Senators Target Wall Street, With Goldman Sachs In Mind

UPDATE : May 10, 2010 -- Senators Carl Levin (D-Mich.) and Jeff Merkley (D-Ore.) will offer their bill to restrict the trading activities of big banks as an amendment to Wall Street reform, the pair announced on Monday. The measure is the next opportunity -- following the beating given to the Brown-Kaufman amendment Thursday by Wall Street and its allies in the Senate; it would have capped the size of megabanks -- to reduce the risks that major banks take by restricting activity that isn't related to commercial banking.

The activity in question -- known as "prop trading" -- is extremely lucrative for major banks, though the risk for failure rests with taxpayers, an enviable position for any trader.

The pair released a summary of the amendment, along with the legislative language.

-- Ryan Grim

* * * * *

A quintet of Democratic senators introduced legislation Wednesday to specifically prohibit investment maneuvers that have been likened to "selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars".

Senators Jeff Merkley (Ore.), Carl Levin (Mich.), Sherrod Brown (Ohio), Ted Kaufman (Del.) and Jeanne Shaheen (N.H.) are pushing the Obama administration's proposal to rein in banks' Wall Street-like practices, such as trading securities for their own profit, while they enjoy the protections afforded by U.S. taxpayers through deposit insurance and access to cheap funds courtesy of short-term loans from the Federal Reserve. Their legislation also attempts to sever the ties between banks and largely unregulated hedge funds and private equity funds -- firms that invest and bet for the benefit of their investors.

Those two proposals try to resurrect the wall between Main Street banking and Wall Street trading, a Depression-era reform that was torn down during the Clinton administration. After excessive risk-taking by Wall Street culminated in the worst economic crisis since the Great Depression, necessitating hundreds of billions of dollars in a taxpayer-funded bailout, top economists and Wall Street veterans have come out in favor of at least partially restoring that divide.

But it's the last two pages of the 11-page bill that gets to the heart of what's been referred to as the most egregious of Wall Street practices -- packaging and selling securities, like those backing home mortgages, to investors worldwide, and then taking contrary positions against them in case they default. Or as Financial Crisis Inquiry Commission Chairman Phil Angelides put it to Goldman Sachs chief executive Lloyd Blankfein during a public hearing in January:

"Your firm sold a significant amount of subprime mortgage-related securities. And it appears, at least according to public documents and other reports, that you may have simultaneously betted against the securities you sold to clients. According to the reports, you sold about $40 billion in 2006, 2007. In December 2006, I think, you came to the conclusion the mortgage market was heading south and you began to reduce your own positions.

And many of the securities that you sold to institutional investors, other folks went bad within months of issuance. Now, one expert in structured financing said, 'The simultaneous selling of securities to customers and shorting them because they believe they are going to default is the most cynical use of credit information that I've seen.'

Do you believe that was a proper legal, ethical practice? And would the firm continue to do that practice? Or do you believe that's the kind of practice that undermines confidence in the marketplace?"

After Blankfein explained that Goldman sells these positions to investors who want them, and then takes contrary positions to protect itself against that risk, Angelides distilled it to its most elemental form:

"It sounds to me a little bit like selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars."

In an interview, a Senate aide said that's exactly what the proposed legislation attempts to end.

The aide, who spoke on the condition of anonymity because he wasn't authorized to comment publicly, said that's what the senators had in mind when the legislation was drafted.

According to the text of the bill, firms involved in bringing an asset-backed security to market -- like those backing home mortgages -- shall not, at any point while the security is held by investors, take any position that would create a "material conflict of interest" or "undermine the value, risk, or performance of the asset-backed security."

The bill "would address fundamental conflicts of interest associated with the sale of packages of securities made up of loans," according to a summary provided by the senators' offices. "Some financial firms put together and sold securities to their clients and then bet heavily against them. As some have noted, this is like building a car with no brakes, and then taking out life insurance on the purchasers. The [bill] would establish strong conflicts of interest protections to protect clients from these unfair and deceptive practices."

In short, firms that sell interests in these securities to investors can't go out into the market and make bets that they'd fail. Or as Angelides told Blankfein:

"And let me just tell you, as someone who's been in business for half my career, the notion that I would make a transaction with you and then the person with whom I made that transaction would then bet that that transaction would blow up is inimical to me."

READ the bill below: