Regulation and Moderation: Lessons from the Subprime Disaster

I’m James Barasch, a 2L and I’m pleased to writing for Impact again this year! I used to run a book and movie review blog during my time at Tufts University, and I thought I’d continue that tradition here at BC Law.

The great financial crisis of 2007-2009 was an economic Pearl Harbor for many of us at BC Law School. As the Crash of 1929 and the Stagflation of the ‘70s did in previous generations, the failure and instability of many seemingly unbreakable banks, financial institutions, and large corporations caused large ripples of financial insecurity and uncertainty that are taking years to work through the economy.

The causes of this most recent disaster, however, are rooted in intricate interactions between passive government regulators, reckless lending, and reliance on vastly complicated financial calculations not fully understood even by their creators. Thankfully, this story of mismanagement, greed, overheated optimism, and system control failure is ably dissected in “The Subprime Virus: Reckless Credit, Regulatory Failure, and Next Steps,” by Professor Kathleen Engel and BC Law’s own Professor Patricia McCoy who clearly explain the many complicated derivative devices used to construct this financial house of cards, and weave a riveting analysis that helps answer the seminal question, “How could this have happened?”

Subprime lending, or loans to unqualified borrowers that often pose substantial risk of default, was once a small, obscure corner of the home mortgage industry. However, starting in the late ‘90s and riding the wave of rising housing prices and government homeownership incentives, lenders began making riskier and riskier loans to NINA (no income, no assets) and NINJA (no income, job, or assets) individuals, relying on the steadily growing real-estate markets to recoup losses.

Not willing to keep these “toxic” assets on their own books, many lenders sought the aid of financiers to bundle subprime mortgages into marketable bond assets that they then sold with the aid of compliant ratings brokers like S&P and Moody’s.

Attracted by the high yields and relatively low risk, due to intricate systems of insurance such as Credit Default Swaps, large banks such as Citigroup, Bear Stearns, and Lehman Brothers increasingly leveraged themselves to take advantage of the booming market while regulators, fully aware of the banks’ addiction to high risk, high debt investments, went along for the ride. Profs. Engel and McCoy concisely explain the many acronyms and arcane financial terms in clear, layman’s language that leaves a reader with a firm understanding of just what was happening in lending offices and board-rooms of the financial world in the early 2000s.

As the real estate bubble began to deflate, the intricate apparatus that had once generated such profits turned into a self-destructive feedback loop that poisoned every institution that had anything to do with the massive derivatives market that grew up around subprime bonds. Though government intervention and billions of taxpayer dollars ultimately halted the tide of failures and prevented complete collapse of the global economic system, Engel and McCoy also emphasize the very human toll of the crisis, documenting the personal misery of thousands who had been foreclosed even with government intervention, and the many, mostly lower-income, communities eviscerated by banks and institutions desperately trying to recoup the consequences of their own recklessness. The book concludes with a vision for the future where conscientious enforcement of existing regulations, as well as additional safeguards, will defuse such toxic systems long before they reach critical mass.

“Regulation” is one of those hot-button topics that appear to have a polarizing effect on national legal and political discussions, especially in election seasons like this one. While some believe that most regulation is stifling to personal expression, economic growth, and occasionally a threat to a free society itself, others see regulations of speech, industry, and life as conducive to a more polite, equitable society through government oversight and supervision.

Both sides have elements of truth and danger to them. Indeed, regulation, as a synonym for law, is a bedrock of civilization, and without them our jobs as future attorneys would be greatly diminished. Without regulations to help ensure our water remains drinkable, food edible, and medicines safe, and without regulations against behaviors that put ourselves and our property at risk, our lives would likely look distinctly Hobbesian in nature: nasty, brutish, and short. At the same time, overregulation of personal, economic, and political choices violates the inherent individuality and autonomy of every human being, discouraging creativity, expression, and innovation of all forms while making government an anchor around the neck of society instead of a foundation upon which society can build.

The recent financial crisis exposed the dangers of too little regulation combined with too-little enforcement of existing regulation. It also showed how the reckless choices of banks and lenders gravely endangered the well-being of millions and highlighted the need for judicious legislation and vigilant watchdogs to protect the public good. Yet regulations of individual action, such as free speech, even for the purpose of promoting a more polite and respectful public forum, are often first steps on the road to censorship, and to stringent legislations of morality, such as the War on Drugs, prohibitions of gay marriage, and denying women the choice of abortion.

There are many difficulties with balancing freedom and order, but if our society wishes to remain free, it should err on the side of empowering individual choice and innovation to the greatest extent possible while wielding regulation as a shield to public good, not as a sword to accomplish ideological goals. We will wrestle with issues like this throughout our personal and professional lives, and whatever answers we find for ourselves, regardless of personal political ideology, the best answers are likely to be found somewhere in a middle ground of practicality and personal freedom.

James Barasch is a 2L at BC Law. He is also a current member of the St. Thomas More Society and the Federalist SocietyFeel free to contact him with questions about his experience, BC Law, or law school in general. Comment here or send him an e-mail at baraschj@bc.edu.

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