Hernando de Soto on the Toxic-Paper Problem

Wall Street harshly judged U.S. Treasury Secretary Timothy Geithner's proposals for saving the nation's banks. His televised remarks in mid-February were supposed to reassure watchers by outlining the Obama administration's plan for fixing the financial markets, but the market plunged as he spoke. Yet Wall Street was wrong. The lack of details in Geithner's presentation doesn't really matter right now. More important is the fact that the administration has finally focused the U.S. on the primary cause of the current economic crisis: the trillions of dollars of "toxic paper" on the balance sheets of financial institutions. This poisonous paper is scaring off potential creditors and investors who lack the legal means to understand what this paper signifies, how much there is, who has it and who might be a bad risk. Finally, policymakers in the White House seem to be coming to grips with the real enemy: the debasement of the legal financial documents that represent value, allow it to be transferred and signal risk.

Look around: everything of economic value that you own—house and car titles, mortgages, checking accounts, stocks, contracts, patents, other people's debts (including derivatives)—is documented on paper. You are able to hold, transfer, assess and certify the value of such assets only through documents that have been legally authenticated by a global system of rules, procedures and standards. Ensuring that the relationship between those documents and each of the independent assets they represent is never debased requires a formidable system of legal property rights. That system produces the trust that allows credit and capital to flow and markets to work.

It is through paper that we connect and know the global economy. It is impossible to do business on a national level—never mind in a globalized marketplace—without reliable legal documentation. Yet this worldwide web of trust is now crashing down. In recent years, governments have debased paper by carelessly allowing into the market a biblical flood of financial instruments derived from bad mortgages nominally valued at some $600 trillion or more—twice as much as all the rest of the world's legal paper, whether it represents cash, traditional financial assets, or property, tangible or intangible.

The astonishing quantity of these documents, and the fact that they're so tangled up and poorly recorded, is making it difficult to determine how much there is, what it's worth or who holds it. Given that the volume of these derivatives dwarfs all other paper, the mess is also undermining one of the greatest achievements of property law: the power to identify and isolate with precision every asset and every particular interest on that asset. Thus a meager 7 percent default on subprime mortgages that were funded or insured by derivatives—maybe only a few hundred billion dollars worth of toxic paper—is debasing the rest of the economic paper and contaminating the entire economy. Because this toxic paper refers to credit and capital, it affects all economic activity; the loss of trust spares no one, spreading out in all directions and beyond local bubbles, whether subprime housing or dotcom. And then staring you in the face may be the worst recession in modern history.

U.S. and European authorities find it difficult to believe that the fundamental cause of a recession could be a poorly paperized legal system. But in emerging markets, like the one I come from, the importance of paper is pretty obvious. Most of our people are poor and live in the anarchy of the shadow economy, where their assets and contracts are covered by paper that is endemically toxic: not recorded, not standardized, difficult to identify, hard to locate and with a real value so opaque that ordinary people cannot build trust in each other or be trusted in global markets. In the shadow economies of the developing world, credit paralysis is a chronic condition. So when I look at the recession that has started in the West—triggered by toxic paper—I feel right at home.

The main challenge for Obama and Geithner is to restore trust in the prime vehicle of credit—not money, which we know how to control, but paper, which we clearly don't. The overwhelming amount of available credit is made up of proprietary paper, such as mortgages, bonds and derivatives, all of which is not money per se but has some of the financial attributes of money—what economists used to call "moneyness." To prevent the debasement of paper and adequately infer its value, the Obama administration must turn to well-tested rules ensuring paper's credibility.

Among those rules: The derivatives scattered helter-skelter all over thousands of idiosyncratic types of opaque documents must be clarified, categorized, standardized and recorded in publicly accessible registries, like all other property documents. The law must take into account externalities—how all financial transactions affect outside, interested parties (the age-old legal principle of erga omnes, "toward all," historically developed under property law to protect third parties from the negative consequences of secret deals carried out by aristocracies unaccountable to no one but themselves).

Moreover, every financial deal must be tethered to the real performance of the originating asset, ensuring that the amount of debt secured on the basis of assets does not become dangerously "out of scale" with those assets underlying the debt—the most prominent cause of a recession, according to the economist John Kenneth Galbraith. And assets can continue to be leveraged and repackaged—but only to improve the value of the original asset. Finally, it must be recognized that clarity and precision are indispensable for creating credit and capital through paper.

These are the criteria for sorting out toxic assets and preventing any future contagion from causing another recession. The Obama team will also have to educate those who still cling to the hope that the existing market will eventually sort things out—that all that is required is recapitalizing banks, stricter oversight and injecting money into the economy. That won't be enough. Modern legal markets only work if paper is reliable and people have access to credit and explicit information. "Let the market do its work" now means, in effect, "let the shadow economy do its work." Yet the main beneficiaries in a shadow economy are vulture capitalists and loan sharks, who devour producers with good credit scores but no credit.

Still another challenge to Obama is that many of those involved in resolving the crisis now claim that it is virtually impossible to identify and value all the toxic paper now on the financial institutions' books. Yet in the past U.S. and European lawyers and bureaucrats have proved brilliant at sorting out toxic paper whether it referred to bad debt, confusing claims or opaque legislation. In doing so, they have untangled claims after the California gold rush, picked up the pieces of Europe's crumbling precapitalist order, converted Japan's feudal enclaves into a market economy after World War II and reunified Germany after the fall of the Berlin Wall. That's the process of capitalism: continuous detoxification. And we're hard at it today, too, in developing countries, searching for toxic paper in our shadow econ-omies—informal titles, licenses, contracts, laundered money and identity documents —in an effort to bring their people into the mainstream.

The Obama rescue plan must also recognize that governments can no longer delegate the solution exclusively to financial specialists who operate within the narrow context of the derivatives market. As it now stands, the law that governs derivatives lacks the standards required to keep paper tethered to reality, the indicators to size up the damage and the tools to sort out the growing conflicts of interest between the holders of derivative paper and the rest of society. Nor does the financial community have the inclination, the incentives or the economic interest for such a down-and-dirty job.

It has always been government's role to establish standards, set and enforce weights and measures, keep records and bring every shadow economy under the rule of law. Escaping this recession requires restoring order, precision and trust to financial paper. That will be a daunting legal and political challenge. But the hard decisions about locating, valuing, and isolating the toxic paper, and figuring out who will foot the bill for the losses—taxpayers, banks or vulture capitalists— will be easier to make the sooner politicians realize that the alternative could be the collapse of the very system that has generated the most prosperity in history—and all hell breaking loose.