Legislative Spotlight Shifts to Financial Reform

Now that health care reform has been passed, President Obama is focused on financial reform and pushing for the formation of the Consumer Financial Protection Bureau, a new watchdog agency to protect the interests of American consumers.

Among other things, it would regulate credit cards, mortgages and nearly all other consumer loans; create transparency and accountability for credit rating agencies; and bring oversight to hedge funds.

“Safety and soundness is important, but the Fed also has a consumer role and it has failed miserably,” said Senate Banking Committee member Bob Menendez (D-NJ). “They didn’t take that part of their charge seriously.”

There are two versions in Congress right now: the House version, which would create a stand-alone agency with the power to write and enforce regulations, much like the Federal Trade Commission; and the Senate version, which would put the agency within the Federal Reserve and make its actions subject to veto by other federal regulators.

“Ultimately, I’d love to have a free-standing entity, but I think the reality is that it may not be possible in achieving the ultimate goal,” Mendez said.

It looks like the Senate version will be passed, but the last-minute changes still have to be hashed out.

Trouble for NRSROs

Senate grandstanding by Levin aside, this does not help the NRSROs’ case.

The headline oversimplifies the story, but the truth is some NRSRO employees saw the conflict and worried about it, while some charged full steam ahead. This is ultimately a management problem. There are inherent potential conflicts of interest in a seller pays ratings model.

Everyone knows this. This horse has already left the barn.

It is impossible to legislate all capital market behavior. Regulation should be observational. We need to set up rules of conduct, keep a level playing field and referee the game, not become part of the game. It is bad public policy when government picks winners and losers.

This still does not address the completely under-reported part of the entire ratings debate: Doesn’t the buyer bear some responsibility for his own action? If you relied on the rating and didn’t do your own due diligence, who is to blame?

Lots of investors didn’t buy these complicated investments, despite the high yield and AAA rating.

Senate panel: Ratings agencies rolled over for Wall Street – McClatchy Newspapers, April 22, 2010

Dodd’s Bill Allows Credit Rating Agencies To Be Sued

Senator Christopher Dodd’s (D-CT) financial industry regulation reform bill was rolled out without too many surprises. However, the bill does include a provision that would, for the first time, allow credit rating agencies to be sued for “a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.”

Deven Sharma, president of Standard & Poor’s, voiced two objections to the draft legislation.  He maintains that the agencies would be subjected to new discriminatory liability standards that would not apply to other market participants, such as accountants and security analysts. This, he argues, could lead to frivolous lawsuits, limit access to capital and delay a full economic recovery.

Second, Mr. Sharma maintains that the language encourages lawsuits against rating agencies whenever ratings change. The bill ignores that ratings may change because of “unforeseen economic developments, technological advances, new regulations or management changes.” In an opinion piece in USA Today, Mr Sharma writes, “Investors want rating agencies to provide updated analysis, and this provision would hamper their willingness and ability to do so.”  Dodd should pull this provision.  Sharma is right.  Investors don’t have to listen to S&P.  This will open the lawsuit floodgates on the NRSROs.  If Dodd wins, ratings will be so cautious as to be valueless.

Portugal’s Finance Minister Blames Ratings Agencies

Fernando Teixeira dos Santos, Portugal’s finance minister was critical of the international credit rating agencies for damaging his country’s economy. He is saying that the risk assessments being made are mistaken.

The Financial Times reports him saying, “Many of the problems we face are related to errors in risk evaluation that have been made, in part, by the rating agencies… We cannot be subject to the commercial strategies [of rating agencies] whose objective may be to increase their market share.”

He went on to say that it was “paradoxical” that the rating agencies (and others in the banking and business communities) had appealed to governments to support economies at the height of the global crisis. Now, however, these same players are insisting that states rapidly consolidate their deficits.

Three credit rating agencies have recently warned that Portugal’s sovereign debt faces downgrading if it should fail to take steps to lower its budget deficit.  That deficit is now at a record 9.3 per cent of gross domestic product in 2009. In contrast, the U.S. 2009 deficit is projected to be 12.4%. of GDP.

Portugal’s long-term debt rating currently ranges from Aa2 at Moody’s to A+ at Standard & Poor’s. Spain and Greece’s credit ratings have also been threatened by their respective deficits forced by the worldwide economic conditions.

Ratings Agencies Relied On Bad Information from Freddie Mac and Fannie Mae

Peter Wallison, a Treasury Official in the Reagan administration, wrote in The Wall Street Journal that Edward Pinto, former Fannie Mae credit manager, discovered that both Fannie Mae and Freddy Mac routinely exaggerated the quality of its mortgages. Mr. Pinto explains that Alt A and subprime mortgages were routinely rated as “prime” to make mortgage credit more readily available to lower income levels.

Because of this misrepresentation, the ratings agencies believed that losses from the securities backed by these mortgages would be “within the historical range for the number of high-risk loans known to be outstanding.” Instead the number of high-risk loans was much larger than anyone knew. When the default rates and losses exploded, Mr. Wallison explains, the subterfuge was exposed, leaving those holding the assets — and the ratings agencies — wondering what happened.

Therefore, the fault for the collapse, Mr. Wallison maintains, was not Wall Street’s or the ratings agencies’, but the misreporting that distorted the perception of everyone who bought and sold securities backed by these mortgages. This misreporting, he believes, was in response to government affordable housing rules. “Fannie Mae and Freddie Mac are inexorably intertwined in the market collapse. It is essential that any examination of the crisis begin with a review of Congress’s use of Fannie Mae and Freddie Mac. We won’t hold our breath.”

S&P President Pushes to Drop Ratings Requirements

Deven Sharma, President of Standard & Poors, has argued for the repeal of regulations that require banks, public pensions, money market funds, and other regulated investors to hold debt evaluated by Nationally Recognized Statistical Rating Organizations (NRSROs). Standard & Poors is one of ten NRSROs, and these regulations originated in legislation following the Great Depression and have existed essentially unchanged for nearly 80 years.

The intent in the ‘30s was to prevent banks from risking their capital in highly speculative investments. The Federal Deposit Insurance Corporation (FDIC) was formed at the same time, and the regulation was, in part, intended to avoid exposing the FDIC to extraordinary risk.

Mr. Sharma speculates that, “rating mandates may have prompted some investors to use ratings in ways they were never intended.” Investors, he suggests, are confused, as they believe that NRSRO ratings are a “government seal of approval” and a short cut for evaluating an investment risk profile. Instead, Mr. Sharma maintains, the ratings should be use as only one of many tools that investors can use to analyze risk. “Hear, hear. Let’s have investors do their own due diligence.”

Instead of requiring regulated investors to hold NRSRO-rated instruments, Mr Sharma believes that the market should determine whether their assessments are used. “Our most important audience will remain the marketplace. If our ratings are valuable, people will use them. If not, market participants should not be forced to use them.”

Back to the Drawing Board…Why?

The SEC. seems to be going back to the same old regulatory structure. Last year, money market funds showed stress, and the US government prevented the funds from breaking the buck.

In the future, don’t we want investors to bear the cost of their own decisions? Do we want the government to remove moral hazard? If you invest, isn’t there any “caveat emptor”?

The Journal takes the SEC to task. Is this what the SEC  really meant to do?

[$$] The SEC v. Investors – Wall Street Journal, February 3, 2010

NAIC Saves Capital

Well, they got it done.

The National Association of Insurance Commissioners saved an approximately $5B in industry capital by ignoring the NRSRO ratings and using a recognized 3^rd party to evaluate mortgage backed securities. The NAIC understood that the rating only described the first dollar of loss, not the magnitude of loss, and that strict use of ratings would unnecessarily drain precious capital out of the industry at exactly when they could least afford it.

PIMCO was interviewed and hired,  and they subsequently evaluated thousands of CUSIPs to make the MBS valuations for the industry before year end. This independent, third party, global,  fixed income  institution was employed to make valuations impartially and consistently across the industry.

Three cheers in the New Year for the NAIC. This is a textbook example of regulators using market resources to make regulation fair, appropriate and realistic.

[$$] Insurance Rule Adds Up to $5 Billion – Wall Street Journal, January 4, 2010

Is the Tide Turning?

While not directly related to ratings, which is the main topic of this blog, the article below discusses a key related issue:  capital shortages at banks and their drag on lending.  A revamp of the ratings system could actually help address this problem because a carefully crafted restructuring of the way securities are rated and a corresponding restructuring of how regulators use these ratings would increase regulatory capital at institutions.  How?  Under the current system, securities that are rated below investment grade are treated as entirely toxic and drain capital from the banks that own them.  In many cases, only a small portion of these securities has been deemed uncollectible and therefore the entire security is not actually toxic.  Designed correctly, a new ratings system and cohesive regulatory framework would treat only the portion of assets at risk of loss as “toxic” and therefore would not punish a bank’s capital levels for the collectible portion.  The result would be a more accurate, reflective calculation of capital that would also increase capital at many banks as it relates to multi-obligor securities.

In the meantime, we can draw some solace from the fact that the White House is at least communicating that they are listening and are aware of the challenges imposed on banks that are keeping them from lending.  The flipside is that at least up to this point it appears the White House has very little practical influence on regulators, who have a different point of view.

Obama Pledges Support for Small Banks to Spur Lending – Bloomberg.com, December 23, 2009

Will New Ratings Reforms Be Effective?

The attached article talks about how the House recently made extensive progress towards eliminating all language from both laws and financial regulation rules that references rating agencies (NRSROs).  The “system” will no longer depend on such agencies.  These are the first steps of progress towards reform and are commendable.  However, the real wood that needs to be chopped is determining what the new system will look like when it no longer relies on the agencies.  This new system must consider many factors, but to ultimately be effective it must lead us to an economic value attached to the assets that are rated versus the simple “good” vs. “toxic” diagnosis that we currently have.

Here is the article:

One Cheer For Barney Frank – WSJ.com, December 23, 2009

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