Let the Investor Beware, Part Deux

Like a horror movie mummy rising from a sarcophagus, the legal doctrine of caveat emptor has re-appeared in the financial markets. Caveat emptor--or, let the buyer beware--harks back to the English common law brought to North America by colonists. It placed the responsibility of evaluating a purchase (of a horse, a farm or an investment) on the buyer. The seller, for the most part, only had to refrain from actively engaging in fraud.

As the American economy grew larger and larger, and the financial markets became more complex and national in scope, the legal responsibilities of sellers grew. In particular, after the 1929 crash, the federal government adopted securities laws that reversed the roles of buyers and sellers in the stock markets. Suddenly, it became the responsibility of the seller to disclose to the buyer all sorts of information. The buyer no longer had to figure out what might be hinky about an investment. The seller had to disclose the hinky features. In the vastness and anonymity of the 20th century's stock markets, this role reversal made sense. A hardworking store owner in Cedar Rapids had little or no ability to figure out whether or not a chemical company in New Jersey or an insurance company in Connecticut was a good investment. The companies had most or all of the relevant information, while the potential investor or depositor had essentially no way to get access to it. If we were to have vibrant capital markets, the sellers of the investments would have to ensure the provision of accurate information.

Similar increases of regulation occurred in the banking industry. The federal government, as the insurer of bank deposits, insisted on all sorts of limitations on the risks that banks took as the price of boosting depositor confidence. The depositor no longer had to beware of the bank.

However, like any industry, the financial services industry shifted activities away from the regulated arena. It saw greater profitability where it would face fewer restraints, and went for the gold.

If we look at the areas in the recent financial crisis where the greatest losses occurred, they were in largely unregulated arenas. The mortgage-backed securities market and the derivatives market (especially for credit derivatives) almost entirely fell outside the scope of federal regulation. The losses there ran into the trillions. These markets amounted to a shadow banking system, where activities and risks received no oversight by federal banking regulators, and disclosures to investors were not generally reviewed by the SEC. This shadow banking system has almost entirely collapsed, just as the recognized banking system collapsed in the early 1930s. The trillions being spent or loaned by the Federal Reserve and Treasury Department (via its TARP program) are primarily devoted to combating the aftereffects of the collapse of the unregulated part of the banking system.

The tens of billions that Bernie Madoff apparently stole are a drop in the bucket compared to the mortgage and derivatives losses. But even his fraud seems to have originated in a largely unregulated corner of the securities market. Although the facts of this scam remain to be fully revealed, it would appear that virtually all of the victims were well off individuals or institutional investors. They would probably have been considered "accredited investors" (i.e., a category of investors deemed capable of taking care of themselves and therefore not needing the extensive protections given to regular investors). In other words, the concept of accredited investors is premised on the doctrine of caveat emptor. Accredited investors have access to hedge funds and other investments that may be more profitable than ordinary investments like mutual funds. The tradeoff for them, though, is less governmental protection, as well as potentially greater financial risk. Many accredited investors accept this bargain, because they want the profit potential of hedge funds and other alternative investments. They have to remember, though, that to a much greater extent they are on their own.

While regulators may have failed to uncover Madoff's shenanigans as quickly as we'd like, we should remember that his victims voluntarily invested in a less regulated sector of the markets. Regulators should bear responsibility for their failures, but investors should bear responsibility for their failures.

Sadly, there probably won't be much that can be done to recompense Madoff's victims. And taxpayers will probably lose shiploads of money bailing out the banking industry for mortgage and derivatives losses. We (and especially the new adminstration and new Congress) should think about the future, by filling the regulatory gaps. We shouldn't expend a lot of effort commiserating with bankers distraught over the burdens of increased regulation. The astronomical size of the losses in question call for an expanded victims' rights program in the financial markets. While regulation should be reasonable and well-tailored to addressing the problems at hand, rolling back the cold hand of caveat emptor would be a good way to begin the healing process.