate to.

Overconfidence: “I built my confidence up to a level where I…felt that…there was nothing that…I couldn’t attain,” Madoff told us. The “slippery slope” that enables a small transgression to grow into a bigger one: “I started to go off the tracks, and I was able to convince myself that this was, you know, a temporary situation,” Madoff said.

Lack of self-control: “I…probably…just didn’t give it enough thought or wasn’t frightened enough…to say to myself, I can’t, you know, I can’t do this, I can’t take the risk,” Madoff told us.

Rationalization of iffy decisions: The piece that’s most humbling in the recording is the realization of rationalization. Madoff recognizes now that it was all rationalization.

Once our readers recognize that this is a smart guy, and he didn’t need to do what he did, but he still did it anyway, there is a degree of humility in the venitism blog. Madoff is an extreme case in many ways, but in other ways, he is just someone who fell prey to biases and the tendency to rationalize.

It’s especially important for budding entrepreneurs to appreciate the link between Madoff’s ambition and his slippery slope to infamy. While Madoff possesses an extraordinary lack of empathy for his victims, he didn’t explicitly set out to commit the crime of the century.

Madoff is respected in prison because it looks like he was the mastermind of this extraordinary plan. But to say that he sat down and planned a two-decade, multibillion-dollar Ponzi scheme, that’s giving him too much credit as an individual financier, or even as a sinister deviant. He couldn’t have planned such a long-running and extraordinarily devastating fraud in advance even if he tried.

Madoff was once best known for pioneering the controversial but legal practice of payment for order flow, in which he would pay brokerage firms a couple of cents per share to send orders through his firm. This made him popular among investors, who previously had to pay brokers for the service of buying shares; now Madoff had turned the practice upside down and was paying them to trade.

That innovation diverted trading away from the New York Stock Exchange floor, and by the early 1990s, Madoff’s firm was handling upwards of 10 percent of all NYSE-listed stock trading. Outside his brokerage business though, in his growing investment management practice, Madoff started to feel greater strain in generating profits.

He began naked shorting to clients. Another controversial but legal practice, this involved short-selling a stock without first borrowing the security, and then acquiring the security after the sale. But then he started conducting short sales without putting them on the books, which is illegal. Eventually he stopped trading altogether, once he realized he couldn’t generate the profits he continued to promise his investors. A few steps down the slippery slope later, he was running a Ponzi scheme.

“It’s like a comedy of errors,” Madoff told us. “I allowed myself—and I really have to say ‘allowed,’ since no one put a gun to my head—to keep taking in more money. I kept on waiting for the environment to change and of course it never did. It turned into a total fiasco.”

It’s a mundane series of errors, one leading to another, which grew into something of remarkable proportions. Even as famous white-collar criminals go, Madoff is an outlier, both in the size of his crime and in its longevity. But it’s important to appreciate the slippery slope of small crimes often becoming bigger ones, especially in today’s entrepreneurial culture, which tends to accept and even glorify bending the law a little.

Within entrepreneurial cultures, there’s often a feeling that it’s OK to ignore or bend some regulation. Sometimes regulations are legitimately outdated or potentially too restrictive to let innovation flourish. But the challenge for entrepreneurs is that the line between appropriate and illicit is often quite murky.

Case in point, the ride-hailing company Uber, which is thriving in spite of pushing legal boundaries—and fighting its case in court—in cities all over the world. In some places Uber is hailed as a brilliant company, and in other places its executives are convicted criminals. Many well-respected entrepreneurs, from Michael Dell to Steve Jobs, have faced their own allegations of wrongdoing, but still managed to build remarkable enterprises. At the same time, many white-collar criminals also break rules in the process of believing they are on the cusp of doing something great. Navigating the fine line of which regulations might be legitimately broken and which cannot is sometimes difficult. But understanding this distinction is critical for entrepreneurs who want to operate on the most innovative frontiers of business. Entrepreneurs who are trying hard to make their mark often need to be aggressive. This sometimes leads to successful businesses like Uber or Airbnb, and other times it leads to terrible failures like Enron.