Professions Crisis
by George Liebmann
Issue 122 - December 17, 2008

There are two competing versions of the causes of the financial crisis. The right points to the Community Reinvestment Act, Fannie Mae and Freddie Mac; the left to the failure to regulate derivatives and the creation of institutions ‘too big to fail’ through dilution of the Glass-Steagall Act, Mc Fadden Act and Public Utility Holding Company Act. Certainly tolerance of dicey mortgages was politically driven, and not just from the left; it was Alan Greenspan who proclaimed that "protection of property rights requires a critical mass of owners to sustain political support."

Both factions are on to something: markets never work more powerfully than when they work in reverse due to perverse incentives. Greenspan’s faith that "markets should remain free to function without the administrative constraints, particularly those on wages, prices, and interest rates that have disabled them in the past" needs to be qualified when guarantees create moral hazard. Guarantees, as Greenspan recognized "lessen the need of financial counter-parties to earn a reputation for honest dealings." It is curious that many of the current cures also partake of this vice. Thus deposit insurance, as we learned in the savings and loan crisis, creates incentives for irresponsible investments, particularly those that allow fees to be raked off up front; it worked well only when banks were regulated in the interest rates they could pay and the investments they could make. Relief for mortgagors like the new Maryland law extending the time necessary for foreclosure from 15 to 175 days, or provisions for ‘cram down’ of new balances, impairs the availability of secured credit; the lack of prompt collection remedies explains much third-world poverty. The Administration proposes to do to the insurance industry what it did to public utilities: to undermine and dismantle the system of state insurance regulation devised by Charles Evans Hughes by repealing the Mc Carran-Ferguson Act.

The recent distempers have a third cause beyond the two commonly invoked: the derogation of professional values, the most conspicuous example of which was Tony Blair’s infamous speech deriding ‘forces of conservatism’ in the professions. The classic warning of what impended was a highly entertaining best-seller, Liar’s Poker, by Michael Lewis (1990 ), a Chapters of Erie for the present age, documenting the cynicism with which derivatives were packaged in the investment banking firms. They were not about the management of risk, but the multiplication of it. The "counter-party surveillance" celebrated by Greenspan was not enough to prevent abuse when the counter-parties were engaged in the same abuses, and naive buyers, including pension funds did not look beyond the label, the once-earned reputation of the issuing firm. The computer and the internet, like the auto and electricity in the 1920s represented real economic growth, not just a speculative bubble, but the use of computers in derivatives trading did not repeal the principle ‘garbage in, garbage out.’

The objection to bare options or margin trading is not new; it was set out by the discerning journalist William Pfaff in a series of articles published over the last five years, and by Mr. Justice Holmes in his first opinion after coming to the Supreme Court in 1903: "We cannot say that there might not be conditions of public delirium in which at least a temporary prohibition of sales on margins might be a salutary thing... a slight fall leaves him penniless, with nothing to represent his outlay, except that he has had the chances of a bet. It is said that in California, when the constitution was adopted, the whole people were buying mining stocks in this way with the result of infinite disaster." Certainly there were no regulations to insure, in Greenspan’s words, "that rapid risk-laden dealings are financed by wealthy professional investors, not by the general public," at least for the secondary effects of such investments. "Reputation," Greenspan rightly said, "and the trust it fosters have always seemed to me to be the core required attributes of market capitalism. When trust is lost, a nation’s ability to transact business is palpably undermined." Who now trusts the ‘masters of the universe’ in investment firms, the lawyers in huge ‘shark tanks’, the inscribers of time sheets in enormous accounting firms, the improperly incentivized loan officers in large and small banks, or the authors of appraisals to order?

There have been jeremiads about the collapse of standards in the legal profession, notably those by Sol Linowitz, Mary Ann Glendon, and Anthony Kronman, richer in lamentation than in prescriptions for cure. Part of the cure is that once prescribed by the most notable twentieth- century law professor, the late Karl Llewellyn, who noted that professionals even in the largest organizations do most of their work in small groups, and who accordingly urged loose confederations or what he called "artels" of boutique firms. Another part of it is repudiation of the purely economic model of professional practice imposed by the invariably narrow-minded Justice Blackmun in several cases on professional advertising. Today’s professional mastodons are not united by personal loyalty, and the recession will dissolve many of them. We cannot expect to return to the twelve-member limit on firm size imposed by the British Law Society well into the 1970s, but it is worth remembering that the great industrial combinations of the early 20th century were put together in law offices whose members numbered in the low double digits. If a reaction in this direction ensues in the professions, we will have cause to apply to the present time the moralistic Justice Brandeis’ reflections on the Depression: "the worst years were before 1929."

George Liebmann, a Baltimore lawyer, is the author of several books on the professions, including The Common Law Tradition: A Collective Biography of Five Legal Scholars (Transaction, 2005) and Diplomacy Between the Wars: Five Diplomats and the Shaping of the Modern World (Palgrave Macmillan, 2008)