SEC probe of bank mortgage sales is much ado about nothing

AgnosticPreachersKid (CC-SA-3.0)

Article Highlights

  • Why is the SEC spending taxpayer resources to try to "protect" professional institutional investors?

    Tweet This

  • This looks suspiciously like an SEC attempt to redeem its public reputation by capitalizing on a target that currently garners little public sympathy

    Tweet This

  • The SEC investigation is not about protecting widows and orphans-- unless the widows and orphans invest in hedge funds.

    Tweet This

Recent press coverage reports that federal authorities are conducting yet another investigation into the sales practices of large financial institutions following the financial crisis. This time, the Securities and Exchange Commission reportedly is investigating whether large institutions, including Barclays, Citigroup, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Morgan Stanley, Royal Bank of Scotland, or UBS misrepresented the "going market price" of mortgage-backed securities they sold following the financial crisis.

While some will applaud the SEC for finally taking some enforcement action, others may read this story and have a different and more puzzled reaction. What exactly is the alleged infraction? Why didn't the bond buyers do their homework? How would anyone think that subprime mortgage-backed securities have a transparent "market" price?
 
First and foremost, it is difficult to understand the alleged crime. Let's hope there is something deeper to this story than the claim that banks "overcharged" when they sold mortgage-backed securities. This market is, after all, made up of "informed" professional investors.

It is not surprising that some securities turned out to be worth less than the buyers paid for them as surely as some turned out to be more valuable. It is also natural that losers will complain and try to assign blame while winning trades will be silent. What is puzzling is why the SEC should be investigating whether the loss side was bilked. By all reports, these securities were "used" already issued securities, and the trades in question occurred well after the subprime crash during a period when these markets were especially illiquid.

Mortgage-backed securities are opaque securities. They do not have prices stamped on them like so many identical cartons of milk in the grocery store. Mortgage-backed security prices are estimated using sophisticated models that predict cash flows that are driven by mortgage defaults, prepayments, and following the crisis, loan modifications. Every model gives a different mortgage-backed security price. During this period, mortgage-backed securities cash flow forecasting was not only complicated by the unprecedented decline in housing prices, but also by reduced consumer access to mortgage credit, highly uncertain future government housing finance policy, and new sources of interest rate uncertainty introduced by experimental Federal Reserve policies. The uncertainty bounds surrounding what might constitute "a reasonable price" for high-risk mortgage-backed securities was unusually large following the crisis. The price an investor was willing to pay for a mortgage-backed security depended in large part on the confidence the investor had in their own model estimates.

Within this context it is important to remember that a good salesperson is one that earns the highest possible profit on his wares. A good purchasing agent negotiates the lowest possible price. This is not news for most people and it is well understood by institutional investors. Indeed these principles are on display daily around the world in all sorts of markets where prices are negotiated. Ever negotiate with a car salesman or real estate agent? What happened to Caveat Emptor?

So why is the SEC spending taxpayer resources to try to "protect" professional institutional investors who made the mistake of falling for standard salesperson ruses normal people encounter every day. It is unsettling that the SEC should be using its scarce enforcement resources to protect sophisticated institutional investors from other sophisticated institutional investors; both of which have their own large legal staffs. This not about protecting widows and orphans-- unless the widows and orphans invest in hedge funds. Based on press reports, a reasonable person might wonder why the SEC is not investigating the competency of the buy-side of these trades as these professional investors seem to have come up short on the exercise of their due diligence duty.

Without further access to the legal facts behind this case, current newspaper accounts alone make it difficult to understand why the SEC should waste resources on this investigation. It looks suspiciously like an SEC attempt to redeem its public reputation as a lax regulator by capitalizing on a target that currently garners little public sympathy.

Paul Kupiec is a resident scholar at the American Enterprise Institute where he studies banking and financial sector regulation. 

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Paul H.
Kupiec
  • Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets. He also follows the work of financial regulators such as the Federal Reserve and examines the impact of financial regulations on the US economy.

    Before joining AEI, Kupiec was an associate director of the Division of Insurance and Research within the Center for Financial Research at the Federal Deposit Insurance Corporation (FDIC), where he oversaw research on bank risk measurement and the development of regulatory policies such as Basel III. Kupiec was also director of the Center for Financial Research at the FDIC and chairman of the Research Task Force of the Basel Committee on Banking Supervision. He has previously worked at the International Monetary Fund (IMF), Freddie Mac, J.P. Morgan, and for the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.

    Kupiec has edited many professional journals, including the Journal of Financial Services Research, Journal of Risk, and Journal of Investment Management.

    He has a bachelor of science degree in economics from George Washington University and a doctorate in economics — with a specialization in finance, theory, and econometrics — from the University of Pennsylvania.

  • Phone: 202.862.7167
    Email: paul.kupiec@aei.org
  • Assistant Info

    Name: Brian C. Marein
    Phone: 202.862.5890
    Email: brian.marein@aei.org

What's new on AEI

image The money in banking: Comparing salaries of bank and bank regulatory employees
image What Obama should say about China in Japan
image A key to college success: Involved dads
image China takes the fight to space
AEI on Facebook
Events Calendar
  • 21
    MON
  • 22
    TUE
  • 23
    WED
  • 24
    THU
  • 25
    FRI
Wednesday, April 23, 2014 | 12:00 p.m. – 1:30 p.m.
Graduation day: How dads’ involvement impacts higher education success

Join a diverse group of panelists — including sociologists, education experts, and students — for a discussion of how public policy and culture can help families lay a firmer foundation for their children’s educational success, and of how the effects of paternal involvement vary by socioeconomic background.

Event Registration is Closed
Thursday, April 24, 2014 | 12:00 p.m. – 1:30 p.m.
Getting it right: A better strategy to defeat al Qaeda

This event will coincide with the release of a new report by AEI’s Mary Habeck, which analyzes why current national security policy is failing to stop the advancement of al Qaeda and its affiliates and what the US can do to develop a successful strategy to defeat this enemy.

Friday, April 25, 2014 | 9:15 a.m. – 1:15 p.m.
Obamacare’s rocky start and uncertain future

During this event, experts with many different views on the ACA will offer their predictions for the future.   

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.