WASHINGTON (Dow Jones)–Former Treasury Secretary Henry Paulson said Thursday underwriters and originators of mortgage-backed securities should retain some “skin in the game” by keeping a portion of those securities.
Paulson said that securitizing home mortgages isn’t in and of itself a bad thing, although such mortgage-backed securities were at the heart of the credit crisis.
“That being said, reforms are unquestionably required. Better disclosure is necessary,” Paulson said in written remarks before the Financial Crisis Inquiry Commission.
“Underwriters and originators should be required to retain some portion of what they sell,” Paulson recommended. “Requiring underwriters to keep some ’skin in the game’ will properly align their incentives with those of investors who end up holding the bulk of the risk.”
Paulson’s testimony is part of a two-day hearing at which the commission is examining the largely unregulated activities of investment banks and other nonbank firms. Shadow banking refers to nonbank institutions that conduct bank-like activities.
At the hearing, Paulson also suggested that it is appropriate for investment banks to bet against financial products they sell by taking “short” positions, with appropriate disclosures.
That question has been posed by lawmakers and the federal government in its case against Goldman Sachs Group Inc. (GS). A Senate investigative panel has accused Goldman of selling toxic mortgage-backed securities to customers while also profiting by betting against them. The U.S. Securities and Exchange Commission has charged Goldman with fraud. Goldman denies any wrongdoing.
“When I was in the business, we sold securities in the public market where an underwriter had a short position,” said Paulson, who was CEO of Goldman before he became Treasury Secretary.
“Is that betting against a security? That was a legitimate function, and it was done to make sure there was a stable market,” Paulson said. “The client or customer expects the banker to take the other side of the trade.”
Commission Chairman Phil Angelides pressed Paulson on the point, asking whether he believes investment banks can bet against their own securities if they provide “complete disclosure.”
“I said appropriate disclosure,” Paulson said.
In written testimony, Paulson also said the commercial paper market needs to be backed up with “bank lines of credit to provide greater stability to the market in times of stress.”
Commercial paper, or unsecured, very short-term notes, virtually dried up during the credit crisis. Paulson said the crisis “exposed the weakness in this market.”
“That said, the commercial paper market remains tremendously valuable” as a source of short-term funding for major industrial and financial firms, Paulson said. “But financial institutions and their regulators must be aware of the risks associated with its use.”
Also slated to appear before the panel are executives from General Electric’s (GE) GE Capital, PIMCO, and State Street Corp. (STT) to discuss their shadow banking activities.
By Fawn Johnson
Tags: business, credit crisis, dow jones industrial, financial, financial crisis, investment bank, investors, mortgage, treasury
