How Do We Prevent Financial Negligence?

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A few days ago, I wrote a piece where I mentioned that for financial markets to work they must eliminate stupidity, evil and negligence.

Albert Einstein once said, "Only two things are infinite, the universe and human stupidity, and I'm not sure about the former." So stupidity is a hard one. My only thought was to have some kind of strange licensing program where investors prove they're smart. That sounds like a dubious idea to me, so feel free to suggest something better.

The evil part, however, should be easy. Fraud laws should do the trick in most of those situations. Of course, you have to actually enforce them.

So that just leaves negligence. How do we eliminate it?

Well, negligence happens every day. It's responsible for making many lawyers very rich. You finish your banana and throw the peel behind you. An old woman slips on it and breaks her hip. Your negligence is to blame. What happens? You get sued.

If negligence was one of the chief problems at the heart of the financial crisis, and I believe it was, then why can't we do anything about it? If Moodys or S&P rated a subprime mortgage-backed security AAA without verifying the income of the mortgage holders, isn't that negligence? Just like throwing your banana peel, it's dangerous to assert that a security is safe without making sure holders of the underlying mortgages can actually afford them.

I don't know the answer to this one, but I have a few theories.

Lawyers generally like to go after people with the deepest pockets. That certainly isn't the rating agencies. It's well known-that most of the smartest guys who get stuck at rating agencies leave as quickly as possible for Wall Street where they can make real money. That's not to say the rating agency analysts are poor, but if PIMCO tried to sue Moodys for $250 million in losses related to MBS, I suspect they'd be very disappointed to learn that Moodys does not have $250 million lying around.

But the investment banks do. Well maybe not at this moment, but generally, they have some money lying around. So why not sue them for creating the bond in the first place?

Well, because they warned you. Every mortgage-backed security has a "Risk Factors" section in its prospectus and prospectus supplement. My guess is nobody read it. Here's a sample from a subprime Countrywide Mortgage-Backed Security issued in 2004 (with Morgan Stanley as an underwriter):

As a result of Countrywide Home Loans's underwriting standards, the mortgage loans in the mortgage pool are likely to experience rates of delinquency, foreclosure and bankruptcy that are higher, and that may be substantially higher, than those experienced by mortgage loans underwritten in a more traditional manner. Furthermore, changes in the values of the mortgaged properties may have a greater effect on the delinquency, foreclosure, bankruptcy and loss experience of the mortgage loans in the mortgage pool than on mortgage loans originated in a more traditional manner. No assurance can be given that the values of the related mortgaged properties have remained or will remain at the levels in effect on the dates of origination of the related mortgage loans.

As if to say: Don't buy this man. Seriously. It could get very ugly. We can't make any promises. I mean, we'll take your money if you insist, but it might not turn out too well for you.

And this is just a small portion of their warnings; they span several pages. They aren't trying to hide them -- on the very cover of the prospectus supplement, right below the title of the transaction the bankers warn:

CONSIDER CAREFULLY THE RISK FACTORS BEGINNING ON PAGE S-7 IN THIS PROSPECTUS SUPPLEMENT AND ON PAGE 5 IN THE PROSPECTUS.

As you can see, they even use scary capital letters to make sure you know they're serious.

So who do you hold responsible for negligence? It could be no one; it could be everyone. I think lawyers and investors don't know who to sue. On some level, investors only have themselves to blame for not doing enough due diligence themselves, which is no consolation for the consumers whose money they manage.

This is a problem that the government needs to deal with. They need to somehow penalize financial negligence. We need to deter it. Specific regulations can't cover the broad range of ways in which negligence can, and probably will, happen.

In pretty much every other aspect of our lives negligence can get us in trouble. Why not in finance?

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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