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Coverage in the press of the Facebook IPO has been sensational, with headlines about Facebook’s “stumble” at the IPO. In this post I’ll suggest a way to think about what happened, who won, who lost, and whether we should care about the decline in Facebook’s share price at the IPO. My answer: No, we shouldn’t care.

During an IPO, a firm and its shareholders wish to sell shares. Generally they want the highest possible price for these shares. Investors, on the other hand, want to pay a low price. The underwriter’s job is to strike a balance. To understand what happened with Facebook, you need to appreciate the difficulty in striking this balance.

The investors who buy in an IPO offer to buy up to a particular number of shares. Suppose Joe Average subscribes to the IPO, offering to buy 1000 shares for the offering price ($38 in the case of Facebook). If demand for Facebook is weak, that is, if there are not many subscribers, then Joe will get the full 1000 shares. However, if demand is strong, there will not be enough shares to go around and Joe will get fewer than 1000 shares. This asymmetry is the key to understanding IPO pricing. Joe thinks: When I get the full 1000 shares, the price will go down, but when I get fewer shares the price will go up. In order for Joe to willingly participate, he must expect that on average, the price will go up at the offering. This positive average return compensates him for getting fewer than 1000 shares in good times. Although the price goes up on average, sometimes it will go down. You can understand why this occurs by thinking about the strategy of those investors who actually have information. They will bid for many shares when the offering is valuable, and for few shares when it is not. This is the flip side of Joe getting all his shares in bad times and fewer in good times.

So  investors lost money in the Facebook offering and we understand that sometimes this is going to happen. Did Facebook do anything obviously wrong? Surely Facebook management should have pushed for a high price and that’s apparently what they did. Does the IPO bode ill for Facebook? Why should it? Facebook is one of the most recognized names in the world. In the future, investors will judge Facebook by its financial success or lack thereof. Do you think that Facebook users will switch to Google+ because the stock fell at the IPO? If the offering price had been $32, Zuckerberg would have earned almost $200 million less in the offering. He looks to me like a smart guy.

The party on the hot seat is Morgan Stanley, the lead underwriter. Their institutional investors will want to know why Morgan Stanley agreed to a $38 price. These things happen: Morgan Stanley will make its mea culpas and be back the next time around.

Finally, what about the retail investors who participated? Were they treated fairly? Press reports made it sound like it should have been a sure thing: buy Facebook at $38 and flip the shares a few hours later at a higher price. Of course it could have happened that way. But anyone sure it was going to happen was expecting Mark Zuckerberg and Morgan Stanley to hand them free money. Here’s an Insider Tip: Zuckerberg and Morgan Stanley are not in business to give money to you. They make money from you.

Brokers and banks love to deal with investors who think otherwise.

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For an article in the Daily Northwestern, I was asked to comment on some pension proposals by State Rep. Daniel Biss of Illinois, one of which would involve the creation of a cash balance pension plan for future state workers. A cash balance plan is a type of hybrid retirement plan in which the sponsor (e.g. the state) promises to grow employer and employee contributions by a certain specified rate, and then pay an annuity based on that balance at retirement.  Here were my comments, which I made via email:

A cash balance system that promises asset growth at a low rate, such as that of long-term Treasury bonds, and converts the balance to an annuity at prevailing rates in insurance markets, could be managed so that it generates no unfunded liabilities for the state. However, the very common temptation is to promise a higher rate of accrual on the plans, and just as with traditional DB plans in the public sector, to hope that those higher returns are achieved by setting aside risky assets.

The extent to which the state can avoid that temptation (to promise safe benefits and attempt to deliver them with risky assets) will determine how successful the plan would be in avoiding new unfunded liabilities.

The author of the article paraphrased the above passage as my indicating that a cash balance plan could eliminate the existing unfunded liability, which of course neither I nor Daniel Biss believe (see his own direct quote in the article).

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In light of the recent GAO report, one question I have received is how public pension solvency dates would change if one assumes an “Ongoing” model instead of a “Termination” model. The Termination approach asks how long existing assets would last to cover liabilities that have already been promised. It assumes that future contributions will cover the cost of future benefit promises and will not be wiped out to fund legacy promises. This is the approach I took in a paper from 2010 that examined exhaustion dates. An Ongoing approach instead assumes that future contributions are available to make payments at the time and could be completely wiped out if necessary to pay legacy liabilities. Note that in many systems departing employees can ask for contribution refunds, so that it is not clear that all future employee contributions are fully available for legacy promises.

Fortunately, Alicia Munnell and coauthors have already analyzed and answered this question in the 2011 paper “Public Pension Funding In Practice,” Journal of Pension Economics and Finance 10: 247-268. The main table from Professor Munnell’s paper is as follows. It shows that under the Termination framework public pension plans nationwide have assets through 2025 assuming 8% returns and 2022 assuming 6% returns. Allowing future contributions to be wiped out to pay for legacy liabilities extends the solvency horizon on average by 4-5 years.

Another interesting graph from the paper is the following, constructed under the 8% return scenario.

It is interesting that even under the Ongoing framework, assets of more than half the plans (7%+29%+33%) are exhausted by 2029, 36% (7%+29%) are exhausted by 2024, and 7% are exhausted before 2020.

At the time of the Munnell study, assets in the sample plans were $2.7 trillion as of 2009, according to the study.  As of the last high-water mark for the stock market (June 2011), total state and local government retirement assets stood at $3.0 trillion according to the Fed Flow of Funds, which also corroborates the 2009 figure. It is telling that even a very strong market in which stocks have returned approximately 10% annually since 2009 have had such a relatively small effect on the situation.

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Pensions in MuniLand

Cate Long, the MuniLand blogger from Reuters, wrote a blog post yesterday that misses the entire point about pensions and spreads gross misunderstanding about the cost of pension promises to taxpayers. The risky assets that pension funds invest in and the returns they have achieved historically have nothing to do with the cost of making these promises. The reason pension promises should be discounted at a default-free rate such as the Treasury rate is that governments are telling public employees that they will get their pensions no matter what happens to the pension funds’ risky investments in stocks and alternative assets.

Certainly if Ms. Long wants to credit state and local governments for their option to default on these promises in the event that asset returns are poor, then a higher discount rate than a default-free rate could be used. But then the contracts with public employees should specify that in fact they may only be paid a fraction of what they are owed and the discount rates should be motivated accordingly, not with historical asset returns.

For deeper analysis, I would refer readers to my paper The Liabilities and Risks of State-Sponsored Pension Plans with Robert Novy-Marx and my Congressional testimony of February 2011.

Finally, the piece by Ms. Long also refers to a statistic that approximately three percent of state and local government spending is used to fund pension benefits for employees of state and local governments. As I have blogged about before, this is very misleading. First, many governments are not making contributions they ought to be even under their own accounting. Under correct default-free measures essentially no government is contributing enough to claim they are truly paying pension costs. Second, the figure cited as a fraction of spending, not revenues. Since states are running deficits, as a share of revenues, pension contributions are higher. Finally, the denominator includes the hundreds of billions of state and local revenues that are direct transfers from the federal government. The right question is not how much is being paid now, but how much would have to be paid in order to claim that states are balancing their budgets. That figure is substantially higher, and amounts to 14% of total revenue excluding federal transfers and 23% of tax revenues.

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Volcker on Volcker


Ex-Fed Chair Paul Volcker has weighed in again with a nice piece for the SEC that defends the rule bearing his name.  The Volcker rule, part of Dodd-Frank, bans proprietary trading by investment banks (and others whose primary role is systemically important and not based on trading) —  the loose version of the rule is rule is “take the casino out of the bank.”  Here is his defense.  The difficulty is measuring proprietary trading – it is not trivial to separate gambling from hedging and even (at least banks claim) from trading on behalf of clients.



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Following Dodd-Frank legislation, the SEC is going to require private equity fund advisers to register with the SEC, which broadens the registration requirements that currently apply to financial advisers   Several members of Congress are complaining (see their letter here) and asking the SEC to not require registration by advisers to funds that are not highly leveraged.  They argue that the typical private equity fund investor is “highly sophisticated” and making illiquid investments.  My response: sure, the typical one is. I expect the typical adviser-investor relationship is not a concern.  That does not mean that we do not want to keep track and be able to find the relationships/advisers that are problematic.  The other argument is that private equity does not post systemic risk issues.  This is silly.  As the letter notes “private equity has a key role to play in our economic recovery.”  A hit to the equity in private equity firms could easily be a systemic problem, like a hit to the equity of investment banks. Finally, the issue of leverage seems misguided.  A fund can use zero leverage, but by holding equity in a venture with a lot debt, it is in effect leveraged.  The exemption could incentivize funds to be less levered and individual start-ups or private firms to become more levered.  And the SEC could not track advisers who advised funds that invested in highly levered private firms.  The big question: why the big fuss?  Who is it that is trying to keep this information out of the SEC and out of the market?


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When the financial crisis came, central banks followed Baghot’s rule: in a financial panic, lend freely against good collateral. It turns out that the US Federal Reserve did this well, in that it is making profits for the US taxpayer and not losing money. (One interpretation, they are earning returns for bearing risk which is another way of saying they were lucky; the other interpretation, they were savvy and profited from providing liquidity when it was scarce.) The New York Times has a piece today noting both how profitable the Fed is and how similar to a hedge fund except for the compensation of its employees. Two differences the article glosses over are the advantage of the Fed — it always can have access to liquidity so can take illiquid positions — and the fact that most hedge funds are quite unprofitable lately (after fees). In contrast, the ECB seems to have lent against bad collateral (article here). It looks like the collateral it received from Lehman did not cover the value of the loan, although it will be close if one thinks of a billion dollars as close and one ignores the costs of asset management. Of course, the US Federeal Reserve in part did so well because the US Treasury took first losses on many loans.

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It is maybe a little early for year-in-review pictorial essays, but the BBC is swinging into the season with the Economic Graphs of the Year.  Not exactly break-out-the-Champaign and Mistletoe stuff, but interesting nonetheless.  Here they are.

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Tom Sargent’s Nobel lecture is one of the most interesting and topical ever.  As he says “between 1780 and 1884 . . . the United States faced institutional choices and policy choices that remind me today of present day Europe.”   In it he considers the question: should a government default on its debt?  Should a central government bail out subordinate states?  Should a monetary union precede a fiscal union or vice versa?  In short, the U.S. began without centralized fiscal power, much as Europe today.  The U.S.  Federal Government faced a fiscal crisis in the 1780’s which lead to increased fiscal authority for the Federal government (the Articles of the Confederation were replaced by the Constitution), which in turn was followed by Federal bailouts of state government debts in the 1790’s.  Fascinating stuff.  The lecture is here, starting at about the 17 minute mark (very nice introduction by my former colleague (and very smart and nice person) Per Krusell starting at about the 10 minute mark). Not sure why the Nobel folks can’t figure out how to edit out the first ten minutes of people filling the lecture hall.

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Last week I attended an engrossing two-day conference hosted by the Searle Center at Northwestern Law School on Government Unions in the United States. Scholars from economics, finance, law, and political science presented their research on an number of different dimensions of this theme.

One question that received a great deal of attention was whether public sector employees are compensated more generously than private sector employees with similar skills and engaging in similar tasks. This is a difficult question for two reasons. First, it is challenging to obtain comparability across individuals and jobs. Many public sector jobs have no private sector equivalent. Second, it is widely agreed that public sector accounting does not accurately represent the value of the benefits that public employees receive.

Presenters reviewed existing research and provided their own evidence. Essentially everyone who looked at the data found that public sector workers on average have slightly lower salaries. The contention was over whether higher public sector benefits more than offset this wage differential in total compensation. My own research with Robert Novy-Marx translates public sector pension costs from accounting where new benefits are discounted at 8% to accounting where new benefits are discounted at a rate that represents the liability as a promise that is invariant to asset returns. This reveals that pension benefits are around 15% of pay more expensive on average than is recognized. Conference participant Andrew Biggs argued that the differences are even larger.

Even going with our lower number, 15% of pay is larger than the public-private salary differential that are found in the data. That suggests to me that total compensation for an average public sector employee might be somewhat higher than that for a private sector employee whom these studies characterize as having comparable individual and job characteristics. I am, however, skeptical that comparability of individual and job characteristics in the public and private sector has been or really can ever be achieved. Attempting to benchmark the compensation of, say, public safety officials to private sector employees is obviously problematic. In such a case, the appropriate level of pay is simply whatever the employers and employees can agree upon – but that only leads to efficient outcomes if there is transparency about the public sector compensation packages that allows all parties, including taxpayers, to understand the value of the benefits. That transparency is currently lacking.

A related question at the conference was whether public sector collective bargaining and public sector unionization actually succeed in raising compensation. Here there was in fact no conclusive evidence. A number of speakers noted that it is possible for workers to be unionized but lack collective bargaining rights. Neither collective bargaining nor unionization seemed strongly correlated with compensation in the studies that were presented — although it is impossible in this setting to have counterfactuals (that is, to know what a given public sector employee would have earned in the absence of the union’s influence).

This all suggests that public sector unions may not be very effective at raising compensation on a case-by-case basis. But one role they clearly have played as a group is to resist measures that would bring the true costs of public sector benefits to light. Currently these costs are concealed from the public by the flawed economics of the Government Accounting Standards Board (GASB) methods. And public sector unions are clearly not in favor of changing these standards, as revealed for example by their opposition to the Public Employee Pension Transparency Act.

For the very reason that many public sector jobs have no private sector counterpart, transparency in public sector benefit costs is essential. Public sector unions could probably gain support with the public if they stopped defending the lack of transparency in public sector accounting.

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