The President’s Working Group on Financial Markets (the “PWG”) undertook a thorough analysis of the recent turmoil in the financial markets triggered by the delinquencies in the subprime mortgages and issued a Policy Statement. The Policy Statement identifies the underlying weaknesses which led to the sub-prime mortgage industry crisis, and to address those weaknesses, makes recommendations for regulators and industry participants, i.e., originators, underwriters, investors, asset managers, and credit rating agencies.
Causes of the Turmoil . The PWG has identified the following factors contributing to the crisis:
Dramatic weakening of the underwriting standards for sub-prime mortgages beginning in late 2004 and extending to early 2007 - participants failed to obtain sufficient information or conduct comprehensive risk assessments on instruments that were often very complex, and instead relied excessively on credit ratings;
Faulty assumptions underlying rating methodologies and subsequent re-evaluations by credit rating agencies (“CRAs”) of credit products - this resulted in significant downgrading of sub-prime residential mortgage backed securities (“RMBS”), especially collateralized debt obligations (“CDOs”) that held RMBS and other asset backed securities (“CDOs of ABS”). The number and severity of negative ratings actions eroded investor confidence causing seizure of many structured finance markets;
Serious risk management weaknesses at some large U.S. and European financial institutions, especially with respect to concentration of risks, valuation of illiquid instruments, pricing of contingent liquidity facilities and management of liquidity risks – these weaknesses were particularly evident with respect to managing risks of holding CDOs of ABS, sponsoring or supporting off-balance sheet conduits that issued asset-backed commercial paper (“ABCP”) and syndicating leveraged loans;
Regulatory policies, including inadequate capital and disclosure requirements, that failed to mitigate risk management weaknesses at financial institutions.
Recommendations . The PWG makes recommendations in the Policy Statement that, broadly speaking, call for adoption of stronger standards with regard to securitized credit instruments by all market participants. The highlights of the recommended measures are as follows:
- Mortgage origination: regulators should adopt stronger standards and conduct more rigorous oversight of entities involved in mortgage origination, including adoption by all states of the standards set forth by federal regulators for non-traditional and sub-prime mortgage lending (along with effective enforcement mechanisms for non-compliance with such standards), stronger licensing standards for mortgage brokers, stronger consumer protection rules and disclosure requirements, which may be effected through Truth in Lending Act (“TILA”) and Home Ownership and Equity Protection Act (“HOEPA”) regulations that are presently under review. (Separately, Ben Bernanke, the Chairman of the Federal Reserve, previewed the proposed HOEPA regulations, as follows: (a) the new stricter rules proposed under HOEPA would, inter alia, prohibit a lender from engaging in a pattern of making higher-priced loans that a borrower could not reasonably be expected to repay from income or assets other than the borrower’s house; (b) lending will no longer be permitted on “stated income” and lenders would have to verify the income or assets of the borrower, (c) higher-priced loans would require an escrow account for real estate taxes and hazard insurance, (d) prepayment penalties would be banned in situations where buyer was particularly vulnerable, e.g., where debt-income ratio exceeded 50% and, when permitted would be required to expire at least sixty days before a scheduled increase in loan payment; and (e) certain advertising practices, which have a tendency to deceive consumers, would be banned);
- Market discipline: overseers of institutional investors should require investors and their asset managers to obtain better information (including information about underlying asset pools) on an initial and on-going basis from underwriters and develop an independent view of the risk characteristics of securitized credit instruments, rather than relying solely on CRAs. The PWG will engage private sector to create a committee to develop best practices regarding disclosure to investors of securitized credits;
- CRAs: CRAs should disclose the qualitative reviews performed by them on originators of assets and require underwriters of ABS to represent the level and scope of due diligence performed on underlying assets, CRAs should adopt measures to enhance the transparency and integrity in credit rating process;
- Risk management practices: financial institutions should review their risk management practices, and US banking regulators and the SEC should review their current guidance, to identify and remedy the weaknesses in risk management practices that the present turmoil has revealed. The PWG will support formation of a private-sector group to reassess implementation of the Counterparty Risk Management Policy Group II’s existing guiding principles and recommendations regarding risk management, risk monitoring and transparency, and supervisors of financial institutions should closely monitor and ensure that their financial institutions remedy risk management weaknesses;
- Regulatory policies: The PWG makes several recommendations for adopting regulatory policies that would, inter alia, provide incentives for financial institutions to hold capital and liquidity cushions, require them to make detailed disclosures of off-balance sheet commitments, improve the quality of disclosures about fair value estimates for complex and other illiquid instruments, and enhance guidance related to pipeline risk management for firms that use an originate-to-distribute model. The Basel Committee on Banking Supervision and IOSCO should review the capital requirements for ABS CDOs and other re-securitizations and for off-balance sheet commitments, and FASB should be encouraged to evaluate the role of accounting standards in current market turmoil;
- OTC derivatives: infrastructure for the OTC derivates market should be enhanced to, inter alia, improve the accuracy and timeliness of trade data submissions and the resolution of trade matching errors. Moreover, supervisory agencies should encourage the amendment of standard credit derivative trade documentation to provide for cash settlement in accordance with the terms of a cash settlement protocol and to develop a longer term plan for an integrated operational infrastructure supporting OTC derivatives that is reliable and efficient, and captures all significant processing events over the entire life-cycle of trades.