Sunday, October 12, 2008

Judaism and the Financial Crisis

The Time website has an article about two scholarly articles about Jewish business ethics and the current financial cresis (link). One article is by R. Aaron Levine, chairman of the Economics Department at Yeshiva University, and the other is by Rabbi Eliezer Diamond, Professor of Talmud and Rabbinics at JTS.

R. Levine is described as saying the following:
Click here to read more

Medieval jurists like Maimonides identified a more specific kind of bad advice. They tackled the idea of the "hidden flaw," which, Levine points out, leads directly to a demand for fiscal disclosure. "If you sell an animal, you had to disclose to the buyer what the hidden flaw is," he explains. Not only that: "the disclosure has to be made so that a 'reasonable,' or average man can decide" whether to buy. Once again, almost the entire chain of transactors in the mortgage crisis is guilty: predatory brokers for not alerting working-class borrowers to the fine print; middle-men selling mortgage debt to investment banks sliced and diced into "tranches" that obscure their riskiness; bankers who used hard-to-fathom financial instruments that leave ultimate responsibility for a loan a mystery even to experts. Like many observers, Levine is particularly exercized about credit default swaps, a largely unregulated field since 2000.) And anyone who willfully ignored the fact that real estate prices must eventually come down.
I haven't seen R. Levine's article and can only respond to what Time is reporting. But if this is correct, I have the following few thoughts that relate only to the reality of the financial market over the past couple of years and not to Jewish law at all. Let me state up front that I have a close personal relationship with R. Levine, whom I hold to be a master of Torah knowledge and ideals, so he knows that this is just me expressing my opinions on everything:
  1. I don't believe that tranched securities were intended to obscure the riskiness of loans. Quite the opposite, they were intended to isolate and emphasize risk, allowing investors to purchase bonds at their risk comfort level. The problem was that, despite all of the disclosures in the Prospectus Supplements, the risks of those tranches was underestimated and they were rated too highly by the rating agencies.

  2. I'm not sure what complex financial instruments are being referenced but I'll assume that they are CDOs. If so, I don't think that the real problem was that people were using them to mask risk. Everyone knew that they were full of junk. The problem was that people underestimated the correlation between the different pieces of junk. They had all of the information but analyzed it incorrectly, and that includes the rating agencies. That last point is significant. Investors accepted the rating agencies' ratings of super-triple-A (not just triple-A but above that) to be a guarantee of quality. That turned out to be a big mistake.

  3. I agree that credit default swaps need to be regulated but I don't think that they are inherently bad (although I don't think R. Levine is saying that either). When used properly, they serve a legitimate purpose of managing corporate risk. However, it is clear that these derivatives were being used for what is essentially gambling.

  4. I don't think that the idea that real estate prices will eventually come down was willfully ignored. People knew that they could and would come down but did not expect them to come down as much as they have and in all places at once. They underestimated the severity and the geographic correlation.

  5. Somewhat unrelated, but I don't think that the answer is necessarily more regulation but better regulation. Banks and insurance companies are already among the most highly regulated industries. Go to any bank and you will find dozens of regulators stationed there on a permanent basis. The problem is that the regulations are outdated and don't accurately reflect the risks and needs of the industry(ies).

  6. All that said, I agree with R. Levine that the roots of this crisis are in "moral failure". Everyone thought they could repackage the immoral junk and spread it and restructure it so that it wouldn't hurt them, and they were wrong. It was so bad that it ended up hurting just about everyone.
Just one man's opinions. I look forward to reading R. Levine's article when it is published.

I contacted R. Levine before posting this and he pointed out that I am not looking at this from the perspective of Jewish law, in the sense of what sellers are obligated to tell buyers about the product. I'll have to read his article to learn more about that aspect. He also mentioned that he raised a legal/regulatory issue that he thinks underlies the entire dilemma that, to his (and my) knowledge, has not been raised elsewhere: Securitizers of loans were exempted from claims of predatory lending. This allowed them to look the other way to the immoral business practices that were rampant.

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