Two key lessons from the lengthy details of two mortgage securities-related regulatory settlements seen in the past week boil down to this first, don’t leave anything out and secondly, stick to the facts.
I'm no regulator or attorney, but when I read about, say, SEC allegations that some sell-side entity or entities had structured and marketed a synthetic collateralized debt obligation without informing investors a hedge fund helped select the assets in a mortgage-related CDO portfolio and had a short position in more than half of those assets, my opinion is—if that’s true—you really do have to mention that somewhere to investors before you sell them those instruments.
Of course these things are always easier said than done.
But particularly if a risk is in the seller’s control and directly affects the performance of the security negatively then the seller has to disclose.
Or better yet, not take the action at all, unless they want to burn their bridges.
Realistically sellers and buyers are going to be at cross-purposes at times and should know it.
However, although I know investors should be all skeptical and “buyer beware,” there is a limit—especially now—when there’s so much talk about regaining their trust on the sell side.
Another key to rebuilding some of that trust could be to keep any analysis or opinion fact-based.
Sure, there is a need to market, but there is a line between marketing and deception and to stay on the safe side it is probably a good idea to have a sound basis for any spin.
Speaking of having a basis for opinions, why do I say that?
Well, because I think then you might have less in the way of allegations/findings/charges like some I saw from the Financial Industry Regulatory Authority last week about an MBS-related fund being improperly marketed as “a relatively safe” mortgage investment. Of course this appeared in part to be based on the “fact” that it was “investment grade,” but that is another opinion (the rating agency or agencies) and another story.
Speaking of another story, let’s get back to the question of short positions, CDOs and the securities market’s propensity for recycling and magnifying risks that the first settlement alludes to.
While this is not so much a direct issue in that settlement I think addressing them is going to continue to be a key issue in going forward in line with the “too big to fail” question.
Observations of my own combined with other myriad accounts, notably Michael Lewis’ book, “The Big Short,” confirms that reusing securities has a way of magnifying risks in systemic ways continues to be a key regulatory concern.
Also, there does seem to be a move toward and interest in more knowledge of when an original security is reused in some new way not anticipated in original disclosed risks.
That should trigger a disclosure if it is bound to affect that securities’ performance in a negative way, or perhaps should set limits to such moves if they, in effect, change the composition of the original product sold.
The market may want to investigate whether this could be applied selectively to known risks, too, such as the subsequent second-lien question that remains a prominent issue with investors. But as always, such things are easier said than done and would bear some thinking through.