The first of this month Goldman Sachs announced that it would be hiring a new “social media community manager.” This report comes on the heels of Morgan Stanley’s announcement in March that it was launching a new social media program designed to enable its nearly 17,800 financial advisers to use Twitter and LinkedIn to disseminate investment information and insights. The moves by these two giants are sure to trigger a race in Wall Street to conquer the social media landscape for financial and investment services.

But why has the financial services industry been so slow to join the social media frenzy? For one, it worries about the legal pitfalls of letting their legions of advisers loose into unchartered territory. And their unease is not totally unfounded. As posted previously on The Network, the Financial Regulatory Authority (FINRA) brought an action last year to suspend and fine a California-based broker $10,000 for promoting certain investments in “a series of ‘misrepresentative and unbalanced’ messages” to her 1,400 Twitter followers. And as recently as a few months ago, the Securities and Exchange Commission (SEC) charged an Illinois-based investment adviser with securities fraud for offering to sell “more than $500 billion in fictitious securities through various social media websites.” These regulatory actions precede a set of notable guidance letters from both the SEC and FINRA, briefly discussed in the prior post, but reviewed in more depth below.

In January the SEC published its first risk alert on the use of social media by investment advisers, cautioning advisers that social media communications are subject to “federal securities laws, including, but not limited to, the antifraud provisions, compliance provisions, and recordkeeping provisions,” of the Advisers Act of 1940. According to Robert Bartlett, a Professor at UC Berkeley School of Law, the fact that many social networking sites combine static information (previously regulated by FINRA as a type of advertisement, requiring prior principal approval) and real-time, interactive information (previously regulated more loosely as a real-time communication) created considerable uncertainty for FINRA members wanting to communicate on sites such as LinkedIn or Facebook, because these sites blend the two mediums.

FINRA has also provided some advice and guidelines on the use of blogs and social media sites. In Regulatory Notice 10-6, published last August, FINRA attempted to explain how existing SEC and FINRA regulations apply to various social media communications. In particular, publicly available sites such as Twitter are considered advertisements while password-protected sites such as Facebook and LinkedIn are deemed sales literature. Chat room discussions and Q&As on Facebook or LinkedIn, for example, are viewed as public appearances, but instant messaging to individual clients or less than 25 potential clients within a 30-day period are classified as correspondence.

This means that firms and financial advisers are subjecting themselves to a variety of recordkeeping requirements, third-party rules and more every time they interact with clients through these various tools and platforms. Something as quick and easy as retweeting a third-party’s comment would be considered an endorsement by the firm or financial adviser and subject them to liability for its content. Professor Bartlett adds, “FINRA has made clear in its enforcement activity that notwithstanding the informal nature of a “tweet” or Facebook “post,” such communications can constitute recommendations for a security, thereby subjecting the communication to the requirements of the investor suitability rule.”

Despite these guidance letters, many financial services firms still prohibit their employees from using Facebook and other social media sites at work. Even Morgan Stanley, which is set to launch its new social media program this June, will restrict its advisers to using only canned or pre-approved messages. While this is a start, firms will need to become increasingly comfortable with loosening the reigns of their financial advisers to keep up with an investor community that is increasingly “living social.”

There is no denying the prominent role that social media has taken in our lives. We are confronted daily with phenomena such as Twitter, LinkedIn and Facebook. Their member totals have grown exponentially and their IPO’s are valued at billions of dollars. Thus, it is no wonder that social media websites are attracting the attention of the business world: They offer an easy and free communication platform to connect, inform and interact with customers.

Although the majority of Wall Street still prohibits employees from using Twitter and Facebook in the office, more and more firms are discovering the strategic value of using social media posts as a supplement to their other corporate communications. For example, Deutsche Bank recently allowed one of its investment bankers to post about IPO’s on Twitter.

But the legal risks of these communications should not be underestimated. The emergence of social media may be a godsend for the marketing department, but it is a nightmare for many compliance officers. Since the use of social media channels involves the dissemination of information, it must comply with federal securities laws, including antifraud, compliance, and recordkeeping provisions.

Plenty of securities laws give rise to uncertainties when it comes to their application to social media. For example, the Regulation Fair Disclosure (“Regulation FD”) prohibits selective disclosure of non-public, material company information. But it is not always clear whether a twitter message or blog post would be considered public disclosure. Another example is SEC Rule 10b-5. This antifraud rule applies to all company statements, including tweets and blog posts. Statements by employees acting as company representatives online will give rise to liability when they include material misstatements or omissions in relation to the purchase of a security. Given the 140-character limitation on tweets, omissions are almost bound to occur. Exchange Act Rule 14a-17, regarding proxy solicitations, permits the use of electronic shareholder forums to facilitate communications, but it is uncertain whether social media channels would enjoy protection of the rule. And when it comes to private offerings, companies must refrain from offering or selling securities through general solicitation or advertisement under Regulation D. It is unclear what types of social media communication would constitute a general solicitation.

On top of all this, there are some additional concerns with regard to investment advisers that market securities on the internet. Investment firms, dby their nature, are particularly prone to compliance issues with social media. Attention should be drawn to Rule 206(4)-1(a) of the Advisers Act which imposes a number of recordkeeping obligations on registered investment advisers (“RIAs”). As currently designed, social media may not allow you to archive and maintain the communications on your own books and records

Back in 2009 the Financial Institution Regulatory Authority (FINRA), the largest private self-regulatory organization for securities firms, created a Social Networking Task Force to deal with these issues. In its Regulatory Notice 10-6, FINRA advises firms to develop clear policies and procedures for the use of social media and to retain records of all such communications. Last year, FINRA suspended and fined California broker Jenny Quyen Ta for sending “misrepresentative and unbalanced” messages on twitter. She had, without notifying her firm, pushed certain investments via Twitter, but had failed to include in her 140-characters-tweets the fact that she herself held stakes in those investments.

With this endless list of liability risks, is a firm better off completely banning social media use? On January 5^th, the day after it accused investment advisor Anthony Fields of selling fictitious securities on Linkedin, the SEC issued its first ever Social Media Risk Alert in order to provide some information on three main topics: compliance strategies, third-party postings and record-keeping obligations.

First, regarding compliance strategies, the alert urges firms to adopt specific social media use compliance programs, rather than relying on the existing general programs that may lack specificity. Second, it addressed third-party postings. Social media often allow third parties to comment on postings, or even to express their opinions through “like” buttons. Again, the alert recommends implementing explicit policies and procedures on what types of third-party postings are permissible. Finally, in accordance with record-keeping obligations under the Advisers Act, the alert explains that adviser’s records of social media communications must be preserved if they contain information that satisfies the recordkeeping obligations.

It is clear that as our society keeps on evolving in this digital age, securities laws must be interpreted and adapted to new technologies. Although tweeting, posting and blogging may have many advantages for Wall Street firms, recent examples show that caution is necessary when wading into such uncharted territory.

The BATS IPO was an ironic disaster. BATS, a stock exchange that billed itself as the future of stock trading, botched the IPO of its own stock, which was supposed to be listed on the BATS exchange beginning March 23^rd. According to the company, the failure was caused by a software bug, and not by high-frequency trading algorithms, as some have speculated. Not only did the failure cause BATS to abandon its own IPO, it also rattled shares of Apple, mirroring the events of the 2010 Flash Crash.

While the IPO was an embarrassment for BATS, it put the SEC’s regulatory response to the Flash Crash on display. The 2010 Flash Crash was a series of events that caused the Dow Jones Industrial Average to plummet more than 700 points in a matter of minutes, only to recover within a half hour. In response to the Flash Crash, single stock circuit breakers were established to curb the effects of extreme market volatility. By most accounts, single stock circuit breakers have been effective in restoring order to markets after numerous test runs during other “mini flash crashes,” hitting a high of 51 in December of 2011.

Despite the successes of single stock circuit breakers, market participants are urging the SEC to approve the “Limit up – Limit down” (LULD) rule to replace circuit breakers. LULD is considered an improvement upon the current circuit breaker rules for various reasons, according to Steve Nelson, founder of the Nelson Law Firm and an attorney for the New York chapter of the Security Traders Association. With respect to the BATS IPO, the refined LULD rules would have prevented disruption in trading of Apple stock. Under LULD, a trade beyond a certain percentage price range, or “limit band,” does not immediately halt trading. Unlike circuit breakers, LULD waits several seconds to see if trading resumes in the allowed price range; if trading remains outside this range, only then is trading halted. Observers note that because of the availability of liquidity in Apple stock during the BATS IPO, markets could have naturally corrected the stock’s price without the shock of a market halt. The SEC is currently considering implementing the LULD rule and has extended the comment period to May 31.

Although high-frequency traders were not implicated in the cause of BATS’s failed IPO, LULD is one of the few tools that the SEC has proposed in its struggle to control the effects of high-frequency trading strategies, which played a role in 2010’s Flash Crash. Though LULD may do a good job in helping the SEC fulfill its mission to facilitate “orderly markets,” academic studies show that LULD may fall short in allowing the SEC to establish “fair and efficient markets” because the plan does not address the information asymmetry and adverse selection issues perpetuated by high-frequency trading strategies. Further rule refinements must be made to reconcile the SEC’s mission with the prevalence of high-frequency trading.

As we discussed in our recent pieces about the Stop Online Piracy Act (SOPA) and the Anti-Counterfeit Trade Agreement (ACTA), online communities have grown increasingly agitated by efforts to globalize the U.S. intellectual property regime.    But the Trans-Pacific Partnership Agreement (TPP), a free trade agreement that liberalizes far more than intellectual property protection, has so far not sparked the type of viral outrage that halted SOPA and ACTA.

The TPP seeks to establish an entirely new free trade zone among Pacific Rim nations.  The agreement originated in 2006 between Chile, New Zealand, and Singapore but participants now include Australia, Brunei Darussalam, Malaysia, Peru, the United States and Vietnam.  Canada, Japan, and Mexico have expressed an interest in joining talks, but membership could require significant changes to domestic laws – for example, Canada may be required to cease its protectionist dairy supply management regime.

TPP responds not only to the breakdown of world trade talks within the framework of the WTO, but also specifically to the emergence of China, whose exclusion from talks is no accident.  As much a successor to NAFTA as to ACTA, the TPP seeks to eliminate all tariffs on a broad range of goods and services (including intellectual property) between members, to establish new rules for determining an import’s country of origin, and to create a new regime of legal remedies available to foreign businesses against national governments.  According to Ron Kirk, the U.S. Trade Representative, the agreement “sets modern trade standards, including ensuring worker rights and protecting the environment.”

One of the means the TPP employs in reaching these stated aims is to prohibit nations from using capital controls (regulation of the flow of speculative capital).  Capital controls remain popular in Asia, where they are sometimes credited with shielding India, China, and Malaysia from the effects of the 1997 Asian Financial Crisis.

TPP’s business community advocates see the agreement’s limitations on regulation of capital controls as an important way to promote foreign investment and job creation – but civil society organizations, trade and labor unions, and technology firms in particular have adopted a less rosy view.  Some policy groups argue that failure to adequately regulate capital markets lies at the core of the global financial crisis.  Last month, a group of over 100 economists from around the world signed a statement issued by the Global Development and Environment Institute of Tufts University, urging that TPP protect governments from shareholder lawsuits for implementing capital controls, especially during periods of crisis.

Lawsuits over capital control measures are not the only type of liability governments could be exposing themselves to by joining TPP.  TPP’s investor state dispute settlement provisions (ISDS) would permit foreign corporations to sue a member government to enjoin regulatory actions that interfere with business activities.  Supporters of TPP assert that ISDS provisions “mirror” American constitutional protections against arbitrary governmental action and taking of property without compensation – and provide a critical “backstop” for foreign investors who undertake massive risks.

But TPP’s opponents see ISDS in a very different light.  They assert that multinational corporations could use ISDS provisions in TPP to roll back or prevent meaningful public health and environmental regulation.  Critics also claim that corporations have heavily litigated similar provisions in NAFTA and other agreements– meaning that nations could be ‘chilled’ from even trying to regulate companies entitled to ISDS.  Citing similar concerns, Australia announced this month that it would oppose strong ISDS provisions in TPP.

However, while capital control prohibitions and ISDS provisions have attracted some attention, it is TPP’s U.S.-drafted intellectual property chapter that is most likely to give it eventual traction in the Twittersphere.  Indeed most of what is known about TPP comes from leaks, and most of the leaked material pertains to these provisions.

As with ACTA, the TPP’s intellectual property rules would effectively export an enhanced version of the American Digital Millennium Copyright Act (DMCA), a scheme critics allege erodes ISP ‘safe-harbors’ and converts ISPs into ‘copyright police.’  Similarly, the IP chapter draft contains anti-circumvention provisions that would criminalize interference with digital rights management (DRM), seemingly even in cases where no actual infringement has occurred.  TPP would also require member countries extend copyright duration to match U.S. copyright terms.

On the patent side, the TPP likewise imposes a version of the U.S. system, which would mean a considerable expansion of the scope of patent in other member countries.  For example, the leaked TPP chapter expressly requires patent protection for software, plants and animals, as well as surgical and therapeutic methods, all of which are currently excludable under the TRIPS Agreement.  The U.S. draft also mandates patent protection for any “new form, use, or method of using” an existing invention – a move opponents say could undermine development of generics.

TPP’s proponents, like the U.S. Business Coalition for TPP, argue that a robust global patent system is essential to driving drug innovation and stimulating investment in research.  But public health advocates like Doctors Without Borders say that the draft would create a conflict between trade policy and existing commitments to health initiatives in developing nations, as well as threaten national public health programs in member states.  Lead by Australia, some TPP member nations have recently expressed disapproval of the U.S. intellectual property provisions, meaning that TPP’s impact on IP could shift as talks proceed.

The USTR has not responded to criticism of its text, but talks are scheduled to continue in May in Dallas, Texas and in September in Santiago, Chile.

On March 27, 2012, Congress passed the final version of the Jumpstart Our Business Startups Act (‘JOBS Act’), aimed at increasing American job creation and economic growth by making it easier for startup companies to raise funds. As a Kauffman Foundation report posits, “Startups aren’t everything when it comes to job growth. They’re the only thing.”

The package of measures in the JOBS Act are intended to promote more initial public offerings (‘IPOs’) through provisions permitting crowdfunding, redefining the divide between “public” and “private” firms, creating a special IPO “on-ramp” for ‘emerging growth companies’, reducing restrictions on advertising of new securities offerings and permitting more analyst reports of companies undergoing an IPO. However, how much of a help are these measures to the tech entreprenuers of Silicon Valley?

Crowdfunding

One component of the JOBS Act is “crowdfunding”, which allows startups to raise funds from small investors. Under current law, only “accredited investors”, i.e. investors with a net worth of at least $1 million (exclusive of their primary residence), may generally invest in private offerings.

However, under  the crowdfunding provisions of the JOBS Act, anyone may invest up to $10,000 per year, or a maximum of 10% of their net income if they earn less than $100,000 per year, in private companies. The startup may seek up to $1 million per year through crowdfunding without providing the standard public-company disclosures to the SEC or to investors. To counter concerns about possible fraud, basic personnel and financial disclosures are required, as well as an audited financial statement for firms raising more than $500,000.

While such democratization of the fundraising process is pertinent to the growth of small businesses across the US, it is unclear exactly how much it will contribute to the financing of venture-backed technology firms commonly associated with the Silicon Valley. The professional venture capital funders preferred by tech startups not only provide significant amounts of investment but are also able to contribute other tangible benefits such as connections, business advice, and partnerships with other startups in their portfolios.

Professor Bartlett, Assistant Professor of Law at UC Berkeley School, states that, “There is a practical limit on crowdfunding as tech startups often want shareholders who they know and who are not inclined to reveal proprietary information. The level of trust between the company and its shareholders may be compromised if the shareholder base is too diffuse. Many tech startups also want the ability to return to existing investors to fill their financing needs from time to time and so may prefer to continue the traditional venture capital route to do so.”

Nevertheless, he adds that, “Crowdfunding is still an attractive option for companies which are not capital-intensive, such as certain software companies, as opposed to pharmaceutical companies which would need significant investments over a long period of time.”

Some lawyers also warn that there are certain risks involved in crowdfunding, including a possible flood of securities litigation. As Antone Johnson, founder of Bottom Line Law Group, which works with early stage web and mobile startups in Silicon Valley, cautions, “If you have a system set up to sell securities to unaccredited investors, in relatively small amounts, to fund risky new ventures, that’s a gigantic flashing sign to attract the worst scumbags on Earth.”

Redefining the Divide Between Public and Private Firms

Private companies with more than 500 shareholders will no longer be forced to register with the Securities and Exchange Commission, as the JOBS Act increases the limit to 2000 shareholders. One of the benefits of staying private is the ability to target financial and strategic updates only to investors who have secured this information as an investment right. Wide reportage before being ready to go public is expensive and puts the company on an uneven playing field with possibly larger competitors, costing jobs concomitantly.

This provision signals a welcome change for Silicon Valley as it provides fundraising flexibility to popular companies that are expanding but do not possess the financial performance that the market would reward, such as Twitter. Additionally, as a result of the Sarbanes-Oxley Act of 2002 (‘SOX’), filing IPO paperwork can be prohibitively expensive for an early-stage company.

Professor Bartlett adds that, “This provision also allows companies to adopt employee compensation structures (such as the issuing of employee equity awards) that might otherwise have been avoided or altered to avoid the 500-shareholder rule.”

‘Emerging Growth Companies’

The JOBS Act creates a new category of companies titled ‘emerging growth companies’ that have less than $1 million in annual revenue or whose publicly traded shares are worth less than $750 million. Such companies would be exempt from some financial and auditing requirements for up to five years after their IPO.

For example, ‘emerging growth companies’ will be obligated to disclose less about executive compensation, two years instead of five years of audited financial statements and sidestep many of the demanding SOX directives – such as hiring an independent auditor to ensure there are proper internal controls over financial reporting.

Silicon Valley tech startups would benefit from this as it will make managing a public company less costly and give the executive team greater freedom. Forbes reports that this provision is not concerned with limiting financial disclosure as “any mature tech startup would have already been through at least several years of annual audits with accredited accounting firms.” Instead, this provision aims to remove the documented internal controls procedures and standardized reporting requirements that can be expensive and burdensome during the post-IPO “honeymoon” period.

During this delicate period, the company would be better off concentrating their efforts and funds on increasing operations, satisfying more customers and fuelling the growth on which new public investors are relying. It is these activities that will result in more assured company and job growth after going public. Further, it supports more logical and constant communication with the SEC and potential public investors within the framework of existing regulations intended to prevent the abuses of the yesteryears.

However, critics argue that loosening regulations on disclosures could expose investors to fraudulent schemes, which could lead to problems later on for companies. “The definition of ‘emerging growth company’ is so broad that it would eliminate important protections for investors in even very large companies,” Mary Shapiro, head of the Securities and Exchange Commission, wrote in a letter to Congress critical of the bill.

Moreover, Kathleen Shelton Smith, co-founder of Renaissance Capital, an IPO research firm, points out that the definition is arbitrary and would categorize 90% of all companies going public as ‘emerging growth companies’. Over the last year, key Silicon Valley IPOs such as Pandora Media and Yelp would be included, while LinkedIn would have been on the fence.

Advertising

Under present regulations, private companies are only permitted to communicate about funding with accredited investors they already know. This precludes fund-raising pitches in the purview of general audiences or the media.

However, the JOBS Act removes many of the restrictions on advertising and marketing. Start-ups intent on raising money only from so-called “accredited investors” (defined to include invididuals with more than $1 million in assets or income of more than $200,000 per year) will be allowed to inform the public that they are raising money, and demo events will become more transparent. Streaming of demo events to the world will be legal and during pitches, spokespeople will allowed to explain more about where their company is and what they require.

Also, the McHenry Amendment to the JOBS Act will remove restrictions on angel networks (like AngelList) and incubators (like Y Combinator) by permitting them to post financial documents on the web about start-ups they represent. A number of platforms in Silicon Valley currently do this but their legality is questionable.

Professor Bartlett explains that “This aspect of the JOBS Act is likely to have a very significant effect on the fund-raising environment for start-ups. Such marketing combined with the enormous appetite for promising tech firms in Silicon Valley will no doubt bolster interest and increase fundraising opportunities for such companies.”

Furthermore, valuations on hot start-ups may increase as more people learn about those companies. This is a double-edged sword for traditional funding sources in Silicon Valley. It will be harder to get into a good early-stage funding deal on a hot start-up but it may also boost valuations as companies expand, which is advantageous to the early investors.

Analyst Reports

The JOBS Act will allow banks to include research analysts in the IPO process by writing reports to tout Emerging Growth Companies to investor (such reports were banned after the dot-com abuses in 1999 and 2000).

Professor Bartlett states that, “While raising a number of conflict of interest concerns, the provision will no doubt aid in the marketing of a technology firm’s IPO, which should make the IPO process less daunting for Silicon Valley startups than has been the case in recent years.”

Conclusion

In order for Silicon Valley to continue to be the awe-inspiring technological growth engine of the world, the need to regulate and report must be balanced with the need to promote job creation. The passing of the JOBS Act by Congress is proof that this message is being heard on Capitol Hill, though only time will reveal the true effectiveness of these measures in the US in general and in Silicon Valley in particular.

Q: What do the panelist think of moral hazard question? Are borrowers likely to default in order to qualify for a loan modification?

David Moskowitz: The moral hazard issue has always been a hot topic behind scenes. I personally think that the threat of strategic default is not substantial. I believe that at the end of the day people tend to do the right thing.

Paul Leonard: The moral hazard question often leads to the distinction of responsible and irresponsible borrowers. I think the borrower’s responsibility is not the key to determine the foreclosure crisis’ primary causes. Bad underwriting standards and lending on future appreciation have to be regarded as the starting point of malfunction. Therefore the evaluation of responsibility of borrowers alone is misdirected. Most loan modification programs are too concerned about moral hazard. The basic question is how far are people willing to go – are they going to quit their jobs in order to meet the requirements for a modification? I believe it is possible to construct the programs in a way that mitigates the risk of moral hazard.

James Rhyne: Borrowers can be broken down in the group of people that have knowledge and can scam the system and those that make decisions out of ignorance that results either from cultural norms or simple imitation. This ignorance of  the system works and what may happen if they default on paying their loans made them believe that they can afford to buy a house and made them trust the people that offered the loans. I think we should find a middle ground between putting too many restrictions on people and precluding them from owning a home ever and letting them make their imprudent decisions.

Q: How does one find out who “holds” a particular loan?

David Moskowitz: Consumers have to be informed about the holder/owner of the loan not only about the servicer.

Nancy Wallace: The problem is that we do not have a uniform system of loan IDs in the U.S. Each time the loan is sold, it is renumbered. Therefore there is no possibility of tracking the loan, the whole process is basically unverifiable.

Paul Leonard:  One problem is understanding which trustee owns the note but what is a really big issue are the services agreements. Often loan modifications are turned down with the explanation that the investor does not allow them but no specific information on the issue is provided.

David Moskowitz: The services rules are hard for people to understand and there is definitely need for improvement in communication.

Paul Leonard: Sometimes the information provided to the borrower is just wrong. Often the investor would prefer to modify than to head for foreclosure.

Q: Is there a significant “shadow inventorial” of banks? Will it hit the market causing a second crisis?

David Moskowitz: There is a strong perception of a shadow inventory of deferred foreclosures. I am not sure when it will clear up but certainly the recovery of the market should lead to moves in that area.

Q: Is Silicon Valley helping to solve the forclosure problem through companies like Zillow that help to evaluate homes?

Nancy Wallace: Collecting and providing data certainly helps to solve the problem partly. What is needed though is a deep, complex, long-term and expensive assessment of house values. Nevertheless companies like Zillow help to enhance transparency.

Laurence Platt: The tech industry jumped into the mortgage industry, but they are not able to handle the regulatory aspects. There is a clash between business efficiency and regulatory requirements. Look at Microsoft, they jumped in and jumped out.

Q: What percentage in dollar volume of loans can be modified in a way that benefits both borrower and lender/owner?

David L. Moskowitz: I don’t have a percentage, but I know a lot of this is driven by employment and life claims. With these denominators, there is a higher percentage of win-win loans, as we have learned.

Q: Is it unethical or immoral for a borrower to walk away from an underwater home borrowing loan? There was recently a news section about somewhere in Cleveland where many people, even though they knew they were way under water, said that they really believed in the sanctity of their contract and that they were going to continue to pay and not go in default. Why would this be?

David L. Moskowitz: I saw that piece, it was quite compelling. In fact, 60% of underwater customers have never missed a payment. It is just not something that people want to do. I do not really have the psychology on this. People have seen the housing market go up and down and don’t know how they will behave at a high or low point. In the end, it all comes down to affordability: if you can afford to pay, you will.

Nancy E. Wallace: I mostly look at subprime pools, and even in there people are making very steady payments. The loans are 3-400% over the value, and yet they carry on making periodic payments. And we are talking about by far the majority of people in these pools. The large majority of borrowers are making steady payments on interest rates that are so high they cannot refinance. This speaks to the point of people’s willingness to hang on no matter what.

Paul Leonard: I am continuingly amazed by the phenomenon described here: homeownership as a sociological phenomenon rather than just a financial investment. Homes are where people live, where their kids go to school, etc. There is a sense of morality that comes with making your mortgage payment. On the other hands it surprises me that we haven’t seen more people say that they are subject to a foreclosure proceedings when they cannot make their payments anymore. From the people that are underwater, I have been surprised that there haven’t been more who have decided: this is not a situation that is financially good for me.

Laurence Platt: As a lawyer, I think it is interesting that if a borrower was to do that voluntarily, it is very hard for them to get to that next task. Rental housing is scarce and going up in price. There is a bit of a cost-calculus of what is going to happen next.

James Rhyne: That cost-calculus is driven by a lot of ignorance. The current legal system is not giving them a lot of security.
As a footnote, there is a subdiscipline in economics called behavioral economics, which has discovered a lot of non-rational economic behavior. I strongly recommend a book Daniel Kahneman, Nobel Prize winner in economics, called Thinking, Fast and Slow.

David L. Moskowitz: Don’t underestimate the economic calculus that goes into the impact on your family. People want to preserve the stability of their families. This is why co-ownership is so important. This is why people might continue to pay loans even if they are underwater, just because they can. People will rather opt for that.

Paul Leonard: From what limited evidence exists about strategic default, there have been some studies that the most likely strategic defaulters are people with higher incomes. It is not the average Joe, it is those who are most sophisticated about it. I would suggest that if you are counting on being able to qualify for a loan modification on the basis of defaulting, you would be taking a huge risk that you will not get the modification and loose your house. This is another mitigating factor for this behavior.

Q: Mr. DeMarco announced yesterday that the FHFA is now suggesting it might change its rules to allow principal reduction on mortgages owned or guaranteed by Fannie and Freddie. He also said that it would have a modest effect on households. Comments, thoughts on ways to make it more effective?

Paul Leonard: I don’t think he said that. Those were indeed the headlines. The quantifiable analysis they have done seems to move in the direction of doing it or not doing it. He is defending greater risk levels of default as outweighing potential benefits. He has promised to come to some conclusion by end of month on what they are going to do.

Laurence Platt: The interesting thing is that the analysis they are doing now is based on a Department of Treasury analysis: if we are to do principled reduction, it costs tax payers money. If we get subsidy, it washes out the loss and we as an institution do fine. But this can ruin US tax payers. Either ways the loan is absorbed. The idea that FHFA is making these learned economic calculations by taking money from taxpayers: only in Washington has that happened.

Paul Leonard: Note that this has already been allocated. They are trying to spend money that has already been allocated. There is a larger issue here: we have approved the funding and directed it away from foreclosure regulation. Clearly, without that intervention, some of these institutions wouldn’t be here today. It is important to remember that those resources were legislated for the purposes of cleaning up mortgage junk and foreclosures. In the end, a small portion has been spent on that.

James Rhyne: Two points: Firstly, I would not be surprised if their record keeping is based on technology that is 15-20 years old. Second point: the IT support for these changes is not a problem that is going to be solved overnight, and not for less than some 100s of millions of dollars.

Q: How is the 10billion dollars for principal elections being proportioned? Who gets it?

David L. Moskowitz: That is a complex questions. Think of it as a loan with a 10 billion dollar balance that you are struggling to repay. The settlement works like this: the bank gets a dollar credit for each dollar it forgives. It is not so much marked-to-market on an individual loan basis. There are minimums and maximums for how these forgiveness dollars get allocated in the total pool.

James Rhyne, gave very valuable insights on constructing a 21st century information processing system for recording titles. In context of National Registry the most significant issue is transparency. Transparency in the mortgage marketplace is valuable for two reasons: a) valuation of the instrument and b) seizure of the underlying asset can be difficult if the legal standards are not followed.

Any future design must cater to improved access to records. Today, in order to trace a record one has to visit the county where the real property is situated in, while instruments are sold worldwide. Also the prospective design should retain compliance with statute and judicial pronouncements.

Recording, as it exists today, is an incomplete view of what actually happened in the transaction. These voids severely effect the pricing of the instruments. It is interesting today’s records, largely paper documents are manufactured from computer software, making the software very vital for the purposes of analysis. Mr. Rhyne added that, software also enables the production of two forms a) physical and electronic, but the system must work towards ensuring consistency. He stressed on taking practical and pragmatic step to build systems, which allow access to documents instead of waiting for a legislative change.

Requirements of title records vary across jurisdiction. Hence a national registry shall require an economical form of representation of information. Since, in the United States, State real estate law cannot be sidelined by a federal fiat – he suggested creation of some third form of reporting to a national agency. A similar harmonization exercise shall also have to be undertaken for transfer of notes.

Though creation of a future national registry would be an expensive proposition, associated economic benefits justify the exercise. For instance, a uniform identifier shall also contain a large variety of secondary sources of information about the property – reducing the cost of title insurance, reduce risk in real estate transactions and increase efficiency.

The brief questions and answer session addressed the problems with foreclosure. The panel identified that the main problem was political in nature as borrowers should be kept in their homes for obvious reasons. California has created several barriers for foreclosure. Furthermore, the panel reached a consensus that the one-off documentation problem was not the cause of the foreclosure crisis. Indeed, the panel highlighted the issue of uncertainty over the authorization of public records as well as the quality or lack thereof of loans.

In addition, the panel addressed whether there is a benefit to synchronizing loans. It was concluded that there is indeed a benefit and that this hasn’t been a controversial issue in most states. It has been clear that the mortgage follows the note and there is no need for mortgage assignments. However, the interpretation and application of law is changing under lenders who are trying to foreclose.

Prof Wallace, highlighted that right now there is no house price index – representing what is actually happening in the marketplace. Hence making the data incredibly expensive to obtain. Mr. Platt, however emphasized that if the goal was never to foreclose – then why not a have an unsecured loan? On being questioned on enormous costs of foreclosure and therefore need explore alternative, Platt responded that foreclosure is a rare occurrence

Prof. Nancy Wallace of the Haas School of Business, UC Berkeley gave a presentation titled Beyond the Mortgage Electronic Registration System (MERS). She explained the mortgage-securitization process as well as the mortgage supply chain. She posits that the efficiencies from the bond market working electronically have a conflict with the lien market which works on paper. This led to the hope of MERS in order to make the system more efficient.

However, MERS has led to very little transparency over how notes and liens travel down the highway because MERS shows up as the only recorded owner. Furthermore, MERS can look up a true owner but the internal database entry is not the same as the recorded assignment even within MERS. In this way, MERS does not maintain a comprehensive database.

Prof. Wallace articulates that the MERS predicament is a symptom of a recording utility that became too greedy. She put forth three alternative proposals: (1) having a more modest private utility, (2) establish a federal recording system that would accept electronic filings, and (3) invest in new infrastructure for existing land title systems to accommodate electronic recording.

She concluded by stating that there is evidence that significant damage may have already occurred in publicly available real property records. Securitized mortgage markets and the efficiencies they afford require a modern electronic and verifiable lien transfer, recording and assignment system that is consistent with the real property laws of states. Indeed, this will affect the cost of mortgage debt.