Would Financial Regulation Have Stopped Goldman Sachs?

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Democratic legislators in the House and Senate are looking to use the SEC's fraud suit against Goldman Sachs to inject some adrenaline into the financial regulation debate. Rep. Barney Frank said reform would have stopped Goldman from selling complex securities that were designed to fail and today Sen. Chris Dodd told CBS, "our bill would have prevented that kind of events from happening, in my view, and that's what the public needs to know."

But is Dodd right? Does the current legislation have anything to do with the allegations that Goldman lied about the contents of a collateralized debt obligation (CDO) to sell investors a product that was designed to fail to enrich another client? Financial regulation probably won't overhaul fraud law, or outlaw German gullibility. But Douglas Elliott of the Brookings Institution said financial reform would have "absolutely" lowered the probability of Goldman's alleged fraud for three reasons:

1. Reform would require "skin in the game"
Reform would require financial institutions that package and sell mortgage-backed securities (MBS) to keep at least 5% of the risk of that security. This is known as having "skin in the game." The idea is that if I'm an investment bank packaging mortgages to create an MBS, I'll have a greater incentive to monitor the quality of that instrument if its disintegration hurts my bottom line.

But here's the catch. Goldman wasn't making a regular MBS. It was packaging collateral to make a CDO. "Skin in the game," Elliott says, would affect the original mortgage loans that were packaged into MBS instruments, and it's not clear that Goldman would need to have a position on the CDO they sold to German investors. But the basic story is that reform should make it harder for banks to design securities they suspect to be weak, or even wish to bet against.

2. Reform would boost transparency
Reform would have required the CDO to have higher information requirements for investors. It would have been easier for the investors to see that Goldman's CDO wasn't such a great pool of mortgages, Elliott says. "You cannot eliminate bad investment decisions, and you cannot eliminate fraud," he continued. "But you can reduce the probability. We want to reduce the probability of fraud. There will be people who are stupid or unlucky. But the opacity of these instruments cried out for somebody to commit fraud."

3. Reform would make rating agencies more afraid
The CDO that Goldman helped design received the highest rating of AAA from rating agencies, even though it might have been designed to fail. We can't force the rating agencies to be smarter, but we can scare them into being more careful. Reform might give rating agencies higher legal liability, in which case hosed investors who've lost billions on bad AAA-rated bets might have recourse to sue a ratings agency for gross negligence. "It's pretty clear that some of that was due the rating agencies not doing their job," Elliott says. Presumably, higher legal liability might encourage them to be more conservative.

Update: Bob Litan from Brookings adds his own three cents, and clarifies some of my language in Point 3 above.

1. On existing law
"First they [the SEC] already have existing law they're already suing under -- some anti-fraud provision. So I'm not sure why you need any additional legislation, or what would make this less likely," he said.

2. On his colleague's first two suggestions: skin-in-the-game and transparency
Litan largely agreed that both skin-in-the-game laws and transparency provisions might lower, but not eliminate, the probability of something like Goldman's accused fraud. But he added that "the argument about exchanges and clearinghouses for derivatives making this less likely is a sidebar point" because Goldman's Abacus CDO was not a derivative and probably wouldn't go through a clearinghouse.

3. On scared ratings agencies
"I'm not so sure it makes it easier to sue the ratings agencies," Litan said. If there are provisions in the final bill that increase increase the regulatory oversight of the ratings agencies, that would conceivably make them nervous about signing off on junk. "But this is a big legal constitutional issue. The reason the agencies haven't been sued up to now is they have legal precedent based in the First Amendment."
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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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