How the Tricks That Crashed Wall Street Can Save the World

As countries including the United States reform their financial sectors, they should look inside the banks themselves for the tools for the fix.

BY OLIVER HART, LUIGI ZINGALES | DECEMBER 3, 2009

Suppose you are woken up in the middle of the night by a police officer telling you that your teenage son is at the hospital in an alcohol-induced coma. You are shocked and search for reasons. You blame his friends and their wild parties. You blame the bartender who broke the law and served alcohol to a minor. You blame the latest sweet cocktails. You blame your spouse. You even blame the media for making alcohol seem attractive.

Now, consider that the alcoholic son is the financial industry and Americans are the parent who received the wake-up call last fall, when banks collapsed, the credit markets seized, and the U.S. recession spread to the world. Since then, Americans have blamed the wild parties (the housing bubble), the bartender who broke the law (the mortgage brokers with their liar loans), the deceptive latest cocktails (the new derivatives), the permissive spouse (deregulation), greed (excessive executive compensation), and even transparency (the new accounting rules that require mark-to-market).

All of these factors have contributed to the problem. And Barack Obama's administration is attempting to ameliorate some of them with Senate legislation designed to give regulators the ability to break up the biggest banks and create a new consumer-protection agency. But these measures, as well as others under consideration in Europe and Japan, do not address the fundamental cause of the crisis, nor will they help the world avoid more financial disasters down the road.

What really caused the 2008 meltdown -- and is certain to create and burst bubbles in the future -- are the financial industry's distorted incentives. For the past three decades, the most fail-safe way to make money on Wall Street has been to take on risk, borrow, and bet; the crisis did not change that. Either you are lucky and you make a bundle, or you are unlucky and you walk away. In other situations, creditors dampen this opportunistic behavior by imposing covenants and monitoring borrowers. But why bother if the government will bail out ruined gamblers? Then, loans are valuable for borrowers and lenders alike, albeit disastrous from the taxpayer's point of view.

The implicit policy of bailing out large financial institutions -- those behemoths widely thought of as "too big to fail" -- will become explicit if the administration's regulatory reforms are approved. They do not stop the encouragement of bald risk-taking by removing the guarantee that the government will never let big, systemically important banks crater. But short of refusing to bail out banks, regulating them out of existence, or somehow miraculously eroding the profit motive, what should the Fed and Congress do?

There is a way forward, beyond new regulators, new requirements, and new rules, for the banks to figure out how to skirt. An intervention mechanism centered within banks and reliant on market signals will work much better than a Washington edict. And we believe such a system is possible to create and put in place.

The way to do it, contrary though it might seem, lies in the much-maligned credit-default swaps (CDSs), which are like insurance policies against a loan defaulting and whose value rises as the chance of failure increases. When these contracts are traded on an exchange that ensures that they are properly collateralized, they provide a daily assessment of the risk of a loan's default. Our idea is to use this timely information to monitor banks.

PAUL J. RICHARDS/AFP/Getty Images

 

Oliver Hart is the Andrew E. Furer professor of economics at Harvard University. Luigi Zingales is the Robert C. McCormack professor of entrepreneurship and finance at the University of Chicago Booth School of Business.

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PLAIN JANE

12:34 PM ET

December 4, 2009

Intelligent regulation

>>Doesn't it make sense to force them to install a device that stops them in their tracks next time they embark on a dangerous journey?<<
I really am just a "plain jane" but it makes sense to me.

 

BUFFALO09

1:33 PM ET

December 4, 2009

Affordabel Housing Program? Government also responsible.

Hart and McCormack's failure to mention the essential role our federal government played that was a key factor which initiated the entire process through the enforcement of new housing legislation passed in the 90's. Are their numerous areas of the private sector which require extensive scrutiny as all of their actions were vital components that provided momentum towards our financial systems collapse? The affordable housing program initiated during the 90's played a major role as govt. penalties and oversight forced institutions like Citi to approve loans for individuals who could not afford to make the payments. Current record foreclosures were a direct result of the enforcement of this legislation. I am not excusing behaviors and practices that occurred at mortgage institutions as many of these companies engaged in techniques that did not accurately explain loans for lower income individuals. With that being said, it is the responsibility of the owner to actually read the contract and be accountable for their decisions. Although there is a large segment of the population that may be categorized as economically challenged, these individuals are immediately labeled as being stupid by academic intellectual elitist. Although it goes unsaid, a generalization evolves due to claims that state these groups are unable to comprehend and understand issues of a complex nature. Money does not make anyone smart and being economically challenged does not automatically classify you as an idiot but by undermining the capability of the entire group by generalizing,: you have essentially insulted the intellectual capacity of every person whose economic status would be designated towards the lower end as you have righteously told them that they are too stupid to make decision on their own. Accessing blame towards any federal government social program like the "affordable housing program" does not bode well in nice academic circles, however by not acknowledging the importance and obvious role this program played towards helping initiate the process not only immobilizes productive discussions, to find more obvious example to illustrate dishonesty would be almost impossible.

Was the "affordable housing program" suggested with good intentions? Of course, no question. If managed efficiently would the program afford lower income individuals an opportunity to live in a descent home, especially in metro areas where the standard of living is extremely high? Absolutely, I live outside of Boulder CO as I can't afford to live in a city where a 70's style ranch house with original shag carpet usually sells for over 700-800K so I am aware of the need for such a program. However, over regulation and enforcement by govt. officials sadly resulted in many of these families having paid months down on principal prior to ARM rate escalations, now being faced with eviction due to foreclosure and this occurrence is still prevalent across our nation.

On a final note; prior to making my final comment I should explain my situation prior to writing in an effort to provide context. I had experienced ten years of successful sales in S.C. and decided to put my professional career on hold and my wife and I moved to Colorado where I attended CU and recently finished my education. My absence in the workforce has given me the opportunity to accumulate a large amount of student loans and so prior to commenting, it should be noted that my wife is working really hard and I have been busting my ass night and day interviewing, filling out applications, and networking. I have never earned a salary over 45k throughout my entire lifetime so I am not accustomed to receiving large compensations. These economic times are quite turbulent however I am quite optimistic and remain positive that things are going to turn around once some people with private sector experience and knowledge are given an opportunity to teach and verse Obama and his administration on the basics of how our economy operates (His entire administration with experience in the private sector is less than 10% which explains the disconnect. I come from a lower/ middle class family that had no money or influence and my wife and I took responsibility for paying for our own wedding, two college educations, house, etc. and have no qualms. We both want to earn our way and do not feel entitled to receive anything that does not require commitment or effort.

However, with all of that being said I believe the authors offered marginally accurate shallow insight regarding this topic as their criticism's which focused solely on blaming private sector businesses while excusing obvious government involvement illustrates obvious favoritism and alignment with political ideologues whose preferences demand extensive govt. roles within personnel lives.

The introduction of greed and executive compensation to explain partial reasoning behind the financial crises was not only childish, it displayed an adherence for the acceptance of helping create and participate in class warfare. Are their many greedy individuals in our society? You are damn right, although it would be hard to beat Saudi Arabia's measly 10K contribution for the Tsunami recovery efforts a few years back in Sumatra. Are their lots of philanthropist with huge hearts and whose efforts and efficiencies outpace govt. services a thousand fold, you are damn right. Before my next and last sentence, keep in mind that I am broke as a joke and have over 70K in student loans to start paying back soon........; I found it utterly disgusting, childish, and tasteless that these authors chose to invoke the elements of class warfare into a discussion of such a serious nature by explaining causation of the financial crisis due to greed and executive comp.
Through the mention of executive compensation that and event like the financial crisis.

Were excessive GREEDY demands insisted upon by the spoiled entitlement UAW members at GM assigned responsibility for the collapse of the auto industry in Detroit? Was corporate responsibility and executive compensation a contributing factor....of course. However, GM alone spent nine billion dollars last year honoring union contracts for workers who no longer work for the company and the only obligation required of them to continue to receive these amenities; they now report to an empty warehouse where they sign in five days a week and play board games. The only difference now resides in the fact that the American taxpayer has to foot the bill for these obnoxious union contracts.
AIG? The only division within the organization to actually post kick ass gains that resulted from hard work entailed that this singular division receive sizable bonuses as a result of their productivity was inaccurately reported and basterdized by the media. The result? All the talent left as a result and the only department within the entire mismanaged insurance giant to exceed expectations and record productivity and growth is no longer.

The main point is that there may be many greedy overpaid executives but it is none of mine, the authors, yours, and especially Obama's goddamn business what anyone in the private sector receives compensation wise. I don't give rat's ass if someone makes a lot of money.....good for them. This whole notion that executive compensation and greed requires acknowledgement reminds me of a kid crying whining because he didn't receive a sucker. Get a life and grow up. Lots of executives receiving large salaries worked hard to get to where they are and should receive attractive compensation packages, but that is not for anyone not associated with the organization in question to decide.

I tend to think that the introduction of loan liquidization by mortgage brokers to banking institutions whose insurance carriers guaranteed the pool of unstable loans should be a focal point where regulation should be considered.

The initial program designed to help families attain ownership of adequate housing facilities ultimately resulted in thousands of people becoming homeless due to loan defaults that ended up in foreclosure and this event spawned the evolution of the entire financial crisis. The affordable housing program.