In view of the role of credit derivatives in the collapse of the financial markets, the Obama administration is proposing to regulate such investments. Credit derivatives are investments backed by mortgages, student loans, commercial paper, or credit card debts that have been bundled and sold to investors in the form of bonds, fund shares or other securities. One reason for the credit crisis was the fact that so many subprime mortgages and other high-risk loans were made by lenders who knew that they were going to sell the paper before the first payment was due, so there was less vigilance on the part of loan originators who at the same time had more money to lend due to falling interest rates and increased leverage that required less operating capital to make loans. When the subprime credit market collapsed, the demand for credit-based securities fell sharply and the holders of those instruments took a big hit. Many, such as the holders of auction rate securities whose interest rates were set by periodic auctions, had a complete loss of liquidity because there was no longer a functioning market where they could cash out.
The proposed regulations would require changes in the way such securities are marketed, perhaps prohibiting the sale of derivatives altogether to unsophisticated investors who are unable to fully evaluate the potential risks. Such a regulation might require an expansion of the definition of “unsophisticated investor,” since many of the investors who were misled by derivatives included large institutional investors such as municipalities and labor unions who are not professional investors and have to rely heavily upon the representations made by the dealer-brokers hawking such investments. The Administration is also considering minimum capitalization requirements that would reduce leverage, and thus the volatility of the markets for these securities. In theory, the proposed regulations would reduce the risk of such investments, but the effects on the credit market would be mixed. On the positive side, the credit markets would become more fundamentally sound and there would be more transparency with respect to who owes whom and who would be impacted by market fluctuations. On the other hand, such regulations would tighten the credit market even more at a time when some economists (and certainly those in the financial industry) would like to see more lending rather than less after the downturn of the past two years.
Increased regulation of derivatives might also impact litigation arising from abuses in the derivatives markets. There are already thousands of investor lawsuits pending, many of them brought by the Atlanta law firm of Page Perry, a financial services fraud boutique firm with a national practice. According to Page Perry’s Craig T. Jones, “government recognition of the problem with these investments may increase public awareness, resulting in more claims and more recoveries for investors.” Although the defendants in these lawsuits might argue that they should not be held liable for losses that occurred before they were regulated and before the risks of derivatives were widely understood, attorney Jones says that “the broker-dealers who sold these investments knew the risks and had a duty to make full disclosure to investors, so they cannot plead ignorance just because the government has waited until now to address the problem.”
In any event, federal regulations may result in future market reforms but will not help the millions of investors who have already been duped. Those investors, including many corporations and other large institutions, are turning to private law firms like Page Perry and to recoup investments that were made in reliance upon false representations about risk and liquidity. According to Jones, “even sophisticated investors have legitimate claims given the level of fraud and misrepresentation that went on in these markets, and it would behoove any investor, large or small, to have a legal review of his or her portfolio to evaluate possible options where losses can be attributed to fraud.” In addition to its experienced staff of attorneys, Page Perry has an in-house securities analyst and a forensic accountant to assist with such reviews.