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QuantumRisk looks at downside risk & lessons we can learn from industry failures. We don’t provide rosy scenarios of the future, that is better left to others. We neither negate nor advocate any persons, entities, products, services or political positions. Neither are we attorneys. Nor do we profess legal opinions on any subject.
 
However, as much as is reasonably possible we present opinions, information and facts that can be tested and verified by & for the benefit of our readers. In so doing, we explore downside risk, their consequences and how we could avoid these future scenarios. Sometimes, the conclusions arrived at may not be desirable but many times if we don’t look an undesirable outcome straight in the eye we usually cannot find a more amenable solution. 
 
An ideal outcome would be the rethinking of private & public policies that lead to a more secure future for all of us.

Goldman Sachs Senate Hearings
I had originally planned to write Part 2 of Loss Containment but realized that the Goldman Sachs Senate Hearings was more pertinent in this time frame. I will get back to Loss Containment next month, if something more pertinent does not surface.

On April 27 2010 the Senate Subcommittee on Investigations held a hearing in which current & former Goldman Sachs employees (including the CEO & CFO) testified. In all fainess we need recognize that many parties by ommission or commission share the blame for this financial crisis. I watched about 7 hours of the hearings, and have several observations:

1. More Main Street
Senator Carl LevinThe goals of these hearings (Goldman Sachs hearing was one of several) are threefold:
1. To construct a public record of the facts to deepen public understanding of what happened and to try to hold some of the perpetrators accountable.
2. To inform the current legislative debate about the need for financial reform; and
3. To provide a foundation for building better defenses to protect Main Street from the excesses of Wall Street.

Sen. Levin had repeatedly brought up the need to protect Main St. and therefore I infer that future regulation will be supportive of Main St. – Wall St. engagements and discourage Wall St. – Wall St. engagements. In this light, we recognize why Glass-Steagall worked at the operational level. It ensured that a substantial portion of the financial services industry was focused on the needs of Main St, and by use of barriers protected these segments of the industry from the influences of its more glamorous kin.

2. Discourage Non-Collateral Based Instruments
Senator Claire McCaskill“It’s gambling, pure and simple raw gambling” said Sen. Claire McCaskill.  This sentiment was echoed by Sen. Carl Levin and was repeated many times by the senators, suggesting that future financial regulation would some day discourage if not curb the development and use of financial instruments that are not directly identifiable with a real physical asset. That futures-like products are acceptable but synthetic-like products are not. This is going to be tricky to do but I infer that this will be the direction of future legislation.

With respect to Mortgage Backed Securities there are two possible requirements to ensure compliance with a possible collateral-based security requirement. First, that an analyst is able to follow the cash flow from the assset to the security, and show how a specific asset default, defeasance, or prepayment would affect the cash flow to a specific security. Second that the master or even the special servicer is able to do the same.

The first requirement is usually a given for straight forward/non-exotic deals, but the second is a problem even for some ‘basic’ deals as some of the data is missing. The MLCFC 2007 9 WF or GSMS 2007 EOP WF deals are good examples where the servicer has difficulty in providing some of the data. The slicing & dicing of some of the properties in these deals has no effect on the risk characteristics of the deals but has resulted in a breakdown in the servicers’ ability to provide current information right down to the property level.

3. Strengthening of Fiduciary Responsibilities
Sen Levin and his colleagues had repeatedly asked questions relating to clients’ interests versus company’s interests. Their focus suggest that future legislation will prevent a bluring of roles with respect to client versus company interests. Therefore we should expect a compartmentalization of financial services to protect the integrity of fiduciary responsibilities

Goldman Sachs Employees Testify (Fox News/AP Photo)

4. Individual Responsibility
Seven current and former Goldman Sachs employees including Chief Executive Officer Lloyd Blankfein testified at the Senate Hearings. First a disclaimer. My comments are based on my inferences as a management consultant working with teams and not as an attorney.

The fact that the Subcommittee required both current and former employees to testify before it suggests that individual employees cannot hide behind company policy or lack of, to defend themsleves against allegations of wrong doing. Further, everybody is doing it will no longer suffice as an acceptable defense or immunity for one’s actions.

Conclusion
History shows that financial regulation (Securities Act of 1933, Securities Exchange Act of 1934, Trust Indenture Act of 1939, Investment Company Act of 1940, Investment Advisers Act of 1940) spawned after the crash of 1929 took 11 years to formulate and implement. Similarly we can expect to see several more new or strenghtened regulations being formulated and implemented over the next 10 years. 
 
Future regulation will further compartmentalize both financial services (e.g. retail banking, investment banking, trading and public-type versus private-type fund management) and financial products (e.g. basic, middle and exotic products).   
 
There will be stronger, clearer guidelines as to how products can be structured. For example (and this is only a suggestion) basic products can be used to structure deals where AAA accounts for up to 90% of the deal. Exoctic products cannot have more than 25% AAA, and middle products cannot have more that 60% AAA

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk
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