PUBLISHED:September 26, 2008

Anatomy of a crisis

Sept. 26, 2008 — Three faculty experts in the areas of capital markets and securities law offered insight into the origins of and exit strategies for the current financial crisis during a standing-room-only lunchtime discussion on Sept. 25.

Professors James Cox, Steven Schwarcz, and Bill Brown ’80 spoke on a day when congressional leaders and presidential candidates met at the White House to discuss proposed fixes for the failing economy.

They agreed that the government’s plan should consist of more than a bailout of failing institutions.

“I think it’s inappropriate to think about this bailout as the only solution,” said Cox, the Brainerd Currie Professor of Law, who specializes in corporate and securities law. Depressed home prices and subprime mortgages will continue to plague America’s economy, and the government needs a plan to address those issues, he noted.

“The large number of foreclosures are yet to come up,” Cox said. “The subprime, adjustable rate mortgages that were issued in the last two years start showing their ugly heads, being readjusted to very high rates, in 2009, 2010. We’re in for a world of pain there. That’s going to be the tsunami, it’s gigantic. And it seems not to be part of the ongoing discussions.”

Schwarcz agreed that addressing the problem will require careful planning, and shouldn’t be rushed out of fear or political expediency. He suggested the establishment of a “brain trust” to advise lawmakers and regulators going forward.

“We need to have people work with government who really understand the markets — scholars, people experienced in how these markets work, like Professor Brown, to really give guidance to Congress, because unless we have that real-life guidance, we’re going to continue to have, basically, bad solutions,” said Schwarcz, the Stanley A. Star Professor of Law.

For his part, Brown, who joined the law faculty last month as a visiting professor of the practice after a long career on Wall Street, was skeptical about “moving a bunch of traders from Wall Street to D.C.” as the federal government gets directly involved in markets.

“I’m a bit cynical about the idea that they’ll be able to do anything better in D.C. than they were able to do when they got us into this mess in the first place,” he said.

All three panelists agreed that a new regulatory framework may be necessary.

Federal powers to remedy economic crises are largely derived from legislation enacted as a response to the Great Depression, said Schwarcz. “The parties that needed saving [during the Depression] were banks and financial institutions,” he noted. “[Federal powers] focused on banks and institutions, not markets.” Because the current crisis is market-based, the remedy also should be, he said.

This could be the chance to restructure and centralize the regulatory agencies overseeing financial markets in the U.S., Brown said. “I think the regulatory framework needs help, it needs streamlining, and that possibly could be one of the real silver linings that comes from all this. This might be the time that we get rid of all these initials and acronyms and create a more consistent regulatory framework than we have.”

Cox suggested a cautious, piecemeal approach to mending the markets and fixing failing institutions.

“We ought to think about a series of authorizations and do something now, then set the clock until the new Congress comes back,” Cox said. “And if you do it in stages that’s one way of policing what happens in the early part of the deal.”

However, he noted that political pressure will likely lead to a hastily formulated deal.

“I imagine something will be inked this weekend,” Cox said. “Nobody wants to be alleged to have derailed the train that was going to rescue America’s fortunes. And this is an election year.”

Treating the event as a “teach-in” for Duke Law students, the panelists also offered perspectives on the root causes of the apparent financial collapse, with Brown outlining how some of the financial markets in question operated.

Schwarcz attributed the crisis to a series of unanticipated events.

“I think the crisis was started by an historically unanticipated depth in the fall of housing prices,” he said. With housing prices in freefall, subprime loans began faltering and the value of mortgage backed securities fell. Lower rated securities went into default and higher rated securities were downgraded.

“This caused a crisis of confidence,” Schwarcz said. “People thought an AAA rating meant no risk. But there can be risk, and people started seeing this.” Investors fled the debt markets, people who bought the securities on credit or used them as collateral had to come up with more collateral, and the effects rippled outward.

“Bubbles, Bailouts, and Bedlam: How bad is the financial crisis?” will be available as a webcast shortly at