The SEC is trying to shake up Wall Street

A hedge fund client, Paulson & Co, had approached them looking for a way to short the subprime market.

Goldman created one — a synthetic CDO — with input from Paulsen, who helped choose the underlying securities. Goldman then sold the product to institutional investors looking for long exposure to the subprime market without notifying them of Paulson’s involvement.

When the crisis hit, investors lost big and Paulson gained big. Goldman, which had little exposure to the portfolio, lost $90 million itself but made billions shorting subprime assets held by other parts of the company.

Goldman Sachs paid $550 million in a 2010 SEC settlement.

Goldman Sachs paid $550 million in a 2010 SEC settlement.Credit:AP

The SEC claimed at the time that Goldman should have told buyers of the synthetic CDOs about Paulson’s involvement in their design.

Goldman argued – with some justification – that the buyers were allegedly sophisticated investors with access to detailed information about the underlying securities in the portfolio who should have known that, as with any securities transaction, there are parties on the other side doing the opposite views and counterpositions.


Should it have specifically told them about Paulson’s involvement? Perhaps. The SEC certainly thought so, and the settlement was the largest penalty ever imposed on a Wall Street company at the time.

In the storm of Wall Street reform and post-crisis banking regulations and laws, the Dodd-Frank Acts, enacted by the US Congress in 2010, included a proposal to ban participants in asset-backed securitization transactions could participate that could represent a conflict of interest with investors.

While the SEC drafted the new rule, which sparked heated debates with and within the financial sector, it was never enforced.

This week she voted to repeat the trial, saying the proposed rule would prohibit securitization participants from engaging in “certain transactions” that could incentivize a participant to structure an asset-backed security in a way that puts its interests above those of the investors would be provided.

There would be some exceptions for risk mitigation hedging activities, fair market making and liquidity provision.

The current chaotic state of Wall Street brings back uncomfortable memories of the 2008 financial crisis.

The current chaotic state of Wall Street brings back uncomfortable memories of the 2008 financial crisis.Credit:AP

In a fact sheet issued Wednesday with the proposed rule, the SEC referred to short selling of asset-backed securities and the purchase of credit default swaps or other derivatives that could allow the participant in the securitization to receive payments in the event of specific credit events as prohibited transactions.

The bans would apply to anyone involved in sponsoring an asset-backed security and would remain in effect for a year after the product is sold to investors.

It is more than questionable whether the SEC proposal is unnecessary. The Goldman transaction, which has been seen as an example of why such a rule should be introduced, involved transactions between experienced and consenting institutional investors who had opposing views about a market’s future.

The buyers were doing their own due diligence and should have known, and likely knew, that they were making a risky bet on the direction of the market.


They should also have known that the type of synthetic product they were buying meant there were parties on the other side of their transactions taking symmetric risk in the opposite direction.

Goldman could, of course, have disclosed Paulson’s involvement in designing the product and selecting the underlying securities, which might have made buyers more suspicious. It was this omission that exposed it to SEC action.

Goldman had created a legitimate, albeit exotic, product in response to a client request, and then marketed the product to other professional investors, not retail investors who would need greater protection.

This is what financial intermediaries do and, in a broader sense, in almost all securities transactions.

Perhaps if Goldman had taken a short position on the product itself without informing investors and/or had designed a product deliberately designed to fail regardless of the circumstances, its actions might be viewed differently.

It should not be for regulators to try to protect institutions or other sophisticated investors from the consequences of their own failings.

Transactions involving institutional participants, who should be able to analyze the risks associated with an investment proposal promoted by a financial sponsor, should present a high barrier to regulatory intervention, whatever the outcome.

It should not be for regulators to try to protect institutions or other sophisticated investors from the consequences of their own failings.


The concept of the waiver of reservations, in short the buyer-beware-principle, is of central importance for the functioning, the efficiency and the innovative power of any market – especially when it comes to demanding participants. Requiring disclosure of actual or potential conflicts would be a better approach when regulatory intervention is actually required than bans.

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Brian Lowry

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