After reading the Lex column’s defense of the not-so-uncommon practice of peddling “crap”, I want to make two points:
(i) Because the asymmetric information is built into many business relationships, it’s impossible to outlaw the sale of “crap” and I don’t think anybody will argue that first goal of financial regulation should be to put an end to transactions involving “crap”. In the initial “caveat emptor” decision the judges explicitly recognize the limits of the law in practical matters of contract. According to Jon Faust:
What is striking is that caveat emptor arises as a legal principle mainly because of the tangle the courts would get into if they tried to enforce a more ambitious standard of right and wrong.
(ii) There’s a big difference between arguing that peddling “crap” is a deplorable practice that it is impossible to end, and arguing that peddling “crap” has economic benefits. (I criticize the “two people made a deal, therefore it must be good” approach to markets here.)
Issuing a security that is designed as a short vehicle and then marketing it to long investors without full disclosure about the design of the security — that is, deliberately creating asymmetric information — quite simply cannot be viewed as a positive contribution to “the liquidity and vitality of our financial system“. In fact as Steve Waldman argues the Abacus CDO — by giving Paulson the opportunity to trade off the public ABX market at below market prices — undermined public information about the state of the subprime mortgage market.
There’s not much that can be done about eliminating the practice of selling “crap”. We can, however, force over the counter markets and any other dark markets to shrink dramatically and drive as much trade as possible to an environment where it will be publicly observed.
Synthetic Assets 