The regulatory framework proposed by the Obama Administration should, if enacted, be “an overall positive development for the majority of creditors of the U.S. regulated financial sector,” according to Moody’s. “Banks, insurers, their counterparties, and their current unregulated competitors would be subject to more uniform and more prudent regulatory requirements on a consolidated basis.”
However, there would also be implications that Moody’s perceives as potentially raising some credit risks or, at least, some questions at this early stage:
- …it may be more difficult for large, systemically important firms that fall into the new category of Tier 1 Financial Holding Companies (subject to more stringent regulation by the Federal Reserve) to generate returns at pre-crisis levels. On the other hand, these higher prudential standards would likely make these firms safer institutions, which in theory should help them obtain lower cost funding. At the same time, we see the Tier 1 FHC category as a soft form of restriction on “too-big-to– fail” institutions. While this would likely also be beneficial to creditors, we believe this could make government support less likely in the future.
As we have mentioned previously, the new resolution powers, if enacted into law, may be detrimental to more junior classes of creditors, including holding company creditors, as it would grant the FDIC expanded authority to impose losses on debtholders.
- … the reforms to the securitization process, and more particularly the requirement for originators and sponsors to retain an unhedged slice, should act as an incentive for prudent underwriting and help revitalize investor confidence. While we would not anticipate negative credit implications from this requirement, the impact of this retention measure might be particularly felt by investment banks that typically bought loans for the sole purpose of repackaging and securitizing. This business’s return on capital would likely become far less attractive for these firms.
- More stringent and uniform capital and initial margin requirements for all OTC derivatives would likely impose economic limits on excessive risk-taking. Moving OTC contracts to exchanges produces negligible systemic benefits, but if done, would disadvantage large dealers, and would benefit exchanges.
- The new Financial Protection Agency for Consumers would regulate and provide consumer education on products that have, at times, generated significant risk-adjusted returns for banks, while also being a source of volatility during economic downturns. Restrained risk-taking with less creditworthy consumers may hurt earnings in the short run, but help stabilize them in the long run, and thus would be construed as a credit positive.
For details see: Preliminary Assessment of the Obama Administration’s Regulatory Reform Proposal.
Technorati Tags: big banks, financial-regulation
CreditSights believes that the prospect of the breakup of big banks such as Citigroup (NYSE: C) is receding in the light of the Obama Administration’s proposed regulatory changes. However, Standard & Poor’s still sees this as a real possibility, according to CreditSights’ interpretation of an S&P conference call on its recent downgrading of many retail banks.
In contrast to our view that the Obama proposal reaffirms the position of large banks, S&P seemed more cautious and stated that it did not know how regulators would look at systemic risks. The agency seemed to believe that there could still be a real possibility for big bank break-up scenarios, whereas we feel that this risk is receding.
S&P noted that the Obama plan seemed to call for a more level playing field between banks and non-banks, but could also lead to differentiation among banks between the Tier 1 FHCs (systemically important financial institutions) and others. The agency stated that it would have to evaluate the implications for competitiveness for institutions which might be subject to different rules and/or higher standards under the proposal.
CreditSights has published its initial thoughts on the plan, especially as it relates to the long-term structure of the banking industry and the creation of new oversight bodies such as the CFPA (see: Bank Regulatory Overhaul: Obama Proposals Reviewed).
CreditSights analysis of S&P’s downgrade actions U.S. Banks: S&P Bank Ratings Revamp includes a useful table showing the degree of downgrades:
Technorati Tags: (c), big banks, Citigroup-Inc., financial-regulation, U.S. banks
Eating crabs on the Chesapeake Bay I noticed this story in the newspaper lining the table:
Nontraditional Mortgages Don’t Wane Under Warnings
by Kirstin Downy, Washington Post Staff Writer
excerpt:
“The lower monthly payments of nontraditional loans have been particularly attractive because home prices have risen so quickly. But regulators have said they worry consumers don’t understand that payments on the loans can double or even triple, and that if they pay less than full payment toward principal and interest, they run the risk of seeing their mortgage balance rise, even after years of payments. Most homeowners are making only the minimum payments, according to banking data.”
“Last month, federal banking regulators issued a warning to federally regulated lenders, including banks, thrifts and credit unions, that the loans could pose risks for lending institutions because consumers can be unprepared for the sudden jumps in payments, known as “payment shock.” These jumps could lead to loan defaults, causing losses for the lenders. Lenders outside of federal oversight, who make 60 percent of these loans, were not affected by the regulators’ warning.”
The article’s date? October 24, 2006.
An archive search turned up the following (emphasis added):
Insurers Urge Action On Risky Mortgages; Firms Want More Loan Restrictions
(Aug 19,2006)
“Many borrowers are paying as little as possible. About 70 percent of the people who take out an option adjustable-rate mortgage, which lets the buyer avoid paying even the full interest on the loan, end up paying the lowest permissible amount each month, according to the Federal Deposit Insurance Corp., which regulates banks. The amount unpaid is added to the mortgage balance, so borrowers end up owing more than when they started. Having no equity in a home increases the risk of foreclosure, especially when housing values fall and houses are hard to sell.”
Regulators To Issue Mortgage Warning; Bank Chief Seeks to Rein In Risky Deals
(Apr 7, 2006)
excerpt:
Speaking to the New York Bankers Association, John M. Reich, director of the Office of Thrift Supervision, warned that some lenders are making it too easy for unsophisticated borrowers to take on risky nontraditional mortgages that they may not fully understand. Reich said regulators are “closely monitoring” the growth of loan types in which the payments can suddenly double, creating a payment shock that could force borrowers into foreclosure if housing values were to fall and could also cause financial losses for the lenders who make the loans.”
and
Interest-Only: Borrower Beware; Popular but Risky Mortgage Draws Government Scrutiny
(Dec 21, 2005)
excerpt
“The federal government yesterday announced that it was considering new restrictions on these nontraditional loans. Lenders would be expected to require borrowers to have higher down payments and better credit, to verify their income, and to be able to withstand a future payment increase, according to proposed “guidance” from the regulators. Lenders would also be required to explain the loans more carefully to borrowers.”
The warning signs were there, and reported in the general media: we just didn’t heed them.
Technorati Tags: credit-crisis, financial-regulation, mortgage, mortgage delinquencies, nontradtional mortgages
Now that US financial institutions have dodged a major bullet and most look likely to live to fight another day, the bullets are being removed from the regulatory firing squad one by one. When the financial system was on the brink of total meltdown, there was widespread agreement that only a thorough overhaul of the regulatory system could prevent a recurrence. But now that things have settled down a bit, it looks like changes will be marginal and will leave the alphabet soup of agencies largely intact.
It’s a depressing but not surprising prospect to see the power of the industry lobbies and the turf fighting of the agencies win out over the public good. There’s a real possibility that the “reform” emerging from the worst financial crisis since the depression will be of the worst kind: adding cosmetic changes that make it look like Congress is doing something meaningful but that only increase the regulatory burden without any significant benefit to the system.
To be sure, as Tyler Cowen points out, the Department of Homeland Security has not been a smashing success and argues that more modest reform may not be such a bad thing. Does anybody seriously believe that if you started with a clean slate, you would end up with anything like the current hodge-podge of overlapping and competing financial regulatory bodies? As Felix Salmon writes, the current regulators have clearly failed at their jobs and there’s no reason for entities like the OCC and the OTS to continue to exist.
It is not more regulation that’s needed, but better regulation.
The testimony of Bank of America chief Ken Lewis was the latest example of the increasingly symbiotic relationship between government and Wall Street, as Lewis refused to admit he had been strongarmed by government heavies Ben Bernanke and Hank Paulson into taking over Merrill Lynch, despite strong evidence to the contrary. After all, he still needs their “protection.”
Visitors to Research Recap are clearly not convinced that the problems are solved, as they show strong interest in posts cataloging continuing problems in the financial markets.
McKinsey’s estimate that commercial loans will bear the brunt of US bank losses of some $125 billion a quarter through 2010 was the most popular recent post, along with Moody’s similar projection that US Banks will lose or write down another $470 billion by 2010.
Visitors are also watching closely the continuing downgrades of prime jumbo and Alt-A mortgage backed securities by Standard & Poor’s.
Two reports from CreditSights also drew strong interest: Warrants remain an issue for US banks exiting TARP, and on a more optimistic note, Rise in credit card delinquencies may be peaking.
Technorati Tags: Alt-A, credit-cards, financial-regulation, mortgage-backed-securities, TARP, U.S. banks, Zeitgeist
Guest post by James A. Kaplan, Chairman and CEO, Audit Integrity
I sense a change in the direction of the tides that bodes well, even during these tough times.
During the late 1990’s, with prosperity rising year after year, it seemed the sky was the limit. The investment industry saw no reason not to remove the regulatory restrictions that had been put in place to safeguard investors after the Great Depression, which, surely, was not going to come again. As share prices went through the roof, shareholders saw no need to question the performance of Company managers, and did not examine the accounting practices that created an appearance of strength. Boards signed off on compensation structures that rewarded management for increasing share prices regardless of fraudulent, or at least, fraud-like behavior.
And from 2002 to 2007 (the Sarbanes-Oxley years), when the shaky underpinnings of these massive corporate megaliths began to give way, stakeholders learned a hard lesson – but the perfect storm of deregulation and deceptive accounting practice only grew in intensity.
In 2008 the real awakening began, and clearly, the emperor has no clothes.
The dramatic deterioration in economic conditions was the shot heard round the world. Economies are suffering in every nation. Foreclosures continue at an astronomical rate.Retirement funds have been decimated through no fault of the people who trusted professional money managers to invest wisely on their behalf.
The chasm between White Hats (companies with strong governance and transparency) and Black Hats (weak governance and transparency) has grown ever wider. Although stakeholders may have learned their lesson the hard way, I believe they have learned it well. When times were good, it may not have occurred to them to carefully examine the behavior of their executives.
Now that the market has deflated, we are discovering that integrity is not optional, but must be demanded regardless of rising or falling share prices. We have learned that fraudulent practices result in egregious short-term gain for the managers, who bear no risk and show no long-term commitment to the company’s health, while resulting in devastating losses to the investors. Of course, our government, hearing the painful screams of stakeholders, has begun beefing up the very same regulatory bodies they de-regulated over the last decade.
I believe this changing tide will reinforce and strengthen the use of Audit Integrity’s Accounting & Governance ratings, which quantify the distinctions between White Hats and Black Hats. Over the ten-year period ending December, 2008, annual stock return spreads averaged 15.29 percentage points difference between companies with the best and worst AGR Equity Factor. During that time the worst decile returned -4.84% annually, while the best decile returned +10.54% annually.
In order to highlight these widening spreads, and to acknowledge those companies with strong governance and accounting, Audit Integrity will begin issuing regular reports on the “Most Trustworthy” companies which Forbes has published annually for the past three years. Our analysis indicates that these companies will continue to generate excess returns and avoid pitfalls over what I forecast to be economically turbulent years ahead.
Technorati Tags: Audit-Integrity, corporate-governance, financial-regulation, Sarbanes-Oxley
Guest post by Oxford Analytica.
A recent report by the Center for Public Integrity, an advocacy group, documents the extensive, long-term lobbying efforts of 25 firms involved in fostering the hectic growth of the sub-prime mortgage industry. During the peak years of the sub-prime market in 2005-07, these leading securities and investment companies made millions of dollars in campaign donations to both Democrats and Republicans with a stake in overseeing the industry.
While the report has received widespread media coverage in the United States, there is nothing particularly remarkable about its conclusions. Business lobbying is as old as the US republic and is constitutionally protected under the First Amendment. Indeed, furious lobbying and overt political corruption (which would be impossible under current rules) facilitated the post-Civil War railroad construction boom — and bust.
However, lobbying may have helped exacerbate the size of the financial services bubble — and the consequences of its implosion.
- • One credible estimate suggests that over the course of the last decade, the financial services sector collectively donated 2.2 billion dollars to political campaigns, and spent 3.5 billion dollars on lobbying activity in Washington.
- • This may have helped produce a sanguine political response to the surge in sub-prime lending: from 2000-07, the most active 25 originator firms issued approximately 1 trillion dollars in sub-prime mortgages to over 5 million borrowers — generating billions of dollars in additional revenue.
- • Of course, the sector’s implosion ultimately created a surge in systemic risk, led to the collapse of several major financial institutions, and necessitated hundreds of billions of dollars in federal bailout outlays.
- Financial lobbying tactics. In their lobbying efforts, the financial services community has pursued two key tactics:
- • Bipartisan focus. Lobbying has been focused on both parties, in an effort to help foster a deregulatory consensus. While Republicans tend to use more pro-business rhetoric during political campaigns, since the 1970s the Democratic party has also increasingly pursued a deregulatory agenda.
- • Structural context. Lobbying has become inextricably, and quite deliberately, interlinked with campaign fundraising; collectively these activities now form the structural context in which Washington law-making operates and in which electoral politics occurs.
Artificial consensus? The influence of lobbying, particularly on legislation affecting financial services regulation, is difficult to quantify or separate from the general trend to the Right in US politics from 1980 to 2006. However, it is striking that there is a far stronger consensus in Washington, in favour of a limited regulatory agenda, than there is among academic or professional economists.
Even the financial crisis and election of President Barack Obama does not seem to have shifted this consensus much. While Obama has intervened massively in the financial services industry to prop up certain banks (chiefly via the 700 billion dollar Troubled Asset Relief Program enacted under his predecessor) and has also facilitated the rescue of the politically sensitive auto sector, he has repeatedly emphasised that such intervention is temporary. Treasury Secretary Timothy Geithner has also pointedly eschewed using federal equity stakes in banks to change their business practices by, for example, dictating broad new executive compensation rules.
Financial services industry lobbying is constitutionally protected, and has promoted beneficial reforms. However, the growth and success of such lobbying may have helped create an unusual degree of deregulatory consensus in Washington — perhaps inhibiting consideration of the downsides of an increasingly laissez faire approach.
Technorati Tags: deregulation, financial crisis, financial-regulation
The Economist argues for incremental changes to the financial system rather than a complete overhaul, in a leader accompanying a new Special Report on the financial crisis.
Excerpts:
“Some argue that only draconian re-regulation can spare taxpayers from the next crisis. The structure must be changed … Yet this search for a big, structural answer runs into two problems. One is that the reform is not as neat as it first appears. Nobody wants to have banks that are so big that they stifle competition (itself a source of stability), but breaking big banks up into tiny bits that pose no systemic risk would be a horribly complex and lengthy task.”
“The second drawback is inefficiency. Limiting banks’ size could stop them from attaining the scale and scope to finance global business.”
Instead, it is better to focus on two more fiddly things that could produce fairly radical results: regulation and capital.
“Regulators should focus on function: if an outfit behaves like a bank, it should be regulated as one, whatever it says on the brass plate. Ideally each jurisdiction will incorporate a set of broad global principles, which establish a benchmark of prudent finance.”
“Regulators can also use markets. Banks’ solvency depends on a bedrock of capital. Regulators could monitor how this trades, or use markets that gauge the risk of insolvency, to help decide when banks must raise more capital. Regulators could get managers to watch for systemic risks by linking their bonuses to the bank’s bonds … Incentives matter: with higher risk charges on banks’ trading books, bankers would become more discerning about how they put their money to work, and less prone to make dangerous bets in pursuit of huge bonuses.”
“Smarter regulators and better rules would help. But sadly, as the crisis has brutally shown, regulators are fallible. In time, financiers tend to gain the advantage over their overseers.”
“Hence the overwhelming importance of capital. Banks should be forced to fund themselves with a lot more equity and other risk capital—possibly using bonds that automatically convert to equity when trouble strikes. Higher capital requirements would put more of the shareholders’ money at risk and, crucially, enable banks to absorb more losses in bad times. Think of it as a margin for regulatory error.”
“Regulation cannot prevent financial crises altogether, but it can minimise the devastation. Loading banks with equity slows the creation of credit, but the reward for a healthy financial system is faster growth over the long term. There are three trillion reasons to think that the trade-off is worth it.”
The full Special Report includes articles on the following topics and can be downloaded as a pdf (fee for non-subscribers):
- Rebuilding the banks
- Banks and society
- Canada’s banks
- Bank balance-sheets
- The future of securitisation
- Gaining from the crisis
- Banking and risk
- Swedish lessons for banks
- The future of banking
Technorati Tags: banking-system, banks, financial crisis, financial-regulation, securitization
Despite the cautious optimism creeping into the financial markets, in light of what some believe are better-than-expected results from the government stress testing of 19 large banks, Standard & Poor’s Ratings Services believes that “banks are far from a recovery, and the banking crisis has merely entered a new phase.”
…although our analytical time horizon for losses extends only through 2010 … there’s nothing to say that this banking crisis can’t go on for another three or four years. - Tanya Azarchs, managing director at Standard & Poor’s
One thing is clear, however: banks will have a tough time surviving unless they have “more capital than even Basel envisioned,” according to Azarchs.
The Federal Reserve Board’s stress testing, the results of which were announced May 7, found that that 10 of the 19 largest banks need a total of $75 billion in capital to maintain at least 4% of common equity Tier 1 capital if the environment becomes a lot more adverse than experts currently expect.
This compares with Standard & Poor’s assessment of an $18 billion need for these 19 banks on the basis solely of credit stress testing. “Despite the significantly higher capital requirements determined by the Fed’s stress tests as compared to our stress tests, we do not see this as an unmanageable amount, and most management teams of the identified banks promptly issued statements about how they would raise the capital (see “The U.S. Federal Reserve’s Stress Test Results: The Beginning Of The End Or The End Of The Beginning For U.S.
Banks?
Standard & Poor’s completed its own base-case stress testing of banks’ loan portfolios, focusing on credit and earnings risks and their impact on capital adequacy (see What Stress Tests Reveal About U.S. Banks’ Capital Needs. On May 4, S&P placed ratings on 23 financial institutions on CreditWatch with negative implications. The results, and the rating actions, are wholly independent of the stress testing regulators conducted and indicate widespread, though not necessarily severe, capital needs that could result in downgrades of several notches.
S&P says The Fed’s stress test has been just another step toward the eventual recovery of the global financial industry, but the industry still faces challenges presented by these developing trends:
- Industry risk is generally creeping higher rather than stabilizing;
- Losses during this downturn will likely be greater than the industry thought when it began;
- Franchise stability and market confidence are increasingly critical components of credit;
- There’s a greater focus on capital adequacy;
- Government support is now explicit in our ratings for highly systemically important U.S. banks;
- Hybrid securities appear to be riskier than we thought;
- The industry structure is changing;
- Volatility appears to be here to stay;
- The originate-to-distribute model is being rethought; and
- Regulation is generally increasing.
Technorati Tags: bank crisis, banking-system, financial-regulation, stress test, U.S. banks
The International Monetary Fund has made available a free pre-publication section of a new Handbook on Securities Statistics, produced in conjunction with the Bank for International Settlements (BIS) and the European Central Bank (ECB).
The Handbook is the first publication of its kind dealing exclusively with the conceptual framework for the compilation and presentation of securities statistics. It directly addresses a recommendation of one of the Group of Twenty (G20) working groups concerning the need to fill data gaps and strengthen data collection.
The aim of the first part of the Handbook is to assist national and international agencies in the production of relevant, coherent and internationally comparable securities statistics for use in financial stability analysis and monetary policy formulation.
A useful feature of the handbook is its clear and simple definitions of terms used in the securities market.
Securitisation results in debt securities for which coupon or principal payments (or both) are backed by specified financial or non-financial assets or future income streams. A variety of assets or future income streams may be used securitised including, among others: residential and commercial mortgage loans; consumer loans; corporate loans; government loans; credit derivatives, and future revenue.
Topics covered include:
- Main features of debt securities
- Institutional units and sectors
- Securitisation
- Accounting rules, valuation and accrued interest
- Classification of debt securities
- Detailed presentation tables
- Metadata
- Structured debt securities
- Islamic debt securities
Technorati Tags: debt securities, financial-regulation, Securities, securitization
Despite increasing scepticism surrounding sophisticated financial products, their use is unlikely to wane massively, according to Oxford Analytica. But not because they are needed:
“There is little financial need for most of these innovations, since financial risks are most conveniently and cheaply hedged by holding liquid assets or government bonds (ie, liquidity preference). ”
The reason why financial derivatives have proliferated is because financial intermediaries are using them to profit from financial instability (rather than just to eliminate the risks attendant upon that instability), or are obtaining fee income from selling such instruments to their customers.
Noting that financial innovation dates back to the Roman Empire, OxAn suggests politics will keep them around. “Political leaders, while claiming the need for stronger financial regulations, are likely to resume a minimalist approach to financial regulation as market conditions improve and governments divest themselves of financial assets acquired during the recession.”
For the full analysis, see “Financial innovation to continue.”
Technorati Tags: derivatives, financial innovation, financial-regulation
