Code, crash, and open source: The outsourcing of financial regulation to risk models and the global financial crisis

Washington Law Review

Volumn 84, Issue 2, 2009, Pages 127-198

  Gerding, Erik F ^a  

^a UNIVERSITY OF NEW MEXICO   (United States)

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[No Author keywords available]

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EID: 69249125735     PISSN: 00430617     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (410)

1. Ronald J. Gilson & Charles K. Whitehead, Deconstructing Equity: Public Ownership, Agency Costs, and Complete Capital Markets, 108 COLUM. L. REV. 231 (2008) (describing how advances in quantitative finance have led to the development of sophisticated derivatives and other financial products that promise both to lead to "complete" capital markets and drain liquidity from equity markets).
2. This system is described in detail in Part I.B infra.
3. The mechanics of securitization are described in greater detail in Part I.B.ii infra.
4. For an analysis of derivative transactions, see Part I.B.iv infra.
5. See Gilson & Whitehead, supra note 1, at 263.
6. Lauren E. Willis, Decisionmaking and the Limits of Disclosure: the Problem of Predatory Lending: Price, 65 Md. L. REV. 707, 719-21, 724-26 (2006) (analyzing how advances in financial industry data collection technologyallow lenders to market highly complex financial products to consumers and gain an information advantage over consumers with respect to predicting consumer defaults and penalties under those products). Use of code at the level of consumer finance is examined further in Part I.B.i.
7. See infra Part I.B.ii.
8. See infra Part 1.B.iii.l.
9. Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. CIN. l. Rev. 1019, 1020-22, 1029-30 (2007) (analyzing two of these devices-credit default swaps and collateralized debt obligations (CDOs)-and emphasizing the importance of mathematical models for CDOs). For an earlier article analyzing use of code in constructing derivatives.
10. see Henry T.C. Hu, Misunderstood Derivatives: the Causes of Informational Failure and the Promise of Regulatory Incrementalism, 102 YALE L.J. 1457, 1476-81 (1993). Use of code in hedging, including in pricing derivatives, is explored in Part I.B.iii.4 infra.
11. Raj Bhala, Applying Equilibrium Theory and the FICAS Model: a Case Study of Capital Adequacy and Currency Trading, 41 ST. Louis U. L.J. 125, 159-62, 178, 183-87 (1997) (detailing arguments for superiority of banks' internal models to measure risk and set capital requirements compared to regulatory methods). Use of code for these purposes is discussed in Part l.B.iii.3 infra.
12. See infra Part 1.B.i.
13. See Frank Partnoy, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, 77 wash. U. L.Q. 619, 681 (1999) (characterizing regulations that limit financial institutions to investments that are rated by rating agencies as giving those rating agencies a "regulatory license").
14. Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards: a Revised Framework (June 2006) [hereinafter "Basel 11"], available at http://www.bis.org/publ/ bcbs128.pdf, permanent copy available at http://www.law.washington.edu/wlr/ notes/84washlrev127n13.pdf. Basel II is the second accord among bank regulators and central bankers from countries that belong to the Basel Committee on Banking Supervision (members come from the so-called "Group of Ten" countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States). The accord consists of a series of recommended bank regulations and principles that national regulators should implement in their home countries. The accord thus attempts to set minimum international banking standards to mitigate both regulatory arbitrage by international banks and financial risks caused by potential bank failure that could spread from one economy to another. For a capsule summary of the Basel accords
15. see Robert Hugi et al., U.S. Adoption of Basel II and the Basel II Securitization Framework, 12 N.C. banking INST. 45 (2008
16. Eric Y. Wu, Basel II: a Revised Framework, 24 Ann. Rev. Banking & Fin. L. 150 (2005).Although non-binding, national regulators exert pressure on one another to comply with the accord, giving it the quality of "soft law."
17. See Michael S. Barr & Geoffrey P. Miller, Global Administrative Law: the View from Basel, 17 EUR. J. INT'L L. 15, 17 (2006) (reciting critiques of law-making by networks of bank regulators and international bureaucrats in the Basel Accord as lacking accountability and legitimacy, but arguing that Basel II is subject to a subtle structure of international administrative law)
18. Dieter Kerwer, Rules that Many Use: Standards and Global Regulation, 18 GOVERNANCE 611 (2005)
19. Joseph J. Norton, A Perceived Trend in Modem International FinancialRegulation: Increasing Reliance on a Public-Private Partnership, 37 INT'L LAW 43,46 (2003)
20. BASEL II, supra note 13, at 19 (permitting banks to set regulatory capital for credit risk in part based on rating agency ratings (i.e., "external credit assessment)).
21. Basel II, supra note 13, at 19 (permitting banks to set regulatory capital for credit risk in part based on rating agency ratings (i.e., "external credit assessment)). See also id. at 27 (establishing the requirements that specify when banks can use "external credit assessment" to support capital-requirement assessments for credit risk).The principle U.S. banking regulators have already issued a final rule setting out the framework for Basel II implementation in the United States. Risk-Based Capital Standards: Advanced Capital Adequacy Framework - Basel II, 72 Fed. Reg. 69,288 (Dec. 7, 2007) (to be codified at 12 C.F.R. pts. 3,208,225,325,559,560, 563,567).
22. Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, Exchange Act Release No. 34-49,830, 69 Fed. Reg. 34,428 (June 21, 2004) (codified at 17 C.F.R. pts. 200 and 240).
23. See Lynn A. Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 DUKE L.J. 701, 704-07 (1999) (noting that OTC market is largely unregulated, but describing debate on regulation in context of proposed Commodity Exchange Act amendments).
24. Then-Federal Reserve Chairman Alan Greenspan expressed concern about how over-regulation of OTC derivatives might impair market efficiency and threaten U.S. competitiveness. Working Group Report on OTC Derivatives: Hearing Before the S. Comm. on Agriculture, Nutrition and Forestry, 106th Cong. (Feb. 10, 2000) (statement of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System), available at http://agriculture.senate.gov/Hearings/Hearings- 2000/wl00210/0029gre.htm, permanent copy available at http://www.law.washington. edu/wlr/notes/84washlrev 127n17.pdf.
25. His position meshed with views among other policymakers and scholars that light regulation was justified given a "set of private mechanisms that facilitate smooth functioning OTC derivatives markets." Garry J. Chinas, Safeguarding Financial Stability: Theory and practice 206 (2006) ("Market discipline, provided by shareholders and creditors, promotes market stability by rewarding financial institutions based on their performance and creditworthiness.") But, Mr. Chinas also notes, "Recent research finds market discipline to be strong only during periods of banking sector stress and volatile financial markets." Id.
26. Dustin G. Hall, Note, The Elephant in the Room: Dangers of Hedge Funds in Our Financial Markets, 60 fLA. L. Rev. 183, 221-26 (2008) (criticizing proposals to regulate hedge funds as too modest)
27. But cf. Troy A. Paredes, On the Decision to Regulate Hedge Funds: the SEC's Regulatory Philosophy, Style, and Mission, 2006 U. ill. L. rev. 975, 977 (2006) (describing possible rationale behind SEC attempt to require registration of hedge funds). The proposed SEC regulation (discussed infra note 19) was opposed by Alan Greenspan, who favors leaving hedge funds unregulated.
28. DIMITRIS N. CHORAFAS, stress Testing for Risk Control Under Basel II 299 (2006) (describing letter Greenspan sent to Congress opposing SEC regulation)
29. Alan Greenspan, The age of turbulence: Adventures in a New World 370 (2007) (arguing that hedge funds are sufficiently regulated by "market surveillance").
30. In one notable example, the Securities and Exchange Commission passed regulations requiring certain hedge funds to register with the Commission.Registration under the Advisers Act of Certain Hedge Fund Advisers,Investment Advisers Act Release No. 2,333, 69 Fed. Reg. 72,054-01 (Dec. 10, 2004) (codified at 17 C.F.R. pts. 275, 279 (2005)), invalidated by Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
31. The SEC's hedge-fund registration rule prompted a sharp dissent from two SEC commissioners who argued that the benefits of registration paled in comparison to the costs the rule imposed on hedge funds. Registration under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2,333, 69 Fed. Reg. 72,089 (dissent of Commissioners Glassman and Atkins). The U.S. Court of Appeals for the D.C. Circuit ultimately struck down the SEC rule on statutory interpretation grounds.
32. See Goldstein, 451 F.3d at 884.
33. See generally Bhala, supra note 10. Federal Reserve Chairman Alan Greenspan typified the optimism for the new financial code. He lauded the benefits of code for the consumer credit market:With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers...Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending.
34. Alan Greenspan, Remarks at the Federal Reserve System's Fourth Annual Community Affairs Research Conference (Apr. 8, 2005) [hereinafter Greenspan Apr. 8, 2005 Remarks], available at http://www.federalreserve.gov/boarddocs/ speeches/2005/20050408/default.htm, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrev 127n21a.pdf
35. Two years earlier, Greenspan touted the ability of these same risk models combined with loan securitization to increase market efficiency and to open "doors to national credit markets for both consumers and businesses." Alan Greenspan, Remarks at the JumpStart Coalition's Annual Meeting (Apr. 3, 2003), available at https://www.jumpstartcoalition.org/fileuptemp/ GreenspanRemarks.htm, permanent copy available at http://www.law.washington.edu/ wlr/notes/84washlrevl27n21b.pdf.
36. Lawrence Lessig, Code and Other Laws of Cyberspace (1999).
37. Id. at 41-53.
38. Id. at 4-8. The architecture of the internet also facilitates government regulation of the web.which threatens to constrain free speech, id. at 164-85, intrude on privacy, id. at 142-63, and consolidate industry ownership of intellectual property, id. at 122-41
39. Id. at 4-8. The architecture of the internet also facilitates government regulation of the web.which threatens to constrain free speech, id. at 164-85, intrude on privacy, id. at 142-63, and consolidate industry ownership of intellectual property, id. at 122-41.
40. Id at 100.
41. Gilson & Whitehead, supra note 1.
42. Cf. Joël Bessis, Risk Management in Banking 11-12 (2d ed. 2002) (analyzing risks faced by banks and defining risk as "uncertainties resulting in adverse variations of profitability or in losses")
43. neil Crockford, An INTRODUCTION TO RISK MANAGEMENT 5-6 (2d ed. 1986)
44. Bessis, supra note 27, at xi.
45. This key distinction was first made by economist Frank Knight over seventy-five years ago, in Frank H. Knight, Risk, Uncertainty and Profit(1921).
46. See Craig S. Lerner & Moin A. Yahya, "Left Behind" After Sarbanes Oxley, 44 AM. Crim. L. Rev. 1383, 1392 (2007) (noting that Knight created this distinction).
47. BESSIS, supra note 27, at 12
48. Id. at 13. Bessis notes that credit risk also covers the decline in the credit standing of an obligor, or bonds or stock held by the institution even short of default, as this decline "triggers an upward move of the required market yield to compensate [for] the higher risk and triggers a value decline" of the security. Id.
49. Id. at 499-504 (discussing credit risk in the context of derivatives). For an economic analysis of the effects of counterparty risk on the pricing of derivatives and other complex financial instruments.
50. see generally Robert A. Jarrow & Fan Yu, Counterparty Risk and the Pricing of Defaultable Securities, 56 J. FiN. 1765 (2002).
51. Hennie van Greuning & sonja Brajovic Bratanovic, Analyzing and Managing Banking Risk: Framework for Assessing Corporate Governance and Financial Risk 111 (2003).
52. Bessis, supra note 27, at 17.
53. Aswath Damodaran, Investment Valuation 60 (2002) (discussing measurement of equity risk through equity-risk premiums).
54. Basel II,supra note 13, at 144,¶ 644.
55. This raises the question of what constitutes "fair market value." There are other variations on the definition of "trading-liquidity risk" or "market-liquidity risk" that have their own ambiguities. According to the Bank for International Settlements, market-liquidity risk occurs when "a firm cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption." Bank for International Settlements, Principles for Sound Liquidity Risk Management and Supervision l n.2 (June 2008).
56. Id.
57. Systemic risk has been defined as "the risk of a breakdown in an entire system, as opposed to breakdowns in individual parts or components." George G. Kaufman & Kenneth E. Scott, What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It, 7 indep. rev. 371, 371 (2003).
58. see also Steven L. Schwarcz, Systemic Risk, 97 geo. L.J. 193 (2008).
59. See Larry E. Ribstein, Fraud on a Noisy Market, 10 lewis & clark l. rev. 137, 142(2006) (discussing how arbitrageurs cannot diversify away systemic risk).
60. Kaufman & Scott, supra note 39, at 372-73
61. See Schwarcz, supra note 39, at 200-02. Professor Schwarcz argues that not only do financial institutions lack the capacity to deal with systemic risk individually (because of an inability to diversify away the risk), but that they also lack incentives due to collective action failure; no one firm can capture all the of the benefit of an action it takes to reduce systemic risk. Id.
62. Frank J. Fabozzi, Bond Portfolio Management 491 (2001).
63. See Konrad S. Alt, Managing Reputation Risk, RMA J., Sept. 2002, at 40-41.
64. Richard Herring & Til Schuermann, Capital Regulation for Position Risk in Banks, Securities Firms, and Insurance Companies, in capital adequacy beyond basel 15, 19-20 (Hal S. Scott ed., 2005). Even non-banks may experience the modem equivalent of a bank run when other firms that have extended credit to them make margin calls.
65. Bhagwan Chowdhry & Vikram Nanda, Leverage and Market Stability: The Role of Margin Rules and Price Limits, 71 J. bus. 179, 182 (1998) (analyzing the potential destabilizing effects of margin calls).
66. DONALD R. VAN DEVENTER ET AL., ADVANCED FINANCIAL RISK MANAGEMENT 9 (2005).
67. Id. at 8-10.
68. BESSIS, supra note 27, at 12.
69. Id.
70. See id.
71. Darrel Duffie & Jun Pan, An Overview of Value at Risk, 4 J. DERIVATIVES 7, 19-20 (1997).
72. Bessis, supra note 27, at 608-21.
73. Id. at 411-12. Extreme Value Theory represents one mathematically sophisticated version of stress testing for fat tails, but this tool still relies on assumptions to model uncertainty in terras of risk Id. at 78,411.
74. Id at 411
75. For a primer on securitizations, see Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 STAN. J.L. BUS. & FIN. 133,135 (1994).
76. Willis, supra note 6.
77. Patricia A. McCoy, Rethinking Disclosure in a World of Risk-based Pricing, 44 Harv. J. ON LEGIS. 123, 126-27 (2007) (comparing "average-cost pricing," in which lenders set interest rates for the average credit risk of borrowers but may reject loan applicants that pose a higher credit risk with "risk-based pricing," in which lenders tailor interest rates to the credit risk of individual borrowers). Professor McCoy notes, however, that interest rates that are ostensibly set to match credit risk may also reflect inefficient and socially undesirable motives of lenders, such as rent-seeking and discrimination. Id. at 127.
78. Oren Bar-Gill & Elizabeth Warren, Making Credit Safer, 157 U. Pa. L. Rev. 1,46-52 (2008) (describing data collection by lenders on consumer borrowing behavior)
79. Elizabeth Warren, The Middle Class on the Brink of Disaster 7-8 (Apr. 17, 2007) (unpublished manuscript, on file with author) (describing interdisciplinary empirical and experimental work by financial industry into consumer borrower behavior).
80. See Willis, supra note 6, at 728-29,737,768,829.
81. See Bar-Gill & Warren, supra note 58, at 23-25.
82. Lessig, supra note 22, at 151-56.
83. See. e.g., Bar-Gill amp; Warren, supra note 58, at 12-14
84. Warren, supra note 58, at 7-13.
85. Lauren A. Willis, Against Financial Literacy Education, 94 IOWA L. REV. 197 (2008) (describing how the revolution in data collection, storage, and processing enable the financial-services industry to model consumer behavior and to market complex products to consumers that exceed consumer understanding).
86. Id. See also Bar-Gill & Warren, supra note 58, at 23-25;
87. Warren, supra note 58, at 13-22.
88. McCoy, supra note 57, at 143-44.
89. The costs to consumers of ARM loans were recognized in legal scholarship over two decades ago.
90. See, e.g., William N. Eskridge, Jr, One Hundred Years of Ineptitude: the Need for Mortgage Rules Consonant with the Economic and Psychological Dynamics of the Home Sale and Loan Transaction, 70 Va. L. Rev. 1083, 1131 (1984)
91. See, e.g., Elizabeth Warren, The Economics of Race: When Making It to the Middle Is Not Enough, 61 Wash. & Lee L. Rev. 1777, 1793 (2004) (citing lender data that subprime mortgage market included middle-class black and Hispanic families).
92. See, e.g., Bar-Gill & Warren, supra note 60, at 70-74.
93. One explanation for regulatory inaction is that the extension of credit with novel features allowed lower-income consumers to buy their first homes and fueled the economy.
94. Cf. Kristopher Gerardi et al., Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market 35 (Nat'l Bur. Econ. Res. Working Paper No. W12967, 2007), available at http://papers.ssm.com/ sol3/papers.cfm?abstract-id=971601, (concluding that deregulation and mortgage innovation made the U.S. housing finance market "less imperfect"). Regulators may have been wary of upsetting either political support for wider home ownership or the financial industry. They also may have been reluctant to disrupt the economic growth stimulated by increased home sales.
95. Cf The President's Working Group on Financial Markets, Policy Statement on FINANCIAL Market Developments (Mar. 2008)
96. reprinted in 14 L. & Bus. Rev. am. 447, 456 (Spr. 2008) [hereinafter President's Working Group] (noting that many originators who sold mortgages for securitization still retained some risk of loss if they purchased or guaranteed the resultant asset-backed securities).
97. See Greenspan Apr. 8, 2005 Remarks, supra note 21.
98. Frederic S. Mishkin, Governor, Board of Governors of the Federal Reserve System, Leveraged Losses: Lessons from the Mortgage Meltdown, Remarks at the U.S. Monetary Policy Forum, New York, NY (Apr. 8, 2005), available at http://www.federalreserve.gov/newsevents/speech/mishkin20080229a.htm, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrev127n72.pdf (discussing incentive problems created by "originate-to-distribute" model).
99. It also depends on whether purchasers of asset-backed securities andtheir market counterparties accurately hedged the risks of those securities
100. See infra Part I.B.iv.
101. See Steven L. Schwarcz, Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown, 93 MINN. L. REV. 373, 376-77 (2008). The underlying mortgages serve as collateral for the securities, and, in the event of a liquidation of the SIV, would be sold to satisfy the claims of the security holders.
102. Collection of monies and enforcement of remedies against consumers would usually be the role of a "servicer," a firm employed by the SIV to conduct these administrative tasks.
103. Anand K. Bhattacharya & Frank J. Fabozzi, Expanding Frontiers of Asset Securitization, in asset-backed Securities 1,9 (Anand K. Bhattacharya & Frank J. Fabozzi eds., 1996).
104. Leon T. Kendall, Securitization: a New Era in American Finance, in A primer on Securitization l, 5,13 (Leon T. Kendall & Michael J. Fishman eds., 1997).
105. Joshua D. Coval et al.. The Economics of Structured Finance 8 (Harv. Bus. Sch. Working Paper No. 09-060, 2008), available at http;//papers.ssm.com/sol3/ papers.cfm?abstract-id=1287363, permanent copy available at http://www,law. washington.edu/wlr/notes/84washlrev127n77.pdf.
106. See Kendall, supra note 76, at 13-15.
107. For an explanation of waterfalls and tranching
108. see Steven p. Baum, The Securitization of Commercial Property Debt, in A primer on securitization, supra note 76, at 45, 49 (describing commercial mortgage-backed securities).
109. For a discussion of the roles of these various players in securitizations
110. see Kendall, supra note 76, at 4-14.
111. For a comprehensive analysis of the modeling that sponsors use for structuring securitizations
112. Andrew S. Davidson et al.. Securitization: Structuring and Investment Analysis (2003).
113. Id. at 68, 340-42.
114. Id. at 307 (discussing types of aggregate data on mortgages that will effect credit risk for mortgage-backed securities).
115. Cf. Kenneth G. lore & Cameron L. Cowan, Mortgage-Backed Securities §§ 4:92-4:104 (describing disclosures on mortgage characteristics that would impact credit risk with respect to mortgage-backed securities), available on Westlaw at "Mortsec."
116. Cf. Davidson, supra note 81, at 314 (discussing how loan-level data can better predict prepayment risk than pool-level data).
117. Id. at 38.
118. Kendall, supra note 76, at 4 (describing insurers' methods for determining excess collateral or guaranty policy, including relying on body of historical data).
119. Asset-backed Securities, Securities Act Release 33-8518, Exchange Act Release 34-50905, 70 Fed. Reg. 1506-01 (Jan. 7,2005) (codified in scattered sections of 17 C.F.R.).
120. Kenneth C. Kettering, Securitization and Its Discontents: the Dynamics of Financial Product Development, 29 CardOZO L. Rev. 1553, 1674-76 (describing rating agencies as "de facto lawmakers").
121. Professors Partnoy and Skeel describe rating agency models as the driving force behind the structuring of securitizations.
122. Partnoy, supra note 12, at 664-68;
123. see also Partnoy & Skeel, supra note 9, at 1029 (analyzing a type of securitization called collateralized debt obligations).
124. This may represent a slight overstatement of the role of rating agencies. Some securitizations- for example, certain mortgage-backed securities issuances guaranteed by Freddie Mac or Fannie Mae-are not rated.
125. Kendall, supra note 76, at 4.
126. Moreover, concerns have been repeatedly raised that rating agencies adjust their ratings and models to fit the demands of securitization sponsors because of inherent conflicts of interest.
127. See, e.g., U.S. securities and exchange commission, Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating agencies 31-32 (July 2008)
128. [hereinafter "July 2008 SEC Rating Agency Report"), available at http://www.sec.gov/news/studies/2008/craexamination070808.pdf, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27n89.pdf Sponsors of securitizations remain the primary architects of the structure of securitizations.
129. Id. at 31. Even so, structurers and sponsors must anticipate the analysis and concerns of the rating agencies given the fact that ratings are indispensable to attracting certain investors, as described in Part I.B.iii.l infra.
130. Partnoy, supra note 12, at 653.
131. In an oft-repeated quote, Yuri Yoshizawa, the head of Moody's derivative group explained the focus of his group's analysis of collateralized debt obligations: "We're structure experts.... We're not underlying-asset experts."
132. Roger Lowenstein, Triple-A Failure, N.Y. times magazine, Apr. 27,2008, at 36.
133. Partnoy, supra note 12, at 621,642,661.
134. Frank Partnoy, How and Why Credit Rating Agencies are Not Like Other Gatekeepers, in financial Gatekeepers: Can They Protect Investors? 59,68-71,83-89 (Yasuuki Fuchita & Robert E. Litan eds., 2006).
135. See, e.g., Partnoy, supra note 12, at 681.
136. See id at 698.
137. Kendall, supra note 76, at 15.
138. James Hedges, Hedge Fund Transparency, in hedge funds: strategies: strategies, risk assessment, and returns 315, 316 (Greg N. Gregoriou et al. eds., 2003) (discussing regulations that discourage mutual funds from investing in debt below investment grade).
139. general accounting office, community and economic development loans: Securitization Faces Significant Barriers 41 n.41 (Oct. 2003).
140. See, e.g., 12 U.S.C. § 1831e(d)(4)(A) (2009) (provision of Federal Deposit Insurance Act permitting insured savings banks to invest in investment-grade debt, i.e., debt securities "rated in one of the 4 highest rating categories by at least one nationally recognized statistical rating organization").
141. Partnoy, supra note 12, at 700-01 (1999) (outlining use by state regulators of rating agencies' ratings in insurance regulations).
142. Cf. Viral V. Acharya, A Theory of Systemic Risk and Design of Prudential Bank Regulation (Jan. 9, 2001) (unpublished manuscript) (analyzing whether prudential bank regulations, including limitations on investments, mitigates systemic risk), available at http://papers.ssm.com/sol3/papers.cfm?abstract-id= 236401, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrev127n101.pdf.
143. Partnoy, supra note 12, at 623.
144. Greg N. Gregoriou, Funds of Hedge Funds 367-69 (2006) (discussing computer-based models used by hedge funds to make investment decisions).
145. See FRANCESCO SAITA, VALUE AT RISK AND bank CAPITAL MANAGEMENT 96-97 (2007) (describing portfolio risk-modeling programs developed by Credit Suisse, J.P. Morgan and others).
146. Id. at 97 (describing J.P. Morgan product features).
147. 17 C.F.R. § 229.305 (2008) (quantitative and qualitative disclosures about market risk). Accounting standards also require disclosure about a firm's market risk.
148. See, e.g., Financial Accounting Standards Board, Original Pronouncements-Accounting Standards as of June I, 2008, Vol. 11, Statement of Financial Accounting Standards No. 133 "Accounting For Derivative Instruments and Hedging Activities" (FAS 133) Paragraph 44 (requiring disclosure in financial statements on market risk for entities with derivative instruments).
149. SEC-registered bank holding companies must also disclose the information required by Guide 3-"Statistical Disclosure by Bank Holding Companies."17 C.F.R. §§ 801(c), 231 (2008).
150. See, e.g., FAS supra note 106, at ¶ 44.
151. 17 C.F.R. §§ 229.305 (a)(l)(ii)(b), (a)(l)(iii)(C).
152. Federal bank regulators are required to set minimum capital requirements under 12 U.S.C. § 18310(c)(l)m (2008) and 12 U.S.C. § 3907 (2008).
153. Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards (July 1988, updated to April 1998) [hereinafter "Basel I"], available at http://www.bis.org/publ/ bcbsc111l.pdf?noframes=1, permanent copy available at http://www.law,washington. edu/wlr/notes/84washlrevl27n111.pdf. For historical background on adoption of this accord.
154. see Joseph Jude Norton, Capital Adequacy Standards: a Legitimate Regulatory Concern for Prudential Supervision of Banking Activities?, 49 ohio ST. L.J. 1299, 1336-42 (1989).
155. See also Jonathan R. Macey et al., banking law and Regulation 281-82 (3d ed. 2001) (discussing history of U.S. risk-based capital standards leading to Basel 1).
156. See basel 1, supra note 111, at Part II. Professor Partnoy notes that, historically, numerous U.S. banking regulations have also keyed off of rating agency ratings. Partnoy, supra note 12, at 687-89,691 n.349.
157. See supra notes 13 and 15 and accompanying text.
158. Norton, supra note 14, at 53-58.
159. Under the new accord, national bank regulators may apply one of three approaches to setting requirements for the level of regulatory capital that banks must hold to offset credit risk. Each of the following approaches allows regulators to permit banks to use private-sector risk models to make credit risk calculations, which determine the amount of capital required to cover that risk:
160. Credit-Risk Standardized Approach: National bank regulators may continue to apply a modified version of Basel I, with its categorical approach to setting capital requirements for credit risk. This "Standardized Approach" categorizes classes of bank assets into "buckets" according to a rough estimate of the credit risk posed by that class. Regulators then assign a fixed risk weight for all assets in a particular bucket. Banks must then maintain a level of capital for each of its assets equal to the value of that asset multiplied by the asset's risk weight.
161. Basel II, supra note 13, at 19-26. The Basel II Standardized Approach keys the risk weights that apply to many of the buckets to rating agency ratings. Id. Furthermore, banks may use certain "external credit assessments"-i.e., rating agency ratings-to lower the risk weights (and thus the capital requirements) for certain classes of assets even further below the amount the Accord specifies for a particular bucket. Id. at 27-28.
162. Credit-Risk Foundation Internal Ratings-Based Approach: Basel II also gives national bank regulators the option to allow a bank to determine credit risk capital requirements using the bank's internal credit risk modeling, what the accord labels the "Internal Ratings-Based Approach."
163. Id. at 52.
164. The Internal Ratings-Based Approach has two versions. The "Foundation Internal Ratings-Based Approach" gives banks less flexibility in calculating their risk exposure. In calculating expected losses from borrower default on a given asset, banks can use their own internal models to calculate the probability of default. But, to calculate the magnitude of loss given a borrower default on an asset, banks must use a categorical, risk-weighted number assigned to all assets of the same class. This mirrors the bucket system of the Standardized Approach.
165. Id. at 59-60.
166. Credit-Risk Advanced Internal Ratings-Based Approach: The "Advanced Internal Ratings-Based Approach," by contrast, allows banks to use internal models to calculate both probability and magnitude of losses from credit risk for purposes of setting risk weights for assets. Id.
167. Basel II also take a bifurcated approach to the standard for regulatory capital that banks must hold to offset market risk, establishing both the following standardized and internal model approaches:
168. Market-Risk Standardized Measurement Method: Basel II's standardized method for market risk specifies a complex mix of bucket risk weights and value-at-risk methodology to set capital requirements covering market-risk exposure. National bank regulators must then ensure that banks follow this standard in determining credit-risk exposure, which then determines capital requirements. For sovereign debt and similar assets, the standardized method again piggybacks on rating agency ratings.
169. Id. at 166-90.
170. Market-Risk Internal Models Approach: As with credit risk, Basel II allows national bank regulators to permit qualified banks to use their own internal risk models to determine market-risk exposure. Basel II favors a value-at-risk approach, and sets standards for these internal risk models, but this "Internal Models Approach" gives banks much more flexibility in using their own methodologies than the standardized approach listed above.
171. Id. at 191-203.
172. Unlike Basel I, the Basel 11 Accord requires banks to set aside capital for operational risk. But again, the newer accord takes a bifurcated approach:
173. Operational-Risk Basic-Indicator Approach & Standardized Approach: These two approaches require banks to set aside regulatory capital to cover operational-risk exposure based on a fixed percentage of a bank's income in previous years. The principal difference between these two approaches-the Basic-Indicator Approach & the Standardized Approach-is that the Standardized Approach is slightly more nuanced. It disaggregates a bank's income according to different lines of business and sets distinct capital requirement weights for each of those lines.
174. Id. at 144-46.
175. Advanced Measurement Approach: This approach gives national regulators the flexibility to allow banks under their jurisdiction to use their internal models based on empirical data of the banks' past operational losses to set operational capital.
176. Id. at 147.
177. See, e.g., Basel 11, supra note 13, at Part 3, Section III (specifying supervisory review process that regulators must undertake to review bank compliance).
178. Risk-Based Capital Standards: Advanced Capital Adequacy Framework - Basel II, 72 Fed. Reg. 69,288 (Dec. 7,2007) (to be codified at 12 C.F.R. pts. 3,208, 225, 325, 559, 560, 563, 567).
179. After conducting a "Quantitative Impact Study" of the prospective effects of the Internal Ratings-Based Approach, U.S. bank regulators expressed concern that this new rule would dramatically lower regulatory capital.
180. See, e.g., Pamela Martin, QIS 4: What Do the Numbers Really Mean?, RMA J., Sept. 1, 2005;
181. see also Paul H. Kupiec, Basel II: A Case for Recalibration (FDIC Center for Financial Research Working Paper No. 2006-13, 2006), available at http://papers.ssm.com/sol3/papers.cfm?abstract-id=942301, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27nl20a.pdf
182. Paul H. Kupiec, Capital Adequacy and Basel II (FDIC Center for Financial Research Working Paper No. 2004-02, 2004), available at http;//www.fdic.gov/ bank/analytical/cfir/2004/wp2004/CFRWP-2004-02-Kupiec.pdf, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27nl20b. pdf(concluding that Basel ll's Internal Ratings-Based Approach drastically undercapitalizes portfolio credit risk);
183. Paul H. Kupiec, Capital Allocation for Portfolio Credit Risk (Dec. 2006) (unpublished manuscript), available at http://papers.ssm.com/sol3/papers.cfm? abstract-id=68I20I, permanent copy available at http;//www.law.washington.edu/ wlr/notes/84washlrevl27nl20c.pdf
184. Final Rule: Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, Exchange Act Release No. 34-49,830, 69 Fed. Reg. 34,428 (June 21, 2004), available at http://www.sec.gov/rules/fmal/34-49830.htm, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrev127n121.pdf
185. Stephen Labaton, Agency's '04 Rule Let Banks Pile Up New Debt, and Risk, N.Y. TIMES, Oct. 3,2008, at Al.The program also responded in part to a European Union (EU) regulatory initiative that would give a non-EU financial conglomerate the ability to obtain a single license to operate across the EU, provided that the firm demonstrated that it (i.e., all the firm's affiliates on a consolidated basis) was subject to sufficient regulatory supervision by a single home-country regulator. Unless U.S. financial conglomerates were bank holding companies and thus subject to ultimate supervision by the Federal Reserve, they would not qualify for special EU status. U.S investment banks not owned by a bank-holding company thus found themselves at a potential regulatory disadvantage.
186. Id. See also Office of Inspector General, SEC's Oversight of Bear Stearns and related entities: The Consolidated Supervised entity Program 4 (2008), Report No. 446-B (Sept. 25, 2008), available at permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27nl22.pdf.
187. Office of Inspector General, supra note 122, at 4.
188. Id. at iv
189. The SEC exercised direct oversight, including with respect to capital requirements for five of these firms; Citigroup and JP Morgan continued to have the Federal Reserve as their principal regulator.
190. Id. at v.
191. Net Capital Requirements for Brokers or Dealers ,17 C.F.R. § 240.15c3-l (2009).
192. See Labaton, supra note 122, at Al.
193. See OFFICE OF INSPECTOR GENERAL, supra note 122, at ix, xi-xii.
194. Bank for International Settlements, Triennial Central Bank Survey: Foreign Exchange and derivatives Market Activity in 2007,2-3 (Dec. 2007).
195. John H. Makin, Hedge Funds: Origin and Evolution, AEl policy series -AEI online, May 15, 2006, http://www.aei.org/publications/pubID.24395/pub-detail. asp, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrevl27nl29.pdf.
196. Aaron Unterman, Exporting Risk: Global Implications of the Securitization of U.S. Housing Debt, 4 Hastings Bus. L.J. 77,89 (2008).
197. See supra note 86 and accompanying text.
198. For the sake of simplicity, this diagram removes the originator. If the originator is deemed to have made a "true sale" of the assets to the SIV, the assets are no longer considered part of the estate of the originatorin bankruptcy. The SIV is then the outright owner of the consumer mortgages, and the originator no longer has any impact on the risk being transferredfrom borrowers to the SIV and investors. For a discussion of "true sales"insecuritizations
199. Steven L. Schwarcz, Securitization Post-Enron, 25 Cardozo L. Rev. 1539, 1543-48 (2004).
200. For an analysis of the extensive use by hedge funds of credit derivatives
201. see Noah L. Wynkoop, Note, The Unregulables? The Perilous Confluence of Hedge Funds and Credit Derivatives, 76 fordham L. Rev. 3095 (2008)(arguing that heavy use of lightly regulated credit derivatives by unregulated hedge funds increases systemic risk).
202. See Willem H. Buiter, Lessons from the 2007 Financial Crisis, centre for economic Policy Research policy Insight No. 18, 2-3 (Dec. 2007) available at http://www.cepr.org/ pubs/Policylnsights/Policylnsight18.pdf, permanent copy available at http://www.law,washington.edu/wlr/notes/84washlrev127nl34.pdf.
203. See supra note 17 and accompanying text.
204. Arthur E. Wilmarth, The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation, and Increased Risks, 2002 U. ILL. L. REV. 215, 343-46 (describing flaws in value-at-risk models used to price derivatives, since these models are only "backtested" by regulators).
205. See supra note 18 and accompanying text.
206. See supra notes 19-20 and accompanying text.
207. Kendall, supra note 76, at 15.
208. Coval et al,, supra note 77, at 10.
209. Unterman,supra note 130, at 70. One presidential commission cited failures of rating agencies to evaluate securitizations of mortgage-backed securities as a key factor in the subprime crisis. President's Working Group
210. supra note 70, at 449.
211. Hu, supra note 9, at 1502.
212. Kendall, supra note 76, at 8-11 (describing valuation of "synthetic securities").
213. Gretchen Morgenson, Home Loans: A Nightmare Grows Darker, N.Y. TIMES, Apr. 8, 2007, at CI.
214. Id. See also Jia Lynn Yang, How Bad is the Mortgage Crisis Going to Get?, FORTUNE, Mar. 31, 2008, at 88.
215. Lowenstein, supra note 91.
216. Nelson D. Schwartz & Vikas Bajaj, Credit Time Bomb Ticked but Few Heard, N.Y. TIMES, Aug. 19,2007, at Al.
217. Greg B. Cioffi, Collateralized Damage, DAILY DEAL, Feb. 1, 2008, available at 2008 WLNR 1910083;
218. Robert Stowe, Anatomy of a Meltdown, 68 MORTGAGE BANKING 38, Oct. 1, 2007, available at 2007 WLNR 21537515.
219. Vikas Bajaj & Julie Creswell, Bond Insurer in Turmoil Turns to Familiar Lender, N.Y. Times, Feb. 20, 2008, at C2.
220. Shawn Tully, Risk Returns with a Vengeance, FORTUNE, Sept. 3,2007, at 50.
221. Charles Duhigg, A Trickle that Turned into a Torrent, N.Y. TIMES, July 11, 2008, at CI (reporting that major banks are writing down twenty to fifty percent of the value of their assets due to losses from mortgage-backed securities).
222. Louise Story, A Values Debate (Not the Political Kind), N.Y. TIMES, May 16, 2008, at CI (reporting on debate over whether mark-to-market rule in Financial Accounting Statement 157 was leading to overstated write- downs)
223. see also Andrew Ross Sorkin, Are Bean Counters to Blame?, N.Y. TIMES, July 1,2008, at CI (same).
224. Buiter,supra note 134, at 3
225. Buiter, supra note 134, at 3. See also Matthew Goldstein & David Henry, Bear Bets Wrong, BUSINESS WEEK, Oct. 22, 2007, at 50 (linking Bear Steams' deteriorating credit situation to uncertain value of "CDO- squared" securities it held).
226. Landon Thomas, Jr., Run on Big Wall St. Bank Spurs U.S.-Backed Rescue, N.Y. TIMES, Mar. 15, 2008, at Al (describing contagious loss of investor and creditor confidence in U.S. investment banks).
227. Liz Rappaport & Justin Lahart, Debt Reckoning: U.S. Receives a Margin Call, WALL. ST. J., Mar. 15,2008, at Al.
228. See, e.g., Jenny Anderson, Hedge Funds Are Squeezed by Investors and Lenders, N.Y. TIMES, Aug. 20,2007, at C1.
229. Id.
230. See, e.g., Eric Dash, IndyMac Announces It Will Close Lending Units and Cut Half of Its Work Force, N.Y. TIMES, July 9, 2008, at C3;
231. David Jolly, After Losses, UBS Seeks to Raise $15 Billion, N.Y. TIMES, May 23, 2008, at C5.
232. Goldstein & Henry, supra note 153 (reporting on bailout of Bear Stearns)
233. Dash, supra note 158 (reporting on insolvency of IndyMac Bank).
234. Herring & Schuermann, supra note 45, at 22 (discussing systemic risk threat posed by securities firms by virtue of OTC derivatives activity).
235. Vikas Bajaj & Julie Creswell, Bear Stearns Staves Off Collapse of 2 Hedge Funds, N.Y. TIMES, June 21, 2007, at CI (reporting that potential failure of Bear Stearns' hedge fund raised investor concerns over systemic risk).
236. See Labaton, supra note 122, at Al.
237. Stephen Labaton, S.E.C. Concedes Oversight Flaws Fueled Collapse, N.Y. TIMES, Sept. 27, 2008, at A17.
238. Joe Nocera, Risk Mismanagement, N.Y. TIMES MAGAZINE, Jan. 2, 2009, at 26-33,46, 50.
239. See OFFICE OF INSPECTOR GENERAL, supra note 122, at 17-23 (criticizing of vetting of CSE risk assessment)
240. 24-27 (criticizing of vetting of CSE risk modeling).
241. Ross M. Miller, The Leap from Free Markets to Autonomous Markets, 63 J. ECON. BEHAV. & ORG. 295 (2006)
242. see also Arthur E. Wilmarth, Jr., The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation, and Increased Risks, 2002 U. ILL. L. REV. 215, 341.
243. Miller, supra note 165.
244. For an account of the role of portfolio insurance in the 1987 crash
245. see generally RICHARD BOOKSTABER, A DEMON OF OUR OWN DESIGN: MARKETS, HEDGE FUNDS, AND THE PERILS OF FINANCIAL INNOVATION 9-31 (2007).
246. Id. at 17.
247. Id. at 17-24.
248. See generally David D. Haddock, An Economic Analysis of the Brady Report: Public Interest, Special Interest, or Rent Extraction, 74 CORNELL L. REV. 841 (1989).
249. ROGER LOWENSTEIN, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT 62-69 (2000).
250. Id. at 63-65.
251. Id. at 64-77.
252. LTCM's models also assumed that the volatility of any security remains constant and that securities trade in "continuous time" with no significant gaps between the posting of new prices for securities.
253. Id. at 68.
254. Id. at 68.
255. Id. at 140-41,144-5.
256. Id. at 145-47.
257. Id. at 185-218.
258. For a discussion of model risk, see Toshiyasu Kato & Toshinao Yoshiba, Model Risk and Its Control, BANK OF JAPAN MONETARY AND ECONOMIC STUDIES (Dec. 2000), available at http://www.imes.boj.or.jp/english/publication/mes/ 2000/mel8-2-5.pdf, permanent copy available at http://www.law.washington.edu/ wlr/notes/84washlrevl27nl78a.pdf
259. see also Ingo Fender & John Kiff, CDO Rating Methodology: Some Thoughts on Model Risk and Its Implications (Bank for International Settlements, Working Paper No. 163, 2004), available at http://papers.ssrn.com/sol3/papers. cfm?abstract-id=623662, permanent copy available at http://www.law.washington. edu/wlr/notes/84washlrev127n178b.pdf
260. See supra note 53 and accompanying text for a definition of stress testing.
261. Id.
262. Oddly, though one of the most outspoken champions of the capacity of risk models (and other aspects of the new financial code)
263. Alan Greenspan (see supra notes 17 and 21) now attributes the cause of the subprime crisis to flaws in risk-model assumptions.
264. Alan Greenspan, We Will Never Have a Perfect Model of Risk, FIN. TIMES, Mar. 16, 2008.
265. see also Jon Danielsson, Blame the Models, -J. FIN. STABILITY (forthcoming 2008) available at http://risk.lse.ac.uk/rr/files/JD-33.pdf, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrev127n181.pdf.
266. The basic construction of a value-at-risk model is outlined in notes 48-51 supra.
267. BASEL COMMITTEE ON BANKING SUPERVISION JOINT FORUM, CROSS-SECTORAL REVIEW OF GROUP-WIDE IDENTIFICATION AND MANAGEMENT OF RISK CONCENTRATIONS (Apr. 2008), available at http://www.iaisweb.org/-temp/Cross-sectoral-review-of-group-wide- identification-and-management-of-risk-concentrations April-2008.pdf, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27n183.pdf.
268. See BASEL COMMITTEE ON BANKING SUPERVISION JOINT FORUM, CONSULTATIVE DOCUMENT: PROPOSED REVISIONS TO THE BASEL II MARKET RISK FRAMEWORK (July 2008) (proposing standards for quality control of market risk models).
269. See supra Part I.D.ii.
270. See supra Part I.D.i.
271. Danielsson, supra note 181.
272. Coval et al., supra note 77, at 10.
273. More complicated statistical methods, including Extreme Value Theory, can build further nuance into models to compensate for the potential of "fat-tails." For a detailed academic work on such statistical techniques.
274. see PAUL EMBRECHTS ET AL., MODELLING EXTREMAL EVENTS FOR INSURANCE AND FINANCE (2003). Technical fixes and additional stress testing and back testing appears to be the approach favored by the Basel Committee on Banking Supervision.
275. See, e.g.,supra notes 183-184.
276. See supra note 29 and accompanying text.
277. Nicholas Taleb & Avital Pilpel, Epistemology and Risk Management, RISK & REG. (Summer 2007), available at http://www.lse.ac.uk/resources/ riskAndRegulationMagazine/magazine/summer2007/epistemologyAndRiskManagement.htm, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrev127n191.pdf.
278. Martin Hellwig, Systemic Risk in the Financial Sector: an Analysis of the Subprime-Mortgage Financial Crisis 16 (Nov. 2008) (Max Planck Institute for Research on Collective Goods Bonn 2008/43), available at http://papers.ssm.com/ sol3/papers.cfm?abstract-id=1309442, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27nl92.pdf.
279. See also Coval et al., supra note 77, at 27-28.
280. Mitchell Y. Abolafia & Martin Kilduff, Enacting Market Crisis: the Social Construction of a Speculative Bubble, 33 ADMIN. SCI. Q. 177 (1988). A sell-off need not be explained solely by irrational panic driven by behavioral biases. Investors who sell off may be completely rational in seeking to avoid losses driven by other investors selling in a panic. Information cascades may also offer a partial explanation.
281. Michael P. Dooley & Carl E. Walsh, Academic Views of Capital Flows:an Expanding Universe, Reserve Bank of Australia Conference Volume, 89, 100 (1999), available at http://www.rba.gov.au/publicationsandresearch/Conferences/ 1999/DooleyWalsh.pdf, permanent copy available at http://www.law.washington.edu/ wlr/notes/84washlrev127n194.pdf.
282. Some scholars have argued that because one particular financial loss may qualify as both a credit risk and market risk, models may therefore double-count risk and lead to overly conservative risk management
283. Bhala, supra note 10, at 149-51.
284. See supra note 156 and accompanying text.
285. See supra note 152 and accompanying text.
286. Andrew Haldane et al., Financial Stability and Bank Solvency, in SYSTEMIC FINANCIAL CRISES: RESOLVING LARGE BANK INSOLVENCIES 83, 109-10 (Douglas D. Evanoff & George G. Kaufman eds., 2005) (noting methodological challenges to measuring systemic risk).
287. Of course, some scholars argue that segregating risk into different types and different models may lead to overestimation of risk because separate credit and market risk models may overlap and capture the same losses-ultimately leading to double-counting and excessive capital requirements.
288. See Bhala, supra note 10, at 150-51. But this contention assumes that the separate models capture the non-linear interactive effects of risks (or, more precisely, that the amount of double-counting outweighs the amount of undercounting).
289. Buiter, supra note 134, at 3-4.
290. Id.
291. Partnoy, supra note 12, at 658-61.
292. Christine Jolls et al., A Behavioral Approach to Law and Economics, 50 STAN. L. REV. 1471 (1998).
293. See, e.g., Willis, supra note 63.
294. See supra note 6 and accompanying text.
295. Nicholas Barberis & Richard Thaler, A Survey of Behavioral Finance, in 1B HANDBOOK OF THE ECONOMICS OF FINANCE 1054,1075-1105 (George M Constantinides et al. eds., 2003).
296. See Oren Bar-Gill, The Law, Economics and Psychology of Subprime Mortgage Contracts, 94 CORNELL L.REV. (forthcoming 2009).
297. Markus K. Brunnermeier & Christian Julliard, Money Illusion and Housing Frenzies, 21 REV. FIN. STUD. 135 (2008)
298. Lee Anne Fennell, Homeownership 2.0,102 Nw. U. L. REV.1047 (2008).
299. See Gregory Mitchell, Tendencies versus Boundaries: Levels of Generality in Behavioral Law and Economics, 56 VAND. L. REV. 1781 (2003) (arguing that behavioral law-and-economics proponents have documented "tendencies" in behavioral biases, but have yet to specify the "boundaries" of those tendencies, i.e., when, and the extent to which, these biases come into play)
300. Richard A. Posner, Rational Choice, Behavioral Economics and the Law, 50 STAN. L. REV. 1551, 1559-60 (1998) (faulting behavioral law-and-economics scholars for failing to offer a theory capable of generating testable predictions that would rival the predictive power of rational-choiceeconomics).
301. Mitchell, supra note 208, at 1804-11.
302. Id.
303. Gregory Mitchell, Why Law and Economics' Perfect Rationality Should Not be Traded for Behavioral Law and Economics' Equal Incompetence, 91 GEO. L.J. 67, 122-23 (2002).
304. In its original computer-programming context, a "killer application" (or "killer app") is a piece of software, the popularity of which drives demand for the underlying platform on which the software runs.
305. STEVE JONES, ENCYCLOPEDIA OF NEW MEDIA 172 (2003).
306. See supra notes 62-64, and accompanying text.
307. John Kiff & Paul S. Mills, Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets, (IMF Working Paper No. 07-188, 2007), available at http://www.imf.org/external/pubs/ft/wp/2007/wp07188. pdf, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrevl27n214.pdf.
308. Complex adaptive systems are systems in which multiple independent agents interact with one another. The capacity of the agents to adapt to changes in the system causes the system to evolve into progressively more complex forms and to change in a non-linear manner.
309. Simon A. Levin, Complex Adaptive Systems: Exploring the Known, Unknown and the Unknowable, 40 BULL. AM. MATH. SOC'Y 3,4 (2002) (defining complex adaptive systems).
310. Id.
311. The complex interactions of agents on the micro level frustrate the prediction of changes to the overall system due to a feature of complex adaptive systems called "emergence." Emergence has been defined as:[T]he appearance of unforeseen qualities from the self-organizing interaction of large numbers of objects, which cannot be understood through study of any one of the objects. The key to emergence is understanding that the emergent behaviors of dynamical systems are high-level patterns arising from the indescribably complex interaction of lower-level subsystems. Hence, removing or otherwise changing any interacting component of the system potentially changes the entire system since the interactions leading to the global emergent behaviors may no longer be possible
312. J.B. Ruhl, Complexity Theory as a Paradigm for the Dynamical Law-And-Society System: A Wake-Up Call for Legal Reductionism and the Modern Administrative State, 45 DUKE L.J. 849, 877-78 (1996) (internal quotations omitted).
313. See, e.g., Cars H. Hommes, Financial Markets as Nonlinear Adaptive Evolutionary Systems, l QUANTITATIVE FIN. 149(2001).
314. Risk models or regulations that rely on linear causality falter when applied to complex adaptive systems. Professor J.B. Ruhl has written extensively on the failures of law to manage nonlinear causality.
315. See J.B. Ruhl, Thinking of Environmental Law as a Complex Adaptive System: How to Clean Up the Environment by Making a Mess of Environmental Law, 34 HOUS. L. REV. 933, 979 (1997) (criticizing environmental statutes for this flaw).
316. John Foster, From Simplistic to Complex Systems in Economics, 29 CAMBRIDGE J. ECON. 873 (2005). Many complex adaptive systems may tend towards disequilibrium because of the concept of emergence (described supra note 216).
317. Ruhl, supra note 218, at 990-91.
318. See generally Alejando Reveiz Herault & Sebastian Rojas, The Case for Active Management from the Perspective of Complexity Theory, 495 Borradores de Economia, 11 (2008), available at http://www.banrep.gov.co/docum/ftp/borra495. pdf, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrevl27n220.pdf
319. Cf. CARLO C. JAEGER ET AL., RISK, UNCERTAINTY AND RATIONAL ACTION (2001). Legal scholars have analyzed how individuals severely underestimate risk when confronted with complex adaptive systems.
320. E.g., Lawrence A. Cunningham, Too Big to Fail: Moral Hazard in Auditing and the Need to Restructure the Industry Before it Unravels, 106 COLUM. L. REV. 1698, 1724-26 (2006) (discussing accounting firms' underestimation of their legal exposure)
321. see also Lawrence A. Cunningham, From Random Walks to Chaotic Crashes,62 GEO. WASH. L. REV. 546 (1994).
322. During asset-price booms, individuals also have a strong incentive to violate internal controls and regulations
323. See, e.g., Erik F. Gerding, The Next Epidemic: Bubbles and the Growth and Decay of Securities Regulation, 38 CONN. L. REV. 393, 424-41 (2006) (analyzing how dynamics of asset-price bubbles and other booms undermine incentives to comply with securities regulation). Non-compliance with laws and other agency costs are discussed in Part II.B infra.
324. At the same time, rule-makers and regulators may also be adapting their behavior to meet the adaptive behavior of players in the financial markets.
325. Katharina Pistor & Chenggang Xu, Incomplete Law - A Conceptual and Analytical Framework and its Application to the Evolution of Financial Market Regulation, 35 J. INT'L L. & POL. 931 (2003). This adds yet another level of complexity to modeling the behavior of consumers, investors and markets.
326. Nocera, supra note 163, at 46.
327. Regulators have increasingly paid attention to agency-cost theories of explaining rating agency failures during the subprime crisis and have focused, in particular, on potential conflicts of interest created by rating agencies receiving payment from the issuers, whose securities the agencies are rating.
328. See, e.g., July 2008 SEC Rating Agency Report, supra note 89, at 23-28, 31-32.
329. Neil Shah, Can Wall Street be Trusted to Value Risky CDOs?, REUTERS, July 13, 2007, http://www.reuters.com/article/reutersEdge/idUSN0929430320070713, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrev127n225.pdf.
330. One real-estate holding company executive commented on the potentials for abuse with this practice:When you use a computer model, you're going to see people make bad decisions ... Sellers were incentivized to say the assets were worth a lot, because they made a commission on sales. Many fund managers charge fees in part based on the value of their assets, so they also had incentives to say this stuff was worth a lot. It's not impossible to choose models that support the need for a high-value product.
331. Tully, supra note 150.
332. See Labaton, supra note 122 (describing increases in investment-bank leverage in wake of CSE program).
333. Cf. OFFICE OF INSPECTOR GENERAL, supra note 122, at xi (recommending that SEC reassess capital rsequirements in CSE Program in light of Bear Stearns collapse).
334. Sam Jones et al., Moody's Error Gave Top Ratings to Debt Products, FIN. TIMES, May 21, 2008.
335. Ann M. Burkhart, Real Estate Practice in the Twenty-First Century, 72 Mo. L. REV. 1031, 1046 (2007).
336. Alan N. Krinsman, Subprime Mortgage Meltdown: How Did It Happen and How Will It End?, 13 J. STRUCTURED FIN. 13 (2007) (discussing data for "past two years").
337. E. Scott Reckard, Adjustable Loans Spur New Worries, L.A. TIMES, Jan. 15, 2008, at A1.
338. Nocera, supra note 163, at 46.
339. See Buiter, supra note 134.
340. The positive externality becomes clearer when considered in reverse; the financial failure of a firm imposes negative externalities.
341. See GARRY J. SCHINASI, SAFEGUARDING FINANCIAL STABILITY: THEORY AND PRACTICE 48-50 (2006).
342. cf. Schwarcz, supra note 39 (positing that because of positive externalities, individual firms have insufficient incentives to mitigate systemic risk).
343. See Schinasi, supra note 235, at 49 (discussing information as positive externality).
344. The "lemons problem" describes how markets can unravel when there are a number of products of varying quality in a marketplace, but consumers cannot distinguish the high-quality products that are more costly to produce (for example, good cars or financial institutions with good risk-management practices) from inferior products produced at lower cost (for example, "lemon" cars or firms with bad risk-management policies).
345. When this situation occurs, consumers will discount the price they are willing to pay for a product and will pay the price for what they perceive to be an average-quality good. This average price will mean sellers of high-quality products will not receive the full value for their products. Many will decide to exit the market (or perhaps produce shoddier, lower-cost products). This will drive the average quality of the product in the marketplace down. This drop in average quality will lead consumers to further discount price, leading above average producers to exit. This creates a vicious cycle. For the seminal work on the lemons problem
346. see George A. Akerlof, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, 84 Q. J. ECON. 488 (1970).
347. Cf. Guillermo Calvo, Author's Remarks, WANTED: WORLD FINANCIAL STABILITY 57 (Eduardo Fernandez-Arias & Ricardo Hausmann eds., 2000) (characterizing cross-border financial contagion, in which financial crises spurred by one sovereign's default spread to other nations, as a lemon problem).
348. An anti-coordination game is a game in which players adopting the samestrategies create losses for all the players. For a more technical definition
349. see Fuhito Kojima & Satoru Takahashi, Anti-coordination Games and Dynamic Stability, 9 INT'L GAME THEORY REV. 667, 668-69 (2007).
350. Carol Alexander, The Present and Future of Risk Management, 3 J. FIN. ECONOMETRICS 3 (2005) (positing that regulation may perversely create this homogeneity).
351. Id.
352. Id.
353. Id.
354. The risk posed by homogeneity points to a need for financial institutions and regulators to focus on a second kind of portfolio diversification; each institution needs to analyze not only whether its own portfolio issufficiently diversified among asset classes, but also whether its portfolio issufficiently differentiated from the portfolios of other firms in the market.
355. See, e.g., Steven Pearlstein, Missed Opportunities, WASH. POST, Aug. 8,2007, available at 2007 WLNR 15269893.
356. See Rainer Bohme, Cyber-Insurance Revisited (2005) (unpublished manuscript), http://www1.inf.tu-dresden.de/~rb21/publications/Boehme2005- CyberInsurance-Revisited-WElS.pdf, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27n246a.pdf
357. Rainer Bohme & Gaurav Kataria, Models and Measures for Correlation in Cyber-Insurance (June 2006) (unpublished manuscript), http://wwwl.inf.tu- dresden.de/~rb21/publications/BK2006-Correlation-CyberInsurance-WEIS.pdf, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrevl27n246b.pdf.
358. Cf. Nocera, supra note 163
359. Felix Salmon, Recipe for Disaster: The Formula that Killed Wall Street, WIRED, Feb. 23,2009, at 74.
360. Robert J. Shiller, Irrational Exuberance 135-68(2000).
361. Shadow Financial Regulatory Committee, Statement No. 257: Reliance on Third-Party Credit Ratings 1 (Feb. 11, 2008), available at http://www.aei.org/ research/shadow/projectID.15/default.asp, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27n249.pdf (asserting that widespread use of credit rating models by financial institutions is problematic because the "use of common models is a key source of systemic risk as they are likely to err in the same direction).
362. This coordination problem was the very reason for the first Basel Accord.
363. See supra note 13.
364. Henry Petroski has popularized the benefits of simplicity in response to engineering problems.
365. See, e.g., Henry Petroski, Invention by Design: How Engineers get from thought to Thing (1996).
366. See supra Part I.B.iii.3.
367. This term thus captures the Internal-Ratings Based Approach for credit risk (supra note 115), the Internal Models Approach for market risk (supra note 116) and the Advanced Measurement Approach for operational risk (supra note 117).
368. See supra notes 126-127, 164 and accompanying text.
369. See supra note 15, at 72 Fed. Reg. 69,288.
370. Supra notes 126-127 and accompanying text.
371. Steven Sloan, Can Even Fed Oversight Alter Investment Banking Giants?, Amer. Banker, Feb. 2,2009.
372. Supra note 120.
373. See, e.g., Basel Committee On Banking Supervision, Revisions to the Basel II Market Risk Framework (Jan. 2009).
374. Shadow Financial Regulatory Committee, Statement No. 238: Basel II: One-and-a-Half Cheers for the Standardized Approach 3 (Dec. 4, 2006), available at http://www.aei.org/research/shadow/projectID.15/default.asp, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrev127n260.pdf.
375. Id.
376. Id.
377. Id.
378. Lawrence Lessig has argued that the transparency of open-source software allows the public to understand and counteract the ways in which internet code allows the private sector and the government to regulate social use of the internet. As noted in the Introduction to this Article, there are parallels between how internet architecture functions as a regulatory code (per Lessig) and how private risk models now function as a new form of financial regulation. See supra notes 22-25 and accompanying text. Lessig's open proposal for checking the regulatory power of internet code has a parallel in this paper's proposal for checking the new financial code. See supra note 25 and accompanying text.
379. Source code of software is the text, written in a programming language that is readable to humans and that converts human instructions into computer executions. Apple Public Source License Version 2.0 (Aug. 6, 2003), available al http://www.opensource.apple.com/apsl/,permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrevl27n265.pdf.
380. See Open Source Initiative, Open Source Definition (July 7, 2006), http://opensource.org/ docs/osd, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrev 127n266a.pdf. The Open Source Initiative is a non-profit organization that promotes open source concepts in software, acts as "steward" of the Open Source Definition, and certifies whether software licenses comply with the standards in the Open Source Definition. Open Source Initiative, About the Open Source Initiative (Sept. 19, 2006), http://opensource.org/about, permanent copy available at http://www.law.washington.edu/wlr/notes/84washlrev127n266b.pdf.
381. See id.
382. More nuanced and more frequent disclosure (perhaps even close to real-time disclosure) of portfolio information might be facilitated by a recent U.S. securities-disclosure initiative. The XBRL program requires that certain securities issuers present financial data in XBRL format (a special standard for business-related computer files that allows for easy sharing of files among different software applications). This format would facilitate easier uploading of financial disclosures straight from the information systems of a securities issuer to the web and easier downloading of that disclosure by web users straight into analytical software programs. Final Rule: XBRL Voluntary Financial Reporting on the EDGAR System, Securities Act Release No. 33-8,529, Exchange Act Release, 34-51,129, 70 Fed. Reg. 6,556 (Feb. 3,2005).
383. Commentators have already lauded the potential of the XBRL Rule to increase transparency in financial markets and allow an "army of citizen regulators" to police risk in financial markets.
384. Daniel Roth, Road Map for Financial Recovery: Radical Transparency Now!, WIRED, Feb. 23, 2009, at 81.
385. See supra Parts Il.A.v and II.B.v.
386. See supra Part II.B.vii.
387. James W. Paulson et al., An Empirical Study of Open-Source and Closed-Source Software Products, 30 IEEE TRANSACTIONS ON SOFTWARE ENGINEERING 246, 252-54 (2004) (finding empirical support for fewer design defects in open-source software than closed-source).
388. See supra Part II.B.vi.
389. Another possible, related concern is that dampening the profit motivation to develop risk models might also dampen valuable innovation in risk management.
390. There may be some precedent for open source leading to homogeneity. J.P. Morgan first developed value-at-risk models and then allowed otherfirms to copy the models, which became an industry standard
391. Nocera, supra note 163, at 33.
392. Supra Part II.B.vi
393. Supra note 188 and accompanying text.
394. Michel Crouhy et al.,The Subprime Credit Crisis of 07 (July 9, 2008) (unpublished manuscript),http://papers.ssrn.com/sol3/papers.cfm?abstract-id= l112467, permanent copy available at http://www.law.washington.edu/wlr/notes/ 84washlrev127n277.pdf.
395. Re-Proposed Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 34-59,343,74 Fed. Reg. 6,485 (Feb. 9,2009).
396. See Standard & Poor's CDO Interface, http://www.sp.cdointerface.com/ CdoOnlineWeb/login.htm (last visited Apr. 15, 2009), permanent copy as site appeared on June 2, 2009, available at http://www.law.washington.edu/wlr/notes/ 84washlrevl27n279.pdf.
397. See supra notes 95-102 and accompanying text
398. Incidentally, these financial regulations that piggyback on NRSRO ratings may provide another lever to open the source code of rating agencies. If the SEC fails to require that rating agencies open the source code of their models as a condition to NRSRO status, these financial regulations could be amended to specify that acceptable "investment grade"securities would only mean securities given an "investment grade rating"by anNRSRO that has opened the source code of the model used to give the rating.
399. Truth in Lending, 73 Fed. Reg. 28,866 (May 19, 2008) (to be codified at 12 C.F.R. pt. 226).
400. See Bar-Gill & Warren, supra note 58.
401. See supra notes 58-65,67-68 and accompanying text.
402. Richard H. Thaler &Cass R. Sunstein, Disclosure is the Best Kind of Credit Regulation, WALL. ST. J., Aug. 13, 2008,at A17.
403. Lessig, supra note 22, at 142.
404. See Gilson & Whitehead, supra note 1.
405. Id. (positing that derivatives, securitizations and similar novel financial products allow companies to sell their residual risk to more efficient risk bearers than equity investors and thus reduce issuer demand for equity markets)
406. Id.
407. Richard A. Brealey, Bank Capital Requirements and the Control of Bank Failure, in FINANCIAL STABILITY AND CENTRAL BANKS: A GLOBAL PERSPECTIVE 149 (Richard A. Brealey et al.eds.,2001)
408. Supra note 200 and accompanying text.
409. Professors Gilson and Whitehead believe that the subprime crisis will only slow the shift in liquidity towards these complex instruments temporarily
410. See Gilson & Whitehead, supra note 1.