Category: Securities

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:
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Cuomo Sues E&Y: Auditing Profession At Risk

Ernst & Young, one of the Big-4 auditing firms left in the world, faces a grave lawsuit filed a couple of hours ago by New York’s Andrew Cuomo, the incoming governor’s last major act as state attorney general.  The lawsuit is based on fraudulent accounting committed by Lehman Brothers, the failed investment bank, that E&Y either overlooked or condoned, as I explained last March.  

The AG seeks unspecified damages the audit failure caused, certainly running to the hundreds of millions and easily reaching into the billions.  Given that E&Y does not have external insurance to cover such losses, but self-insures, the lawsuit could put the firm’s survival at risk.   Even so, settlement talks, going off-and-on since March, failed, suggesting that the firm is banking on being exonerated.  That is quite a gamble. 

As I told the New York Times and readers of this blog in March, if the case impairs E&Y’s viability as a going concern, a corporate financial reporting crisis should be expected.  It would be acute compared to the modest scramble that corporate America faced after government prosecutors a decade ago drove from the profession the Big-5 firm, Arthur Andersen, auditor of Enron Corp.   Then, 1/5 of companies needed to find a new auditor and most were able to count on one of the remaining four with little trouble. 

Today, 1/4 of public companies would be obliged to find a replacement auditor; thanks to rules stated in the federal response to Enron, the Sarbanes-Oxley Act of 2002, about 1/3 of those would be unable to engage any of the 3 remaining firms because of conflicts of interest (those other firms provide internal control or tax advisory services making them ineligible to render financial audits).   Amid such a crisis,  and with only 3 available firms, the existing structure of the auditing profession would be unsustainable.     

It would be reassuring if the Securities and Exchange Commission could tell the nation that is has foreseen this contingency and developed plans for addressing it, as urged last March and in 2006.  Alas, I am not sure that it is prepared to do either.

Finance Sector as Ultimate Risk Manager?

David A. Moss’s When All Else Fails: Government as the Ultimate Risk Manager should be a vital guide to our future. Moss describes programs ranging from social security to bankruptcy as backstops of support for all classes. As volatility in prices, employment levels, and wages climbs, we should be exploring new “automatic stabilizers” to guarantee every family a “social minimum.” Instead, we appear to be privatizing and financializing risk via opaque institutions whose only mandate is to increase their own profits.

Consider, for instance, this vignette from Louise Story’s excellent reporting on derivatives trading:
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Closed-Circuit Economics

The economy has now reached a “new normal” of soaring profits and stalled employment. Why aren’t stock market gains, bank bonuses, and rising CEO pay translating into more jobs for American workers?

Firms could be buying more labor-saving technology or speeding up production. They may also be investing overseas. Brazil, India, and China have more growth potential than the US. As Keynes stated, “Owing to [a developed economy’s] accumulation of capital already being larger . . . the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate.” While American securities markets have long been reputed to be far more transparent and law-governed than “developing” markets, the gap may not seem so great nowadays. This will be a painful transition for the U.S., all the more so due to our repeated failure to follow stabilizing models of industrial policy. But it is an overdue “rebalancing” of global economic flows.

More troubling is the possibility that buying power is being segregated by the very wealthy into closed circuits of spending and investment (among themselves). Inequality has now become so extreme that it’s difficult to imagine how, say, America’s Fortunate 400 could spend their money. Consider this analysis of Sandy Weill’s recent purchase of a $31 million estate:

Although the value of most housing in Sonoma County, in the heart of the wine country, is down 30 to 50 percent, Weill was willing to pay close to the asking price for his new property. And why not? As the San Francisco Chronicle quoted one Coldwell Banker real estate agent, the sale “is not an indicator of an emerging real estate recovery, but rather the ability of the world’s wealthiest individuals to buy what they desire.”

In a transaction like Weill’s, some real estate agent(s) probably made a good commission. But the home’s former owner may just use that $31 million to buy a Damien Hirst work. Or stocks. Or gold. The possibilities are limitless, of course, but as the top 5% of earners now account for 35% of consumer spending (and a far higher proportion of investing), we might learn something from modeling ideal-typical economic decisions of the very wealthy.
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Treasury’s Prime Directive: Protect the Banks

Adam Levitin has been one of the most courageous and compelling commentators on the financial crisis. So it’s not much of a surprise to see this report on his latest testimony before the Senate Banking Committee:

First off, he lamented the fact that we have been holding hearings like this since 2007. “Every year we have another set of hearings, and you can add 2 million foreclosures” to the bottom line. Nothing gets fixed, despite all kinds of documented evidence that the banks and servicers have committed fraud. Levitin’s position is that the servicers should be banned from the loan modification business entirely, because they don’t have any interest in it except as a profit-maximization scheme, and they have massive conflicts of interest that cut against doing right by the borrowers (and even the investors for whom they work).

Levitin said that we don’t have the full data sets from the servicers, or any comprehensive data to see whether there is a full-on crisis of unclear title and improper mortgage assignment. In other words, we don’t quite know the full extent of the problem. Levitin said, essentially, “The federal regulators don’t want to get info from servicers, because then they’d have to do something about it.” They don’t want to recognize the scope of the problem because it would require them to act. And Levitin in particular singled out the Treasury Department. “The prime directive coming out of Treasury is ‘protect the banks’ and don’t force them to recognize their losses.”

While I’m sure the FCIC will issue a nuanced report on the web of causes behind the foreclosure crisis, Levitin sees the spider. It looks like courts are beginning to identify it, too. As Kate Berry reported in the American Banker,
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Flaming the Victims

Two recent items have me wondering about overinvesting in victim claims: (1) Christine Hurt’s new article on the implications of the Madoff scandal, Evil has a new name, and (2) Janet Tavakoli’s claim (if the link doesn’t work, this is also squibbed in the margin) that financial institutions caused the mortgage mess, the “biggest fraud in history.”  Both tell important—and perhaps accurate—stories about massive frauds that certainly produced victims. But both overlook an obvious point:  Not all victims are created equal.  As Pogo said, “we’ve seen the enemy, and he is us.”

Pogo victim dance

When Madoff first hit, I heard two interesting things from (reasonably) reliable sources which complicate the victim calculus.  First, one person who claimed to know a number of Madoff investors, said that many  believed that Madoff was able to guarantee outsized returns because of his access to inside information.  This, of course, is a kind of securities fraud. So, my friend said, “everyone knew Madoff was committing fraud—they just thought it was a different fraud.” You have to wonder how innocent investors were if, as Hurt reports, they were sworn to secrecy when they gave him their money.

I realize I will likely be flamed by holocaust survivors for insensitivity to their losses.  To the extent they were innocent, of course, I have nothing but sympathy for them.  The point, however, is that, as Madoff’s bankruptcy trustee is learning, there is little moral clarity in some of these claims.

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Where Have You Gone, Hernando de Soto?

Remember Randy “Duke” Cunningham’s “bribe list” pricing—“$50,000 for every $1 million in appropriated funds he would obtain?” There are now allegations that certain firms offered to “fabricat[e] documents out of whole cloth” to lubricate the foreclosure machine. For a mere $95, one could “recreate entire collateral file,” which is all “the documents the trustee (or the custodian as an agent of the trustee) needs to have pursuant to its obligations under the pooling and servicing agreement on behalf of the mortgage backed security holder [including] the original of the note (the borrower IOU), copies of the mortgage (the lien on the property), the securitization agreement, and title insurance.” Yves Smith draws some interesting implications:

Amar Bhide, in a 1994 Harvard Business Review article, said the US capital markets were the deepest and most liquid in major part because they were recognized around the world as being the fairest and best policed. As remarkable as it may seem now, his statement was seem as an obvious truth back then. In a mere decade, we managed to allow a “free markets” ideology on steroids to gut investor and borrower protection. The result is a train wreck in US residential mortgage securities, the biggest asset class in the world. The problems are too widespread for the authorities to pretend they don’t exist, and there is no obvious way to put this Humpty Dumpty back together.

Smith’s global perspective reminds me of two items. I once heard that, in the wake of Bush v. Gore, a representative of the OAS began a meeting by saying something along the lines of: “We are now to hear from a fragile democracy, one that has suffered severe strains but which looks capable of attaining legitimate procedures for governance. Would the United States representative please come to the dais?” And policymakers who prescribe the titling work of Hernando de Soto for Latin America might want to apply it a bit more carefully at home.


On the Colloquy: The Credit Crisis, Refusal-to-Deal, Procreation & the Constitution, and Open Records vs. Death-Related Privacy Rights


This summer started off with a three part series from Professor Olufunmilayo B. Arewa looking at the credit crisis and possible changes that would focus on averting future market failures, rather than continuing to create regulations that only address past ones.  Part I of Prof. Arewa’s looks at the failure of risk management within the financial industry.  Part II analyzes the regulatory failures that contributed to the credit crisis as well as potential reforms.  Part III concludes by addressing recent legislation and whether it will actually help solve these very real problems.

Next, Professors Alan Devlin and Michael Jacobs take on an issue at the “heart of a highly divisive, international debate over the proper application of antitrust laws” – what should be done when a dominant firm refuses to share its intellectual property, even at monopoly prices.

Professor Carter Dillard then discussed the circumstances in which it may be morally permissible, and possibly even legally permissible, for a state to intervene and prohibit procreation.

Rounding out the summer was Professor Clay Calvert’s article looking at journalists’ use of open record laws and death-related privacy rights.  Calvert questions whether journalists have a responsibility beyond simply reporting dying words and graphic images.  He concludes that, at the very least, journalists should listen to the impact their reporting has on surviving family members.


Goldman’s $550 Million SEC Settlement

The SEC announced this afternoon that Goldman Sachs agreed to settle, for $550 million, the civil lawsuit against it alleging materially misleading disclosures in circulars for some mortgage-backed securities it hawked.  As I wrote on this blog, in a post of April 19 called SEC v. Goldman as a Simple Case, the case was simple. 

In a bruising Consent to a Final Judgment in the federal case against it, Goldman acknowledges the point I made that makes the case simple.  Its marketing circular said the reference portfolio was “selected by” the independent firm, ACA Management LLC, when in fact Paulson & Co. Inc., an interested party, played a role in that selection. 

Within 30 days, Goldman must pay investors it misled by the marketing materials: $150 million to Deutsche Bank and $100 million to the Royal Bank of Scotland (known as ABN AMRO Bank when it bought Goldman’s securities).  It must pay another $300 million to the SEC.  

The SEC’s press release headlined that this amount set a “record” for the agency and is non-trivial even for a firm of Goldman’s size.   Its enforcement chief, Bob Khuzami, boasted that “half a billion dollars is the largest penalty ever assessed against a financial services firm in the history of the SEC.”

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Here Comes FinReg

Via Ezra Klein’s Wonkbook (definitely one of my favorite morning emails), a variety of takes on what’s in the financial reform bill:

1. From Deloitte’s 12-page summary:

Because the new U.S. law is complex, it can be helpful to remind ourselves that its underlying purpose is relatively simple and has two powerful strands: 1. ‘De-risk’ the financial system by constraining individual organizations’ risk-taking activities and capturing a broader set of organizations’, including the so-called “shadow” banking system, in the regulatory net 2. Enhance consumer protections. . . .For example, the need for “arm’s-length” swap desk affiliates combined with the move from over- the-counter to exchange trading for derivatives, tighter constraints on leverage and risk-taking, and higher liquidity requirements imply lower profit margins in future from those activities.

Some estimates I’ve seen have estimated the profit margins might be around 15% lower.

2. Simon Johnson on the Kanjorski Amendment as a “new kind of antitrust:”

Effective size caps on banks were imposed by the banking reforms of the 1930’s, and there was an effort to maintain such restrictions in the Riegle-Neal Act of 1994. But all of these limitations fell by the wayside during the wholesale deregulation of the past 15 years. Now, however, a new form of antitrust arrives – in the form of the Kanjorski Amendment, whose language was embedded in the Dodd-Frank bill. Once the bill becomes law, federal regulators will have the right and the responsibility to limit the scope of big banks and, as necessary, break them up when they pose a “grave risk” to financial stability.

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