How can regulators best respond to financial crises? In a forthcoming article in the Duke Law Journal, I show how a law-and-economics framework can guide regulators’ responses. There are two kinds of remedies for failing to comply with a law: property rules and liability rules.  Liability rules require compensation, such as money damages.  Property rules impose draconian penalties, such as injunctions, punitive damages, or large fines.  Property rules can make sense during normal times, because the threat of harsh penalties ensures compliance.  But financial crises upend many normal assumptions and prevent some entities from complying with all of their legal requirements.  Imposing a draconian property rule on an already-distressed entity would worsen its plight – and deepen the crisis.  Regulators naturally respond to crises by suspending the enforcement of laws protected by property rules.

Such responses have two serious failings.  First, most laws exist to protect some interest, so non-enforcement results in windfalls to many entities whose existence is not threatened by the crisis.  Second, regulators try to minimize these windfalls by extending non-enforcement to as few entities as possible, yet this narrowness inevitably leaves out many distressed entities that need relief.

An example from the 2007-09 financial crisis demonstrates both failings.  Mortgage-backed bond pools are generally tax-free, as long as at least 99 percent of their assets are mortgages held since around the time the pool was formed.  If a pool fails this stringent 99 percent requirement, the pool is subjected to full corporate taxation permanently, a harsh property rule.  Unfortunately, modifying a mortgage to prevent a likely foreclosure removes the modified mortgage from counting towards the 99 percent, which effectively prevents mortgage modifications.  During the 2007-09 financial crisis, the IRS temporarily suspended enforcement of this rule, at least for modifications of certain mortgages.  But renegotiating mortgages is a business activity, typically associated with businesses like banks, which are subject to full corporate tax, unlike mortgage-backed bond pools, which are tax-free.  The IRS knew that non-enforcement would create windfalls for some mortgage-backed bond pools, which could engage in bank-like activities, tax-free.  So the IRS kept the non-enforcement limited to narrow classes of mortgages, leading to many avoidable foreclosures.

My article demonstrates that a better approach is to temporarily move from property rules to compensatory liability rules.  Requiring compensation prevents windfalls, while also making broad relief palatable to agencies.  Regulators have occasionally taken this better approach.  For example, the IRS used it to prevent the 2007-09 financial crisis from worsening mutual funds’ plights.  Tax law requires mutual funds to distribute at least 90 percent of their income each year to their investors.  Failing this 90 percent distribution requirement incurs a property rule.  Many common investment strategies cause mutual funds to recognize income for tax-accounting purposes years before they receive cash.  Normally when this happens, mutual funds simply borrow cash to meet the 90 percent distribution requirement.  But the cash crunch during the financial crisis made borrowing money difficult, putting many mutual funds at risk of failing the 90 percent distribution requirement and suffering a draconian penalty that would destroy them.  The IRS responded by temporarily turning the property rule into a liability rule that required compensation from a mutual fund’s investors for the amount by which the mutual fund failed the 90 percent requirement.  This response prevented windfalls and kept tax law from wrecking mutual funds during the crisis.

How would this approach have worked for mortgage-backed bond pools?  The IRS could have temporarily allowed all mortgages to be modified, but imposed normal corporate tax rates on any gains from the modifications, which is a liability rule.  Such a response would have permitted all economically sensible mortgage modifications, while preventing any tax windfalls.

This approach has long been used in tort law.  In normal times, dock owners have property-rule remedies against boaters who use the dock without the dock owner’s consent.  But during storms, boaters have the right to dock temporarily, but must pay compensation to the dock owner, which is a liability rule.  This doctrine of necessity prevents unnecessary shipwrecks, while also avoiding windfalls to boaters.  In other words, this doctrine temporarily moves a property rule to a liability rule.

Although agencies can effectively respond on the fly to crises with temporary moves to liability rules, arranging the moves before a financial crisis hits allows even more effective responses.  Readying the response in advance allows its prompt deployment, and speed is of the essence in fighting financial crises.  Prearranging also allows agencies to ensure proper legal authority, so that legal uncertainty does not hamper their crisis response.  Moreover, when an agency announces its crisis response in advance, the drafters of private documents have the opportunity to adapt.  For example, the governing documents of many mortgage-backed bond pools barred modifying mortgages, since drafters feared running afoul of tax law’s 99 percent requirement.  When the IRS moved to non-enforcement of the 99 percent requirement for modifying some mortgages, these governing documents prevented many pools from modifying even those mortgages that were eligible.

All areas of law touching on finance can better handle financial crises with prearranged, temporary moves from property rules to liability rules.  Liability rules need not always involve monetary compensation.  For example, they can consist of shifting costs like illiquidity or risk.  Agencies and anyone interested in crisis responses should consider which requirements protected by property rules might worsen future financial crises and should arrange temporary shifts to liability rules before the inevitable next crisis.

This post comes to us from Andrew Blair-Stanek, associate professor of law at the University of Maryland Carey School of Law.  It is based on his recent article “Crises and Tax,” available here.