February 01, 2012
Steven M. Davidoff had a Dealbook column complaining about a Dodd-Frank regulation that he argues is slowing the supply of capital to finance corporate takeovers. The issue in question is a requirement that the creator of a collaterized loan obligation (CLO) keep a 5 percent stake in the issue. Davidoff argues that many issuers of CLO’s are relatively small businesses and don’t have the capital to allow them to hold a 5 percent stake.
He then asks:
“So why add a new regulatory burden? It’s unclear what benefit a “skin in the game” rule would provide, given that C.L.O.’s are more akin to commercial loans, for which Dodd-Frank deems risk-retention rules unnecessary.”
The answer is that financial firms can make money by misrepresenting the products they sell. Those who are good at misrepresentation can get very rich. While some misrepresentations may be in violation of the law, it is often difficult to prove that misrepresentations were made to sell a product. This makes even civil litigation difficult, criminal prosecution is rare.
Forcing the creators of CLO’s to keep a stake is a way to help ensure that they consider the asset they have created to be good. In principle, the sophisticated institutional investors who buy stakes in CLO’s should be able to assess their quality themselves, however one lesson from the housing bubble is that they seem to lack this ability.
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