The Sub-Prime Bubble & Its Mates

Harry Hillman Chartrand, PhD

Revised March 6, 2008

Compiler Press

The most recent investment bubble of 2007-8 is rooted in the 'securitization' of Property. From the perspective of cultural economics Law is not a technical subject but rather a cultural artifact arising from the unique historical experience of a specific culture with its distinctive patterns of custom, habit and life ways (Schlicht 1998).  More to the point, each system of Law has its own definition of what can be bought and sold, i.e., What is Property?  This contrasts with other things that are not Property especially People.

Today, legal title to Property usually takes the form of a document, deed or certificate establishing the right to possession. The coercive power of the State protects and defends it. There are three forms. There is immovable or ‘real’ Property such as land, buildings and fixtures which together with moveable Property or ‘chattel’ (derived from the Anglo-Saxon for cattle) constitute tangible Property.  Then there is intangible Property such as business ‘good will’, stocks, bonds, and intellectual property such as copyrights, patents, registered industrial designs and trademarks.  Each involves associated rights & obligations granted by and subject to the pleasure of the Sovereign - Crown or State.  Each consists of differing bundles of rights & obligations, e.g., the differing term for a patent and a copyright  or between allodial, freehold or usufruct (tenant) title to real Property. [1]

John R. Commons observed in his classic Legal Foundations of Capitalism (1924) that Property, in the economic sense of what can be bought and sold, is the history of its ever increasing intangibility.  In this sense, Property has become not so much the thing in-and-of-itself but rather an evolving set of rights & obligations associated with it, e.g., a warranty.  Thus Property today includes intangibles like artistic & literary works, inventions, futures options, equity shares, software and investment certificates in land and buildings, e.g., ‘CDOs’ or Collateralized Debt Obligations including an unknown number of sub-prime mortgages.  Such intangible income earning Property is arguably the legal foundation of the knowledge-based economy (Chartrand 2007).  According to Commons, the transition from tangible to intangible Property began in the 1700s with recognition, under Common Law, of business 'goodwill' and copyright as income earning assets.  What is bought and sold, in effect, is the expectation of profit, e.g., of a going concern.

'CDOs' are part of a more general and widespread securitization of Property intended to spread and minimize risk.  This is done using probability calculations derived from physics and mathematics rather than traditional actuarial calculations. [2]  In fact major firms hired high energy particle physicists and mathematicians right out of school to do the calculations.  Title is created, as a financial instrument, to a mix of thousands of primary financial instruments such as copyrights, mortgages, patents and even student loans.  The mix is 'hedged' (one primary against another so to speak) to assure (mathematically) a stable return with zero to minimal downside risk.  Slices or shares in this consolidated  'exotic' (now 'toxic') is then offered to investors.  Title is granted as a share in the resulting pool. 

As demonstrated in an article by the Economist, "Securitization: Fear and loathing, and a hint of hope" February 14, 2008  it is no longer clear what is in any given instrument, i.e., how much sub-prime, prime or super-prime.   Their complexity is such that they are not traded to the general public and therefore not subject to 'retail' security & exchange as well as banking oversight.  Essentially they are sold bank to bank, hedge fund to hedge fund, investment house to investment house, intra alia.  What is being bought and sold is new exotic and very complicated financial instrument designed to securitize all income earning Property.   Their complexity is such that very few understand the math including CEOs of financial institutions buying and selling them.  But they have 'the numbers'.  The bond and other rating agencies agreed and initially granted 'AAA' ratings to many such securitized financial instruments.

The 'dotcom' bubble of 2001 demonstrated the need for the U.S. Government to regulate the accountancy industry and its clients following the collapse of Arthur Anderson, the fifth largest global accountancy (see the Sarbanes-Oxley Act) .  Arguably, the 'sub-prime' bubble demonstrates the need for tighter banking and investment regulation.  Why?  Simple:  Fear & Greed.  For whatever reasons investors periodically, throughout capitalist history, come to believe that what goes up does not come down and that the business cycle has ended and there are only blue skies above.  This was a theme of the dotcom bubble, i.e., the so-called 'New Economy' based on the internet.  When the sky falls the investment community tends to duck for cover in what was called 'a bunker mentality' after the dotcom bubble burst.  Fear & Greed are facts of financial life.  It is not just cold calculation that motivates investment decision but also raw emotion.  Financial loss is right up there with sickness and the emotional loss of a loved one.  Financial gain, at the extreme of pure gambling, is arguably as addictive as hard drugs - the rush.   Ego deflation and inflation naturally follow.  Short-run speculation rather than long-run enterprise too easily became the game [3].

Creation of the Bank of Canada in 1935 represented recognition that the financial community could not be trusted to contain its 'animal spirits' and 'excessive exuberance' while Government could not be trusted to keep its hands off the printing press.  The Bank represents a new 4th order of Government - executive, legislative, judiciary and central bank.  In effect it represents a marriage between Government and Finance in the money market of a capitalist economy.  Tight central banking and security & exchange regulation were, until recently, the norm.  Recent deregulation arguably went too far and did not kept up with financial innovations trading between 'Masters of the Universe' (a term coined in the 1980s to describe Wall Street brokers in that Age of Greed).  Through conglomeration, de-regulation, financial innovation and lax public oversight a 'shadow banking system' has been created beyond the pale of public scrutiny.

Government's role, cum Keynes, is not to inhibit risk taking and financial innovation but to compensate for the bi-polar animal spirits of investors and hence the extremes of the business cycle through 'workable' regulation.  This requires, however, recognition on the part of the financial industry itself of a self-felt public responsibility given its privileged status in a capitalist society - noblesse oblige.  Arguably there is a generalized need for heightened public accountability and transparency, not just on the part of Government, [4] but also all self-regulating professions, e.g., accountants, architects, engineers, lawyers and physicians.  The market works on what Adam Smith called 'moral sentiments' or what today we call ‘market trust'.  Trust is a two-way street.  And in the current crisis it is lack of trust between banks that is fueling the ongoing problem.  In effect we are in an institutional liquidity trap.  Interest rates are zero but no one will invest.  When one bank is asked to borrow from another, the potential lender looks at a balance sheet that shows securitized assets whose worth cannot be easily determined. Therefore banks will not lend to banks and the entire financial system seized up and its effects are now rippling through the 'real' economy.

Just before the fall of Communism this need for accountability and transparency of all self-regulating agencies of the State including the Party - the leading vanguard of the Revolution - was called  perestroika and glasnost.  Arguably, the same is needed for the troubled capitalist world order.  The 'off loading' of responsibility for the public purpose into semi-public/private hands (the pattern of 'privatization' since the days of Margaret Thatcher, Ronald Reagan and Brian Mulroney), does not relieve Government of responsibility for monitoring and regulating performance.  The problem and suggested solutions are presented in my book review of Government by Moonlight - Hybrid Parts of the State (Birkenshaw, P., Harden I. & Lewis, N., Unwin Hyman, London, 1990).  For my part, as a Canadian, one possibility is Senate reform inclusive of the self-regulating professions that, through secret ballot, each would elect their own Senator as representative of the profession before the people of Canada.

[1] For a fuller exploration of Property in the Anglosphere please see my recent article "Equity & Aboriginal Title", Compiler Press, January 2008.

[2] It is critical to note that physics rests on the Laws of Nature ewhile financial investment rests on human laws and human nature, both culturally expressed.

[3] This distinction between short-term speculation, e.g., on the stock market, versus long-run expectation of enterprise, i.e., between nominal and real gains,  was a central theme of Keynes' analysis of the Great Depression.  See Chapter 12 of his General Theory.

[4] For my views on what are the continuing inadequacies of the federal and provincial system of Budget, Estimates and Public Accounts please see: “The 1995-96 Federal Cultural Budget“, Government Information in Canada, University of Saskatchewan, Winter 1995. http://www.usask.ca/library/gic/v2n3/chartrand2/chartrand2.html