First, it is a bad idea because it addresses a symptom rather than a cause of financial rot. The problem with the mortgage-brokers-as-villains narrative is that it fails to explain why the brokers could do a land office business selling toxic junk to a voracious secondary market. One explanation – the one implicit in section 1501 – is that brokers were taking advantage of purchasers, selling them supposedly sound financial assets that the purchasers were too unsophisticated or blinded by greed to realize were junk. To state this assumption explicitly is to see its limitations. The purchasers of mortgages were not unsophisticated consumers or little old ladies entrusting their savings to fast talking swindlers. These were a bunch of extremely wealthy, extremely sophisticated, extremely large financial institutions. It is rather unlikely that these guys were “fooled” by the mortgage brokers.

A more plausible story, in my opinion, looks at the underlying supply and demand for credit. First, why did the mortgage brokers go into the subprime market? At least in part the answer is that they could afford to do so. With the short term wholesale funding on which they relied to originate loans costing them essentially nothing, it was extremely inexpensive to originate loans. At the same time, the massive subsidization of the subprime market through implicit guarantees to the Fannie and Freddie, the so-called “Greenspan Put” on which Wall Street relied, and various (admittedly much smaller) direct subsidies created a massive demand for the assets churned out by the mortgage brokers. Add to this the impact of monetary and Chinese balance of payments factors on asset prices, and the notion that the subprime crisis was really the result of agency costs in the OTD model looks implausible. Absent macro-economic and regulatory distortions, I suspect that market competition and reputational sanctions are sufficient to keep the OTD brokers honest. Given those distortions, we have seen spectacular examples of those who did have skin in the game responding perversely to the perverse incentives with which they were presented.

If this were all, the risk retention provision would simply be useless. Unfortunately, it is more than simply a regulation aimed at a phantom villain – in this case the OTD model. As written it is likely to have positively perverse consequences. Section 1501 will create regulations requiring any lender originating a loan to retain some of the risk associated with the loan. Such a rule will potentially play havoc with entirely ordinary and unobjectionable credit transactions. Consider a business that sells its goods or services on short-term or medium-term credit, creating a pool of accounts receivable. It is standard practice for the business to pledge such accounts receivable as collateral on a bank loan. However, should the business default on the loan, under current law the bank would foreclose on the collateral – in this case receivables – and sell them off to satisfy the business’s debt. This foreclosure sale, however, would necessarily mean that the business would no longer retain any of the risk associated with the receivables that it generated, violating section 1501 of the proposed act. In other words, in the name of eliminating what is essentially a symptom rather than a cause of the financial panic, the House proposal seems to put a stake through the heart of garden variety receivables financing.

It gets potentially worse.

It is pretty standard for banks to loan money against inventory. Often the inventory is sold on credit. Inventory financers look to the receivables generated by these sales to satisfy their loans, and under Article 9 of the UCC their security interest automatically attaches to the receivables as proceeds. The analysis above, however, suggests that these proceeds-based security interests are open to the same problems under section 1501 as transactions where receivables are used as original collateral. We are now quite a ways away from the exotic world of Wall Street credit derivatives, potentially sweeping up such thoroughly ordinary transactions as taking a security interest in goods on a retailer’s shelves.

The irony, of course, is that should section 1501 have this consequence, its effects could be bargained around using asset securitization. Rather than pledging the receivables themselves as collateral, an originator could securitize them through a SPV in which it retained some residual risk. The securities created by the SPV could then be held by the originator and they (as opposed to the underlying receivables) could be pledged as collateral to a lender. There is something a bit perverse, however, about creating an extra level of credit derivative complexity in order to bargain around the problems created by regulations designed to simplify credit derivative driven complexity.

I did, however, discover one great advantage of the legal academy in bringing scholars together. With the possible exception of the business school, we can offer better food.

I wonder if there is a similar bias at work in the legal academy. One story that you might tell is that relative to legislators judges are going to be more intellectually sophisticated when it comes to the law. Accordingly, one would expect to see more pieces explicitly addressed to judges than to legislatures. Hence, doctrinal scholarship would dominate over more straight forward law reform proposals. I think that there may have been a point in time at which this was true, but it seems to me that the trend in legal scholarship has been to move away from work that is explicitly addressed to either judges or legislatures. One way of understanding this might be simply in terms of the rising sophistication of interdisciplinary legal scholarship. Sticking with the analogy to economists, however, I wonder if the turn away from work more explicitly aimed at judges might be a result of the ideological divergence of the judiciary and the legal academy since the early 1980s. The academy, of course, has always steered left and given that since 1968 only three of the ten presidential terms have been served by Democrats the federal judiciary at least has been moving to the right. Hence, one might tell a story of the rise of “law and ….” scholarship as the academy’s response to their increasing awareness of their ideological irrelevance to what was going on in the courts.

Just a thought.

But that isn’t what worries me.

Oppenheimer and the other funds that refused to roll over to the feds and the unions were at least behaving responsibly.  If they go down, at least they will go down swinging for their shareholders.  My hat is off to them.  They are doing what we want large financial institutions to do, particularly if they are the sort of large financial institutions that pose systemic risk, are too big to fail, or the like.  We want these guys to fight to keep their balance sheets healthy.  We have a name for financial firms that don’t do this: AIG and Bear Sterns.  No.  What really worries me is a fact that has gotten less attention.  The Administration has been able to demonize the hold-out funds as irresponsible speculators because most of the banks that loaned Chrysler money are standing with the government.  This creates an aura of a responsible establishment working out a solution in the face of a small band of greedy and irresponsible plutocrats.  The real question, however, is why aren’t Goldman Sachs, Citigroup, J.P. Morgan, and Morgan Stanley standing with Oppenheimer and the other hold-out funds?  Why are they, in effect, standing demurely behind the President, clapping politely while he wipes enormous sums off of their already strained balance sheets?

The answer is that these firms are all TARP-recipients, banks joined at the hip with the U.S. Treasury and the Administration.  Another way of putting this is that they are banks that are now under huge pressure to make lending and loan administration decisions (like how hard to fight in a debtor’s reorganization) based on political considerations rather than the bottom line.  By going along with the feds plan for Chrysler’s reorganization they were in essence willing to degrade their balance sheets to keep political elites happy.  In the short term, I have no idea what the hit that these banks have been willing to take does to their balance sheets, and I hope and pray that they can disentangle themselves from the government before this becomes a habit.  Otherwise, we are on our way down a scary path, a path that leads to southeast Asia in the late 1990s.  Except in our case there is no IMF big enough to rescue us or bully our political elites into responsible behavior.

The put-option state is not the same thing as the deregulated state.  Of course, by definition it is always possible to say ex post that any particular crisis could have been solved by better regulation ex ante.  After all, if set of actions X had horrible consequences, it is tautalogical to claim that we could have avoided those consequences had we forbidden set of actions X at the outset.  Hence, every problem can be seen as a failure to regulate ex ante.  What the failure of regulation story doesn’t tell us, however, is why institutions engaged in self-destructive behavior in the first place.  Yes, they did so because they were allowed to do so, but why did they want to?

The answer, of course, is that they didn’t think that they would have to pay if the whole thing blew up.  They had the “Greenspan Put.”  They could force the government to buy their bad investments at a mark-up and save themselves from bad decisions.  This is not really what happened in 1929, but it is what happened all over the emerging market world in the late 1990s.  Bankers in Thailand, Korea, and Indonesia with powerful political connections made out like bandits on risky or self-dealing transactions with the knowledge that they could bend the state (and through it the tax payers) to their benefit if things went bad.

The put-option state, however, is not a regulatory creation.  There was no explicit government guarantee of the GSEs.  There was no explicit government guarantee of money market funds.  There was no explicit government guarantee of the commercial paper market.  There was no explicit government guartantee of AIG, CitiGroup, Bank of America, Bear Sterns, or the rest.  The put options on which these institutions built themselves don’t exist in our laws.  They still don’t exist in our laws, as each of these bailouts has been conducted on an ad hoc, transaction by transaction basis.  The put-option exists at the level of political practice rather than at the level of enacted law.

What this means, however, is that fixing the real problem — the put option state — is not a matter of simply changing our regulations.  It is a matter of changing our political culture.  It was the political culture, not the laws, that gave the put to the barons of Wall Street.  What is needed to fix this is not a new relationship between the SEC and the CFTC.  What is needed is political leadership that can shift the political culture itself.  It is here, I believe, that the Obama Administration has made its gravest errors.  It looks as though the stress tests are going to result in a further rescue of “solvent”-but-still-mysteriously-in-need-of-capital banks by converting billions of dollars in government preferred shares into common equity.  In short, the tax payer goes from creditor to investor in order to save institutions that cannot save themselves by raising capital in the real market.  We simply continue the put-option state.

The truth is that our current regulatory system actually has in place a set of procedures for dealing with insolvent banks, albeit procedures that would need to be beefed up to deal with current volume.  When a bank is insolvent we put them in recievership, wipe out the equity and perhaps the junior debt and then sell off the profitable bits that are left.  New managment is installed.  The bank never shuts its doors.  Money continues to flow in and out.  Depositors and other senior creditors are protected.  For any other kind of institution we would call this process bankruptcy, and it is blessedly where Chrystler has finally ended up (although it should have been there months ago).  In the patois of the put-option state, however, this orderly process of liquidation and reorganization of the insolvent (the process that actually exists within our legal structure) has been tarred as “nationalization,” in order for the government to take even larger equity positions in banks.  This is Orwellian rhetoric of the first order.

To paraphrase Cassius, the fault is not in our laws but in ourselves that we are underlings.  As much as we may need regulatory reform, we need a new political culture more.

Of course, I — and I suspect that many law profs fall into the same category — am engaged in a bit of pedagogical hypocrisy here.  It is not that the I think that the little hymns to casuistry that I give my students are false.  I certainly think that they are good bits of practical advice about how to make successful legal arguments.  It is just that when I sit down and write my articles I am generally not engaged in casuistic case chopping.  For example, my most recent paper does not try to draw careful distinctions between closely similar fact patterns.  Rather, I paint in broad brush strokes at the level of entire bodies of law — contract law v. employment law, etc. Likewise, while I read lots of cases, when it comes to secondary sources I am more likely to hunker down with an article on the philosophy of law or legal history than a bit of casuistry.  I wonder if my praise of casuistry and common law is simple pedagogical laziness.  The case method is ready at hand, and it’s easiest to simply do what has always been done.

Perhaps not.  Last night I was reading Blackstone and I came across the following passage.  Speaking of the right to distraint of animals on rented land by a land lord as security for payment of rent, he wrote:

With regard to a stranger’s beasts which are found on the tenant’s land, the following distinctions are however taken.  If they are put in by the consent of the owner o fthe beasts, they are distreinable immediately afterwards for rent-arrere by the land lord.  So also if the strangers cattle break the fences, and commit a trespass by coming on the land, they are distreinable immediately by the lessor for his tenants’s rent, as a punishment to the owner of the beasts for the wrong committed through his negligence.  But if the lands are not sufficiently fenced so as to keep out cattle, the landlord cannot distrein them, til they have levant and couchant (levantes et cubantes) on the land; that is, have been long enough there to have laid down and rose up to feed; which in general is held to be one night at least: and then the law presumes, that the owner may have notice whither his cattle have strayed, and it is his won negligence not to have taken them away.  Yet if the lessor or his tenant were bound to repair the fences and did not, and thereby the cattle escaped into their grounds without the negligence or default of the owners; in this case, though the cattle may have been levant and couchant, yet they are not distreinable for rent, til actual notice is given owner that they are there, and he neglects to remove them: for the law will not suffer the landlord to take advantage of his own or his tenant’s wrong.

I had this odd moment of delight in the filigreed set of distinctions drawn in the fact patterns here; the basic right to distrain cattle being honed by each slight change in the circumstances.  When I read the passage to my wife she was less taken by its beauty.  I loved it, though.

[God] said to him, “Bring me a heifer three years old, a she-goat three years old, a ram three years old, a turtledove, and a young pigeon.” And he brought him all these, cut them in two, and leach half over against the other; but he did not cut the birds in two.

It is, to modern ears, a very strange story. Abram doubts God’s promise, but his doubts are allayed when God instructs him to dismember three animals and then lay the bits of the carcasses against one another. Why does the bloody ritual with the mutilated animals convince Abram that God’s promise is meant seriously? While the answer is obscure to us, it would have been immediately apparent to an ancient reader. God’s response to Abram transforms his promise into a legal covenant by invoking the formality that by which such covenants were created in the ancient world.

The slaughter of the heifer and the she-goat was an enacted penalty clause. In effect, the parties to a covenant agreed that in the event that they failed to fulfill their part of the bargain they should be treated in the same manner as the dismembered animals. Indeed, in Biblical Hebrew one does not “make a covenant” rather the phrase often translated that way in English editions of the Bible could be more literally rendered as to “cut a covenant.” The formality of killing an animal to seal a deal was widespread in the ancient world, showing up in Babylonian treaties and the agreement dividing Alexander the Great’s empire upon his death, where his generals hacked up a dog. In part the ritual invoked the punishment of the gods (an ironic position for the militantly monotheistic Yahweh to take in Genesis 15), but it also may have been embedded in a system of self-help. The relationship is nicely captured in Book III of The Iliad when Priam, King of Troy, and Agamemnon, leader of the besieging Acheans, agree to end their war through single combat between a champion from either side, and formalize the agreement by slitting the throats of a brace of sheep and pouring their blood, along with wine, on to the ground as a libation to the gods. The Trojans and Acheans then join in a prayer:

Most powerful, mighty Zeus, and you others,

you immortal gods, may you make sure

the men who first violate these oaths

will have their brains spill out onto the ground,

just like this wine, they and their children.

May their wives be carried off by other men.

Notice, the prayer invokes not only the wrath of the gods, but also suggests the legitimacy of violence against oath breakers. In an anarchic world of feuding tribes this ex ante authorization would have been particularly important, because it would allow a disappointed promisee to exact vengeance on a promisor without fear of retaliation by members of the promisor’s tribe.

All of this sounds very quaint and barbaric, of course, but of late I have been reading Benjamin Zipursky’s work on civil recourse theory. I suspect that we are closer to the goat-hackers than we suppose. One of the striking features of private law is that nothing happens unless a wronged party sues. If A breaches a contract to B, A may have liability to B but there is no independent legal duty to tender damages. Contrast this, for example, with tax liability, where one can be judged to not only owe the government money but can also be punished civilly or criminally for failing to tender payment of the debt. I am increasingly convinced that there is a very real sense in which the law doesn’t enforce contracts at all. It simply provides plaintiffs with an orderly and controlled way of attacking plaintiffs. This is essentially what the Acheans and the Trojans did with their covenant before the high walls of windy Ilium. They made a bargain and in doing so authorized a kind of limited attack in the event of breach. The main difference between them and us is the nature of the limits placed on the right of attack. At the end of the day, however, I suspect that we are all just cutting up goats.

(ht Megan McArdle)

I run into two problems. First, the volume of things that I am potentially interested in vastly exceeds my ability to read it. The result is that there are lots of things that I don’t read but would like to. Indeed, given that I am a particularly slow reader, this is a bigger problem for me than for my co-bloggers, all of whom seem much better read than me. (My excuse is that I had a learning disability as a child, didn’t learn to read until I was about 12 years old, and am still very slow.) The result is that much of the scholarship I read is directly related to a something that I am writing at the time. It is simply difficult to read much else. This feeds into my second problem: namely that most of my ideas (to the extent that I have ideas) come about serendipitously. I can plan and organize research on a particular idea. It is difficult, however, for me to plan and organize research on finding an idea. For me at least, the most effective way of stumbling on to new ideas is to read randomly what interests me and then engage in intellectual day dreaming. It can be time consuming.

I think that a large part of what counts as thought is simply arbitrage. It is taking ideas from one area and applying them to a new area. This structure, however, means that often the most useful research that you do is unrelated to any research project. Another way of putting this is that new research projects develop when I am thinking and reading about something else and then find a connection. (For example, my Georgetown piece, which looks at generality and specificity in contract law grew out of an analogy I saw between contract law and Federalist No. 10.) There is thus a sense in which intellectual browsing is immensely important for research. I need a way of dabbling and dreaming efficiently.

The “problem” with something like the Pocket Part is that it rather than decreasing the cost of browsing, it simply increases my ability to analyze a particular argument in greater depth. There is a sense, however, in which I don’t really need help doing this. This is what I do when I do specific searches of the literature and amass all of the articles on a particular topic. The Harvard Law Review Forum doesn’t really make this process any easier, even if it provides a home for good material that might otherwise not be written. It’s good but it simply doesn’t do anything to reduce my browsing costs because the new material that it generates in some sense requires or assumes that I have already read the articles in the main journal. That, however, takes time. Ideally, however, the Legal Worship should increase the efficiency of my browsing. What I am hoping is that it will let me consume more ideas than I would get from either skimming SSRN abstracts (broad but shallow) or reading long-form articles (deep but time consuming). I am hoping that it will open me up to more moments of serendipity, which is what I ultimately need.

She’s shaky on the legal details, but I am assuming that there are terms in the CDS contracts whereby the protection seller is relieved of any obligation to pay the full value of the debt that is compromised by the creditor. It would certainly make sense to have such a term in the contract, as otherwise the protection seller would in effect be financing the restructuring of the over-leveraged firms whose debt they are insuring. She writes:

This is very troubling. We know from multiple economic studies that systems that are too creditor-friendly have lower rates of entrepreneurship and innovation. We all have a vested interest in forcing creditors to the table short of liquidation (though to be fair, in this particular case, my sense is that the bankruptcy is expected to result in a reorganization, not a liquidation). Perhaps swap contracts should allow the issuers to get involved in these negotiations, the way insurance companies sit at the table during lawsuits.

This is where I get a little bit confused. First, I reject the notion that a rule that forces a firm into bankruptcy is per se a pro-creditor rule. Indeed, the bankruptcy re-organization process itself is a pro-debtor system that allows firms to walk away from debt, retain assets, and pay their creditors only a fraction of what they are owed. Furthermore, I don’t see that there is any impediment right now to CDS issuers being in the room when the terms of an out-of-bankruptcy reorganization are negotiated. The issue is that they have limited incentives to do so. Forcing them to pay out under a protection agreement on debt compromised by the debtor and the creditor would, it seems to me, transform them from a provider of insurance to a provider of financing. They agreed to insure creditors against default, not to step in as what in some sense amounts to distress investors. A company, however, that can free up income and assets by avoiding debt because a third party will pay off the creditors gets a de facto infusion of cash from the third party.

If a company really wants to negotiate a restructuring outside of bankruptcy, it seems to me that they can still repudiate their debt, threatening to go into bankruptcy if the creditors pursue a judgement against them. The creditors could then collect under their CDS contracts, and if the CDS issuers have some sort of subrogation claim against the firm it seems to me that we are in exactly the position that we would have in a world of debtors and creditors with no CDSs.

At the end of the day, I think that there are all sorts of pathologies in the CDS markets — complexity, bad documentation, counter-party risk, short-squeeze problems, etc. Going forward I suspect that most of these problems will be solved by a clearing house system and burned investors who no longer want to sell a credit default swap on the default of a pool of collateralized Indonesian car loans denominated in Thai baht that was then indexed to a bundle of commodities, South American currencies, and the combined scoring averages of all of the teams in the NBA.

The danger to entrepreunership comes from punishing risk takers by holding unpayable debts over their heads in perpetuity. I am less convinced that requiring shaky firms to reorganize in bankruptcy or liquidate is such a bad thing.