Eight more states have joined a lawsuit challenging the constitutionality of various provisions of the Dodd-Frank financial reform law. The states are Alabama, Georgia, Kansas, Montana, Nebraska, Ohio, Texas and West Virginia. As three states (Oklahoma, Michigan, and South Carolina) had already brought suit, this brings the total number of states involved in the suit to eleven.
For links to Michael Greve’s take on the suits, see here.
UPenn’s David Zaring comments in Dealbook:
Courts are supposed to put the policies of presidents and Congress to the test of judicial review, to evaluate decisions by the executive to sanction someone for wrongdoing and to resolve disputes between private parties. But the really sweeping programs that Congress and the president put in place during the financial crisis will not receive much courtroom attention at all, even as the executive’s individual enforcement decisions receive scrutiny. It is only in private disputes that the facts of the financial crisis will get a judicial airing – and even then, all signs point to the airing being a modest one.
The courts have played such a low-key role for three reasons: the government has rarely been challenged for its own crisis-related conduct; at the same time, the Justice Department and other federal agencies have hesitated to prosecute the financial executives in place during the crisis; finally, private litigation over losses sustained during the crisis has been slow to develop, and quick to settle. In all, it is likely to be a disappointment to those who believe that the blame for the financial crisis can only really be apportioned through verdicts and judgments. . . .
In many ways, this modest turn to the courts is underwhelming. Practicing finance during a recession should not necessarily be a criminal offense, but holding no executives responsible for the actions that led to the housing market collapse, after hundreds were imprisoned during earlier downturns, suggests arbitrariness. Even worse, it sets a different standard for Wall Street financiers of today and the bankers who went to jail in the wake of the 1980s bailout of the thrifts.
And while the government has been criticized for not holding individuals accountable for the crisis, the really huge decisions it made – on whom to bail out, and how to stimulate the economy – will be subject to little judicial oversight. Even though those are precisely the kinds of decisions for which a second look might be helpful.
“Yes, it did,” is the conclusion of a new NBER study of bank lending behavior, “Did the Community Reinvestment Act (CRA) Lead to Risky Lending?” by Sumit Agarwal, Efraim Benmelech, Nittai Bergman, Amit Seru, Here’s the abstract, which begins uncharacteristically with direct answer to the question in the paper’s title:
Yes, it did. We use exogenous variation in banks’ incentives to conform to the standards of the Community Reinvestment Act (CRA) around regulatory exam dates to trace out the effect of the CRA on lending activity. Our empirical strategy compares lending behavior of banks undergoing CRA exams within a given census tract in a given month to the behavior of banks operating in the same census tract-month that do not face these exams. We find that adherence to the act led to riskier lending by banks: in the six quarters surrounding the CRA exams lending is elevated on average by about 5 percent every quarter and loans in these quarters default by about 15 percent more often. These patterns are accentuated in CRA-eligible census tracts and are concentrated among large banks. The effects are strongest during the time period when the market for private securitization was booming.
If anything, the authors note, their study underestimates the CRA’s effecton lending practices because it only looks at landing activity around examination dates. IBD has more. (Hat tip: Hit & Run)
UPDATE: There’s a discussion about the paper at Marginal Revolution. Note that the paper does not claim that the CRA was the cause of the financial crisis. As Tyler Cowen notes, the claim is that the CRA was an “amplifying mechanism” — a contributing factor to the severity of the crisis, but hardly the only contributing (or causal) factor.
Former White House counsel Boyden Gray and Adama White explain how Dodd-Frank effectively subsidizes large financial institutions at the expense of smaller institutions and “Main Street.” Gray and White are also representing some of the plaintiffs who are challenging Dodd-Frank’s constitutionality (see here and here).
A news release from the Competitive Enterprise Institute notes that the attorneys general of Michigan, Oklahoma, and South Carolina have joined their lawsuit challenging the constitutionality of portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The original suit challenged several Dodd-Frank provisions, including creation of the Consumer Financial Protection Board. The states’ challenge focuses on Title II’s “orderly liquidation authority,” which allows the federal government to seize allegedly troubled financial institutions with minimal notice or recourse. According to the states, these provisions lack adequate due process and could threaten state pension funds. Here’s the amended complaint.
Posner:
“I was an advocate of the deregulation movement and I made — along with a lot of other smart people — a fundamental mistake, which is that deregulation works fine in industries which do not pervade the economy,” he said in the appearance on Spitzer’s viewpoint.” “The financial industry undergirded the entire economy and if it is made riskier by deregulation and collapses in widespread bankruptcies as what happened in 2008, the entire economy freezes because it runs on credit.”
Michael Greve [my GMU colleague]:
The mea culpa—hedged with a supercilious “I may have started it but conservatism got out of hand” aside—fails to satisfy minimum standards of intellectual coherence and empirical evidence.
The suggestion that the markets that produced the 2008 financial crisis were “free”—in the sense of unregulated—is charitably described as contrary to fact. The money that juiced the markets wasn’t supplied by some reckless profiteer; it was supplied by the Fed. The GSE’s that by everyone’s admission contributed (and on many accounts caused) the disaster operated (and are still operating) with government guarantees.
Similarly, but more broadly: the financial system operated and continues to operate against the rule that depositors—unlike shareholders, bondholders, vendors, employees, or anybody else—will in the event of failure get 100 cents on the dollar. That arrangement encourages banks to play with somebody else’s money. It is not a “free market” rule. It is a law and a regulation, and the source of a convoluted system that desperately tries to cope with the risks of its own creation by piling layer upon regulatory layer.
It’s true that if you “deregulate” one piece of a market that’s already shot through with government regulation, subsidies, guarantees, and warped incentives, you can increase risk further and get very bad results. Maybe that’s what happen in the run-up to the crisis. But if this is Judge Posner’s position, he should say so. He doesn’t. It’s all “deregulation increases risk, and regulation reduces it.”
It does? Dodd-Frank has done nothing about the GSEs. It has, however, accelerated an already-dangerous concentration in the financial industries; institutionalized the bailout culture; created a gargantuan rulemaking apparatus and a world in which no one knows what might happen next; and armed hordes of officials—folks like Eliot Spitzer—with criminal and civil enforcement authority over “abusive” lending practices and other undefined infractions.
UPDATE: Bonus from the same (Law and Liberty blog): Mike Rappaport takes on Posner’s claim that the original meaning of “freedom of speech” in the First Amendment did not include symbolic speech like flagburning, citing our own Eugene Volokh.
Tags: Richard Posner
The New York Times Room for Debate Blog, where various Conspirators have served as discussants one time or another, has a very interesting discussion on whether and in what respects the financial crisis might have been avoided. It’s a good short read. From the introduction:
Last week, the Financial Crisis Inquiry Commission, after reviewing thousands of documents, issued a report, which explained the causes of the financial unraveling, the role of government and the banks, and the aftershocks of the crisis. The 10-member commission, however, split along party lines, with the six Democrats voting to adopt the report and its findings, and the four Republican members issuing two dissenting reports. On NPR, Keith Hennessey, one of the Republican commissioners, said that the disagreement could perhaps be boiled down to one statement in the majority report: “We conclude this financial crisis was avoidable.”
The report, majority and dissents, is well worth reading as well. I agree with some of the criticisms that it is too much narrative history and too little analysis, but there’s still value in creating a record of what happened for its own sake.
What are the books specifically about the financial crisis 2007-2009 that that you would put on the genuinely short list for reading?
(Update. Megan McArdle has a number of interesting comments and posts on foreclosure, modification, the effect of securitization, and the processes for recording title and other things. This blog post has very interesting comments as well.)
Adam Levitin writes at the ForeclosureBlues blog about the Ibanez decision in the Supreme Judicial Court of Massachusetts (pdf via Creditslips blog), handed down last Friday. (Actually, I think Adam’s post originated at CreditSlips.) This is an important decision in addressing the exceedingly vexed and, as Megan McArdle notes, highly technical legal questions surrounding the property issues – chain of title, etc. – in foreclosures on mortgages that have been securitized. Levitin offers this assessment of the holding in Ibanez (I recommend also his article with Anna Gelpern, Rewriting Frankenstein Contracts):
The Ibanez case itself is actually very simple. The issue before the court was whether the two securitization trusts could prove a chain of title for the mortgages they were attempting to foreclose on.
There’s broad agreement that absent such a chain of title, they don’t have the right to foreclose–they’d have as much standing as I do relative to the homeowners. The trusts claimed three alternative bases for chain of title:
(1) that the mortgages were transferred via the pooling and servicing agreement (PSA)–basically a contract of sale of the mortgages
(2) that the mortgages were transferred via assignments in blank.
(3) that the mortgages follow the note and transferred via the transfers of the notes.
The Supreme Judicial Court (SJC) held that arguments #2 and #3 simply don’t work in Massachusetts. The reasoning here was heavily derived from Massachusetts being a title theory state, but I think a court in a lien theory state could easily reach the same result. It’s hard to predict if other states will adopt the SJC’s reasoning, but it is a unanimous verdict (with an even sharper concurrence) by one of the most highly regarded state courts in the country. The opinion is quite lucid and persuasive, particularly the point that if the wrong plaintiff is named is the foreclosure notice, the homeowner hasn’t received proper notice of the foreclosure.
Regarding #1, the SJC held that a PSA might suffice as a valid assignment of the mortgages, if the PSA is executed and contains a schedule that sufficiently identifies the mortgage in question, and if there is proof that the assignor in the PSA itself held the mortgage. (This last point is nothing more than the old rule of nemo dat–you can’t give what you don’t have. It shows that there has to be a complete chain of title going back to origination.)
I don’t think it is too much to ask the financial services industry to follow the rules on title and transfer. I have been surprised by how many people, including lawyers, have simply said that intentions were clear even if the requirements of transfer were not followed. I don’t think that’s good enough, not for the past and less so going forward. There are reasons why we treat transfer of property, and real property and associated rights, differently than contract. I have no doubt that things are much more complicated than I imagine, but with computerization and technology, on a regulatory reform basis, shouldn’t we be able to do a whole lot better than this?
What would a rational, going forward system of title and transfer look like – tell me in ways that take advantage of technology as it is, not some imagined possible world, and tell me ways that match up to things already being done in the securities industry.
While everyone is at it, tell me how we should address the Frankenstein hangover of the past.
(Note: I was writing this on the plane without quite being able to see the computer screen, so I’ve gone back and corrected some grammar and spelling, and tried to make a couple of things clearer. I’ll post separately as well on the topic of national security and the financial crisis, and the role of executive discretion in responding. But I also wanted to note that over at The Conglomerate, the compadres there are also having a discussion of Professor Skeel’s book, including my friend David Zaring, who, along with the redoubtable Steven Davidoff, was responsible for a seminal article and concept in this question of discretionary regulation, “Regulation by Deal.”)
Flying to and from meetings this week at the Hoover Institution, I re-read David Skeel’s brand-new book, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (Wiley 2011), for a second time. I am even more impressed with this book the second time around, and I believe that it is one of the short list of essential books on the financial crisis and the regulatory aftermath. If you have any interest at all in these topics, this is a book to give serious consideration to reading.
The New Financial Deal is very far from being a dense, specialist book readable only by a lawyer, or law professor, or bankruptcy or finance expert. You might guess from the title that the book is a technically useful, but, for the general reader, impenetrable commentary on the Dodd-Frank bill. After all, the bill itself runs several thousand pages of impenetrable legislative language and Skeel himself one of the country’s leading bankruptcy scholars. It might seem from the title that it is simply an unpacking – at the technical level – of what Dodd-Frank says. Technical experts can benefit enormously from such unpacking, but not so much the policy person or general reader.
But it’s not that. On the contrary, Skeel’s considerable achievement in this book is to write accessibly and persuasively about the Dodd-Frank bill. Skeel is an an admirably clear and graceful writer on very difficult topics; it shows in the sentence by sentence prose, but equally in the overall organization and selection of topics for discussion. It doesn’t seek encyclopedic analysis of the zillions of legislative provisions, but instead makes a judicious and profoundly informed selection of the main achievements (and lack thereof) of the legislation. It then succeeds better than anything I’ve read on the topic of financial regulatory reform at placing this in the context of “political economy.” I don’t mean politics in the day to day sense, but instead the interaction of these financial rules with the political process and the intended and unintended consequences.
II
Corporatism and Brandeis-ism, and the New Resolution Authority
The fundamental reform measures of the Dodd-Frank bill correspond roughly to financial institutions and financial markets. As to institutions, Skeel examines the new mechanisms designed to address systemic risk and the mechanisms created to address supervision of those institutions both before a crisis and after the effective failure of an institution.
The political economy of this institutional supervision is given as two alternative tendencies in American economic regulation. One is the “corporatist” tendency to create a quasi-partnership between government and the largest corporations, so that government is able to exercise in some respects closer control over those corporations but also bending them to its political will – but losing the distance between regulator and regulated that usually makes regulation more effective and more importantly ensuring that those privileged institutions will not be allowed to fail, at least if they play political ball.
The other is what Skeel astutely calls the “Brandeisian” tendency to break up the largest financial institutions so that they cannot become too big, or too interconnected, to fail. He notes – this might surprise some readers – that the New Deal, however empowering government in many matters, was essentially Brandeisian on the treatment of banks, insisting on confining them in function (Glass Steagall, etc.) and in many other ways.
The tendency adopted by both the Bush and Obama administrations has been firmly corporatist. It is evident in the definitions in the Dodd-Frank bill of institutions formally designated as systemically important, but also thereby too big to fail. The corporatist tendency is also a founding feature of Freddie and Fannie, and the extraordinarily politicized activities of both firms as integral to their business models – both buying off Congress and yet chanelling the political will of administrations and bureaucracies – is what Skeel suggests will result from the corporatist model, quite apart from the problem of a lack of moral hazard leading to a regime of permanent bailouts. (Too big to fail is sometimes correctly criticized as really meaning “too systemically interconnected to fail.” This is right, but that translates to systemically interconnected firms that, with respect to this feature of risk, are “cartelized” as though they were a gigantic, if loosely, connected enterprise.)
Skeel’s other fundamental point concerning institutions is that the nature of regulatory authority is essentially unconstrained discretion. It is not discretion of the kind exercised by a bankruptcy judge – gap filling and interpretive and discretion existing only for defined issues, existing yes, but within a tightly bound box. It is, instead, one single non-discretionary norm – that certain institutions are too big to fail – but that everything else is discretionary (I exaggerate some, but it helps illustrate the point). It is discretion not as filling in the inevitable gaps, but instead deliberately widening discretion to cover as much as possible. Though Skeel does not frame it this way, I would describe it as “discretion as strategic ambiguity” in which the rule of law is set aside for the purpose of making it impossible to know how you will be treated: allowed to fail in some cases, taken over in others, not allowed to fail and not taken over, with no standards for knowing what results in what. This is the criticism that Skeel makes of the new “resolution authority” for institutions.
Skeel’s deepest normative point, however, is that the regulatory model deliberately undermines the rule of law – particularly the careful establishment of judicial discretion contained with bankruptcy’s special rules of law. Instead, the Dodd-Frank model finds predictable rule-based regulation inapposite to the task at hand and seeks to displace it by deliberate uncertainty, on the one hand, infused with government’s political preferences, on the other. The political preferences are analyzed against one of the most provocative but also, to my mind, persuasive turns of Skeel’s argument: to show how the auto bailouts are the template for the future bailout regime of the financial institutions. The short, accessible yet expert discussion of the treatment of senior creditors in the auto bailouts is outstanding – but most important is how Skeel shows that this, rather than the earlier bailouts in the financial services industry, is the template for future behavior under Dodd-Frank. That, and Fannie and Freddie. Continue reading ‘David Skeel’s Excellent Book, and Comparing Discretion in the Financial Crisis and National Security’ »
I am curious as to whether any law school offers a (seminar?) course on the law and regulation of central banking, either specifically on the Fed in US domestic law or else something like “comparative central banking” in the transnational law curriculum. I’d be interested in responses as to courses, syllabi, reading, and course topics. Serious responses please; no rants or off topic responses. (Let me add that I don’t mean exactly what typically features in the banking course, which is, in my experience, less about the law governing central banking than the legal mechanisms by which the central bank interacts with the rest of the banking and financial services sector. They are not quite the same thing.)
The legal powers of the Fed – and their limits, regulatory, statutory, and Constitutional – are obviously a question of importance today. The financial crisis, the response, and the continuing unemployment rate make the question of the Fed’s mandate, independence, and limits germane in a way that has only rarely been true in the economic history of the US since creation of the Federal Reserve. Consider one of the latest arguments – will the Fed move to monetize the fisc, meaning the fiscal deficits of states and municipalities, as a source of – not liquidity of last resort – but instead as a provider of solvency? A George Will column expressed the concern, set against public pension issues, this way:
People seeking backdoor bailouts hope that the fourth branch of government, a.k.a. Ben Bernanke, will declare an emergency power for the Federal Reserve to buy municipal bonds to lower localities’ borrowing costs. This political act might mitigate one crisis by creating a larger one – the Fed’s forfeiture of its independence.
Will obviously has a side in this debate, but that is not what interests me; it is that the law governing central banking is up for serious debate in a way that is historically not often true. Please leave aside any comments as to the policies involved, good or bad. I am interested in understanding the underlying sources of law and regulation at issue here. If the Fed were so to act, are there legal limits on the ability of the Fed to act in this way – and does it matter one way or another, as a matter of law, if Congress has declined to provide a fiscal bailout?
I am also particularly interested in anything offered somewhere in the law school curriculum on comparative central banking, in universities here in the US or elsewhere. Again, same interest in curricula, syllabi, readings, etc.
Update: Thanks for the responses below, they are very helpful, and I’ll be in touch with Eric and some others mentioned below. I’ve deleted some comments that are not relevant to my inquiry; I’d like the comment thread to be useful to people who are searching for the same materials I mention in the post, and don’t want other things there. Also, I should add that I’m not actually contemplating teaching a class on this topic – I don’t know whether there is enough material for a course on the law of the Fed or not, although I do think that a comparative central banking course surely offers sufficient materials. Rather, I would like to know more about the area substantively, and this seemed like an easy way in. As well as helpful to others looking for materials in the field. Thanks everyone.
Over at the business law professor blog, The Conglomerate, the book club has been reading Bethany McLean and Joe Nocera’s book on the run-up to the financial crisis, All the Devils Are Here: The Hidden History of the Financial Crisis. David Zaring introduces the book, his brief take, and the book club discussion here - then scroll up for the other mini-reviews and comments. The Conglomerators think the book is worth reading, and I’ve just ordered it. (For my own part, I have just finished a second, closer read of David Skeel’s The New Financial Deal, which is outstanding, and on which I’ll post a short review later.)
Although I have a few reservations about the tone of the article being just slightly conspiratorial, Louise Story’s front page NYT story today on the evolution of derivatives clearinghouses is highly informative and very well done. The graphics showing how the bilateral trades would turn into centralized clearing are quite good and would be useful with a class. On balance, I think the overall shift to centralized clearing is a good move. But I also have a bad, bad feeling about this in the context of Dodd-Frank and future expectations. As I have said in past posts, in a future of financial regulation in which the central question of systemic risk and moral hazard has not been addressed, the result of what is otherwise a sensible move (yes, yes I’m skipping over all the concerns about end-users and Main Street, etc.) could turn out to create not so much a central clearing house but instead ... a central address for depositing unwanted risk.
After all, why should any of these leading market participants believe at this point that the government would allow the central clearinghouse to burn down in a crisis? And if they don’t believe that, then what is their incentive to set terms that will adequately address the risk as a matter of private ordering of fees, margin, whatever form of insurance the central risk-clearer needs? Having a central clearing counterparty is a great idea – if it and the actors that run and control it have the private incentives to make sure it is not a mechanism for accumulating and compounding risks.
Presumably the answer is that government regulators will set those requirements and solve the problem. But the general theory of financial regulation used to be that systems would be monitored for risk-taking, after private parties (with well-structured incentives forcing them to internalize the risks) had already made the first round of risk-decisions. Regulators would be kicking the tires for safety and soundness, as a second line of regulatory defense, not the first. I am an admirer overall of Gensler’s efforts, but he cannot be Batman to Financial Gotham. The peculiarity is that a structure that ought, in principle, to reduce risk might wind up leveraging it. The clearing house might turn out to be the one address market participants need to send their unwanted risks.
ps. Here are a couple of possible unaddressed risk scenarios:
If the clearinghouse system could achieve the third as its long term behavior, then I think it is on balance a good move. The fact that the fourth exists is not a reason not to create an otherwise rational scheme of regulation; if it is, nearly by definition, unforeseeable with sufficient specificity to prevent it from happening, that might be a pretty good definition of what the role of institutional and liquidity provider of last resort is supposed to be. One of the peculiarities of financial regulatory reform, after all, is that one can always object to nearly everything on the grounds that there is radical uncertainty and there might be unforeseen and unpredictable consequences ... so better not do that. Or that, or that, or that. But of course not doing anything at all is also doing something with equally radical uncertainty.
I sometimes think that we should all re-take Philosophy 101 in Skepticism and Rationality in embarking on academic discussion of financial regulation and risk. What is the appropriate kind of skepticism about the limits of our rationality in creating regulatory systems for complexity? Sometimes I ask a question about what I think is a fairly concrete, rationally predictable thing in financial regulation – close, in my mind, to asking what the weather is likely to be tomorrow – and get an answer back that sounds a bit too much like, “We cannot say, because after all we have no proof of the existence of the external world. La vida es sueno.”
Hmm, I think, vale. It is a little like what the late philosopher of mind Rogers Albritton referred to as the skeptic’s devious willingness to shift to another existential form of skepticism just when we thought we had answered him on this one, but not quite saying that he had shifted skeptical grounds. (“Shapeshifting skepticism,” one might call it.) We ordinarily wouldn’t worry much about this possibility, obviously – except that many people think we just experienced this radical uncertainty, come to pass, in the financial crisis.
Other people think, of course, that it was imminently foreseeable, if not because of the actual (disputed) causes, then because the procedural combination of complexity, conflicts of interest, and moral hazard driven complacency strongly implied something that could not go on as it was going – a matter of a visibly flawed process, so to speak. If that is one’s view, however, then the lurking question of number four is less whether the tail risk was actually foreseeable and preventible, but instead whether relations of complexity of systems, conflicts of interest, and attendant complacency meant that no one had enough at stake to find it. In which case, the prescription for public regulators in regulation is less to try and find it, than to give all those other, deeply interested, but also potentially deeply conflicted, parties reasons to overcome their complacency and conflicts, and have them dig through the complexity to find it, instead.
(Moreover, the point of providing liquidity as the provider of last resort in number four is in order to allow markets to make an orderly path to price discovery that is not simply a strategically forced run on the banks. It can’t magically remake insolvency into solvency except by fiat – or fiat money.)
The Wall Street Journal and New York Times each have good, comprehensible explanations of the eurozone sovereign debt crisis on the front pages today. (The Journal has a particularly useful graphic that breaks out each country.)
While I wait for David Skeel and William Cowan’s new book on the Dodd-Frank financial reform bill to appear next month (The New Financial Deal), I have tried to make my own assessment of what the bill means in the aggregate. In order to do this, I have read the bill in its entirety twice. The first time was when the bill was first passed, and this was in order to see if anything in it took me by total surprise. That amounts to a search for particular nuggets that jump out at you, not the “totality” of the bill. I’ll add that he experience of reading the entire thing as a “thing” made clear to me why “reading” bills before you pass them, if it is a good idea, needs to mean “reading” in a really different way. You have to read the bill with all the cross references to other legislation being amended to hand in advance, and a staff of experienced people to make sure that you know the context into which this change or that fits. One hopes, of course, that this was also part of the drafting of the bill ... but let’s pass over that detail. (Update: I just ordered Skeel-Cowan from Amazon.)
The second time around reading it was not for nuggets, but instead to try and understand the whole thing, as a comprehensive thing. I realize that this makes little sense given that it is not a “thing” but an agglomeration of many things, some of which fit together and some of which don’t. But this second time, I read it with some research help, and more importantly with the several hundred page bill summary to hand. This was partly to understand the bill, but partly to get a reality check, at least for parts of the bill in which I have a good grasp of the issues, whether the summary is accurate as to the bill and its impacts. I can report that for at least sizable chunks of the bill where I think I’ve got a strong sense, the summary is outstanding, and unless someone points out to me big areas where it is not, I’d urge those working with the bill to go to it. I am open to correction on this point, if you are genuinely expert in these matters.
My one graf takeaway on the bill is this, however. Parts of the bill have little relevance to the financial crisis, although they might still be part of an overall package of reform of financial regulation; one can always tell a story about how they have an impact on crisis through accumulations of bad issues, but realistically, whatever point they might have or not have – the consumer protection provisions come to mind – they are adjunct. If the underlying rationale and point of the bill is to alter the regulatory conditions that allowed for the development of the crisis, then it should be fundamentally about addressing systemic risk, too big or too interconnected to fail, and attendant moral hazard; complexity, complacency, and conflicts, as Steve Schwarcz says. As a substantive matter, however, the bill in total effect does not address too big or too interconnected to fail as a matter of private ordering, and so has the regulatory authority assume the moral hazard. Which leads to this dismaying conclusion: There are important parts of the bill that would make a great deal of sense (leave aside various particulars), in a regulatory environment that properly put the moral hazard of systemic risk on the private actors. To take one example – and leaving aside the WSJ editorial today about Main Street’s risk management issues – the proposal to move OTC standard derivatives onto centralized clearinghouses that would both provide greater transparency and reduce the scary information asymmetries and provide for centralized clearing. Great idea, with appropriate tweaks, in my view – until it becomes clear that because the bill does not put the risk burden on the private actors ultimately – does not force the private players to internalize their risks in derivatives trading, the clearing house and ultimately the taxpayer serve as the guarantor of last resort. The effect of an otherwise sensible regulatory change in the derivatives market, under conditions in which moral hazard has not been addressed, is not to reduce systemic risk, but to leverage it up by centralizing it in the ultimate public counterparty. The ironic result of the bill, in other words, is that by failing to address the systemic risk problem other than by telling the Fed and the Treasury and the “council” to figure it out, and so leaving too big or too interconnected to remain in place, otherwise sensible regulatory reforms that should reduce risk and increase transparency and informed pricing instead turn out to ratchet it up, leverage it up, for the ultimate government counterparty of last resort. That’s not what I was hoping for.
Long graf, yeah, I know. But while I await Skeel and Cowan’s book, I am willing to be told that this is not correct and I don’t understand what the bill does. However, if you’re going to correct me, please confine discussion to the main issue here, which is the overall impact of the bill, taken as a whole, as defined by the systemic risk question. I should also note, as I have earlier, that a very impressive theoretizing of systemic risk has just appeared from Steven Schwarcz and Iman Anabtawi, Regulating Systemic Risk. It is the most striking attempt to give an account of systemic risk that I have seen in several years; what it consists in and how it propagates. (I re-read it yesterday, and looking at the turmoil in the eurozone, wondered whether this same account could be applied to what we might call “sovereign systemic risk.” I wonder.)
UPenn law professor and corporate finance and bankruptcy specialist David Skeel has an important article in this week’s Weekly Standard talking about the possibility and utility of bankruptcy for states. The article argues first that a new chapter for states in the Federal bankruptcy statute would be constitutional, and then turns to argue, second, that the benefits to the public would be considerable:
When taxpayer-funded bailouts are inserted into the equation, the case for a new bankruptcy chapter becomes overwhelming. And it’s a case for Congress to move now on the creation of a state bankruptcy law.
With the presidential election just two years away, the pressure to bail out California, Illinois, and perhaps other states is about to become irresistible. As we learned in 2008 and 2009, it is impossible to stop a bailout once the government decides to go this route. The rescue of Bear -Stearns in 2008 was achieved through a “lockup” of its sale to JPMorgan Chase that flagrantly violated corporate merger law. To bail out Chrysler and General Motors, the government used funds that were only authorized for “financial institutions,” and illegally commandeered the bankruptcy process to give the car companies a helping hand. There is, in short, no law that will stop the federal government from bailing out profligate state governments like those in California or Illinois if it chooses to do so.
The appeal of bankruptcy-for-states is that it would give the federal government a compelling reason to resist the bailout urge.
This is an important piece of public advocacy by a leading scholar, agree or disagree with its two main contentions, and repays close reading. (The illustration above is a thumbnail from the WS.)
Update: Thanks, Glenn, for the Instalanche – but also for the very interesting updates at Insta, including some important comments and emails that I encourage VC readers to check out.
Also, Co-Conspirator Todd notes above the Stanford Law School conference on the Constitution and the Financial Crisis, at which both he and I spoke a couple of weeks ago. It was a great conference, and CSPAN, as he notes, has put online a couple of the sessions. One of them includes a discussion of bankruptcy and the auto bailout, and the lineup includes both Todd and David Skeel, UPenn professor and author of the above Weekly Standard article.
I have not tried to comment on the constitutional questions, as I do not have the expertise to do so. But I wanted to make a different kind of point about bankruptcy processes that involve quite important areas of judicial discretion – equitable discretion in a generic sense – within a given structure of rules that can force creditor-parties who otherwise would not be likely to overcome collective action problems to come together. Leaving aside constitutional questions that I am not competent to address, I favor as a policy matter something like Professor Skeel’s position. Likewise, I favored bankruptcy as the proper process in the auto bailouts, among others.
That said, I express one caution (I’ve put up a longer version of it as a separate, later VC post). When in a crisis, or contemplating responses to crises, we naturally look around and see an existing mechanism that seems to have worked pretty well. Bankruptcy judges and courts, for example, in parts of the financial crisis. We think that they have worked out pretty well how to cabin judicial equitable discretion in these matters within rules, precedents, codified law, etc. So we collectively think, let’s assign them this big new thing – sure, it’s kind of a stretch (such as bankruptcy for states), but these mechanisms and actors have a stable procedural path that has been well worked out and well trod.
The risk here is that we do not take into account the way in which the addition of this new social and political and legal task is not just stretching existing institutions – taking on these new functions involves addressing whole new categories. Bankruptcy of sovereign entities, for example. It is categorically different, and has the effect of altering the nature of judging, because it just is, by its nature, political in way that no commercial activity is. It alters the nature of discretion, the role of the judges, and how the judges see their role – how they cabin their discretion within a body of rules. It alters the terms of legitimacy when they shift from purely commercial and private players to sovereign actors.
Now, I describe this as a risk and I perhaps overstate by calling it a category rather than a stretch. After all, municipalities have been in these processes before, and states have defaulted before, and so an existing system might well simply grow into this role without warping it out of identification. But it is a risk. At a minimum, it should not be assumed that the mechanisms established by law for dealing with private actors within a structure of sovereign law can automatically work with sovereigns themselves, without altering the notion of “cabined discretion.”
Finally, note that this problem is by no means limited to this kind of financial crisis and bailout problem. The same conceptual problem arises whenever judges are proposed to be tasked with some kind of new activity – precisely because we think that they embody both legitimacy and discretion. Discretion that carries legitimacy because it is limited in many ways. Think about arguments that we could have federal judges giving advance and necessarily secret review of targeting decisions for drone warfare attacks; or issues related to detention and rendition before the fact; or many other related issues.
The assumption is that judges have this legitimate discretion as an attribute of being a judge and that it can be carried around from political activity to political activity as an independent quality. But of course it does not work that way. Legitimacy, and equitable discretion that carries legitimacy, is a function of the activity and how it is not just legally, but also socially and culturally embedded with particular structures of law and sovereignty. The exercise of those powers in ways that are alien to the terms of the judiciary – a judicial function that is embedded within the domestic structure of constitutional law, not a writ that runs to the world, to start with – seems to me inevitably to shift the nature and self-perception of the judiciary itself.
Judges start out reviewing national security decisions; they are gradually drawn in, as one speculative possibility, to police and enforce some rights concepts, until a bunch of Americans get blown up; and eventually the judges see themselves as being the political actors who make the decisions about the tradeoffs between security and liberty. The judges that result from that process will not be the same, in their self-perception or legitimacy, as the judges that preceded it.
These are risks, not certainties. But whether in the national security area or the financial crisis area – I draw here on some of Eric Posner’s comments at the Stanford conference on comparisons between the two – one must take appropriate account of the dynamic social nature of the process by which one assigns activities to actors that are attractive because they have discretionary authority and the legitimacy to exercise it. The exercise of that authority changes with its exercise in new venues – and in ways that one might not anticipate or particularly want.