by Adam Tempkin
NEW YORK, Sept 26 (IFR) - A rule proposed by the SEC last week to prohibit the conflict of interest between deal arrangers and investors such as the one in Goldman Sachs' infamous Abacus CDO raises more questions than answers about what securitization arrangements will ultimately be permissible under the law, market participants say.
"The SEC has acknowledged that this is a grey area," said a managing director in the structured finance department of a rating agency, who requested anonymity since the SEC is involved.
"Distinguishing between the most egregious abuses of 'conflicts of interest', which is what the SEC is going after, and what is considered 'normal' risk-mitigating activities in the securitization markets, is an extremely difficult task."
The SEC nearly admits as much.
For most of the 118-page proposed rule now out for 90-day comment, the regulator asks for guidance from the market via detailed and open-ended questions.
"Are certain types of ABS more susceptible to conflicts of interest?" the SEC queries market participants.
"What are the key features of the securitization process that bear on the existence or significance of conflicts of interest between participants in that process and investors in the ABS?"
The SEC voted unanimously last Monday to propose a rule intended to prohibit certain "material conflicts of interest" between those who package and sell ABS and those who invest in them.
It is designed to ensure that those who create and sell ABS cannot profit by betting against those same securities at the expense of those who buy them.
One problem: The SEC refuses to define a "material conflict of interest".
"We preliminarily believe that any attempt to precisely define this term in the text of the proposed rule might be both over- and under-inclusive in terms of identifying those types of material conflicts of interest arising as a result of or in connection with a securitization transaction .. especially given the complex and evolving nature of the securitization markets, the range of participants involved, and the various activities performed by those participants," the SEC writes.
The conflict-of-interest proposal, therefore, is clearly just a starting point for the SEC, securitization specialists say. The agency is expecting a hearty response from industry lawyers.
The regulator also carved out exceptions to the rule, such as if parties to a transaction participate in risk-mitigating hedging activities, liquidity commitments, or "bona-fide market-making".
The new rule could prohibit a firm from allowing a third party to help assemble an ABS in a way that creates an opportunity for the third party to profit from its failure.
Although the SEC never mentions the Abacus CDO by name in the 118 pages, this aspect of the rule seems like a clear attempt to ban Abacus-like trades.
Goldman Sachs agreed to pay $550 million in July 2010 to settle civil fraud charges relating to its marketing of the Abacus 2007-AC1 CDO. Although the bank did not admit or deny any wrongdoing, it did acknowledge that it was a mistake for the marketing materials not to disclose the role of hedge fund Paulson & Co. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors.
Paulson was not charged at all.
"The SEC rule is reasonably well crafted to reduce this type of conflict of interest," said Darrell Duffie, a professor at Stanford University graduate school of business.
"By ruling out these types of conflicts of interest, however, it is also ruling out what some investors may want to do with bona-fide reasons, completely open-eyed. It's not a cost-free improvement in the law, and it may reduce the liquidity of the securitization market. The SEC itself mentions this tradeoff."
Indeed, the regulator acknowledges that there are a number of conflicts of interest inherent in, and possibly essential to, the securitization process. It refers to one commenter who listed more than 20 categories of potential conflicts of interest that may be inherent in the ordinary course of securitization but, in the commenter's view, should not be prohibited by the SEC.
Examples include the basic risk transfer that occurs in structuring a securitization; the tranching of debt; risk retention; and providing financing through a warehouse line of credit.
MORE CLARITY NEEDED
Some say the SEC may be walking a fine line as it attempts to differentiate between transactions that have a clear conflict of interest and were designed to fail, and others that represent the desire of a fully knowledgeable party to take a point of view on a trade.
"Generically, our concern is that a general definition of 'material conflict of interest' may be hard to apply to specific areas of the market," said Tom Deutsch, the executive director of the American Securitization Forum.
"There are many potential conflicts in individual situations that we don't think should be prohibited under these rules without additional clarity.
"The devil is in the details."
One pressing concern is that a broad interpretation of "material conflicts of interest" could prohibit mortgage servicers from pursuing customary servicing activities, including loss mitigation efforts such as loan modifications under the Home Affordable Modification Program (HAMP), he said.
If a loan servicer holds a subordinate tranche of a securitization, for example, this can be construed as an inherent conflict of interest.
In a statement released on Friday, Fitch Ratings said that it is concerned for the potential for confusion among market participants between true conflicts and certain normal hedging or risk management practices.
"The securitization market's recovery remains fragile," said Ian Linnell, group managing director of Fitch's structured finance group. "There remains the risk that multiple layers of regulation may become burdensome for certain market participants."
Moreover, Stanford University's Duffie suggested that this rule, by itself, may ironically not apply to Goldman's specific role in the Abacus CDO, since the bank was actually on the long side of the trade, and did ultimately take some losses.
Every example cited by the SEC in its proposal references situations where a party shorts a transaction. Paulson & Co rted the Abacus CDO, yet was not sued by the SEC; Goldman was not directly involved in the short side of the deal -- unless one makes the argument that it received a fee associated with Paulson's participation.
Some market participants will likely also demand more concrete examples of what it means to be a "liquidity provider" or "market maker" in a transaction -- two statuses that exempt deal participants from the rule.
As a theoretical example, had Goldman Sachs merely taken a position on a trade in order to allow the deal to go ahead and meet the needs of a client -- in a liquidity provider role, for instance -- the bank may actually be protected under this new rule, Professor Duffie said.
"The rule might actually serve to protect intermediaries in situations where it can be shown that they are just providing liquidity services," he noted.
(Reporting by IFR senior analyst Adam Tempkin)