Hernando de Soto Says Toxic Assets Emerged From a Shadow Economy

[R.A. Hettinga]

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The Wall Street Journal
		
OPINION
MARCH 25, 2009
Toxic Assets Were Hidden Assets
We can't afford to allow shadow economies to grow this big.

By HERNANDO DE SOTO

The Obama administration has finally come up with a plan to deal with  
the real cause of the credit crunch: the infamous "toxic assets" on  
bank balance sheets that have scared off investors and borrowers,  
clogging credit markets around the world. But if Treasury Secretary  
Timothy Geithner hopes to prevent a repeat of this global economic  
crisis, his rescue plan must recognize that the real problem is not  
the bad loans, but the debasement of the paper they are printed on.

Today's global crisis -- a loss on paper of more than $50 trillion in  
stocks, real estate, commodities and operational earnings within 15  
months -- cannot be explained only by the default on a meager 7% of  
subprime mortgages (worth probably no more than $1 trillion) that  
triggered it. The real villain is the lack of trust in the paper on  
which they -- and all other assets -- are printed. If we don't restore  
trust in paper, the next default -- on credit cards or student loans  
-- will trigger another collapse in paper and bring the world economy  
to its knees.

If you think about it, everything of value we own travels on property  
paper. At the beginning of the decade there was about $100 trillion  
worth of property paper representing tangible goods such as land,  
buildings, and patents world-wide, and some $170 trillion representing  
ownership over such semiliquid assets as mortgages, stocks and bonds.  
Since then, however, aggressive financiers have manufactured what the  
Bank for International Settlements estimates to be $1 quadrillion  
worth of new derivatives (mortgage-backed securities, collateralized  
debt obligations, and credit default swaps) that have flooded the  
market.

These derivatives are the root of the credit crunch. Why? Unlike all  
other property paper, derivatives are not required by law to be  
recorded, continually tracked and tied to the assets they represent.  
Nobody knows precisely how many there are, where they are, and who is  
finally accountable for them. Thus, there is widespread fear that  
potential borrowers and recipients of capital with too many  
nonperforming derivatives will be unable to repay their loans. As  
trust in property paper breaks down it sets off a chain reaction,  
paralyzing credit and investment, which shrinks transactions and leads  
to a catastrophic drop in employment and in the value of everyone's  
property.

Ever since humans started trading, lending and investing beyond the  
confines of the family and the tribe, we have depended on legally  
authenticated written statements to get the facts about things of  
value. Over the past 200 years, that legal authority has matured into  
a global consensus on the procedures, standards and principles  
required to document facts in a way that everyone can easily  
understand and trust.

The result is a formidable property system with rules and recording  
mechanisms that fix on paper the facts that allow us to hold,  
transfer, transform and use everything we own, from stocks to  
screenplays. The only paper representing an asset that is not  
centrally recorded, standardized and easily tracked are derivatives.

Property is much more than a body of norms. It is also a huge  
information system that processes raw data until it is transformed  
into facts that can be tested for truth, and thereby destroys the main  
catalysts of recessions and panics -- ambiguity and opacity. To bring  
derivatives under the rule of law, governments should ensure that they  
conform to six longstanding procedures that guarantee the value and  
legitimacy of any kind of paper purporting to represent an asset:

- All documents and the assets and transactions they represent or are  
derived from must be recorded in publicly accessible registries. It is  
only by recording and continually updating such factual knowledge that  
we can detect the kind of overly creative financial and contractual  
instruments that plunged us into this recession.

- The law has to take into account the "externalities" or side effects  
of all financial transactions according to the legal principle of erga  
omnes ("toward all"), which was originally developed to protect third  
parties from the negative consequences of secret deals carried out by  
aristocracies accountable to no one but themselves.

- Every financial deal must be firmly tethered to the real performance  
of the asset from which it originated. By aligning debts to assets, we  
can create simple and understandable benchmarks for quickly detecting  
whether a financial transaction has been created to help production or  
to bet on the performance of distant "underlying assets."

- Governments should never forget that production always takes  
priority over finance. As Adam Smith and Karl Marx both recognized,  
finance supports wealth creation, but in itself creates no value.

- Governments can encourage assets to be leveraged, transformed,  
combined, recombined and repackaged into any number of tranches,  
provided the process intends to improve the value of the original  
asset. This has been the rule for awarding property since the  
beginning of time.

- Governments can no longer tolerate the use of opaque and confusing  
language in drafting financial instruments. Clarity and precision are  
indispensable for the creation of credit and capital through paper.  
Western politicians must not forget what their greatest thinkers have  
been saying for centuries: All obligations and commitments that stick  
are derived from words recorded on paper with great precision.

Above all, governments should stop clinging to the hope that the  
existing market will eventually sort things out. "Let the market do  
its work" has come to mean, "let the shadow economy do its work." But  
modern markets only work if the paper is reliable.

Government's main duty now is to bring the whole toxic environment  
under the rule of law where it will be subject to enforcement. No  
economic activity based on the public trust should be allowed to  
operate outside the general principles of property law.

Financial institutions will have to serve society and fully report  
what they own and what they owe -- just like the rest of us -- so that  
we get the facts necessary to find our way out of the current maze.  
They must begin learning to put on paper statements about facts,  
instead of statements about statements.

Mr. de Soto, the author of "The Mystery of Capital" (Basic Books,  
2000) and "The Other Path" (Harper and Row, 1989), co-chairs the  
Commission on Legal Empowerment of the Poor.