The attorney general of Michigan thinks that if GM or Chrysler file for bankruptcy protection, they should do so in the state of Michigan. Seems he sent a letter (PDF) to the two companies about that. This is my favorite part:

I am gravely concerned about the impact of any bankruptcy filing in a jurisdiction outside Michigan.  Since Billy Durant formed the General Motors Company in 1908, Michigan has been GM's home.  Michigan is the site of your corporate headquarters, most of your manufacturing facilities, hundreds of thousands of your active and retired employees, and home to the vast majority of your suppliers and their employees.  The financial health of General Motors and Michigan has been intertwined for decades.  Accordingly, any potential bankruptcy filing outside the State of Michigan seems bizarre.  More importantly, such a filing would inconvenience and unfairly impact the vast majority of your creditors who are located in Michigan.  The costs for many of these creditors to participate in a New York or Delaware bankruptcy is overwhelming and would undoubtedly lead to unjust results.  I am confident that you, as a lifelong Michigander and the leader of one of  Michigan's most beloved institutions, would want to avoid that potential outcome.

Sounds similar to something I've read before.

Barbara!

After Citigroup and Bank of America both reported profits that were boosted perversely and dramatically (in Citi's case there would have been no profit without it) by declines in the value of their debt and debt-related derivatives, now we get the opposite situation in Morgan Stanley's quarterly earnings report:

these results were negatively impacted by the $1.5 billion decrease in net revenues related to the tightening of Morgan Stanley's credit spreads on certain of its long-term debt (MS debt-related credit spreads)

If it weren't for this, Morgan Stanley would have reported a profit for the quarter. That's right: Because credit markets gained confidence in Morgan Stanley's prospects, the company had to report that it lost money. Isn't mark-to-market accounting fascinating? At least in this case its impact is countercyclical—the usual complaint is that it artificially boosts earnings in good times and depresses them in bad times.

Morgan Stanley did benefit from the same fiscal-year move that Goldman Sachs did: By switching its fiscal year to begin in January instead of December, the company gets to forget forever about $1.3 billion in losses in December 2008. So it all evens out in the end. Maybe.

The Harvard Business Review has for the past couple of weeks been hosting a hoedown of an online debate on How to Fix Business Schools. Upon initial examination I thought it suffered a little from the usual malady of such giant group blog efforts: Lots of people saying their piece with little reference to what everybody else has said. But then I started looking at the comments. The discussion after Chicago business school prof Steve Kaplan's defense of economists in business schools, for example, is pretty cool.

Wrote Kaplan:

Human beings are self-interested today and they always have been.

The economy has experienced booms and busts for decades, if not centuries, well before economists taught in MBA programs. The geneses of the Panic of 1907 and the Great Depression have many similarities to those of the current crisis. The tools economists give to students better equip them to understand the business world they will experience. In fact, one of the ways CEOs of financial services firms (e.g., Lehman's Dick Fuld, Merrill Lynch's Stan O'Neal and Citigroup's Charles Prince) failed was in not understanding the agency theory and economics taught in business school. In particular, it is a simple economic point that it is a bad idea to pay up front fees and bonuses for investments or loans that have long-term payoffs.

Responded Stanford's Bob Sutton, whose anti-economist screed had set off Kaplan:

I ... want to challenge the Professor Kaplan's comment that "Human beings are self-interested today and they always have been." There is a stream of research -- which economists routinely ignore, reject, or are unable to process -- that shows self-interest is not hardwired as he implies, and it is fact a social norm that gets stronger or weaker depending on the assumptions that people hold about their own behavior and those around them.

Elaborated management consultant Dev Patnaik:

Business schools moved to a model that emphasized quick thinking, confident elocution and a style of reasoning that looked more like combat than it did contemplation. Indeed, the entire case study approach values explicit data (economic or otherwise) at the expense of intuition, snappy answers at the expense of thoughtful questions, and competition at the expense of collaboration. Students are rarely encouraged to confess “I don't know, but wonder if…” They're instead encouraged to look like they know the answer, whether they know it or not. We didn't just teach students that economists view people as self-serving with guile. We taught students that they should be self-serving with guile if they wanted to do well in our classes. And we taught them the “soft skills” they needed to get really good at it.

My book just got its first media coverage. And it's on a Dutch financial Website. How cool is that?

(The writer, Katrijn de Ronde, happened to be in New York a couple of weeks ago working on another article. She had gotten all interested in financial market theory after reading Roger Lowenstein's When Genius Failed, and came across my writings on the subject. Hence the article.)

My favorite bit is in the comments, where Piet J.W.Duffhues, a finance professor at the University of Tilburg, complains (translation mine):

Efficient market theory deserves more study

The EMH [efficient market hypothesis] is an extraordinarily interesting and relevant theory of the behavior of investors. Many write about it without giving it thorough study. This book appears to suffer from this flaw, and therefore contributes to the confusion.

I knew it. Shoulda spend another six years working on the thing!

(I should add that Professor Duffhues makes this criticism without having given my book any study at all—it's not out yet, and I sure didn't send him a galley. I promise, it really is pretty danged thorough.)

Gabriel Sherman's New York magazine article about Wall Streeters and their pay is full of gems. But, partly because I've got efficient markets on the brain as I prepare to flog my anti-efficient-markets book, this passage interested me most:

A few weeks ago, I had drinks with a friend who used to work at Lehman Brothers. She had come to Wall Street in the mid-eighties, when the junk-bond boom spawned a new class of globe-trotting financiers. Over two decades, she had done stints at all the major banks—Chase, Goldman, Lehman—and had a thriving career directing giant streams of capital around the world and extracting a substantial percentage for herself. To her mind, extreme compensation is a fair trade for the compromises of such a career. “People just don't get it,” she says. “I'm attached to my BlackBerry. I was at my doctor the other day, and my doctor said to me, ‘You know, I like that when I leave the office, I leave.' I get calls at two in the morning, when the market moves. That costs money. If they keep compensation capped, I don't know how the deals get done. They're taking Wall Street and throwing it in the East River.”

Now, a lot of people in New York have BlackBerrys, and few of them expect to be paid $2 million to check their e-mail in the middle of the night. But embedded in her comment is the belief shared on Wall Street but which few have dared to articulate until now: Those who select careers in finance play an exceptional role in our society. They distribute capital to where it's most effective, and by some Ayn Rand–ian logic, the virtue of efficient markets distributing capital to where it is most needed justifies extreme salaries—these are the wages of the meritocracy. They see themselves as the fighter pilots of capitalism.

Actually, they may more closely resemble the bumper-car drivers of capitalism, spending more time tangling with each other than doing anything useful. When their numbers are relatively few, Wall Streeters probably do perform something like the capital distribution function outlined above. But as the financial sector gets more crowded and more frenetic, it always seems to reach a point where more activity—those calls at 2 a.m.—leads to a less efficient allocation of capital.

There's evidence for this, of a sort, in the computer market simulation that Brian Arthur, Blake LeBaron and John Holland ran at the Santa Fe Institute in the early 1990s (pdf). They found that when the "agents" in their market were slowpokes who adjusted their views only infrequently, the market settled into something close to a rational equilibrium. But when they upped the "learning speeds" of their agents, the market was much more prone to bubbles and crashes. So we might actually all be better off if Wall Street weren't populated by quite so many bright, hardworking (and highly paid) people.

Standard & Poor's released its latest Indices Versus Active Funds Scorecard today, and the headline result is the same one delivered by almost every study of mutual fund performance since the 1960s: Most actively managed mutual funds underperform the market. To be precise, 66.21% of actively managed domestic stock funds underperformed the S&P Composite 1500 Index in the five years from 2004 through 2008. During the previous five-year period, a smaller majority—50.76%—had underperformed.

But here's something that struck me as odd in the S&P 500's results: Large cap funds did better in relation to their benchmark than their mid-cap and small-cap brethren did. This was true from 2004 through 2008, and it was true from 1999 through 2003. You'd expect the market for large-cap stocks to be more efficient—and thus presumably harder for a fund manager to outwit—than those for mid- and small-cap stocks. There's far more information available about large-cap stocks. Large-cap funds are bigger and more numerous than their smaller-cap counterparts. So they ought to find it harder to beat the market.

Yet they don't. That is, most of the large-cappers still can't beat the market. But 85.45% of small-cap managers underperformed the S&P SmallCap 600 from 2004-2008 and 79.06% of mid-cap managers underformed the S&P MidCap 400, while 71.90% of large-cap managers underperformed the S&p 500. From 1999 through 2003 the difference was even more pronounced: 53.41% of large-cap funds trailed the market, while 91.36% of mid-cap funds and 69.38% of small-cap funds did.

I called Vanguard founder Jack Bogle, who has spent an inordinate amount of time over the past decade digging through mutual fund performance data, and asked him to explain this strange result. He first gave me an earful about how dodgy mutual fund performance data is–mainly because the worst-performing funds go out of business, a bias that researchers try to correct for but are unable to do perfectly. Also, the data aren't dollar-weighted: It's entirely possibly that small-cap managers do just as well on a per-dollar basis as the large-cap guys. You just can't tell. "It makes you conscious of the inadequacy of statistics," Bogle said.

But then he went out on a limb and offered this explanation: "Yes, less-efficient markets make it easier to win. But less-efficient markets make it easier to lose, too." While large-cap funds converge toward mediocrity, small-cap performance is all over the place. There are often some really big winners in the small-cap world, leaving precious few spoils for the rest to divvy up.

Then there's cost. In general, Bogle said, "fund managers tie the market before costs and lose after costs." Small-cap investing is more costly, therefore small cap investors as a group are more likely to trail the market.

So there you have it. It may be easier to beat the market investing in small-cap stocks. But your average actively managed small-cap mutual fund still won't succeed at it.

On Friday I noted that Citigroup wouldn't have reported a profit if it hadn't been for a $2.5 billion derivatives valuation adjustment "mainly due to the widening of Citi's CDS spreads." Citi's CDS spreads widen when traders think Citi is more likely to default. So basically, Citi was able to report a profit because fears grew that it would go under. Weird, huh?

Today, Alea notes, Bank of America joined in the weirdness with "$2.2 billion in gains related to mark-to-market adjustments on certain Merrill Lynch structured notes as a result of credit spreads widening." This didn't make the different between profit and loss—BofA reported net income of $4.2 billion. But it does point out again that bank earnings reports have become very strange things. As commenter sulliclm explained, with reference to Citi's earnings:

Basically this is the side of mark to market accounting that nobody talks about. FAS 157 (the accounting term for mark to market accounting) applies to both assets and liabilities. So for Citigroup and other banks, they have to mark their liabilities to fair value, and in the case of their own debt (or in this case liabilities on derivative positions), they have to consider their own default potential as a component of fair value. So the more likely it becomes that Citi will default on their debt/swaps, the less those instruments are worth to the investors that hold them. Therefore the accounting guidance says that Citi should reduce the value of the liabilities on their books, and they book this reduction as a gain through the income statement. As an auditor I find the guidance to be ridiculous, but its the rule so companies are following it ...

There's a great passage in Jamie Dimon's letter to shareholders on this practice, "The theory is interesting, but, in practice, it is absurd. Taken to the extreme, if a company is on its way to bankruptcy, it will be booking huge profits on its own outstanding debt, right up until it actually declares bankruptcy–at which point it doesn't matter."

In fact, Lehman Brothers booked repeated debt valuation gains as it went down last year—although they weren't big enough to offset its other losses. And it seems clear that there really is something screwy about mark-to-market accounting that goes beyond the simple fact that markets are volatile.

I spent a couple hours this morning listening to yesterday's JP Morgan Chase earnings call and this morning's Citigroup call. And I wrote this about it.

In my post Wednesday about asset-price bubbles and income inequality, I cited finance scholar Richard Roll's 1987 discovery that economic data and news seemed to explain less than 40% of the stock market's movements. I had totally forgotten about superquant David Leinweber's subsequent—and totally brilliant—discovery: that butter production in Bangladesh, U.S. cheese production, and sheep population in Bangladesh and the U.S. together "explained" (in a statistical sense) 99% of the annual movements of the S&P 500 between 1983 and 1993. (The paper in which he demonstrates this can be downloaded here.)

Sadly, this correlation fell apart after 1993. But a friend just alerted me to the fact that Leinweber has a new book coming out on June 9 (the same day as mine), titled, Nerds on Wall Street: Math, Machines and Wired Markets. I'm sure it will contain an irrefutable explanation of the movements of stock prices (I'm hoping it's all about Greek yogurt production, because I eat a lot of Greek yogurt).

The FT's John Gapper thinks it would be a big mistake for Treasury to allow Goldman Sachs to pay its way out of the strictures of the Troubled Asset Relief Program. He writes:

[W]e now know unambiguously that Goldman is a “systemically important financial firm”. In other words, Goldman is too big to fail and would be bailed out by the US government if its balance sheet failed. That privilege should come with weighty conditions.

Note that Goldman's status is a choice, not a tag it has unwillingly been given. It could avoid this by shrinking itself into an institution like a private equity group or a merchant bank, which can take all the risks it desires because its partners lose everything if it fails.

Goldman does not want to do that because it likes having the engine of its capital markets division and equities operations alongside its advisory and fund management arms. It calculates, probably correctly, that the pay-obsessed Congress is not sufficiently serious to put a new Glass-Steagall Act in its way.

It would be monumentally stupid not to come up with some new way of organizing our financial system after this crisis. Or old way: After being extremely skeptical at first, I've been warming up to the idea of a new Glass-Steagall Act to divide conventional banking from other financial activities, although—as Gapper himself put it a while back, "where would you draw the line?" Wherever the line is, I think the partnership form of organization is going to have to make a big-time comeback if Wall Street is to become a place capable of doing business in a sustainable, responsible fashion. So maybe that's the ticket for Goldman (which was the last of the big Wall Street firms to go from partnership to public company, a mere 10 years ago): As soon as you buy out your outside shareholders and become a partnership again, you can do whatever the heck you want.