How ‘fabulous Fab’ and 2008 still haunt markets

Mention “fabulous Fab” in markets circles these days, and you’ll show your age. Probably only those on the far side of their mid-30s recall the Goldman Sachs banker whose jokey email came to epitomise Wall Street’s poor behaviour in the run-up to the 2008 financial crisis.

Fab is back — or rather, the regulations inspired by his deal are. Twelve years since it last tried to ban the conflicts of interest that made Fab a poster child for pre-crisis banker attitudes, the US Securities and Exchange Commission is quietly having another go. The interval has not made its task any easier, nor have the complexities of financial rulemaking and the potential for unintended consequences — a point worth bearing in mind as policymakers probe the recent banking turmoil.

To start at the beginning. Fabrice Tourre was a Goldman banker tasked in early 2007 with constructing a synthetic collateralised debt obligation — a vehicle holding derivatives that enabled investors to make leveraged bets on the loans those derivatives were tied to.

What Goldman didn’t tell buyers of that CDO was that hedge fund manager John Paulson had helped select the subprime mortgages that it was based on. Nor did it tell them that he was betting against those loans.

The SEC’s filing of civil charges in 2010 against the bank and the banker cited an email from Tourre to a friend at that time in which he said, “the whole building is about to collapse anytime now . . . Only potential survivor, the fabulous Fab[rice Tourre] . . . standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities [sic]!!!”

Goldman Sachs paid $550mn to settle with the SEC in July 2010 without admitting or denying the charges in what was then the biggest fine ever paid by Wall Street. Tourre fought his case, but in August 2013 a jury found him liable and he was ordered to pay $825,000.

It’s worth noting that Goldman wasn’t alone. Almost a year after its landmark settlement, JPMorgan paid the SEC $154mn to settle accusations it had misled investors in a 2007 CDO deal in which a hedge fund had also helped select the underlying assets.

Fast forward, and the SEC is again working on rules to ban deals such as Goldman’s infamous transaction. The watchdog hasn’t said why it has taken so long to return to the issue — or why it has done so now, although it was always obliged to do so having been mandated to make such a rule by the post-crisis Dodd-Frank Act.

“People think if you change the law, it changes. But it goes to the rule writers. And if they choose to ignore it, they can somewhat,” said one staffer involved in the earlier efforts.

The far-diminished role played by crisis-era instruments such as CDOs could be one reason it slipped down regulators’ worry list. Just $64bn were sold last year compared with $490bn in their 2007 heyday.

The industry has evolved in other ways, too. The 2014 Volcker rule outlawing much proprietary trading by banks has changed practices. Priorities also change with different SEC chairs. Current boss Gary Gensler has a strong connection to that era, since he was then running another critical markets watchdog, the Commodity Futures Trading Commission. Still, given his current efforts to establish oversight of the crypto industry, improve climate disclosures and overhaul stock trading, it is hardly as if he was short on things to get stuck into.

And while theoretically a ban seems easy, that hasn’t proved the case. Securitisations — the practice of selling bundles of loans priced according to their riskiness — is critical to financing swaths of mortgages, student loans and car purchases, among other things. Get a rule wrong, and it could unintentionally hurt the supply of credit, just as many banks are becoming cautious on lending following last month’s turmoil.

As proposed, the rules would block any party involved in a securitisation, including affiliates and initial buyers of the deals, from anything that would result in a material conflict of interest — a definition that could include buying derivatives to hedge the risk. The affiliates angle worries Wall Street: what if another unit of a bank, operating independently, unwittingly bought derivatives for some other purpose, but which hedged the same risk?

“Even transactions that are an intrinsic component of a securitisation transaction could be prohibited,” industry body Sifma warned in its recent response.

Of course, Wall Street has rarely met a rule it didn’t try to at least narrow the scope of. In its 2012 response, Sifma cautioned that the rule as then proposed “will make impossible customary, beneficial and safety-and-soundness enhancing risk management practices which [use] securitisation”.

Both sides — regulators and practitioners — have good arguments in this case. The SEC has to make a rule at some point, and even though practices have been better since the financial crisis, it would be naive to leave it to banks to police their own behaviour.

Beyond the mind-numbing detail of both regulation and the securitisation industry is the fact that rules don’t exist in a vacuum. Delaying this one hasn’t made anyone’s job easier, although resurrecting it has proved a useful reminder of the bad-faith dealing that made it so necessary in the first place.