Protecting financial markets: Lessons from the subprime mortgage meltdown

Minnesota Law Review

Volumn 93, Issue 2, 2008, Pages 373-406

  Schwarcz, Steven L ^a  

^a DUKE UNIVERSITY   (United States)

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EID: 58149508305     PISSN: 00265535     EISSN: None     Source Type: Journal    
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References (226)

1. The term "subprime" includes both loans to borrowers of dubious creditworthiness and very large loans to otherwise creditworthy borrowers.
2. See, e.g., Systemic Risk: Examining Regulators' Ability to Respond to Threats to the Financial System: Hearing Before the H. Comm. on Financial Serv., 110th Cong. (2007)
3. [hereinafter Systemic Risk Hearing], As this Essay was going to press, Congress enacted, and the President signed the Emergency Economic Stabilization Act of 2008, Pub. L. 110-343, 122 Stat. 3765.
4. See Greg Ip et al., Stronger Steps: Fed Offers Banks Loans Amid Cri sis, WALL ST. J., Aug. 18, 2007, at A1.
5. See Greg Ip, Fed's Rate Cut Could Be Last For a While, WALL ST. J., Nov. 1, 2007, at A1.
6. See Randal Smith et al., How a Panicky Day Led the Fed to Act: Freezing of Credit Drives Sudden Shift; Shoving to Make Trades, WALL ST. J., Aug. 20, 2007, at A1.
7. Ip et al., supra note 3 ("[The Fed's] discount window's reach in the current crisis is limited by the fact that only banks can use it, and they aren't the ones facing the greatest strains.").
8. Cf. How Three Economists View a Financial Rescue Plan, N.Y. TIMES, Sept. 22, 2008, at C4.
9. In this article, the author states that the U.S. Treasury Department's proposal to use government money to purchase mortgage-backed securities held by banks and other financial institutions was "the first serious attempt by government to cure the underlying financial disease and not merely its symptoms." Id.
10. The author goes on to state that financial institutions are in trouble "because of falling prices of mortgage-backed and other securities, requiring these institutions to market their securities down to the collapsed market prices ... ." Id.
11. Mortimer B. Zuckerman, Preventing a Panic, U.S. NEWS & WORLD REP., Feb. 11, 2008, at 63 (observing that "[l]ower interest rates promoted by the Federal Reserve Bank cannot fully counter the forces of credit and liquidity contraction" caused by the subprime mortgage crisis);
12. see Seth Carpenter & Selva Demiralp, The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations, 38 J. MONEY CREDIT & BANKING 901, 918-19 (2006) (concluding that although a change in monetary policy can begin to affect the cost of capital within a day, its full effects can take much longer);
13. Serena Ng et al., Fed Fails So Far in Bid to Reassure Anxious Investors, WALL ST. J., Aug. 21, 2007, at A1.
14. See Steven L. Schwarcz, Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures, 70 U. CIN. L. REV. 1309, 1315 (2002).
15. Capital markets are now the nation's and the world's most important sources of investment financing. See MCKINSEY GLOBAL INST., MAPPING THE GLOBAL CAPITAL MARKET THIRD ANNUAL REPORT 8 (2007), available at http://www.mckinsey.com/mgi/reports/pdfs/third- annual-report/CapMarkets-perspective.pdf (reporting that as of the end of 2005, the value of total global financial assets, including equities, government and corporate debt securities, and bank deposits, was $140 trillion).
16. Although there is some concern about capital levels at banks, the losses giving rise to this concern are not due to bad mortgage loans made by those banks but rather to investments in mortgage-backed securities or loans made to entities, such as hedge funds, holding mortgage-backed securities as assets. See infra note 64 (reporting on write-downs stemming from bad mortgage-backed securities);
17. see also David Wessel, Magnifying the Credit Fallout, WALL ST. J., Mar. 6, 2008, at A2 (discussing the erosion of the capital level at banks due to the falling value of bank-owned mortgage loans and mortgagebacked securities).
18. See Anthony W. Ryan, Assistant Sec'y for Fin. Mkts., U.S. Dep't of the Treasury, Remarks Before the Managed Funds Association Conference (June 11, 2007) (transcript available at http://www.ustreas.gov/press/releases/hp450.htm) (discussing the market-discipline approach).
19. For an explanation of the types of securities involved in the subprime financial crisis, see infra notes 14-26 and accompanying text.
20. See JOHN DOWNES & JORDAN ELLIOT GOODMAN, DICTIONARY OF FINANCE AND INVESTMENT TERMS 662-63 (7th ed. 2006).
21. There are arcane variations on the CDO categories, such as CDOs "squared" or "cubed," but these go beyond this Essay's analysis.
22. See DOWNES & GOODMAN, supra note 13, at 434-35.
23. See id. at 35.
24. See id. at 630.
25. See id. at 121.
26. "Synthetic" CDOs, which do not appear to be relevant to this Essay's analysis, own derivative instruments, such as credit-default swaps, rather than receivables, ABS, or MBS.
27. See DOWNES & GOODMAN, supra note 13, at 749.
28. See id. at 637.
29. See id. at 369.
30. See id. at 421.
31. In MBS and ABS transactions, the term "equity" is not generally used because the company originating the securities (the "Originator" ) usually holds, directly or indirectly, the residual claim against the SPV. See id. at 491 (defining "originator").
32. See id. at 121 (defining CDO as an investment-grade bond backed by a diversified pool of bonds including junk bonds). The equity class is generally not rated.
33. See Investopedia, http://www.investopedia.com/terms/w/ waterfallpayment.asp (last visited Sept. 20, 2008) (defining waterfall payment as "[a] type of payment scheme in which higher-tiered creditors receive interest and principal payments, while the lower-tiered creditors receive only interest payments. When the higher tiered creditors have received all interest and principal payments in full, the next tier of creditors begins to receive interest and principal payments").
34. See Kemba J. Dunham & Ruth Simon, Refinancing May be Harder to Enjoy, WALL ST. J., Nov. 24, 2007, at B1 (discussing the difficulty of refinancing due to tighter lending standards and falling home prices).
35. Rick Brooks & Constance Mitchell Ford, The United States of Subprime, WALL ST. J., Oct. 11, 2007, at A1 (analyzing high-rate mortgages).
36. Although rate increases on ARM loans (through rate resets) were not per se unexpected, the end of the liquidity glut made it harder for subprime borrowers to refinance into loans with lower, affordable interest rates. See id.
37. Anthony B. Sanders, Bob Herberger Ariz. Heritage Chair Professor of Fin., Ariz. State Univ., Incentives and Failures in the Structured Finance Market: The Case of the Subprime Mortgage Market, Presentation to the Federal Reserve Bank of Cleveland Workshop: Structured Finance and Loan Modification (Nov. 20, 2007) (notes on file with author). But cf. Ruth Simon, Rising Rates to Worsen Subprime Mess, WALL ST. J., Nov. 24, 2007, at Al (reporting that many mortgages defaulted even before interest rates increased).
38. See Carrick Mollenkamp & Serena Ng, Wall Street Wizardry Amplified Credit Crisis: A CDO Called Norma Left 'Hairball of Risk'; Tailored by Merrill Lynch, WALL ST. J., Dec. 27, 2007, at Al (reporting on the downgrade of one CDO's AAA rated tranches to junk status).
39. See id.
40. Reference in this article to "investors" means investors in capital market securities, not investors in the homes financed by the mortgage loans ultimately backing such securities.
41. See, e.g., Paul Krugman, Rashomon in Connecticut: What Really Happened to Long-Term Capital Management?, SLATE, Oct. 2, 1998, http://www.slate.com/toolbar.aspx?action=print&id=1908.
42. Jack Guttentag, Shortsighted About the Subprime Disaster, WASH. POST, May 26, 2007, at F2 (explaining that because housing prices had been rising for a long period of time, it was assumed that they would continue to rise).
43. See Christine Harper, Death of VaR Evoked as Risk-Taking Vim Meets Taleb's Black Swan, BLOOMBERG.COM, Jan. 28, 2008, http://www.bloomberg.com/apps/news?id=20601109&sid=axoloswvqx4s&refer= home (reporting that financial models at Merrill Lynch, Morgan Stanley, and UBS failed to foresee the decline in housing prices).
44. See generally NASSIM TALEB, THE BLACK SWAN: THE IMPACT OF THE HIGHLY IMPROBABLE (2007) (discussing human tendency of failing to anticipate improbable events).
45. One commentator suggests that the disclosure also did not adequately address the relatively illiquid nature of the securities: "It is true that the level of default was unusually high, but the bulk of the problem is coming from liquidity issues - no one wants to hold these [securities], and if you try to find [a buyer] you have to trade them at a very low price." E-mail from Richard Bookstaber, author, A DEMON OF OUR OWN DESIGN, to author (Nov. 30, 2007, 08:11:08 EST) (on file with author).
46. Lack of liquidity, however, appears to have been a standard disclosure item. See, e.g., Soundview Home Loan Trust, Prospectus Supplement (WMC1) (Mar. 12, 2007), available at http://www.secinfo.com/dqTm6.uPa.htm: There is no assurance that ... a secondary market [in the securities] will develop or, if it develops, that it will continue. Consequently, you may not be able to sell your [securities] readily or at prices that will enable you to realize your desired yield. The market values of the [securities] are likely to fluctuate; these fluctuations may be significant and could result in significant losses to you.
47. Id. at "Lack of Liquidity" subsection under "Risk Factors." I therefore believe that the problem was less issuer failure to disclose the illiquidity risk than investor failure to appreciate that disclosure.
48. See infra notes 38-51 and accompanying text. Query, however, whether anyone knew - much less knew enough to disclose-the extent of the illiquidity problem.
49. See E-mail from Bookstaber, supra ("[N]o one knew how levered [sic] funds were, and therefore how quickly they would need to dump [securities] if they faced a market shock.").
50. But cf. Atif Mian & Amir Sufi, The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Subprime Mortgage Default Crisis 1, 4 (Nat'l Bureau of Econ. Research, Working Paper No. 13936), available at http://www.nber.org/papers/w13936 (arguing that investors and rating agencies likely did not fully appreciate that the mortgage supply expansion itself was in part driving house price appreciation).
51. In other words, Professors Mian and Sufi argue that home prices dropped radically, as a percentage, once mortgage money tightened, and that investors and rating agencies should have anticipated that possibility. See id.
52. Monty Python's Flying Circus: The Spanish Inquisition (BBC television broadcast Sept. 22, 1970).
53. See infra notes 48-51 and accompanying text (discussing herd behavior and the availability heuristic).
54. Daniel Andrews, The Clean Up: Investors Need Better Advice on Structured Finance Products, 26 INT'L FIN. L. REV. 14 (2007), http://search.ebscohost.com/login.aspx?direct= true&db=buh&AN=26885198&site=ehost-live.
55. This form of the hypothesis, of course, is now even more dubious as a predictor of (at least near-term) future investor reliance.
56. This Essay later examines why rating agencies failed to anticipate the downgrades. See infra Part U.E.
57. See infra notes 59-63 and accompanying text.
58. Individual investors face relatively high costs to assess the creditworthiness of complex ABS, CDO, and ABS CDO securities, whereas rating agencies make this assessment on behalf of many individual investors, thereby achieving an economy of scale. See infra notes 52-53 and accompanying text (discussing the complexity of these types of transactions and the volume of associated disclosure documents).
59. Alan S. Blinder, Six Fingers of Blame in the Mortgage Mess, N.Y. TIMES, Sept. 30, 2007, § 3 (Business), at 4.
60. See Sam Segal, Tulips Portrayed: The Tulip Trade in Holland in the 17th Century, in THE TULIP 17-19 (Michael Roding & Hans Theunissen eds., 1993) (noting that all levels of the population from the weaver to the aristocrat were buying tulips at staggering prices in hopes of making a profit from the "tulip mania").
61. RICHARD BOOKSTABER, A DEMON OF OUR OWN DESIGN: MARKETS, HEDGE FUNDS, AND THE PERILS OF FINANCIAL INNOVATION 169-70 (2007).
62. Segal, supra note 45, at 19.
63. Cf. Steven L. Schwarcz, Rethinking the Disclosure Paradigm in a World of Complexity, 2004 U. ILL. L. REV. 1, 14-15 (observing and explaining this behavior in a related context).
64. Paul Slovic et al., Facts Versus Fears: Understanding Perceived Risk, in JUDGMENT UNDER UNCERTAINTY: HEURISTICS AND BIASES 463, 465 (Daniel Kahneman et al. eds., 1982).
65. Id.
66. Cf. Larry Light, Bondholder Beware: Value Subject to Change Without Notice, BUS. WK., Mar. 29, 1993, at 34 (discussing that within years after the "Marriott split," investors favor higher interest rates over "event risk" covenants, once the examples of events justifying the covenants have receded in memory).
67. "Bondholders can-and will-fuss all they like. But the reality is, their options are limited: Higher returns or better protection. Most investors will continue to go for the gold." Id.
68. See, e.g., Aaron Lucchetti & Serena Ng, Credit & Blame: How Rating Firms' Calls Fueled Subprime Mess, WALL ST. J., Aug. 15, 2007, at A10 ("A lot of institutional investors bought [mortgage-backed] securities substantially based on their ratings [without fully understanding what they bought], in part because the market has become so complex.");
69. see also Blinder, supra note 44 (arguing that the MBS, especially the CDOs, "were probably too complex for anyone's good");
70. Malcolm Gladwell, Open Secrets: Enron, Intelligence, and the Perils of Too Much Information, NEW YORKER, Jan. 8, 2007, at 44-53 (distinguishing between transactions that are merely "puzzles" and those that are truly "mysteries").
71. To the extent complexity is merely a puzzle, investment bankers theoretically could understand it. See id. at 46 (stating why puzzles are easier to solve than mysteries).
72. The disclosure documents ordinarily consist of a prospectus and a prospectus supplement, each close to 200 pages long.
73. Schwarcz, supra note 48, at 7.
74. For a definition of "Originator," see supra note 24.
75. Schwarcz, supra note 48, at 30.
76. See also id. at 32-33 (showing how to identify these transactions, which are defined as "disclosure-impaired transactions").
77. If mortgage originators take a risk of loss prior to, or pari passu (i.e., equal and ratable) with, investor risk of loss, their incentives would be aligned with investor incentives.
78. See infra notes 70-83 and accompanying text.
79. Most investors were institutions. See SEC. & EXCH. COMM'N, STAFF REPORT: ENHANCING DISCLOSURE IN THE MORTGAGE-BACKED SECURITIES MARKETS (2003), http://www.sec.gov/news/studies/ mortgagebacked.htm (reporting that investors in MBS are "overwhelmingly institutional").
80. See, e.g., Kate Kelly et al., Two Big Funds At Bear Stearns Face Shutdown, WALL. ST. J., June 20, 2007, at A1.
81. James Surowiecki, Performance-Pay Perplexes, NEW YORKER, Nov. 12, 2007, at 34.
82. Hedge funds sometimes impose a limited punitive downside by ensuring that managers who lose money may not receive future bonuses until they subsequently make money above a "high water mark." MARK J. P. ANSON, THE HANDBOOK OF ALTERNATIVE ASSETS 361 (2002).
83. Generally, however, there is no clawback of past bonuses, so these managers can go to another hedge fund where they will not be subject to this liability. Id. at 85 ("[C]lawbacks are rare in the hedge fund world.").
84. In this regard, the reader should distinguish these conflicts of interest not only from the agency-cost problem discussed above but also from the potential conflict of interest between mortgage originators and investors discussed in footnotes 70-83 and accompanying text.
85. See, e.g., Schwarcz, supra note 48, at 2, 14-15.
86. Outside of an institutional-industry context, there may be further misalignment of incentives because of higher employee turnover. Id. at 14 (observing that employee turnover reduces accountability).
87. See, e.g., Jenny Anderson, Wall St. Banks Confront a String of Write-Downs, N.Y. TIMES, Feb. 19, 2008, at C1 ("[M]ajor banks . . . have already written off more than $120 billion of losses stemming from bad mortgagerelated investments.");
88. Randall Smith, Merrill's $5 Billion Bath Bares Deeper Divide, WALL ST. J., Oct. 6, 2007, at A4 (reporting a total of $20 billion in write-downs by large investment banks).
89. Cf. infra note 74 and accompanying text (cautioning against "throwing out the baby with the bathwater").
90. Although otherwise beyond this article's scope, certain CDO products, the so-called CDOs "squared" and "cubed," might be worthy of special consideration because they are subject to "cliff risk," or suddenly losing 100% of their value. See, e.g., MICHIKO WHETTEN & MARK ADELSON, NOMURA FIXED INCOME RESEARCH, CDOS-SQUARED DEMYSTIFIED 12-13 (2005), http://www.math.ust.hk/~maykwok/courses/ MAFS521-07/CDO-Squared-Nomura.pdf;
91. Janet Tavakoli, Leverage and Junk Science: A Credit Crunch Cocktail, TOTAL SECURITIZATION, Sept. 20, 2007, http://www.totalsecuritization.com.
92. In this context, the tort law doctrine of "unavoidably unsafe products" may help to inform a regulatory analysis. In tort law, an "unavoidably unsafe product" is subject to strict liability unless its utility outweighs its risk. Joanne Rhoton Galbreath, Annotation, Products Liability: What Is an "Unavoidably Unsafe" Product, 70 A.L.R. 4th 34 (1989).
93. For example, the vaccine for rabies is inherently dangerous, but rabies can result in death, so the vaccine is not subject to strict liability. RESTATEMENT (SECOND) OF TORTS § 402A cmt. k (1965).
94. See Steven L. Schwarcz, Systemic Risk, 97 GEO. L.J. 193, 196-97 (2008).
95. In other words, the externalities of systemic failure include social costs that can extend far beyond market participants. Id. at 208-09.
96. See id. at 228-30, 248-49.
97. Id.
98. This may have been further exacerbated by certain mortgage lenders without balance-sheet assets simply advancing to borrowers the proceeds of selling the loans. Confidential Interview with a monoline insurance executive (Oct. 18, 2007) (notes on file with author).
99. See, e.g., Legislative and Regulatory Options for Minimizing and Mitigating Mortgage Foreclosures: Hearing Before the H Comm. on Financial Serv., 110th Cong. 74 (2007) (statement of Ben S. Bernanke, Chairman, Board of Governors, Fed. Reserve System).
100. There is also speculation that some mortgage-loan originators might have engaged in fraud by manipulating borrower income, and that some borrowers may have engaged in fraud by lying about their income, in each case to qualify borrowers for loans. See, e.g., Vikas Bajaj, A Cross-Country Blame Game, N.Y. TIMES, May 8, 2007, at C4. If such fraud occurred, it would exacerbate but is unlikely to be significant enough to have caused the subprime financial crisis.
101. See Gary B. Gorton, The Panic of 2007, at 68 (Nat'l Bureau of Econ. Research, Working Paper No. 14358, 2008), available at http://www.nber.org/ papers/w14358.pdf (stating that the originate-and- distribute model and resulting moral hazard are the "dominant explanation" for the financial panic).
102. To some extent, the drop in underwriting standards under the originate-and-distribute model may reflect distortions caused by the recent liquidity glut, in which lenders competed aggressively for business and allowed otherwise defaulting borrowers to refinance. See Ravi Balakrishnan et al., Globalization, Gluts, Innovation or Irrationality: What Explains the Easy Financing of the U.S. Current Account Deficit? 5 (Int'l Monetary Fund, Working Paper No. 07/160, 2007), available at http://www.imf.org/ external/pubs/ft/wp/2007/wp07160.pdf (discussing this liquidity glut).
103. This model is also referred to as "originate to distribute."
104. See, e.g., Joseph R. Mason, Assoc. Professor of Fin. & LeBow Research Fellow, Lebow Coll. of Bus., Drexel Univ., Presentation to the Federal Reserve Bank of Cleveland: Mortgage Loan Modification: Promises and Pitfalls (Nov. 20, 2007) (presentation notes on file with author) (showing that fifty-eight percent of mortgage liquidity in the United States, and seventy-five percent of mortgage liquidity in California has come from structured finance).
105. See Xudong An et al., Value Creation Through Securitization: Evidence from the CMBS Market 3 (SSRN Working Paper No. 1095645, 2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract-id=1095645 (concluding that despite the recent mortgage crisis, securitization has created value in the financial markets).
106. See supra text accompanying notes 57-58.
107. See Vincent Ryan, Debt in Disguise, CFO MAG., Nov. 2007, at 80 (reporting that most securitization agreements include overcollateralization).
108. See infra notes 87-89 and accompanying text.
109. The failure to monitor also can be explained by systematic underestimation of the risk by all market players. See, e.g., Oz Ergungor, The Mortgage Debacle and Loan Modification 7-8 (2008) (unpublished manuscript, on file with author).
110. Sanders, supra note 29.
111. Cf. id. (arguing that mortgage originators be required to post capital to backstop their representations and warranties for loans originated and then sold).
112. Representations and warranties are even more patently illusory for mortgage originators lacking assets, who simply advance to borrowers the proceeds of selling the loans. See supra note 70.
113. The market actually was beginning to adjust in this fashion shortly before the subprime mortgage crisis started. See Jon D. Van Gorp, Capital Markets Dispersion of Subprime Mortgage Risk 10 (Nov. 2007) (unpublished manuscript, on file with author) (observing that, at the beginning of 2007,
114. "early payment default protection became standardized across the market," requiring loan originators to repurchase loans that fail to make any of their first two or three scheduled payments). Obligations to repurchase can become ineffective, however, when so many loans default that the obligor is unable to make its required repurchases. Ergungor, supra note 79, at 4-5.
115. In the author's experience, this observation is accurate. Cf. Blinder, supra note 44 (suggesting that mortgage-loan originators "retain a share of each mortgage");
116. supra notes 40-41 and accompanying text (discussing underwriters retaining a portion of the equity when selling ABS CDO securities).
117. Cf. Blinder, supra note 44 (suggesting a "suitability standard" for selling mortgage products and that all mortgage lenders be placed under federal regulation).
118. 12 C.F.R. § 221.3 (2008).
119. One might also consider imposing lending "suitability" standards and predatory-lending restrictions. For example, North Carolina's Home Loan Protection Act, among other things, mandates that lenders verify borrower income and also review the borrower's ability to repay the loan after introductory rates adjust upwards. N.C. GEN. STAT. § 24-1.1E (2007) (amended by 2008 N.C. Sess. Laws).
120. The U.S. Congress also has considered mortgage suitability standards and anti-predatory-lending restrictions. See, e.g., Mortgage Reform and Anti-Predatory Lending Act, H.R. 3915, 110th Cong. (2007).
121. There is dispute, however, over whether the North Carolina law has negatively impacted home ownership. Compare Raphael W. Bostic et al., State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mechanisms, 60 J. ECON. & BUS. 47, 50 (2008) (lending evidence that anti-predatory-lending laws have not curtailed credit mortgage markets),
122. and Nanette Byrnes, These Tough Lending Laws Could Travel, BUS. WK., Nov. 5, 2007, at 70 (reporting that North Carolina's housing market has not, according to "academic studies," been negatively impacted),
123. and ROBERTO G. QUERCIA ET AL., CTR. FOR COMMUNITY CAPITALISM, THE IMPACT OF NORTH CAROLINA'S ANTIPREDATORY LENDING LAW: A DESCRIPTIVE ASSESSMENT (2003), http://www.planning.unc.edu/pdf/CC-NC-Anti-Predatory-Law-Impact.pdf (stating that since the law was passed, there has been a reduction in predatory loans, but there has been "no change in the cost of subprime credit or reduction in access to credit for high-risk borrowers"), with Byrnes, supra (reporting that groups such as the Mortgage Bankers Association argue that tough loan underwriting standards will prevent needy borrowers from obtaining mortgage loans). Some argue also that the "borrowers are not victims of inappropriate loan prospecting (such as predatory lending). Rather, they [or, at least, many] were willful participants." Sanders, supra note 29.
124. But cf. Gretchen Morgenson, Blame the Borrowers? Not So Fast, N.Y. TIMES, Nov. 25, 2007, § 3 (Business), at 1.
125. Douglas Elmendorf, Notes on Policy Responses to the Subprime Mortgage Unraveling, BROOKINGS INST., at 9 n.6, Sept. 17, 2007, http://www.brookings.edu/~/media/Files/rc/papers/2007/ 09subprimemortgageunravelling/09useconomics-elmendorf.pdf;
126. see also Darrell Duffie, Innovations in Credit Risk Transfer: Implications for Financial Stability 1-2 (Bank for Int'l Settlements, Paper No. 255, 2008), available at http://www.bis.org/publ/work255.pdf? noframes=1 (arguing that instruments that transfer credit risk improve financial stability by dispersing risk among investors).
127. The very assumption that structured finance reallocates risk to parties best able to bear it also may have failed in the subprime context. E-mail from Bookstaber, supra note 35 ("Rather than spreading the risk to those who were most comfortable holding the assets and taking the risk, many of the [holders] were 'hot money' hedge funds that would have to run for cover at the very time the risk taking function was most critical.").
128. See supra text accompanying note 82 (arguing that prudent investors should insist that mortgage originators retain some direct risk of loss to mitigate moral hazard).
129. Gretchen Morgenson, More Home Foreclosures Loom as Owners Face Mortgage Maze, N.Y. TIMES, Aug. 6, 2007, at Al.
130. A somewhat related issue is that, at least heretofore, individual borrowers could not use Chapter 13 bankruptcy to restructure their home mortgage-loan liabilities. See 11 U.S.C. § 1322(b)(2), 1332(b)(5) (2006).
131. Bills have been introduced into both houses of Congress to amend Chapter 13 and allow for restructuring of home mortgages by bankruptcy courts. See Emergency Home Ownership and Mortgage Equity Protection Act of 2007, H.R. 3609, 110th Cong. (2007);
132. Helping Families Save their Homes in Bankruptcy Act of 2008, S. 2136, 110th Cong. (2008).
133. In a corporate-reorganization context, however, debtors can, with the lender's consent, use bankruptcy to restructure their secured-loan liabilities. Cf. 11 U.S.C. § 1123(a)(5) (2006) (listing the contents of a bankruptcy plan); §1126(c) (acceptance of a bankruptcy plan); § 1129(a)(7)-(8) (confirmation of a bankruptcy plan).
134. 15 U.S.C. § 1641(f)(2) (2006). Identification would be even less of a problem if the underlying receivables are not consumer assets, like mortgage loans, since the amounts involved in consumer receivables are typically relatively small.
135. See JAMES A. ROSENTHAL & JUAN M. OCAMPO, SECURITIZATION OF CREDIT 49-51 (1988) (explaining the general structure of a grantor trust when the originator of asset-backed securities services the pool of assets);
136. Gretchen Morgenson, Countrywide Is Upbeat Despite Loss, N.Y. TIMES, Oct. 27, 2007, at C1 (reporting that Countrywide is the nation's largest loan servicer).
137. In addition to a primary servicer, there are often other servicers involved in MBS transactions including a specialized servicer who services defaulted mortgage loans. See Mortgage Bankers Ass'n, Presentation to the Securities and Exchange Commission on the Proposed Asset-Backed Securities Rule (Sept. 23, 2004), available at www.sec.gov/rules/proposed/s72104/ mba092304.ppt.
138. Morgenson, supra note 90 (observing that a servicer might, for example, be permitted to restructure only five percent of the loans). Sometimes, however, the servicer is limited as to the percentage of loans in a given pool that can be restructured. Id.
139. Financial Asset Securities Corp., Pooling and Service Agreement for Soundview Home Loan Trust Asset-Backed Certificates § 3.01 (Mar. 1, 2007), available at http://www.sec.gov/Archives/edgar/data/1386634/ 00008823770700 1029/d650626ex4-1.htm. 95. Mason, supra note 74 (observing that servicers will prefer to foreclose, even if it is not the best remedy, when foreclosure costs, but not modification costs, are reimbursed).
140. Id.
141. Id.
142. Id.
143. Kathleen C. Engel, Assoc. Professor of Law, Cleveland-Marshall Coll. of Law, Presentation to the Federal Reserve Bank of Cleveland: Modifications of Loans in Securitized Pools: Obstacles and Options (Nov. 20, 2007) (notes on this presentation on file with author).
144. Van Gorp, supra note 82, at 7-8.
145. The conflicts among tranches can become even more complicated because subprime MBS, CDO, and ABS CDO securities sometimes also include prepayment-penalty tranches, and the different tranches "have different priorities relative to one another for the purpose of absorbing losses and prepayments on the underlying subprime mortgage loans." Id. at 8.
146. Telephone Interview with Alan Hirsch, Dir., N.C. Policy Office (Feb. 20, 2008) (describing tranche conflicts as a significant reason why servicers choose foreclosure over restructuring). 103. In the current subprime crisis, of course, the underlying deal documentation is already in place. Because existing documentation cannot be easily renegotiated, the government might consider legislating changes. Any such changes that are subsidized in whole or part by government, however, could foster moral hazard, potentially making future homeowners more willing to take risks when borrowing.
147. Engel, supra note 99.
148. Cf. Andrews, supra note 39 (observing from the subprime financial crisis that "liquidity in markets for structured investments can disappear immediately as soon as there are any shocks-no buying or selling at all in an entire sector," though not explaining why this occurrs).
149. A somewhat related question might be why the U.S. domestic real estate collapse is having a significant impact overseas. The answer is that foreign investors purchased a significant amount of the CDO and ABS CDO securities backed (directly or indirectly) by such real estate. Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis Is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1. 106.
150. Thanks to Rick Bookstaber for this term. Bookstaber himself borrows it from engineering nomenclature. See Systemic Risk Hearing, supra note 2, at 8 (statement of Richard Bookstaber).
151. See, e.g., Paul Davies & Gillian Tett, 'A Flight to Simplicity': Investors Jettison What They Do Not Understand, FIN. TIMES (London), Oct. 22, 2007, at 9.
152. Cf. Markus K. Brunnermeier, Deciphering the 2007-08 Liquidity and Credit Crunch, 22 J. ECON. PERSP. (forthcoming Fall 2008), available at http://www.princeton.edu/~markus/research/papers/ liquidity-crunch-2007-08.pdf (speculating that when investors realized how difficult it was to value mortgage-structured products, the volatility of all structured products increased).
153. Cf. supra note 72 and accompanying text (explaining that lenders competed aggressively for business during the recent liquidity glut, which allowed otherwise defaulting borrowers to refinance).
154. Many CDO and ABS CDO products are valued by models rather than market price because they are issued in private placements and not freely traded. Valuation models are imperfect because they are based on assumptions. See Floyd Norris, Reading Write-Down Tea Leaves, N.Y. TIMES, Nov. 9, 2007, at C1 (discussing the problems related to using valuation models).
155. See generally Ingo Fender & John Kiff, CDO Rating Methodology: Some Thoughts on Model Risk and its Implications (Bank of Int'l. Settlements, Working Paper No. 163, 2004), available at http://www.bis.org/publ/work163.htm (discussing the problems associated with the valuation models used by rating agencies).
156. See, e.g., Zuckerman, supra note 8, at 63 (stating that the "credit system has been virtually frozen," which poses a problem "since few people even know where the liabilities and losses are concentrated").
157. Under the indirect holding system for securities, intermediary entities hold securities on behalf of investors. Issuers of the securities generally record ownership as belonging to one or more depository intermediaries, which in turn record the identities of other intermediaries, such as brokerage firms or banks, that buy interests in the securities. Those other intermediaries, in turn, record the identities of investors that buy interests in the intermediaries' interests. See Steven L. Schwarcz, Intermediary Risk in a Global Economy, 50 DUKE L.J. 1541, 1547-48 (2001).
158. Because of this ownership chain, there is no single location from which third parties can readily determine who ultimately owns specific securities. Id. at 1583.
159. ZVI BODIE ET AL., INVESTMENTS 78-79 (6th ed. 2005).
160. See, e.g., Gikas A. Hardouvelis & Panayiotis Theodossiou, The Asymmetric Relation Between Initial Margin Requirements and Stock Market Volatility Across Bull and Bear Markets, 15 REV. FIN. STUD. 1525, 1554-55 (2002) (finding a correlation between higher margin calls and decreased systemic risk, and speculating that higher margin calls may bleed the irrationality out of the market until only sound bets are left).
161. See Rodrigo Cifuentes et al., Liquidity Risk and Contagion, BANK OF INTERNATIONAL SETTLEMENTS, at 2, Apr. 2, 2004, http://www.bis.org/bcbs/ events/rtf04shin.pdf;
162. see also Clifford De Souza & Mikhail Smirnov, Dynamic Leverage: A Contingent Claims Approach to Leverage for Capital Conservation, J. PORTFOLIO MGMT. 25, 28 (Fall 2004) (arguing that, in a bad market, shortterm pressure to sell assets to raise cash for margin calls can lead to further mark-to-market losses for remaining assets, which triggers a whole new wave of selling, the process repeating itself until markets improve or the firm is wiped out; and referring to this process as a "critical liquidation cycle").
163. De Souza & Smirnov, supra note 115, at 26-27.
164. Rachel Evans, Banks Tell of Downward Spiral, 27 INT'L FIN. L. REV. 16 (2008), http://search.ebscohost.com/login. aspx?direct=true&db=buh&AN= 33588387&site=ehost-live.
165. Cf. Schwarcz, supra note 66, at 202-04 (discussing the danger of converging hedge-fund investment strategies).
166. Amir Khandani & Andrew W. Lo, What Happened to the Quants in August 2007? 2 (SSRN Working Paper No. 1015987, 2007), available at http://papers.ssrn.com/sol3/papers.cfm?abstract-id=1015987.
167. Id. Essentially, the authors argue that if shared models are wrong, an unanticipated error is shared by everyone.
168. There also might have been amplifying mechanisms that exacerbated or expanded market losses. For example, highly leveraged hedge funds apparently borrowed money from banks and invested in significant amounts of MBS, CDO, and ABS CDO securities backed by subprime mortgages. See, e.g., Paul Davies & Gillian Tett, supra note 104 (reporting that hedge funds borrowed large amounts of money to invest in CDO securities).
169. Failure of these hedge funds resulting from losses on these securities can affect the bank lenders. Another possible amplifying mechanism is that certain bank-sponsored investment conduits purchased AAA-rated CDO and ABS CDO securities with the proceeds of short-term commercial paper. As the CDO and ABS CDO securities were marked down in value and investors failed to roll over their commercial paper, the bank sponsors faced the prospect of having to make payments to the conduits pursuant to liquidity and credit-enhancement facilities. See Carrick Mollenkamp & Margot Patrick, Credit Crunch: Citigroup Moves to Quell SIV Concerns, WALL ST. J., Sept. 7, 2007, at C2 (reporting that Citibank was unable to raise money through the sale of asset-backed commercial paper);
170. see also infra note 148 and accompanying text.
171. Cf. Ben S. Bernanke, Chairman, Bd. of Governors, Fed. Reserve Sys., Remarks at the Federal Reserve Bank of Atlanta's 2006 Financial Markets Conference (May 16, 2006), available at http://www.federalreserve.gov/ newsevents/speech/Bernanke20060516a.htm (observing that, to the extent hedge funds are regulated solely through market discipline, government's "primary task is to guard against a return of the weak market discipline that left major market participants overly vulnerable to market shocks").
172. See, e.g., Helen A. Garten, Banking on the Market: Relying on Depositors to Control Bank Risks, 4 YALE J. ON REG. 129, 129-30 & n.1 (1986);
173. Albert J. Boro, Jr., Comment, Banking Disclosure Regimes for Regulating Speculative Behavior, 74 CAL. L. REV. 431, 471 (1986).
174. See sources cited supra note 123;
175. cf. Ben S. Bernanke, Chairman, Bd. of Governors, Fed. Reserve Sys., Remarks at the New York University Law School (Apr. 11, 2007), available at http://www.federalreserve.gov/newsevents/speech/ Bernanke20070411a.htm ("Receivership rules that make clear that investors will take losses when a bank becomes insolvent should increase the perceived risk of loss and thus also increase market discipline. ... In the United States, the banking authorities have ensured that, in virtually all cases, shareholders bear losses when a bank fails.").
176. See generally supra Part II.A.
177. See supra notes 52-54 and accompanying text.
178. See supra notes 59-63 and accompanying text (observing potential agency-cost conflicts between investment bankers who structured, sold, or invested in securities and the institutions for which they worked).
179. See supra notes 87-88 and accompanying text (arguing that structured finance may have dispersed subprime mortgage risk so widely that there was no clear incentive for any given investor to monitor it);
180. see also infra text accompanying note 131 (observing that from the standpoint of systemic risk, a market-discipline approach is inherently suspect because no firm has sufficient incentive to limit its risk taking in order to reduce the danger of systemic contagion for other firms).
181. See Roberta Romano, A Thumbnail Sketch of Derivative Securities and Their Regulation, 55 MD. L. REV. 1, 79 (1996) (discussing greed as a central factor that, in the hedge-fund context, transforms a successful hedging or moderately risky investment strategy into one of high-risk speculation).
182. But cf. Bernanke, supra note 122 (suggesting a possible alternative psychological explanation, at least in the case of the failure of market discipline with respect to LTCM's investors, that those "[i]nvestors, perhaps awed by the reputations of LTCM's principals, did not ask sufficiently tough questions about the risks that were being taken to generate the high returns");
183. supra note 39 and accompanying text (describing the "overreliance" hypothesis).
184. See supra notes 48-49 and accompanying text.
185. See generally supra notes 65-67 and accompanying text.
186. See E-mail from Bookstaber, supra note 35.
187. See supra text accompanying notes 41-43.
188. Steven L. Schwarcz, Private Ordering of Public Markets: The Rating Agency Paradox, 2002 U. ILL. L. REV. 1, 15.
189. See id. at 3.
190. See id. at 16.
191. See id. at 14.
192. See id. at 16 n.94.
193. For other possible ideas of how to avoid conflicts of interest in paying rating agencies, see Alan S. Blinder, Economic View: The Case for a Newer Deal, N.Y. TIMES, May 4, 2008, § 3 (Business), at 4 (noting ideas of his Princeton University colleagues, such as paying rating agencies with some of the securities they rate, or having a governmental entity pay rating agencies from the proceeds of a tax levied on issuers).
194. Professor Blinder admits the difficulty of avoiding conflicts of interest, requesting that "[i]f you have a better idea, write your legislators." Id.
195. Cf. Steven L. Schwarcz, Temporal Perspectives: Resolving the Conflict Between Current and Future Investors, 89 MINN. L. REV. 1044, 1053-54 (2005) (observing that, to the extent ratings affect not only new investors but also existing investors, the analysis is complicated by the inherent conflict between those two sets of investors).
196. See supra notes 33-38 and accompanying text.
197. See supra text accompanying notes 34-37.
198. See supra notes 48-51 and accompanying text.
199. In order to qualify as a Nationally Recognized Statistical Rating Organization (NRSRO), the rating agency must employ "an adequate number of staff members with the education and experience necessary to competently evaluate an issuer's credit." Arturo Estrella et al., Credit Ratings and Complementary Sources of Credit Quality Information 51 (Bank for Int'l. Settlements, Paper No. 3, 2000), available at http://www.bis.org/publ/ bcbs-wp3.pdf? noframes=1.
200. But cf. Gerry McNamara & Paul Vaaler, A Management Research Perspective On How and Why Credit Assessors 'Get it Wrong' When Judging Borrowers 3 (May 3, 2008) (unpublished manuscript, on file with author) (suggesting that rating-agency models may have failed in part because of systematic biases resulting from behavioral factors).
201. See Mian & Sufi, supra note 36, at 24-25.
202. See supra note 71.
203. See Schwarcz, supra note 134, at 6 (observing that rating agencies do not, and cannot pragmatically, rate for fraud).
204. One explanation for the erosion of diversification is the growth of synthetics. See infra note 145.
205. See also Jody Shenn, Overlapping Subprime Exposure Mask Risks of CDOs, Moody's Says, BLOOMBERG.COM, Apr. 4, 2007, http://www.bloomberg.com/apps/news?pid=20601170&sid=aszosOrxVmjk&refer= home (reporting that the growth of synthetics in the CDO market has created situations where assets and the synthetic products derived from those assets are in the same CDO, causing the CDO to be exposed to the same risk twice);
206. see also E-mail from Bookstaber, supra note 35 (discussing this link).
207. See The Role of Credit Rating Agencies in the Structured Finance Market: Hearing Before the Subcomm. on Capital Markets, Insurance and Government Sponsored Enterprises of the H. Comm. on Financial Servs., 110th Cong. 63 (2007) (statement of Mark Adelson, Member, Adelson & Jacob Consulting, LLC).
208. Another possible hypothesis is that there has been ratingagency "grade inflation." See Charles W. Calomiris, Not (Yet) a Minsky Moment, AMERICAN ENTERPRISE INSTITUTE, at 18, Oct. 5, 2007, http://www.aei .org/doclib/20071010-Not(Yet)AMinskyMoment.pdf ("Grade inflation has been concentrated particularly in securitized products, where the demand is especially driven by regulated intermediaries."). However, even if there was grade inflation, the consequences are unclear since investors were probably not misled but simply did not care so long as the securities purchased were in fact rated investment grade.
209. S&P Announces New Actions to Strengthen the Ratings Process, CREDIT WK., Feb. 13, 2008, at 12 (proposing various procedural review steps to minimize human failure in the ratings process and to increase the efficiency of, and public confidence in, credit ratings).
210. See supra note 43.
211. I am grateful to Professor Jonathan Lipson for suggesting these categories.
212. Systemic Risk Hearing, supra note 2, at 27 (statement of Steven L. Schwarcz, Stanley A. Star Professor of Law and Business, Duke University).
213. Cf. supra note 51 and accompanying text (observing that investors quickly forget past financial crises and "go for the gold").
214. Collective approaches, though, might face potential antitrust hurdles.
215. Cf. Michael Mandel, The Economy's Safety Valve, BUS. WK., Oct. 22, 2007, at 36 ("In today's complex and globally integrated financial markets, it's almost impossible for regulators to plug every hole.").
216. See, e.g., Interview with Hirsch, supra note 102 (observing that, because of these layers, the "instruments were so complex that no one followed the trail").
217. See, e.g., Steven L. Schwarcz, Complexity as a Catalyst of Market Failure: A Law and Engineering Inquiry 2 n.5 (SSRN Working Paper No. 1240863, 2008), available at http://papers.ssrn.com/sol3/papers.cfm? abstract-id=1240863.
218. See Schwarcz, supra note 66, at 241-42.
219. Cf. Balakrishnan et al., supra note 72, at 8 (discussing the liquidity glut).
220. Mandel, supra note 156, at 34.
221. Id.
222. Id. at 36-37.
223. That many of the affected individuals have been "low-income" individuals does not conflict with this Essay's earlier observation that QIBs are the investors who lost the most money in the subprime crisis. See supra text accompanying note 64. Low-income individuals lost money not as investors but as foreclosed homeowners.
224. Mandel, supra note 153, at 37;
225. see also Vikas Bajaj & Louise Story, Mortgage Crisis Spreads Beyond Subprime Loans, N.Y. TIMES, Feb. 12, 2008, at A1 (discussing the spread of the subprime crisis to other markets);
226. cf. Michael D. Bordo et al., Real Versus Pseudo-International Systemic Risk: Some Lessons from History 10 (Nat'l Bureau of Econ. Research, Working Paper No. 5371, 1995), available at http://www.nber.org/papers/ w5371.pdf (discussing how normal market expansions and contractions can turn into market crises in situations of "speculative mania").