This paper explores certain legal acts and omissions that facilitated the over-leveraging and near collapse of the global financial system. These “Legal Enablers” fostered the boom that enriched a class of financial intermediaries who followed a storied tradition of gambling away “other people’s money.” These mechanisms also made the pain of the bust disproportionately felt by the middle class and poor while shielding the middlemen who created the problems. These Legal Enablers permitted the growth of a shadow banking system, without investment limits, transparency or government oversight.
In the shadows grew a variety of highly leveraged private investment pools, undercapitalized conduits of securitized loans and speculation in complex credit derivatives. The rationale for allowing this unregulated, parallel system was that it helped to create innovation and provide liquidity. The conventional wisdom was that any risks associated with a hands-off approach could be managed by the “invisible hand” of the market. In other words, instead of public police, it relied upon private gatekeepers. A legal framework including legislation, rules and court decisions supported this system. This legal structure depended upon corporate managers, counterparties, “sophisticated investors” and the market generally to prevent irrational conduct.
The hands-off approach was premised upon a series of beliefs or expectations. The first was that corporate managers would not sacrifice long-term shareholder value for short-term gains. The second was that trading counterparties would monitor each other closely and discourage excessive risk. The third was that “sophisticated investors” had the ability to select and monitor “private” unregulated investment options and that such decisions affected the direct owners, not underlying investors and market integrity. And, the catch-all fourth belief was that even if there were blips and bubbles, the market would quickly “heal itself” before causing any major disruption or harm to society.
Only after the global financial crisis struck and the government committed nearly $13 trillion and spent almost $4 trillion, to rescue the financial system and the economy, did many ministers of “private ordering” admit that these premises were faulty.
This paper contends that if we wish to restore investor confidence and sustain a stable financial system, we must stop enabling the excessive leverage and speculation that create cycles of irrational exuberance followed by financial panics.
Specifically, it recommends that we eliminate the loopholes that allow unregistered investment pools broad discretion to operate in the shadows, without transparency or supervision, to engage in self-dealing or related-party transactions, to inaccurately value and inadequately protect assets and to take on excessive leverage and illiquid portfolio holdings.