Hockett on the Financial Crisis

There is a growing consensus that our mortgage markets are fundamentally broken. In a recent article in The American Prospect, Robert Kuttner surveys a number of leading legal academics’ prescriptions for the foreclosure crisis:

Katherine Porter, a law professor at the University of Iowa and an expert in mortgage servicing, recently testified to the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP) that according to lawyers for both home-owners and banks, “a very large number (perhaps virtually all) securitized loans made in the boom period in the mid-2000s contain serious paperwork flaws, did not meet underwriting or other requirements of the trust, and have not been serviced properly as to default and foreclosure.” . . . .

One remedy, proposed by professor Adam Levitin of the Georgetown Law Center, would create a new chapter of the bankruptcy code and allow a home-owner to come before a bankruptcy judge and get the mortgage reduced to the present value of the home. The process would also clear the title. Another proposal, by professor Howell Jackson of Harvard Law School, would use government’s power of eminent domain to take securitized mortgages, compensate the holder at the securities’ (much reduced) fair market value, and use the savings to turn the paper back into whole mortgages with steep reductions in interest and principal. This would also allow millions of people to keep their home and help stem the broad decline in housing values.

I think each of these ideas is valuable. I’d also like to see them complement a broad set of proposals articulated by Robert Hockett in a recent piece in the Washington University Law Review. Hockett’s proposals are worth quoting at length, since he keenly grasps the historical dimensions of this crisis:

1. Regulation as Modulation: The Fed and Bubble Preemption
Easily the most important lesson to be drawn from the model of asset price bubbles and bursts schematized [earlier in the article], I think, is the critical role that the Fed must play in preventing bubbles from emerging and inflating in the first instance. . . . While, of course, it is not easy to separate out “fundamental” value and “merely speculative” value with scalpel-like precision or an entirely bright line, it is often quite easy to find reasonable proxies for fundamental value and then to compare prevailing market prices to them. When home prices depart as significantly from counterpart rental prices and from building costs . . . there simply cannot be serious doubt that a bubble is afoot. . . .

Second, and relatedly, any inadequacy in private rates of betting against bubbles could readily be supplemented by regulatory action. For one thing, of course, the Fed now would have means of better timing their boosting of the market rate of interest, the credit-dampening margin requirements imposed upon financial institutions, or both. For another thing—and here we would be speaking not simply of the Fed, but the IRS working in cooperation with the Fed—we could readily impose a form of “Tobin taxation” on the capital gains realized by those who “flip” assets like houses during times of speculative excess, as now would be newly determinable by the Fed.

2. Portfolio Regulation by Reference to Underlying Assets
Asset markets’ overvaluation of assets during times of speculative excess, and their undervaluation of such assets during times of symmetrical “depressive” excess, are problem enough in themselves. But their harmful effects are transmitted more widely when assets are valued by regulators–not just the Fed, but other financial regulators as well—and private institutions by reference to market value. So-called “market value” and “mark-to-market” accounting—employed by our financial regulators, our rating agencies, and many other institutions alike . . . played a critical role in enabling our stock and real estate bubbles to inflate. . . .I]t has never been obvious why such measures should altogether supplant, rather than simply complement, measures-by-proxy of more lasting, “fundamental” value. . . .

3. Derivative and Hedge Fund Disclosure
[T]he multitude of derivative financial arrangements pursuant to which asset price risk was transmitted worldwide have been occluded. . . . [which] is surely one of the most remarkable and surprising features of our current finance-regulatory environment. As any student of securities regulation knows, the leading strategy adopted by Congress in the 1930s for purposes of securities regulation was that of disclosure. . . . Up through the mid-1990s, there might arguably have been reason for this. Derivative transactions were, well, derivative—they were, at most, the tail on the dog of securities. . . . But that growth has long since occurred, and the once-tail now very much wags the dog.

4. A Glass-Steagall for Auditors, Rating Agencies, and Regulators
Banks now are able to affiliate with securities firms, as well as insurance companies, with abandon. A single financial holding company may hold multiple such firms. . . . [T]here are two conspicuous conflicts of interest that proliferate right now and are clearly germane to the integrity of our financial system. One is the case of auditors and rating agencies. These reputational intermediaries are retained and paid by the very financial firms that they audit and rate. And significant evidence already is emerging that some of these intermediaries have been lax in rating many of our recently worst-hit financial institutions. A related conflict is that raised by the practice of many financial regulators–not to say Members of Congress–who pursue careers with financial institutions after brief careers regulating them. . . .

[S]omething in the way of imposition of walls of separation here could be managed at little public cost. It would not be at all difficult, for example, simply to prohibit former regulators from taking positions with financial firms for some lengthy period–say five years or more–following their stints in office. By the same token, it would not be that difficult to impose upon financial firms, as a sort of licensing cost, fees of the sort that they pay auditors and raters, with a view then to publicly paying those intermediaries. . . .

5. Originator Liability
We do not, after all, permit manicurists and pizza delivery companies to underwrite or sell securities. Why, then, did we permit them to originate mortgages–a form of asset at least as critical to wealth and the health of the macroeconomy? The final reform that I take our present troubles to show critical, then, is just this: Recognize once and for all that real estate finance is as critical as is corporate finance, and regulate markets in these assets accordingly.

These are all excellent ideas, and illuminate a holistic response to the crisis. Hockett’s article is well worth reading in toto. He notes that “among the many accomplishments of the first Roosevelt Administration touted on campaign flyers during the 1936 reelection campaign now on display at [the Roosevelt Library in Hyde Park, New York], upwards of half are finance-regulatory in nature.” A party that took Wall Street reform seriously could expect similar electoral dividends.

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