"I've been everywhere and seen everything and done everything...sophisticated, God, I'm sophisticated." -- Daisy Buchanan, The Great Gatsby
Daisy Buchanan may have been sophisticated. But recent revelations, most recently those involving Goldman Sachs and the seven other investment banks being investigated for their mortgage CDO practices, demonstrate that when it comes to investing, many commercial banks, pension funds, endowments and other institutions are not sophisticated.
The ultimate losers are the shareholders, retirees and other individuals represented by these institutions, and at times taxpayers.
Therefore, it is time to revisit provisions that deny these institutions basic protections afforded to all other investors by federal law.
The Investment Company Act of 1940 was enacted precisely to protect investors in pooled investment funds. The 1920s had been marked by the popularity of investment trusts, companies that invested in securities and issued their own shares to the public.
While many trusts were well run, others engaged in questionable activities such as nondisclosure to investors, excessive leverage and insider transactions. Congress responded by enacting the Investment Company Act, which imposes strict standards on the structure and day-to-day operations of investment companies, broadly defined to include any company which “is or holds itself out as being engaged primarily in the business of investing, reinvesting, or trading in securities."
Congress provided an exemption from the law for an investment company with no more than 100 shareholders and which is not making a public offering.
In 1992 the SEC adopted a rule creating a second exemption — for asset-backed pools that meet certain conditions, regardless of the types of investors in these pools. In 1996, Congress enacted a third exemption — for a fund whose securities are owned exclusively by natural persons with $5 million in investments and institutions with $25 million.
The SEC justified this third exemption on the grounds that the Investment Company Act of 1940 “is likely to stifle innovation,” and that the rule contained a number of supposed safeguards, including requiring that the securities be rated in one of the four highest categories by a nationally recognized rating agency.
Based on these three exemptions, Wall Street firms have securitized just about every type of loan, including mortgages, auto loans and credit card receivables, and marketed interests in these asset-backed pools to investors.
Wall Street’s insatiable demand for loans that could be securitized caused lenders to make increasingly risky loans since they knew Wall Street would buy them. (Wall Street was so hungry for product that it even created synthetic assets that could be securitized.) Meanwhile, institutional investors, relying on ratings, bought hundreds of billions of dollars of securities backed by these unregulated investment pools.
Borrowers, lenders, investors and the economy as a whole have been reaping the whirlwind. Institutional investors in asset-backed securities have lost hundreds of billions of dollars. Many have collapsed due to their investments in these securities.
Congress is in the midst of enacting legislation designed to prevent a repeat of the recent financial catastrophe. If this effort is to succeed, Congress must recognize that many institutions are not sophisticated investors.
Congress should repeal the SEC’s 1992 blanket exemption for asset-backed pools and re-examine the appropriateness of the $5 million-$25 million tests in the 1996 exemption.
Unsophisticated institutions and their beneficiaries need to be protected, and innovation that is little more than gambling with other people’s money needs to be “stifled.”
Matthew P. Fink is the former president of the Investment Company Institute and author of The Rise of Mutual Funds: An Insider's View (Oxford University Press, 2008).
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