Conflicts of Interest Rule for Asset-Backed Securities
May 20, 2016
Conflicts of Interest Rule for Asset-Backed Securities
The conflict of interest rule for asset-backed securities
the average price for the pool. Guarantees and other private
(ABS) refers to Section 621 of the Dodd-Frank Act (P.L.
contract provisions try to address these “lemons” problems.
111-203). The policy goal is to prevent people who help
construct or underwrite ABS from having interests in
Dodd-Frank Section 621 and SEC Proposed Rules
opposition to the purchasers of the securities. Although the
During 2007-2008, there were many complaints about
Securities and Exchange Commission (SEC) issued a
potential conflicts of interest in the securitization chain for
proposed rule on September 9, 2011, a final rule has yet to
mortgages. Ratings agencies were accused of giving
be issued. Difficulties in defining statutorily required
favorable ratings in return for repeat business. Thinly
exemptions for hedges and traditional underwriting
capitalized intermediaries were accused of “taking the
activities may be contributing to the delay. This In Focus
money now” with a plan to declare bankruptcy “when the
describes incentive problems inherent in ABS, summarizes
music stopped.” These and other accusations were used to
how Section 621 addresses incentives issues, and analyzes
describe a purported “pass the trash” business model for
some of the policy trade-offs that must be decided in the
ABS, including mortgages.
final rule.
Although some of these accusations seem to ignore many of
Background
the longstanding contractual safeguards used among
ABS are financial instruments that represent a stream of
intermediaries (other assets have asymmetric information
revenues flowing from a pool of collateral, typically loans.
problems), several high profile failed transactions
For example, 1,000 auto loans can be pooled in a trust, with
demonstrate that traditional safeguards did not always
the revenues being distributed to 20 securities. This
dissuade behavior that appears like conflicts of interest.
structure can be used to diversify investor portfolios
equally; that is, each security buyer may face greater risk of
In April 2010, the SEC alleged that the investment bank,
a “bad bunch” of auto loans by individually buying 50
Goldman Sachs (Goldman), had been derelict in failing to
rather than buying 1/20th share of 1,000 loans. Or, this
provide investors vital information about the significant
structure can be used to customize the risk/return profile in
role that a hedge fund client had played in a synthetic
each category of security; that is, if some securities bear
collateralized debt obligation (CDO) composed of subprime
first loss and others last loss, then the first set will be higher
residential mortgage-backed securities, ABACUS 2007-
risk and higher return, but the second set will be lower risk
AC.1 (ABACUS), which Goldman structured and then
and lower return. Many other securities structures can be
marketed.
arranged.
According to the SEC allegation against Goldman, in 2007,
Economists have analyzed several common information
the hedge fund Paulson and Company (Paulson), a
issues related to securities, including ABS. Underwriters
Goldman client, approached the bank, asking it to help buy
and other financiers often get paid as a percentage of the
protection against what it predicted would be a fall in the
deal, which, while maximizing the value of financial
value of residential mortgage-backed securities. Later,
services, may also encourage investment bankers to
Paulson and Goldman allegedly discussed potential
exaggerate the quality of the securities. Anticipating these
transactions in which other investors would be the
incentives to exaggerate (or hide defects), securities laws
counterparties for the hedge fund’s short trades. That
require an affirmative disclosure of material risks and
Goldman vehicle CDO became ABACUS, which the SEC
market contracts include certain representations and
alleged Paulson shorted and played a “significant role” in
warranties on the part of various participants.
the selection of its underlying securities, while failing to
disclose those activities to investors.
Another potential information problem from an economics
perspective is adverse selection. In markets in which prices
In July 2010, before the enactment of the Dodd-Frank Act,
must be based on pools or averages, adverse selection can
a settlement was announced between Goldman and the
occur when people know where their interests lie in relation
SEC. Goldman did not admit wrongdoing, but agreed to
to the average. For example, if an auto dealer self-finances
pay the then record settlement amount of $550 million, and
some of its customers and sells some of its other auto loans,
acknowledging that it should have disclosed Paulson’s role
the auto dealer has an incentive to keep the loans that look
in the selection of the ABACUS portfolio.
like they are most likely to repay and sell the loans that look
least likely to repay. But this strategy only works if the
The Dodd-Frank Act included requirements for ABS
people buying the auto dealer’s loans do not anticipate this
sponsors to retain some of the risk (Section 941), and
behavior. Otherwise, prices adjust accordingly. Left
included provisions intended to minimize conflicts of
unaddressed, economists generally believe that potential
interest (Section 621) among sponsors and other ABS
buyers will penalize such sellers by not be willing to pay
participants even if not sponsors.
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link to page 2
Conflicts of Interest Rule for Asset-Backed Securities
Section 621 prohibits ABS sponsors, underwriters,
activities. For example, in its view, there are permissible
placement agents, initial purchasers, or any affiliates from
ways to finance another securitization participant, service
engaging in a transaction that would involve a material
and manage collateral assets, exercise remedies in the case
conflict of interest with any investor in the ABS for one
of loan default, receive payments for additional
year. Establishing a conflict of interest requires both:
securitization services, and retain rights in specific tranches
of securities (credit enhancement).
(1) A securitization participant would benefit directly
or indirectly from the actual, anticipated or potential
Other Issues and Trends
adverse performance of the underlying pool of assets;
Some legal issues are beyond the scope of this In Focus.
or loss of principal, monetary default or early
The term ABS is defined slightly differently in different
amortization event on the ABS; or decline in the
places in the law. Of the covered entities (underwriters,
market value of the relevant ABS; and
placement agents, initial purchasers, and sponsors), only
underwriter had a definition in the securities act prior to
(2) There is a substantial likelihood that a reasonable
Dodd-Frank. The SEC would also like to include collateral
investor would consider the conflict important to his or
managers among the covered participants.
her investment decision.
Although Section 621 applies to residential mortgages as
The statute exempts risk mitigating hedges arising out of
well, Figure 1 shows the trend in ABS issuance during
underwriting, placement, initial purchase, and sponsorship
1998-2015. Unsurprisingly, annual ABS issuance grew
of securitization. The statute directs the SEC to finalize the
during the securitization boom of the early 2000s, fell
rule within 270 days of enactment (July, 21 2010), but the
steeply during the priod of financial crisis and recession of
rule has still not been finalized.
2008-2009, and has since generally recovered. However,
the 2015 annual issuance was still close to 30%t below peak
Policy Trade-Offs in Constructing Exemptions
ABS issuance in 2007.
Section 621 requires that the SEC’s final rule include
exemptions for certain hedges that are part of the
Figure 1. U.S. ABS Issuance, 1998-2015
underwriting, placement, initial purchase, and sponsorship
Millions of U.S. Dollars
process of bringing ABS to market. To the extent that some
of the traditional contract arrangements in securitization
may look like bets against the interest of investors, but may
instead be risk mitigating actions that facilitate the
securities offering, the SEC faces a trade-off between
attempting to reduce apparent conflicts of interest and
unintentionally reducing the efficiency of capital markets.
Finding ways to provide the equivalent of insurance for the
securities deal may appear like a conflict of interest. For
example, a person who buys car insurance is betting against
himself or herself in the sense that the insurance policy pays
off when the person has an accident. Similarly, in some
parts of the underwriting and placement process, investment
Source: SIFMA
bankers may provide the issuing firm certain guarantees.
Note: Some of the largest asset classes include autos, credit cards,
Traditionally, investment banks have not only been able to
equipment, and student loans.
protect themselves in relation to such guarantees, but have
been encouraged to do so. However, a risk mitigating hedge
Further Readings
against the possibility of exercising the guarantee may be
CRS Report R41381, The Dodd-Frank Wall Street Reform
akin to a bet against the securities, basically similar to an
and Consumer Protection Act: Standards of Conduct of
insurance policy. Section 621 specifically exempts this type
Brokers, Dealers, and Investment Advisers, by Michael V.
of risk mitigating activity.
Seitzinger
Although insurance was merely an example to illustrate
CRS Report R43345, Shadow Banking: Background and
how a risk-mitigating hedge can appear like a conflict of
Policy Issues, by Edward V. Murphy
interest, commenters on the proposed rule listed a number
of other activities that they were concerned could be
CRS In Focus IF10032, Introduction to Financial Services:
diminished or eliminated by a broad definition of conflict of
The Securities and Exchange Commission (SEC), by Gary
interest. Some of the general activities that often support
Shorter
securitization include providing credit enhancement,
liquidity facilities, warehouse lending, and the exercise of
control rights.
Gary Shorter, Specialist in Financial Economics
IF10410
The SEC proposed rule included an explanation that it
believes that its exemptions can accommodate traditional
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Conflicts of Interest Rule for Asset-Backed Securities
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https://crsreports.congress.gov | IF10410 · VERSION 3 · NEW