Lack of Disclosure the Root Cause of the Financial Crisis

Economists and historians will be debating for years the causes of the financial crisis that, like a global array of dominoes, now threatens to take down the "real" economies of countries big and small, both "developed" and "emerging," in a massive flight from investment risk unlike anything experienced since 1929.

To the experts' lists of causes, let me add a lack of information--specifically, the systemic failure of lenders to disclose ample information about the risks of the mortgage loans being made to thousands of borrowers whose homes have since tanked in value, resulting in unprecedented rates of default. These defaults leave the holders of the affected mortgage investments--primarily banks around the world--with sizable loan portfolios that they can't value and for which there is no functioning market.

It is the absence of information that prevents the markets from valuing so-called mortgage-backed securities--a failure which, in a vicious cycle, forces banks to write down the securities' value on their balance sheets, resulting in huge losses that precipitate a sell-off in the banks' stock. The fall in the stock price, in turn, causes the banks to stop lending in order to preserve much-needed capital--which leads to, what: A recession? A depression? Whatever, it isn't pretty.

What information, exactly, did lenders fail to disclose? Not the fact that large numbers of home purchasers were poor credit risks who could barely afford to service their mortgages. That much the market understood, although it was lulled into complacency by reassuring credit ratings, the prospect of refinancing the mortgages as houses appreciated, and by diversification theoretically achieved through the bundling of multiple mortgages.

The market, however, did not know--or did not understand--that families buying homes would, in many cases, have an incentive to default on their mortgage obligations if, contrary to the supposed birthright of all Americans, and particularly those living on the east or west coasts, housing prices stopped rising or actually declined.

For example, in California, ground zero for the national housing bust, homeowners, by state law, have no personal liability for a first mortgage. Lenders' only security is the home itself. This means that homeowners whose homes decline in value below the amount of their mortgage may simply stop making monthly payments--with no legal responsibility or liability to the lender. Default for these homeowners is the rational choice in a declining housing market, not the dreaded denouement of families attempting unsuccessfully to claw their way to the middle class.

Although one feels sympathy for any family whose house falls into foreclosure, most homeowners in California who bought their homes in 2004 or later are not victims. Many paid no money down on homes which, had the market continued to rise, would have received equity at no risk. They were like characters in a Las Vegas movie who, staked by a rich stranger, are allowed to keep their gambling winnings but are not responsible for losses. Who wouldn't take that deal everyday?

The irony is that California's misguided law shielding holders of a first mortgage from personal liability was enacted in the Depression of the 1930s--one is tempted to say the "last" Depression--to protect homeowners, who obviously vote in larger numbers than owners of banks and mortgage companies.

How could this risk not be adequately disclosed? One reason is that investors are so accustomed to sky-is-falling disclosure rhetoric--written by lawyers whose legal boilerplate describes every investment as insanely risky--that they are unable to distinguish between investments posing an average risk from investments posing an extraordinary risk. When every legal disclosure says, in effect, "you have to be crazy to buy this security," no security seems more or less risky than any other.

Another reason is complexity. Some securities have become so complicated that even sophisticated institutional investors can't comprehend their relative risks. Investors were introduced to this phenomenon in the 2002 collapse of Enron. In recent years analysts have pointed out that the transactions that sunk Enron were in fact disclosed, although few could understand them--much less evaluate their likely impact on the company's earnings--because of their incredible complexity.

Financial markets need meaningful and comprehensible information in order to function. The purpose of the recently enacted federal "rescue plan" is to provide a crucial piece of information that panicked markets have been unable to establish--namely, the value of collateralized securities tied to home mortgages--so that buyers and sellers can resume trading them, even at heavily discounted values.

The financial markets are like representative government. Just as democracy requires transparency so that voters can hold elected officials accountable, so the financial system requires transparency so that investors can understand and place a value on the risks associated with certain assets or transactions. In the recent financial bubble, investors preferred ignorance to credible and understandable information. Now that the bubble has popped, let's hope investors once again insist on meaningful disclosure.

Peter Scheer, a lawyer and journalist, is executive director of the California First Amendment Coalition, www.cfac.org

Comments

[practicalidealist]

The lack of disclosure the root of the financial crisis? I don't think so. But the root of our problems is the lack ideas the meet the challenges that history presents.

Can Sustainable Cities Save The Planet?

By Walter Libby
http://theendpoint.blogspot.com/


Can sustainable save the planet? This is a good question and it deserves a good answer. But a more relevant question is, can sustainable cities save the United States? Our rising unemployment rate in the global economy has finally caught up with us"we are out of bubbles and are now a nation at risk. With nine straight months of job losses and a looming financial crisis, our prospects look grim"despite the efforts being made to prop up our financial system.

[practicalidealist]

Lack of disclosure the root cause of the financial crisis?

[Pdubya]

the true free market disclosed to us: it called for a deep, corrective recession. painful but shor-lived.

instead, and largely due to political reasons and graft, the complicit and clueless on the Hill opted to give full authority to the puppet masters to dump more fiat currency into a defunct fiat system.

instead of allowing a vestige of free market principles to trump a managed market - corporatism - fascism, they removed that principle. the federal reserve's unconstitutional authority to create money out of thin air, aka a bailout, will destroy our dollar. it is this very hidden tax, the most regressive, that will cause these foreclosures. it is this very mechanism that gave fertile ground to "free money".

support HR 2755 to phase out the Fed.

[Henry]

Please give us the primer on sound money. Just what would the fed be replaced with?

[jusion]

Fannie Mae was originally a US government agency, but became a public company in the 1970s. Despite being a public company, Fannie Mae has remained a quasi-government agency subject to federal oversight and regulation. This government regulation, combined with a few perks such a direct credit line from the US Treasury has resulted in what amounts to an implicit US government guarantee that Fannie Mae (and its cousin brother Freddie Mac) will never default on their debt.

Traditionally, because of the government stipulations, Fannie had required the mortgages it purchased to be so-called 80/20 mortgages wherein the borrower puts at least a 20% down payment on the mortgage. The problem with a 20% down payment is for many people it was very hard to come up with that big a down payment.

Fannie began a campaign to increase "home ownership" and "affordability". It created a home ownership "foundation" which opened offices in almost every congressional district and promptly set about mobilizing all the local advocates for "affordable" housing to put pressure on their elected representatives to let Fannie Mae offer "affordable housing programs". Mainly Democratic politicians saw political advantages in supporting the programs because it cast them in the role of trying to help families buy a new home.

Fannie"s and the Democrats' drive to lower underwriting standards had created the current financial crisis.

[Henry]

Jusion,
You are not even close. Why waste our time?

[widereader]

You seem to be saying that the BANKS (US AND AROUND THE WORLD) did not understand or know that persons taking out mortgages could default without personal liability, in states such as California, if the housing market declined because there was either no discloser or inadequate disclosure (caused by complex language). I think those BANKS were and are sophisticated and knowing lenders who thought the market would continue to rise and in the event of default they would end up with property that was worth more than the original mortgage - plus payments already made. Thus the BANKS felt they were not at RISK. You also seem to be saying that individuals taking out a mortgage should not only loose the money that they paid on the property, but loose the property and also guarantee the BANKS the difference between the mortgage and the cost of the decline - so the BANKS would have no risk in states such as California. So according to you, it isn't the persons who were offered loans for which they really couldn't qualify, but those greedy California buyers who are deciding not to pay on their mortgages because the market has fallen off - now it's is the poor BANKS who were victimized because they couldn't understand the language contained within the loan agreements that they no doubt wrote--- and which were bundled together and then sold off to other BANKS AND FINANCIAL INSTITUTIONS that likewise couldn't understand the complex language. POOR BANKS

[Sundialsvc4]

I do not believe that anyone "did not know."

The market knows one thing: "the Full Faith And Credit Of The United States" will, in the end, pay for everything. A $700-billion bailout, a $612-billion defense bill, and anything and everything else.

The market rode this train because they knew that, in the end and no matter what, "Uncle Sugar" would (and will!) literally manufacture the dollars needed to "make everything balance."

It may seem strange to say this, but remember that governments do not play by ordinary rules. They have the power to issue money "and to regulate the value thereof." Yet they buy and sell things on-the-market as though they were a regular player. Who do you want to buy-and-sell to, exclusively? Yep, the guy with the bottomless wallet.

There will be no Depression. The government will simply print money. Watch.

[Henry]

Standard & Poors and Moodys are ratings agencies. They rate secruities that trade in the market with respect to risk. An "AAA" rating is a professional, market tested, measure of risk in the market place for securities. All these mbs, mortgage backed securities had ratings and their market price was a function not only of supply and demand, but also the "AAA"(or other) rating. The trader, the market investor do not take out the prospectus for each security and perform their own "pro forma" analysis before they trade, they do not have the time or the expertise. The market in form of the "AAA" has done it for them. Standard & Poors and Moodys are the abject failures for their respective brands of "AAA" on questionable paper. It is that simple. It is kind of like Yale and Harvard presenting degrees to George Bush. The degree is there (AAA) but how it ever got there is beyond us all. (the truth is we all know how these things happen....it is who we are as a people)