August 28, 2010
Murdock on The Financial Reform Act
The Financial Reform Act: Will it Succeed in Reversing the Causes of the Subprime Crisis and Prevent Future Crises?, by Charles W. Murdock, Loyola University Chicago School of Law; Loyola University of Chicago, was recently posted on SSRN. Here is the abstract:
The current financial crisis, which could have plunged the world into a financial abyss similar to the Great Depression, is far from resolved. The financial institutions, which this article asserts caused the crisis, have returned to profitability and have paid billions of dollars in bonuses, while ordinary Americans have borne the brunt of the meltdown, with formal unemployment hanging around the 10% mark. This has caused some to comment that profits have been privatized and risk has been socialized. Two years after the economic meltdown, the impact continues as local governments turn off streetlights, cut back on police and fire departments, close down transit systems, return paved roads to gravel, and put schools on a four-day week.
Democrats in the House and Senate finally agreed on a financial regulation bill. Opposition to the bill in part was based on the belief that Fannie Mae and Freddie Mac were the cause of the subprime crisis. However, as this article demonstrates, it was the “big banks,” by funding the subprime lenders, buying their mortgages and securitizing them, slicing them to form CDOs and synthetic CDOs through derivatives, and leaning on the credit rating agencies to get AAA ratings for junk, there were the primary cause of the financial crisis.
Parts I and II are fairly dry: they deal with data. But, in a financial crisis, numbers are important. Part I deals with the incredible increase in assets under investment, which created the demand for the toxic mortgages, while Part II analyzes the changing characteristics of the subprime mortgages and their dramatic increase in volume and riskiness, a fact that was not recognized by the financial professionals.
In Part III, the roles of the borrowers, the mortgage brokers, the mortgage lenders, Fannie Mae and the investment banks, the credit rating agencies, and derivatives are explored, together with the incentives that drove each participant. The various titles of the Financial Reform Act are analyzed from the standpoint of the impact they will have on the foregoing players in order to prevent future crises.
The Conclusion asserts that the Financial Reform Act should prevent a future financial crisis that mirrors the past crisis. However, it does not adequately deal with the underlying issue that drives any financial crisis: management incentives that lead to excessive risk-taking. Nor does it deal with the ever increasing aggregation of financial power in large financial institutions.
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Opacity reduces scrutiny and confers power on the few with the ability to pierce the veil. Although derivatives have indeed become extremely complex, in actuality, they are as old as the idea of finance itself. The credit derivatives market should borrow a thought from Leonardo: "Simplicity is the highest form of sophistication."
For a clearer understanding of subprime mortgage-backed credit derivatives, visit:
Posted by: Brian J. Donovan | Aug 28, 2010 9:31:45 AM