Conflicts of Interest and Securitizations

The Big Short highlighted some of the difficulties of taking an investment position in a real estate downturn. The situation was taken a step further with Goldman Sachs’ help in putting together mortgage backed securities with the primary purpose of helping a client take an investment position that the securities will default. It turned out very well for Goldman’s client and terrible for the purchasers of the securities.

Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security from engaging in a transaction that would involve or result in certain material conflicts of interest. It then leaves it up to the Securities and Exchange Commission to issue rules for the purpose of implementing this new prohibition.

The SEC published a proposed rule at its Open Meeting on Sept. 19, 2011: Prohibition against Conflicts of Interest in Certain Securitization (.pdf).

The proposed rule could — if certain conditions are otherwise met — prohibit a firm from packaging Asset Backed Securities, selling them to an investor, and subsequently shorting the Asset Backed Securities to potentially profit at the same time as the investor would incur losses.