Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Sunday, March 6, 2011

Stout on The Origins of the Credit Crisis

The Legal Origin of the 2008 Credit Crisis, by Lynn A. Stout, University of California, Los Angeles (UCLA) - School of Law, was recently posted on SSRN.  Here is the abstract:

Experts still debate what caused the credit crisis of 2008. This article argues that dubious honor belongs first and foremost to a little-known statute called the Commodities Futures Modernization Act of 2000 (CFMA). Put simply, the credit crisis was not due primarily to changes in the markets, it was due to changes in the law. The crisis was the direct and foreseeable (and in fact foreseen by the author and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.

Derivative contracts are probabilistic bets on future events. They can be used to hedge, which reduces risk, but they also provide attractive vehicles for disagreement-based speculation that increases risk. Thus the social welfare consequences of derivatives trading depend as an empirical matter on whether the market is dominated by hedging or speculative transactions. The common law recognized the differing welfare consequences of hedging and speculation through a doctrine called “the rule against difference contracts” that treated derivative contracts that did not serve a hedging purpose as unenforceable wagers. Speculators responded by shifting their derivatives trading onto organized exchanges that provided private enforcement through clearinghouses in which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives risk. In the twentieth century, the common law was replaced by the Commodity Exchange Act (CEA). Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. This regulatory system also for many decades kept derivatives speculation from posing significant problems for the larger economy.

These traditional legal restraints on OTC speculation were systematically dismantled during the 1980s and 1990s, culminating in the 2000 enactment of the CFMA. That legislation set the stage for the 2008 crises by legalizing, for the first time in U.S. history, speculative OTC trading in derivatives. The result was an exponential increase in the size of the OTC market, culminating in 2008 with the spectacular failures of several systematically important financial institutions (and the near-failures of several others) due to speculative derivatives losses. In the wake of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Title VII of the Act is devoted to turning back the regulatory clock by restoring legal limits on speculative derivatives trading outside a clearinghouse. However, Title VII is subject to a number of possible exemptions that may limit its effectiveness, leading to continuing concern over whether we will see more derivatives-fueled institutional collapses in the future.

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Without speculators hedging will be severely limited or non-existent. For example, suppose you have 20 large agribusinesses that would like to hedge the price of their upcoming corn crops. Suppose you also have 10,000 or more industrial or retail producers/users of corn products, such as cornstarch, corn meal, corn fructose, feed for livestock, corn as a vegetable to use directly or as an ingredient, etc. It is quite possible that none or very few of the producers/users care to hedge the corn price because its price is a small component of the final industrial or retail product cost, or the final product with a corn ingredient is a small percentage of their total portfolio of products' sales volume.

The corn producers may have a strong economic concern about future corn prices on their future business well-being. The retail and industrial sellers who use corn in their products may not care enough about the future price of their corn-derived ingredients to hedge. The price impact of corn on their profits may not be enough to incur the cost of hedging the future price of corn, there may be ready available substitutes or a corn price change has a minimal impact on their business volume and profit.

Hedging is about risk transference. Risk transference requires a counter-party who is willing to absorb the risk. Without speculators, there will be potential hedgers who cannot find a counter-party to take the risk.

Hedgers may not recognize who their counter-parties are. A corn grower may initially hedge with a corn user, but the corn user may transfer the hedge to a speculator, which then allows the original corn user to hedge again with another corn grower. Growers may think they are hedging with users, but without allowing speculators, one of those growers would not be able to hedge.

To facilitate hedging, hedgers must be able to find counter-parties quickly and easily. If there are only a few speculators, then the search will be delayed and costly. The few speculators may not be willing to take on more risk. If there are many speculators, then a search will be quick, easy and cheap, and the transaction costs of hedging will be low.

Speculators are not an evil. They facilitate quick hedging transactions at low transaction costs.

Additionally, speculators increase the volume of derivative contracts, which generate more frequent price points. Hedgers will have more accurate pricing about the demand and future price expectations for the product.

Posted by: Milton Recht | Mar 6, 2011 2:31:20 PM

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