Wall Street and the Financial Crisis-19 Recommendations for Change

Yesterday I quoted the preamble to the Senate Subcommittee on Investigation’s Wall Street and the Financial Crisis and promised that I would review each of the 19 Recommendations for Change contained in that document.  Here are each of the proposed measures and my opinion about them…

LENDERS

1.  Ensure “qualified mortgages” are low risk. Federal regulators should use their authority to ensure all mortgages deemed to be qualified residential mortgages have a low risk of delinquency or default.

Commentary: This recommendation needs to have some sort of criteria for evaluating what qualifies as “low risk.”  What would be helpful is if minimum guidelines were established that are very stringent.  In other words, banks would be free to set more stringent, that is, lower risk, requirements if they felt like it.  But anything riskier would be forbidden.  Sans these criteria this requirement is the equivalent of when friends tell you to “drive safely” when you are leaving their house.

“Really? I should drive safely?  No kidding.  I would never have thought of that!”

2.  Require meaningful risk retention. Regulators should issue a strong risk retention requirement, mandating retention of at least a 5% credit risk in each, or a representative sample of, an asset-backed securitization’s tranches. It should also ban a hedging offset for a reasonable but limited period of time.

Commentary: This is a very powerful recommendation.  If implemented it would help to ensure that mortgage underwriters had higher risk standards.  How?  Because if a bank retained an interest in the mortgage it could potentially suffer losses if the initial underwriting was not done well.  This occurs because they retain a 5% interest in the mortgage’s performance.  In the past, the lending institution would just off load the mortgage to a mortgage bundler that would just turn around and package the mortgage into a mortgage backed security.  I would have liked to see a higher percentage recommended, say 15%.

I also think the bank on a hedging offset makes a tremendous amount of sense.  This also would ensure that mortgage underwriting is more sound.  However, that the Subcommittee only recommended “a reasonable but limited period of time” is disappointing.  Why?  Because you would like people to have “skin in the game” for as long as the mortgage is outstanding.  If the mortgage fails you want pain – that is, the feedback of the mortgage market – to reach the lending institution that created the problem in the first place.  This serves as a lesson of how the institution can improve its future underwriting.

3.  Safeguard against high-risk products. Banking regulators should mandate that banks with high-risk structured products, including products with little or no reliable performance data, meet stricter loss reserve, liquidity and capital requirements.

Commentary: Here-here.  I totally agree.  There are already loss reserve, liquidity and capital requirements in place as mandated by Dodd-Frank.  However, it would have been nice if the Subcommittee had made a more specific, numerical recommendation.  I am certain that this document has avoided such specifics in order to enable regulators to do their jobs and to avoid the appearance of a congressional mandate.  But this is somewhat cowardly on the part of the Subcommittee.

4.  Require greater reserves for negative amortization loans. Banking regulators should use their power to require banks issuing these loans that allow borrowers to defer payments of interest and principal to maintain more conservative loss, liquidity and capital reserves.

Commentary: I agree, and again, see the above commentary for #3.

5.  Safeguard bank investment portfolios. Federal banking regulators should use a study required by the Dodd-Frank financial overhaul law to identify high-risk structured products and impose a reasonable limit on the amount of these that can be included in a bank’s investment portfolio.

Commentary: I agree, and again, see the above commentary for #3.

BANKING REGULATION

6.  Completely dismantle the Office of Thrift Supervision. The Dodd-Frank law eliminated the OTS, some of which was subsumed into the Office of the Comptroller of the Currency (OCC), another banking regulator. The report recommends against any preservation of the OTS’s influence within the OCC.

Commentary: This is a very strong recommendation and I agree with it.  The OTS was basically a regulator-for-hire during the financial crisis.  To streamline the regulatory process ensures that jurisdictional issues are limited.  It also helps to ensure that the left hand knows what the right hand is doing at a regulatory level.  It used to be that financial institutions would “shop” for the best regulator; read: the one least likely to be able to do anything to stop the bank from doing what it wanted.

7.  Strengthen enforcement. Federal banking regulators should conduct a review of their big financial institutions to identify those with major deficiencies, review their enforcement strategy to eliminate any policy of deference to bank management, inflated ratings, or use of short-term profits to excuse risky activities.

Commentary: YES! And…duh!

8.  Strengthen ratings given to banks by regulators. Banking regulators should review the ratings system to ensure banks operate in a safe and sound manner over a specified period of time, and look at long-term risks, among other factors.

Commentary: I especially think the emphasis on long-term risks is important.  I have long decried that financial institutions are led by individuals whose annual bonuses are predicated on very short-term performance (usually 1 year’s worth).  This creates a “swing for the fences” mentality that results in great risk being taken on in order to maximize potential returns, and therefore annual bonuses.  Ugh!

9.  Evaluate high-risk lending impacts. The Financial Stability Oversight Council should study high-risk lending practices at financial institutions, and evaluate the impacts on the US financial system.

Commentary: Really?  You think?

CREDIT RATING AGENCIES

10.  Rank credit rating agencies by accuracy. The Securities and Exchange Commission (SEC) should use its authority to rank the nationally recognized statistical rating organizations in terms of performance, including accuracy of their ratings.

Commentary: This is a unique idea and I like it.  It would certainly encourage greater diligence on the part of analysts creating credit ratings.  An additional wrinkle would be that analysts would have to publish their ranking on the front of any research report.  That way investors who are opening up the report to evaluate the prospective investment would know just how good, or bad, the analyst is.  That alone would force a huge shift at the ratings agencies.

11.  Help investors hold agencies accountable. The SEC should use its regulatory power to help investors hold credit rating agencies accountable in civil lawsuits for inflated credit ratings.

Commentary: If the SEC through its heft behind investor lawsuits it would also change the behavior of ratings agencies.  Imagine being in court and the shareholder says: “As my first witness I’d like to call the SEC.”  This is another good recommendation.

12.  Strengthen agency operations. The SEC should use its power to ensure credit rating agencies impose internal controls, credit rating methodologies and employee conflict-of-interest safeguards to promote rating accuracy.

Commentary: Really?  No kidding.  This should be obvious.  That this has to be stated at all is evidence of how ridiculous the U.S. financial system has become.

13.  Ensure agencies recognize risk. The SEC should ensure credit rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted, or that rely on assets from parties with a record for issuing poor quality assets.

Commentary: This is in keeping with what I wrote about last week on the blog: the greatest risk is the one that you don’t account for.  If you cannot reliably predict something then there is greater risk inherent in the investment.  Ergo, that investment should have a higher risk rating.

14.  Strengthen disclosure. The SEC should use its authority to ensure that credit rating agencies complete required new ratings forms by the end of the year and that the new forms provide useful ratings information to investors.

Commentary: Duh!

15.  Reduce ratings reliance. Federal regulators should reduce the federal government’s reliance on privately issued credit ratings.

Commentary: I think that this is a useful admonition.  However, without some sort of quantitative reason as to why, this just rings as a qualitative mandate.  It begs the question: why?  The answer is that the ratings agencies cannot be trusted.  But if the Federal government cannot trust the ratings agencies, then why should consumers and other institutions?  This recommendation does not make that clear.

INVESTMENT BANKS

16.  Review structured finance transactions. Federal regulators should review the structured finance product activities described in the report to identify any violations of law and examine ways to strengthen existing regulatory prohibitions against abusive practices.

Commentary: Yes.

17.  Narrow proprietary trading exceptions. To ensure a meaningful ban on proprietary trading, any exceptions – such as for market-making or risk-mitigating hedging activities – should be strictly limited in the implementing regulations to activities that serve clients or reduce risk.

Commentary: Here I may seem like a hypocrite, but I agree only weakly.  I think one of the great things about the investment banks is that two separate parts of a bank can disagree with one another about the direction or quality of an investment.  That independence is important.  These kinds of recommendations basically make investment banks responsible for having an “institutional opinion.”  Effectively, it means that there can be no disagreement.  But that is exactly what you want within an institution: the freedom to disagree.

This recommendation mandates group think.  Imagine as an investor that you follow the “institutional opinion” then lose large amounts of money, only to learn that only 51% of the institution’s thought leaders actually held the “institutional opinion.”  You would clearly be upset and would wonder why the other opinion wasn’t allowed to be expressed.

A better recommendation would be to continue to allow institutions to disagree, but to require that the differing opinions, and the supporting facts to be disclosed to the investor.  That way investors can use their judgment to assess the quality of the opinions.  Alternatively, if the investor sees that there is strong disagreement, then they may avoid the investment altogether.

18.  Design strong conflict-of-interest prohibitions. Regulators implementing these prohibitions consider the types of conflicts of interest in the report’s Goldman Sachs case study.

Commentary: I agree.

19.  Study bank use of structured finance. Banking regulators should consider the role of federally insured banks in designing, marketing and investing in structured finance products with risks that cannot be reliably measured and naked credit default swaps or synthetic financial instruments.

Commentary: I totally agree.  The fallout from the mortgage bubble, The Great Recession, has proven definitively that the risk side of the return:risk equation is important and worth acknowledging and honoring.  Long-term costs from ultimately failed short-term investment successes is why this recommendation is necessary.  In other words, the system as a whole needs less risk.

Overall I feel that these recommendations are a powerful reminder that the U.S. financial system is deeply flawed.  Some of these recommendations are so obvious that they are almost surreal.  Other recommendations are innovative and, if implemented, have the ability to help to repair the damage to investor trust done over the past many years.

Jason