Dood-Frank may signal an end to the Fed’s security-blanket
by James Frischling, Ron D’Vari & Asim Ali
Weekly market view from New Oak FinancialMoody’s downgraded the long-term senior unsecured ratings of four major US banks – JP Morgan, Morgan Stanley, Goldman Sachs and Bank of NY. The headline reason for the downgrade was the agency’s view that as a result of the regulatory changes and specifically the Dodd-Frank banking reforms, the US Government will be less likely to bailout a troubled institution.
The rating agency is saying that the new rules reduce the notion and protection of too big to fail. That shifts the risk of a troubled financial institution from the government (aka: the taxpayer) to the bank’s creditors. The rating downgrade was therefore driven by the apparent lack of government support and reflects the strength of support from private capital.
However if Moody’s believes the regulatory reforms will work to protect the taxpayer from funding another round of bailouts and will force the bank’s creditors to own the risk, why doesn’t it believe that the reforms will also curb the type of risk-taking that put the banks at risk in the first place? Don’t the other rule changes which are resulting in increased capital, reduced leverage and greater transparency as a result of the increased regulatory oversight reduce the risk that these banks will find themselves in trouble and in need of a bailout in the first place?
The government led litigations and investigations against the banks are resulting in increased reserves and expenditures. The mortgage fight is today’s hot topic, but we already know Libor manipulation and a Foreign Exchange scandal are next on the docket.
Did the government solve too big to fail and is that why the Moody’s downgraded these four banks? Maybe, but more likely reflects all the negative headwinds which will impact the operations and business of the largest financial institutions.
U.S. Regulatory Goal of Not Bailing Out Banks: Bigger Banks’ Debt Riskier?
Moody’s downgraded four of the largest banks a notch after reviewing them in light of the new framework for resolving failed banks in an orderly fashion. Previously they were bailed out with taxpayers money.
Not having the ‘too-big-to-fail’ protection from the Federal Reserve or the U.S. Treasury Department appears at first to make them riskier. However that assumes everything else is equal. Actually the new regulations emphasis on disciplined risk management will reducing equity returns, yet should lead to a more bond-friendly financial institutions.
Three key aspects of the new regulations that come to impact banks behavior and capitalization going forward are: (1) more severe stress tests and tighter scrutiny of model/trade/risk process validation, (2) higher capital ratios, and (3) disciplined regulation of lending and securitization processes and sounder practices. They would all intended to banks less likely to default and lower systematic overall risks.
The more severe stress tests and capital requirements for larger banks will incentify them to reduce risk in several areas such as counterparty, implied leverage, mortgage credit, esoterics, interest rate mismatch, and proprietary trading. The requirement to withstand a 25% drop in housing, 300bp rise in rates, double digit unemployment, fifty percent drop in equities, and instantaneous failure of a major counterparty will definitely force banks to reduce risk taking activities while improving their capital ratio. As a result many larger banks have started to sell or get out of non-core banking activities and reduce leverage to optimize their capital ratios.
While the annual stress testing exercise will undoubtedly reduce profitability of the world’s largest financial institutions, its impact on risk reduction and senior debt holders should be net-net positive.
Larger banks categorized as potential systematic risk need to hold more capital. For example JP Morgan Chase and HSBC need to hold a 9.5% capital to their risk weighted assets (“RWA”). While they have time to meet this requirement by 2019, most banks have already signaled they will try to meet them earlier to manage the markets.
Bank examiners are requiring a much tighter risk process management and validation to ensure full capacity and transparency of adherence to the enacted Dodd Frank rules. While costly, this should keep origination, securitization, and servicing credit and structured products (consumer, mortgages, commercial, public finance, and project finance) more disciplined and subject to less operational, reputational, and litigation risks.
Even without government bailout option, the larger banks will in fact be less risky than the past as the bailout option was not a sure thing. As to the bank equities, they will also be less risky but have commensurate less return.
A New Wave of Securitization and the Role of Credit Rating Agencies
The much-misunderstood term in structured finance – securitization – is back again, and with it has refocused the spotlight on the uncertain role of credit rating agencies.
With the collapse of the mortgage finance sector in 2008 and the global financial tumult that followed, the word ”securitization” crept into everyday speech along with other technical terms such as credit default swaps, collateralized debt obligations, collateralized loan obligations, asset-backed securities (ABS), mortgage-backed securities, etc. An important variable in the securitization markets was and remains the role and criteria for credit rating agencies (CRAs) in rating of ABS.
A meteoric rise for securitization
As an investment practice, securitization has experienced a meteoric rise from a modest beginning in 1970s to becoming an important anchor of the capital markets. According to the International Finance Corporation (IFC), “By late 2004, (the securitization market) had grown to represent 31% of the $23 trillion US bond market.” Securitization is a financing process that involves converting illiquid cash-flow producing assets into securities with varying priority and credit enhancement suited to investors with different risk capacities. In some cases, the more senior tranches can be traded, but the main purpose of securitization and rating is to create a vehicle for medium- to long-term investment. As a result, the securitization market has been an important channel for attracting pension funds and foreign capital into US credit markets and a driver of broader consumer financing.
Due to tighter bank lending practices and the importance of capital efficiency, there has been a push into securitizing certain emerging assets to optimize balance sheet considerations. For example, Blackstone, an investment management firm, issued a single-family rental (SFR) securitization – backed by cash flows of recently acquired foreclosed homes across the country now operated as rental units. This was mostly intended to reduce loan exposures by the banks and create more capacity. There was also another development on the securitization front: SolarCity issued $54.4 million “sunshine bonds,” a new type of securitized asset backed by cash flows generated from rooftop solar panels leased to US home owners. Both issues involved collateral assets with very short historical performance but relatively known sponsors.
New assets reopen the debate on the appropriate criteria and basis for rating them, even without long-term history. If anything, the credit crisis has proved that historical performance is not enough to prevent a systemic avalanche. This debate is highlighted by Blackstone’s SFR securitization ending up with divergent perspective adopted by various credit rating agencies.
Securing a credit rating for an asset is considered desirable as it can attract a broader base of investors over time. Each CRA develops its own methodologies for privately or publicly rating various asset classes and publishes their results. However, market participants have come to treat them as a “private authority” in global finance. This may have indirectly influenced investor behavior towards different asset classes in the global capital markets. The investors’ total reliance on CRAs can lead to “group think” and create systemic risks of its own.
Following the 2008 financial crisis, the role of CRAs vis-a-vis investors has become the subject of debate, with focal areas including the extent of diligence required and what systemic risks should be considered.
In the case of Blackstone’s SFR issuance, one of the credit rating agencies (Fitch) refrained from granting a AAA rating to the newly issued security. Unlike the three other rating agencies (Kroll, Morningstar and Moody’s), which assigned the highest rating to some parts of the investment transactions backed by the SFR securitization, Fitch, in a statement entitled, “Too Soon for ‘AAA’ on Single Family Rental Securitization” said, “Insufficient history along with a number of structural challenges prevent Fitch Ratings from considering ‘AAA’ ratings on single-family rental (SFR) securitizations at this time.”
Given the debate on the precise role of CRAs, diversity in opinion among them is a welcome development.
For example, the European Union Regulation, “Credit Rating Agencies Regulation III,” was established in December 2010 as Europe’s response to the commitments made by the Group of 20 (G20) at the November 2008 Washington Summit. Key provisions of this European directive revolve around ensuring that financial institutions not blindly rely on credit ratings for their investments as they may have done so pre-crisis. The directive is also meant as a demand for transparency, accountability, and diversity across non-banking entities and CRAs alike. This directive has not quite yet made its way to the US, but it was instituted, in part, as a mandate aimed to increase competition amongst rating agencies, reduce the inherent monopoly and reliance on the Big Three (Moody’s, S&P, and Fitch) seen pre-crisis, and to ultimately give smaller, up-and-coming and more conservative credit rating agencies such as DBRS and Kroll a fair chance.
Coming full circle, when it comes to the securitization markets, recent more cautious approaches taken by rating agencies in different transactions appear to suggest that there might be institutional change underway in how credit rating agencies evaluate and rank ”slice and dice” securitized assets.
