This particular lawsuit involves “structured investment vehicles” that held subprime mortgages that eventually went bust. Other disputes have involved nonprofits and local governments that borrowed money via “auction rate securities.” But they all involve nearly identical issues.
Just what role one thinks government or the courts should play in these situations depends on one’s beliefs about how perfectly markets operate.
To individuals like Milton Friedman or Alan Greenspan, who believe unregulated markets nearly always result in better outcomes, the answer is that government should stay out. If charitable foundations or a workers’ comp investment fund has millions to invest, they have the means and the motivation to carry out any due diligence necessary to correctly judge the risk involved in any possible investment.
Yes, perhaps there should be some criminal statutes governing deliberate fraud, but otherwise, the old principle of “buyer beware” should rule. Any government action will just increase costs for society and waste resources, this group argues.
At the other end of the scale, those who are skeptical that free markets ever result in good outcomes want extensive disclosures of risks, combined with broad bans on selling specific categories of investments to certain potential buyers.
In between are pragmatists like me who are convinced that disparities of information between sellers and buyers of financial securities can lead to outcomes that not only hurt individual investors but also can harm society as a whole. At the same time, not all such problems can be fixed easily by government regulation. And regulation inevitably uses up some resources.
So it is necessary to find a middle ground that balances limiting potential harm to society from imbalances in knowledge and power against the costs and waste resources from excessive regulation.
That middle ground generally has dominated regulation for a couple of centuries. But as events over the past three years demonstrate, the question of exactly where to draw the line never goes away.
One long-established policy is to ban putting money held for vulnerable third parties into investments deemed risky. Thus, laws long have specified that inheritances held in trust for minors can be put only in well-rated bonds or stocks. State insurance regulators often imposed similar rules on life insurance companies to protect policyholders from being harmed by an insurer that made imprudent investments, then went broke. Similar restrictions often applied to pension funds.
One problem is that this depends on the competency and honesty of ratings firms, an assumption that has been shot full of holes in the past three years.
The larger problem is that lower risk means lower returns. Large pension funds, in particular, eventually demanded the right to invest in higher-yielding assets, even if this involved taking on more risk. They argued that with tens or even hundreds of billions of dollars under their care and with highly qualified analysts on staff, they were big boys who could take care of themselves. Most states bought this argument, and restrictions on government and private pension fund portfolios were progressively eased in recent decades.
The federal Securities and Exchange Commission took a similar tack. Investments sold to anyone in the public were subject to extensive disclosure requirements, but those sold to “accredited investors” were subject to fewer restrictions. The idea is that if you pass a certain threshold, currently more than $1 million of net worth, outside of your residence, and more than $200,000 in annual income, you are in a position to watch out for your own interests.
When markets are booming and most securities provide satisfactory returns, no one complains. But whenever a bubble pops, some investors get hurt and are convinced that they were tricked by whoever sold them the investment. Lawsuits, like the one that succeeded in part Wednesday against Wells Fargo, are the inevitable result.
I couldn’t serve on a jury in such a case because I am biased against the plaintiffs. The idea that institutions, which pay their well-educated investment officers salaries of hundreds of thousands of dollars to manage tens of millions, did not understand that any investment potentially can turn sour boggles my mind.
But that is why we have laws and courts. Some judge and jury must examine the law and the facts of specific cases and determine whether the seller, in this case, Wells Fargo, did in fact breach its legal duties to buyers. On Wednesday, a jury decided it did and awarded plaintiffs some $30 million. Punitive damages could come next.
From the point of view of society, it is important that the law be written as clearly as possible to minimize such litigation, which inevitably consumes resources. University of Chicago economist Ronald Coase won a Nobel Prize for specifying just how important clearly defined property rights are in this and other situations.
In the meantime, we are stuck in a familiar cycle where investors want freedom to deploy their money freely when the horizon is clear but demand protection when it starts to rain. And financial firms want freedom to sell any product they can dream up and not bear any of the consequences as long as they furnish enough small-print boilerplate disclosures. It all means securities attorneys will always have work.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.