Spring 2011

       The Purpose and Role of Government Regulation in the Financial Markets

Readings:

Primary Reading: Partnoy, Frank, Fiasco: The Inside Story of a Wallstreet Trader, Penguin Press, 1999, pp. 1-288.

Plato, The Republic, Book VII, [pp. 514-530] 

Plato's Allegory of the Cave

2000 Annual Report: “The Economics of Property/Casualty Insurance,” pp. 8-15.

http://www.berkshirehathaway.com/2000ar/2000ar.pdf

2002 Annual Report: “Derivatives and Corporate Management,” pp. 13-17.

 http://www.berkshirehathaway.com/2002ar/2002ar.pdf

Annual Report: “Regulated Utilities and Insurance Investing,” pp. 4-10 and 16-21.

http://www.berkshirehathaway.com/2004ar/2004ar.pdf

2010 Annual Report: Responsibilities of Business Leaders, Need for Keeping Reserves, Difficulties of Black-Scholes Option Pricing in Valuing Long Option Contracts, pp. 14-24.

2010 Berkshire Hathaway Annual Report

Dichotomy of Models and Segments of Reality

Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-term Capital Management, (Random House Publishing, New York, NY, 2000).

Joel Bakan, The Corporation: The Pathological Pursuit of Profit and Power, (Free Press, New York, NY, 2005)

Assignment: After completing all the reading assignments, prepare a 15 page response the following financial management and ethical questions with bibliographic and outside references included in your essay. 

1. In Bakan's book on the corporation, the author examines the issues associated with liability and form of business organization that impacts agency, profit maximization and pursuit of the common good. Partnoy's book FIASCO examines how Wallstreet trading firms used their financial expertise to sell derivatives in pursuit of short term, corporate profit maximization. What are the risks associated with trading derivative securities on wallstreet according to the book FIASCO? How does Professor Partnoy characterize the ethics and intelligence of the typcial wallstreet derivatives dealer? What mistakes would you say were made by those purchasing derivatives from the investment bankers over the 1990's? What role does the limited liability and financing of corporations play in enabling the types of behaviors documented in FIASCO, Long-term Capital Management and more recently AIG, Bank of America-Merrill Lynch, Enron, Tyco and Worldcom? According to the berkshire hathaway reports, what parts do accountants and government regulators play in either restricting or condoning the manner in which derivatives are marketed? Would you say that the investment bankers described in the book FIASCO acted honorably, ethically and professionally when selling derivatives to mutual funds, pensions and individual investors? According to Bakan's treatise would the activities of those brokers be considered unusual or expected from a corporate investment banking house? Is there a difference between acting ethically and performing services within the requirements of current regulation? Are there any consequences to acting legally, but unethically in the financial markets? If we were to apply the allegory of the cave to the application and reporting of financial management decisions to the business markets, who or what would represent the roles of the prisoners, Glaucon, and the cave today?  From the perspective of Plato's allegory should there be a difference in the quality or manner in which financial information is conveyed depending on whether the firm operates in a regulated versus unregulated industry? What is the role of the regulator in a financial market? One of the themes in Shakespeare's play, "Much Ado About Nothing" is the significant aspect of one's good name and character in terms of defining an individual within society. Why is it that with respect to recent financial scandals there does not appear to be a very strong relationship between the fear of tarnishing one's reputation within society and activities that bear on name and character [e.g. Bernie Maddoff]?

2. What does the allegory have to say about the role of financial information in determining good decisions? How does Bakan argue that the current corporate form of organization may interfere with the flow of accurate information to the financial markets? Why may we continue to experience difficulties in securing reliable financial information despite the passage of Sarbanes-Oxley? What insights does Plato's allegory have on a financial manager's obligation to provide an accurate picture of reality to the financial markets?  If a financial manager is unable to fully evaluate the consequences of an investment decision, but is merely seeing the shadows on the wall, what ethical choices are there to protect shareholders?

3. According to this allegory why or why not is it important for the prisoners to have a truthful portrayal of reality. How does this apply to the quality and quantity of financial information provided investors?

4. In a recent interview with Warren Buffett and Charles Munger of Berkshire Hathway in the Quarterly Investor Digest, Vol. XVII, No. 3 & 4, 2003, the following statements were made relative to insurance and the use of financial derivatives (futures/options):

Buffett: (Page 31) "If you are willing to do dumb things in insurance, the world will find you.  You can be in a rowboat in the middle of the Atlantic and just whisper out, 'I'm willing to write this,' and name a dumb price, and you will have brokers swimming to you - you know, with their fins showing, incidentally. It is brutal.  If you are willing to do dumb things, there are people out there -- and it's understandable --that they will find you.  And you will get the cash up front.  You'll see a lot of cash.  And you won't see any losses.  And you'll keep doing it because you won't see any losses for a little while.  So you'll keep taking on more and more of it.  And then the roof will fall in.

Talking about derivatives and the potential for loss:

Buffett: We've had some experience at both Solomon and at Gen Re.  Charlie was on the audit committee at Solomon.  And he saw some things in the audit committee in relationship to trading itself and derivatives in particular that made him wonder why in the world people were doing these sorts of things.  I'll let Charlie expand on that.

Munger: Yeah.  In engineering projects, people build big margins of safety into systems -- atomic power plants being an extreme example.  But in the financial world, in derivatives, it's as though nobody gives a damn about safety--and they just let it balloon and balloon and balloon in usage and number of trades and size of trades.  And that ballooning is aided by this false accounting where people are pretending to make money that they're not really making.  I regard this as very dangerous.  I'm more negative than Warren in the sense that I'll be amazed if I live another 5 or 10 years, if we don't have some significant blowup.

Buffett: They've been advertised - and sometimes in a fairly prominent way -- as shedding risk for participants in the system and reducing risk for the system.  But I'd say that they have long crossed the point where they decrease risk for the system -- and now they increase risk.  It's true that the Coca-Cola Company couldn't bear the foreign exchange risk or the interest rate risk that they run and all of that sort of thing.  But when Coca-Cola starts laying those off, and every other major company does too, with just a relatively few players, you have now intensified the risks that exist in the system. You have not shed risk at all.  You've transferred it.  And you've transferred it to a very few players with huge interdependencies with each other.  And to some extent, central banks and all of those similar institutions are vulnerable to the weaknesses of those institutions.

In light of these comments, and based on the allegory of the cave, how should investors and members of the public react to the information provided by financial analysts, governmental bodies such as the SEC, FDIC, FRS and the Department of the Treasury concerning the use and benefits of financial derivatives?

How does this view comport with those of Bakan, Partnoy and Lowenstein?

5. When faced with two different segments of reality,  how should corporate managers determine the appropriate course of action when there is a conflict between preserving the current management or protecting shareholder interests?  To what extent do financial managers have an obligation to making decisions for the greater good of society? Would pursuing the greater good be at variance with the interests of corporate shareholders? In such an instance, how would you make a decision in such a case?