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Regulating Collateralized Debt Obligations, the Elephant in the Room Untouched by Financial Reform Bills

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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).2010-06-09-FINALYEP2.jpg 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.

Beguiled By Their Own Business Speak?

Investment bankers still have not recognized this conflict of interest. When asked whether they saw a conflict of interest, Goldman Sachs executives implied, and senators seemed to suppose, that if there were a conflict of interest, it would obtain because an investor was already a customer. In this they were mistaken. When Goldman Sachs denied that its investors were advisory clients, it knocked down a straw man. The aforementioned conflict of interest inheres in the transactional structure, no matter who the investors are.

Perhaps the investment bankers have believed their own business speak. Consider the characterization, mustered in Goldman Sachs's defense, that its ABACUS deals were a "platform originated as a way to hedge Goldman Sachs' exposure." Rabobank has alleged that Merrill Lynch viewed a CDO deal as a "hedging instrument." Cant about "managing our risk" and "hedging our exposure" betrays the promotion of a self-benefiting interest despite an other-regarding commitment.

When joined with a conception of self as market maker, this view loses sight of legal obligations. A market maker buys and sells extant securities. An underwriter participates in creating, presenting, and selling new securities. An underwriter chooses to enter into a transaction subject to the antifraud provisions of the securities laws--which govern "in the public interest and for the protection of investors." Investment banks orchestrating CDO deals act as underwriters. To hear Goldman Sachs executives testify that their firm acted as a market maker, one would think that they had not read their own offering circulars.

Proposed Constraint to Prevent Harm from Conflict of Interest

The situation at hand wants for some constraint, counterincentive, or mechanism to engage an incentive to deceive that has punctured the integrity of a market, and the integrity of participants. I propose a protective incentive. The provision works by precluding the second of the circumstances that would present the conflict of interest. It removes the short side incentive. It replaces that incentive with what we may call 'Alignment With Investors in Portfolio Selection' ('AWIPS'). The provision takes the form of the following amendment of the Securities Exchange Act of 1934.

(a) An underwriter or initial purchaser of collateralized debt obligations, any other party acting as protection buyer from the issuer, and any party acting as portfolio selection agent must, prior to the offering of such securities, obligate itself by contract to the indenture trustee for benefit of the noteholders that it will maintain an investor-aligned position in the issuer's portfolio obligations and in the notes until maturity of the notes, and that if it does not do so, it will disgorge to the trustee any profit from a net short position. An 'investor-aligned position' shall be a net long position of at least such magnitude, relative to the notional size of the offering, as the Securities and Exchange Commission by rule determines to be requisite so as to provide sufficient disincentive against effecting or favoring adverse selection of the portfolio. The Commission may elect to establish a higher such magnitude for offerings of synthetic securities.

(b) An underwriter, initial purchaser, protection buyer, or portfolio selection agent shall disclose for benefit of prospective investors any attempt to influence selection of the issuer's portfolio obligations by any prospective or actual short side counterparty of any party acting as protection buyer, or by any other party believed to be interested in taking a short position in the notes or in any part of the portfolio. Such disclosure shall include the identities of any securities proposed by any such party for inclusion in the portfolio.

(c) For structured finance securities other than collateralized debt obligations, the Commission shall have the authority to establish by rule such provisions corresponding to subsections (a) and (b) as the Commission determines to be appropriate so as to provide sufficient disincentive against adverse selection of the issuer's portfolio.

The moral foundation of AWIPS consists in the following. Prospective CDO investors will be given the impression, explicitly or implicitly, that the portfolio selector has acted in "alignment of economic interest" with the investors. That's what Goldman said in an ABACUS "flip book," and that kind of pitch is inevitable when an underwriter tries to sell a deal. Salesmen praise their products. When the typical narrative is given of how the portfolio was selected with the benefit of credit analysis and expertise, prospective investors should be able to rely upon it. Because we are each bound by a duty not to deceive, an underwriter should not presume to select securities while benefiting from the impression of selection in alignment with investors even as the underwriter seeks to foster a bet, for itself or another, that the securities will default. If one exploits an impression of alignment, the alignment should obtain. Investors rightly expect enough integrity of underwriters that investors are not forced to guess whether the deal was designed to fail.

As a policy, AWIPS constitutes a counterpart of, and its rationale is at least as compelling as that of, the "skin in the game" rule. In legislating so that securitizers "won't sell garbage to investors," Congress wisely mandates that securitizers be long in assets pooled--assets in which transactions would otherwise leave securitizers neutral and untempted by any opportunity to short. A fortiori, Congress should require that underwriters be long in assets as to which a transaction dangles--often having been initiated for the purpose of creating--an opportunity to short.

Requiring alignment with investors qualifies as an appropriate protection whenever a party is given the opportunity both to compose and to short the exclusive source of investor returns. We have seen how that dual opportunity arises when the issuer is a shell corporation holding only those assets selected directly or indirectly by an underwriter. The dual opportunity does not arise in the general case in which an issuer constitutes an active business not run by an underwriter. The special case warrants a constraint not needed in the general case.

AWIPS does not prescribe the quality of a security: it is a constraint on transactions, not securities. Such constraints are numerous (e.g., the SEC rule constraining short selling in anticipation of public offerings). AWIPS is a small price for underwriters to pay for the integrity of markets and control of systemic risk. A CDO's asset-backed portfolio obligations are not requisites of an institutional investor's portfolio; there exist many alternatives. If by dint of AWIPS, large institutions who underwrite offerings can no longer efficiently make markets in asset-backed securities, other firms will.

More on AWIPS is given in my memorandum. The pending conference between House and Senate presents an opportunity, which should not be missed, to fill the legislative lacuna with this protection.

Disclosure Alone Will Not Prevent Harm

Underwriters expect sophisticated investors to bear the burden of their own risk-taking in good faith dealings. The following answers a predictable plea to do nothing about the identified conflict of interest other than require disclosure.

We tolerate some circumstances characterized by conflicts of interest in the belief that disclosure minimizes harm. Such is the case for a physician who enrolls her patients in a clinical drug trial under appropriate constraints. We disallow other circumstances characterized by conflicts when we judge that the average mortal probably would not faithfully serve the two masters. A lawyer may not represent two adverse parties, a mayor may not award his company a no-bid contract. Circumstances characterized by conflicts in the joint conduct of commercial banking and investment banking were barred by the Glass-Steagall Act. The choice to tolerate or prohibit conflict-ridden circumstances turns on expected harm.

Suppose that instead of AWIPS, we require only disclosure of an underwriter's conflict of interest. Would that prevent the harm? We've already run that experiment. In the recent debacle, offering circulars routinely stated under the heading "conflicts of interest" that CDO underwriters might take either long or short positions. They also precisely identified each portfolio obligation. This did not spare investors the alleged fraud worked by manipulating portfolios to subserve short interests of both underwriters (e.g., in Goldman Sachs's Hudson Mezzanine 2006-1, Anderson Mezzanine Funding 2007-1, and Timberwolf I, and UBS's North Street 2002-4) and counterparties (e.g., in deals by JPMorgan Chase, Merrill Lynch, Deutsche Bank, and other banks at the behest of Magnetar, and ABACUS 2007-AC1 challenged in SEC v. Goldman, Sachs & Co. et al.).

Would more disclosure prevent the harm? Consider that if a prospective investor reads an expose that a portfolio was assembled to serve an underwriter's short interest, or skewed to favor the demands of a short side counterparty, that will kill any interest in the offering. So the underwriter will not write such an expose. If instead the prospect reads a predictably wooden passage relating underwriter freedom to be short or long, and adverting to negotiations that led to the portfolio, what inference may the investor draw?

The market in CDOs is, in respect of information, far from efficient. A sophisticated institutional investor's window of time to consider a pending offering may be small, as the SEC has recently emphasized. Reading a negotiating history probably will not provide enough information reliably to infer effects of indicated bias. The history surely will not reveal any nonpublic information that the underwriter used in portfolio selection--yet the gravamen of a claim against UBS is that just such information was used in portfolio selection to defraud CDO investor HSH Nordbank. Goldman Sachs itself argues that when the short side is participating in portfolio negotiations, disclosure of the back-and-forth communications will not much help prospective investors. Investors, it says, need an assessment of portfolio content.

As to that content, because CDOs are second-level asset-backed securities, CDO underwriters will not know much about the mortgages or like assets lying two levels below. Those assets constitute the ultimate source of payment and risk. The SEC has confirmed that CDO issuers are not expected to provide information about that ground-level collateral, but only about the CDO issuers' own portfolios. As for that, institutions that invested in Magnetar-initiated deals, so ProPublica reports, "simply didn't have the time or the inclination to investigate the contents of every triple-A bond they were shown. Most investors chose not to dig too deeply." As the SEC has noted, busy investors rely on ratings (and thus again on the underwriter-cultivated impression, in this case given to rating agencies, of a valuable portfolio). The rational reader of an offering circular will infer that the described credit expertise has been deployed to select worthy investments for investors, for otherwise, the reader will reason, how could the deal successfully be marketed? Under these circumstances, disclosure of a conflict of interest, joined with more disclosure about the portfolio expanding an already fulsome circular, will likely be insufficient for a reliable inference about what effect the conflict has had on the portfolio.

No transaction party is likely to serve well both short and long interests. Absent constraints, we cannot expect financial institutions presented with powerful and incompatible incentives to act like archangels. We can only assume that they will act as aggressive, creative profit-maximizers. When underwriters think credit defaults likely, they will bet accordingly if the opportunity arises. Underwriters who choose to bet on the short side will then face a choice between deceiving investors and killing a deal. If the fix is in, they doubtless will not risk killing a deal.

Thus mere disclosure will not reliably prevent the harm threatened by the conflict of interest. Appropriate policy therefore will constrain the transaction to prevent the harm.

Observations on Ethics and Economics in Finance

It is a sad state of affairs to hear a commentator refer, even if hyperbolically, to "what the investment banks do every day, which is spin rampant-conflicts-of-interest into megasurefire profits." We are repeatedly reminded that people nowadays arrive in the business world unaccustomed to recognizing ethical concerns in everyday encounters. The societal origins of this may lie in a decline in religious influence on the young. The solution to the problem for adults already in the workforce is not obvious.

A second concern provoked by this latest display of homo oeconomicus run amok is the prejudice, rife among financiers, that all market problems will self-correct. As every first-year student of macroeconomics learns, there exist no perfectly competitive markets. Like the frictionless plane, perfect competition is an idealization. There obtains amongst economists a long-acknowledged verity: government performs the salutary function of counteracting imperfections in actual markets. If that were not already clear from theory, we learned it from the Great Depression.

Republican Congresses and administrations in recent times seemed blind to that history. They appeared oblivious to the dangers of monopoly that motivated Teddy Roosevelt's trust-busting. They insisted on the improvident repeal of the Glass-Steagall Act, a cornerstone of the institutional structure erected in 1932 to assure soundness of the banking system. They were, to paraphrase what Paul Samuelson once said of utilitarians, drunk on market-romanticizing antigovernment moonshine. On an economy that had experienced during the Clinton years a record-setting combination of robust growth, low inflation, and low unemployment, they foisted their two panaceas--tax cuts and "deregulation." The economy now lies in the throes of these excesses.

"Deregulation" across the board subverted the public interest by allowing the regulated to shackle the regulatory agencies. Statutes concerning agencies usually grant them authority, but Congress went so far as veritably to prohibit the SEC from imposing registration or reporting requirements concerning credit default swaps. The SEC's Division of Enforcement, whose day-to-day business is litigation, did little of it. The Antitrust Division of the Department of Justice did not enforce the antitrust laws. As Goldman Sachs alumni administered the TARP program, they did not require banks to covenant that they would lend the money provided to them.

We are paying a heavy price for this latter-day experiment in laissez faire. We are enduring the sort of crisis that our post-Depression institutions were constructed to prevent.

As the Duchess says to Alice, "Everything's got a moral, if only you can find it."

Louis M. Guenin's research interests lie in moral philosophy, metaphysics, and the philosophy of science. He is the author of The Morality of Embryo Use (Cambridge University Press), honored as Choice Outstanding Academic Title for 2009. He has written on the ethics of candor (in 'Intellectual Honesty') and served the federal government as a consultant on ethics. He began his career in the practice of securities law at Cravath, Swaine & Moore.

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