 By Nancy Stein The financial crisis hitting the nation has Wall Street, investors, the government and the average man on the street concerned about the future. In fact, this disaster is having a global impact. What caused it? How can it be resolved? How can we protect ourselves in the future? John Coffee, a professor at the Columbia University School of Law and the director of its Center on Corporate Governance, is one of the foremost authorities on securities issues. He granted Lawdragon an interview to share his views on the financial disaster, including its causes, how he expects it to play out and what needs to be done to prevent a reoccurrence. Regulation will certainly come into play. The goals are many: assuring continued operations and services, attaining financial stability and devising a plan for the future. Nancy Stein: My first question is who is at fault in our current financial crisis? What happened to due diligence and what can be done to rectify the situation? John Coffee: There is plenty of blame to allocate. Private actors made reckless decisions to concentrate their highly leveraged financial firms in real estate investments and thereby exposed themselves to market turndown. Many relied on short-term debt to finance long-term illiquid investments, and that also courted disaster (it killed Drexel Burnham at the end of the 1990s). I think the CEOs at Merrill Lynch and Lehman Brothers went further than their contemporaries in basically destroying their franchises by overindulging in high leverage while heavily investing on an undiversified basis in mortgages and real estate. At AIG, Price Waterhouse found that AIG had a “material weakness”—that’s a defined term under Sarbanes-Oxley’s accounting rules—in its internal controls that centered on AIG’s inability to value its credit default swaps. Price Waterhouse made these findings public in its 2007 opinion on AIG’s internal controls. Thus, the disaster at AIG was foreshadowed. Although it is a small consolation, Sarbanes-Oxley seems to have worked in forcing this disclosure. You asked about due diligence. Most of the investment banks used to do due diligence in asset-backed securitizations by hiring professional due diligence firms with expertise in real estate to test the loan originator’s portfolio of mortgages before the bank acquired its loans. They began to abandon that practice after 2002, as the market became more bubbly and demand for these deals grew and grew. Investment banks got into a mad competition with each other as to who could more quickly satisfy the worldwide demand for asset-backed securitizations. To make the pipeline move faster, they dispensed with prudence and due diligence, believing perhaps that real estate values would never fall. They were wrong. NS: And the big problem is that conducting due diligence is so time-consuming? There was time greed? JC: If you are in competition and others are bidding on the deal as well, you may feel compelled to act as quickly as possible. So long as the investment bank could get an investment grade credit rating from one of the big 3 credit rating agencies, it could sell anything, even if it consisted of toxic garbage. And that’s the classic problem of gatekeeper failure: the credit rating agencies had no liability or responsibility to investors, and because they faced little competition, they faced less need to protect their reputational capital. Still, conflicted and ineffectual as the rating agencies were, the investment banks themselves have to accept most of the blame. Although many talk about this problem in terms of the bubble in real estate and the deterioration of lending discipline in real estate, there was no reason to expect that the mortgage brokers and the other loan originators would ever exercise any restraint or discipline. As soon as they found they could sell anything to the investment banks without having to justify that their loans were creditworthy, they understandably rushed to do so. They were in a fee-based business seeking to generate high fees from packaging together mortgages. Increasingly, they found that the only demand they were getting from the investment banks was for quantity, not quality. They responded to that demand for quantity and began to make loans without documentation, the so-called “liars’ loans.” NS: What about the lack of effective regulation that many talked about? JC: When the SEC relaxed its net capital rule in 2004 and gave the industry—that is, the big 5 investment banks—an alternative net capital rule that had no ceiling on debt to equity ratios, this meant that overnight the major investment banks were freed of the traditional net capital rule’s requirement of a basically 12-1 debt-to-equity ratio. Instead, the investment banks were able to leverage up to their eyeballs, so long as they could point to Basel II-style internal models that arguably demonstrated that they were sufficiently diversified. Now that’s a game at which the industry is much faster and better than the regulators. The investment banks were miles ahead of the SEC in developing computer models with all their Monte Carlo simulations, showing that these assets were never going to deteriorate in value. But of course they failed. The regulators—basically the SEC—never really had the capacity to stay even with the industry once they moved from a world of simple prophylactic rules (such as a fixed leverage ratio) to a model in which you employ computer simulations to determine how much was at risk. So we have a regulatory failure here. The real lesson is that the optimal regulatory model for risk management will not work if it is too complex for regulators to implement. We also have a Congressional failure. A lot of these problems go back to decisions Congress made back in 2000 when Congress deregulated over-the-counter derivatives in the Commodities Modernization Act. I am surprised that so much attention has been given to Christopher Cox and so little to Phil Gramm. Due diligence tended to disappear from asset-based securitizations. This was the result both of investment bankers’ choice and of the SEC’s deregulation of asset-backed securitizations. This was unfortunate because, unlike very seasoned companies where you can look at their prior financial history, their SEC disclosures and their stock trading prices, asset-backed securitizations are inherently opaque. Everything depends on the quality of the collateral, and the ratings agencies verify nothing and assume everything. Hence, much more disclosure was needed. NS: What should be done in terms of reform? What can we expect? JC: Any comprehensive proposal for reform must build on what the Treasury Department said back in April of this year when it issued its Blueprint. Even in a very deregulatory, conservative administration, the Treasury Department put out a Blueprint that says that the U.S. has the most fragmented system of financial regulation of any country in the world. Because it is so Balkanized, the sophisticated players can engage in a game of regulatory arbitrage, exploiting whatever legal form gets the least regulation. The Treasury Department proposed instead that there should be a regulatory consolidation under which one agency has supervision over the safety and soundness and risk-management practices of all major financial institutions. That would mean that the Federal Reserve, either alone or in combination with the Comptroller of the Currency, would have jurisdiction over insurance companies, which today have no federal regulators, over hedge funds, which also are not subject to federal regulation, and over state banks and thrifts. Ideally, one common standard of prudential financial supervision would be applied to the capital adequacy and risk-management practices of any large financial institution. The core idea is that if you are too big to fail, then you have to be supervised by a financial regulatory agency that is focused on risk and leverage and treats like cases alike. In terms of regulatory reform, some agency must also be given jurisdiction over credit default swaps and focus on the accounting and risk-management practices of their dealers. The Treasury Department proposed what is known as a “twin-peaks” model. You would have the SEC focusing on things like disclosure, consumer protection, anti-fraud enforcement, all of which they are good at, but not focusing on prudential financial regulation, which means the leverage level of the firm, its capital adequacy and risk-management practices. These issues are not ones that the SEC is good at or particularly focused on. Review of these issues should be shifted to the agency with the greatest comparative advantage—the Federal Reserve. NS: What do you think about the government bailing out the financial institutions? JC: First of all, $700 billion is going to be too little. It will cost more than that. We see this already as the Federal Reserve is beginning to buy commercial paper outside of the bailout program. The Federal Reserve has shifted from a policy of bailing out financial institutions by acquiring their most opaque and sticky assets to a policy of trying to prop up the most fragile institutions, including money market funds and mutual funds. They faced, at least for a time, a real risk of major runs on the banks. They may begin to make loans or direct investments in major companies, such as GM. At this point, the real issue is how to liquidate those stakes and return to capitalism. NS: What causes the bank runs and what problems result? JC: The nature of most financial institutions is that they have a lot of short-term capital that either can be withdrawn on a daily basis or that has to be rolled over periodically in the short run. They use that short-term capital to purchase long-term illiquid assets. The result of this dubious business model is that you have a mismatch of assets and liabilities that predictably creates liquidity crises on rollover dates. Ever since the failure of Washington Mutual two months ago, this has told mutual funds, hedge funds, and money market funds that they also have to worry about the prospect of a run. Normally such institutions might have only 10% of their assets in cash. Yet, if you are a mutual fund, your shareholders have the right to redeem all of their shares on a daily basis. Therefore you have to be prepared for that and that forces you to sell stocks and any asset that is not a cash equivalent. If you now sense that shareholders are very nervous and may want to withdraw in volume, you may have to switch from a 10% cash component to, say, maybe a 30-35% cash component to your portfolio. The only way to do that is to dump your securities, sell anything illiquid that you can sell and move into either cash or Treasury bills because those are the only things that are truly cash equivalents in this very illiquid market. As a result we are seeing massive sell offs by mutual funds, and I think that is what’s causing some of these 500 point declines. It’s not so much new information, although there is new information too, but rather the tremendous need to increase liquidity and shift to cash. As a result, the normal commercial paper market that financially solvent industrial companies like GE and IBM would use for short-term financing has simply closed down and frozen. Commercial paper was usually purchased by mutual funds, and right now they are buying nothing. They are finding it hard to sell their commercial paper and other semi-liquid investments, and this increases the panic. Therefore, a paralysis has developed with banks, mutual funds, money market funds all trying to increase their level of cash by selling off anything that is sellable. As a result, banks aren’t even loaning to banks. Page: 1 of 2 pages for this article 1 2 >
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