Thursday, October 25, 2007

Subprime Socialization

I was responding to a post in The Informed Reader section of The WSJ Online Edition (here: regarding His Honor Richard Posner’s discussion of third party liability. The question is whether a bartender or host should be liable for another person who drinks too much, gets in their car, and then causes a seriously unfortunate accident.

Because I have been following this whole subprime mortgage debacle I decided to take the opportunity for an analogy. Here is what I wrote:

“I wonder what His Honor would think about holding the Wall Street securitization players (banks, bankers, rating agencies, etc.) liable for the devastation caused in the mortgage, commercial paper, and real estate markets. That’s where a lot of the profits went, but it looks like much of the cost will ultimately fall to the taxpayers, the note holders, and the homeowners. I suppose one important question would be whether they are third parties or conspirators. If they are third parties, perhaps we could apply a Grokster inspired logic and find them contributorily liable: “When a widely shared product [MBS, SIV, ABCP Conduit, etc.] is used to commit infringement [fraud by mortgage bankers and clients], it may be impossible to enforce rights in the protected work [prevent the fraud] effectively against all direct infringers [fraudsters (mortgage bankers, etc.)], so that the only practical alternative is to go against the device’s distributor [Wall Street et. al.] for secondary liability on a theory of contributory or vicarious infringement [fraud]. One infringes [commits fraud] contributorily by intentionally inducing or encouraging direct infringement [fraud], and infringes vicariously by profiting from direct infringement [fraud] while declining to exercise the right to stop or limit it.” (From the Grokster syllabus here:, pg. 2.) Hum, it definitely needs some work and it sounds a lot like conspiracy, but it’s not too much of a stretch. I guess I am assuming that people in the securitization stream had actual knowledge that these mortgages were not what they were supposed to be, and I do not really know that for sure. It could just be a massive case of due diligence failure or, if the loans are actually what they were supposed to be, stupidity.

“In any event, it seems to this admittedly smaller legal mind that the moral hazard of a social solution is far worse than the financial losses of those who profited from this misadventure. Of course, that’s just my opinion, and I already hear Mr. Becker speaking up about the social costs of a major credit de-leveraging throughout the economy should we let the liability fall to these parties through whichever legal theory you like. In the interim, I really hope someone is checking the documentation on those loans Countrywide is transferring to FHA loans because I have a guess about just how good the due diligence has been there lately and I, for one taxpayer, do not feel the need to pick up the tab for this one.”

This issue of third party liability comes up a lot, and there is a current third party liability case in front of the Supreme Court now, STONERIDGE INVESTMENT V. SCIENTIFIC-ATLANTA, INC. ET AL. The issue in this case:

Plain language version:
Company A enters into transactions with Company B that have no real business purpose, but which allow Company A to report more earnings than it really had using hocus-poke-us accounting. Company A publishes its financial reports and its stock goes up. People buy the stock. Then the hocus-poke-us stuff is revealed, and the stock tanks. Now the stockholders want Company B to pay because without its participation in the scheme the fraud would not have happened (so they claim).

The way lawyers do it:
The issue presented is whether shareholders of a company that committed fraud resulting in losses to those shareholders can recover damages for deceptive conduct from a third party company that engaged in transactions with the public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where the third party themselves made no public statements concerning those transactions. (Butchered from the court records)

Well, this raises all kinds of questions. If you allow Company B to get away with this, investors will be unprotected and invest less. This dries up available capital and slows the economy. On the other hand, the Banks (often third parties in these misadventures) argue that if they are held to account for the sins of their clients, they will stop lending (and/or it will cost more) and that could dry up capital and hurt the economy. Oh yes, there is also the usual lawyer bashing with claims that it’s the lawyers pushing for liability because they want to be able to bring law suits against all of those third party companies (probably some truth to that too).

Decision due out soon. I have my money on no liability for third parties here. My reason is simple; the banks are on that side and it seems to me that the banks have been getting whatever the banks want these days.

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Matt said...

As long as the Fed keeps bailing out bad business practices such as bundled sub prime paper sold as investment vehicles these type of events will never stop. It seems we are due for another rate cut at the next meeting.

Anonymous said...

I agree completely. The moral hazard is huge. But Merrill shareholders paid though.

Palermo's Blog said...

If you are curious, the company I refer to in the Supreme Court Case as Grokster is more widely recognized as Morpheous, the company with the file sharing program that was shut down (due to that decision by the Court).

Michael Z, Loan Orignator said...

Thanks for the post! I agree that the wrong people are targeted in the report..I am one of the loan originators that was just doing what we get paid for..finding a loan the buyer could qualify for. We did not make up the lending guidelines.. I never funded a option arm to my clients but am getting painted as somehow who caused this mess.
So now the reforms are going to be written by the banks, eliminate competition from the state bankers and brokers.. remove YSP which are designed to assist borrowers in obtaining loans such as Fed VA, Rural development, etc when they are short of funds to pay costs.. BUT the banks are still advertising the No-cost loans, and other deceptive products to the consumer...where are the regulators?
so the banks get what they want more market share, reduced competition from state licensed competition...and the big one.....
a waiver from any of the proposed reforms because the (OCC) Office of the Comptroller of the Currency is protecting the consumer. Am I the only one who is concerned this garbage will pass?

Lawrence D. Loeb said...


I've been contemplating how to comment on this and some of your other posts for the last few days.

The temptation was to write a book that would be: inappropriate in length, and of a potentially inflammatory tone.

I like you, so I didn't want to do something like that.

Instead, I'd like to refer you to my post on the subject. It was inspired by a class I attended at my graduate school alma mater.

I look forward to any thoughts you might have on the matter.