Dodd Bill Gives SEC Oversight Role in Federal Purchases of Mortgage-Backed Securities; Addresses Executive Compensation

Going beyond the Treasury bill authorizing the federal purchase of up to $700 billion in distressed mortgage-backed securities, Senate Banking Chair Christopher Dodd has proposed legislation that would also set up an oversight board, require more transparency, and establish executive compensation standards for financial institutions selling asset-backed securities to the Treasury. The Dodd measure also includes a number of provisions to assist homeowners.

Similar to the Treasury bill, the Dodd bill allows the purchase of up $700 billion in distressed assets, but that number includes any expenditures made to the Exchange Stabilization Fund for any funds used for the temporary guaranty program for the US money market mutual fund industry.

Like the Paulson bill, the Dodd bill would authorize Treasury to set up the purchase program under the Secretary’s terms and conditions. However, unlike the Paulson bill, the Dodd measure would require the Secretary to implement the program through an Office of Financial Stability to be set up within the Treasury Department.

Similar to the Treasury bill, the Secretary is authorized to appoint employees and enter into contracts to help carry out the transactions and designate financial institutions as federal financial agents to perform reasonable duties related to the purchase of the asset-backed securities. Similarly, the Secretary could establish vehicles to purchase mortgage-related assets and issue obligations. The Treasury is also empowered to issue guidance and regulations to carry out the purposes of the legislation.

But the Dodd bill would also require the Treasury to lay out its program, policies and procedures to ensure that the new authority is not used on a completely ad hoc basis. The bill also strengthens reporting provision by requiring monthly, rather than the Paulson bill’s semi-annual, reports to Congress regarding the exercise of authority under the Act. In order to ensure proper use of funds, and prevent waste and fraud, the Dodd bill adds a new provision requiring the Secretary to annually submit to Congress, and make publicly available, audited financial statements prepared in accordance with GAAP.

Importantly, unlike the Treasury bill, the Dodd bill would establish a five-member Emergency Oversight Board to review the purchase regime set up by Treasury. The Board would be composed of the Chairs of the Federal Reserve Board, the FDIC, and the SEC, as well as two private sector members appointed by bi-partisan congressional leadership. The Act requires that the private sector members have financial expertise in both the public and private sectors. The Board will have broad authority to review all actions taken by the Secretary, including the appointment of financial agents and the designation of asset classes to be purchased.

Also, replacing the Treasury bill provision providing that the Secretary’s determination are not subject to judicial or administrative review, the Dodd bill would allow review of determinations found to be arbitrary, capricious, an abuse of discretion, or not in accordance with the law.

The Dodd bill would also require that all financial institutions seeking to sell assets through a program established under this Act must satisfy appropriate standards for executive compensation in order to be eligible. One standard is that executive compensation must exclude incentives for executives to take risks that the Secretary deems inappropriate or excessive. There must also be a claw-back provision for incentive compensation paid to a senior executive based on earnings, gains, or other criteria that are later proven to be inaccurate. More broadly, there must be limitations on the entity paying severance compensation to its senior executives as are determined to be appropriate in the public interest in light of the assistance being given to it

The Treasury bill allows the Secretary to hire large asset management firms to organize the purchases of the asset-backed securities as well as their sale. However, Senator Dodd noted that Treasury ignores the fact that many of these firms have large positions in the same assets; and that those positions could be affected by the way they manage the federal government’s portfolio.

Thus, the Dodd bill would add a provision requiring the Secretary to issue rules on conflicts of interest that may arise in connection with the administration of the authorities provided in the Act. The conflicts include, but are not limited to, hiring contractors or advisors, management of assets, bidding or purchasing of assets, and employees leaving to work for an institution that has benefited from the program.

Similar to the Treasury bill, the Dodd bill requires the Secretary to ensure that any repurchase program will provide stability or prevent disruption to the financial markets and the banking system, as well protect the taxpayer.

Unlike the Treasury bill, the Dodd bill requires the Secretary to receive contingent shares in the financial institution from which the assets are to be purchased equal in value to the purchase price of the assets. In the Secretary’s discretion, the contingent shares may include shares of the financial institution, its parent company, its holding company, or any of its subsidiaries. If the purchased securities are not publicly traded, the Secretary must acquire a senior contingent debt instrument in lieu of contingent shares.

The Treasury Department has offered temporary, unlimited deposit insurance for money market funds. This has caused considerable concern in the banking industry that this will precipitate a run on the banks by large depositors, who can now access unlimited deposit insurance in money markets. To allay this concern, the Dodd measure would create parity between banks and money market funds in terms of insured deposits during the period in which Treasury offers the insurance. Also, in exchange for the guarantee being provided to the money market funds, Treasury must charge them a premium equivalent to the rate the FDIC charges banks providing deposit insurance. Finally, in providing guarantees to money market funds, the Treasury is ordered to consult with the FDIC and the SEC.

In an effort to assist homeowners, the Dodd bill would require the Treasury to shift the whole mortgages and residential mortgage-backed securities it purchases to the FDIC to manage; and add the requirement that the FDIC modify those loans where possible. The bill similarly requires other federal agencies that hold or control mortgages or residential mortgage-backed securities to modify whenever possible. In addition to FDIC, this includes FHFA, which controls Fannie Mae and Freddie Mac’s portfolios, and the Federal Reserve Bank of New York, which owns a portfolio of mortgages acquired from Bear Stearns.

The Dodd bill orders the Comptroller General to determine the extent to which leverage and sudden deleveraging of financial institutions was a factor behind the current financial crisis and report back to Congress by June 1, 2009. The report must include an analysis of the roles and responsibilities of the SEC and the banking regulators with respect to monitoring leverage and acting to curtail excessive leveraging.

A mortgage-backed security is generally one that represents an undivided interest in a group of mortgages. Investors in mortgage-backed securities receive pro rata shares of principal and interest payments on the loans backing the securities. There are different types of mortgage-backed securities. Residential or private label mortgage-backed securities are those issued by a private entity, other than Fannie Mae or Freddie Mac. A mortgage-backed security representing an undivided interest in mortgages made to finance retail, office, industrial, hotel and resort, or multi-family properties is a commercial mortgage-backed security. See OFHEO, Mortgage Market Note 07-1,Portfolio Caps and Conforming Loan Limits, 9-06-07. According to Senator Olympia Snowe, in hindsight, it appears that it was the inability to gauge risk in mortgage-backed securities that caused much of this financial turmoil.