Osler, Hoskin & Harcourt LLP Lecture sparks debate on due diligence in the sub-prime mortgage crisis

Photo by Chris Ng

Professor Bernard S. Black (right) of Northwestern University meets faculty and students at a reception in Macdonald Hall on March 22, 2010, after presenting the Osler, Hoskin & Harcourt LLP Distinguished Lecture in Business Law on "Due Diligence: Failures and Remedies."

On March 22, Queen’s Law welcomed Professor Bernard S. Black of Northwestern University as the third Osler, Hoskin & Harcourt LLP Distinguished Lecturer of 2010. Students and professors packed a lecture room in Macdonald Hall and alumni watched on webcast to hear him talk about the recent sub-prime financial crisis in the U.S. under the title of “Due Diligence: Failures and Remedies.”

Black, an internationally recognized business law scholar, began with a brief analysis of the sub-prime mortgage-lending debacle in the United States and how non-prime securities, or low-grade credit, grew to a level of popularity that dominated much of the financial markets before the shattering fall of 2007. “How did we do something so silly?” he asked the audience. “That’s what my talk is about.”

Having warmed his audience for a lively academic discussion and debate, he continued by analyzing the housing market and explaining how non-prime (high-risk) securities became packaged and traded in the financial markets, “Hindsight, of course, is 100%,” he quipped. “How much shouldwe have known and how much didwe know about the possible housing bubble?”
 
Black described the credit crisis and non-prime lending as a “Ponzi scheme in disguise,” explaining how non-prime credit parallels that elaborate investment scheme that has made so many headlines since 2007. The financial model that almost every rating agency followed, upon which this housing bubble was built, was based on the fundamental assumption that nominal housing prices would continue to rise, which they had always done, historically. A Ponzi scheme succeeds by paying off existing investors via fresh money from new ones.

However, this reliance on a rise in nominal housing prices was misguided, particularly since real housing prices were fluctuating, showing both increases and decreases. Yet there was never a cushion built into the rating models to entertain the possibility of problems arising -- nor ways to alleviate them -- should the housing markets ever decline. This was precisely what occurred in the course of the sub-prime mortgage crisis.

Bankers, lawyers, regulators, rating agencies, and accountants alike contributed to the built-up expectations of the market. These sub-prime securities managed to take hold successfully and  soon were being packaged and resold habitually in the markets, despite their high risk, through a shoddy lack of due diligence. Much of this was the result of what Black considers misaligned incentives. Many of the major actors chose not to undertake their own due diligence, he explained, believing it to have been conducted already and bolstered by the other stakeholders. With no explicit standards of disclosure or liability attached to these actions, there were no incentives for bankers to act other than they did; they went on encouraging the sale of these commodities.

During the question period, Professor Joshua Karton asked Black how his advocacy of regulating due diligence could be bolstered and applied internally by the varied institutions who are affected.

What he advocates, Black responded, is “soft” regulation. “Financial innovation would definitely continue; bankers could continue to repackage innovative securities.” He pointed out that his analysis of what went wrong did not advocate an overly strict regulatory regime, but rather “put teeth” into what people had always considered good practice. What was missing in innovative practices during the sub-prime crisis, he added, was even “an iota of caution.”

The students peppered Black with questions about the repercussions of the financial crisis and how new developments, including Washington’s incentives in bailing out American banks, related to his topic.

At the reception afterwards in the student lounge, David Cai, Law ’11, offered this summary: “Overall, I think Bernard's lecture provided an insightful perspective on the recent economic crisis and possible problems that arise as the result of de-regulation and lack of due diligence.” Speaking as a student in the Osler Business Law seminar course for which this lecture series serves as a basis, Cai admitted that his initial concerns that a lack of business background would disadvantage him in the class had quickly dissipated.

“I really enjoyed this Osler lecture,” he added. “The theories presented and the debates that followed made corporate law seem more real and organic.”

In the distinguished business law lecture series generously sponsored by Osler, Hoskin & Harcourt LLP and directed by Professor Paul B. Miller, five internationally renowned academics delivered topical and scholarly papers in the 2010 winter term. For more information on the other lecturers and to see a video of Professor Bernard Black’s presentation and a photo gallery of the reception, go to http://law.queensu.ca/events/oslerDistinguishedLecturesInBusinessLaw.html.