Tuesday, June 08, 2010

House-Senate Conference Must Decide on New Approach to Rating Agency Regulation and Carve Out from Risk Retention

As House-Senate conferees begin meeting this week to reconcile two different versions of financial reform legislation, they must decide how revolutionary they want to be with regard to the regulation of credit rating agencies. Another decision facing the conferees is whether to include a carve out of qualified residential mortgages (currently only in the Senate bill) from the risk retention (skin in the game) requirement as part of securitization reform.

The Senate legislation conducts a frontal attack on the issuer-pays conflict of interest problem by creating a new SRO overseen by the SEC that will assign credit rating agencies to provide initial ratings for structured financial products on a rotating basis. This was a provision authored by Senator Al Franken (D-MN) and adopted as an amendment to the Senate bill. Under the provision, the SEC must create a Credit Rating Agency Board, a self-regulatory organization, tasked with developing a system in which the Board randomly assigns a credit rating agency to provide a product’s initial rating.

Requiring an initial credit rating by an agency not of the issuer’s choosing, but randomly selected by the Board, will put a check on the accuracy of ratings and end forum shopping, in the Senator’s view. The provision does not prohibit an issuer from then seeking a second or third or fourth rating from an agency of their choosing. The provision leaves flexibility to the Board to determine the assignment process. Thus, the new Board gets to design the assignment process it sees fit, which can be random or based on a formula, just as long as the issuer doesn’t get to choose its initial rating agency. This should eliminate the current incentive for a rating agency to give an inflated rating in the hope of getting repeat business. Cong. Record, May 10, 2010, S3465.

Senator Franken has emphasized that the Credit Rating Agency Board will be a self-regulatory organization that will eliminate the current rating shopping process and the conflict of interest inherent in that process. Since the Board can take past performance into account in handing out rating assignments to agencies, the new process will incentivize accuracy in the market. Cong. Record, May 19, 2010, S3955.

The Credit Rating Agency Board would be comprised of industry experts: investors, issuers, raters, and, independents. A majority of its members would be investors, including institutional investors who have experience managing pension funds and university endowments. According to Senator Franken, they would have a vested interest in accurate credit ratings because they depend on them when making investments. Cong Record, May 5. 2010, S3155.

Another key element of the new SRO regime is that the Board will regularly evaluate the performance of the credit rating agencies, and they would have to take that performance into account in coming up with an assignment mechanism. In Senator Franken’s view, there is no better way to get accurate ratings than giving more initial rating jobs to the
most accurate raters and fewer jobs to those that repeatedly do a sloppy job. The Board will also be able to prevent raters from charging unreasonable, which strikes at the heart of sweetheart deals in which a rater asks for more money for a better rating. Cong Record, May 5. 2010, S3155.

In addition to randomly assigning credit ratings, the Board will also qualify rating agencies to issue ratings for structured products. The term qualified nationally recognized statistical rating organization with respect to a category of structured finance products means a nationally recognized statistical rating organization that the Board determines, using statutory criteria, to be qualified to issue initial credit ratings with respect to such category.

Senator Franken noted that the provision establishing the Board does not conflict with the section of Act eliminating provisions in federal laws requiring reliance upon ratings from NRSROs. The latter section does not eliminate the NRSRO designation or eliminate credit rating agencies Eliminating federally mandated reliance on NRSRO credit ratings doesn’t change the fact that state laws, pension fund policies, and other private market actors will still explicitly rely on NRSRO ratings. Many states incorporate NRSRO ratings into their State laws. So NRSRO ratings are not going anywhere. The section ending reliance on ratings has absolutely no effect on those requirements. The simple fact is that credit rating agencies have a place in the market and they perform a needed function. Cong. Record, May 19, 2010, p. S3956.

Qualified Residential Mortgage Carve Out

An amendment carving out qualified residential mortgages from the requirement in the Senate financial reform bill that securitizers retain a 5 percent interest in mortgages underlying mortgage-backed securities was approved. Sponsored by Senators Mary Landrieu (D-LA) and Johnny Isakson (R-GA), the amendment ensures that securitizers of mortgages that have 20 percent down and a high FICO rating will not have to retain the 5 percent skin in the game required of other securitized assets. According to Senator Isakson, the only risk retention that will be required is when someone is making a bad loan. The amendment embodies the principle that underwriting, not risk retention, is the cure all to good lending. Cong. Rec. May 12, 2010, S3576. While skin in the game is important, echoed Senator Mark Warner, more important is the underlying quality of the mortgage. Senator Warner added that the amendment remains true to the intent of the legislation to ensure that the mortgage securitization process requires the originators of the mortgages to have some skin in the game. Cong. Rec. May 12, 2010, S3576.

The amendment to Section 941 of S3217, which effectively amends new Section 15G of the Exchange Act, requires the SEC and the federal banking and housing authorities to jointly issues regulations exempting qualified residential mortgages from the risk retention requirements of S3217. In defining the term qualified residential mortgage, the amendment directs the SEC and the other authorities to consider underwriting and product features that historically have indicated a low risk of default, such as, in addition to 20 percent down, the mortgagor’s residual income and ratio of the mortgage payment to total monthly income. The SEC must also consider whether the mortgage prohibits or restricts the use of ballon payments, prepayment penalties, interest only payments, and other features that have historically demonstrated a higher risk of borrower default.

The regulations must provide that an asset-backed security that is collateralized by tranches of other asset-backed securities must not be exempted from the risk retention requirements.

An important part of the amendment directs the SEC to require an issuer to certify, for issuances of asset-backed securities exclusively collateralized by qualified residential mortgages, that the issuer has evaluated the effectiveness of its internal controls with regard to the process for ensuring that all the assets collateralizing the asset-backed security are qualified residential mortgages.

There is broad agreement that a key element of the reform of the securitization process is that originators of mortgage-backed securities must retain a portion of the risk, discouraging them from selling junk because they would have to keep some of it for themselves. The House financial reform legislation, HR 4173, would require companies that sell products like mortgage-backed securities to keep some “skin in the game” by retaining at least five percent of the credit risk. Section 1502. However, the House legislation does not have an analog to the Landrieu-Isakson Amendment carving out securitized qualified residential mortgages form the risk retention requirement.