Some 18 months ago, I sat at the big table at the Board of Governors of the Federal Reserve System to talk about the Dodd-Frank Act. The Federal Reserve, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency held a meeting in November of 2010 to discuss the requirements of Dodd-Frank law to remove all references to the credit ratings agencies from federal banking law.
The meeting, which was hosted by Fed Gov. Daniel Tarullo, then FDIC Chairman Sheila Bair and then-acting Comptroller John Walsh, focused on the OCC’s ANPR OCC-2010-0016 and asked a series of questions about how to replace the use of third-party ratings in the regulatory process. In June, the OCC finalized the rule prohibiting banks from relying on credit ratings agencies to determine whether a security is “investment grade.”
But at the time of the meeting, regulators, banks and risk managers in the industry were taking an “oh me, oh my” attitude toward the requirements of Dodd-Frank. They even discussed asking the Congress to make “technical amendments” to allow banks to continue to use third-party ratings to make credit and asset allocation decisions. This is, after all, the way that the industry has evolved, with a series of agents supposedly providing services to manage money for the parties of the first part. But our beloved regulators had again fallen victim to the siren song of the experts.
Alex Pollock of the American Enterprise Institute noted in a 2008 interview published by Institutional Risk Analytics (“Conflicted Agents and Platonic Guardians,” May 13, 2008) the peculiar structure of the markets today:
“As a democracy and a republic, we should not believe in Platonic guardians, but we keep setting up these people and agencies that are not accountable. It is the progressive ideal of a hundred years ago that there must be experts that can be formed into a committee to address whatever problem exists. These experts are unelected and their power grows beyond anybody’s control, including the political appointees who are supposedly managing their activities.”
Despite the reluctance of regulators and bankers, the Dodd-Frank Act, with respect to ratings, has gone into effect. What will this mean for banks? Will community/regional banks suffer under the weight of this rule? In both cases the answer will have grave implications for both bank profitability and the housing market.
Under Dodd-Frank, banks can no longer rely exclusively on ratings from Securities and Exchange Commission-approved ratings agencies to make investment and asset allocation decisions. This is significant for banks because many of them, large and small, lack the ability to underwrite credit risk — either for loans or securities. Whether you are a bank or investor, making a loan or buying a bond is the functional equivalent in terms of risk.
Surprised that commercial banks cannot underwrite credit risk? In fact, during the meeting led by Tarullo, several banks came right out and said that they could not possibly track all of the credit risk for the hundreds of names in their corporate bond portfolios.
I asked whether it was even legal for banks to utilize ratings in the way that was commonplace prior to the passage of Dodd-Frank. Using a third-party opinion to make credit risk decisions for an insured depository is a violation of the Committee of Sponsoring Organizations framework (www.coso.org). COSO is the organization that develops risk management guidelines that form the wellspring from which laws such as Sarbanes-Oxley and Dodd-Frank have arisen.
RMBS CHALLENGES
The OCC rule means that banks will have to spend far more time and money tracking credit decisions involving investments in securities. This will not only add to the expenses of banks, but will make it far more difficult for banks to hold large, diverse portfolios of securities. Let’s face it, government bonds of many nations — which once carried zero risk weights under the Basel capital framework — have collapsed in value over the past few months, leaving banks with big losses on bond portfolios that were once viewed as “risk free.”
The impact of the debacle surrounding Moody’s, Standard & Poor’s and Fitch, to mention but a few agencies, has been felt far beyond the pedestrian world of bank investments in investment-grade corporate bonds. Mortgage-backed securities have been literally abandoned by the major ratings agencies, causing the market for private-label securities to implode. Even corporate debt issuers have been affected because Dodd-Frank strips ratings agencies of their special legal protections dating back to the 1930s. Danielle Carbone of Shearman & Sterling wrote in 2010:
“Perhaps unwittingly, with the stroke of a pen, President Obama single-handedly shut down the new offerings markets for both investment grade debt and asset-backed securities on July 22 (2010) and left public companies unable to raise capital in offerings registered under the Securities Act.”
While the SEC has taken steps to help corporate issuers operating in the post Dodd-Frank world, the negative effects on the RMBS world remain. Agency securities guaranteed by Fannie Mae and Freddie Mac still have a strong following, but only because of the full faith and credit guarantee from the U.S. Treasury. The fact is an investment grade rating for agency paper is irrelevant to the decision to invest in agency securities.
ARTIFICIAL MARKET
The market for agency mortgage paper is an artificial, heavily subsidized world. While most Americans think that it is normal for a bank to make a 3%, 30-year, fixed- rate loan, only the federal guarantee with respect to principal loss enables banks and investors to buy this paper. The federal guarantee, not the rating, allows banks to sell these loans to investors and at yield far below the economic risk of default in every RMBS.
Move to the world of private-label, residential mortgage-backed securities, on the other hand, and the first-loss risk pushes coupons up to the 7-8% range for private-label production. Since the investor faces first loss in the event of default, the issuers of the securities must offer much higher yields. In this example, having a rating from Moody’s or S&P would certainly help to sell the paper to investors.
Unfortunately, while banks badly needed higher yielding securities to support revenue and earnings, the Dodd-Frank rules make it just about impossible for banks to purchase private-label securities. Even though the intent of Dodd-Frank has been to make banks do the hard work of credit analysis, the practical reality is that banks are steering clear of this paper — as are many institutional investors outside the banking world.
The negative impact of Dodd-Frank’s changes on the world of RMBS is profound. If a nonbank issuer wants to increase volumes through a conduit, it must first find an investor to take that production without an investment-grade rating. Not an easy assignment. But in order to get the green light from the warehouse lenders who fund the conduit, the investor must first be found.
Without an investment-grade rating, investors will not buy private-label mortgage paper. And without investors willing to buy, lenders cannot revive the market for private mortgage finance. This is the crucial “Catch-22,” to use the 1970 satirical war film adapted from the book of the same name by Joseph Heller, between funding new private-label mortgage production and selling this paper to investors. Until we find a way to again assign reliable ratings to these securities, it will be difficult to restore financing to the U.S. mortgage sector.
Christopher Whalen is a regular columnist for HousingWire and senior managing director of Tangent Capital Partners in New York where he provides advisory services focused on companies in the financial services sector. He is co-founder and vice chairman of the board of Lord, Whalen LLC, parent of Institutional Risk Analytics, a provider of bank ratings, risk management tools and consulting services.
