By W. Bernard Mason
We seem to be awash in media reports touting the return to health for the nation’s largest financial institutions. Another year of big profits and big bonuses is well underway for these firms. Much of this success can be attributed to the emergency programs implemented by the federal government within the past year. As The New York Times recently pointed out, “Many of the steps that policy makers took last year to stabilize the financial system – reducing interest rates to near zero, bolstering big banks with taxpayer money, guaranteeing billions of dollars of financial institutions’ debts “ helped bring about this robust return.
These same Washington policymakers now seem to be puzzled over the fact that, while the big banks are even bigger and stronger, there still seems to be a lack of available credit for “Main Street.” At virtually every Congressional hearing on the subject of banking reform, at least one lawmaker laments that his/her constituents continue to complain about the lack of consumer and small business lending activity.
Recalling what now seems ancient history, TARP was sold to Congress as a way to stabilize the markets and bring liquidity back to credit functions. We know what ultimately occurred: capital contributions to the largest institutions with little accountability for fund use to increase lending. With a couple of notable exceptions, we also know these funds have been repaid to the Treasury with interest. However, there was no significant increase in the availability of credit for consumers and small businesses as a result of this effort.
When a U.S. Senator most recently asked the now familiar question regarding lack of credit availability, FDIC Chairman Sheila Bair responded by noting that there had been “100% participation” in the TARP by the largest U.S. Banks, whereas only 9% of all other banks had received TARP funding. She stated that community banks are disproportionately the source of credit for small businesses and pointed out that lending by the largest banks had declined in the second quarter while lending by smaller institutions had actually increased. Her conclusion was that these smaller institutions are striving to make sound loans to “Main Street,” but are hindered in their capacity by a lack of capital and balance sheets already laden with devalued and non-earning assets. She said that funding costs for the largest institutions had declined, while these costs for smaller institutions had been increasing. Sitting alongside Ms. Bair at this particular hearing was North Carolina Banking Commissioner Joseph Smith, who fully concurred in this view and stated that smaller banks must be given a mechanism by which to cleanse their balance sheets of these weaker assets in order to restore robust lending activities.
Chairman Bair suggested that TARP should be restructured to make it more accessible for smaller institutions and those that may not now meet the stringent eligibility requirements. She said she had discussed with Treasury a plan, perhaps employing a “one-for-one” matching arrangement where private capital would be used alongside TARP money, to bolster the capital of smaller institutions, thus giving them the capital cushion necessary to dispose of weaker assets and allow for new lending. She believes it is critical that capital be made more available to these smaller institutions.
Other policymakers and critical observers have raised objection to the entire notion of TARP and more specifically any desire to continue its usage now that the large “systemically important” institutions have repaid their TARP funds. Many (including lawmakers on both sides of the aisle) were skeptical of the proposal at inception, and they believe their skepticism was validated by the subsequent decision to deploy taxpayer funds in ways not initially envisioned when the program was hastily approved. These observers believe the market should allow entities to succeed and fail without government intervention and without the subjective picking of winners and losers. They believe government intervention sends the message that taxpayers will step in to assist troubled entities when times are tough, furthering the problem of moral hazard. In their view, the economy will work itself out in due course, with credit and employment improving over some natural period of time.
Discussion Topic: Join the discussion in the Comment Box below.
Given these observations, should the federal government do more to assist smaller institutions in raising capital (either through direct capital infusions or through other mechanisms to improve balance sheets) as a means to more quickly bring credit to consumers and small businesses, or should government now remove itself from direct intervention in banking activities?
Wednesday, October 21, 2009
Friday, September 18, 2009
Compliance with 2006 Commercial Real Estate Regulatory Guidance
In 2006 the bank and thrift regulators issued industry guidance entitled Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. By now, institutions with significant exposure to commercial real estate lending activities should be well aware of the principles embodied in this document. While there is little debate with respect to the principles and concepts contained in the guidance, questions have arisen regarding supervisory expectations in assessing compliance with certain provisions.
More particularly, smaller community banks (arguably those that possess the greatest levels of individual exposure to CRE) are concerned that examiners may apply unreasonable standards when determining the adequacy of portfolio and credit risk management policies and practices. Banks are concerned that regulators may have unrealistic expectations regarding the level of risk management sophistication appropriate for community banks.
In recent discussions, banking agency senior staffs state that they do not apply a "one size fits all" approach in assessing individual bank compliance with the CRE guidance. Regulators understand the varying levels of risk management expertise and the budgetary constraints impacting institution operations. However, in individual conversations, representatives of each of the four banking agencies stand unified in their position that bank concentrations need to be properly managed and monitored. In essence, each regulator's position was: if an institution is sophisticated enough to create a concentration risk, it should be sophisticated enough to properly manage it.
Therefore, while regulators will accept varying levels of sophistication in applying the principles contained in the CRE guidance, the level of risk management in individual institutions must be adequate for the risks presented. The banking agencies have consistently held to their view that institutions with CRE concentrations, regardless of asset size, must meet all the provisions of the guidance. Institutions have the discretion to determine how best to do this. Regulators do not expect small institutions to employ sophisticated modeling in their ongoing risk analyses; simple Excel spreadsheet analysis and reporting may be sufficient. However, the goal of guidance compliance should not be simply to satisfy the regulators; the goal should be proper management of CRE concentration risk, including adequate reporting to the institution's board of directors.
Recently, regulators have expressed concern that a significant number of smaller institutions appear to have given little, if any, attention to the provisions contained in the CRE guidance. Some institutions have been subjected to formal enforcement actions regarding noncompliance. As CRE becomes a more significant concern in the current economy, regulators certainly will devote increased attention to the adequacy of CRE risk management programs and practices in individual institutions.
On September 21, 2009, at 2:00 PM EST, RMA will hold the first in a series of Regulatory and Legislative Update audio conferences. The primary discussion topic for this first audio conference will be compliance with the CRE guidance, and a senior bank regulatory official will present supervisory expectations, observed deficiencies and proposed courses of action regarding compliance. Adequate time will be allotted for participant questions and regulatory responses. RMA members are invited to register for this event and participate in the discussion of this timely and important topic.
Monday, August 10, 2009
FDIC Issues Financial Institution Letter on Immediate Applicability of Credit Card Act
By W. Bernard Mason
On August 6, 2009 the Federal Deposit Insurance Corporation issued Financial Institution Letter (FIL) 44-2009 advising its supervised institutions of certain aspects of The Credit Card Accountability Responsibility and Disclosure Act of 2009 that take effect on August 20, 2009. It advises institutions to take appropriate steps to ensure compliance with these new requirements.
The FIL advises that, with regard to all open-end consumer credit accounts, including credit cards and home equity lines of credit accessed by a credit card, creditors must mail or deliver periodic statements at least 21 days before the payment is due. Applicable to credit card accounts, creditors must give 45-days’ notice of increases in the Annual Percentage Rate (APR) or other significant changes in terms, including a notice of the right to cancel the account. Both of these provisions become effective on August 20, 2009.
Further, all increases in the APR of a credit card account after January 1, 2009 must be reviewed beginning in August 2010 for a possible reduction in the APR based upon the same factors used to justify the increase. This mandatory “look-back” review will occur at least once every six months and will require creditors to use “reasonable methodology” in making assessments regarding possible rate decreases.
The Federal Reserve Board is required to issue final rules within nine months after enactment of the new law to implement these provisions. The FDIC is advising its supervised institutions to demonstrate regular meaningful progress in preparing for full compliance with these new restrictions and requirements, including adoption of reasonable methodologies for determining rate changes as well as adequate procedures to review accounts.
The Federal Reserve’s interim final rule, adopted on July 15, 2009 and applicable to all insured institutions, is available at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090715a1.pdf - PDF
On August 6, 2009 the Federal Deposit Insurance Corporation issued Financial Institution Letter (FIL) 44-2009 advising its supervised institutions of certain aspects of The Credit Card Accountability Responsibility and Disclosure Act of 2009 that take effect on August 20, 2009. It advises institutions to take appropriate steps to ensure compliance with these new requirements.
The FIL advises that, with regard to all open-end consumer credit accounts, including credit cards and home equity lines of credit accessed by a credit card, creditors must mail or deliver periodic statements at least 21 days before the payment is due. Applicable to credit card accounts, creditors must give 45-days’ notice of increases in the Annual Percentage Rate (APR) or other significant changes in terms, including a notice of the right to cancel the account. Both of these provisions become effective on August 20, 2009.
Further, all increases in the APR of a credit card account after January 1, 2009 must be reviewed beginning in August 2010 for a possible reduction in the APR based upon the same factors used to justify the increase. This mandatory “look-back” review will occur at least once every six months and will require creditors to use “reasonable methodology” in making assessments regarding possible rate decreases.
The Federal Reserve Board is required to issue final rules within nine months after enactment of the new law to implement these provisions. The FDIC is advising its supervised institutions to demonstrate regular meaningful progress in preparing for full compliance with these new restrictions and requirements, including adoption of reasonable methodologies for determining rate changes as well as adequate procedures to review accounts.
The Federal Reserve’s interim final rule, adopted on July 15, 2009 and applicable to all insured institutions, is available at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090715a1.pdf - PDF
Friday, August 7, 2009
Senate Hears Testimony on Credit Rating Agencies
By W. Bernard Mason
On August 5, 2009 the Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Examining Proposals to Enhance the Regulation of Credit Rating Agencies”. The Committee heard from two witness panels. The sole witness on the first panel was Michael Barr, Assistant Treasury Secretary for Financial Institutions. The second panel consisted of: John Coffee, Professor of Law, Columbia University; Lawrence White, Professor of Economics, New York University; Stephen Joynt, President and CEO, Fitch Ratings; James Gellert, President and CEO, Rapid Ratings; and, Mark Froeba, Principal, PF2 Securities Evaluations, Inc.
Committee Chairman Christopher Dodd (D – CT) opened the hearing by pointing out two areas that he felt were primary problems causing the current crisis: the first was the marketing of unacceptable loan products that mortgage originators knew would never be repaid at fully indexed rates and the subsequent securitization and sale of these products and the receipt of substantial compensation for doing so; and, the failure of the credit rating agencies to properly evaluate and rate these products for the use and benefit of investors. He said instead of helping investors understand risk, these organizations were “hiding” risks. He wondered if the credit rating agencies were even needed in today’s environment.
Ranking Member Shelby pointed out The Credit Rating Reform Act, passed in 2006, was intended to address the perceived weaknesses in the credit rating agency system and in the Nationally Recognized Statistical Rating Organization (NRSRO) process administered by the SEC. He said this legislation was not enacted until 2007, too late to deal with the problems already existing in the system. He remarked that in considering new measures, “every option should be on the table”. He stated that he believes the rating agencies played a “pivotal role” in the collapse of our financial markets.
Senator Dodd began his questioning of Secretary Barr by stating his amazement to discover that the rating agencies, in many cases, do not verify the underlying information presented to them before assigning ratings and asked if it would not be appropriate to require such verification. Mr. Barr said he believed it would be inappropriate for the government to design a particular methodology; he said the primary issue is disclosure and transparency so that, if no independent verification has been performed, potential investors clearly understand that situation.
Senator Shelby asked what could be done to bring back investor confidence, since the NRSROs have failed so badly. He said the SEC had given considerable confidence to these rating agency firms, so what should be done now that that confidence was misplaced? Secretary Barr said there should be greater competition, with more entrants into this activity and more diversity of approach. Mr. Barr said the Administration wants to reduce regulatory agency reliance on these agencies by removing regulatory requirements that require NRSRO ratings.
Senator Bob Corker (R – TN) observed that we have just witnessed the worst regulatory failure in 30-40 years and regulators outsourced oversight of the securitization market. He marveled that the Administration wants to specifically dictate consumer financial products but only seeks transparency with respect to credit rating agencies. Mr. Barr first clarified that the Administration was not proposing that the government dictate specific products, only that a standard, easily understood product be part of a financial institution’s array of product offerings. He said in dealing with these consumer issues, we are assuming unsophisticated customers who need more specific protection. With respect to the securitization market, investors are more sophisticated and this market would benefit more from clear and complete disclosure. Senator Corker then asked where the Administration stands with respect to the question of who pays for the services of the NRSROs. Mr. Barr said he believes it makes sense to have different payment models. He said the goal is to reduce reliance on these credit ratings, but it will take time to develop alternatives. Senator Corker then asked if it would be wise to require the NRSROs to have “skin in the game” with respect to the performance of the securities they rate. Secretary Barr said he believes that would be beneficial.
Senator Mark Warner (D – VA) asked if it would not be important to translate the NRSRO ratings into something more meaningful that would provide a sense of the actual chance of default and of the magnitude of loss given default. Secretary Barr said such a system would be very beneficial. Senator Dodd took specific note of this issue and said it was deserving of further attention.
Senator Mike Johanns (R – NE) asked if the “little guy” wouldn’t end up paying the costs of any plan implemented to improve the current system. Secretary Barr said that everyone is now paying for the effects of a broken system and we need to get these problems under control. He said “the trade-offs are not even close”.
Senator Jeff Merkley (D – OR) observed that the Administration’s proposal to ban credit agency consulting fees and introduce better disclosure of payments still may not eliminate the perception of a conflict of interest on the part of the NRSROs. He asked if other approaches had been considered. Secretary Barr said that banning consulting fees, requiring better disclosures, closing the personnel “revolving door”, and creating a strong SEC compliance office would go a long way in addressing these concerns. He said the Administration had looked at different pay models (issuer, user, etc.) and all had particular deficiencies. Senator Merkley then asked if some security instruments simply weren’t too complicated to understand and properly rate, and if the better approach wouldn’t be to simply ban them. Secretary Barr said that was an option, but he believed there were ways to deal with these problems without an outright ban.
Senator Jim Bunning (R – KY) said everyone agrees the current system has failed. He said we must break the hold of the top three NRSROs and asked if all regulatory requirements for the use of these ratings shouldn’t be eliminated. Secretary Barr said this should be pursued, but he felt each requirement needed to be analyzed individually. Senator Bunning obtained agreement from Secretary Barr that there are basic conflicts existing in the current system.
Senator Charles Schumer (D – NY) said he had hoped with the passage of the 2006 legislation that the ratings agencies would be one of the cornerstones of a sound credit market; instead the credit rating agencies turned out to be one of the weakest links and this needs to be fixed. One of the weaknesses was that issuers “went shopping for ratings just like they were shopping for used cars”. He said because the revenues of the NRSROs increased with the increase in the securitization market, the agencies had every incentive to help issuers structure the products to get the ratings they wanted. The result was that ratings agencies rubber-stamped as” investment-grade” complex products they didn’t understand, and their flawed models didn’t factor in such adverse assumptions as escalating mortgage defaults. He wondered if the message was getting through to the NRSROs that change was necessary. He then cited a recent example of a questionable issuance that had just been highly rated by Moody’s. He put forth a suggestion that the SEC randomly select particular security issuances (he suggested one out of every ten rated products) for a secondary review by another rating agency as a means of encouraging proper conduct by the primary NRSRO on the selected issuance. Secretary Barr said he shared the conceptual goal to have more than one NRSRO rate particular issues, particularly in the case of structured finance products. Mr. Barr said the Administration suggests having the selected agency provide all information on their particular issuance to all the other rating agencies so that they can do their own analysis and “demonstrate their prowess” in assigning ratings as a means of competitive control over ratings quality.
In commencing questioning of the second panel, Senator Shelby asked Professor White if the government wasn’t sending a confusing message to regulated entities by instructing them to invest only in products possessing an acceptable NRSRO rating, while the NRSRO’s rating disclosure informs that no investment reliance should be placed on the assigned ratings. Professor White said he didn’t know “whether to laugh or cry” over this situation, and said this was one reason he advocated removing such reliance on the NRSROs. He said the burden should be on the investment manager to justify the investment, and that could be done through independent research either directly or by an independent third party (who could be an NRSRO or some other expert). Professor White said we should recognize that these complex products are not being purchased by unsophisticated investors, and investment managers should have the responsibility to either research the product or find someone to do it for them.
Senator Shelby then asked how we can bring confidence and trust back to the securitization market. Professor Coffee said we had a very good securitization market In the 1990s, but it got corrupted through the creation of more complex products that no one could completely understand. He said a good rule would be – if a product is too opaque to explain and understand, it should not be issued. He foresees simpler forms of asset-backed securities in the future, because the market will insist upon it.
Senator Corker said it was obvious that Committee Members were shocked to discover that no due diligence had been performed by the NRSROs as part of their process for assigning ratings. He asked Mr. Joynt what value the credit rating agencies were providing the public, given this lack of due diligence. Mr. Joynt said he believed there was enough public information available such that independent due diligence reviews were unnecessary. He viewed the NRSRO’s service to be the analysis of that public information and the projection of future performance based upon that public information. Senator Corker said he understood this concept as it relates to corporate issuances, but he fails to see what real assurance an NRSRO rating provides when considering an asset-back product, not backed by a corporate issuer but by mortgages, and the rating agency does not actually research and analyze the underlying mortgages. He said he failed to see any value being offered in this situation. Mr. Joynt said the NRSROs look to the issuing entity, the servicer, the accounting firm that signed off on the financial statements and then make a determination.
Senator Bunning stated that, during the housing boom, the rating agencies issued ratings without reviewing any information regarding the underlying mortgages. If they had, perhaps they would have detected some of the fraud and bad underwriting practices. Professor Coffee agreed with the assessment and pointed to information indicating that the percentage of “liar loans” expanded from approximately 28 percent in 2001 to 51 percent in 2006. Senator Bunning then asked if information on existing “toxic” securities should be shared with all the rating agencies so a better picture could be developed regarding the true condition of these products. Mr. Gellert said he believed this was the most important first step in getting the securities market moving again. Senator Bunning then asked if rating agencies should be subject to suit for errors in their ratings. Professor Coffee said he did not think there should be a cause of action simply for negligence. Misjudgments should not produce litigation; instead, it should be in instances where there is recklessness. In his view, giving ratings with no facts is “reckless”.
The hearing was adjourned with the understanding that this subject will be further explored following the August recess.
On August 5, 2009 the Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Examining Proposals to Enhance the Regulation of Credit Rating Agencies”. The Committee heard from two witness panels. The sole witness on the first panel was Michael Barr, Assistant Treasury Secretary for Financial Institutions. The second panel consisted of: John Coffee, Professor of Law, Columbia University; Lawrence White, Professor of Economics, New York University; Stephen Joynt, President and CEO, Fitch Ratings; James Gellert, President and CEO, Rapid Ratings; and, Mark Froeba, Principal, PF2 Securities Evaluations, Inc.
Committee Chairman Christopher Dodd (D – CT) opened the hearing by pointing out two areas that he felt were primary problems causing the current crisis: the first was the marketing of unacceptable loan products that mortgage originators knew would never be repaid at fully indexed rates and the subsequent securitization and sale of these products and the receipt of substantial compensation for doing so; and, the failure of the credit rating agencies to properly evaluate and rate these products for the use and benefit of investors. He said instead of helping investors understand risk, these organizations were “hiding” risks. He wondered if the credit rating agencies were even needed in today’s environment.
Ranking Member Shelby pointed out The Credit Rating Reform Act, passed in 2006, was intended to address the perceived weaknesses in the credit rating agency system and in the Nationally Recognized Statistical Rating Organization (NRSRO) process administered by the SEC. He said this legislation was not enacted until 2007, too late to deal with the problems already existing in the system. He remarked that in considering new measures, “every option should be on the table”. He stated that he believes the rating agencies played a “pivotal role” in the collapse of our financial markets.
Senator Dodd began his questioning of Secretary Barr by stating his amazement to discover that the rating agencies, in many cases, do not verify the underlying information presented to them before assigning ratings and asked if it would not be appropriate to require such verification. Mr. Barr said he believed it would be inappropriate for the government to design a particular methodology; he said the primary issue is disclosure and transparency so that, if no independent verification has been performed, potential investors clearly understand that situation.
Senator Shelby asked what could be done to bring back investor confidence, since the NRSROs have failed so badly. He said the SEC had given considerable confidence to these rating agency firms, so what should be done now that that confidence was misplaced? Secretary Barr said there should be greater competition, with more entrants into this activity and more diversity of approach. Mr. Barr said the Administration wants to reduce regulatory agency reliance on these agencies by removing regulatory requirements that require NRSRO ratings.
Senator Bob Corker (R – TN) observed that we have just witnessed the worst regulatory failure in 30-40 years and regulators outsourced oversight of the securitization market. He marveled that the Administration wants to specifically dictate consumer financial products but only seeks transparency with respect to credit rating agencies. Mr. Barr first clarified that the Administration was not proposing that the government dictate specific products, only that a standard, easily understood product be part of a financial institution’s array of product offerings. He said in dealing with these consumer issues, we are assuming unsophisticated customers who need more specific protection. With respect to the securitization market, investors are more sophisticated and this market would benefit more from clear and complete disclosure. Senator Corker then asked where the Administration stands with respect to the question of who pays for the services of the NRSROs. Mr. Barr said he believes it makes sense to have different payment models. He said the goal is to reduce reliance on these credit ratings, but it will take time to develop alternatives. Senator Corker then asked if it would be wise to require the NRSROs to have “skin in the game” with respect to the performance of the securities they rate. Secretary Barr said he believes that would be beneficial.
Senator Mark Warner (D – VA) asked if it would not be important to translate the NRSRO ratings into something more meaningful that would provide a sense of the actual chance of default and of the magnitude of loss given default. Secretary Barr said such a system would be very beneficial. Senator Dodd took specific note of this issue and said it was deserving of further attention.
Senator Mike Johanns (R – NE) asked if the “little guy” wouldn’t end up paying the costs of any plan implemented to improve the current system. Secretary Barr said that everyone is now paying for the effects of a broken system and we need to get these problems under control. He said “the trade-offs are not even close”.
Senator Jeff Merkley (D – OR) observed that the Administration’s proposal to ban credit agency consulting fees and introduce better disclosure of payments still may not eliminate the perception of a conflict of interest on the part of the NRSROs. He asked if other approaches had been considered. Secretary Barr said that banning consulting fees, requiring better disclosures, closing the personnel “revolving door”, and creating a strong SEC compliance office would go a long way in addressing these concerns. He said the Administration had looked at different pay models (issuer, user, etc.) and all had particular deficiencies. Senator Merkley then asked if some security instruments simply weren’t too complicated to understand and properly rate, and if the better approach wouldn’t be to simply ban them. Secretary Barr said that was an option, but he believed there were ways to deal with these problems without an outright ban.
Senator Jim Bunning (R – KY) said everyone agrees the current system has failed. He said we must break the hold of the top three NRSROs and asked if all regulatory requirements for the use of these ratings shouldn’t be eliminated. Secretary Barr said this should be pursued, but he felt each requirement needed to be analyzed individually. Senator Bunning obtained agreement from Secretary Barr that there are basic conflicts existing in the current system.
Senator Charles Schumer (D – NY) said he had hoped with the passage of the 2006 legislation that the ratings agencies would be one of the cornerstones of a sound credit market; instead the credit rating agencies turned out to be one of the weakest links and this needs to be fixed. One of the weaknesses was that issuers “went shopping for ratings just like they were shopping for used cars”. He said because the revenues of the NRSROs increased with the increase in the securitization market, the agencies had every incentive to help issuers structure the products to get the ratings they wanted. The result was that ratings agencies rubber-stamped as” investment-grade” complex products they didn’t understand, and their flawed models didn’t factor in such adverse assumptions as escalating mortgage defaults. He wondered if the message was getting through to the NRSROs that change was necessary. He then cited a recent example of a questionable issuance that had just been highly rated by Moody’s. He put forth a suggestion that the SEC randomly select particular security issuances (he suggested one out of every ten rated products) for a secondary review by another rating agency as a means of encouraging proper conduct by the primary NRSRO on the selected issuance. Secretary Barr said he shared the conceptual goal to have more than one NRSRO rate particular issues, particularly in the case of structured finance products. Mr. Barr said the Administration suggests having the selected agency provide all information on their particular issuance to all the other rating agencies so that they can do their own analysis and “demonstrate their prowess” in assigning ratings as a means of competitive control over ratings quality.
In commencing questioning of the second panel, Senator Shelby asked Professor White if the government wasn’t sending a confusing message to regulated entities by instructing them to invest only in products possessing an acceptable NRSRO rating, while the NRSRO’s rating disclosure informs that no investment reliance should be placed on the assigned ratings. Professor White said he didn’t know “whether to laugh or cry” over this situation, and said this was one reason he advocated removing such reliance on the NRSROs. He said the burden should be on the investment manager to justify the investment, and that could be done through independent research either directly or by an independent third party (who could be an NRSRO or some other expert). Professor White said we should recognize that these complex products are not being purchased by unsophisticated investors, and investment managers should have the responsibility to either research the product or find someone to do it for them.
Senator Shelby then asked how we can bring confidence and trust back to the securitization market. Professor Coffee said we had a very good securitization market In the 1990s, but it got corrupted through the creation of more complex products that no one could completely understand. He said a good rule would be – if a product is too opaque to explain and understand, it should not be issued. He foresees simpler forms of asset-backed securities in the future, because the market will insist upon it.
Senator Corker said it was obvious that Committee Members were shocked to discover that no due diligence had been performed by the NRSROs as part of their process for assigning ratings. He asked Mr. Joynt what value the credit rating agencies were providing the public, given this lack of due diligence. Mr. Joynt said he believed there was enough public information available such that independent due diligence reviews were unnecessary. He viewed the NRSRO’s service to be the analysis of that public information and the projection of future performance based upon that public information. Senator Corker said he understood this concept as it relates to corporate issuances, but he fails to see what real assurance an NRSRO rating provides when considering an asset-back product, not backed by a corporate issuer but by mortgages, and the rating agency does not actually research and analyze the underlying mortgages. He said he failed to see any value being offered in this situation. Mr. Joynt said the NRSROs look to the issuing entity, the servicer, the accounting firm that signed off on the financial statements and then make a determination.
Senator Bunning stated that, during the housing boom, the rating agencies issued ratings without reviewing any information regarding the underlying mortgages. If they had, perhaps they would have detected some of the fraud and bad underwriting practices. Professor Coffee agreed with the assessment and pointed to information indicating that the percentage of “liar loans” expanded from approximately 28 percent in 2001 to 51 percent in 2006. Senator Bunning then asked if information on existing “toxic” securities should be shared with all the rating agencies so a better picture could be developed regarding the true condition of these products. Mr. Gellert said he believed this was the most important first step in getting the securities market moving again. Senator Bunning then asked if rating agencies should be subject to suit for errors in their ratings. Professor Coffee said he did not think there should be a cause of action simply for negligence. Misjudgments should not produce litigation; instead, it should be in instances where there is recklessness. In his view, giving ratings with no facts is “reckless”.
The hearing was adjourned with the understanding that this subject will be further explored following the August recess.
Wednesday, August 5, 2009
Senate Hearing on Strengthening and Streamlining Prudential Bank Supervision
By W. Bernard Mason
On August, 4, 2009 the Senate Committee on Banking, Housing and Urban Affairs heard testimony from the heads of the four federal banking agencies on the subject of bank regulatory restructuring. In their opening statements, each of the panelists stated their positions regarding the major elements of the Administration’s reform proposal. There was general agreement among the witnesses that creation of a new Consumer Financial Protection Agency would be a positive move (although Federal Reserve Governor Tarullo indicated the Federal Reserve Board had not taken an official position on this point). They also agreed that some form of systemic risk oversight was called for, but disagreed on how this could best be accomplished. FDIC Chairman Sheila Bair argued that a council of regulators would be the best approach, while Comptroller John Dugan and Governor Tarullo argued that the Federal Reserve was well-situated to assume this role. None of the panelists argued strongly for further consolidation of the agencies beyond the Administration’s announced proposal to merge the OTS and the OCC (OTS Acting Director John Bowman expressed no view). Each witness also expressed support for the creation of a resolution mechanism for large, systemically important financial firms.
Committee Chairman Christopher Dodd (D – CT) commenced the questioning by asking the panel why it would not make sense to merge all prudential supervision functions under one agency. Ms. Bair stated that creation of one agency would not address the causes of the current crisis, that other countries that had such arrangements faired no better than the U.S., and multiple regulators actually strengthens the financial system by allowing for different regulatory points of view. Governor Tarullo added that it would weaken the regulatory system if the Federal Reserve and the FDIC did not play an active role in day-to-day supervisory activities because they would lose touch with banking operational issues.
Ranking Member Richard Shelby (R – AL) stated that, in terms of regulatory failure, “all roads lead to the Federal Reserve”. He then asked what steps should be taken to reduce “moral hazard” – do we need to just let big firms fail? Ms. Bair said we need a clear resolution authority for these firms. Mr. Dugan added that while we need more orderly resolution processes, we also need up-front supervision that sets strong capital and liquidity requirements, with flexibility for the government to intervene if necessary. Mr. Tarullo said we need more transparency and disclosure and alternative capital structures such as convertible debt. In response to Sen. Shelby’s Federal Reserve observation, Governor Tarullo pointed out that Bear Stearns, AIG, Fannie, and Freddie were not regulated by the Federal Reserve. Sen. Shelby answered by stating that the Federal Reserve was the supervisor for the large banking organizations that received government funding in the current crisis.
Senator Bob Corker (R – TN) stated his understanding that the Administration had originally contemplated having the new National Bank Supervisor (the consolidated OTS/OCC) structured as an independent agency, and asked Comptroller Dugan why this was changed in the final proposal. Mr. Dugan said he pushed for the change, because he believed it would be more cumbersome to have another banking agency with yet another board of directors populated by individuals simultaneously serving on other regulatory boards (FDIC and the new consumer agency). He believes the present structure, with the national bank supervisor as an independent bureau within the Treasury Department, is the best approach. Chairman Bair disagreed, stating it would be best if this regulatory body were completely independent of the Administration.
Senator Robert Menendez (D – NJ) asked the panel members if consolidating the agencies wouldn’t eliminate the opportunity for regulatory arbitrage? Governor Tarullo said the agencies had already addressed this potential through an interagency agreement prohibiting charter changes for institutions undergoing enforcement or other supervisory actions. Chairman Bair and Comptroller Dugan supported making this prohibition statutory to eliminate future discretion or flexibility. The panelists uniformly stated that “regulator shopping” among the closely regulated was not a problem; instead, it was the lack of regulatory oversight regarding the “shadow banking industry” that was the problem and attention should be focused on closing those regulatory gaps.
Senator David Vitter (R – LA) asked for the regulators’ views on FASB’s effort to move off- balance sheet activities clearly onto the books of insured financial institutions. Chairman Bair said banks need to follow the dictates of Generally Accepted Accounting Principles. She said the capital rules need to be reviewed, and she was particularly concerned about the timing of this effort because she believed it could be damaging when efforts are underway to get the securitization market functional again. Senator Vitter asked if regulators had any flexibility on this. Comptroller Dugan said there may be some regulatory flexibility, but the issue is timing. He said regulators were discussing how this issue affects capital, and interagency guidance and rulemaking may be forthcoming.
Senator Mel Martinez (R – FL) asked the panelists if interstate branching contributed to the current crisis. None of the panelists felt this was a problem, and Comptroller Dugan said it would not be a good idea to attempt to restrict interstate activities at this time. Governor Tarullo agreed. Senator Martinez then asked about the Administration’s proposal to designate certain firms as “Tier 1 Financial Holding Companies”. Ms. Bair said this was a bad idea, since identifying these firms would create moral hazard under the assumption they would be too big to fail.
Senator Robert Bennett (R – UT) stated his objection to the Administration’s proposal to prohibit industrial loan companies, arguing that these firms played no role in the current crisis. He then offered his observation that the primary problem in the current crisis was not “too big to fail” but the lack of a systemic supervisor to recognize the system-wide risk created by the poor lending and resulting inferior securitization process where no player had any risk of loss in the process. Governor Tarullo agreed with this assessment.
Senator Mark Warner (D – VA) stated his view that there should be one consolidated bank regulator, with the FDIC maintaining its back-up supervisory role enabling it to participate in selected examinations. He said his concern was the non-bank sector – do we need prudential oversight of that business segment? Ms. Bair said the new consumer protection agency would adequately address this; that the federal government did not need to get into the safety and soundness operations of uninsured entities. Comptroller Dugan said prudential supervision of these entities would be a daunting challenge, but he was concerned that some of the weak underwriting that caused the current problems may not be addressed if we approach them from strictly a “consumer” point of view. Governor Tarullo said there should be some government body looking at such practices beyond simply the consumer aspect.
Senator Charles Schumer (D – NY) observed that there was clearly a turf battle going on among the agencies, which he characterized as understandable. He said there are good reasons for one, strong prudential regulator: (1) prevents charter-shopping; (2) removes regulator conflict and burden; (3) allows for closer oversight of the entire industry; and, (4) eliminates regulatory arbitrage. He asked the panelists if they disagreed with this view. Governor Tarullo said he agreed with each point, but said there are “cons” to be considered: the Federal Reserve would lose insight into how banks are functioning, eliminating a valuable perspective for the Central Bank. Comptroller Dugan said he agreed with Sen. Schumer’s points. Chairman Bair said that, while she agreed with the points, there is no evidence that a single-regulator model works any better. She said competition among regulators is a good thing.
Senator Schumer said he has always been puzzled as to why the Federal Reserve and the FDIC have supervisory responsibility for state-chartered banks, and why should they keep such responsibility? Chairman Bair said the FDIC finds it extremely helpful to be “on the ground” on a continuous basis as a regulator, and believes its resolution process and abilities would suffer if it lost its examination and supervision responsibilities. Governor Tarullo added that state chartered institutions have always been hesitant to have the national bank charterer and supervisor also serve as their federal supervisor.
A second witness panel, consisting of independent experts and industry observers, was scheduled to testify but was postponed due to Senate scheduling issues. This witness panel will be heard at a later time.
On August, 4, 2009 the Senate Committee on Banking, Housing and Urban Affairs heard testimony from the heads of the four federal banking agencies on the subject of bank regulatory restructuring. In their opening statements, each of the panelists stated their positions regarding the major elements of the Administration’s reform proposal. There was general agreement among the witnesses that creation of a new Consumer Financial Protection Agency would be a positive move (although Federal Reserve Governor Tarullo indicated the Federal Reserve Board had not taken an official position on this point). They also agreed that some form of systemic risk oversight was called for, but disagreed on how this could best be accomplished. FDIC Chairman Sheila Bair argued that a council of regulators would be the best approach, while Comptroller John Dugan and Governor Tarullo argued that the Federal Reserve was well-situated to assume this role. None of the panelists argued strongly for further consolidation of the agencies beyond the Administration’s announced proposal to merge the OTS and the OCC (OTS Acting Director John Bowman expressed no view). Each witness also expressed support for the creation of a resolution mechanism for large, systemically important financial firms.
Committee Chairman Christopher Dodd (D – CT) commenced the questioning by asking the panel why it would not make sense to merge all prudential supervision functions under one agency. Ms. Bair stated that creation of one agency would not address the causes of the current crisis, that other countries that had such arrangements faired no better than the U.S., and multiple regulators actually strengthens the financial system by allowing for different regulatory points of view. Governor Tarullo added that it would weaken the regulatory system if the Federal Reserve and the FDIC did not play an active role in day-to-day supervisory activities because they would lose touch with banking operational issues.
Ranking Member Richard Shelby (R – AL) stated that, in terms of regulatory failure, “all roads lead to the Federal Reserve”. He then asked what steps should be taken to reduce “moral hazard” – do we need to just let big firms fail? Ms. Bair said we need a clear resolution authority for these firms. Mr. Dugan added that while we need more orderly resolution processes, we also need up-front supervision that sets strong capital and liquidity requirements, with flexibility for the government to intervene if necessary. Mr. Tarullo said we need more transparency and disclosure and alternative capital structures such as convertible debt. In response to Sen. Shelby’s Federal Reserve observation, Governor Tarullo pointed out that Bear Stearns, AIG, Fannie, and Freddie were not regulated by the Federal Reserve. Sen. Shelby answered by stating that the Federal Reserve was the supervisor for the large banking organizations that received government funding in the current crisis.
Senator Bob Corker (R – TN) stated his understanding that the Administration had originally contemplated having the new National Bank Supervisor (the consolidated OTS/OCC) structured as an independent agency, and asked Comptroller Dugan why this was changed in the final proposal. Mr. Dugan said he pushed for the change, because he believed it would be more cumbersome to have another banking agency with yet another board of directors populated by individuals simultaneously serving on other regulatory boards (FDIC and the new consumer agency). He believes the present structure, with the national bank supervisor as an independent bureau within the Treasury Department, is the best approach. Chairman Bair disagreed, stating it would be best if this regulatory body were completely independent of the Administration.
Senator Robert Menendez (D – NJ) asked the panel members if consolidating the agencies wouldn’t eliminate the opportunity for regulatory arbitrage? Governor Tarullo said the agencies had already addressed this potential through an interagency agreement prohibiting charter changes for institutions undergoing enforcement or other supervisory actions. Chairman Bair and Comptroller Dugan supported making this prohibition statutory to eliminate future discretion or flexibility. The panelists uniformly stated that “regulator shopping” among the closely regulated was not a problem; instead, it was the lack of regulatory oversight regarding the “shadow banking industry” that was the problem and attention should be focused on closing those regulatory gaps.
Senator David Vitter (R – LA) asked for the regulators’ views on FASB’s effort to move off- balance sheet activities clearly onto the books of insured financial institutions. Chairman Bair said banks need to follow the dictates of Generally Accepted Accounting Principles. She said the capital rules need to be reviewed, and she was particularly concerned about the timing of this effort because she believed it could be damaging when efforts are underway to get the securitization market functional again. Senator Vitter asked if regulators had any flexibility on this. Comptroller Dugan said there may be some regulatory flexibility, but the issue is timing. He said regulators were discussing how this issue affects capital, and interagency guidance and rulemaking may be forthcoming.
Senator Mel Martinez (R – FL) asked the panelists if interstate branching contributed to the current crisis. None of the panelists felt this was a problem, and Comptroller Dugan said it would not be a good idea to attempt to restrict interstate activities at this time. Governor Tarullo agreed. Senator Martinez then asked about the Administration’s proposal to designate certain firms as “Tier 1 Financial Holding Companies”. Ms. Bair said this was a bad idea, since identifying these firms would create moral hazard under the assumption they would be too big to fail.
Senator Robert Bennett (R – UT) stated his objection to the Administration’s proposal to prohibit industrial loan companies, arguing that these firms played no role in the current crisis. He then offered his observation that the primary problem in the current crisis was not “too big to fail” but the lack of a systemic supervisor to recognize the system-wide risk created by the poor lending and resulting inferior securitization process where no player had any risk of loss in the process. Governor Tarullo agreed with this assessment.
Senator Mark Warner (D – VA) stated his view that there should be one consolidated bank regulator, with the FDIC maintaining its back-up supervisory role enabling it to participate in selected examinations. He said his concern was the non-bank sector – do we need prudential oversight of that business segment? Ms. Bair said the new consumer protection agency would adequately address this; that the federal government did not need to get into the safety and soundness operations of uninsured entities. Comptroller Dugan said prudential supervision of these entities would be a daunting challenge, but he was concerned that some of the weak underwriting that caused the current problems may not be addressed if we approach them from strictly a “consumer” point of view. Governor Tarullo said there should be some government body looking at such practices beyond simply the consumer aspect.
Senator Charles Schumer (D – NY) observed that there was clearly a turf battle going on among the agencies, which he characterized as understandable. He said there are good reasons for one, strong prudential regulator: (1) prevents charter-shopping; (2) removes regulator conflict and burden; (3) allows for closer oversight of the entire industry; and, (4) eliminates regulatory arbitrage. He asked the panelists if they disagreed with this view. Governor Tarullo said he agreed with each point, but said there are “cons” to be considered: the Federal Reserve would lose insight into how banks are functioning, eliminating a valuable perspective for the Central Bank. Comptroller Dugan said he agreed with Sen. Schumer’s points. Chairman Bair said that, while she agreed with the points, there is no evidence that a single-regulator model works any better. She said competition among regulators is a good thing.
Senator Schumer said he has always been puzzled as to why the Federal Reserve and the FDIC have supervisory responsibility for state-chartered banks, and why should they keep such responsibility? Chairman Bair said the FDIC finds it extremely helpful to be “on the ground” on a continuous basis as a regulator, and believes its resolution process and abilities would suffer if it lost its examination and supervision responsibilities. Governor Tarullo added that state chartered institutions have always been hesitant to have the national bank charterer and supervisor also serve as their federal supervisor.
A second witness panel, consisting of independent experts and industry observers, was scheduled to testify but was postponed due to Senate scheduling issues. This witness panel will be heard at a later time.
Tuesday, August 4, 2009
FDIC Legacy Loans Program Gets a Test
By W. Bernard Mason
On July 31, 2009 the Federal Deposit Insurance Corporation announced commencement of the first test of the Legacy Loans Program funding mechanism. Using this funding process, the FDIC will transfer a receivership portfolio of residential mortgage loans (servicing released) to a limited liability company (LLC) in exchange for an ownership interest in the LLC. The LLC will also sell an equity interest to an approved investor, who will manage the loan portfolio. Other investors will be offered equity interests in the LLC under two options: (1) an all cash basis, with an equity split of 80 percent (FDIC) and 20 percent (investor); or, (2) a sale with leverage, under which the equity split will be 50/50.
Under the funding mechanism, financing will be offered by the receivership to the LLC using an amortizing note guaranteed by the FDIC. The FDIC will be protected against losses on the guarantee by leverage limits (both a maximum ratio and a dollar amount), the mortgages collateralizing the guarantee, and a guarantee fee.
The FDIC will analyze the results of this sale to determine how the Legacy Loans Program can best further the removal of troubled assets from bank balance sheets. The FDIC said this announcement was for informational purposes only, and not an offer for the sale of securities. A formal offering will be made to accredited investors in accordance with applicable securities laws.
On July 31, 2009 the Federal Deposit Insurance Corporation announced commencement of the first test of the Legacy Loans Program funding mechanism. Using this funding process, the FDIC will transfer a receivership portfolio of residential mortgage loans (servicing released) to a limited liability company (LLC) in exchange for an ownership interest in the LLC. The LLC will also sell an equity interest to an approved investor, who will manage the loan portfolio. Other investors will be offered equity interests in the LLC under two options: (1) an all cash basis, with an equity split of 80 percent (FDIC) and 20 percent (investor); or, (2) a sale with leverage, under which the equity split will be 50/50.
Under the funding mechanism, financing will be offered by the receivership to the LLC using an amortizing note guaranteed by the FDIC. The FDIC will be protected against losses on the guarantee by leverage limits (both a maximum ratio and a dollar amount), the mortgages collateralizing the guarantee, and a guarantee fee.
The FDIC will analyze the results of this sale to determine how the Legacy Loans Program can best further the removal of troubled assets from bank balance sheets. The FDIC said this announcement was for informational purposes only, and not an offer for the sale of securities. A formal offering will be made to accredited investors in accordance with applicable securities laws.
House Passes Compensation Legislation
By W. Bernard Mason
On July 31, 2009 the House of Representatives, by a vote of 237 to 185, approved H.R. 3269, the Corporate and Financial Institution Compensation Fairness Act of 2009. Republican opposition centered primarily on Section 4 of the bill that requires financial institutions to file reports with their appropriate federal regulator regarding any incentive compensation plans and authorizes federal regulators to intervene in any instance where such a program could threaten the safety or soundness of the institution or have serious adverse effects on economic stability. Republicans also objected to the concept of an annual, non-binding shareholder vote on compensation, arguing instead for such a vote once every three years. Republicans argued that the provisions of H.R. 3269 should apply exclusively to TARP recipients and other beneficiaries of taxpayer funds.
Rep. Scott Garrett (R – NJ) said the odd thing about the legislation is that it “gives with one hand, and takes with the other”. It allows shareholders to vote on pay, but it permits the government to later say the shareholders made an incorrect decision and allows some bureaucrat to make the final decision. He said the bill will create unintended consequences and may worsen undesirable aspects of compensation arrangements. He also said he has seen no factual proof that the underlying cause of the current crisis was excessive pay.
Rep. Mel Watt (D – NC) stated that the House debate “is a commentary on how out of whack our whole system has become”. He said this was a modest bill, providing for a nonbinding shareholder vote on executive compensation plans. He said the opposition is arguing that the owners of a company should not have the right to express their opinions on compensation to the officers of the company. He said this was not the government taking over corporate decision-making, not even with respect to the financial industry.
On July 31, 2009 the House of Representatives, by a vote of 237 to 185, approved H.R. 3269, the Corporate and Financial Institution Compensation Fairness Act of 2009. Republican opposition centered primarily on Section 4 of the bill that requires financial institutions to file reports with their appropriate federal regulator regarding any incentive compensation plans and authorizes federal regulators to intervene in any instance where such a program could threaten the safety or soundness of the institution or have serious adverse effects on economic stability. Republicans also objected to the concept of an annual, non-binding shareholder vote on compensation, arguing instead for such a vote once every three years. Republicans argued that the provisions of H.R. 3269 should apply exclusively to TARP recipients and other beneficiaries of taxpayer funds.
Rep. Scott Garrett (R – NJ) said the odd thing about the legislation is that it “gives with one hand, and takes with the other”. It allows shareholders to vote on pay, but it permits the government to later say the shareholders made an incorrect decision and allows some bureaucrat to make the final decision. He said the bill will create unintended consequences and may worsen undesirable aspects of compensation arrangements. He also said he has seen no factual proof that the underlying cause of the current crisis was excessive pay.
Rep. Mel Watt (D – NC) stated that the House debate “is a commentary on how out of whack our whole system has become”. He said this was a modest bill, providing for a nonbinding shareholder vote on executive compensation plans. He said the opposition is arguing that the owners of a company should not have the right to express their opinions on compensation to the officers of the company. He said this was not the government taking over corporate decision-making, not even with respect to the financial industry.
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