Explorations

David Lipton and Heidi Schooner, two CUA law professors

What’s the main cause of the economic crisis that’s roiling America? Is it greed? Subprime loans? The government’s refusal to sufficiently regulate financial markets?

An even more important question focuses on the future: Can any good come out of what CUA law Professor David Lipton calls “the worst economic disruption since the Great Depression”?

Lipton and Heidi Schooner, two CUA law professors whose research focuses on the regulation of financial institutions, have given much thought to those issues. Lipton is the author of the two-volume book Broker-Dealer Regulation, published by Westlaw. Schooner is co-writing a book on regulating the banking industry, to be published by Elsevier Press in September 2009.

The current economic crisis is the result of the following chain of extraordinary financial events, Lipton says:

Spurred on by low interest rates and presidential policy, mortgages were issued to many families that, it turns out, couldn’t afford them.
The mortgage market was expanded through the creation of $10 trillion to $20 trillion of collateralized mortgage obligations, which bundle home loans and enable banks and others to invest in them, essentially wagering that home buyers will pay off their loans.
Investment banks and insurance companies further ratcheted up the stakes by issuing more than $50 trillion of insurance wagers called credit default swaps. Through these, holders of the mortgage obligations paid an annual fee and, in exchange, the banks or insurance companies committed themselves to pay off any financial losses incurred by the obligations.
As more homeowners defaulted on their mortgages, the value of the bundled mortgage obligations plummeted and financial institutions were called to pay off their insurance wagers. The resulting bankruptcy of banks and insurance companies has led to the inability of businesses to obtain loans to fund normal operations.

The false assumption underlying the fiasco was that housing prices always go up, says Schooner.

The “perfect storm” of mishaps included one other: The new financial instruments such as mortgage obligations and debt swaps were introduced at a time when advances in computer technology allowed those instruments to proliferate at astounding speed and in unprecedented dollar amounts, making it difficult to keep abreast of the instruments’ problems and risks.

That’s a nutshell picture of what caused the crisis. Where does the country go from here?

In the long run, says Schooner, consumers will need to increase their savings rate and decrease their reliance on borrowing. The government will need to consider raising taxes — to shore up the annual $1 trillion shortfall of tax revenues compared to government expenditures. The government will also need to keep pumping money into the banks to replenish the credit market and restore public confidence in the financial system.

Government regulation of banks and brokers can’t stop the ongoing crisis, but it might help prevent another such crisis in the future, says Schooner. The opportunity to institute that kind of preventive regulation may be the small bright side to the calamity. “Pretty much the only times the country has been able to pass meaningful legislation with respect to the regulation of financial institutions is during crises,” she says. “Our current regulatory framework was created during the Great Depression of the 1930s.”

One proposal for regulatory change came from the U.S. Treasury Department in March 2008. It mirrors a proposal that Schooner made in a 1999 law journal article: to decrease the number of regulatory agencies and give each regulator responsibility for a single important goal: e.g., having one regulator protect against risk to America’s financial system, another focus on consumer protection of investors and consumers, and so on.

Schooner doesn’t see the financial picture as hopeless. “We’ve weathered crises before,” she says. “I don’t see why we can’t weather this one. I don’t see this as the apocalypse or the end of capitalism as we know it.”

In fact, she says, “Some people will make money because of the crisis. That’s uniquely American — we’re going to look at the bright side. It’s like I tell my law students: ‘It’s a great time to be a lawyer. There’s going to be so much litigation relating to this crisis. What a great time to be able to help clients figure out who’s to blame and help them find a way to dig out from this.’ ” — R.W.

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Revised: March 2009