Conflict-of-Interest Amendment Wouldn't Have Stopped Goldman


During the marathon Goldman Sachs hearing a few weeks ago, Sen. Carl Levin (D-MI) threatened to offer a financial reform amendment to prohibit the wrongs he believes the bank committed. Yesterday, he delivered. His amendment (.pdf) seeks to prevent the conflicts of interest that he and other Senators chastised Goldman's bankers over. Yet, as currently written, it doesn't appear it would have prevented Goldman's behavior.

Included in the amendment is the Volcker rule, but that's old news. The interesting part is the new conflict-of-interest provision, arising out of the Goldman hearing. Let's look at the commandment that Levin wishes to require banks to live by:

(a) An underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security (as such term is defined in section 3 of the Securities and Exchange Act of 1934 (15 U.S.C. 78c), which for the puroses of this section shall include a synthetic asset-backed security), shall not, during such period as the asset-backed security is outstanding or such lesser period as the Commission determines is appropriate, engage in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity.

Before explaining why this rule actually makes no sense in the context of what the amendment says next, let's consider this new requirement.

Why Just ABS?

The first oddity in the language above is that it's limited to just asset-backed securities. Why stop there? Surely, conflicts-of-interest like these can exist for other securities as well. If a bank owns or sells $5 billion in credit-default swaps on General Electric, can it still underwrite and sell $1 billion of the firm's unsecured debt? The legislation would allow it, as written. Yet how is that any better than doing the same for a mortgage-backed security?

No Hedging For Life?

It also seems a little bit extreme to say that the bank can't short a security for its lifetime. That means, even if the bank had completely honest and noble intentions in selling a product initially, but realizes five or even 20 years later that a market is faltering, it can't protect its shareholders. If this provision had been in effect as the banks were scurrying to cover their housing market exposures in 2007, then the financial crisis would have been even worse. At least they managed to spread losses over investors who remained foolishly bullish on real estate.

The Key Exception

You might think that this provision would essentially outlaw synthetic collateralized-debt obligations (CDOs). After all, you can't create those without hedging them or selling a short interest to someone else. But there's a big exception:

(c) EXCEPTION.--The prohibitions of subsection (a) shall not apply to risk-mitigating hedging activities necessary to conduct the underwriting, placement, initial purchase, or sponsorship, provided that this subparagraph shall not otherwise limit the application of section 15(G) of the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.).

So that means that a bank can write a synthetic CDO and also sell protection on it to another party or hedge their exposure -- just like Goldman did in the ABACUS case the SEC inquiry is based on. Yet much of the hearing was dedicated to criticizing Goldman for hedging their exposure to the security that they created. But according to this exception, Goldman still would have been able to sell investors these securities and maintain a short interest, so to hedge their exposures if it was "necessary" to conduct the placement.

Of course, this is an inescapable reality. There are two sides to many transactions, so a bank can't create certain securities without either finding a counterparty to take the opposite bet, or taking on the exposure itself. And those actions would just hedge their exposure, as permitted. Throughout the hearing this appeared to be the sort of "conflict of interest" the Senators objected to, but the exception would continue to allow that practice to continue.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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