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Paving the Way for the Next Financial Crisis

Banking & Financial Services Policy Report, Vol. 29, No. 3, 2010

20 Pages Posted: 8 Apr 2010  

Michael Simkovic

USC Gould School of Law; Harvard Law School - John M. Olin Center for Law and Economics

Date Written: January 1, 2010

Abstract

Twenty years from now, we may look back on 2009 as the year when Congress paved the way for the next financial crisis. One of the most important contributors to the financial crisis of 2008 was the proliferation of opaque and complex financial instruments that effectively withheld key information from market participants. Without detailed, reliable information about debtors’ off-balance-sheet debts and conditional liabilities such as derivatives exposures, creditors cannot accurately evaluate the creditworthiness of debtors and the markets cannot appropriately price risk.

A simple and relatively low cost regulatory response is therefore to mandate disclosures that would provide market participants with the information they need to conduct their own credit analyses and make their own judgments.

The derivatives market reform proposals winding through Congress take a different approach. Rather than broadly disseminate information about the exposures of entities that participate in the derivatives market, these proposals would confidentially aggregate such information through intermediaries such as clearing agencies and exchanges.These intermediaries and government regulators would be charged with policing counter-party risk for the entire derivatives market, and would only release sanitized, anonymous, aggregated information about price and volume of various derivatives contracts. Such aggregate information is not very helpful for measuring counterparty risk.

Rather than co-opt the skills and motivation of sophisticated market participants, journalists, and scholars, these regulatory proposals would force market participants to accept the judgments and assurances of intermediaries with monopolistic access to critical information. And such unavoidable dependence would obligate taxpayers - morally if not legally - to make good on those judgments and assurances if intermediaries prove mistaken.

Worse yet, regulation aimed specifically at protecting derivatives counter-parties might exacerbate counter- party risk in other markets. Other creditors will have neither the protection of a dedicated regulator nor the ability to protect themselves by conducting their own credit analysis.

It is this unique combination of secrecy from other creditors and priority in bankruptcy - what common law judges refer to as “secret liens” - that enabled off- balance-sheet debt and derivatives to play a critical role in the financial crisis of 2008.

What follows is a summary of an article that first appeared in the American Bankruptcy Law Journal as Michael Simkovic, Secret Liens and the Financial Crisis of 2008, 83 Am. Bankr. L.J. 253 (2009).

Keywords: Financial Crisis, Derivative, CDO, Credit Default Swap, CDS, Regulation, Financial Reform, Financial Regulation, Disclosure, Credit, Credit Crunch, Credit Crisis, Bankruptcy, AIG, Lehman, Citi, Citibank, Congress

Suggested Citation

Simkovic, Michael, Paving the Way for the Next Financial Crisis (January 1, 2010). Banking & Financial Services Policy Report, Vol. 29, No. 3, 2010 . Available at SSRN: https://ssrn.com/abstract=1585955

Michael Simkovic (Contact Author)

USC Gould School of Law ( email )

699 Exposition Boulevard
Los Angeles, CA 90089
United States

Harvard Law School - John M. Olin Center for Law and Economics ( email )

Cambridge, MA 02138
United States

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