Securitization Conflict of Interest Rule Would Restore Confidence

Last week’s decision by the SEC to put forth proposed Rule 127B could be a huge step in restoring confidence and integrity in the securitization markets.

Deserved or not, many investors, regulators and other government officials still blame the investment banks for the collapse of the credit markets in 2007.  What remains a particularly “hard to explain away” fact is that at least several of the banks that were underwriting mortgage-backed and CDO programs in 2006 and 2007 were simultaneously shorting those securities for other clients and worse, in some cases, for their own account.

One has to fully understand the complexities and separation of information, client and  risk strategies to even begin to understand how the investment banking side of a company could have been hawking a new CDO, while at the same time, that company’s asset management group or proprietary trading desk was shorting the same security.  Even if you buy into the argument that these groups did not and should not have been communicating with each other, the sheer fact that the bank was on all sides of the market for this security seems to most rationale thinkers like a clear conflict of interest.

It now seems that the SEC agrees with that point of view and we don’t really see how they could have come to any other conclusion.

We believe that the industry should warmly embrace the proposed rule 127B and move on. 

We note that the American Securitization Forum has given a somewhat reserved endorsement of the proposed rule.  Their concerns are that activities including legitimate hedging and market making are not impinged by an overly conservative implementation of 127B.

We would suggest that these concerns, while academically legitimate, are way “over baked”.  Cleary, banks that are active in the underwriting of securitized debt will not underwrite every transaction, even for the same issuer.  As this is clearly the most predictable outcome, the abilities of any single bank to conduct active investment businesses (both for third-party clients and for their own account) can’t really be expected to be a hindered by this rule. 

In fact, we would argue that by forcing firms to choose which roles or sides they take for individual transactions, we would do much to encourage competition and market efficiency.

If the ASF meant in their commentary to include concerns about an investment bank being restricted from hedging against a deteriorating portfolio position during the first 12 months (the proposed rule suggests a 12 month prohibition for underwriters), we would acknowledge that the rule will put more pressure on the investment banker to construct a transaction with better fundamentals. But isn’t that really the point after all? 

If the banker doesn’t think the security has at least a year’s worth of legs, why were they underwriting it to begin with?  If they still hold a substantial percentage of the issue on their books 12 months out, perhaps they should question why they did the deal in the first place.

We see proposed rule 127B as perhaps the most legitimate fix to the securitization industry since the financial crisis.  We believe the entire industry should embrace the rule and take a major step towards reviving market confidence across the board.

About markferraris
Managing Principal Orchard Street Partners LLC

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