by Craig Eastland

[Editor's note: West Librarian Relations Manager Craig Eastland is a law librarian who is also an avid follower of securities law and the financial crisis. In our November/December 2008 issue, Craig described the building blocks of the current financial crisis. In this issue, he describes how the tower of blocks ultimately toppled. To read more of Craig's insights on the subject, see his blog, The Speculative Debauch at speculativedebauch.blogspot.com.]

When I took high school physics, my teacher demonstrated a chain reaction by setting 30 mousetraps, placing them in the bottom of a box and very, very carefully covering them with a layer of ping-pong balls. Once everything was set, he stood back and threw one ping-pong ball into the box. BANG! The last installment of this article (see Law Librarians in the New Millennium, Nov/Dec 2008) was devoted to describing how the financial sector set its mousetraps. In this one we'll talk about what happens when the ping-pong ball goes in.

To comprehend what triggered the collapse of our economy and why the effects were so widespread, it is useful to consider the psychology of two key participants: the ordinary home buyer and the ordinary banker.

By 2007, rising home prices had outstripped increases in income for many years. As a result, ordinary home buyers had to contemplate committing a higher and higher percentage of their income to housing costs. At some point, responsible home buyers looked at their projected monthly expenses (for the next 30 years!) and said, "We can't afford that! We'll rent until prices go down." Even though the obscure machinery of asset-backed securities (ASB) finance continued to rain money on them, they opted not to take it. Prices couldn't go up forever! They decided they'd be better off waiting. When enough buyers made that decision, of course, lower home prices became a self-fulfilling prophecy.

This development had a catastrophic effect on the balance sheets of institutions holding the alphabet soup of mortgage-derived securities (ABS, credit default swaps (CDS), collateralized debt obligations (CDO), etc.) As mentioned in the last installment, the ability of these securities to generate income was predicated on the conditions of the few previous years: rising home prices, low interest rates, and a strong debt market, continuing forever.

But, as Lawrence Summers put it, "trees don't grow to the sky." When the income stream from mortgage-derived securities began to falter, other market forces quickly turned bad news into an apocalypse.

Most of the mortgage-derived instruments were marketed as being as liquid as cash because they could always be sold in the thriving secondary market. However, when some of them stopped generating reliable dividends, secondary market prices began to falter. Because of the mark-to-market accounting rules in FASB Statement No. 157,¹ any entity carrying these securities on its balance sheet had to mark down their value as their potential resale price decreased. When the secondary market dried up completely, mark-to-market wasn't helpful–holders were forced to guess what their securities were worth.

The markets knew that the valuations were guesswork. Short sellers in particular cast a critical eye on the balance sheets of institutions with large holdings of mortgage-derived securities and found them overvalued. Short sellers are investors who sell stock, wait a bit, and then buy it back. They are betting that the stock will decrease in price between when they sell and when they buy again. For instance: if you sell Lehman for $10, wait a couple of hours and buy it back for $5 you net twice as much Lehman for the same money. Selling and buying repeatedly as a stock goes down is called a "bear raid." Bear raids were outlawed in1938 by Securities and Exchange Commission (SEC) rule 10a-1 because "The preponderance of available evidence points to the conclusion that in a declining market certain types of short sales are seriously destructive of stability".² Rule 10a-1 (called the "uptick rule") made short sellers buy at market price or above. The SEC repealed the uptick rule in 2007.

The difference between borrowing money and issuing equity is that debt investors (creditors) contract to be repaid on a set schedule. They sacrifice a share of potential profits for a steady return. This can mean big profits for the debtor if it buys something that increases dramatically in price, but if the opposite happens, the debtor can quickly become insolvent. Because so many of these mortgage-derived securities were bought with borrowed money, exposed entities had to sell good assets in a falling market to cover their debt payments. This panic selling caused the whole market to fall.

A combination of debt coming due and collapsing equity made a number of institutions insolvent in very short order. They had to go bankrupt or be acquired.

That's how we arrive at the second psychological portrait: Why did nearly every member of the nation's financial elite stake their money (and yours) on the proposition that housing prices would keep going up? Why did so many allegedly smart people think that this time trees might grow to the sky? Imagine you are an economist at Lehman Brothers in 2006, and you have come to the conclusion that when housing prices start to go down, your company will be wiped out. So you go to your boss and you advise her to get out of the mortgage-backed securities (MBS) market and into something safer with lower returns. What happens? You get sidelined and someone less conservative gets your job. But what makes that other economist so sanguine? Nobody can say for sure, but here are a few theories:

All of these explanations boil down to the same thing-willful blindness caused by greed. Reason #4, reliance on math, is one of the unique features of this collapse. As I mentioned in the first installment, starting in the 1980s Wall Street employed quantitative analysts known as quants to use math to find new ways to make money. The math was often abstruse and based on very small data samples (for more see the excellent article in Wired on Gaussian copula function).³ It is also clear that the bankers didn't understand the math, and in their zeal to make money, they misused it badly. They misused it because they didn't see the math as an analytical tool; they saw it as a way to disguise risky investments–from investors, from themselves, or both.

So, that's how we got here. Where are we going next? Will we be getting our own '33 Act, and if so, what will it look like? Since last April, when the Treasury released its proposed blueprint, the scalpel of reform has been poised over the corpus of securities regulation. A survey of recent legislation found no brave new reform proposals–the fixes coming from Congress are strictly of the tweak-and-band-aid variety.

Pronouncements from the administration's inner circle show a preference for cooperation between agencies that suggest that the SEC may have to cede its place as the preeminent securities regulator. The most significant indications come from a report titled Financial Reform: A Framework for Financial Stability produced by the Group of Thirty Working Group on Financial Reform. The Framework is important because among its authors are Timothy Geithner, Paul Volcker, and Lawrence Summers. Volcker called it "a reasonable indication of the direction in which we might go." Uh huh. I'll take it anyway. Core Recommendation 2 calls for enhanced international coordination to "modify material national differences in standards" and "develop processes for joint consideration of systemic risks." This is in line with Lawrence Summers' expressed desire to prevent regulatory competition by curbing what he calls a regulatory "race to the bottom."⁴ The alternative, Summers suggests, is "global cooperation to raise standards."

¹ Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 157, Fair Value Measurements (Sept. 2006).

² Securities and Exchange Act, Release No. 1548, 1938 WL 32911 (Jan. 24, 1938).

³ Felix Salmon, Recipe for Disaster: The Formula That Killed Wall Street, Wired (Feb. 23, 2009).

⁴ Lawrence Summers, A Strategy to Promote Healthy Globalisation, http://blogs.ft.com/economistsforum/2008/05/a-strategy-to-promote-healthy-globalisation/ (May 5, 2008).