While many have been struggling to cast the SEC v Goldman filing as a fillip to regulatory reform, it is not supportive of ninety percent of the regulatory reform currently before Congress.
Every financial crisis is initially fuelled by investment losses. This crisis is no different. It is important to realize, however, that those losses came from loans to people that could not (and many times still cannot) afford them. As revealed by the Financial Crisis Inquiry Commission, sometimes those loans were made with borrowers’ consent and sometimes they were not. The former is tantamount to borrower fraud and the latter to lender fraud. Both result inexorably in irreversible dollar losses.
After the losses are incurred financial crises are fuelled by information problems: investors want to know which firms experienced losses in what proportions as well as how well sovereign countries can support their own borrowing. Without information, bad things happen, like “contagious” runs and manifestations of “systemic” risk among firms that have lent to one another and are left to speculate as to the sizes one another’s losses and who committed the fraud.
Unfortunately, the focal point of financial reform consists of measures to stem the “systemic” transmission mechanisms that merely propagated the crisis. With the exception of the Bureau of Consumer Financial Protection – which, itself, takes a somewhat tangential approach to the problem – the rest of the proposed legislation ignores the fraud and the losses that caused it in the first place.
Moreover, that ignorance in some cases magnifies the unintended consequences of the legislation. Take, for instance, the ratings agency liability provision. If the proposed financial reform were in place during the Paulson-Goldman deal, the rating agencies would be liable for the fraud and would be more easily pursued than Goldman for resulting damages.
The reason is that the rating agency liability provision in both the Dodd and Frank bills places a lower standard of evidence on rating agency liability than on securities or accounting firm, much less loan originator, liability. If the SEC wants to pursue Goldman, they have to specify what, in particular, Goldman did wrong. If the SEC or others want to pursue the rating agencies under the new provision, they only have to allege the agencies did not “do enough,” without specifying what, in particular, they should have done (as under the Public Securities Litigation Reform Act), instead, only that rating agencies did not perform a “reasonable verification of … factual elements.”
What is a “reasonable verification”? Well, along the way to the liability provision, policymakers have maintained that ratings agencies should perform “due diligence” – that is, re-underwrite – the loans within the mortgage-backed securities they rated. While rating agencies have never performed due diligence, there is an entire industry that routinely carries out those investigations. Why did that industry not reach sound conclusions? Perhaps because of the widespread fraud in the mortgage industry.
Nevertheless, a rating agency under the proposed liability provision would be liable for any misdeed anywhere along the chain of origination or securities underwriting anywhere in the market, a standard of liability shared by no other market participant. Without the ability to adequately price litigation risk, rating agencies would logically exit the rating of new innovative financial instruments. But that is precisely the part of the market where they are most necessary, where information is less understandable, where they can add value to investment decisions. Rating agency liability will not make the financial system work better: it will help shut it down.
The important lesson to learn from last week’s SEC filing, therefore, is that current regulatory reform misses the point. Perhaps, therefore, we should allow the Financial Crisis Inquiry Commission to finish its work identifying the proximate causes of the crisis before jumping to “reform.”