an unanticipated consequence of
Jack M. Balkin
Jack Balkin: jackbalkin at yahoo.com
Bruce Ackerman bruce.ackerman at yale.edu
Ian Ayres ian.ayres at yale.edu
Mary Dudziak mary.l.dudziak at emory.edu
Joey Fishkin joey.fishkin at gmail.com
Heather Gerken heather.gerken at yale.edu
Abbe Gluck abbe.gluck at yale.edu
Mark Graber mgraber at law.umaryland.edu
Stephen Griffin sgriffin at tulane.edu
Bernard Harcourt harcourt at uchicago.edu
Scott Horton shorto at law.columbia.edu
Andrew Koppelman akoppelman at law.northwestern.edu
Marty Lederman msl46 at law.georgetown.edu
Sanford Levinson slevinson at law.utexas.edu
David Luban david.luban at gmail.com
Gerard Magliocca gmaglioc at iupui.edu
Jason Mazzone mazzonej at illinois.edu
Linda McClain lmcclain at bu.edu
John Mikhail mikhail at law.georgetown.edu
Frank Pasquale pasquale.frank at gmail.com
Nate Persily npersily at gmail.com
Michael Stokes Paulsen michaelstokespaulsen at gmail.com
Deborah Pearlstein dpearlst at princeton.edu
Rick Pildes rick.pildes at nyu.edu
Alice Ristroph alice.ristroph at shu.edu
Neil Siegel siegel at law.duke.edu
Brian Tamanaha btamanaha at wulaw.wustl.edu
Mark Tushnet mtushnet at law.harvard.edu
Adam Winkler winkler at ucla.edu
In his press conference last week, Ben Bernanke concluded on an upbeat note. He had high hopes for a US recovery, since he believed that the Great Financial Crisis (GFC) of 2008 hadn't taken from the US any of its basic productive capacity.
Whatever the merits of that view, the GFC did highlight debilitating trends in US finance infrastructure that have been intensifying for years. In this week's Businessweek, Hernando de Soto (with Karen Weise) highlights one of the most important: the opacity of key markets and relationships. With scant exaggeration, de Soto warns that the US is on its way to levels of uncertainty more common in developing and communist countries:
During the second half of the 19th century, the world's biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial, and tribal relationships. . . . The result was a huge rift between the old, fragmented social order and the needs of a rising, globalizing market economy.
To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. . . . The result was the invention of the first massive "public memory systems" to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, [etc]), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: "economic facts."
Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. . . . In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.
de Soto gives a number of concrete examples of how we are kept in the dark about the "thousands of filaments that businesses are creating between themselves," including:
1) Mortgage Bundling: Law professor Christopher L. Peterson observes that, "For the first time in the nation's history, there is no longer an authoritative, public record of who owns land in each county."
2) Default Swaps: "these risks have slipped outside the public memory systems, making it very difficult to know who ultimately bears the risk and where it is." And you can count on Tim Geithner to exacerbate the problem. McClatchy's Greg Gordon identified the issue in 2009:
Cayman Islands deals . . . became key links in a chain of exotic insurance-like bets called credit-default swaps that worsened the global economic collapse by enabling major financial institutions to take bigger and bigger risks without counting them on their balance sheets. The full cost of the deals, some of which could still blow up on investors, may never be known.
3) Exemptions: "Businesses are left to figure out [accounting realities] on the basis of connections, influence, and private information. Just like we do in developing and former communist countries."
4) Off-Balance-Sheet Accounting: "In the 1990s governments began . . . allowing companies in financial difficulty to pass facts concerning debts from their public balance sheet to a less visible memory system called a special purpose entity (SPE) (or to sweep debt information into the balance sheet's footnotes in words so obtuse that the statements cease being factual)."
5) Government Use of Swaps and Repo Markets: "Gary Norton at the Brookings Institution has argued that we still do not have the vaguest idea of the size of the repo market."
6) Rating Agencies: We need "to consider whether overreliance on ratings based on co-variance formulas is a trustworthy substitute for facts. Any reform effort must keep in mind the difference between facts, which can be tested for truth, and opinions, such as ratings, which can't. Facts are not simply about transparency; facts are about empirical truth."
de Soto has long been a hero of conservative property rights groups. Unfortunately, the official Republican position on finance reform appears not merely to tolerate, but to affirmatively encourage the "destruction of economic facts" that de Soto laments. Leaders like Spencer Bachus want to reduce funding for the SEC, the Office for Financial Research and the Office of Credit Ratings (or kill the latter offices outright).
Some might be astonished that a political movement based on the rhetoric of "property rights" sees fit to undermine the very institutions necessary for us to understand who owns (and owes) what. But perhaps we shouldn't be surprised, since rapidly increasing opacity in political donations makes it very difficult to understand what dominant donor classes are demanding. Just as the Koch-allied groups have largely drown out other libertarian voices on monetary policy, so too can veiled money flows trump the doux commerce ideal of an invisible hand. Who wants to be on the wrong side of Rove's Crossroads group? There is a much broader "process of social control" at work here.
Ideas for Reform
de Soto gives several brief suggestions for reform; more are developed in detail in the Roosevelt Institute report "Make Markets Be Markets." For example, Joshua Rosner elaborates on worries about bundled mortgages, and proposes a solution:
[K]ey terms that define contractual obligations are not standardized across the industry, across issuers of securities with the same type of collateral (e.g. RMBS, CMBS or RMBS based CDOs) or even by issuer (each issuer often had several different Pooling and Servicing Agreements and Representation and Warranty Agreements).
The lack of standardization and the length of the documentation effectively created opacity, which contributed to the problems in the securitization market. When panic set in and investors began to question the value of their securities, they knew that they did not have the time to read all of the different several- hundred page deal agreements. This reinforced the rush to liquidate positions. . . .
In order to accurately price securities, investors need timely loan-level performance data on the assets backing each deal. We need loan-level data on a daily, or at least monthly, basis in both the primary and secondary markets. Without frequently updated and standardized disclosure of loan-level data, market participants can’t independently analyze and credibly value asset-backed securities based on full information.
I think these are very good points, but reformers will need to overcome much entrenched dogma about the sanctity of trade secrets and proprietary information. In coming weeks, I'll be focusing on other solutions, suggested in sources ranging from the de Larosiere report to Eric J. Weiner's book The Shadow Market. I'll also look at journalists' ideas of their role, ranging from Gillian Tett's pre-crisis "Iceberg Memos" (which warned FT managers that they were only covering the tip of an increasingly murky financial world) to Joe Nocera's recent declaration that journalists have a fundamentally different role than, say, law enforcement, because they lack surveillance tools.
I have one more big picture point to make: "gotcha capitalism" extends from the highest levels of finance down to the consumer end of the economy. As Nathalie Martin recently noted:
I heard a humorous radio program this morning in which Europeans were complaining about how you never know the real price of anything in America. Things seem cheap, but once you consider the taxes, the tipping, the hidden ad-ons, the price is so much more. There is no transparency. Boy, they don’t know the half of it. At times it seems everywhere you turn, you find a scam or an unauthorized fee.
The current personal lines insurance marketplace is largely organized around a myth. That myth is that personal lines insurance policies are completely uniform. This myth explains regulatory rules that do nothing to promote insurance contract transparency. It explains the ignorance of most information intermediaries about the details of contract terms. And, to a substantial degree, it explains the willingness of courts to treat insurance policies as ordinary contracts. . . .
[The situation] reflects the efforts of carriers to limit coverage relative to the presumptive industry baseline. These insurers have actively hidden and obscured this trend, in notable contrast to the comparatively transparent marketing of the few carriers who have departed from standardized policies to improve coverage. If regulators do not act to substantially improve consumer protection in this domain, then it can be expected that coverage will continue to degrade for most carriers, in a modern day reenactment of the race to the bottom in fire insurance that triggered the first‐wave of standardized insurance policies.
Many commentators have worried that consumer protection has been a neglected goal of bank and insurance regulators, whose primary goal was promoting credit and industry. Consumer protections in the financial world have too often been treated as a distraction from the primary goals of regulators, rather than as a critical part of their mission. As work from de Soto's to Schwarcz's shows, that attitude is impossible to sustain. Practices that harmed borrowers contributed to a larger crisis of confidence that threatened to initiate a chain reaction of catastrophic consequences for the finance system. In 2010, legislators realized that the regulatory arbitrage persistent in the financial sector—where the Office of Thrift Supervision, Office of the Comptroller of the Currency, and other regulators competed to offer the most lax regulatory regime—served neither consumers nor the larger economy. The Dodd-Frank Act addresses both concerns by establishing a Financial Stability Oversight Council, the Consumer Financial Protection Bureau, and the Office of Financial Research. Each could help rebuild institutions devoted to the "economic fact-finding" that de Soto recommends.