Thursday, March 26, 2009

Hernando de Soto on property and the financial crisis

I thought this article in the WSJ was really interesting. De Soto argues that a lack of a recording system for derivatives is a key component of the problem:
[A]ggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property.

Ever since humans started trading, lending and investing beyond the confines of the family and the tribe, we have depended on legally authenticated written statements to get the facts about things of value. Over the past 200 years, that legal authority has matured into a global consensus on the procedures, standards and principles required to document facts in a way that everyone can easily understand and trust.

The result is a formidable property system with rules and recording mechanisms that fix on paper the facts that allow us to hold, transfer, transform and use everything we own, from stocks to screenplays. The only paper representing an asset that is not centrally recorded, standardized and easily tracked are derivatives.

Of course, de Soto's claim that recording systems govern all valuable property rights is true for patents, but not for copyright (no registration required for protection, thanks, Berne Convention!) nor for trademarks--though one can expect the most valuable of both to be subjects of filing with the appropriate government office, so it's not as bad as all that.


Anonymous said...

This is a strange article.

First, that the lack of transparency in derivatives is immensely problematic because it makes it impossible to estimate counterparty and systemic risk is not exactly a shockingly new idea. You can find it even in financial journalism for the layman (it's discussed in When Genius Failed, for instance).

Second, I don't think that MBSes and CDOs *are* derivatives as classically defined. They're not contracts based on the value of an underlying asset; they're (fractional) ownership of (aggregated) assets. That's an odd error for a WSJ author to make, if I'm right. More importantly, just about any contract that doesn't involve real property isn't recorded centrally, either. I don't know what the magnitude of their value is by comparison but it's not negligible.

RT said...

I have to defer on the points you make; I simply don't know enough. It occurs to me that the real jump up in (face) value of the obligations came with the credit default swaps etc., which is like insurance, and I don't think insurance is subject to recording, which I take is your point about contracts. But perhaps other rules limit insurance (like my ability to bet on the continued life of someone with whom I have no relationship), or perhaps packing so much value into contracts is just new. Anyway, I thought this piece was an interesting extension of de Soto's work on getting record title to poor people as a way of encouraging development.

Benjamin Wright said...

Professor Tushnet:

Part of the issue with the recordation of derivatives is that technology (e-mail, text message and so on) has made the formation of legally-binding contracts very cheap and easy. Efforts to promote better documenation on derivatives (advocated by both de Soto and Geithner) will provoke massive campaigns to capture, archive and comprehend electronic financial records. See Details --Ben