Emperor's old clothes

At times it is hard not to wonder about the engagement of corporate law centres, corporate governance centres and business schools that at best have been silent about egregious commercial practice and at worst have acted as cheerleaders for people such as Bond, Skilling, Ebbers and Lay.

The Sydney Morning Herald, in reporting on questions by the current parliamentary Inquiry into Financial Products & Services in Australia regarding Commonwealth Bank involvement in the collapse of Storm Financial, refers to "a secret agreement", "months-long delays in effectively notifying customers of margin calls" and omission of signatures from financial documents.

Irrespective of indolence or incapacity on the part of financial regulators, whom we might trust were more engaged than APRA when it failed prevent the HIH collapse (or the SEC in dealing with Madoff), what was academia saying about such practices and that culture?

Author Stuart Washington comments that

the inquiry has heard incredible evidence about the differing standards of documentation required by different banks before putting people into hock.

For example, evidence was given that it is apparently common Commonwealth Bank practice to make loans to retirees without requiring their signature on any loan application form.

No wonder Storm's production line favoured the bank - it was so much easier than the fuddy-duddies at National Australia Bank who required people to actually go to a branch and sign their loan application.

The production line starts to explain the plethora of mixed-up, clearly wrong and possibly wilfully misleading data on home loan documents now confronting people in the fallout.

Meanwhile the New York Times, in 'New Exotic Investments Emerging on Wall Street' by Jenny Anderson, reports that those lovable bankers and even more lovable lawyers in Manhattan are at it again.

After the mortgage business imploded last year, Wall Street investment banks began searching for another big idea to make money. They think they may have found one.

The bankers plan to buy 'life settlements', life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to 'securitize' these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

The earlier the policyholder dies, the bigger the return — though if people live longer than expected, investors could get poor returns or even lose money.

Those unhappy investors will presumably include pension funds and insurance companies ... and thus people like you and me. The securitisers will have got their fees and be smiling all the way to the Hamptons. The Times comments that

In the aftermath of the financial meltdown, exotic investments dreamed up by Wall Street got much of the blame. It was not just subprime mortgage securities but an array of products — credit-default swaps, structured investment vehicles, collateralized debt obligations — that proved far riskier than anticipated.

The debacle gave financial wizardry a bad name generally, but not on Wall Street. Even as Washington debates increased financial regulation, bankers are scurrying to concoct new products.

In addition to securitizing life settlements, for example, some banks are repackaging their money-losing securities into higher-rated ones, called re-remics (re-securitization of real estate mortgage investment conduits). Morgan Stanley says at least $30 billion in residential re-remics have been done this year.

Financial innovation can be good, of course, by lowering the cost of borrowing for everyone, giving consumers more investment choices and, more broadly, by helping the economy to grow. And the proponents of securitizing life settlements say it would benefit people who want to cash out their policies while they are alive.

But some are dismayed by Wall Street’s quick return to its old ways, chasing profits with complicated new products.

"It’s bittersweet", said James D. Cox, a professor of corporate and securities law at Duke University. "The sweet part is there are investors interested in exotic products created by underwriters who make large fees and rating agencies who then get paid to confer ratings. The bitter part is it's a return to the good old days." ... Defenders of life settlements argue that creating a market to allow the ill or elderly to sell their policies for cash is a public service. Insurance companies, they note, offer only a 'cash surrender value', typically at a small fraction of the death benefit, when a policyholder wants to cash out, even after paying large premiums for many years.

Enter life settlement companies. Depending on various factors, they will pay 20 to 200 percent more than the surrender value an insurer would pay.

But the industry has been plagued by fraud complaints. State insurance regulators, hamstrung by a patchwork of laws and regulations, have criticized life settlement brokers for coercing the ill and elderly to take out policies with the sole purpose of selling them back to the brokers, called 'stranger-owned life insurance'.

In 2006, while he was New York attorney general, Eliot Spitzer sued Coventry, one of the largest life settlement companies, accusing it of engaging in bid-rigging with rivals to keep down prices offered to people who wanted to sell their policies. The case is continuing.

As one commentator reported, "Predators in the life settlement market have the motive, means and, if left unchecked by legislators and regulators and by their own community, the opportunity to take advantage of seniors".

Perhaps we need to actively move beyond the "emerging new regulatory paradigm" discerned by Roman Tomasic in 'From White Collar to Corporate Crime and Beyond: The Limits of Law and Theory' (here) and consider a new academic paradigm that empowers effective regulation of global financial markets and innovations such as flash trading and deep pools.

Paul Krugman in today's Times claims that

the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn't sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession's failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy's operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don't believe in regulation.