Abstract Wall Street’s House of Cards By Ann Lee Finance Professor, Lubin Business School of Pace University The

paper draws attention to the disturbing developments in the structured products market--CDOs, CLOs, MBSs, ABSs, credit derivatives etc.-- that have been responsible for the consistently outsized earnings of Wall Street firms –but include risks that can make the current subprime mortgage meltdown look like a minor event. It will explain in layman’s terms the highly technical and esoteric world of structured products and detail how these financial engineering innovations create conflicts of interest and moral hazards. It concludes with proposed policy and market reforms.

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Wall Street’s House of Cards
Copyright 2006 Ann Lee

For the last few years, large banks on both sides of the Atlantic have been selling complex financial products called “structured products,” which have fueled years of easy lending and borrowing in not just subprime but across all credit sectors. According to the Bank of International Settlements, the notional value of structured products exceeded $26 trillion in 2006, equal to roughly six times the U.S. gross national product, and was the fastest growing investment product. The losses that could result from this unbridled proliferation could rival the S&L bailout given the large volume. At their core, structured products are financially engineered vehicles that allow financial institutions such as banks to transfer credit risk to other institutions or investors. Credit risk, which is the likelihood that borrowed money will be repaid, has been financially engineered and repackaged into structured products that are inexpensive to create and easy to buy and sell. By using structured products, financial institutions can treat credit risk like a hot potato, buying and selling credit risk between themselves and investors with the goal of making a profit. Structured products can be built with many types of underlying collateral, ranging from home mortgage loans to credit card receivables to junk bonds to corporate bank loans. The construction and sales process for structured products is opaque, and no one really knows what credit risk is transferred to whom and who is left holding the credit risk bag, certainly not regulators, who lack access to the necessary information.

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There are a number of reasons why structured products have become so prolific. With the rise of hedge funds, more and more money have been chasing fewer and fewer investment opportunities, thus pushing down investment returns. With potential returns being lackluster, the appetite for investors to use more leverage to amplify returns has increased. Banks and investment banks invent new and falsely attractive investment opportunities through structured products that incorporate greater and greater degrees of leverage. Structured product sellers’ margins are fat and buyers believe they will earn a high rate of return (although in reality, they may be manipulated by the seller through opaqueness). Structured products essentially provide easy money for both sellers and buyers--until unexpected (but likely to occur) losses in the structured products’ underlying assets appear. For example, an increase in home mortgage defaults can produce sudden and large losses for investors in structured products built on home mortgage loans. These financial innovations have allowed banks to increase diversification in their portfolios, resulting in regulators permitting increased leverage by banks and in banks creating a massive fee stream for themselves. While there are clearly benefits for spreading credit risks amongst a broad investor base, nothing comes without a price tag. The complexity and opaqueness of these products has created two major problems that can lead to a systemic financial crisis: 1) they create incentives for potential fraud and conflicts of interest, and 2) they exacerbate concentration and liquidity risks for all market participants due to their inherently high embedded leverage and tranching. How Structured Products Breed Conflicts of Interest That Rise To Fraud

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The opaqueness of structured products is precisely the reason they are so potentially dangerous. Structured products often include hidden or open conflicts of interest whose potential impact may not be understood by their buyers. Because of their opaqueness, structured products are also difficult to price, and neither buyer nor seller may know if the price of a structured product is fair. Furthermore, the complexity of structured products makes them an ideal tool for persons with fraudulent intent. The secondary market provides some examples of how these products can also abet conflicts of interest and potential fraud. The large banks own or control to a great extent all the components of the structured products market: confirmations, valuations, brokerage, and electronic trading. With so much control, the move to automate the markets has been slowed significantly as banks have no desire to increase transparency which can erode pricing power and margins. On trading desks, banks who are the sole underwriter of a structured product may even mis-price the tranches for their own benefit by using a theoretical, model-based price rather than a market price because of low trading volume. There are also competing proprietary models which may each determine a different price for the same financial product, allowing banks easier ability to cover up fraud. An example was the case when Bankers Trust was the only bank with an advanced derivative model at one time that enabled employees there to mis-price their products to many customers before being sued by P&G and Gibson Greetings. Mark-to-market (MTM) is the price at which a trade can be executed, but without readily available market data, banks can easily manipulate these prices. If a financial product is overvalued and mis-priced, or if people learn that the model is wrong, it can

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experience a sudden and dramatic decline in value when the product’s underlying collateral experiences a higher than expected default rate or a reduction in credit quality, resulting in a declining rate of return for the financial product. A sudden decline in market value for a financial product is also likely to result in a loss of the product’s market liquidity. Dramatic declines in value and liquidity together can generate systemic levels of market disruption. Another conflict of interest lies in bank loans. Bank loans are an important and significant component of the credit markets and provide financing for both individuals and business enterprises. However, today banks can offload these credit risks by selling loans to structured products or by buying credit default swaps (CDS) which act like insurance contracts against defaulting credit products. As a result, their concerns about the long-term credit worthiness of the loans they underwrite are limited. Instead, the banks become more interested in the fees they can make from origination because if they don’t ultimately keep the loans in their portfolio, they have no other reason for underwriting. Since banks are no longer responsible for the risk of the loans they underwrite, the rapid disintermediation of credit risk between lender and creditor often results in weakened underwriting practices such as looser covenants and insufficient due diligence. Such self-interested and short horizon decisions can create the seeds for systemic market risk. A concrete example of such lending practices is sub-prime lending to individuals. Sub-prime mortgage structured products, which provide financing for sub-prime mortgages to individuals, have exploded over the past few years according to SEC filings, increasing from $48 billion in 2000 to $464.9 billion in 2005. Sub-prime loans

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are, by definition, risky, and as their volume radically increases, there is potential for significant increases in the risks borne by financial market participants. Subprime lenders such as Fremont used the capital extended by the large banks such as UBS or JP Morgan to underwrite. Once the subprime mortgages were underwritten, the loans were packaged into structured products and sold to investors by the large banks. The money collected from selling the structured products was then used to repay the loans originally extended by the large banks. The large banks made huge profits from putting the structured products deals together. While these structured products were marketed to investors as relatively safe investments because they used historical subprime default rates from good economic cycles to make predictions about future default rates, the underwriting standards for the underlying subprime loans became progressively worse. All kinds of new mortgage loans whose default rates could not be accurately reflected or predicted by historical data such as Alt A loans which didn’t require proof of income or wealth were being underwritten and thrown into structured products. Greentree Financial provides an example of what can happen when sub-prime lending increases rapidly. Greentree’s primary business was financing manufactured housing, a sub-prime market. After Greentree’s acquisition by Conseco, the market for manufactured housing loans suffered great losses, eventually resulting in Conseco’s bankruptcy. Greentree’s lending decisions were based upon a need for volume, to create more loans that could result in gain-on-sale accounting for Conseco, as opposed to a concern for the credit worthiness of the loans. When the manufactured housing loan market subsequently suffered great losses, Greentree’s gain-on-sale accounting was

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exposed as fictional, and both Greentree and investors in financial products created by Greentree suffered large losses. The sub-prime loan market has similar incentives for lenders to the manufactured loan market that brought down Greentree, but the sub-prime lending market is much larger than the manufactured housing loan market ever was. Such sheer volume involved in just this segment of the structured products market alone could result in the potential for institutional failure leading to financial contagion. Besides lax underwriting of the collateral that go into structured products, active mis-pricing can also occur in deal terms of the structured products themselves. Since these products are not standardized like other derivative products such as foreign exchange contracts, structured products underwriters can discreetly create opaque products. According to a senior manager at Tricadia, an institutional investor, UBS allegedly marketed a deal called “Buchanan,” by intentionally mis-pricing it as a typical credit-linked note, a type of “standard” structured product, as opposed to a customized one. Unless investors read and understood the fine print regarding the definition of how loss amounts were unusually allocated on page 7 of the memorandum, he believed that the deal was potentially sold under false assumptions and misleading representations and thus may have been mispriced by some investors. Clearly, institutional investors have the fiduciary responsibility to read the documents carefully, but when deals come at a rate on average of 2-3 a day, rarely do portfolio managers ever spend the time to read through 200-page prospectuses before investing in these deals. If enough institutional investors shirk their responsibilities, there could be many more ticking time bombs in the pipeline as their risk management could be based on false assumptions when these deals rapidly default and lose value

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without sufficient capital or liquidity to cushion these blows. These portfolio managers are, in a sense, playing Russian roulette thinking there is only one bullet in the barrel as opposed to five and praying that they made the correct bet. Another concrete example of active mis-pricing of structured products occurred in the portfolios of Freddie Mac and Fannie Mae. Since both of these entities are exempt from the 34 Act and therefore were not required to disclose their financials in offering documentation, the management at these entities misapplied accounting rules for years to the public in order to meet stock incentives. The limited disclosure required of these entities made it difficult for analysts and investors to decipher their true financial state, especially because of the sheer size of their portfolios which ran in the hundreds of billions of dollars. Small mistakes in hedging such large sums of money could have enormous implications. Another major related conflict of interest lies in the codependency between dealers and structured products managers. It is an incestuous machine that feeds upon itself, as structured product managers must buy deals from dealers, and the dealers can only do deals if structured products managers buy from them. The structured products must be warehoused at the dealer until the structured product vehicle has been filled with collateral by the designated structured products manager. The collateral can be almost anything, and increasingly has become synthetic in nature, meaning it doesn’t reference a real asset but rather a contract created by a bank, such as a credit default swap (CDS) or even other structured products which could be managed by the same manager, creating circular logic.

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The latter situation is called “CDO squared” because it is a collateralized debt obligation (CDO), which is one form of a structured product, with other CDO- issued securities as collateral, but since each CDO-issued security can reference other CDOissued security as collateral, the number of CDOs embedded within one CDO-issued security can be several layers deep. Due to the potential for significant overlap in these CDOs, a CDO manager or investor may each think he has achieved diversification in the underlying collateral when in fact, the opposite may be true. For example, multiple CDOs may have GM loans as underlying collateral. A CDO squared may purchase different CDOs thinking that it will achieve a diverse underlying portfolio when in fact, the concentration risk for GM loans may be exponentially compounded. When it is virtually impossible for an investor to figure out where the money is coming from, the uncollectible debts underlying the structured products make these investments become essentially worthless even though the banks who sold them have made a killing from their sale. The other circular logic occurs when one division of the bank sells a specific credit derivative swap (CDS), a type of derivative that acts as insurance against the reference credit instrument, and a different division of the bank buys it. For example, the brokerage division of a bank could sell CDS on a CDO while the bank’s asset management division that owns CDOs in its portfolio may buy that same CDS because they manage separate profit and loss responsibilities and respect informational barriers, meaning that the divisions are not supposed to communicate with each other to avoid insider trading. In this case, the bank will have created insurance for itself, an absurd situation, but it theoretically can happen.

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How Leverage In These Markets Can Create A Systemic Crisis The high embedded leverage of structured products compounds the problem of opaqueness. Leverage is a way to use borrowed money to amplify potential gains at the risk of amplified losses, thus magnifying the credit risk for buyers of structured products. A good example of financial leverage is an investment in an index mutual fund. If you invest a dollar without leverage, and the fund declines by 10%, you then lose ten cents. However, if you invest a dollar in the same mutual fund with 10 times leverage, and the fund declines by 10%, then you lose the entire dollar. In the case of structured products, many include leverage of 10 times or more, and 100 times is common. As a direct result, the magnitude of an unexpected or poorly understood potential loss of structured products can have far greater impacts to the financial system and the economy. In a way, “CDO squared” structured products enable banks to create money practically out of nothing because they are so synthetic in nature that the ultimate underlying collateral is unknown. Each tranche incorporates leverage and each investor is permitted leverage, sometimes as high as a hundred times, against CDO collateral to buy more CDO tranches. Even small market movements or inaccurate estimates of defaults can amplify losses quickly and trigger liquidity crises that could result in a cascading avalanche that overwhelms our financial system. Leverage by itself is not dangerous, but combined with conflicts of interest, it becomes lethal. For instance, some banks pressure CDO managers to buy CDOs that the bank couldn’t sell from prior issuances or structure a CDO to provide insurance on the bank’s own portfolio, thus increasing systemic risks because bad credits become more

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concentrated and leveraged while remaining hidden and marketed to unsuspecting CDO investors. This elite circle of buyers and sellers of structured products collateral is small relative to other financial markets, perhaps a few hundred worldwide, although the dollar amounts exceed those of the equity markets. As a result, if either party decides to exit the market, the foundation for these arrangements, amounting to trillions of dollars, can quickly unravel given the small community, destroying the house of cards. Up until recently, the risk of one player leaving the party has been largely ignored because the deals were far too lucrative, and defaulting collateral has not been an issue in a benign economic environment. However, should investors shun these products or dealers get nervous with the market outlook, the warehousing mechanism could halt at any time, causing panic and a domino effect in trading that could lead to enormous losses for banks, potentially evaporating their entire capital base in a very short time frame, leaving little time for a solution to be implemented. Moreover, from a liquidity and concentration perspective, structured products also create systemic risks that are unlike other financial products due to their complexity and leverage characteristics. While the institutions that traffic in these instruments tend to be large financial firms such as commercial banks, investment banks, insurance companies, and hedge funds, it is not safe to assume that they have the systems sophisticated enough to understand and manage all the risks associated with these products. In fact, risk management of these products has lagged far behind the innovation of these products. Although most of the major banks now have credit risk management tools that are more robust than ever before which monitor credit risk at a federated level

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and explicitly manage/hedge credit risk and stress test for liquidity and dealer exits, the growth in these markets and instruments has still outpaced the developments in risk management, documentation, back office facilities, models, and risk management safeguards. The quality of pricing data, data integrity, their dissemination, and the ability to perform “what if” analysis all have lagged the growth of these products and strategies, increasing systemic risk. Any risk management official at a bank will readily admit that no perfect hedge exists for structured products. Risk management for tranched credit portfolios in particular, is by far more difficult from a theoretical and practical perspective than risk management for other products, and to this day, no general market consensus has been established on how those risks should be measured. It is therefore likely that these market participants did not transfer the risk they were supposed to transfer or thought they transferred.

What To Do The public has a right to be worried about these developments and demand regulation in this unregulated market because if one or more of these large institutions fail due to these products, the financial damage could be extensive not only to the Federal Deposit Insurance Corporation (FDIC), but could have a ripple effect throughout our economy similar to the aftermath of the S&L crisis or even the 1929 stock market crash. Even Gerry Corrigan, the former New York Federal Reserve President and Vice Chairman of Goldman Sachs, has called structured products “financial instruments of mass destruction.”

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As everyone knows, the stock market crash of 1929, loose credit markets, and flawed trade policy contributed to the Great Depression, an example of financial markets failing to self-regulate, resulting in widespread economic consequences for every sector of society. Today, excessive leverage and speculative trades in the structured products market threaten to repeat history. The financial institutions’ collective desire to reap enormous short-term profits conflict with society’s collective need to maintain stable, fair, and functioning global financial markets. The New York Fed has begun to consider these issues by (a) pushing banks to expedite trade confirmation and document and reduce mountain-like backlogs, (b) saying it wants to measure individual and aggregate counterparty risk exposures, (c) trying to estimate the domino effect to the financial system of a few counterparty failures, and (d) attempting to coordinate such tracking/measurement efforts with foreign regulators, namely the Financial Services Authority (FSA) in the UK. Through the Report of the Counterparty Risk Management Policy Group II published in July 2005, private sector participants led by Gerald Corrigan, Vice Chairman at Goldman Sachs and former New York Fed President, also acknowledged problems with these new class of financial products and proposed solutions for addressing some of the shortfalls. At the time the report was issued, tens or hundreds of thousands of credit derivative transactions remained unsettled for weeks given that these transactions were processed by hand. When the Fed and the media learned of this operational failure, broker/dealers began hiring more operational employees to process the trades. But these efforts fall woefully short of what is needed. The 200-page Counterparty report acknowledged outstanding issues that needed fixing such as faster

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transaction processing, but focused on operational risk, not financial and credit risk. Concern over operational risk is understandable since operational failure in the settlement process for equity trades in the late 1960’s became serious enough to produce systemic risk. However, the counterparty report did not address all the problems, especially the ones highlighted in this article. In reality, meltdowns are much more likely to occur when banks and broker dealers suffer tremendous losses, to the tune of billions of dollars, due to market corrections after years of mis-pricing, as opposed to the timing of back office settlements. Measuring domino effects/risks to the financial system from structured products, for instance, often demands accurate and timely information different from what is currently provided to the Fed. Currently, banks and broker dealers issue “call reports” only on a monthly basis. Such information could not possibly help the Fed respond rapidly to any crisis given that the risk profiles of banks and brokerage firms change by the hour. Our current regulatory system is ill-equipped to address the issues and concerns posed by these new financial engineering innovations. It is too fragmented, and most regulators do not have the appropriate skill set to understand and sniff out potential problems generated by these instruments. While all financial institutions are linked together through investment and trading in the same structured products, different regulators oversee the different counterparties so that no one has complete authority over this area. Banks, insurance companies, and investment banks all have different regulators, but does it make sense for an insurance company and a bank that are counterparties in the same structured products transaction to have different regulators?

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After Glass-Steagall was dismantled, these businesses now significantly overlap, making our current regulatory structure particularly unwieldy, outdated, and ill-prepared to address the problems these new financial innovations present. Self-regulation by trade associations have also proven inefficient in setting standards and ineffective in bringing more transparency to these markets. The International Swaps and Derivatives Association (ISDA), an important trade association that has offices worldwide, has difficulty persuading its members to accept a standardized format for settlement after years of a product being traded. Standardized loan-only CDS documentation, for example, took several years to develop with many prior trades done on varying legal documentation. With multiple legal agreements being used for the same product, the potential for loopholes, confusion, and disputes also increases, thus further increasing the loss of investor confidence in the markets. Regulation entails costs and benefits; the trick is finding the right balance so that costs of unintended consequences such as stifling innovation do not overwhelm the benefits. The role of a good democratic policy should be to protect basic human rights and property. But presently, the government arguably is failing to adequately protect its citizens by allowing financial institutions to undertake and engage in undue risk and permit breeding grounds for fraudulent practices that could subvert our entire financial marketplace. Although regulators have acknowledged the problems and risks posed by structured products, not enough has been done to date and no comprehensive solution has been proposed. Any solution must increase transparency for sellers, buyers and regulators and impose limits to ensure that market participants do not assume more risk. At the very least, the government should do the following:

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1. IMPOSE LIMITS ON LEVERAGE AND COUNTERPARTY RISK AND IMPROVE DATA TRANSPARENCY AND REGULATORY FILINGS. Naturally, in order to research the appropriate amount of leverage allowed in the financial system, the Fed needs transparency into the leverage extended by banks and broker-dealers. When the Fed announced in March 2006 that it will no longer report M3, the measure of money supply that would include all such leverage, it essentially chose to ignore the high existing levels of leverage. Measuring only M1 and M2 means the Fed is only counting paper money, checking accounts, and savings accounts less than $100,000. All the money outside of these parameters is not counted, which means the Fed is assuming that at least half or more of the money supply outstanding does not exist or matter and is operating monetary policy based on that belief. At the very minimum, the Fed should restore reporting M3. But in order to measure leverage in a meaningful way, it must also have visibility into where the risks lie. As such, the Fed should also require all financial institutions to report, on a real time basis, risk reports including leverage, rather than the monthly call reports that are presently used but are of limited utility. The Fed should also require companies to report their true value at risk (VAR), their solutions to it, their top 25 counterparty exposure, the kind of products to which they have exposure, and transaction documentation for all material transactions. Only with up-to-the minute information can the government develop a rapid response system that could minimize damage if a systemic market failure should occur. 2. REGULATORY AGENCY CONSOLIDATION. Enforcement is another issue. Once limits have been determined and agreed upon, they must fall under the

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purview of some regulatory agency. Since current and future financial products do not neatly conform to traditional definitions and distinctions that led to separate regulatory authorities in the first place, a regulatory environment needs to evolve to reflect the realities of the new financial landscape if it is be effective. Specifically, since the elimination of Glass-Steagall restrictions, all financial firms are increasingly performing the same or similar functions. It follows that only one financial regulator should be in place to oversee all the activities so that new developments do not fall through the cracks. 3. HARSH PENALTIES FOR THOSE WHO CHEAT AND REWARDS FOR WHISTLE BLOWERS. Moral hazard must be addressed. Today, no real penalties exist for individuals or firms that undertake too much risk except for the possibility of losing a job and the temporary loss of reputation. However, these risks are far outweighed by the potential for enormous wealth in very short periods of time. As many Wall Streeters know, hundreds, perhaps thousands of young traders under the age of thirty can make many millions of dollars in a single year. Seasoned professionals like George Soros have earned almost a billion dollars in a single year. Unless there are stiffer penalties for taking undue risks that could have the unintended consequence of bankrupting large financial firms, resulting in significant market disruption and losses for individuals and possibly even the government, many financial professionals will be prone to reckless speculation because of the current risk/reward payoff. The American people should demand to remove or limit moral hazard from developing by forcing the government to ensure the sellers and purchasers of structured products and credit derivatives bear the costs of a financial crisis that damages the bank insurance deposit fund system. For example, sellers of loans to structured product vehicles who reduce retained credit risk

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could be required to make a premium contribution to the bank insurance deposit fund. Only by holding them responsible will our country have the best hope of aligning the interests of banks and the public and prevent such speculative activities from growing out of control. 4. INCORPORATE THESE STANDARDS INTO BASEL III. Work has already begun on Basel III, following the second Basel Accord which represented recommendations by bank representatives and central bankers from 13 countries to revise international standards for measuring bank’s capital adequacy. Basel II was designed to address the weaknesses in Basel I, and Basel III will further refine the definition of bank capital, quantify further classes of risk, and improve sensitivity of risk measures. Now is an ideal opportunity to enlist international support and coordination in developing banking and brokerage standards so that regulatory arbitrage can be minimized. Foreign regulators have just as much incentive to limit economic destruction of systemic risk. If they know that the standards will be uniform in the international banking community, they will find it more palatable to comply. If all countries agree to the same laws and cooperate, no financial firm will have an incentive to move their business, and there will be no “race to the bottom” by various countries. Critics will likely claim that such regulation will only drive the structured products business as well as all other OTC derivatives business to other jurisdictions where regulatory burdens are not so heavy. They will claim the current U.S. competitiveness in financial markets will be eroded while not reducing systemic risks. They have used similar arguments as reasons to repeal Sarbanes-Oxley, because many IPOs have moved offshore.

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Such arguments seem specious when a company’s decision where to launch an IPO involve other factors besides regulatory burdens. Offshore offerings may be at least driven by increased capital availability in emerging markets and would happen even if Sarbanes-Oxley was never implemented. More likely, SEC Chairman Christopher Cox rather than Sarbanes-Oxley is the reason why foreign companies have chosen to list on other exchanges. These companies feared the political risk of dealing with capricious U.S. lawmakers, not increased transparency. Opponents of regulation of this market cite that there is lack of empirical evidence of wrongdoing. They will also point out that there have now been several credit events which while operationally intensive, did prove the sustainability of the market. In most hypotheses, counter examples often exist, but that doesn't necessarily negate the overall theory. Arguably, most things in life are difficult or impossible to prove, but the evidence could be so consistent with the hypothesis that it would suggest a causal relationship where a strong correlation exists. For instance, there was no direct evidence that Salomon Brothers cornered the bond market, but the behavior was strongly consistent in support of that conclusion. No one can directly point to greenhouse gases as the cause for global warming, but enough evidence has convinced the majority of scientists that it is conclusive. In the case of structured products, no banker will ever admit that he or she was stuffing bad loans into these financial vehicles. Even with complete data and all the time in the world, it would be a difficult study from which to extract empirical data and still probably no one would do it. However, it is well understood that underwriters always have inventory that they cannot sell. It is widely accepted that there are clear financial incentives for these underwriters to place them with

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less sophisticated managers. The widespread subprime mortgage meltdown suggests that the conflicts of interest are indeed pervasive. Another anti-regulatory argument is that more regulation would disrupt markets because of the increased legal liability exposure for investors, both real and perceived. Traders in money losing transactions may simply not honor their trades if they believed that the transactions would be deemed illegal under a new regulatory regime. With any change in rules, disruption is expected to happen, but that alone is a poor reason not to correct abuses. One solution could be to smooth the transition period by announcing a future date that new rules would be effective which gives plenty of lead time for market participants to adjust their strategies and positions without causing panic in the marketplace. Perhaps the unintended effect may even result in stronger volume growth and wider participation, since the global markets will be assured that our government is not ignoring market developments and innovations. Some business leaders have promoted the notion of “principles-based” rather than “rules-based” governance as the best way to protect the integrity and competitiveness of our markets. They argue essentially that it is better to avoid enacting laws and simply trust corporate management to exert moral leadership. The Delphi credit event in which the market was able to avoid a bond squeeze by agreeing to some principles that worked well suggests a case of professionalism over regulation. However, this idea is convenient for management, but may not be realistic in the long run. It is possible that not one but multiple major defaults could happen simultaneously in the future in which orderly professionalism may not succeed when much more capital is at stake. The Delphi example in reality may be simply a close call because it happened during a benign

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economic environment and should be seen as a warning shot to regulators that a more rigorous system should be put in place in the event several major defaults happen during a weak economic backdrop. Without the requisite public constraints, corporate economic corrupt activity, both legal and illegal misappropriation of wealth and income, can make it difficult for our markets to survive the fallout. Instead, a hybrid approach of principles and rules-based governance should be adopted. Principles-based governance is needed so that participants can’t evade the law, and rules-based governance should be implemented simultaneously so that participants have guidance for the principles. While the FSA uses more of a principles-based approach, the British system differs from the U.S. in that it is harder to litigate there, and it is easier for them to change laws since they don’t have a system of checks and balances similar to ours. An analogous situation would be taxes. Principles-based governance would say that everyone who can afford to pay taxes should pay at least 20% in income taxes. However, rules-based governance is required so that taxpayers would understand what constituted income and understand how to interpret the law when uncertainties arise. Principles-based governance works well only if everyone can agree on the prohibited outcome so that methods are irrelevant. In some ways, existing laws such as the 33 Act are short principles-based legislation, yet they are difficult, cumbersome, and confusing to apply. Defenders of the present system also complacently believe that no systemic risks will result from any major market disruption in this area. Monetarists, popularized by Milton Friedman, contend that something akin to the Great Depression can be avoided simply by pumping more money into the system to avoid a liquidity crunch. Fed

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Chairman Ben Bernanke has stated that the Fed under his watch will “have the keys to the printing press, and we are not afraid to use them.” The quote was used in the context of his argument that monetarism will respond to zero interest rate conditions. However, injecting money into the system does not necessarily create more capital for financial institutions in crisis. Evidence from the Japanese stock market crash that doomed Japan to a decade of recession despite monetary stimulus of zero interest rates may suggest that aggressive monetary stimulus will not be enough. Worse, if the rest of the world knows that the U.S. will simply print more money rather than correct abuses and structural problems, confidence in the U.S. dollar and thus in the U.S. government will disappear, causing even further economic damage. “Not worth a continental” referred to the worthlessness of U.S. currency during the American Revolution because of government overprinting; we do not need a 21st century repeat of that 18th century fiasco. Since this is a complex problem, no solution will be free from criticism. In fact, previous proposals such as those from CFTC Chairman Brooksley Born who advocated increased regulation of over-the-counter (OTC) derivatives were rejected and maligned by financial circles and their Capital Hill supporters. Even the collapse of Long Term Capital did not redeem her progressive calls for action, because the political power was too beholden to private financial institutions unwilling to surrender their pecuniary interest for safer, more stable markets. Bottom line, self-regulation has not worked well. In a paper titled, “Cautious Evolution or Perennial Irresolution: Self Regulation and Market Structure During the First 70 Years of the Securities Exchange Commission,” Joel Seligman, considered the nation’s foremost expert on securities law, comments that self-regulation prompted “the

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most serious failure in securities industry, a collapse of industry regulatory controls so complete, it permitted, in the agency’s retrospective view, ‘the most prolonged and severe crisis in the securities industry in forty years.’” Our financial markets will always attract the foolish and the greedy—even the fraudulent-- and no amount of regulation can completely eliminate fraud and reckless behavior. But if we want to ensure financial market integrity and stability, then we should consider the ethical obligations to move beyond a system of self-regulation. While possibly no perfect solution exists, society should still seek to remedy what are clear abuses to the system. Through public education and by taking steps to safeguard a dynamic financial market through improved market transparency and balanced regulation, we can prevent these problems from reaching systemic levels.

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