In Alice in Wonderland, a young man remarks to Father William, "You incessantly stand on your head. Do you think, at your age, it is right?" Members of the U. S. Senate manifested a like puzzlement at a recent hearing as they observed the stance taken by Goldman, Sachs & Co. as seller of collateralized debt obligations.
CDOs are notes or bonds dependent for repayment on their issuer's stake in a designated portfolio of asset-backed debt obligations. The recent allure of CDOs lay in high yields coupled with high credit ratings. Institutions are reported to have purchased more than $1 trillion of these securities before the bubble burst. Then consumers began to default in large numbers on underlying loans. Lenders holding CDOs found themselves without an active market in which they could sell or evaluate their doomed holdings. So lenders curtailed lending. The resulting credit freeze contributed to the near collapse of our financial system.
What caught senators' attention was the good fortune of those CDO sellers that managed to turn profits as their customers lost their shirts. Goldman Sachs accomplished this by positioning itself not only as well-compensated CDO organizer-seller, but as holder of short positions in the CDO issuers' portfolios. The organizer bet on the portfolios' demise. To senators, this self-serving posture bespoke a conflict of interest. For the investment bankers, as for Father William, the stance evidently was so habitual that it did not even seem odd.
When challenged on this at the hearing, Goldman Sachs responded by cloaking itself in the mantle of market maker. It had been a mere trading intermediary whose advice was neither sought nor given. To which one of its executives added, "I do not believe that we were acting as investment advisers." As the Senate hearing adjourned, there the matter stood. Senators had condemned the conduct they observed. They had not given a cogent moral argument for a rule that the conduct violated. The investment bankers had understated their role--of which more shortly--and that portrayal had gone unrefuted.
The Legislative Gap
Whereas the issuer of "cash" CDOs invests note proceeds in asset-backed and other securities, the issuer of "synthetic" CDOs, the sort most commonly issued, takes a long position in a hypothetical (or "reference") portfolio. The synthetic issuer acquires that position in a credit default swap--a contract in which, in exchange for periodic payments from a credit protection buyer, the issuer assumes risk of default on the reference portfolio obligations. That is to say that the issuer sells the equivalent of a naked put. Critics maintain that synthetic CDOs do not provide significant economic benefit and succeed only in spreading risk too widely. The economist Paul Krugman and others have recommended that Congress prohibit synthetic CDOs.
About a month after the aforementioned hearing, the Senate passed its financial reform bill. That bill now awaits reconciliation with its House counterpart. Surprisingly and inexplicably, the Senate and House bills fail to institute any significant regulation of CDOs. Both bills are entirely silent on synthetic CDOs. Only one sentence might be read to reach cash CDOs (this in the Senate bill about disclosing underlying assets, though that reading would require wrenching the sentence from its context of asset-backed securities other than CDOs). It seems that as the drafters trained their sights on credit default swaps and mortgage-backed securities, they missed another elephant in the room.
How could this omission occur after havoc so notorious? I have given the details of the legislative analysis elsewhere (see memorandum). Confusing draftsmanship in the Senate bill may have left the impression that its "skin in the game" rule captures CDOs. Such rule provides that if an organizer wishes to arrange an offering of mortgage-backed or like securities--this by selling to an issuer mortgage loans or similarly self-liquidating obligations to serve as collateral--the organizer must retain at least 5% of the credit risk on obligations sold. The committee report states that thus allowing organizers to unload assets only if they are willing to maintain a partial stake in them will "ensure they won't sell garbage to investors."
This rule is salutary so far as it goes, but it does not capture CDOs. A cash CDO issuer may acquire its collateral not from the organizer but in arm's length transactions in the open market where sellers do not retain interests in assets sold. The collateral will usually comprise asset-backed and other securities, and might not include any loans or unsecuritized obligations. In the case of synthetic CDOs, no one ever sells reference portfolio obligations to the issuer.
Locating the Conflict of Interest
For both understanding and action, we can do better. An objectionable conflict of interest does lie athwart the transactions in point. We shall see this after first defining a conflict of interest, then observing carefully what goes on in a CDO offering. Because it does not seem politically likely that any type of CDO will be prohibited, this conflict's potential for future havoc beckons us to act. I propose below a legislative provision that, by establishing a counterincentive, will preclude one of the circumstances that presents the conflict. In support of that proposal, I argue that disclosure of the conflict would not suffice to prevent its harm.
A conflict of interest in the present context consists in an intrinsic incompatibility of a self-benefiting interest or commitment with an other-regarding commitment. If you find that you cannot fulfill your duty of promise-keeping to Jack while fulfilling your duty of truthfulness to Jill, you face a conflict between two other-regarding commitments, not a conflict of interest. An interest or commitment may be both self-benefiting and other-regarding (e.g., your interest in compensation for performing your duties at work). If you work such long hours that you neglect the care of your elderly parents, you may be overcommitted, but your commitments are not intrinsically incompatible. An intrinsic incompatibility obtains when, even assuming that the agent possesses unbounded resources, the self-benefiting action or forbearance would inevitably compromise fidelity to the other-regarding commitment.
An investment bank effectuates an offering of CDOs by planning the structure of a deal, arranging for formation of a Cayman Islands corporation to issue notes, recruiting buyers, purchasing notes, and reselling notes to buyers. In such capacity, the bank is known as the "underwriter" in a public offering and as the "initial purchaser" in an offering to qualified institutional buyers. We shall use "underwriter" for both cases.
In its preclosing activities, a CDO underwriter selects the issuer's portfolio obligations. Or in some cases, it delegates selection to a firm regarded as an expert in credit risks. Investors' returns depend entirely on that portfolio. The underwriter's direct or indirect involvement in portfolio selection constitutes the first of two circumstances that bring to bear a conflict of interest.
A CDO deal will also present the underwriter with the opportunity to acquire and maintain a short position in the issuer's portfolio or the notes. In the case of synthetic CDOs, the underwriter acts as credit protection buyer and acquires a short position at the closing. This is a valuable opportunity: the underwriter probably could not find a seller in the credit default swap market of credit protection on so large a stake in the selected portfolio. Or so the decision to pursue the CDO deal indicates.
If the underwriter expects to maintain a net short position, then in the period before the closing, as the underwriter participates in portfolio selection, a strong incentive will arise to arrange a weak portfolio--a portfolio expected to experience defaults generating profits for those who have shorted it. Even if the underwriter does not want a short position, the underwriter is keen to collect large underwriting fees and profits at the closing. If, as commonly happens, the request of a party desiring to acquire a short position in a contemplated portfolio initiated the CDO offering, and if that single firm is local, insistent on getting what it wants, and has spent months saying so to the underwriter, while, on the other hand, prospective investors are diverse, remote, less frequently in communication, and in some cases are given only a matter of days to review a circular before deciding whether to subscribe, the underwriter may tilt the balance between the two sides in favor of the more demanding short side.
Meanwhile the underwriter will be representing to prospective investors that the portfolio has been chosen on the basis of astute credit analysis. If there is a selection agent, the underwriter will speak, as did Goldman Sachs, of the agent's "alignment of economic interest" with investors. The underwriter's opportunity to acquire and maintain a short position, and, in the synthetic case, the asymmetrical pressure to satisfy the short side notwithstanding what the offering circular says about criteria of selection, constitute the second of the circumstances that bring to bear a conflict of interest.
In selling securities, it is unlawful to utter a false material statement or to fail to disclose any material information needed to avoid a misleading presentation. This places a burden on an underwriter to disclose how a CDO issuer's portfolio was selected. If the underwriter has contributed to crippling the portfolio, then as the underwriter hunts for investors and pursues rating agencies for favorable ratings, a powerful incentive against candor comes to bear. The underwriter will not want to offer a thoroughly candid revelation of any adverse portfolio selection for fear of scaring off prospective investors.
Prospects understand that any proffered portfolio will have been composed with an eye to what a short side counterparty would accept. They also rely on the explicit or implicit characterization of the portfolio as a product of credit analysis that in some significant sense serves the interests of investors. They do not assume that the underwriter, the only transacting party that could foster investor interests, has thwarted those interests. If that understanding were exploded by a revelation that the underwriter has been aligned in economic interest with the short side, the revelation could kill the deal.
A conflict of interest thus obtains in any CDO offering whose underwriter wishes to maintain, or elects to favor, a short position in the portfolio or notes. The conflict of interest consists in intrinsic incompatibility between, on the one hand, an interest in crippling the portfolio while still attracting purchasers of the CDOs, and, on the other hand, the duty not to mislead investors in any material respect.
An underwriter who skews and then shorts a CDO portfolio has been compared to a boxing promoter who fixes and then bets on a fight. In both cases the scheme defrauds those unaware of the fix.