January 1, 2011 / Javier Gómez Gálligo
I. Financial crisis: Lack of control?
The current financial crisis gives us the opportunity to think about the role control institutions ought to have in markets. The debate between regulation and complete deregulation seems to have gone to those who uphold the need for a legal system that provides preventive security and avoids excessive risks. In his recent book, The Financial Crisis. Who is to Blame? (Polity Press, 2011), Sir Howard Davies points out up to 38 strands that have led to the current crisis. And many of them have to do with the lack of proper supervision. Here are some of the things Sir Howard has to say: And what of the institutions put in place to regulate these markets? Auditors facilitated accounting tricks which concealed leverage. Regulators had the power to require banks to hold more capital and larger reserves, yet did not use them. They allowed new instruments of speculation to be introduced, without adequate risk management controls around them (…) Regulators rarely confess to having been asleep at the wheel (…) Thatcherism has turned on its creators (…) President Sarkozy of France told supporters in 2008 that the present crisis must incite us to refound capitalism on the basis of ethics and work … laissez-faire is finished (…) The crisis revealed the absence of a regulator able to take a comprehensive view of financial markets There was a significant gap in terms of the enforcement of consumer protection. In addition, in his book Davies cites the words of Paul Krugman, who said in the summer of 2009, “Deregulation bred bloated finance, which bred more deregulation, which bred this monster that ate the world economy”. Of course Davies sees other causes of the financial crisis, such as:
- Globalisation associated with increasing inequality of income within countries (global imbalances).
- Financial excess. In the USA the Federal Reserve’s (FED’s) interest rate policy was too loose. This long period of low short-term rates created very loose credit conditions.
- Banks’ capital shortage. It’s surprising that Basel II –related to banks’ capital reserves- had not been implemented in some countries, like the USA.
- Conflicts of interest in credit-rating agencies. The business model has changed from an investors-pays system to an issuer-pays system, whereby the entity that is issuing the bonds also pays the rating firm to rate the bonds. So they assigned excessively high ratings without due diligence.
- Greed and lack of ethics in all agents.
But the lack of control seems to be decisive in the financial crisis. Speculative finance products were allowed. And the Federal Reserve failed to regulate mortgages. It is accepted that the financial crisis began in the US subprime mortgage market. Many of the lenders were not regulated, and nor were the mortgage brokers themselves. BBB mortgages were packaged and divided in tranches, to construct additional securitisations that were sold around the world. It’s funny or surprising to see now how the States give Europe advice when the real cause of the financial crisis originated in the USA. But Howard Davies sees not only a lack of control, but in some cases, a mistaken way of control. I’m referring to the thousands of mortgage defaults and foreclosures in the subprime mortgage market that were the result of 30 years of government policy that forced banks to make bad loans to low-income borrowers and ethnic minorities, without economic criteria. Certainly the Community Reinvestment Act (CRA) of 1977 is an example of excessive control, of an inappropriate mode of supervision.
II. Information asymmetries
We propose to fight against information asymmetries that aid some agents more than others in decision making and help place the risks on the shoulders of the less-informed agent. An efficient market requires equal means of access to information and information symmetry where telling decision-making factors are concerned. In this sense, the role institutions play is fundamental. Douglas North regards institutions as key in order to understand the way politics and economics are interrelated, and he sees institutions as the basis for economic growth. Institutions provide the basic structure through which humanity has created order throughout history and has incidentally managed to reduce uncertainty. Together with technology, institutions determine transaction and transformation costs and thus the usefulness and feasibility of participating in economic activity. That is why one of the most important factors in achieving an efficient, fair, balanced market is equal opportunities. For this reason, there must be institutions that ensure that everybody plays by the same rules. It just makes sense for the agents who participate in the market not to participate in market-control institutions, at least not in a decision-making capacity. The controller must be independent and must not be chosen by interested parties. In this context there must be institutions that provide enough protection to the property rights.
III. Property rights
In practice failure to register ownership automatically reduces a property’s value by close to 50%. Or the other way around: A property buyer will pay nearly twice as much for registered real estate as for unregistered real estate. It often happens that an investor (the potential purchaser of the asset) will decide against transactions to buy unregistered real estate, given the risks of eviction, that is, the risk that somebody else with a better right in the property might appear, or the risk that the unregistered property might be encumbered with unknown liens. In the latter case, those unknown liens are going to be enforceable against the purchaser, because the purchaser, having bought unregistered ownership, will not be able to claim immunity from unregistered charges. And if the purchaser wants to get financing, he or she is going to get less than half the property’s value, or else will have to pay usurious interest rates, because the unregistered property offers lenders no security. The risks involved in buying property without registered public title (possible loss of ownership due to eviction, emergence of unregistered charges, need to take disputes to court, lack of legal protection of possession) are so great that they discourage investment and therefore the economic development of an entire people. When institutional investors are involved and there is no ownership protection through registration, investments will necessarily target other countries or other zones where ownership is formalised. This is what is happening in many developing countries that largely lack registered property ownership and countries from the Communist area of influence, where property ownership is not fully clarified and property registries are outdated.
IV. Risk shifting
Another problem is to determine who has to assume the risk of a contract. Before risks can be allocated by means of a contract, there has to be equal opportunity of access to information. Otherwise, if the party that specialises in the subject at issue in the contract fails to share information or otherwise fails in performance, that party ought to assume the risk, even if it is not at fault in causing the damage. Curiously enough, in Spanish law, back in the nineteenth-century Civil Code, legislators chose to assign the risk of casualty loss in sales to the buyer, except when the seller was late delivering the purchased item. Nowadays we might well extrapolate this solution to other contract fields, especially the realm of financial products. This is the same line the Spanish Supreme Court is leaning toward in its rulings on cases concerning mortgage loans at variable interest rates where consumer information legislation is not obeyed. And it is the same case as derivatives that are rendered null and void (under the European Union’s Markets in Financial Instruments Directive) for failure to comply with legislation on consumer information about products, instruments or systems for hedging against interest rate increases, in the case of variable-interest mortgage loans. What happens otherwise when mortgaged property is devaluated? Unlike in the US system and Anglo-Saxon systems in general, in Spanish law foreclosure or surrender of the property is not enough to pay off the debt unless the parties have expressly agreed so. The lender can still throw an attachment on other assets belonging to the borrower if foreclosure on the mortgaged property does not yield enough money to pay off the loan. Is this so even when the initial appraised value of the property is greater than the sum the lender seeks? There are court rulings in Spain that say no. And legal thought is heading toward allocating some share of the risk not only to the owner of the mortgaged property, but also to the financial institution, which miscalculated how property market prices would go. At all events, the financial institution must accept some liability if the appraisal was higher than the law allows (In Spain a bank cannot make a loan for more than 80% of the appraised value of the collateral) or if the appraisal firm is linked to the financial institution and transparency requirements have not been met. European legislation on financial securities follows this line of demanding adequate information from the financial institution, depending on how specialised the consumer is. How much advice the bank must give therefore hinges on the type of product concerned, the product’s complexity and the client’s financial expertise. If there is non-compliance, it must be possible to allocate the risks to the financial institution, which failed to explain things sufficiently. In short, not everything can be entrusted to market self-regulation and suits filed after the damage is done. There must be institutions to ensure that the rules are the same for everybody, complied with and enforced. Otherwise the kind of market efficiency economists demand will remain out of reach, and furthermore consumers will not venture to enter into contracts, either. Probably the best thing here, as elsewhere, will be to find some middle ground, at neither one extreme nor the other, so markets are not so heavily regulated as to choke off freedom of contract, nor so utterly unregulated that all the spoils go to the lawbreakers, the free traders who try to take advantage of other market participants’ good faith.
V. Efficient economic market
Within this context, there are several requisites needed, from the legal standpoint, for an efficient economic market:
- It has to be possible to get enough information quickly, without information asymmetries between the parties.
- Contracted obligations have to be fulfilled.
- Lenders have to have instruments for quick foreclosure, to collect what they are owed in the event of default.
- Borrowers’ rights have to be protected, to provide borrowers with the incentive to participate in the system.
1. Sufficient information
Economic analysts who have studied civil law say that an efficient market needs not only instruments to facilitate decision-making, but also freedom from information asymmetries. Proper pricing in an ideal market is based on reducing the transaction costs involved in decision making to a minimum. Although zero-cost transactions are hard to achieve, we ought at least to pursue the goal of making transaction costs as cheap as possible and making them the same for everybody. The more difficult it is for a party to consent to a transaction due to ignorance of the potential legal consequences, the more inefficient the market will be, from the economic and pricing standpoint. It is thus highly important for the buyers of goods and services to know precisely not only who the owners of the goods and services are, but also the charges and liens involved, plus (and this is essential) the legal consequences of the transaction they are about to conclude. Hence, it becomes essential for the law to provide standard definitions of the sphere, breadth and effects of exchangeable rights. That is all the doctrine of property rights really is: the clear definition of real rights to facilitate trading in assets by providing market traders with quick, reliable information about the legal consequences of their decisions.
2. Fulfilment of obligations
One basic premise of a market where resources are assigned efficiently is that obligations, once contracted, are fulfilled. Transaction costs increase as delinquency grows, and they make the market unviable when payment or discharge of debts creaks to a stop. The law offers a great many mechanisms for ensuring adequate fulfilment of obligations, from self-regulation by the parties (freedom of contract) to legislation that erects guarantees to ensure payment. Foremost among the self-regulation options are penalty clauses, interest on late payment and cancellation clauses. And the typical guarantees offered by the law include personal guarantees and collateral. Only collateral fully ensures payment, because personal guarantees (such as bonds) are subject to sureties’ rights (such as the benefit of division and the benefit of discussion), which force the lender to try to cover the debt first with the borrower’s assets, and then to claim payment from each surety in the proper proportions. Collateral, on the other hand, as used in pledges and mortgages, goes straight toward paying the debt, regardless of who possesses the collateral. This makes collateral more efficient, because there is no hazard of borrower insolvency or other credits that take priority.
3. Fast collection instruments
Acknowledgement of a subjective debt involves not only the attribution of powers to the parties, but also acknowledgement of the action the parties can take. And therefore acknowledgement also of the procedures for taking that action. We cannot regard a market as efficient if it fails to offer lenders proper channels for recovering their investments and calling in borrowers’ guarantees. Similarly, the slower foreclosure procedures are, the greater the depreciation of the mortgaged assets and, in short, the greater the overall transaction costs. In Spain the average length of court procedures for foreclosure is not too long, but even so it could be substantially shortened. Now that the European Commission has abandoned mortgage market unification as a short-term goal, making mortgage foreclosures speedier and easier is precisely one of the few objectives generally aspired to in the European Union. The existence of a monitory procedure for debt collection, foreclosure procedures and particularly the procedure for direct foreclosure on mortgaged assets are examples of fast, efficient collection procedures in Spain.
4. Consumer right protection
But a fabric of rules making an efficient market possible will be of but little use if consumers are wary of participating in the market. If their rights are not guaranteed, they will be afraid to throw in with the system, and the market will grind to a standstill. To a certain extent, this is what has happened in the current financial crisis situation: A social reaction to mortgages has been triggered, in the belief that financial institutions have taken an abusive position that can be traced to their lack of an adequate risk-assessment policy. For that reason, in my opinion, what needs to be sought is an adequate balance between efficient rules to ensure the lender’s loan and sufficient protection for consumer rights. Overprotecting the end consumers of goods and services as if people were incompetent should be avoided as well. That would work out to the disadvantage of all consumers in general by raising prices (which would happen if the possibility of surrendering mortgaged properties as payment of loans were to become widespread). But adequate protection of means of self-defence gives users incentive to participate in legal and economic trade. In Spanish law, consumer protection of this sort takes many forms in the financial and real estate market, even forms that do not exist in other EU countries. For example, there is the right to cancel debts early (although in general the payment period is established to benefit both parties, not just the borrower); the borrower’s right to change mortgage lenders through subrogation; and the borrower’s right to stop foreclosure without the need for the lender’s consent by paying the sum claimed, right up to the very instant of auction in the case of the borrower’s regular residence. And consumer protection also takes the form of the proscription of abusive clauses, especially in mass negotiation, by which I mean the general conditions of companies’ standard contracts. In addition, Spanish legislation calls on companies to make a special effort to use specific, clear, simple language, and it urges registrars to take an active role in preventing abusive clauses.
In short, we feel that a transparent market requires equal information for all participants, truthfulness and a certain amount of institutional control. Information asymmetry is a consequence of the lack of transparency, and it helps distort the market. It prevents a fair allocation of risks from being one economic purpose of a contract. That is why institutions that increase the amount of information available and avoid information asymmetries are a good idea. Institutions that supervise markets thus have a fundamental role to play in forestalling economic crises.