Each year, the Pomerantz firm hosts the Pomerantz Lecture at Brooklyn Law School, which honors the life and work of Abraham L. Pomerantz, a 1924 graduate of Brooklyn Law School and the founding partner of the Pomerantz firm. The lecture series focuses on topics of corporate securities law and related issues of professional responsibility. This year’s lecture, held on March 31, explored the topic of Due Diligence: Failures and Remedies with featured guest speaker Bernard S. Black. An esteemed scholar, Professor Black is the Hayden W. Head Regents Chair for Faculty Excellence at the University of Texas School of Law, and Professor of Finance at the University of Texas, McCombs School of Business.
Professor Black’s lecture focused on how the participation of investment bankers, auditors, securities lawyers, and sometimes rating agencies and other professionals is central to both public and private securities offerings. Professor Black addressed why due diligence failures are common and why reputational concerns may provide suboptimal due diligence incentives. He also suggested a number of legal standards for minimum due diligence. Professor John C. Coffee, Professor of Law at Columbia Law School, and Pomerantz senior partner Marc I. Gross provided commentary on the lecture.
Professor Black began by advancing his thesis that the failure of anyone to do sufficient due diligence during the recent wave of nonprime mortgage securitizations was a major cause of the subprime mortgage fallout, which in turn, was a major force behind the current widespread economic crisis. Specifically, said Professor Black, when the volume of nonprime loans soared from $2 trillion in 2000 to $8 trillion in 2006, the mortgage market turned into a giant Ponzi scheme. That is, mortgage originators began loaning money knowing that “the only way you get your money out is when someone else puts new money in.”
Given the mostly known risks presented by investments in shaky mortgage loans, Professor Black asked: “Why did smart money managers buy this stuff? Why did smart investors give funds to these managers? Why did smart investment bankers securitize this stuff? Why did smart insurers sell cheap credit protection? Why did rating agencies bestow AAA ratings? Why did originators hold on to some of this stuff?” The answer is that all of these market participants had “too much incentive not to look too closely at how the structured finance goose produced golden eggs.” In reality, said Professor Black, “the more-or-less willfully blind sold to the more-or-less willfully blind. And in the land of the blind, the one-eyed banker is out of a job, the one-eyed money manager underperforms and loses clients, and the one-eyed rating agency rates no deals.”
What might have saved the financial markets from catastrophe? Good due diligence, said Professor Black – something that was notably lacking in all segments of the mortgage market. Professor Black posited that due diligence, which is crucially important in securities offerings, failed miserably in the current crisis. In response, Professor Black would like to see created a “web of diligence” in which all market participants are responsible – and liable – to each other. We need explicit diligence standards in the form of written guidelines and rules for bankers, money managers, and rating agencies, he said. There must be diligence disclosure and effective liability for bad diligence – not just for affirmative misstatements, but for “not having done your homework.”
Professor Coffee responded by advancing the following “moral hazard hypothesis.” Loan originators were not irrational; they recognized that investment banks would increasingly buy any portfolio of mortgage loans without due diligence. So, the mystery was not why originators made unsound loans but why bankers bought them. The answer, said Professor Coffee, is that bankers knew that they could securitize them on a global basis so long as they could obtain investment grade ratings. Mystery solved. Thus, the true question became why rating agencies lowered their standards. And Professor Coffee believes he has found the answer: because structured finance became such a huge source of income for the rating agencies, their concern went from preserving their reputations to preserving their core business. To prevent a recurrence of the mortgage market meltdown, Professor Coffee recommended revisions to Regulation AB (“Asset-Backed Securities”), adopted in 2005, to include due diligence requirements. Further, Professor Coffee recommended defining “recklessness” under SEC Rule 10b-5 to include the failure to give a security rating without conducting reasonable verification.
Mr. Gross suggested that large financial firms simply lacked the internal controls needed to head off the mortgage crisis. Although all of the big banks relied on normally reliable quantitative measures, like “value-at-risk” modeling, the perfect storm hit, leading to the 1% of scenarios that the banks’ models were ill-equipped to handle. This situation landed banks in a “black hole” where the models no longer worked and the old rules no longer applied. Mr. Gross suggested that we need enhanced regulatory regimes that require increased standards for investment and far greater disclosure of risk. He also suggested a universal reorientation of financial performance measurement from the short to the long term, which would serve to reduce the appeal of risky investments with the attendant hope of large near-term profits.
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