Senate Passes Wall Street Reform Bill

Posted on May 27, 2010 by Michael Stocker

 On May 20, the Senate approved a bill that, if enacted, would represent the most sweeping regulatory overhaul since the Great Depression. Among other things, the Senate bill would:

  • Establish a new council of “systemic” risk regulators to monitor growing risks in the financial system.
  • Empower the Federal Reserve to supervise the largest, most complex financial companies to ensure that the government understands the risks and complexities of firms that could pose a systemic risk.
  • Give the Securities Exchange Commission the authority to grant shareholders proxy access to nominate directors.
  • Establish a new self-regulating organization for credit rating agencies designed to eliminate conflicts of interest in the issuer-pay model. The SEC would appoint members of the regulatory body which would assign rating agencies to provide initial credit ratings of financial instruments.

The Senate bill differs significantly in some ways from the House version of the Wall Street reform legislation. While both bills contain provisions calling for the creation of a new consumer protection agency, in the House version the agency would be substantially independent, while the Senate version would put the agency under the umbrella of the Federal Reserve, an institution not famous for its concern for consumer rights.

With respect to regulating the massive over-the-counter derivatives market, however, it is the Senate bill that calls for stricter rules—perhaps because it passed in the wake of the recent Goldman Sachs imbroglio   Both bills give regulators new powers to oversee the derivatives market and to force most derivative contracts to be traded through third party “clearing houses.” However, the Senate bill would make it more difficult for companies to seek exemption from the new rules.

Investors and taxpayers alike should stay tuned to what happens in the process of reconciling the two bills: the results may shape the U.S. markets for generations to come.

Contributed by Yoko Goto

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Should We Trust Companies to Rate Their Own Asset-Backed Securities?

Posted on April 19, 2010 by Michael Stocker

Last week, the SEC proposed new rules that would require issuers, instead of credit rating agencies, to vouch for the soundness of their asset-backed securities. The types of securities that would be affected by these regulations are bundles of loans that generate profits through regular payments, such as residential mortgages, student loans and commercial loans.

While current rules require that such asset-backed securities be rated “investment grade” by a nationally recognized statistical rating organization, the 667 page proposal would require asset-backed securities issuers to (1) certify that the assets will likely produce the type of return described in the prospectus; (2) keep at least a 5% stake in the asset backed securities; (3) provide investors with a way to confirm that the assets conform to the issuer’s representations and warranties; and (4) update the SEC with Exchange Act reports on an ongoing basis (as opposed to only updating the SEC with Exchange Act reports after the first year, as these issuers are currently allowed to do).

Credit rating agencies generated large fees in the years leading up to the recent financial crisis when they offered AAA ratings to catastrophically risky bundles of home loans made to unqualified buyers. These ratings failed to give investors sufficient notice of the true risk associated with many asset backed securities, a phenomenon that played a significant role in the financial sector collapse. The SEC has stated that the rule changes, which would also seek to regulate expedited “shelf offerings,” are intended to “eliminate the appearance of an imprimatur” that might result from a rating issued by a government-approved agency.

There is no question that proposed regulations' intent "to better protect investors in the securitization market" is a laudable one.  However, some might suggest that the proposed rules serve mainly to distance the government from the acts of the credit rating agencies, without addressing the conflicts of interest that give rise to flawed ratings in the first place.

Contributed by Carol Villegas

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The Great White Whale

Posted on September 23, 2009 by Michael Stocker

Of all the major players in the mortgage-backed asset debacle of the last two years, credit rating agencies have proven to be the great white whale for injured investors: an attractive target, but difficult to catch. This may be about to change.

The ire directed at the agencies is easy to understand. Only months before the spectacular collapses of Lehman Brothers and AIG, credit rating agencies gave these companies investment grades of A or higher. In email comments uncovered in a recent SEC investigation, one rating analyst suggested that, at her firm, a deal “could be structured by cows and we would rate it.”

Historically, the First Amendment was one of the greatest impediments to suits against the ratings agencies. Ratings agencies argued that a rating is an “opinion” that is entirely protected, or is an assertion about a matter of public interest that is protected by the “actual malice” standard set forth in New York Times Co. v. Sullivan, 376 U.S. 254, 279-83 (1964).

There was a time when such arguments might have made sense. Originally, rating agencies were paid by subscribers to rate most or all of a particular kind of securities for the benefit of the public. However, by the 1970s, they had transitioned to a model where the agencies were paid by the companies whose products they rated, creating insoluble conflicts of interest.

Courts are increasingly unwilling to interpret the First Amendment as giving carte blanche to the agencies.  The U.S. District Court for the Southern District of Ohio recently refused to extend the First Amendment defense to a rating agency because its ratings were not published for the benefit of the investing public at large, but rather were distributed only to a select class of institutional investors.  In re National Century Financial Enterprises Inc., Inv. Litigation, 580 F. Supp.2d 630, 640 (S.D. Ohio 2008).

Such decisions should give investors some cause for hope that credit ratings agencies may yet be held responsible for their role in the market crisis.

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