Archive for October, 2010|Monthly archive page

Moral Hazard and the Foreclosure Crisis

An important fact has been omitted from the ongoing discussion of the widespread failure to follow legal procedure not only in foreclosures, but also in forming and managing mortgage backed securities:  This is just another example of the consequences of moral hazard that is deeply engrained in the way our financial markets work.  The financial industry functions on the assumption that contracts and activities that are either illegal or unenforceable under current law will – as long as they involve significant bank losses or liabilities – always be made legal retroactively.

Over the past half century the financial industry has not treated the law as a bedrock institution that constrains the nature of its activities, but rather as a set of rules that can be forced to adapt to the industry’s needs and desires.  Thus, the industry knowingly and deliberately creates standardized contracts that are either designed to circumvent the law or in some cases flatly illegal under current interpretations of the law, and then when a case involving the contract arises (which in many instances happens only long after the standardized contract has become an institution), the financial industry tells the court that the dubious or illegal contract is so widespread that the court would create systemic risk by enforcing the law.  (This idea was established by Kenneth Kettering in “Securitization and its Discontents” and the next two paragraphs draw very heavily from Kettering’s article and perhaps form little more than an opinionated summary of several of his sections.)

Standby letters of credit are a clear example of this phenomenon.  In the 1950s banks started issuing “standby” letters of credit, which unlike traditional letters of credit (which were a form of secured loan) are nothing more than guarantees of the debt of bank clients.  As banking law in the United States has prohibited banks from issuing rendered bank guarantees of client debt unenforceable since at least the early years of the 20th century, the “standby” letter of credit was just an effort to repackage a product that was clearly unenforceable by making use of the name of a bank product of long-standing.  This effort was successful.  By the time that a bank failure led the FDIC to challenge the validity of the standby letter of credit in 1973, the market was so big that the FDIC was not willing to put forth its strongest argument – that as a guarantee, the product was unenforceable – because of the consequences of annulling such a large quantity of bank liabilities.  The consequence of this timidity was to grant the standby letter of credit the same standing in an FDIC resolution as a bank deposit.

Repurchase agreements are another example.  The UCC since 1972 has stated that its provisions on secured transactions apply “to any transaction (regardless of its form) which is intended to create a security interest …”  To argue that repurchase agreements did not fall under UCC §9-102 (now §9-109) because they took the form of a sale and repurchase is to engage in sophistry with the clear purpose of subverting the intent of the law.  And yet in the early 1980s – after the market for repurchase agreements had grown to exceed 5% of US GDP – this is precisely the argument that banks were making to judges in an effort to keep repurchase agreements out of bankruptcy court.  Because there were in fact judges who viewed it as their duty to protect the rule of law from the sophistry of the financiers despite – possibly genuine – claims of systemic risk, the industry did an end-run around the Bankruptcy Code by convincing Congress in 1984 to exempt from the Code those categories of repurchase agreements that were actually traded.

The whole over the counter derivatives market also falls into this category.  In 1936 the Commodities Exchange Act (CEA) codified the common law rules (pp. 722 – 23 in link) that had developed over the previous century by making contracts for future delivery (i.e. derivatives and forwards) legal if either (i) they were traded on an exchange or (ii) the intent of the parties was to settle the contract by transferring the underlying asset.  In 1974 the CEA was amended to explicitly include financial contracts under the provisions above and creating the CFTC as an agency enforcing the CEA.  In short, under the CEA the whole over the counter derivatives market as it developed through the 80s and early 90s was plainly illegal – until in 1993 Congress amended  the CEA to allow the CFTC to exempt certain contracts from the law.  (The CFTC under Wendy Gramm promptly exempted swaps and the controversy over Brooksley Born’s stymied attempts to oversee the over-the-counter derivatives market revolved around the wisdom of this exemption — see especially the comments in this link.  In the second comment, note the securities lawyer’s observation that there was not a single law firm in New York at the time willing to support Rubin/Treasury’s so-called claim that the CFTC did not have jurisdiction over swaps.  The Rubin/Treasury view is here and a more objective view here.)

We have a financial industry that views as normal the practice of deliberately creating systemic risk by developing financial instruments that will cause our largest banks to collapse, if the law in its current form is in fact enforced.  The end result of this process is that we have a legal system that – at least when it comes to financial transactions – is composed of laws written by and for the benefit of financial institutions themselves.

While I have a lot of sympathy for Paul Jackson’s point that these procedural matters don’t really matter to those who have defaulted on their mortgages, because in the vast majority of cases their default means they don’t have much of a legal claim to the house, the complete failure by a financial industry full to the gills with well-paid lawyers and real estate experts to comply with the laws governing mortgages and the transfer of real property is a big issue.  (And I see that Paul Jackson agrees with me on that last point.)  It is a big issue precisely because it demonstrates in very plain terms the financial industry’s utter contempt for the rule of law and for the tax-paying public that is counted on to open its wallet every time a bank sneezes.

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