"If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations or consumers, often poses greater systemic risks than it seems during a boom." - Carmen Reinhart and Ken Rogoff in This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009)
"I like my players to be married and in debt. That's the way you motivate them." - Ernie Banks (Legendary baseball player and manager and perhaps the greatest Chicago Cub)
Federal Financial Regulators Describe Progress on Monitoring Systemic Risk
Heads of all the major financial regulatory agencies appeared at an Oversight Hearing called by Senator Tim Johnson (D-SD), the Chairman of the Senate Banking Committee on May 12th to discuss their progress and that of the Financial Stability Oversight Council (FSOC) in implementing provisions of Dodd-Frank related to monitoring systemic risk and promoting financial stability. While most of the testimony was a review of actions taken to date, some insights were provided on the process surrounding the establishment of enhanced prudential standards for Systemically Significant Financial Institutions (SIFIs), the designation of nonbank financial SIFIs and actions in response to the flash crash.
Fed Chairman Bernanke said that to meet the January 2012 implementation deadline for enhanced prudential standards for SIFIs, the Fed anticipates "putting out a package of proposed rules this summer." The Fed's goal is to produce a "well-integrated" set of rules to accomplish the objectives of the Dodd-Frank Act. Acting Comptroller of the Currency John Walsh noted that, in response to comments on the nonbank SIFI designation proposal, "there appears to be general agreements among the agencies [on the FSOC] on the need to provide and seek comments on additional details regarding FSOC's standards for assessing systemic risk before issuing a final rule."
FDIC Chairman Sheila Bair elaborated further on the Comptroller's statement of the need for additional comment by noting as well the need to be able to collect detailed information on a limited number of nonbank financial institutions as part of the designation process. Firms should be selected to provide this information, which should be around simple and transparent metrics. However, she cautioned that no one "should jump to the conclusion that by asking for additional information the FSOC has preordained a firm to be systemic." It is also worth noting that in discussing SIFI designation, Chairman Bair also stated that if "an institution can be reliably deemed resolvable in bankruptcy by the regulators, and operates within the confine of the leverage requirements established by bank regulators, then it should not be designated a SIFI."
SEC Chairman Mary Schapiro also stated that the FSOC plans "to provide additional guidance regarding the FSOC's approach to designations and will seek public comment." Chairman Schapiro devoted a major part of her testimony to the flash crash and the most recent SEC/CFTC Report. Among her major concerns is the lack of a standardized automated system to collect data across the various trading venues, products and market participants, noting that only some markets have their own individual and often incomplete audit trails. She said that this requires the SEC to obtain and merge "a sometimes immense volume of disparate data from different markets". Given these challenges, Chairman Schapiro noted that the SEC's proposal on large trader reporting requirements and a consolidated audit trail would for the first time "allow SROs and the Commission to track trade data across multiple markets, products and participants simultaneously."
SEC Proposes Rules to Increase Transparency and Improve the Integrity of Credit Ratings
On May 18, 2011, the Securities and Exchange Commission (SEC) voted unanimously to propose new rules and amendments intended to increase transparency and improve the integrity of credit ratings. Since the passage of the Dodd-Frank Act, the SEC has issued proposals that would:
Change existing rules related to money market funds that allow such funds to only invest in securities that have received one of the two highest categories of short-term credit ratings.
Remove references to credit ratings from broker-dealer capital and other financial responsibility rules and, where necessary, substitute alternative standards of creditworthiness.
Remove credit ratings as one of the conditions for companies seeking to use short-form registration when registering securities for public sale.
The proposed rules would implement certain provisions of Dodd-Frank and are intended to enhance the SEC’s existing rules governing credit ratings and Nationally Recognized Statistical Rating Organizations (NRSROs).
SEC Chairman Mary L. Schapiro stated that "In passing the Dodd-Frank Act, Congress noted that credit ratings applied to structured financial products proved inaccurate and contributed significantly to the mismanagement of risks by financial institutions and investors. Our proposed rules are intended to strengthen the integrity and improve the transparency of credit ratings."
Under the SEC’s proposal, NRSROs would be required to:
Report on internal controls.
Protect against conflicts of interest.
Establish professional standards for credit analysts.
Publicly provide, along with the publication of the credit rating, disclosure about the credit rating and the methodology used to determine it.
Enhance their public disclosures about the performance of their credit ratings.
The SEC’s proposal also requires disclosure concerning third-party due diligence reports for asset-backed securities. Public comments on the SEC’s proposal should be received within 60 days after it is published in the Federal Register.
Highlights from an SEC Fact Sheet on its proposals follow: The Proposed Rules
The SEC proposed rules relate to NRSROs and third-party due diligence providers as well as issuers and underwriters, of asset-backed securities. Some of the proposed rules would expand upon provisions in Dodd-Frank that are self-executing, while others proceed from provisions in the Act that require SEC rulemaking.
Section 932 of the Dodd-Frank requires an NRSRO to have an effective internal control structure governing the way in which it determines credit ratings. The Act also requires each NRSRO to submit an annual report to the SEC about its internal controls. Under the proposed rule amendment, the NRSRO would be required to file a report with the SEC containing a description of management’s responsibility in establishing the internal control structure and an assessment of the effectiveness of those internal controls.
Preventing Conflicts of Interest
Section 932 also seeks to prevent an NRSRO’s "sales and marketing" considerations from influencing its credit ratings. Under the proposed rule amendments, an NRSRO would be prohibited from issuing or maintaining a credit rating where an employee of the NRSRO " who participates in the sales or marketing of a product or service of the NRSRO or of a person associated with the NRSRO " also participates in determining or monitoring a credit rating or developing or approving procedures used for determining a credit rating. The Act also requires NRSROs to establish policies regarding former employees who participated in determining a credit rating, and were subsequently employed within one year " by an entity subject to that credit rating"– or by the issuer, underwriter, or sponsor of a product subject to that credit rating. In such cases, the NRSRO must conduct a "look-back" review to determine whether any conflicts of interest influenced the credit rating. Under the proposed rule, if the "look-back" review determined that a conflict influenced a rating, the NRSRO would be required at a minimum to take certain actions, including to immediately place the credit rating on a credit watch and include, among other things, an explanation that the reason for the action is that the rating was influenced by a conflict of interest.
Standardizing Disclosure of Information About the Performance of Credit Ratings
The Act's Section 932 also requires NRSROs to publicly disclose information on their initial credit ratings" and subsequent changes to such ratings "so users can evaluate the accuracy of the ratings and compare the performance of different rating agencies". The SEC proposals would, among other things, standardize the way an NRSRO calculates and presents aggregate information about how its ratings change over time (the transition rate) and how often a rated entity or product subsequently defaulted. The enhancements would, among other things require that the disclosures include any credit ratings that were outstanding as of June 26, 2007, and any subsequent rating actions taken with respect to those ratings.
Strengthening Credit Rating Methodologies
Dodd-Frank also requires the SEC to adopt rules requiring an NRSRO to have policies and procedures governing the way it determines credit ratings. Under the proposed rule, those policies and procedures would have to be reasonably designed to ensure, among other things, that: the board of directors approves them, material changes are applied consistently, and changes to surveillance procedures are applied within a reasonable period of time. The NRSRO would have to promptly publish notice of material changes to rating methodologies and of the discovery of significant errors in rating methodologies. The NRSRO also must disclose the version of the methodologies used with respect to a particular credit rating.
Leveraging Third-Party Due Diligence for Asset-Backed Securities
As required by Section 932, the SEC’s proposed rule would require that due diligence providers for asset-backed securities must provide a written certification to any NRSRO that rates the securities. The certification would be made on a new form "Form ABS Due Diligence-15E" which would describe the due diligence undertaken and the findings and conclusions resulting from the due diligence. This information would be required to be made public by the NRSRO, or if the NRSRO does not do so, by the issuer or underwriter of the securities.
Enhancing the Disclosure of Information About Credit Ratings
The SEC is also required to issue rules that require NRSROs to publish a form with each credit rating. Under the proposed rule, the NRSRO would be required to include in the form information about the credit rating, such as information relating to the assumptions underlying the methodology used to determine the credit rating and include any certification of due diligence providers described above. The form and certifications would have to be published in the same medium and made available to the same persons who can receive or access the credit rating. The NRSRO would need to disclose in the form substantial qualitative and quantitative information about the credit rating and methodologies used to determine the credit rating.
Upgrading Standards of Training, Experience, and Competence
Consistent with Section 936 of Dodd-Frank, the proposed rule would require NRSROs to establish standards of training, experience and competence for credit analysts and to consider certain factors when establishing the standards, for example the complexity of the securities that will be rated by the analyst. An NRSRO would also have to periodically test its credit analysts on the credit rating procedures and methodologies it uses.
Addressing Rating Symbols
Consistent with Section 938(a) of the Act, the rule proposal would require an NRSRO to have policies and procedures that are reasonably designed to assess the probability that an issuer of a security or money market instrument will default. The NRSRO would have to clearly define each symbol in its rating scale and apply any such symbol in a consistent manner.
Acting Comptroller of the Currency John Walsh Addresses Issues Facing the Mortgage Industry
On May 19, 2011 Acting Comptroller of the Currency (OCC) John Walsh addressed the Housing Policy Council of the Financial Services Roundtable on developments in the mortgage lending and servicing industry. Comptroller Walsh noted an extensive list of changes facing the mortgage lending and servicing industry which he likened to a "tsunami" not a wave:
Mortgage servicing model is under "severe stress"
Basel III takes a "highly skeptical view of the value of mortgage servicing assets as bank assets"
15 to 20 new mortgage lending requirements in the regulatory pipeline
The agency enforcement actions against the largest servicers
Comprehensive mortgage servicing standards (agencies aiming for year-end)
The credit risk retention rule that will fundamentally change the securitization business
Fannie and Freddie to issue detailed guidelines for mortgage servicing and delinquency management, including financial sanctions for servicers
Other rule-makings due within 18 months on ability to repay, restrictions on prepayment penalties and comprehensive new mortgage disclosure rules
Comptroller Walsh noted that while "there are lots of good ideas in Dodd-Frank," his concern is that with so many changes and requirements coming at once, that there is a risk "of drug interactions: you take one pill that's good for your head, another that helps your heart, but taken together they fatten you." With respect to the mortgage industry, he indicated that one regulation may strengthen the quality of capital; another might fix problems with servicing, and yet another may ensure that compensation policies don't create improper incentives. The Comptroller noted that "[all] of those goals are worthy, but it is hard to predict how they will all work together."
While recognizing that banks will face increased costs and reduced revenues, Comptroller Walsh expressed his view that they will find a "new normal." His "real concern" is the impact of all these new requirements on the housing market and homeowners. He also highlighted his concerns as to what the new regulations will mean for industry competition by stating, "...they will change the servicing business in important ways, and it may be that some providers will decide that the high-volume, low-margin, technology-dependent model no longer works financially."
In light of his concerns, Comptroller Walsh encouraged the "affected industry [to] study the individual and cumulative impact of the changes" For market participants, Comptroller Walsh believes "it is essential to define likely impacts: how they will affect the business and how markets may evolve."
Comment: Comptroller Walsh is, of course, on to something here. Implementing Dodd-Frank is like trying to assemble a gigantic jigsaw puzzle, with different participants in the implementation process assigned different parts of the puzzle. Their job is to make all these disparate pieces somehow fit together without a clear picture of what the puzzle will look like when it is done. While as Acting Comptroller Walsh implied, the regulated industries will adapt as they always have, the ultimate question is what will be the impact of these multiple, virtually simultaneous changes on business models, key markets and the customers they serve. While individual institutions and markets may be safer on paper will they become more concentrated not only in terms of who provides services but whom they serve? Will more customers be forced into a new shadow financial system and to unregulated firms that may be on someone's drawing board today? Comptroller Walsh's speech is a valuable reminder not to lose sight of the big picture in commenting on scores of rules.
The OCC Provides Clarification to Dodd-Frank Preemption Provisions
In a letter dated May 12, 2011, Acting Comptroller of the Currency John Walsh provided the OCC's interpretation of the preemption provisions of Dodd-Frank, which were among the most hotly contested provisions in the Act.
In particular, astute legal minds have been arguing over the exact meaning of a key preemption provision in Dodd-Frank which provides that a "state consumer financial law" is preempted if, "in accordance with the legal standard for preemption in the decision of the Supreme Court of the United States in Barnett Bank of Marion County, N.A. v. Nelson, Florida Insurance Commissioner et al, 517 U.S. 25 (1996) the state consumer financial law prevents or significantly interferes with the exercise by the national bank of its powers." The question has been does this "prevent or significantly interfere" language constitute merely a reference to the Barnett standards or does it impose a statutory gloss on Barnett making interpretation more difficult.
The Comptroller reasons that while the provision incorporates the "prevent or significantly interfere with" language as a "touchstone or starting point" for analysis, the legal interpretation of those terms must consider the whole of the conflict preemption analysis in Barnett. Comptroller Walsh notes this result is also supported by a recent Appeals court decision holding that the proper preemption test under Barnett is "conflict preemption" -- whether there is a significant conflict between state and federal law. Baptista v. JPMorgan Chase, N.A., (11th Circuit, May 11, 2011, to be published). The Comptroller went on to cite other authority in support of his position.
What does this mean? In practical terms, it appears to mean that to preempt a state consumer financial law consistent with Barnett the OCC has to find a significant conflict between state and federal law, and does not have to meet as well a separate test of "prevent or significantly interfere with." Consult your counsel, however, for their view, as even in the best of times preemption can be somewhat murky. Importantly, the Comptroller noted that precedents that are consistent with the principles of the Barnett conflict preemption analysis are preserved, including judicial decisions and OCC interpretations and rules where preemption is based on Barnett-based principles of conflict preemption. That said, Comptroller Walsh acknowledges that going forward on July 21, 2011 and after the Act imposes new procedures and consultation requirements with respect to how the OCC reaches future preemption decisions, including how the case-by-case requirement is to be applied.
In other less esoteric matters, Comptroller Walsh indicated that the OCC would be proposing changes to its rules where such appear clearly required by Dodd-Frank. Specifically:
Because the law eliminates preemption of state law for national bank subsidiaries, agents and affiliates, the OCC plans to propose rescission of 12 CFR Section 7.4006 which is the OCC's rule applying state laws to national bank operating subsidiaries.
The Act also changes the preemption standards under the Home Owners' Loan Act for federal thrifts to conform to those applicable to national banks. The OCC thus plans to proposed amendments to thrift regulations to make clear that federal thrifts and their subsidiaries are subject to the same standards applicable to national banks and their subsidiaries.
The OCC also plans to propose revisions to 12 CFR Section 7.4000 to provide that action by a State Attorney General in a court of appropriate jurisdiction to enforce a non-preempted state law against a national bank does not constitute an exercise of visitorial powers, The OCC views this as consistent with the Supreme Court's decision in Cuomo v. Clearing House Association L.L.C.129 S. Ct.2710 (June 29, 2009).
NY Lawmakers Urge Regulators to Reconsider Margin Proposal for Swaps
On May 18, 2011, lawmakers from New York sent the heads of all the major federal regulatory agencies a letter asking for to limit the proposed margin rules for uncleared swaps to U.S. transactions only. They note that the application of the proposed margin rules to swaps between non-U.S. affiliates of U.S. entities and non-U.S. counterparties will create competitive inequities. Foreign clients would choose to trade with non-U.S. counterparties to avoid margin costs applicable to transactions with U.S. affiliated counterparties, the letter infers. The letter describes this effect as "inconsistent with Congressional intent regarding the territorial scope of the new regulatory framework for derivatives."
The international reach of derivatives regulation under Title VII of Dodd-Frank has been a source of considerable concern from the market place but little clarity from the regulators. The letter notes that Congress required a "direct and significant connection" with U.S. activities in defining the extraterritorial reach of Dodd-Frank, suggesting that the proposed margin regulations extend beyond this scope when applied to non-US affiliates trading swaps with non-US counterparties. It also notes that new margin requirements for transactions "taking place wholly outside the United States" should await further international harmonization of derivatives regulation, which hopefully would mirror the U.S. approach. European efforts to build a new derivatives regulatory regime is lagging reform in the U.S. by at least 18 to 24 months.
The letter was signed by U.S. Senators Charles E. Schumer and Kirsten Gillibrand and Representatives Carolyn Maloney, Gregory Meeks, Joseph Crowley, Carolyn McCarthy, Gary Ackerman, Steve Israel, Anthony Weiner, Peter King, Michael Grimm, Nan Hayworth, Chris Gibson, Richard Hanna, Tom Reed, Ed Towns, Eliot Engel and Yvette D. Clarke.
The Government Accountability Office (GAO) said in a recent report that the banking regulators and Consumer Financial Protection Bureau (CFPB) should develop plans to regulate mortgage servicers and standards for foreclosure practices. The report concluded "Federal laws do not specifically address the foreclosure process, and federal agencies' past oversight of servicers' foreclosure activities has been limited and fragmented." While several federal laws include mortgage-servicing provisions, they are focused on consumer protection at the time of origination, not specific foreclosure requirements, the GAO said.
GAO also reported that regulators "expressed uncertainty about how their organizations will interact with and share responsibility with the new CFPB regarding oversight of mortgage servicing activities."
The report included the following recommendations:
To help ensure strong and robust oversight of all mortgage servicers, the Agencies (including the CFPB) should develop and coordinate plans to provide ongoing oversight and establish clear goals, roles, and timelines for overseeing mortgage servicers under their respective jurisdiction.
The Agencies should, if national servicing standards are created, include standards for foreclosure practices.
To reduce the likelihood that problems with mortgage transfer documentation problems could pose a risk to the financial system; the Agencies should assess the risks of potential litigation or repurchases due to improper mortgage loan transfer documentation on institutions under their jurisdiction and require that the institutions take action to mitigate the risks, if warranted.
The Agencies have not formally responded with actions to address the recommendations.