Circuit City's Gift Card Redux!

Earlier this year, we heard lots about gift cards when Sharper Image went into bankruptcy. In the end, customers only partially lost out: to use a gift card they had to make double the purchase. So, a gift card for $50 could be used on a purchase of $100 or more.

Today, Circuit City, one of my favorite stores for customer service and service plans, filed for Chapter 11 bankruptcy. Of course, many consumers own gift cards for Circuit City and other troubled retailers. Gift cards may look like everything else in our wallets, but are not. Gift cards are really just unsecured debt. The consumer gives Circuit City money in exchange for the gift card, which is merely a promise to supply goods later. The consumer is just an unsecure debtor of Circuit City, which means if the company goes bankrupt the consumer may lose out. Circuit City has asked the Bankruptcy Court for permission to honor the gift cards. With the holidays looming ahead, gift card sales can be an important sales tool for a retailer whose customers want the chance to take advantage of after holiday sales by purchasing gift cards for loved ones. Circuit City's bankruptcy should remind consumers of the fragile state of gift cards at a time when credit is already tight. Consumer's desire for low cost gifts for family will be pitted against the risk of company failure that might make a gift worthless. Cash, as impersonal as it is, may win out over gift cards this year. Let's add to the many things needing attention is some protection for consumers who are lending to companies through the use of gift cards.

On a broader note, history shows that unless the credit markets unfreeze, consumer confidence is restored and consumers have money to spend, we will see more like this. The past week has revealed to us:

• U.S. auto makers on the brink of failure with GM stock trading at 60 year lows,
• more money needed for the AIG bailout (now at $150 billion),
• Amex becoming a bank holding company to better weather volatility and gain access to bailout funds,
• Bank of America announcing that it is assuming $16.6 billion of Country Wide's debt as part of its purchase of the troubled lender,
• Fannie Mae lost $29 billion this quarter,
• Google stock down 55% this year, and
• Starbuck's, my favorite home of the perfect coffee, reported weak earnings and will close some stores.

I could go on with more, but the point is that it is a tough world out there right now. The bailout needs more time to take hold, but for now we all better hang on for more bad news.

— JSM

What's the Holdup?

Photo by wharman

The pessimists' position seems to be gaining ground as we look back at the effects of the liquidity infusion into the banking system. They feared that banks would take Treasury's $250 billion and hoard it, rather than lending it to businesses to get the economic machine running again. Today's depressing jobs report (1.2 million jobs lost in 2008, unemployment at 6.5%) illustrates the real economic harm that the continuing lack of liquidity in the lending markets is having. Very sad.

Watching the interest rate trajectories, one would think the problem was nearing a solution. 3-month dollar LIBOR is down 253 basis points (2.53%) over the past month, and overnight LIBOR has plummeted 655 basis points (6.55%)! Note, by the way, the misleading way in which these lower rates are being described in the media: 3-month LIBOR at its lowest rate since November 2004--well, in Nov. 2004, the Fed Funds rate was much higher, so comparing one rate with its historical antecedents is almost entirely unhelpful without reference to the driver-rates, like the Fed Funds rate, as I suggested earlier. The Bloomberg story linked above makes this point, noting that the spread between 3-month LIBOR and the Fed's target lending rate continues to be much wider than historical averages, by about 100 bp, or an entire 1%. Nonetheless, LIBOR's freefall is good news in and of itself, as lots of adjustable loans pegged to LIBOR will reset to more reasonable rates as LIBOR falls. But it's not as good news as we might have hoped.

Though banks are apparently quite willing to lend to each other (at 0.33% in the overnight market), they remain reticent to lend to businesses and individuals. This is very frustrating. While more careful underwriting is a positive thing, continued blockage in the financial markets is apparently a tough nut to crack.

This post by David Zaring (particularly the comments) over at the Conglomerate offers a nice insight into why this is happening. Rate cuts by central bankers can only go so far to encourage subsequent lending when the real economic fundamentals of the market for potential borrowers are weak. Fears of a long and deep recession probably should make banks hesitant to lend to borrowers who might not make it through, though this is a vicious cycle. Uncertainty with respect to the economic plans of President-elect Obama (boy, it feels good to write that!) also puts a damper on lending markets.

Let's hope the brilliant inspirational oratory skills of our new President-to-be can convince the financial markets that brighter days are on the horizon . . . and soon!

Contesting Arbitration Clauses in Credit Card Agreements

Cardholder credit card agreements typically include an arbitration provision requiring that “[a]ny dispute, claim, or controversy ... arising out of or relating to relating to this Agreement” be settled in an arbitral, not a judicial, forum. These provisions have been under attack in two on-going antitrust conspiracy cases before Judge Pauley in the Southern District of New York. In the first case, the plaintiffs alleged that Visa, MasterCard, American Express and several large credit card issuers, conspired to inflate foreign currency transaction fees. (Visa, MasterCard and the issuer defendants have reached an agreement in principle to settle the case that is currently being reviewed by the court.) Although the plaintiffs are not American Express cardholders, AmEx has argued that they should be bound nonetheless by the arbitration provisions in their cardholder agreements. The plaintiffs should not be permitted to circumvent their arbitration agreements, AmEx claims, by joining an outside party to a conspiracy claim.

Judge Pauley agreed with AmEx on that point, finding that principles of equitable estoppel prohibited the plaintiffs from refusing to arbitrate. The court further recognized, however, that the arbitration agreements might nonetheless be unenforceable as a product of the antitrust conspiracy. It ordered a trial on the validity of the agreements before reaching a final decision on whether the plaintiffs could be compelled to arbitrate.

The plaintiffs appealed, and the Second Circuit reversed. Recognizing that a non-party to an arbitration agreement may in some cases rely on principles of collateral estoppel to compel arbitration, the court held that a more significant connection between the parties was required than AmEx could show with the plaintiffs. For example, the Second Circuit pointed to cases dealing with corporate affiliates or others with whom the plaintiff had interacted directly. Since the plaintiffs were not American Express cardholders, and they had no reason to anticipate any direct interaction with AmEx when they entered their cardholder agreements, the plaintiffs could not be compelled to arbitrate. Ross v. American Exp. Co. --- F.3d ----, 2008 WL 4630314 (2nd Cir. 2008).

In the second case, cardholder plaintiffs allege that card issuers have violated the antitrust laws by agreeing to include arbitration provisions in all of their cardholder agreements. Judge Pauley initially dismissed the suit for lack of standing, reasoning that any injury would be contingent on future disputes that cardholders might be forced to arbitrate. Again, however, the Second Circuit reversed, holding that an agreement not to compete on a critical contract provision deprived the plaintiffs of a meaningful choice and thus resulted in injury in fact.

Discover now argues that the claim against it should be dismissed because its arbitration provision permits cardholders to opt out within 30 days. The plaintiffs have responded that the opt out provision is inadequate because it places too high of a burden on cardholders. The court is currently considering Discover’s motion. Ross v. Bank of America, N.A., 524 F.3d 217 (2nd Cir 2008).

Letterman's Top Ten Sarah Palin Excuses for Spending $150,000 on Clothes

In case you missed Letterman's top ten last week, here it is. With retailers struggling and worried about sales and already promoting holiday sales through discounting earlier in November than usual, Letterman could also add to the top of the list that she "wants to do her part for the economy!"

— JSM

Battle of the Forms

Over at the ContractsProf Blog Jeremy Telman posted his Battle of the Forms Limerick:

To rhyme on the battle of forms
Would intrude upon poetic norms.
2-207 in verse
Might even be worse
Than an ode to the new tax reforms.

Battle of the forms cases are still routine fare, with the recent case of NIC Holding Corp. v. Lukoil Pan Americas LLC, 2008 U.S. Dist. Lexis 74034 (S.D.N.Y. 2008) adopting a textbook application of the rules. In the NIC case, NIC, a petroleum trader, sought damages for Lukoil's failure to deliver gasoline at the appointed time. Although the court denied NIC's motion for summary judgment, the Court did find that a warranty requiring the delivery vessel to have an international carrier bond was part of the contract between the parties because NIC's form reply to Lukoil's form contract contained the warranty provision which Lukoil did not "object to" and did not "materially alter" the contract as was not a "surprise" or "hardship." This is the type of classic fact-pattern which makes me think of examinations!

— JSM

The New Deal for the American People

Much about the economic issues of this election season is reflective of the pledge of "a new deal" made by Franklin D. Roosevelt (FDR) when he entered office in 1933. FDR's initiatives to tackle the Great Depression, including the creation of the Federal Deposit Insurance Corporation (FDIC), Tennessee Valley Authority (TVA), and the United States Securities and Exchange Commission (SEC) continue to have important roles in our economy today. Whether McCain or Obama wins the election tomorrow, the new President will face economic challenges that bear resemblance to FDR's time. The financial crisis will test the President from the outset and give him an opportunity to create lasting changes of the type that FDR initiated (see Crisis Creates Opening).

The credit crisis has eased, but not gone away. Even with LIBOR rates declining and the numerous programs that the Federal Reserve has initiated (see my post on the Federal Reserve's Money Market Investor Funding Facility), banks nevertheless remain cautious and have imposed higher credit standards for consumer mortgages and credit cards. Couple this with the record $1.4 trillion that analysts expect the government will borrow over the next year alone. The credit crisis has put pressure on business enterprises, especially manufacturing which has faced a substantial downturn. Both Bernanke and Greenspan have warned us that substantial economic problems will remain for some time (see earlier posts of Bernanke and Greenspan speeches)

The economy has been much on the minds of voters. Political rhetoric aside, we all want to know the details of who will do what and how. This is the part that is lacking during a political season. One of the early signals to the economy about direction that the business and financial reforms will take is what key cabinet members the President will choose to address these critical problems. FDR's words remind us that economic problems are much of our own creation:

While they prate of economic laws, men and women are starving. We must lay hold of the fact that economic laws are not made by nature. They are made by human beings.

The economy will have to wait a short time to see who the next President will be. Let's hope that action is decisive and effective.

— JSM

Bernanke on the Mortgage Meltdown

Federal Reserve Chairman Ben Bernanke spoke recently at the UC Berkeley/UCLA Symposium: The Mortgage Meltdown, the Economy, and Public Policy, Berkeley, California. Although Bernanke spoke in general terms about the importance of mortgage securitization, he did not say much about short term initiatives or what should really become of Freddie Mac and Fannie Mae.

— JSM

Mandated Financial Counseling--Some Initial Empirical Results

In 2005, as a response to concerns over predatory lending, Illinois began to require financial counseling for a very limited number of high-risk mortgage applicants (generally those with a FICO score of less than 620) in a limited number of Chicago zip codes. Although the pilot program was quickly suspended, there was the opportunity to test the program's effect, as Sumit Agarwal et al. do in a new paper just released on SSRN, here.

The study concludes that counseled borrowers appeared to take on less risky mortgage obligations than non-counseled borrowers. Although counseling appeared to reduce the supply of credit and demand for credit among affected borrowers, property values increased and lower foreclosure rates were documented in affected areas. What is especially interesting to me is that, of the borrowers receiving counseling, "an overwhelming majority" of borrowers did not understand that their ARM rate, often a teaser rate, was not fixed over the period of the loan (p. 6) and that over half of applicants received a recommendation from the counselor that they could not afford the loan under consideration (p.7). Albeit limited, the results do illuminate the extreme informational deficit that likely characterized some high risk borrowing in the last few years, and the limits to disclosure as a consumer protection mechanism. While mandated counseling raises a host of other legal & policy concerns (paternalism, discrimination, costs of implementation, just to name a few), the study does present some data that it at least does lead to better-informed borrowers.

Is Congress Afraid or Unwilling to Compare?

Photo by nromagna

I recently found yet another striking illustration of the stark contrast between U.S. and European legislative efforts to explore comparative (foreign) solutions.

When the U.S. Congress was considering the wholesale revision of the Bankruptcy Act in the early 1970s, the Bankruptcy Commission report contained a section on "Contemporary Bankruptcy Experiences in Other Nations." I was excited to see this early openness to comparative analysis . . . until I read the two-paragraph section. After a number of observations on how different the "legal, economic, and social conditions" are in the U.S. and elsewhere, and without saying anything about the approach(es) taken by foreign systems, the report concluded glibly "the bankruptcy experience of other countries is not a useful resource." [H.R. Doc. No. 93-137, Pt. I, at 66 (1973)] Sigh. Granted, at least in my area of interest (consumer bankruptcy), there wasn't much to compare in the early 1970s, but one might have expected a bit more effort from U.S. policymakers . . .

In contrast, when Denmark set out to consider adopting the first consumer insolvency law in Continental Europe, it took careful account of comparative lessons to be learned. Like the U.S. commission's report, the 1982 report of the Danish commission assigned to explore this issue contains a section on "Foreign Law." [Betænkning on Gældssanering, nr. 957 (1982)] This section, though, is not two paragraphs, and it doesn't dismiss all foreign legislation as "not a useful resource." Instead, it undertakes an impressively sophisticated analyis of consumer bankruptcy legislation and practice in England, Ireland, the U.S., Canada, and New Zealand (11 pages). Though the approaches of these "Anglo-American" systems was ultimately rejected as inconsistent with Danish-Continental legal philosophy and practice, at least they considered--quite carefully and sensitively--relevant foreign models.

Note that the language of all of the systems considered by the Danes was English. So there's one less excuse for the U.S. Commission's failure to consider these comparative models. But it gets better! Midway through the Danish report's comparative consideration of U.S. law, it directs the reader to consider a lengthy passage from the legislative history of the U.S. Bankruptcy Code, enacted a few years earlier. The entire page-and-a-half passage is reproduced in English! The message is clear and impressive: Any educated reader of this Danish report would read English well enough as to not require a translation of the legislative history of the U.S. law. Stunning. Granted, a country with a language not widely in use, like Danish, might be expected to take seriously the notion of English proficiency, but the contrast between the attitudes and abilities of the Danish and U.S. bankruptcy commissions is shocking.

Unlike in the early 1970s, U.S. legislators now have a wealth of comparative analysis of both legislation and practice in European bankruptcy systems, especially consumer bankruptcy. Doug Boshkoff pioneered this area of research with his 1982 empirical article on the discharge process in England (Limited, Conditional, and Suspended Discharges in Anglo-American Bankruptcy Proceedings, 131 U. Pa. L. Rev. 69 (1982)). The rapidly developing consumer insolvency systems in Continental Europe have also been explored in detail in recent years (see, e.g., here and here).

So when Congress returned to the drafting table to revise (many would say deform) the consumer bankruptcy law in 2005, did they consider comparative experience then? I searched in vain for any comparative reference in the legislative history of BAPCPA (the 2005 reform law's acronym). So is Congress afraid, or does it just not care . . . ?

Yet Another Reason to Hate the IRS (and OCC)

Photo by SC Fiasco

As if it weren't hard enough to get banks to offer workouts to overindebted consumers! While I find the premise of the following story hard to believe, apparently major credit card lenders want to forgive significant portions of credit card debt that borrowers can't currently repay, but the Office of the Comptroller of the Currentcy and the IRS have conspired to prevent this.

Currently, when overburdened debtors (or their counselors) call up asking for a workout, credit card lenders will generally only agree to reduce interest rates and penalties and perhaps extend repayment terms to reduce payments. I had always attributed this to avarice and irrational refusal to accept the economic reality that borrowers would repay more if only they were given a bit of a break. As it turns out, I might well have been wrong, as explained in this letter describing a new pilot program to expand credit card debt forgiveness. According to the Financial Services Roundtable (whom I don't trust, by the way) and the Consumer Federation of American (whom I emphatically do trust), lenders appreciate the economic reality point, but the OCC and IRS inhibit lenders from offering significant reductions of principal. They do this by (1) requiring OCC-regulated lenders to demand payment of reduced principal amounts (and book the loss) within three to six months maximum, which (2) triggers a requirement that lenders send a 1099-C "Cancellation of Debt" tax form to borrowers, which in some cases might require the recently forgiven debt to be recognized as taxable income to the hapless debtor [NOTE: most debtors in this position will have been insolvent before (and probably still after) the forgiveness, in which case the COD/forgiveness "income" is excludable from taxable income, see IRS Pub 4681].

For decades we've been trying to convince lenders to act more reasonably in extending workout terms to borrowers WAY over their heads in debt, and now this. Just when you solve one problem, the IRS and some other regulatory agency create another one.

Though the accounting principle in play here doesn't strike me as so intrusive as to have prevented realistic debt forgiveness by banks, I nonetheless hope the OCC and IRS go for this proposal to eliminate the problem, however slight. The FSR/CFA letter promises that "virtually all of the largest national credit card banks" have agreed to offer "significant reductions in the principal [credit card] debt owed" to see if collections increase (my bet: they will!). Speaking as a proud paternalistic supporter of government intervention, I really hope the OCC and IRS get out of the way on this one!

Update 11/12/08: The proposal was rejected in what seems to me like record time for government bureaucrats. Hmmm.

Margaret Atwood's "Payback"

Commercial law scholars looking for a fascinating literary diversion should consider picking up Margaret Atwood's new book "Payback: Debt and the Shadow Side of Wealth". This short book is a free-ranging (indeed sometimes annoyingly meandering) exploration of the concept of debt in religion, literature, and society, interspersed with frequent references and allusions to the modern realities of debt and the current credit crisis, for example when Atwood observes that "Hell is like an infernal maxed-out credit card that multiplies the charges endlessly." (p. 168). The essays are a nice reminder of the fact that, at a basic level and throughout history, debt is a very human enterprise. Going through it also provides a handy recommended reading list for distracted commercial lawyers, transforming Thackeray's Vanity Fair and Marlowe's Tragical History of Doctor Faustus into, in many odd respects, payments books.

We Didn't Start the Fire

What would a Twenty-First Century version of Billy Joel's 1989 hit "We Didn't Start the Fire" would sound like? Certainly, the state of things now, as when Joel wrote the song, have their roots in events well into the past.

— JSM

Pick a Card!

Photo by eliazar

In Payment Systems class, we recently had our "why do students prefer to use debit cards" discussion. I'm continually amazed that, even after learning how much more practically and legally protected users of credit cards are (TILA and Reg Z) as compared to users of debit cards (EFTA and Reg E), students still express a strong preference for using debit cards. Note that my question relates only to the payment function of the card, not the (dangerous) credit function. I use credit cards for every possible payment, but I have not paid a penny of interest or fees since I was a poor judicial clerk years ago outfitting my first apartment (and I've received hundreds of dollars in rewards over the years to offset those early interest payments). I understand (and explain to my students) that card issuing banks are still making money from my use through interechange fees imposed on merchants, but I'm quite willing to pay marginally higher prices at the counter (though I doubt this happens) in exchange for the fabulous convenience and protections of credit card use.

Students' explanations for their preference for debit cards make sense--they fear credit cards inherently (see Angie Littwin's fascinating paper on this subject), they fear the lack of external control on spending and the psychological effect of credit card use increasing spending, and they really fear the credit card issuing banks' game of imposing confusing interest calculations and hefty and spiraling fees for any minor deviation from the contract (overlimit, late payment, etc.).

The credit crisis has brought us one more explanation for why many payors might prefer debit cards: in an abrupt about-face from recent practice, card issuing banks are slashing access to consumer credit! Increasingly today for those with imperfect or underdeveloped credit histories, credit cards may not be an effective option for making all monthly payments, as credit limits may be insufficient to cover a month's payments (even if the payor has money in the bank--or will by month's end--to cover the charges).

It occurs to me that this might be a blessing in disguise. Perhaps the scaled-back credit limits can act as the external spending limit that my students fear. If people can discipline themselves to remain under their lower credit limit, they might develop better spending and budgeting habits that can carry over to the post-crisis time when credit becomes more freely available. I hope at least some people can use this period of tighter credit to begin using their credit cards as disciplined payment devices that offer really substantial protections against fraud and merchant machinations, not to mention real financial rewards (eventually) for those with good histories.

A friend of mine recently acquired a credit card with a reasonable limit. S/he has found that pulling out the card for every payment has disciplined her/him to control spending, at least for now, as s/he is now acutely aware that all purchases are mounting on one bill, which can (and should) be checked periodically (weekly?). That fat "balance" figure, though it is no different from what s/he used to spend monthly, makes an impression that a list of debits and a shrinking bank balance does not . . . and the credit card again offers better legal and practical protections in case of fraud or other transaction problems.

I'd really like to see credit card issuing banks hoisted by their own petard. Fine, you want to cut credit limits, well we'll respond by training people to use your product in a more constructive way for us, avoiding the traps you've set while taking advantage of the benefits for which merchants are now paying. This last part might change ultimately if the interchange fee war is decided in merchants' favor, but I'm not betting on that, and I'll change my practices when and if that happens. Vive la carte de crédit!

Update: For a discussion of people who use this strategy successfully, see here.

Hungary following the way of Iceland

Not to be continually negative about what is going in in the world, but today the International Monetary Fund (IMF) announced what has been coming together over the last week or so. The IMF, European Union and the World Bank have put togother a $25.1 billion bailout package for Hungary. We've seen our markets here in the United States go down, up and down (today up 889.35 to 9,065.12). Sure, I like to complain about the battering my accounts have taken, just like everyone else. As bad as we've seen our markets, though, emerging economies are really having a tough time riding the storm of these markets. Hungary is not alone. The IMF also has tentative agreements with Iceland and Ukraine. And, the IMF is in discussions with other countries as well. The IMF typically imposes restrictions on monies it loans, which for Hungary may include health care and local government support limitations.

Much of the word out of the IMF sounds familiar. We must restore investor confidence in the financial markets. Without that, the economies struggle, both here in the United States and in countries like Hungary. There is also a similar vein in the actions underway across Europe to make sure that the banking systems are stable. So, our market ups and downs have an even greater impact abroad. Thankfully, in the end, it seems like world leaders have realized the inter-twined nature of the economies and are attempting quick action.

Hungary's bailout is $25.1 billion. Sure, we are talking about an entire country needing a bailout. Just the thought of country bailouts is imposing. This amount, though, pales by comparison to the $122.8 billion the Treasury has extended to AIG alone (see Explaining the Financial Crisis to Students). Keeping focus on the financial magnitude of government intervention, AIG is receiving close to five times what the whole country of Hungary will receive. To borrow a concept recently used by Jim Chen over at Moneylaw to refer to a greater magnitude of financial measurement, we might say "Now that's a lot of Smoots!" Of course, we might wonder if $25.1 billion will be enough for Hungary (or, whether AIG will stop at $122.8 billion).

Dominique Strauss-Khan, Managing Director of the IMF, spoke recently about the need of the IMF to be in a position to act quickly to respond to financial crises in emerging markets. It seems that the IMF's proactive stance was a wise route. One can hope that these early interventions by the IMF will help ease the ride of this financial crisis in developing countries. Time will tell in the end, just how much intervention will be needed in developing economies.

— JSM

Marginal Tax Sleight of Hand

Photo by Kyknoord

I have had it with the misleading rhetoric on comparisons of the McCain and Obama tax plans! Whatever your political persuasion, I hope most of us (about 99%) can agree that the "marginal tax rate" is just irrelevant, though this comparison continues to occupy center stage because it's an easy target.

A recent W$J piece (hat tip to Paul Caron at TaxProf Blog) compares . . . yet again . . . the McCain and Obama tax plans based on marginal rates; that is, the highest rate at which your LAST dollar of income will be taxed in our graduated (progressive) income tax system. One's first dollars of taxable income are taxed at 15% up to a limit, then 25% beyond that, then 28% beyong that, etc., until the highest "marginal rate" of tax on one's last dollar(s) is reached. Not suprisingly, the marginal income tax rate under McCain's plan is reported to be 35% (just as under current law, NOT rolling back the temporary Bush tax cuts from the former 39.6% rate), while the Obama plan's marginal rate is higher (the W$J suggests it's 41%, but this must represent a combination of the 39.6% reinstituted marginal rate plus losses of deductions and exemptions for high earners). So, the average person considering this issue might be concerned that an Obama administration would "spread the wealth around" by taking 5%-6% more tax from our last dollars--oh, my!

Here's the rub: how much do I have to earn, you ask, to break into the highest marginal tax "bracket"? The answer, in 2008, is $357,700 (either single or married filing jointly)! I don't know about you, but I'm FAR from having to worry about the highest marginal tax rate. I can't imagine that more than 1% of the U.S. population (even the U.S. taxpaying population) receives this much taxable income (remember--deductions, etc., allow particularly high earners with big deductible expenses to pay tax on only a fraction of their income).

Two observations follow from this. First, this talk of marginal rates is just silliness. Can we just agree that all of the extremely fortunate people who make (even combined-earnings couples) more than $350,000 of taxable income would prefer a McCain tax approach and leave it at that (though I see WAY more Obama signs in the yards of the rich suburb of River Forest, just north of where I live in Forest Park, outside Chicago)?! Marginal tax rates are utterly irrelevant for 99% of the population, and they show whom each candidate favors tax-wise: McCain favors high earners to offer incentives to produce jobs (trickle-down economics), while Obama favors middle-class earners and those who depend upon social programs (funded by wealth redistribution from the rich 1% to the not rich 99%). This is not news, it seems to me, and all the chatter about comparing tax plans is pointless. Far too much attention seems to be paid to the thin margin of "high-earner-not-rich-yet" (HENRY) people out there (and come on--if you make more than $300,000, you're wealthy in the mind of most Americans!!).

Second, the rate that matters is the effective rate; that is, the combined average rate applied to every dollar evenly. Effective rates vary greatly, too, but I would really like to see a more nuanced analysis of how the effective rate of the "average American" (or groups of them) would fare under McCain and Obama. I suspect effective rates would remain largely unchanged for all but the wealthy for McCain (that is, the Bush tax rollbacks would be made permanent, perhaps with a kicker cut for the wealthy), and effective rates for most people below the top tax bracket or two would go down under Obama (with tax shifted up to the higher earners).

I just can't imagine that the average U.S. voter really cares about this marginal tax rate issue--or at least, s/he wouldn't care if s/he realized how irrelevant the issue was for her/him. I would bet that the percentage of people who pay the marginal income tax rate is lower than the percent of U.S. voters who have lost a friend or relative in the war in Iraq, who are or know someone who has been victimized by immigration authorities or over-zealous federal prosecutors, or who are or know someone who has been wrongly convincted and is sitting on death row. The number and percent of people who pay marginal tax rates is clearly lower than the number and percent of voters who lack adequate health insurance and access to quality education. Aren't these issues far more important than marginal tax rates?

Update: Check out this cool CBO report on effective rates (its complexity suggests why we haven't seen more of this type of analysis).

Update 2 (10/29/08): Ask and ye shall receive! This CNNMoney story offers the sort of info I suggested would be more helpful . . . and it confirms my unsurprising speculation about how the candidates' tax plan effects would shake out (McCain blasting all taxes, with a big gift to the rich; Obama sticking it to the ultra-rich, favoring everyone else). For an even better discussion, see this paper by Citizens for Tax Justice.

Comparative Mortgage Confusion

Photo by juria yoshikawa

Even very smart analysts seem to have a tough time understanding the most basic elements of the current crisis. The Economist for this week contains an "Economic Focus" section (Oct. 25th, p. 92) that discusses several plans for providing aid to homeowners to try to stem the tide of foreclosures and finally put an end to the basic problem at the heart of this financial mess. A key question is how to keep people in their homes and avoid mortgagees suffering 40% and higher losses on the increasingly depressed foreclosure market.

The premise of the introduction to the Economist's discussion is that declining house prices are getting in the way of this effort by undercutting mortgagors' (homeowners') incentive to work something out, keep making their payments, and stay put. While Alan White has convincingly and repeatedly pointed out that it is irrational resistance by lenders (and servicers) that is to blame here (see, e.g., here and here), not hesitancy by homeowners, the Economist perspective intrigued me . . . until I saw this catchy line: "Two features of housing finance make the crisis hard to resolve. The first is so-called 'no-recourse' home loans, which are standard in America (though not elsewhere)." [emphasis added] The second feature, by the way, is securitization and the problem of getting consensus from the pool investors for a workout, a problem that FDIC chairperson Sheila Bair seems to have largely disproved.

This observation from the non-U.S. Economist writers on American home finance seems to me patently false. Lesson for comparative researchers: if you discover that fundamental financing practices in a major region (like the U.S.) are different from "elsewhere," best check again. Non-recourse home mortgage loans (where the borrower is not legally indebted on the loan if the home value upon foreclosure does not retire the loan) are decidedly not standard in the U.S. (or anywhere else, so far as I know). While some states, like California and Arizona, make purchase-money loans for residential home mortgages non-recourse as a matter of law, these exceptional statutory impositions don't come close, it seems to me, to making non-recourse lending "standard" in the U.S.

Yes, many (but not all) U.S. home loans are secured by purchase-money residential mortgages, many (but not even most) of those loans are in California, and many (perhaps most) of the most troubled loans are in California, too, so the non-recourse issue has major relevance to the crisis. But let's not overdo it. Anecdotal evidence suggests that many of the troubled mortgages in California are investor properties--not residences--so these loans are most likely recourse in California, too. As for the practice of "jingle mail," where people just walk away from their hideously depressed-value homes and say "come get me" (or bettter yet, "ha, ha, you can't come get me") to the lender, I have yet to see any credible evidence that this is at all common, especially for residential mortgages (as opposed to investment units). It seems to me that, if the American Bankers' Association had hard, credible evidence of a high incidence of jingle mail, it would make serious political hay by sharing that evidence and decrying the sorry state of mortgagor morality in America. The fact that the ABA has remained mum on this issue (so far as I know) strongly suggests there's no "there" there.

So while ideas for getting folks to stay in their homes should be at the heart of a real solution to this crisis, such solutions should be neither explained in terms of nor based on the incorrect notion that most (or even many) home loans in the U.S. are non-recourse, and it's homeowners who need to be convinced to cooperate in workouts. If we can get lenders and servicers on board with the FDIC's IndyMac approach to mortgage modifications, we'll be moving in the right direction . . . and we don't need to worry about homeowners following.

Toxic Debt Holders in Due Course

I had the opportunity to hear Christopher Peterson (Utah) speak last week at Loyola (New Orleans) on Predatory Structured Finance. His talk on the causes of the subprime crisis encompassed one issue that was hotly contested in the last few years: the potential exposure of assignees of mortgages to defenses and claims of debtors arising out of the origination of the mortgages. It is at a basic point a classic holder in due course question. Kurt Eggert has discussed at length the defense-stripping effect of the hdc doctrine in the context of predatory lending. In a related vein, efforts by states to place liability on secondary market assignees of mortgage notes for violations of state predatory lending statutes were met with, charitably, strong resistance, as this Business Week article on the political struggles between the states and the federal government pre-crisis recounts.

In the end, the issue of assignee liability boils down to a bread and butter holder in due course/doctrine of bona fide purchase question. HDC status for secondary market assignees promotes liquidity to be sure. And, liquidity of subprime loans, that we certainly got. On the other hand, stripping of hdc status forces assignees/secondary market purchasers to exert more care over the practices of the origination market. As government turns to the reform stage of the crisis, one of the more interesting commercial paper questions will be whether to continue to insulate the secondary market from abuses at the origination level through application of principles of good faith purchase, or whether to move in the other direction, for example by extending the FTC HDC regulations to encompass all or a larger portion of mortgage loans.

Alan Greenspan Testimony: Was the Market Listening?

Alan Greenspan testified in front of the House Oversight and Reform Committee today, saying the current credit crisis is a rare event, a once in a century credit tsunami. Although Greenspan said to expect layoffs and unemployment, he seemed to think that this too shall pass. Happily, the market went up 172 points today. Was this a result of Greenspan's words? Here is his testimony:

Greenspan attributes the failure to properly price the mortgage based securities as causing most of the trouble here. Basically, the risk models were wrong, so capital requirements were too low. Greenspan believes that whatever regulatory changes are made may ultimately seem minimal when compared to the changes in the marketplace landscape after having sufferred through the credit crisis.

While I agreed with much of Greenspan's observations, he lost me on this last point. History has a way of showing that greed, fraud and excess of various types persist despite calamity. Alexander Hamilton wrote in 1792 after the "first" stock market crash which was trigged when William Duer, the Assistant Secretary of the Treasury under Hamilton, used inside information to speculate on bank stocks:

Tis time, there must be a line of separation between honest Men & knaves, between respectable Stockholders and dealers in the funds, and mere unprincipled Gamblers.

After panic insued due to the actions of speculators, Hamilton intervened to make sure that the panic did not bring down sound banks. That was 1792.

We are still working toward Hamilton's line of separation in 2008. While I have the utmost respect for Greenspan, we seem not to learn our lesson. The risky models to which Greenspan referred have been met by government intervention saving the day and hoping to avoid a deeper financial calamity. If anything, history has a way of repeating itself.

— JSM

Grandma Fraud By Wire Transfer

Saw this story today from the BBC about "Grandma Scams" and thought a break from the credit crisis was in order. An enterprising group of criminals has been calling grandparents in the United States and United Kingdom posing as a grandchild in trouble who is in need of a wire transfer to get out of legal trouble or for emergency medical bills. The ploy is a call with "Hi, Grandma, It's me, your favorite grandchild." The scammers ask the grandmas to wire money using Money-Gram. Of course, the big point to remember here is that the wire transfer system is not for those who aren't absolutely sure who they are sending money to. I tell my students to check, double-check and triple-check wire transfer information because once each party bears responsibility for its own errors. Once sent, the sender is obliged to pay a payment order that the bank executes as instructed. UCC 4a-402.

Grandmothers beware . . .

— JSM

The Federal Reserve's Money Market Investor Funding Facility

The Federal Reserve seems to have an endless supply of new programs to roll out these days in its attempt to further ease credit markets (particularly short term). Of course, we already have:

1. the Commercial Paper Funding Facility (CPFF), which on October 27, 2008 will begin funding purchases of highly rated, U.S.-dollar denominated, three-month, unsecured and asset-backed commercial paper issued by U.S. issuers, and


2. the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), announced on September 19, 2008, which extends loans to banking organizations to purchase asset backed commercial paper from money market mutual funds.

Now, we also have the Money Market Investor Funding Facility (MMIFF), also rolling out on October 27, 2008! The AMLF, CPFF and the MMIFF are all intended to ease credit by making sure that there is liquidity in the short term debt markets. Yet, each program is targeted at a limited slice of short term debt. The MMIFF will be a Fed credit facility provided to certain private sector "special purpose vehicles" (PSPVs). The PSPVs can purchase eligible money market instrument. The Fed's term sheet provides for purchase of certificates of deposit, bank notes and commercial paper with a materity of ninety days or less. Purchases will be made using asset backed commercial paper or funding from the MMIFF. This program is intended to be short-term, with a termination date of April 30, 2009.

All of this should go to show the commitment of the Federal Reserve to backing up the short term credit markets. All of this might seem a collection of fancy programs. Ben Bernanke (I think correctly) is worried that any further problems with short term will cause more mischief in the markets if not attended to by the Federal Reserve. With company earnings reports for the third quarter being sluggish for many companies, problems with the short term credit that companies depend on would only make matters worse. Score 3 for the Fed on short term credit. And, if it doesn't do the trick here by April, the Fed left open the window to extend programs.

Bernanke is also calling for more stimulus programs. We'll see if they too are innovative. They very well may have to be in order for our economy to recover more quickly. Bernanke has been short on details about programs that might help, but expect wider based programs to be in the mix. Although Bernanke is not yet saying we are in a recession, the outlook is not rosy.

— JSM