The Financial Crisis Inquiry Commission Issues its Final Report on the Causes of the Financial Crisis with Dissenting Views
After much sturm and drang, the Financial Crisis Inquiry Commission (Commission) issued this week its Final Report on The Causes of the Financial and Economic Crisis in the United States. Commission Member Peter Wallison noted that the most frequent question he was asked was why did Congress authorize the Commission, especially since the Dodd-Frank Act proceeded apace to enactment last year without any hope of benefitting from the Commission's wisdom. In Mr. Wallision's view the Commission's work has served a "useful purpose by focusing attention again on the financial crisis" and perhaps, with the benefit of more distance, "we can draw a more accurate assessment than what the media did with what is often called the 'first draft of history.'" In its official Preface, the Commission underlines the fact that it was created -- with a 10-member private bipartisan panel --to examine the causes of the crisis and "help policymakers and the public better understand how this calamity came to be." The Report analogizes the Commission's role to that of the National Transportation Safety Board (NTSB) after a plane crash.
Amid the Report's 675 pages and reams of additional material on the Commission's website -- www.fcic.gov -- there is a wealth of information to be mined for various purposes by legislators, regulators, trade associations, lobbyists and lawyers of all stripe, and scholars and historians. But, of course, what really counts now is exactly what did the Commission find in this comprehensive cornucopia of facts, figures, charts, graphs, testimony (700 witnesses), congressional committee reports, agency materials, academic articles, journalist stories, legal investigations and many other sources? Were their causes hitherto unknown, nefarious conspiracies at work, singularly important evildoers, Dan Brown secret societies at work or financial modelers fueled by mysterious substances? Alas, nothing so dramatic emerges, except for the fact that the six Democrats members take one point of view, three Republican members take another, and the Republican Mr. Wallison yet a third. As Jerry Seinfeld might say -- Not that there is anything wrong with that -- indeed given the multiple contributors (if not causes) to the crisis, it would have been more surprising had there been unanimity. As President Obama said in his State of the Union address, while our democracy can be contentious, messy and frustrating, it beats the alternative of a government that can unilaterally dictate change.
Save for Mr. Wallison, who believes that the sine qua non of the financial crisis was "U.S. Government housing policy, which led to the creation of 27 million subprime and other risky loans," . the Majority and Minority Commission members draw somewhat similar conclusions on the contributing causes, albeit with substantially different approaches and viewpoints on relative importance and impact. Causation, whether in a legal, scientific, philosophical or existential sense, is difficult to prove when so many different factors, actors and events were at work.
In the Majority's view the crisis could have been prevented -- the warning signs though many were discounted and ignored; the Majority takes special pains to characterize the Fed's failure to stem the flow of toxic mortgages as "pivotal" to the crisis. The Majority describes what it believes to have been widespread failures in regulation and supervision as particularly destabilizing, with the regulatory agencies coming in for severe criticism; but the Majority casts an equally jaundiced eye on what it views as "dramatic failures of corporate governance and risk management" at systemically important financial institutions. A perfect storm combination of excessive borrowing, risky investments and of a lack of transparency put the financial system on a collision course with crisis.
While the Majority concludes that the government was "ill-prepared" to deal with the crisis and its "inconsistent response" added to the crisis, it nonetheless expresses deep respect and appreciation for the dedication of Secretary Paulson, Chairman Bernanke, and (now Secretary) Geithner and "so many others" for their extraordinary work to stabilize the financial system and our economy. In terms of more specific causes, the Majority singles out (i) a systemic breakdown in accountability and ethics (noting estimates of mortgage fraud north of $100 billion), ii) collapsing mortgage underwriting standards fueled by a relentless mortgage securitization pipeline, (iii) Credit Default Swaps which contributed significantly to the crisis by, in effect, facilitating the mortgage pipeline and synthetic CDOs as well as the collapse of AIG, and (iv) finally the failures of credit rating agencies. Certainly, the majority's viewpoint provides underlying support for the remedies of Dodd-Frank. The Majority;s picture is fairly consistent with popular perception and what formed the legislative drivers of Dodd-Frank. That a majority of six Democrats should take that view is clearly not surprising.
The Minority (Messrs. Hennessey, Holtz-Eakin and Thomas) take in their words a "different approach". The Minority effectively rejects the "single cause explanation" implied by Mr. Wallison and others and criticizes the Majority's approach as "too broad," noting in particular that non-credit derivatives did not in any meaningful way contribute to the financial crisis. The Minority also chafes at viewing causes of the crisis as particularly American in origin. In this regard, the Minority sees more bubbles than Lawrence Welk -- housing bubbles in the UK, Spain, Australia, France and Ireland, some more pronounced than in the U.S., The Minority lists what it views as the ten "essential causes" of the crisis: (i) the credit bubble; (ii) the housing bubble; (iii) nontraditional mortgages; (iv) credit ratings and securitization; (v) financial institutions correlated risk; (vi) leverage and liquidity risk; (vii) risk of contagion; (viii) common shock (a lot of bad stuff happening at the same time); (ix) financial shock and panic; and (x) financial crisis causes economic crises.
Perhaps a more apt analogy then the NTSB as a guide to understanding the cause of the crisis is to consider the crisis as the equivalent of a financial system heart attack. The proximate cause of a heart attack is usually blocked arteries; the proximate cause of the financial crisis was frozen or blocked credit channels, which have to flow to keep the financial system functioning. Thankfully the US had a good medical team that pulled the patient through on the operating table. Having done so, this same medical team, after getting a power of attorney, is imposing a number of major lifestyle changes on the patient -- the financial system -- with the intention that there won't be any repeat incidents. Just as poor diet, lack of exercise, high blood pressure and other adverse factors can lead to a heart attack, the Commission's report identifies a number of contributing factors. The medical team didn't wait for the report, confident that it too had identified the key causes. The medical team has prescribed a combination of medications and lifestyle changes the patient needs to make for a complete recovery. The patient is unfamiliar with some of these remedies, e.g., the CFPB, and wants the medical team to reduce and adjust the number and dosages of medications to minimize the side effects. The challenge for the medical team is that as the patient feels better, it's always easy to slip back into bad habits. If that happens the medical team will not be pleased and will fear that the next time around a commission may be needed to do an autopsy rather than a post-operative report.
SEC Staff Study on Broker-Dealers and Investment Advisers -- Fiduciary Duty
On January 21, 2011, the SEC submitted to Congress a study recommending a "uniform fiduciary standard of conduct" for broker-dealers and investment advisers -- when they provide personalized investment advice about securities to retail investors. These conduct standards must not be less stringent than currently applied to investment advisers under the Advisers Act. The study, which examines the obligations and standards of conduct for financial professionals, was required under the Dodd-Frank Act.
In the study, the SEC staff notes that investment advisers and broker-dealers are regulated extensively under different regulatory regimes, but retail investors are often confused by the roles played by investment advisers and broker-dealers and the standards of care that apply to their provision of services. The study takes the view that retail investors "should not have to parse through legal distinctions" to determine the type of advice they are entitled to receive. "Instead, retail customers should be protected uniformly when receiving personalized investment advice about securities regardless of whether they choose to work with an investment adviser or a broker-dealer." At the same time, the study notes that retail investors should "continue to have access to the various fee structures, account options, and types of advice that investment advisers and broker-dealers provide." As a result, the study "recommends that the Commission . . . adopt and implement, with appropriate guidance, the uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers."
The study also "recommends that when broker-dealers and investment advisers are performing the same or substantially similar functions, the SEC should consider whether to harmonize the regulatory protections applicable to such functions. Such harmonization should take into account the best elements of each regime and provide meaningful investor protection." The study concludes that the "staff's recommendations were guided by an effort to establish a uniform standard that provides for the integrity of personalized investment advice given to retail investors. At the same time, the staff's recommendations are intended to minimize cost and disruption and assure that retail investors continue to have access to various investment products and choice among compensation schemes to pay for advice."
Commissioners Casey and Paredes issued a joint statement opposing the study because it "fails to adequately justify its recommendation that the [SEC] embark on fundamentally changing the regulatory regime for broker-dealers and investment advisers providing personalized investment service to retail investors." In particular, the Commissioners stated that the study does not adequately articulate or substantiate the problems that would purportedly be addressed by regulatory change. The Commissioners suggested additional research and analysis be completed to support a conclusion that the study's recommendations should be implemented or will be effective.
Section 913 of Dodd-Frank provides that the SEC may commence a rule-making -- as necessary or appropriate to the public interest --for the protection of investors taking into account the findings conclusions and recommendations of the Study.
SEC Approves New Rules Regulating Asset-Backed Securities
On January 20, 2011, the SEC approved two final rules governing issuer due diligence and disclosure regarding asset backed securities (ABS), as required by the Dodd-Frank Act. The SEC believes that these two new rules will help revitalize the ABS markets by restoring transparency and integrity to the product class. The rules will be effective 60 days after publication in the Federal Register, which is pending, but will have delayed compliance dates. The first filing under the ABS due diligence rule is due from all but municipal securitizers by February 14, 2012, and must contain information for three years ending December 31, 2011, with a one year look back rolled phase-in. The disclosure requirement applies to registered ABS issued after February 14, 2012.
ABS Issuer Due Diligence Final Rule
The issuer due diligence rule seeks to address "perceived uncertainly" about the accuracy of information regarding loans backing ABS during the financial crisis. It adds a minimum standard requiring each issuer of ABS registered after December 31, 2011 to conduct due diligence that provides "reasonable assurance that the prospectus disclosure about the assets is accurate in all material respects." The issuer is the depositor or sponsor of the securitizations. The SEC describes this standard as principle-based and permits issuers to develop different approaches to due diligence that are tailored for the underlying assets. Issuers must disclose the type of review conducted, which, of necessity, must include a review of credit quality and underwriting of the assets. The type of review is driven by the nature of the underlying asset and may include sampling. Third-parties may perform this due diligence for ABS issuers. If an issuer attributes its due diligence findings to a third-party, the third-party must be named in the registration statement and consent to treatment as an "expert" under Section 7 of the Securities Act and Rule 436 issued thereunder. The final rule postponed requiring issuers or underwriters of ABS to publicize findings and conclusions of any third-party due diligence report it obtains. This will be addressed in a larger, related rulemaking.
ABS Representations and Warranties Disclosure Final Rule
New disclosure Rule 15Ga-1 seeks to identify loans with characteristics or qualities that do not comply with the representations and warranties about the pool of assets contained in the ABS documentation. Since an ABS issuer or lender may have to repurchase or replace an asset that violates the representations or warranties, this disclosure requirement seeks to identify originators with clear underwriting deficiencies. The disclosure obligations will phase-in depending on the type of issuer starting after December 31, 2011, with the earliest filing deadline falling on February 14, 2012.
Securitizers of ABS must disclose fulfilled and unfulfilled repurchase requests across all trusts aggregated by a securitizer. For issuances receiving credit ratings from national rating agencies, credit agency reports issued with the rating must include information describing the representations, warranties and enforcement mechanisms available to investors in ABS. This must also reflect how such representations and warranties differ from issuances of similar securities. This requirement applies to any report issued six months after the effective date of the rules. The disclosure must follow a prescribed format, which includes a mandated table, and provide a phased-in three year look back at demand, repurchase and replacement history starting with periods ending December 31, 2011. This same information, plus all fulfilled, unfulfilled and pending repurchase requests, must be disclosed thereafter within 45 days after the calendar quarter ends. This disclosure must be made on new Form ABS-15G and may be filed on EDGAR or, for municipal securitizers, EMMA.
The new rule adopts a broad definition of "asset-backed security" (termed an "Exchange Act ABS") which includes ABS securities that are exempt from registration under the Securities Act. Examples of Exchange Act ABS are collateralized debt obligations and securities issues that are guaranteed by a government sponsored entity, such as Fannie Mae, Freddie Mac or a municipality. As a result, unregistered ABS offerings must comply with the new disclosure rules if the underlying transaction agreements contain a covenant to repurchase or replace an asset for breach of a representation or warranty. For registered offerings, the disclosure must appear in the prospectus. There are several dates for compliance with the new disclosure rule. The earliest filing date is February 14, 2012, for issuers of ABS other than municipalities. Municipal securitizers have until February 14, 2015, to file because they have less experience with developing and providing the required information.
SEC and CFTC Propose Private Fund Systemic Risk Reporting Rule
On January 25, 2011, the SEC proposed a rule to require advisers to hedge funds and other private funds to report information for use by the Financial Stability Oversight Council (FSOC) in monitoring risk to the U.S. financial system. The proposed rule would implement Sections 404 and 406 of the Dodd-Frank Act. The proposal creates a new reporting form (Form PF) to be filed periodically by SEC-registered investment advisers who manage one or more private funds. Information reported on Form PF would remain confidential.
Proposed Reporting Requirements
Under the proposed reporting requirements, advisers to private funds would be divided into two groups, large private fund advisers and smaller private fund advisers. The amount of information reported and the frequency of reporting would depend on the group to which the adviser belongs. Large private fund advisers would include any adviser with $1 billion or more in hedge fund or "liquidity fund" (i.e., unregistered money market fund), or private equity fund assets under management. All other private fund advisers would be regarded as smaller private fund advisers. The SEC anticipates that most private fund advisers would be regarded as smaller private fund advisers but that a limited number of large private fund advisers providing more detailed information would represent a majority of industry assets under management. As a result, this threshold would allow FSOC to monitor a significant portion of private fund assets while reducing the amount of reporting required from private fund advisers.
Smaller Private Fund Advisers
Smaller private fund advisers would file Form PF once a year and would report basic information regarding the private funds they advise. This would include information regarding leverage, credit providers, investor concentration and fund performance. Smaller private fund advisers managing hedge funds would also report information about fund strategy, counterparty credit risk and use of trading and clearing mechanisms.
Large Private Fund Advisers
Large private fund advisers would file Form PF quarterly and would provide more detailed information than smaller private fund advisers. The focus of the reporting would depend on the type of private fund that the adviser manages: Large hedge fund advisers would report, on an aggregated basis, information regarding exposures by asset class, geographical concentration and turnover. In addition, for each managed hedge fund having a net asset value of at least $500 million, these advisers would report certain information relating to that fund's investments, leverage, risk profile and liquidity. Large liquidity fund advisers would provide information on the types of assets in each of their liquidity fund's portfolios, certain information relevant to the risk profile of the fund, and the extent to which the fund has a policy of complying with all or aspects of the Investment Company Act's principal rule concerning registered money market funds (Rule 2a-7). Large private equity fund advisers would respond to questions focusing primarily on the extent of leverage incurred by their funds' portfolio companies, the use of bridge financing, and their funds' investments in financial institutions.
Although the SEC expects that this heightened reporting threshold would apply to only about 200 U.S.-based hedge fund advisers, these large private fund advisers manage more than 80 percent of the assets under management in private funds.
The CFTC approved this joint private fund release on January 26, 2011. Private funds that are already registered with the CFTC as commodity pool operators or commodity trading advisors would file Form PF as well, but in compliance with CFTC reporting obligations. The public comment period on the proposed joint rule will last 60 days from the date the proposal is published in the Federal Register.
Agencies Release Joint Implementation Plan for Transfer of OTS Personnel, Authority, Responsibilities, Funds and Property
The four federal banking agencies, as required by Dodd-Frank, issued a Joint Implementation Plan (Plan) for the transfer of OTS personnel, authority, responsibilities, funds and property. Of principal interest to thrifts and thrift holding companies are those sections of the Plan describing the transfer of key regulatory, supervisory, examination and reporting requirements.
OCC. The OCC's objective is to fully integrate OTS staff and functions into the current OCC organizations structure and supervisory model. This will effect approximately 670 federal thrifts. The vast majority of thrifts will be supervised by the OCC's Community Bank Supervision function, Larger thrifts will be supervised by the Midsized and Large Bank supervision programs. The Special Supervision Program will be expanded to include troubled thrifts. There will not be a separate reporting line for thrifts, However, the OCC will be adding a Senior Advisor for Thrift Supervision in each OCC district office reporting directly to the Deputy Comptroller for each District. New field offices are to be opened in Des Moines and Seattle. The OCC has been working with the OTS to review all of the OTS regulations governing savings associations and anticipates some changes will be effective on July 21, 2011.
FDIC. As of the date of enactment, there were 61 state-charted savings associations supervised by the OTS. The OTS will continue to have responsibility for exams of these institutions that will occur before July 21, 2011, Thereafter, the FDIC will fully integrate the supervision of state thrifts into its supervision program, which can be absorbed by the appropriate FDIC Regional offices. The FDIC will assume temporary responsibility for TFR reporting by thrifts beginning with the second quarter of 2011. However, the Thrift Financial Report will be phased out and integrated into the bank call report beginning with the March 2012 reporting period.
Fed. Dodd-Frank transfers authority for consolidated supervision of Thrift Holding companies and their non-depository subsidiaries to the Fed effective July 21, 2011. The Fed will carry out its supervisory oversight of thrift holding companies consistent with the established approach as set forth in SR Letters 09-9 and 08-12. The Fed also has authority to require grandfathered unitary thrift holding companies to establish an intermediate holding company over all or a portion of the company's financial activities. The Fed has established a working group in this area and will first publish regulatory proposal on its use of such authority for notice and comment.
Any changes to existing OTS regulations for thrift holding companies will not occur until after July 21, 2011 and will do so through a public comment and notice process. Similar to the OCC, noncomplex Thrift HCs will be supervised in the Community Banking Portfolio, while larger, more complex companies will be supervised in the Regional or Large Banking Organization portfolios.The Fed is in the process of issuing a separate notice of its intention to phase out the thrift holding company reporting scheme and to require thrift holding companies to adopt reporting standards and processes required by the Fed of BHCs. The new Thrift Holding Company Reporting requirements would also come into effect beginning with the March 2012 reporting period.
Inspector Generals of Treasury and the Fed Provide Insight and Information Regarding the Establishment of the Consumer Financial Protection Bureau
In a letter dated January 10, 2011, the Inspector Generals for Treasury and the Fed respond to a series of questions posed by House Financial Services Committee Chairman Bacchus and House Subcommittee Chairman Judy Biggert on Treasury's activities to establish the Consumer Financial Protection (Bureau). The letter is instructive in many respects in describing Treasury's activities but also it various related authorities under Dodd-Frank.
Scope of Bureau Authority Without a Director. Even if the Bureau does not have a Senate-confirmed Director by July 21, 2011, it nonetheless can perform all authorities except the following: (i) prohibiting unfair, deceptive or abusive acts or practices; (ii) prescribing rules and required model disclosure forms to ensure that the features of a consumer financial product or service are fairly, accurately, and effectively disclosed both initially and over the term of the product or service; (iii) prescribe rules relating to the filing of limited reports to the Bureau for the purpose of determining whether a nondepository institution should be supervised by the Bureau or; (iv) supervise nondepository institutions, including the authority to (a) prescribe rules defining the scope of nondepository institutions subject to the Bureau’s supervision, (b) prescribe rule establishing recordkeeping requirements that the Bureau determines are needed to facilitate nondepository supervision, and (c) conduct examinations of nondepository institutions.
Organization Structure. The Bureau implementation team currently has a draft plan of the Bureau’s organizational structure and a draft budget for FY 2011 and FY 2012. A December 8, 2010, draft of the Bureau’s organizational structure indicates that, in addition to administrative divisions and offices, the Bureau is considering three mission-related directorates: (i) Education and Engagement, (ii) Supervision and Enforcement,; and (iii) Research, Markets, and Rules. The Bureau implementation team plans to include an Office of Small Business and Community Banks within the Bureau’s organizational structure. The Research, Markets, and Rules division, according to Treasury, would comprise three components: a research team that studies consumer behavior and product risks; a rulemaking team that drafts rules, interpretations, and guidance; and a markets team that focuses on understanding and monitoring markets for individual products, such as mortgages, credit cards, and student loans.
Initial Priorities. Professor Warren and the Bureau implementation team are in the process of identifying priorities for rulemaking proceedings to be undertaken after the designated transfer date. Professor Warren indicated that cost savings, improved regulatory compliance, and simplified consumer disclosures are among the factors being considered in establishing the rulemaking priorities. In addition, Professor Warren and members of the Bureau implementation team have met with staff from the financial regulatory agencies that will be transferring rulemaking authority to the Bureau in an effort to better understand existing regulatory priorities. Professor Warren provided examples of two policy initiatives that will receive priority: (1) consolidating duplicate and overlapping mortgage disclosure forms mandated by the Truth in Lending Act and the Real Estate Settlement Procedures Act and (2) simplifying credit card agreements to ensure that customers fully understand fees and finance charges.
Chairman Spencer Bachus of the House Financial Services Committee has announced that the Committee will "be busy this year addressing the issues of concern to Americans: jobs, economic activity, Fannie and Freddie reform, and implementation of Dodd-Frank. We will work to ensure that taxpayers are protected. This hearing schedule is tentative but is intended to inform Americans on the issues the Committee will be tackling."
The Schedule below is tentative because it will depend on witness availability and other factors that may require changes. Therefore, each meeting will become final only when the official notice is distributed.
Wednesday, February 9 (10 am)
Monetary policy and jobs (DMP)
Wednesday, February 9 (2 pm)
GSE reform (CM)
Thursday, February 10 (10 am)
Markup of Committee Oversight Plan (FC)
Tuesday, February 15 (10 am)
Implementation of derivatives provisions of Dodd-Frank Act (FC)
Tuesday, February 15 (2 pm)
GSE legal fees (O&I)
Wednesday, February 16 (10 am)
Financial Crisis Inquiry Commission report (FC)
Wednesday, February 16 (2 pm)
Housing finance (IH)
Thursday, February 17 (10 am)
Federal Reserve proposal on interchange (FI)
Tuesday, March 1 (10 am)
GSE reform (FC)
Wednesday, March 2 (10 am)
HUD FY 2012 budget (FC)
Thursday, March 3 (10 am)
Federal Reserve semi-annual report on monetary policy (FC)