11/07/2008 05:12 am ET Updated May 25, 2011

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,