News Flash for NYT Dealbook: Financial Firms Are Not Always Honest

Steven M. Davidoff had a Dealbook column complaining about a Dodd-Frank regulation that he argues is slowing the supply of capital to finance corporate takeovers. The issue in question is a requirement that the creator of a collaterized loan obligation (CLO) keep a 5 percent stake in the issue. Davidoff argues that many issuers of CLO's are relatively small businesses and don't have the capital to allow them to hold a 5 percent stake.

"So why add a new regulatory burden? It’s unclear what benefit a “skin in the game” rule would provide, given that C.L.O.’s are more akin to commercial loans, for which Dodd-Frank deems risk-retention rules unnecessary."

The answer is that financial firms can make money by misrepresenting the products they sell. Those who are good at misrepresentation can get very rich. While some misrepresentations may be in violation of the law, it is often difficult to prove that misrepresentations were made to sell a product. This makes even civil litigation difficult, criminal prosecution is rare.

Forcing the creators of CLO's to keep a stake is a way to help ensure that they consider the asset they have created to be good. In principle, the sophisticated institutional investors who buy stakes in CLO's should be able to assess their quality themselves, however one lesson from the housing bubble is that they seem to lack this ability.

Cheaters Oppose Regulations Supported by Honest Businesses
written by izzatzo, February 01, 2012 5:51 AM

Exactly. Any economist knows from game theory that businesses support regulations that would have occurred in the same outcomes anyway absent regulation, or conversely are needed to achieve outcomes collectively that cannot be achieved individually.

All businesses cannot benefit from misrepresentation because it would kill the sales in question. Cheaters will exist as long as some businesses are honest but end up getting a black eye from the bad apples who scab on honest businesses to survive.

Since self regulation fails along with market failure in free markets, the only solution is
is voluntary regulation from external socialist coercion without admitting it.

This is achieved by hiring Nanny Lobbyists who specialize in achieving highly suppressive regulations supported and financed by unidentified third parties which allows honest businesses to continue strutting around in public as the Flaming Libertarian Marketeers they really are.

Stupid liberals.

-2

Skinny dipping
written by David, February 01, 2012 5:59 AM

And God forbid that these firms would have to pay a reasonable/minimum tax rate on those proceeds...

Are these guys so thin-skinned they can't keep in a measly 5%? Then they shouldn't be playing ball in the major leagues.

...
written by Kat, February 01, 2012 7:01 AM

And even when misrepresentation is clear cut and there is evidence of such (emails!) the fines are nominal.

Fine!
written by David, February 01, 2012 7:37 AM

As Kat suggests, "spare the rod, spoil the child."

It amazes me that these "conservatives" are anything but.
Izzatzo says it more humorously though.

...
written by skeptonomist, February 01, 2012 8:26 AM

One way to avoid regulatory complexity is just to outlaw "financially innovative" vehicles that are themselves inherently complex. Collateralized obligations usually involve collecting a lot of debts, then arranging them according to maturity and risk and reselling the bundled debt. Evaluating the quality of the resultant bundles is difficult under the best circumstances, and of course the rating agencies made a complete hash of it in the housing bubble. Various parties in the process - not just one - have incentives to make these things look better than they really are. Trying to regulate these obligations with things like the retention requirement is probably futile, since there are multiple points where they can go wrong - and have actually gone wrong in the recent past. When one point of attack is stopped by a regulation, those who game the system can shift to another.

http://www.beezernotes.com
written by beezer, February 01, 2012 10:28 AM

Financial products are based upon assumptions. Competition within this industry favors those who make the rosiest assumptions. They thus force out of the market those who make more conservative assumptions.

The net result is an increase in financial risk. It works as long as 'rosy' rules the roost. Once 'reality' steps in to take over from 'rosy,' the house of cards collapses.

That's pretty much the history of banking in a nutshell.

Seems, madam! nay it is; I know not 'seems.'
written by Ellen1910, February 01, 2012 1:51 PM

Dean -- his eyebrow cocked -- notes that "sophisticated institutional investors" are incapable of judging the quality (riskiness) of complex financial instruments.

Acquiring information is costly -- and wasteful. Best to see what others are doing and do the same -- especially if you're investing other peoples money.

". . . a sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way with his fellows, so that no-one can really blame him." JMK (1931)

Really?
written by James, February 01, 2012 1:51 PM

5% stake to the Street guys is almost nothing but they love to complain on any little inconvenience. The fees from the deal is likely more than 5%.

Moreover, they could also obtain hedging instruments to offset the 5% stake, could they? In fact, they could get significantly larger hedges too.

News Flash for NYT Dealbook: Financial Firms Are Not Always Honest

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