Will the Dodd Frank Act Be Watered Down?

By Bruce J. Coin

To me this year should be one that can be described as a transition year. The Federal Reserve is investing $600 billion to purchase U.S. Treasury notes in a plan, known as QE II, to help keep long term interest rates low to aid economic growth. The national economy should continue to grow slowly and unemployment should decline further. By year’s end we should look back and see that during 2011 we went from a slowly recovering economy to one that has recovered and is well on its way to being strong once again. The wild card that could affect that is any shock from rising oil and gasoline prices. But as much as I watch the economy I am also very concerned about how the requirements of the 2,319 page Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) will be finished, implemented and enforced. All of its aspects and requirements are to be in place and operational within 24 months of its enactment or on or about July 21, 2012. Some aspects are to be in place well before then.

The Dodd-Frank was signed into law on July 21, 2010 just under six months ago. Among other things, it was sponsored as “a bill to promote the financial stability of the United States by improving accountability and transparency in the financial system”. It was supposed to “rein in” the Wall Street firms including the rating agencies: Standard and Poor, Moodys Financial Services, Fitches and the seven other such agencies that are approved by the Securities and Exchange Commission (“SEC”).

Implementation and enforcement of the various provisions of Dodd Frank was left to regulators and thirteen new administrative boards, bureaus or offices. Even before its passage special interest groups and lobbyists were hard at work trying to convince those in power to minimize its impact on the areas they represent and they are continuing to exert pressure. 

In an attempt to protect purchasers of mortgage backed and other Asset Backed Securities (ASBs), Dodd Frank required sellers of ASBs (Wall Street investment banks, large banks and other issuers) to retain a minimum 5 percent interest in the ASBs they sell, i.e., to have “skin in the game” so that they would be somewhat responsible for and at risk, right along with the ASB purchasers, for the quality of what they sell.  The Dodd Frank provision that requires the retained interest has been named the Volker Rule after its advocate former Federal Reserve Chairman and presidential adviser Paul A. Volker.

An early sign that the intent and strength of the Dodd Frank would be watered down appeared when exceptions were negotiated to allow the sellers of “low risk mortgages” to escape the Volker Rule and avoid the need to retain the minimum 5 percent interest. The term “low risk mortgages” (perhaps “prime”) has not, as of this date, been fully defined.  There continues to be ongoing discussion and negotiations between bank regulators and the Treasury department about what will be deemed as a low risk mortgage. Among other aspects, negotiations include addressing how much down payment is required, if an interest only mortgage can be included and how long a borrower’s income must be verified. It appears as if a standard, first lien, amortizing residential mortgage that is the lesser of 80% of the purchase price or appraised value of a residential property (with insurance for amounts above 80%) and with borrowers that have demonstrated income sufficient to support such a mortgage will meet the definition. The majority of the basic residential mortgages in this country will meet that definition including those insured by the FHA.  For the present, jumbo, sub-prime, balloon, no doc and similar mortgages will not meet the definition of a low risk loan.  Apparently borrowers that qualify as a low risk mortgage will receive a slightly lower interest rate than those that do not as the lender/seller will not need to retain a 5 percent interest.  Reciprocally, that means that borrowers that do not qualify will pay a higher rate and lenders may even shy away from providing non-low risk mortgages which will adversely impact the supply of mortgage money.  In addition, and also of major significance, is the yet to be defined “low risk” commercial mortgage.  Remember that one defaulting $15,000,000 commercial mortgage is the equivalent of fifty $300,000 residential mortgages all going into default simultaneously.

Perhaps a more important sign occurred on July 22, 2010 only one day after the president signed Dodd Frank into law, when SEC Chair Mary Schapiro granted an initial six month waiver to the “expert” designation of the rating agencies. 

In earlier writings I explained that the rating agencies were escaping liability for their past improper (bad) ratings based on a pre-Dodd Frank exemption (to the Securities Act of 1933) that permitted them to avoid having their ratings opinions considered as “expert” opinions.  As their ratings were considered just “opinions” as opposed to “expert opinions” many of the law suits filed against them in the last two years have been dismissed.  However, some suits are still ongoing wherein the rating agencies defense has argued that their ratings were protected under the First Amendment to the Constitution (freedom of speech) but some courts have not agreed with that position. Dodd Frank removed the expert exemption making the rating agencies properly liable for their rating opinions. The removal of the exemption was designed to make it easier for harmed investors to successfully sue.

 It is important to point out and understand that immediately upon the passage of the Act, the rating agencies very publicly notified clients and debt underwriters that they were withholding permission to allow their ratings to be published on any debt issues.  Their immediate announcement indicating that they were unwilling to stand behind their own ratings and allow them to be published effectively shut down the multi-billion dollar registered securities debt market. 

That’s when Chair Schapiro promptly gave in to pressure and provided the rating agencies with the initial six month waiver thereby allowing pending and proposed debt issues to proceed. 

When the waiver was issued, Meredith Cross, director of the SEC’s division of corporation finance stated: “This action will provide issuers, rating agencies and other market participants with a transition period in order to implement changes to comply with the new statutory requirement (of Dodd Frank) while still conducting registered ABS offerings”. The SEC’s waiver was set to expire on Jan. 24

It is also important to remember that the Wall Street “Capital Markets”, prior to the financial/credit crisis of 2007-08, had become the largest single source of mortgage capital (RMBS and CMBS) in the U.S.  Consequently, Wall Street firms (for money making purposes), Fannie Mae, Ginnie Mae and Freddie Mac (for purposes of selling their securities) and even the federal government all see a strong return of the Capital Markets as vital and necessary for economic recovery and the best source of providing financing liquidity to the mortgage and other industries including credit cards, equipment financing and student loans.  The Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF, sold billions of dollars low-cost asset-backed bonds, as rated securities, through the Capital Markets.

Conscious of the impending January 24th waiver expiration, in a little publicized announcement on November 23rd, the SEC INFEFINITELY EXTENDED THE WAIVER. 

In a letter posted on the SEC’s website and addressed to the Ford Motor Credit Company (issuers of auto loan backed securities), the SEC said it wouldn’t require the ratings information in bond documents “pending further notice.” The SEC said it was waiting for new rules in Dodd Frank for credit raters and ABS to be implemented.

In the letter, Katherine Hsu, an SEC senior special counsel, wrote: “We are doing this to facilitate our consideration of whether and, if so, how those final regulatory actions should affect the Commission’s disclosure requirements regarding credit ratings for asset-backed securities, while permitting registered asset-backed securities offerings to continue without interruption,”

“We are pleased,” said Margaret Mellott, a spokeswoman for Ford Motor Credit. “The SEC recognizes the importance of the public ABS markets, and we are glad the staff is ensuring the public ABS markets remain available.” I guess so.  Can you see the external pressure on the SEC?  But where is any indication or explanation that the SEC and the rating agencies have been working to find a solution?  I haven’t seen or heard anything about committees being formed or on-going negotiations between the SEC and the rating agencies to try to find a way to comply with the intent of the Dodd Frank Act and the expert exemption and it’s been five months.  Do we need to treat them like the employers with unionized workers and require binding arbitration? 

This indefinite waiver extension will allow the rating agencies to continue to behave as in the past with no concern for recourse of their opinions.  Until this ultimately plays out one can’t know for sure but my bet is that this provision of Dodd Frank that was really going to make the rating agencies be legally responsible for their opinions will be tremendously watered down before it is finalized.  I hope not as the Dodd Frank was supposed to rein in these rating agencies and removing the expert exemption was one good way to do that.

What has surprised me a little is that none of the seven other rating agencies has stepped up by providing ratings and assuming full responsibility for their ratings. There appears to be a real business opportunity there that is not being seized. The other seven Nationally Recognized Securities Rating Organizations are:

  • DBRS, a Canadian firm
  • Egan-Jones, a Philadelphia, PA based firm
  • A. M. Best Co, Oldwick, NJ
  • Japan Credit Rating Agency, LTD.
  • Rating and Investment Information, Inc. , a Japanese firm
  • LACE Financial of Frederick, MD was acquired 8/31/10 by Kroll Bond Ratings of NYC.
  • Realpoint, LLC., of Horsham, PA, acquired 5/3/10 by Morningstar Inc. of Chicago, IL
  • Maybe the acquisitions of LACE and Realpoint will lead to one or more of these “stepping up” to offer ratings that they will be legally willing to stand behind.  

    The elections this past November showed that the American public was displeased with the actions or non-actions of national, state and local political office holders. The Dodd Frank was highly touted and took a long time to negotiate.  If it continues to be watered down once again the congressional legislators, while appearing to have done something meaningful, will have put on a show and “passed the buck to others” that can ultimately result in its substance being reduced to having little benefit to the American people.  

    Where is the outrage at what is and is not taking place? I hope that our national press corps and other media start watching this closely and reporting as important news the actions of the SEC and the thirteen new administrative boards or agencies that were formed by Dodd Frank that are responsible for finalizing and enforcing respective provisions of the act. The Act requires most of its provisions to be finalized and in place within 24 months, i.e. by July 21, 2012.  With 18 months to go I hope everyone pays attention to what happens to the different aspects of Dodd Frank during the 12 months of 2011.  Think about what has occurred when you enter the voting booth next November.

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