20th September 2011
The move will prevent them from selling products – usually sophisticated packages of securitised assets such as mortgages or credit card loan books – to investors on the one hand and then making money when those assets fail to perform.
According to the Financial Times the rule stems from the "Abacus" deal.
This involved Goldman Sachs selling sub-prime mortgage backed securities to investors in 2007. The bank told investors this would be profitable. But the bank also did a deal with hedge fund Paulson which wanted to "short" the mortgage market. Paulson was a favoured client and source of fees.
The bank and the hedge fund together removed higher quality assets from the mix to leave the portfolio vulnerable to the extent of $1bn when sub-prime assets fell to earth.
The deal was similar to a doctor prescribing incomplete cures to patients and then betting on their deaths with life insurance plans.
What happened then?
When the both sides of the fence deal were revealed last year, Goldman Sachs agreed to settle the case, paying $550m to the US regulator. It conceded that the marketing materials issued to Abacus investors were "incomplete" and did not give a true picture of the product – the Paulson deal was not mentioned. Investors saw 99% of the $1bn they put into the product evaporate – Royal Bank of Scotland was a big loser. Goldman Sachs blamed employee Fabrice Tourre. This "rogue trader" still faces charges.
Why is this important?
It will rein in complex deals where investors are promised gains by an issuer who is also involved in producing gains for other investors who are betting against (shorting) the product. This should help restore confidence in such transactions as it should remove a conflict of interest.
What will happen now?
There will be new rules to prevent investment banks and others from profiting from losses on products they create. These should come into force after a 90 day consultation period. The new control is part of the Dodd-Frank probe into financial regulation. However, the protection for investors will only last for a year after the issue. It may also be difficult to distinguish legitimate hedging from the practices the new rule seeks to prohibit.
Sign up for our free email newsletter here, for your chance to win an iPad 2.