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Cracks appear in the Dodd-Frank Act (Part 1)

One gets the sense, just three weeks after Barack Obama signed into law the 2300 page Dodd-Frank Act, that legislators may have put the cart before the horse, so to speak. The Dodd-Frank Act represents the most far-reaching overhaul of the US financial system since the Glass-Steagall Act of the 1930s. Despite its length, most observers would agree that it has been scripted relatively quickly, having ridden a tsunami wave of political momentum. It includes numerous and substantial changes to previously unquestioned financial practice. Yet, just three weeks after being ratified by the President, the first cracks have already started to appear.


cracksThe particular case in point revolves around the question of the limitation included in the Act that disallows the use of external credit ratings in capital calculations. Specifically, the Act disallows banks to make use of ratings provided by External Credit Assessment Institutions (ECAIs) in rating their counterparties’ credit worthiness for the purpose of capital requirement calculations. Despite the fact that this limitation constitutes less than one page of the 2300 page Act, it has tremendous ramifications.


To put the limitation into perspective: the bulk of regulatory capital that a bank is required to set aside with the Federal Reserve is derived from credit risk calculations. That is, from banks’ own assessment of the credit risk inherent in their lending. This assessment, especially in the case of large corporate and bank counterparties, is substantially based on making use of external ratings. Importantly, this requirement includes not only retail and commercial lending but also includes counterparty risk in the trading book, a risk that emerges out of interbank activity. It is this interbank activity that dried up during the financial crisis that began with the failure of collateralized debt obligations (CDOs) and securitized debt in 2008, but which quickly transformed into a far more sinister monster – interbank liquidity risk. Essentially, banks no longer trusted each other in the short-term liquidity markets, and it was the seizing up of these markets that really brought down numerous banks worldwide, rather than credit risk on its own.


The business of interbank lending has been based, for the past several decades, on the perceived validity of the credit ratings for banks and other institutions that have been provided by ECAIs. The rating agencies, however, have been heavily discredited following the failure of an untold number of debt securities, which they had rated with their most prestigious rating grade. In the case of Standard and Poor’s, as just one example, Credit Suisse wrote down a loss of 36 percent on a face value of over $300 million of CDOs, all of which were rated AAA, the highest S&P rating. This loss was incurred despite the fact that a AAA rating is meant to represent a default frequency of 1 in every 10,000, or 1 basis point, over a one-year horizon.


The argument for the inclusion of the limitation in the Dodd-Frank Act is therefore quite simple: the rating agencies got the business of rating the creditworthiness of counterparties horribly wrong. The arguments against the limitation are equally simple, but perhaps a little more vague: first that the cost of not using rating agencies, particularly for smaller banks, will be too high, and second that the alternatives to the rating agencies may not work.
Ironically, it is the regulators themselves, in one form or another, that are doing the back-pedalling against the current of the Act. Both the Federal Deposit Insurance Corporation as well as the Comptroller of the Currency have made recent public statements to the effect that there are no real viable alternatives to the current status quo of rating agencies dominating the markets.


One understands, however, why Chris Dodd and Barney Frank would have included the limitation. Firstly, there is the issue of the business model itself that rating agencies have managed to embed in the system over the years. Rating agencies are paid by the institutions and issuers of debt which they rate, a fact that cannot result in any other conclusion than that there exists in this model an ‘agency’ dilemma. Moody’s, as an example, actually upgraded the ratings on Iceland’s banks in 2007, despite severe warnings made by analysts at Danske Bank. These analysts had pointed out the relatively simple fact that the economy of Iceland would never be able to handle a single bank failure, never mind multiple bank failures, in an environment in which bank assets had reached a point of being 10 times larger than the Icelandic GDP.


In general, during the crisis, ratings were always overly optimistic, rather than overly pessimistic. The skewness inherent in the distribution that describes the difference between prediction and reality is such as to suggest strong statistical evidence that there was a substantial overly optimistic bias in the ratings themselves. It is a fair question to ask whether this bias would have existed in a world in which the rated entities were not charged for the privilege of being rated.


Secondly, one needs to consider the incredible growth in the rating business. In the past, in the 1980s, the ratings agencies would compete with each other to rate large listed corporations, banks and sovereign debt. The business model was fairly simple, and could expand over time to include corporate bonds as that market took hold. With the advent of securitized debt, however, and with the invention of CDOs, the business could explode. Think of it: whereas one could previously rate Royal Bank of Scotland, one could now rate each and every tranche of a single CDO issued by Royal Bank of Scotland. And there would be many of these CDOs – those backed by mortgage loans, those backed by credit cards, those backed by corporate loans, and so on and so forth. It had previously been a rare event for S&P to rate any entity AAA. There were now thousands of such ratings made against debt securities issued out of securitization vehicles that possessed funky names, that were held at an ‘arm’s length’ from the banks themselves, and that no-one had ever heard of. Naturally there were good reasons for this flourish of superior ratings – they were supported ‘traditionally’ by lower-rated tranches, or supported ‘synthetically’ by credit default swaps. But fundamentally the economics would not make that much sense – no matter how one packages debt, its ultimate risk lies in the basic economics of debt service cover, numbers that do not change other than through economic growth. It is not too far-fetched then to believe that the rating agencies may have missed this in the rush to rate new instruments and to grow their own balance sheets.


Thirdly, and perhaps most fundamentally, there has been – over an extended period of time – the implementation of significant barriers to entry into the business of external credit rating. Whilst most countries have local agencies that provide external opinion on retail customers and their credits, the world is pretty much dominated by only three agencies that provide ratings for large corporate, parastatal, and sovereign entities. This is partly a result of the expense involved in hiring the kind of analytical skills required to rate external entities. However, the barriers to entry are primarily a result of the market preference for the three large players, owing to regulatory accreditation of these three players. It would appear that very, very few ECAIs ever get the level of accreditation required to effectively compete in a market dominated by three large players.


David Buckham, CEO of Monocle