How Dodd-Frank Act Tackles the Subprime Crisis

 San Diego Business Attorney Sergei Tokmakov
Owner@TheCorporateAttorneys.com

Contents

I. INTRODUCTION.. 3

II. CAUSES OF THE CRISIS. 3

       a. Too much extra money. 3

        b. Mortgage originators with no skin in the game. 4

        c. Credit rating agencies. 7

        d. GSEs and investment banks. 9

III. THE FINANCIAL REFORM ACT RESPONSE. 11

        a. Dodd-Frank response to toxic mortgages. 11

        b. Dodd-Frank on credit agencies. 15

        c. Dodd-Frank on investment banks. 17

IV. CONCLUSION.. 20

       I.            INTRODUCTION

On the night of Sept. 18, 2008, United States Treasury Secretary Hank Paulson told Senator Dodd and other members of Congress that “unless you act, the financial system of this country and the world will melt down in a matter of days.”[1] The Financial Reform Act[2] is a response to the biggest financial crisis since the Great Depression.

This paper analyzes major causes of the crisis and the legislative response, and concludes that the Financial Reform Act is a step in the right direction that covers major issues. Nevertheless, much of the meaningful decision making has been left up to the agencies that will be heavily lobbied once the public pressure somewhat lessens. Overall efficacy of the Act, thus, remains to be seen.

    I.             

    II.            CAUSES OF THE CRISIS  

a.      Too much extra money

Many countries of the world experienced a significant increase in wealth and needed to safely invest the extra money. While in 2002 the global volume of assets available for investment amounted to $37 trillion, by 2007 this number almost doubled to $73 trillion.[3] U.S. Treasury bonds have traditionally been a safe investment but in the early 2000’s the return ranged from a just around 1% to 4%, depending on the terms.[4] U.S. real estate securities became the next best option for many investors due to a historically low default rate of those securities. From 1990 to 2007, prior to the crisis, only around 1% of total loans were in foreclosure process.[5]

Mortgage-backed securities (MBS) gave global investors all the benefits of the supposedly safe investment into the U.S. real estate market without dealing with the hassle of individual mortgages: divorces, catastrophic health problems etc. Here is how it works. A broker sells an individual’s mortgage to a bank, which in turn sell it to a Wall Street investment firm. These firms acquire thousands of mortgages, which makes the firms entitled to thousands of checks coming in each month from the individual borrowers. The firm then sells shares of that income stream to investors, who rest peacefully knowing that their investment is backed by valuable assets and proven steady income streams, all thanks to the supposedly wonderful vehicle of securitization.[6]

b.      Mortgage originators with no skin in the game

When the demand for U.S. real estate securities surged, loan originators began looking to expand the supply side of the market by including riskier pools of borrowers. When a loan is made to somebody who may have trouble repaying it, it’s called subprime loan. The volume of subprime mortgage loans climbed from $100 billion in 2000 to $600 billion in 2006.[7] Adjustable rate mortgages were among the riskier types because they would entice borrowers with low “teaser” rates which would reset to much higher rates, resulting in many defaults.

Mortgage broker is a go-between that brings a borrower and a creditor together to

obtain a mortgage loan. Since the brokers’ livelihood directly depended on the commission, they had an incentive to charge higher commission rates and make more loans. On average, U.S. mortgage brokers collected 1.88% of the loan amount for originating a subprime loan.^[8] Some dishonest brokers, however, charged points and origination fees exceeding 10%, and financed those fees at high interest rates.[9]

Broker’s commission and profits were highest in the subprime market.[10] This incentivized brokers to sell subprime loans to anybody they could find, even borrowers qualified for conventional loans. In 2005, during the peak of the subprime boom, 55% of subprime borrowers had credit scores high enough to qualify them for conventional loans with significantly better terms.[11] Mortgage fraud by brokers increased dramatically.[12] In 2004, the FBI warned of an "epidemic" of financial crimes in the mortgage market which could lead to "a problem that could have as much impact as the S&L crisis."[13]

The mortgage qualification guidelines were getting looser and looser. Limited-documentation mortgages, called "low-doc" and "no-doc," became increasingly available. With the stated income, verified assets (SIVA) loans borrowers only needed to “state” their income and show some money in the bank. With the no income, verified assets (NIVA) loans, the borrowers did not need to state income, just show the money in the bank. Finally, no income no assets (NINA) loans did not require borrowers to state or prove anything except a credit score.[14] In 2007, 40% of subprime loans were approved automatically without proper review and documentation.[15]

Subprime lenders, who weren’t covered by federal banking laws that provide consumer protection, have increasingly targeted borrowers that were traditionally underserved by the conventional banks, such as undocumented immigrants.[16] In a bid to entice minority and low-income borrowers, lenders started offering them risky loans that had been traditionally reserved for sophisticated clients.

One such product was payment-option adjustable-rate mortgage (ARM), colloquially known as “pick-a-payment” loan.[17] Adjustable-rate mortgages are those where the interest rate on the note fluctuates in relation to a variety of indices.[18] The initial interest rate of an ARM is lower than that of a fixed rate mortgage.[19] Nevertheless, after the initial grace period, the interest rate periodically resets to a market rate, which can be significantly higher. In a conventional loan, the borrower’s monthly payments reduce both principal and interest. “Pick-a-payment,” however, is an especially treacherous form of ARM because it results in negative amortization (meaning the principal owed rises over time). The borrowers could choose an amount they are most comfortable paying, with difference between the payment and the accruing interest rate being added to principal. When the loan resets, the mortgage payment increases dramatically. These loans were designed for sophisticated investors to free up some cash for other purposes. Nevertheless, the lenders marketed those loans as “affordability” products.[20] In 2000, when “pick-a-payment” loans were still primarily sold to sophisticated clients, the default rate was less than 1%.[21] In 2006, when these loans were sold to less-creditworthy individuals, the default rate was 37%.

c.       Credit rating agencies

It is not surprising that poorly regulated, sketchy mortgage originators were able to entice low income minorities and immigrants to borrow more than they could afford. But why would sophisticated institutional buyers, inured to the rough and tumble world of international commerce, buy this risky stuff? It’s because they relied on reputable credit rating agencies that rated most MBS as exceptionally safe investments. [22] Most MBS were rated AAA, a rating given to safest securities such as U.S. government bonds.  The investors believed it because few would have the time or expertise to analyze large and diverse volumes of such complex securities as MBS.[23]

The ratings were flawed because they were based on the wrong data. Historically, there was a very low foreclosure rate. However, with the new lax qualification requirements and a growing speculative housing bubble, foreclosures were much more likely. The rating agencies did not assign enough weight to these risk factors but chose instead to 1) make overly optimistic assumptions on the new, untested types of mortgages; 2) use an actuarial approach to evaluating risk (which tends to be backwardlooking); and 3) assume home prices would not fall sharply but instead would only moderate.[24]

The ratings of these securities was a profitable business for the rating agencies, who repeatedly eased their standards while enjoying record revenues, profits and share prices. The rating companies could earn as much as three times more for grading subprime mortgage-backed securities than corporate bonds (their customary business). [25] Competitive pressure among the companies to rate favorably was strong, which gave management financial incentives to lower standards. The agencies had a good deal of levy since the U.S. courts have largely upheld the claim that the ratings were a form of “free speech” immune to liability lawsuits notwithstanding an element of conflict of interest (the agencies are paid by the issuers whose securities they rate).[26]

d.      GSEs and investment banks

It was easy for the lenders to sell the risky subprime loans to Fannie Mae, Freddie Mac and investment banks. After the sale the lender no longer had any “skin in the game” and did not care if the borrower would repay. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSE) created in order to expand the secondary mortgage market by securitizing mortgages in the form of MBS, which allows lenders to reinvest their assets into more lending.[27] Rather than making home loans directly to borrowers, GSEs buy mortgages on the secondary market, pool them and sell as mortgage-backed securities.[28]

Government-sponsored entities began receiving government tax incentives for purchasing mortgage-backed securities, which included loans to low income borrowers, in 1995. This is how Fannie Mae and Freddie Mac began their involvement with the subprime market.[29] For 1996, the Department of Housing and Urban Development (HUD) mandated Fannie and Freddie that at least 42% of their total purchased mortgages be issued to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.[30]  By 2008, the Fannie Mae and Freddie Mac owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, approximately half of the total U.S. mortgage market.[31] The government-sponsored entities have always been highly leveraged, so when concerns arose in September 2008 regarding their ability to make good on their guarantees, the Federal government was forced to place the companies into a conservatorship, effectively nationalizing them.[32]

Some of the questionable underwriting practices of Fannie Mae and Freddie Mac contributed significantly to the subprime crisis[33] but the investment banks’ practice of underwriting the private-label securities (PLS) was a bigger contributor. In 2003, Fannie Mae and Freddie Mac issued about 66% of the total of mortgage-backed securities.[34] By 2007, however, this number dropped to 54% because investment banks more than doubled the volume of private-label securities from 2004 to 2007.[35]

Banks took excessive risks with others’ money. Even though investment banks’ private-label securities accounted for less volume of mortgage-backed securities than the GSEs, private-label securities were riskier. Half of the PLS loans were the risky adjustable-rate loans with “teaser rates,” as compared to 28% of the Fannie Mae loans. Twenty percent of the PLS loans had negative amortization while only 3% of the Fannie Mae loans were. [36] As it turned out, the likelihood of default was the highest when the borrower could not afford to pay an adjustable-rate mortgage when the interest rate reset. As a result, private-label loans’ default rate was approximately double that of the Fannie Mae loans.[37]

 III.            THE FINANCIAL REFORM ACT RESPONSE

a.      Dodd-Frank response to toxic mortgages

Mortgage brokers steered borrowers into the subprime market because this is where brokers received highest commissions. The Act attempts to take away some of the incentives of putting a borrower into a more expensive loan when the borrower is qualified for a conventional loan. Sec. 1403 of the Act prohibits steering incentives by barring compensation “based on the terms of the loan (other than the amount of the principal).”[38] Mortgage broker and a lender are bound by this rule since both are deemed “mortgage originators”[39] prohibited from steering a customer to a loan which he or she does not have the ability to repay or which is predatory in nature.[40] prohibited from steering re deemed "the first place.e borrower is qualified for ing thwmselves into,These common sense rules would have avoided much grief and are long overdue.

Lenders did not seek financial documentation from borrowers because the lenders’ compensation did not depend on whether the loan would be repaid. The Financial Reform Act amends the Truth in Lending Act by creating minimum standards for residential loan mortgages. Lenders are prohibited from making a loan unless the lender “makes a reasonable and good faith determination” that is “based on verified and documented information” that the consumer “has a reasonable ability to repay the loan”; including “taxes, insurance (including mortgage guarantee insurance), and assessments.”[41] It seems like these simple provisions alone would have alleviated many subprime lending problems. Unfortunately, mortgage brokers and lenders had no reason to follow this basic prudence in order to satisfy the high demand for subprime mortgages.

Determination of the ability to repay must be based upon a payment schedule “that fully amortizes the loan over the term of the loan.”[42] In calculating the payment, the interest rates over the entire term of the loan is to be “a fixed rate equally to the fully indexed rate at the time of closing without considering the introductory rate.”[43] This will circumvent the practice of predicting the ability to repay based on the initial low teaser rates of some adjustable rate mortgages, where monthly payments can double or triple the original payment when the interest rate resets. Such practice resulted in many mortgage defaults because even below-market teaser rates were burdensome for borrowers who should have never gotten the loan in the first place.

The lender may presume that the ability to repay has been met if a loan is a “qualified mortgage.”[44] The term “qualified mortgage” generally means any residential mortgage loan that 1) does not result in a balloon payment (large final balance due at maturity) or permits negative amortization, 2) for which the income and financial resources relied upon to qualify the obligors on the loan are verified and documented, 3) for which total points and fees do not exceed 3 percent, and 4) the term of the loan does not exceed 30 years.[45]

Many problems arose when mortgage brokers steered borrowers into exotic loans. The Act deals with “nonstandard loans,” such as variable rate loans that defer repayment of any principal or interest, interest-only loans or “pick-a-payment” loans with negative amortization. The Act requires that in those cases the creditor must use a fully amortizing repayment schedule in assessing the borrower’s ability to repay.[46] This will abrogate the practice of basing the calculation on the assumption that the buyer has the option of not paying the interest and just adding it to the principal.

The Act also deals with the “hybrid adjustable rate mortgages,” where “a fixed interest rate for an introductory period… adjusts or resets to a variable interest rate after such period.”[47] Variations of these loans are called 2/28 or 3/27 because the interest rate of a 2/28 hybrid ARM carries a fixed rate for two years before resetting to an adjustable-rate mortgage for 28 years (or, in the case of a 3/27 loan, the rate remains fixed for 3 years). Under the Act, six months before the reset, the creditor or servicer of the loan must furnish the borrower with a notice that includes the basis for the reset, a good faith estimate of the new monthly payment, a list of alternatives such as refinancing or pre-foreclosure sale, and the names and contact information of consumer counseling agencies.[48] Since hybrid adjustable rate mortgages have significantly contributed to the subprime crisis in large part because borrowers did not have a clear idea of what they were getting themselves into and did not expect payment increases to be drastic, the rule providing for a notice to adjust to the higher payments may alleviate some of the problems.

The Act increases ceiling for civil liability to the greater of actual damages or up to three times the compensation accruing to the mortgage originator in connection with the loan, plus costs and a reasonable attorney’s fee.[49] The borrower can also assert violation by originator as a defense or set-off in foreclosure proceedings.[50]

Effectiveness of the new requirements will ultimately depend on the many regulations to be promulgated by the Federal Reserve Board and other administrative bodies. The new Consumer Financial Protection Bureau is also empowered to circumvent abusive mortgage lending practices.[51] The Bureau may conduct investigations[52] into unfair, deceptive or abusive lending practices and prescribe rules defining such practices. [53] Nevertheless, unfairness is defined rather narrowly as the act or practice that a) causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers; and b) such substantial injury is not outweighed by countervailing benefits to consumers or to competition.[54] Due to the well known reverence of the U.S. courts for the free market, the Bureau may have a tough time promulgating and enforcing its rules. Nevertheless, Dodd-Frank provides basic framework that makes it feasible to circumvent many of the abusive lending practices that caused the subprime crisis.

b.      Dodd-Frank on credit agencies

Sec. 931 of the Financial Reform Act enumerates congressional findings relating to the “importance of credit ratings and the reliance” that are “matters of national public interest.”[55] Congress found that credit rating agencies play a critical role “that is functionally similar to that of securities analysts,” which “justifies a similar level of public oversight and accountability… the same standards of liability and oversight as apply to auditors, securities analysts, and investment bankers.” Congress also found that “credit rating agencies face conflicts of interest that need to be carefully monitored.” The foregoing justifies “increased accountability on the part of credit rating agencies.”[56]

Credit rating agencies will face increased scrutiny, the depth of which will be determined by the SEC rules. The Financial Reform Act creates the new SEC Office of Credit Ratings to administer rules with respect to credit rating practices. The Act empowers SEC to suspend or revoke the registration of the rating agency with respect to a particular class or subclass of securities if the “rating organization does not have adequate financial and managerial resources to consistently produce credit ratings with integrity.”[57] The latter was likely implemented in light of the 2008 SEC report that disclosed that the credit rating staff dedicated to reviewing the CDO deals was increased only slightly even though the number and complexity of CDOs grew significantly.[58]

Dodd-Frank imposes additional obligations upon management. The Act requires each credit rating agency to have a board of directors, at least half of whom are independent. Each organization must also designate a compliance officer who cannot perform credit ratings or participate in marketing or sales activities. The officer’s compensation cannot depend on financial performance of the organization. This person must submit annual compliance reports to the SEC.[59] Compliance officers are becoming more and more common nowadays in the aftermath of the Sarbanes-Oxley Act and accounting scandals such as Lehman Brothers and AIG. Given the volume and complexity of securities rated by the rating agencies, it is not clear how helpful the compliance officer will be but this officer is a welcome addition nevertheless.

Credit rating agencies were able to rate with impunity in large part because courts extended the First Amendment protection to the agencies “speech.” The Financial Reform Act places credit agencies outside of the First Amendment protection by subjecting them to a private cause of action and penalties “in the same manner and to the same extent as such provisions apply to statements made by a registered public accounting firm or a securities analyst under the securities laws.”[60] Furthermore, the agencies’ statements “shall not be deemed forward-looking statements.”[61] This means that the agencies’ statements do not enjoy a limited liability regime provided to forward-looking statements.

Credit rating agencies may now be liable as experts. Section 939G of the Dodd-Frank Act overrides Rule 436 of the Securities Act of 1933 which exempted the agencies’ ratings assigned to a public offering from being considered as an expert-certified part of the registration statement. Now, the agencies will have expert liability under Section 11 of the Securities Act if the credit rating is included in a registration statement. The rating, however, cannot be included in the registration statement without the agency’s consent.  The four largest credit rating agencies, Fitch, Standard & Poor’s, Moody’s, and DBRS, responded that they will not allow their companies to be named as expert in the SEC filing documents.[62]

According to the Act, multiple studies and reports which affect the credit rating agencies must be prepared. Among these are: a report on independence of rating organizations and how it affects their ratings, a study on the feasibility and desirability of standardizing credit rating terminology, a study of alternative means for compensating the agencies in order to achieve more accurate ratings, and a study on the feasibility of creating an independent professional organization for rating analysts to establish standards and oversee the profession.

c.       Dodd-Frank on investment banks

            The banks had “no skin in the game” because they were selling off the risk and were “too big to fail” because the failure would impact the rest of the economic system. The Financial Reform Act addresses both of those concerns.

            The Act imposes credit risk retention in special circumstances. Risk retention requirements are eliminated for qualified residential mortgages.[63] However, risk retention requirement of at least 5% must be established by regulations.[64] The risk retention can be less than 5% if the loan originator meets the criteria to establish low credit risk.[65] The risk retention cannot be hedged.[66] The Federal banking agencies and the Securities and Exchange Commission must jointly prescribe regulations to allocate the retained risk between the originator of the loan and the securitizer who converts loans into securities. The regulations will establish underwriting standards for different classes of assets, such as residential mortgages, commercial mortgages, commercial loans, and other types of assets.[67] Each issuer of an asset-backed security must perform a due diligence review of the underlying assets and to disclose the extent of the compensation of the broker or originator of the assets backing the security; and the amount of risk retention by the originator and the securitizer of such assets.[68]

            It seems that, although the Act provides for a basic risk retention framework, most of the real decision-making is left to the SEC and other agencies. It is quite plausible that this is a result of lobbying, and the regulatory agencies will be lobbied as well to implement exemptions and diluted rules.[69] The 5% risk retention minimum is definitely better than nothing but it can be split between originator and securitizer, who used to receive commission in excess of that amount.

            The “too big to fail” risk to the economic system is due to the banking industry size. In 2007, commercial banks held $11.8 trillion of assets, or 84% of GDP.[70] Former Chairman of the Federal Reserve Alan Greenspan suggested the most obvious way to deal with this, “If they’re too big too fail, they’re too big.”[71] He then went on to remind that when Standard Oil was broken up in 1911, “the individual parts became more valuable than the whole.”[72] It has also been suggested that the assets of a commercial bank be limited to 4% of GDP, and the size of an investment bank be limited to 2% of GDP.[73] This would limit the size of six banks: Bank of America (16% of GDP), J.P. Morgan Chase (14% of GDP), Citigroup (13% of GDP). Wells Fargo (9% of GDP), Goldman Sachs (6%) and Morgan Stanley (5%).[74] Some argue to the contrary that large multinational corporations need large banks.[75] At present, however, these corporations are serviced by a combination of banks, so that should not be a major obstacle.[76]

Ultimately, the Financial Reform Act does not seem to adequately address the “too big to fail” problem.  The Act states that a financial company may not merge, consolidate, acquire all or substantially all of the assets of, or otherwise acquire control of, another company, “if the total consolidated liabilities of the acquiring financial company… would exceed 10 percent of the aggregate consolidated liabilities of all financial companies at the end of the calendar year preceding the transaction.”[77] Unfortunately, there is an exception to this limit if a bank is in default or in danger of default.[78] Also, the prohibition does not touch institutions that already exceed the 10% limit.

            The Act establishes a Financial Stability Oversight Council and procedures for orderly liquidation authority.[79] The Council must “identify risks to the financial stability of the United States,” in order to foresee the threats to the financial system “that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.”[80] The Council must also “promote market discipline, by eliminating expectations… of such companies that the Government will shield them from losses in the event of failure.”[81] If a company presents a systemic risk, the FDIC can be appointed receiver of the company, either with the consent of the board of directors or pursuant to a court order.[82] The Council has already conducted several meetings and got overwhelming volume of input from all sides of the market.[83] The Council has rather broad regulatory powers and potential to positively shape market oversight. Whether or not it uses its powers effectively remains to be seen.

 IV.            CONCLUSION

Mortgage brokers, lenders, credit rating agencies and investments banks were the major causes of the subprime crisis. The Financial Reform Act addresses these major causes, and had the Act been in effect, the crisis probably would not have occurred. Those opposing the Act generally argue that too much government intervention reduces competition and profits. No doubt, dangers of overregulation or misregulation should be dealt with seriously. However, when the profits come at the expense of mislead customers and endangered global financial system, it is hard to argue against at least the basic common sense rules that prohibit deception in steering unsophisticated borrowers into the loans they can’t afford, gambling with other people’s money, and irresponsibly issuing flawed ratings.

While the Act promulgates the basic necessary rules, much of the real decision making has been left up to the agencies that will most likely be more vulnerable to lobbying pressure than Congress. The Act had a hard time passing through Congress, despite public outcry and the high level of attention the Act has received. Now, the public attention will be split between different agencies, and the overall level of public scrutiny will be lower as the time passes and people start worrying about other issues. However, there will be no decrease in lobbying pressure from the companies that are now required to have skin in the game. That is why one of the sponsors of the bill, Senator Dodd, is worried that some of the rules will be watered down, especially considering the recent shift of power to Republicans, who generally opposed the Act.[84] He is also worried that the agencies could be “starved” with inadequate budgets as a form of political pressure.[85] Some provisions of the Act have already been repealed, and we can expect to see more scaling back in the near future.[86]

Nevertheless, the Financial Reform Act is a step in a right direction. Its overall real world efficacy remains to be seen.