X

Thank you for sharing!

Your article was successfully shared with the contacts you provided.
The intimate details of the subprime mortgage mess are still hard to trace, but we know that many players are rightly worried as this troublesome bit of recent financial history is excavated. The list of who should have known better is long and growing longer as the obvious questions are being pressed. Why did the subprime mess happen? How can it be fixed? Can a recurrence be prevented? Can future financial fiascos be averted? So far, most of the answers have involved specific mortgage market breakdowns � whether brokers matched financially shaky potential borrowers with unsuitable loans, whether appraisers fudged, whether banks blithely flipped bad loans through market makers and underwriting arms to investors. And that’s not all. It looks as if underwriters continued to facilitate the securitizing of dubious tranches even after ringing internal alarms, rating agencies ignored signs of trouble and loan servicers strayed from proper documentation practices. Nor are the investors clean, having dumbly trusted the fraying reputation of mortgage instruments for financial soundness despite being bombarded on their computer screens with pop-up reminders of lousy lending practices. When you consider that the regulators themselves brushed aside warnings, you begin to believe Treasury Secretary Henry M. Paulson Jr.’s recent intimation that there’s plenty of blame to go around. What’s less clear is how to prevent new problems from re-emerging on the financial horizon. If past be prologue, policymakers should be cautious about relying on the ability of government regulators to detect and respond with sufficient speed, sophistication and firmness to the next potential financial crisis. The history of the financial services business is littered with instances in which new practices and products have, in the hands of undisciplined and sometimes unscrupulous players, threatened the integrity of financial markets. The subprime mortgage mess is not too different, for instance, from the rash deposit-taking and go-go lending practices of the 1980s that led to the thrift debacle. Regulators have several systematic disabilities that make them unlikely candidates to forestall the next analogous financial crisis. Regulators are latecomers to the financial marketplace � followers, not leaders. They typically lack the best information about the inside details of new financial risks. When they do become aware of possible risks, they are subject to political pressure not to stifle efficiencies by overregulating. Even if they tried to monitor every financial trend, they would be practically overwhelmed by the task. And so we have an apparent paradox. If classic regulation is typically a poor device for regulating new financial practices and avoiding attendant abuses, why do some potentially risky new financial activities, products and players do just fine? Private interbank discipline The answer lies in the presence in other settings of private interbank discipline � and its glaring absence in the subprime mortgage mess. Financial intermediaries like banks have created sometimes-elaborate, often-elegant and surprisingly rigorous regulatory systems to facilitate the innovation of novel financial activities and products. The phenomenon is generally seen in closed-loop settings in which the banks, rather than third parties, would suffer losses in the absence of discipline. In several prominent innovations � e.g., checking, credit cards and derivatives � banks voluntarily developed and maintained highly effective disciplinary regimes to forestall latent risks. Potentially risky products were ably monitored privately because the institutions were best positioned to understand the risks of the newfangled devices, and the major institutional players assumed that they would bear the primary cost of failure in case things didn’t work out. In the subprime mortgage fiasco, the reason for the absence of private discipline was that the major institutional players assumed (probably mistakenly, as it turns out) that third parties would bear all the risks of failure. Under the revised bankruptcy code, borrowers were seen to be under pressure to take extreme financial steps to protect their homes from foreclosure. If foreclosures did occur anyway, the intermediaries assumed that downstream investors would shoulder any losses, as if the 1999 repeal of Glass-Steagall’s barrier between commercial and investment banking somehow gave lenders license to lay all risks off on the well-heeled pals of investment bankers. The single legal change that therefore seems most likely to prevent analogous future fiascos is simply to make it unmistakably clear that all major financial intermediaries will be strictly liable for basic flaws that they should have known about in the use of the instruments that they significantly shared in creating, marketing, lending on or selling. Once the intermediaries know that they can’t lay off the risks of sloppy and unprofessional practices, they will impose sensible, rigorous discipline on themselves and all parties working with them to wring out the risk of trouble. Give the intermediaries a strong incentive to regulate themselves and others in the transactional pipelines, and they will do just fine, thanks � with little need for governmental oversight. David G. Oedel is a professor at Mercer University Walter F. George School of Law.

This content has been archived. It is available through our partners, LexisNexis® and Bloomberg Law.

To view this content, please continue to their sites.

Not a Lexis Advance® Subscriber?
Subscribe Now

Not a Bloomberg Law Subscriber?
Subscribe Now

Why am I seeing this?

LexisNexis® and Bloomberg Law are third party online distributors of the broad collection of current and archived versions of ALM's legal news publications. LexisNexis® and Bloomberg Law customers are able to access and use ALM's content, including content from the National Law Journal, The American Lawyer, Legaltech News, The New York Law Journal, and Corporate Counsel, as well as other sources of legal information.

For questions call 1-877-256-2472 or contact us at [email protected]

 
 

ALM Legal Publication Newsletters

Sign Up Today and Never Miss Another Story.

As part of your digital membership, you can sign up for an unlimited number of a wide range of complimentary newsletters. Visit your My Account page to make your selections. Get the timely legal news and critical analysis you cannot afford to miss. Tailored just for you. In your inbox. Every day.

Copyright © 2021 ALM Media Properties, LLC. All Rights Reserved.