US SEC securitization conflict plan traceable to Goldman Sachs’ 2007 securities shorts

A US Securities and Exchange Commission proposal to prohibit conflicts of interest in securitization transactions can be traced to Goldman Sachs’ sale of subprime mortgage-backed securities while betting against them as the 2007 housing market started to collapse.

The 189-page proposal today cited a Senate investigation that found Goldman “used net short positions to benefit from the downturn in the mortgage market, and designed, marketed and sold [collateralized debt obligations] in ways that created conflicts of interest with the firm’s clients.”

The Senate Permanent Subcommittee on Investigations probe, led by then-senator Carl Levin, said the firm’s net short position produced $3.7 billion in record profits in 2007. In addition, Goldman marketed a CDO to investors while failing to disclose that Paulson hedge fund played a key role in portfolio selection and planned on shorting the security.

“In late 2006 and 2007, Goldman’s securitization business was marked, not just by its hard-sell tactics, but also by multiple conflicts of interest in which Goldman’s financial interests were opposed to those of its clients,” the Senate report said.

In a regulatory enforcement case, Goldman paid what was then a record $550 million in 2010 to settle SEC charges involving the Paulson conflict of interest.

Definitions

In short-selling, a firm seeks to profit for its own account by betting against a security. The firm borrows the security and sells it in the open market, then buys it back later at what it hopes is a lower price.

Securitizations, or asset-backed securities, are bundled loans – such as mortgages – that are sold as a bond or some other security. CDOs are more complicated products backed by a pool of securitizations in an attempt to diversify risk. During the subprime crisis, they sometimes consisted of mortgage-backed securities from multiple mortgage pools, or securities from 100 different securitizations.

Today’s proposal refines a 2011 plan that wasn’t adopted by clarifying the scope of the prohibited conduct, the exceptions, and the participants subject to the proposal, SEC Chair Gary Gensler said.

He cited the findings of the Levin report which said market participants “from time to time may have put their own interests ahead of investors’ interests, and profited at investors’ expense.”

Dodd-Frank Act

The 2010 Dodd-Frank Act responded to the financial crisis, in part, by mandating the SEC prohibit securitization conflicts.

The law provided that securitization participants — underwriters, placement agents, initial purchasers, sponsors, affiliates or subsidiaries — shouldn’t engage in any transaction that would result in conflicts with an investor for a year after the sale of an asset-backed security.

It provided exceptions for some risk-mitigating hedging, liquidity commitments, and bona fide market-making.