From the Subprime Mortgage Markets’ Collapse to the Credit Markets Implosion’ and Beyond: Identifying and Putting the Pieces of the Puzzle into Place (Part One)

As I have noted before, plenty of blame can be shared for the missteps that have led to and deepened the subprime debacle that now has morphed into far more serious credit liquidity problems which have spread throughout financial markets in this country and worldwide, and which also have caused trillions of dollars in losses for investors as the markets struggle to find a bottom. As I explain below, a substantial part of the blame is placed fairly at the feet of our elected government representatives and those officials selected by the Executive Branch to oversee the financial and housing markets.

Is Deregulation Always Appropriate? (Clearly not in Some Marketplaces)

In 1999, Congress removed the last limitations imposed by the Banking Act of 1933 (commonly called the Glass-Steagall Act and codified in scattered parts of Title 12 of the United States Code) about the types of activities that banks could legally undertake. In retrospect, Congress’s decision resembles its similar, unfortunate decisions leading up to the Savings and Loan debacle—which deepened taxpayers’ ultimate losses.

During the late 1970’s, while facing an impending financial crisis in that industry, members of Congress chose a pathway of non-accountability instead of recognizing the costs from closing “brain dead” savings institutions. Congress "deregulated" the savings and loans, betting that they could successfully compete with banks and brokerage firms in areas where they had no experience—including lending for speculative commercial development. Unfortunately, these institutions soon began to book progressively bigger and more speculative deals without much consideration of prudential underwriting practices and good business sense. The depth of the losses consequently deepened until Congress and the White House could no longer ignore what should have been done years before. Recent lessons of history about this debacle seem to have been forgotten or ignored.

For additional background about the Glass Steagall Act, see, e.g., L. Randall Wray, Lessons from the Subprime Meltdown, Working Paper No. 522 (Dec. 2007), at 4; available at http://www.levy.org, and Mah Hui Lim, Old Wine in New Bottles: Subprime Mortgage Crisis—Causes and Consequences, 3 J. APPLIED RESEARCH IN ACCOUNTING AND FINANCE No. 1, 3, 8 (2008) (“After the Great Depression . . . , the U.S. government tightened anti-trust laws and banking regulations to protect and stabilize the financial system. One of the important pieces of legislation was the Glass-Steagall Act, which separated commercial from investment banks and prohibited interstate banking. The Act also regulated the activities of commercial banks, including interest rates charged and the restricted entry into riskier investments. Beginning in the seventies, commercial banks lobbied hard for the dismantling of the Act. This picked up pace under Reagan and by 1999, the last vestige of the Act was scrapped under President Clinton. Commercial banks could now engage in investment banking activities that included not only trading bonds and other types of securities, but also underwriting them. . . .”).

Accounting Problems: Rules-based Approaches do not Work

Not surprisingly, other critical pieces of the puzzle which make up the current financial mess involve structuring financial deals to facially fit arcane accounting standards while too often ignoring core business fundamentals. In particular, large, byzantine financial devices were developed and sold to domestic and foreign investors as relatively safe products. How these accounting rules and requirements contributed to the current crisis is clear. In part, banks and thrifts were incentivized by these rules and regulations to move mortgages off their books through securitization. This let them free up capital for more lending that, otherwise, would have to be used to cover reserves and capital requirements under applicable banking regulations. See Joseph R. Mason and Josh Rosner, Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, 1, 15-16 (May 3, 2007) (“In practical terms securitization is the process by which an institution transfers its assets to a legally isolated and bankruptcy remote “special purpose entity” . . . . The assets, structured properly, are allowed to be removed from the balance sheet of the selling company [which] then records a gain in accordance with accounting standards. . . . Auditors will not sign off on moving of assets ‘off of the balance sheet’ for accounting purposes without a legal opinion recognizing the securitization as a ‘true sale.’ That is to say, simply, that the assets have moved beyond the control of the seller. This serves several purposes, especially for financial institutions. Among them, it generally allows the firm to have less deposits to fund loan activity, in most periods this market financing will be less costly to larger institutions than other funding, and it generally allows them to hold less regulatory capital than they would have to if they held all of the credit risk.”); available athttp://ssrn.com/abstract=1027475.

Transparency is Needed to Restore Confidence in the Markets

Another critical piece of the puzzle was the development (and widespread acceptance) of new products tailored to the subprime and credit markets through financial alchemy. Basically, by securitizing bundled mortgages of subprime loans, these products could be sold to (supposedly) sophisticated and institutional investors. Securitization, it was believed, would disperse the different underlying risks involved with making loans to riskier borrowers. In theory, investors willing to take on proportionately more risk would obtain higher returns on investments, while their counterparts would obtain safer investments in exchange for lower returns. It was also believed that, if properly handled, making such loans not only would make money for lenders, but would also assuage pressures exerted on lenders from government agencies to make housing available to borrowers who had not been able to enjoy the benefits associated with home ownership. Yet, as progressively more elaborate devices and credit enhancements were created and marketed, not only did these instruments become harder to understand, but they also became more widespread. Investors adopted a lemming-like approach to these products. In ever-increasing amounts they no longer evaluated the incumbent risks associated with buying such securities—apparently using heuristical devices as a substitute (such as relying on the reputation of the counterparties, the investment grade ratings provided by the rating agencies, and, more than likely in some cases, relying on material false representations that brokers made as to the quality of the underlying products and the degree of safety involved).

Unfortunately, as these new financial instruments became more widely accepted, mortgage brokers competing for such loans (and not subject to the key rules and regulations by which federally-insured financial institutions must operate) ignored or gave little consideration to the prudential risk underwriting standards that commercial bankers would have been forced to apply. Instead, mortgage brokers crafted ever-riskier ways to qualify more subprime borrowers, including “low doc” loans, “no doc” loans, “liar” loans, and “Ninja” loans (an acronym for the nature of the borrower involved: i.e., no income, no job, and no assets). See Wray, Lessons from the Subprime Meltdown, at 8.

The Financial Markets Remain Subject to the Laws of Gravity–Even in “New” Markets

As these events occurred, the underlying subprime mortgage loans began to completely depend on real estate markets attaining higher prices. In short, this "bubble" transmogrified into the structure of a classic Ponzi scheme. See Lim, Old Wine in New Bottles: Subprime Mortgage Crisis—Causes and Consequences, 3 J. APPLIED RESEARCH IN ACCOUNTING AND FINANCE, No. 1, at 5 (“What we witnessed in the subprime and LBO financing is nothing short of Ponzi financing. Added to this are the advent of derivative transactions and financial products . . . so closely interlinked that disruption in any one part has immediate knock-on effects on the other parts. These have multiplied the risks and made the financial system even more fragile and unstable . . .”). At bottom, such blind reliance on the belief that housing markets could only go up in light of the hot markets ignores the basic laws of financial gravity which impact home prices, albeit perhaps not quite as often as they have done in the stock markets.

©Michael E. Clark

More to come soon

  • In a prior, related series of blogs entitled "Subprime Mortgages and Theories of Liability," I discussed some issues and problems. Part One of that series covered some features of the subprime mortgages now defaulting in huge numbers and how these features had been seen in many improper transactions that led to the Savings and Loan Crisis of the early 1990s, and in the more recent corporate governance scandals associated with enormous investor losses typified by Enron and WorldCom. Part Two examined some statistics and problems with liability theories plaintiffs are asserting to establish the liability of defendants in various securities class actions seeking damages claimed to have been caused by the implosion of the subprime mortgage market. Part Three addressed the heightened pleading requirements for falsity and scienter imposed by the Private Securities Litigation Reform Act of 1995 (PLSRA) and how the case law interpreting these provisions makes it very hard for class action plaintiffs to successfully establish secondary liability of defendants. And, Part Four provided hyperlinks to and summarized some of the more interesting observations made by leading commentators about various aspects of the subprime market collapse and related issues.

  • Information provided in this blog does not create an attorney-client relationship or constitute advertising. Rather, it is offered solely for informational purposes. More information about me, my practice, background, and interests, is available from the firm website, www.lawyers.com/hamelbowers&clark, and from the following websites (including some links to my published papers and articles: www.avvo.com/attorneys/77007-tx-michael-clark-121553.html and www.superlawyers.com/texas/lawyer/Michael-E-Clark/a051f497-181f-4399-862b-cd4a7ad5c1cf.html. The pharmaceutical law treatise for which I am Editor-in-Chief was published in December 2007 by BNA and is now being supplemented for 2008. See http://storefront.bnabooks.com/epages/bnabooks.storefront/en/product/1576. /p>

Upcoming events:

  • November 12, 2008: I will be speaking at the BNA Legal & Business EDge® Conference entitled "Pharmaceutical Patent Laws: A Prescription for Success in Challenging Times" being held at the Ritz-Carlton Pentagon City Hotel in Arlington, VA on a panel entitled "Pharma Post-election: Predictions for the Future" with Professor John “Jay” R. Thomas, Professor of Law, Georgetown University Law Center, the author of Pharmaceutical Patent Law (BNA 2005 and 2008 Supp.).

This is part one of a series of related blogs that examines the credit market problems now being experienced in part because of the implosion of the subprime markets.  It builds upon and adds to my prior blogs which focused on the subprime market problems and related issues. In upcoming blogs, I plan to refocus on some of the theories being asserted for damages by private plaintiffs and government entities in suits and actions against various party defendants, address some of the defenses b
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