The Securities and Exchange Commission yesterday unveiled proposed rules to ban hedge funds and banks from assembling risky securities, marketing them to investors and then immediately betting against their own creations, reaping profits when they fail. The rule would also ban firms from setting up risky securities for the benefit of an undisclosed third party.
As we detailed last year, exactly those kinds of questionable deals helped fuel the financial crisis and resulted in huge losses for investors.
Goldman Sachs and JPMorgan Chase have already paid millions of dollars—a relatively small sum for both banks—to settle SEC charges that they misled investors. Several other banks, including Citigroup and Mizuho of Japan, are being investigated by the SEC for similar deals.
“It was as if a car dealer sold a car with bad brakes, then bought insurance that paid off when the car crashed,” Sen. Carl Levin, chairman of a Senate committee that investigated such deals, said in a statement yesterday.
The SEC’s new rule is designed to target two potential conflicts of interest:
For instance, a firm might package an asset-backed security, sell that security to an investor and then short the security to potentially profit as the investor incurs a loss.
Or a firm might allow a third party to help assemble an asset-backed security in a way that creates an opportunity for the third party to short the security and reap a profit.
The rule would ban any party who participates in the creation of a security from betting against the security. The ban would remain in effect for one year and would also apply to the affiliates or subsidiaries of the participants.
As we reported last year, the hedge fund Magnetar often pushed for riskier assets to be included in deals and placed bets against many of the same investments. Its deals helped create more than $40 billion in the securities known as collateralized debt obligations, or CDOs, and pumped more hot air into the housing bubble. When the housing market finally collapsed, nearly all of those securities became worthless, but Magnetar’s bets against them reaped handsome profits.
Magnetar was involved in the Merrill Lynch and Mizuho deals that the SEC is now investigating, as well as the deal that cost JPMorgan Chase $154 million in a settlement with the SEC. (Magnetar has always maintained that it did not have a strategy to bet against the housing market. The hedge fund has not been accused of wrongdoing as part of the SEC probes.)
Anticipating criticism, including from one of its own commissioners, that its new rules could stifle the free flow of capital, the SEC noted in a press release that the rule “is not intended to prohibit traditional securitization practices.” SEC Chairman Mary Shapiro said the rule “would provide exceptions for risk-mitigating hedging activities, as well as activity consistent with liquidity commitments and bona fide market-making.”
The rule was created to fulfill the demands of the Dodd-Frank Reform Act and will be finalized after a 90-day period for public comment.