Iowa Banking Law Blog

Seeking Safe and Sound Securitization

In a recent speech given before the American Securitization Forum, John C. Dugan, the Comptroller of the Currency, discussed how the securitization market might be reformed and revived.  Some highlights of his remarks are set forth below:

• A properly functioning securitization market “helps consumers and businesses by increasing the availability of credit on terms that might otherwise be unavailable.
• A revival of securitization must guard against abuses, “such as creating inventive for lax underwriting of underlying assets; opaque and complex asset pools; credit rating failures; inadequate risk capture in both accounting standards and regulatory capital and breakdowns in disclosure.”
• There are limitations associated with proposals for mandatory risk retention (“skin in the game”). New accounting standards (FAS 166 and 167) create uncertainty about the extent to which securitized assets involving risk retention will qualify as true sales and must remain on the securitizer’s balance sheet. To the extent that such assets do not qualify for true off-balance sheet accounting treatment, they would increase required regulatory capital levels.
• There are advantages to an approach based on “establishing minimum underwriting standards directly by regulation.” Such standards should apply uniformly and should be made equally applicable to “unregulated mortgage originators and brokers.” Such standards should require effective verification of income and financial information, meaningful down payments, reasonable debt-to-income ratios, and qualifying borrowers based on the highest monthly payment required by the terms of the loan.

Another perspective on the path to safe and sound securitization is provided in a speech given before the Mortgage Securities Association Annual Conference by FDIC Chairman Sheila C. Bair.  Some highlights of her remarks are set forth below:

• Among the factors that caused the recent financial crisis was an approach to securitization that encouraged a focus on “deal production and fee generation at the expense of consumer protection and sound underwriting.”
• Changes in accounting standards required the adoption by the FDIC of a transitional safe harbor rule under which “all securitizations or participations in process through March 31, 2010 would be permanently grandfathered” and thereby protected against the risk that the FDIC as conservator or receiver might try to reclaim loans transferred in connection with a securitization or participation or delay access to securitized assets.
• The FDIC has issued an Advance Notice of Proposed Rulemaking (the “Advance Notice”) providing 35 questions and a sample regulatory text and “seeking public comment on what standards should be applied for safe harbor treatment for transactions created after March 31st.”
• To correct weaknesses in securitization, the FDIC’s sample regulatory text contained in the Advance Notice “outlines four fundamental requirements for a well-structured securitization process in which risks can be properly evaluated and managed.” Those four fundamental requirements are (1) simpler and more transparent structures, (2) loan level disclosures with an adequate due diligence period and updates, (3) compensation tied to performance, and (4) origination standards and some retention of interest in the transaction.

The 35 questions and sample regulatory text contained in the Advance Notice provide some insight into the standards the might be included in a future rule protecting securitized assets in situations in which the FDIC has power over the underlying assets as conservator or receiver.  Among other things, the 35 questions and sample regulatory text suggest that the following standards might be included in a future rule:

• Limitations on permissible capital structures (e.g., limits on external credit support, leveraged tranches, re-securitizations, and other such features).
• Detailed disclosures concerning the structure of the securitization and credit and payment performance of the obligations, underwriting standards, and compensation and risk retention provisions.
• A periodic reporting requirement.
• Required provisions authorizing modification of loans and other actions to mitigate losses and governing the timing of such actions and the allocation of responsibility for such decisions.
• Provisions limiting the amount and timing of compensation and providing for appropriate alignment of incentives to promote actions that maximize value and mitigate losses.
• Risk retention requirements, seasoning requirements (e.g., origination of obligations more than one year before securitization), and verified representations and warranties with recourse.

If you have questions, please contact Howard O. Hagen at 515-246-4543 or hhagen@dickinsonlaw.com or Arthur Owens at 515-246-4515 or aowens@dickinsonlaw.com or Jeff Andersen at 515-246-4503 or jandersen@dickinsonlaw.com.

Examination Resolutions for 2010

According to this FinCriAdvisor article, there are two primary concerns that will impact every bank’s examinations in 2010: asset quality and liquidity.  Your bank’s New Year’s resolutions will need to include steps to ensure your examiners are assuaged on both counts.

• Resolve to have credit. One FDIC examiner stated the most common reason for enforcement orders with stringent progress report requirements is credit issues. Asset values are being challenged by examiners as a result of the real estate impact on the market. The examiner’s suggestion to satisfy regulators? Take a look at your bank’s reserves, then add to them.
• Resolve to be liquid. Bank deposits are a cause for concern for regulators. If the stock market continues to recover, customers may want to pay down debt or invest in the market again, instead of making cash deposits. This may cause problems for banks to retain their deposit funding. The examiner’s suggestion to satisfy regulators? Make sure you have access to sufficient amounts of liquidity, and don’t rely on deposits.

The FDIC has reported it will be growing its risk management staff by about 31% and its total examination staff by 25%.  For more information, please contact Mary Zambreno at 515-246-4512 or mzambreno@dickinsonlaw.com.

Is Your Institution Red Flag Compliant?

The FTC announced in late October that the enforcement deadline for the Identity Theft “Red Flags” Rule would be extended to June 1, 2010.  This extension should be viewed as an indication of the time required for financial institutions and creditors to implement identity theft programs in compliance with the Red Flags Rule, rather than a license to procrastinate.  The announcement of the deadline extension came amid discoveries by federal regulators and examiners that a handful of institutions still had not implemented or formalized their identity theft programs, just days before the previous deadline of November 1, 2009.  The Identify Theft Red Flags Rule was adopted two years ago by the OCC, the Board of Governors, the FDIC, the OTS, NCUA and the FTC.  The original mandatory compliance deadline was November 1, 2008.

 

The Red Flags guidelines require that financial institutions and creditors offering or maintaining “covered accounts” must develop an identity theft prevention program designed to:  1) identify red flags for covered accounts and incorporate those red flags into the program; 2) detect those red flags; 3) respond to the red flags; and 4) ensure the program is updated periodically to reflect any changes in the risks to the customer or to the institution.

 

To administer the program, steps must be taken to address misidentified covered accounts, a lack of security training for employees, and insufficient oversight of third-party service providers’ compliance with the rules.

 

The OTS, which has incorporated this program into its safety and soundness exam process, is reporting that some institutions have not performed a risk assessment, established a written program, or updated their program and materials.  OTS safety and soundness examinations typically occur once every 12-18 months, so it is anticipated that by the middle of next year all OTS institutions will have been examined for their compliance with the Red Flags Rule.

 

NUCA has identified 55 credit unions that have had violations, with a majority of those violations having to do with the failure to establish and implement an identity theft prevention program.

 

If you have questions regarding the Red Flags Rule, please contact Mary Zambreno at 515-246-4512 or mzambreno@dickinsonlaw.com.

Some Takeaways from the Policy Statement on Prudent Commercial Real Estate Loan Workouts

On October 30, 2009, the FDIC and other financial regulators released a 33-page Policy Statement on Prudent Commercial Real Estate Loan Workouts describing how examiners should evaluate the efforts of financial institutions to renew or restructure loans to commercial real estate (“CRE”) borrowers.  Some key points contained in this policy statement that should be of interest to lenders are set forth below:

• The policy statement applies to borrowers who “continue to be creditworthy customers who have the willingness and capacity to repay their debts” and is intended, among other objectives, to “ensure that supervisory policies and actions do not inadvertently curtail the availability of credit to sound borrowers.”
• Examiners are to take “a balanced approach” in assessing risk management in CRE workout situations.
• CRE workout arrangements that are “prudent” and that are based on a “comprehensive review of the borrower’s financial condition” should not be criticized “even if the restructured loans have weaknesses that result in adverse credit classification.”
• Such renewed or restructured loans that involve “reasonable modified terms” and “prudent underwriting standards” are not to be the subject of adverse classification solely because the collateral value has become less than the loan balance, and they “should not be adversely classified or criticized unless well-defined weaknesses exist that jeopardize repayment.”
• In connection with such renewed or restructured loans it may be necessary to obtain a new or updated appraisal that reflects “current project plans and market conditions that were considered in the development of the workout plan.”
• Assumptions that were recently made by qualified appraisers (and, as appropriate, by the lender) that are reasonable under the circumstances should be given a reasonable amount of deference by examiners.
• It may be permissible to enter into a “multiple note structure in which, for example, a troubled loan is restructured into two notes.” A note that is “reasonably assured of repayment and performance according to prudently modified terms...may be placed back on accrual status in certain situations.” A note “that is not reasonably assured of repayment (i.e., the second note) should be adversely classified and charged-off as appropriate.”
• Such renewed or restructured loans “need not be maintained in nonaccrual status” if “supported by a well-documented credit assessment of the borrower’s financial condition and prospects for repayment under the revised terms.” 

Each bank’s situation is unique and the policy statement should be reviewed carefully as to its applicability to specific loans.  In some instances, it may be necessary to confer with your primary federal bank regulator.

 

If you have questions, please contact Howard O. Hagen at 515-246-4543 or hhagen@dickinsonlaw.com or Arthur Owens at 515-246-4515 or aowens@dickinsonlaw.com.

FDIC Provides Guidance on Interest Rate Caps

The Federal Deposit Insurance Corporation (“FDIC”) has issued a notice entitled “Weekly National Rates and Rate Caps” in which it reminded less than well capitalized FDIC-insured institutions that they can use the redefined national rate to determine their compliance with interest rate restrictions under Part 337.6 of the FDIC Rules and Regulations.  The notice lists the national rate and rate cap for various products as updated November 2, 2009.  Although the rule redefining the national rate does not become effective until January 1, 2010, such institutions are free to choose between using the national rate or continuing to use the local market approach until that date.  After January 1, only the redefined national rate may be used in making such determinations.  The rule redefines the national rate to mean a simple average of rates paid by depository institutions as calculated by the FDIC.  The rule also limits rates paid on deposits solicited by less than well capitalized FDIC-insured institutions to prevailing rates in the applicable market area plus 75 basis points.  Unless an institution seeks and receives a determination from the FDIC that it is operating in a high-rate area, the prevailing rate in all markets will be deemed to be the national rate after January 1.  The notice refers to Financial Institutions Letter FIL-25-2009.  These documents, as well as related Questions and Answers, are available at http://www.fdic.gov.  National rates and national rate caps are posted weekly at http://www.fdic.gov/regulations/resources/rates/index.html.

 

If you have any questions, please contact Howard O. Hagen at 515-246-4543 or hhagen@dickinsonlaw.com, or Arthur Owens at 515-246-4515 or aowens@dickinsonlaw.com.

Dealing with the Unresolved "Too-Big-to-Fail" Problem

Articles that appeared recently in The Financial Times and on Bloomberg.com highlighted the systemic problems that arise when financial entities are deemed too big to allow to fail.  As the first anniversary of the failure of Lehman Brothers Holdings, Inc. is being observed, there seems to be no plan to address this aspect of the financial crisis.  Ironically, the financial crisis has resulted in even greater concentration.  There is a danger that the new motto of market participants will become “Being too-big-to-fail means never having to say you’re sorry. . . and never having to admit you were wrong.”    

 

In their opinion article in The Financial Times, John McFall (Chairman of the Commons Treasury Committee) and Philip Augar (a former investment banker and the author of Chasing Alpha) advocate breaking up “a defective business model,” which they described using the following colorful language:

               

"Conflict of interest is embedded and this is unfair on other market users.  It is 'heads we win, tails you lose' as the banks make off like bandits in the good times and become pious onlookers as the taxpayer foots the bill when it all goes wrong." 

 

The article in Bloomberg.com is entitled “Lehman Monday Morning Lesson Lost with Obama Regulator-in-Chief," and it points out that the Obama Administration’s Plan for a financial regulatory overhaul would not force the largest financial entities “to shrink or simplify their structure.”  The article includes the following interesting quotations:

• Niall Ferguson, a professor of history at Harvard University, is quoted as follows: “The system is essentially unchanged, except that post-Lehman, the survivors have ‘too big to fail’ tattooed on their chests.”

• Simon H. Johnson, a former chief economist at the IMF, described the Obama Administration’s proposal as follows:  “The biggest problem is it doesn’t deal with too-big-to-fail.  It doesn’t say anything.  You have to make things a lot smaller.”

• Former Federal Reserve Chairman Paul A. Volcker argued in a speech delivered on April 8, 2008, that a “demonstrably fragile financial system that has produced unimaginable wealth for some, while repeatedly risking a cascading breakdown of the system as a whole, needs repair and reform.”

• FDIC Chairman Sheila Bair told the Senate Banking Committee in May of 2009 that a financial system “characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet that those few banks and their regulator over a long period of time will always make the right decisions.”   

• Camden R. Fine, President of the Independent Community Bankers of America, asked “Does anyone think it’s a coincidence that less than 10 years after they repealed Glass-Steagall, the financial markets collapsed?”

If you have questions, please contact Arthur Owens at 515-246-4515 or aowens@dickinsonlaw.com.

FDIC Issues New Guidance for Private Equity Investors

New guidance for private equity investors is contained in the Final Statement of Policy on Qualification for Failed Bank Acquisitions (the “Final Policy Statement”) issued by the FDIC on August 26, 2009.  The Final Policy Statement includes significant changes in response to numerous comments concerning the FDIC’s initial proposal published on July 9, 2009.  The changes incorporated into the Final Policy Statement will make transactions involving failed banks somewhat more attractive to private equity investors, although not all of the proposed restrictions on private equity investors were eliminated.  FDIC Chairman Sheila Bair said that the Final Policy Statement “strikes a thoughtful balance” between the policy objectives of attracting non-traditional investors and maintaining necessary safeguards to protect the interests of taxpayers. 

 

The need to attract additional investors seems clear.  There were 416 banks on the FDIC’s problem bank list at the end of June with combined assets of approximately $300 billion.  At that date the FDIC’s deposit insurance fund had a remaining balance of $10.4 billion. 

 

Set forth below is a partial list of restrictions contained in the initial proposal that were reduced or eliminated in the Final Policy Statement:

 

• Provisions for retroactive effect of the Final Policy Statement were eliminated
• Restrictions will not apply to investors holding certain minority interests
• The 15% Tier 1 leverage ratio was changed to a 10% Tier 1 common equity ratio
• The higher capital commitment can no longer be extended beyond 3 years 
• The requirement that investors serve as a source of strength was eliminated
• A cross guarantee would be required only when there is common 80% ownership
• A 30-day ownership provision was added to restrictions on affiliate transactions
• A provision for protection of confidential business information was added

Set forth below is a partial list of restrictions applicable to private equity investors that are contained in the Final Policy Statement:

 

• A 10% Tier 1 common equity ratio must be maintained for 3 years
• Common 80% ownership would require a cross-guarantee
• Transactions with affiliates owned for more that 30 days would be restricted
• Ownership structures must meet the FDIC’s disclosure standards
• Investors from bank secrecy jurisdictions would be ineligible
• Investors must maintain continuity of ownership for three years after acquisition

 If you have questions, please contact Arthur Owens at 515-246-4515 or aowens@dickinsonlaw.com.

Turf Battles May Impede Financial Regulatory Reform

The global credit crisis, the global recession, the decline in real estate values and the negative effects of these events on the banking industry have stimulated interest in regulatory reform of the financial sector.  The existence of complex interactions among participants and products in the global financial markets has become more apparent.  Unprecedented measures have been taken to address frozen credit markets, the collapse of massive financial firms and the spreading contagion associated with “toxic” assets.   Questions have been raised about the adequacy and effectiveness of many existing regulatory structures and about whether regulation should be extended to activities that currently are unregulated.  There are perceived advantages and risks associated with concentrating regulatory authority in a single regulator.  There has been discussion of the possibility of having a panel of regulators deal with systemic risk issues. Such an approach would be similar to the proposed European Systemic Risk Council, which would include the president of the European Central Bank and central bank governors from the European Union’s 27 member countries. 

 

Although there is general recognition that disruptions in financial markets cannot be eliminated, the need for more effective safeguards against systemic risk is clear.  Despite statements that something must be done, there is considerable disagreement about the exact nature of the changes that should be made.  Reform will be politically difficult because of the interests of market participants, regulators and Congressional committees in preserving existing regulatory jurisdictions and objectives. Any financial industry regulatory reform raises questions about who should be performing particular kinds of regulation and how that regulation should be performed. Set forth below are some of the more contentious issues:

• Should there be one or more than one systemic risk regulators?

• Should hedge funds be regulated?

• Should currently unregulated derivatives be regulated?

• Should there be increased regulation of the mortgage industry?

• Should there be regulation of the sale of securitized assets?

• Should there be federal regulation of the insurance industry?

• Should some or all federal bank regulatory agencies be consolidated?

• Should failing non-bank financial companies be placed into receivership?

• Should there be a reallocation of jurisdiction between the SEC and the CFTC?

• Should there be a clearinghouse for over-the-counter derivatives?

• Should credit default swaps be regulated?

• Should short selling be more tightly regulated?

• Should there be more countercyclical capital requirements?

• Should the use of leverage be more tightly regulated?

• Should there be more regulation of money market funds?

• Should the role of state banking regulation be diminished?

• Should there be more robust enforcement of consumer protection laws?

• Should there be more disclosure of positions of larger market participants?

• Should regulatory changes extend to compensation and corporate governance?

Whether or not all of these issues are resolved in the near future, it seems clear that substantial changes in the operation of financial market regulation lie ahead. What is also clear is that the outcome of turf battles will have a major role in determining the future of the financial regulatory structure.

 

Recent news reports highlight some of the problems that can arise in the context of turf disputes.  According to a recent article in The Economist, “The stiffest resistance to change is coming not from Wall Street but from Washington, DC, where government officials, regulators and congressional leaders are locked in turf wars and ideological battles.”  Bloomberg reports that because of “resistance on Capitol Hill” and “pushback from entrenched interests,” a merger of the SEC and the CFTC may not be pursued.   An article in The Wall Street Journal comments on the FDIC’s “increasingly tough position” toward the management of Citigroup Inc. leading to “a bitter clash between regulators” about the speed and adequacy of efforts to improve the firm’s capital position.  In an earlier article The Wall Street Journal reported on Congressional committee disputes over jurisdiction of the regulation of over-the counter derivatives.  As the most traumatic aspects of the financial crisis pass into memory, it seems increasingly likely that bureaucratic infighting will play a major role in limiting the scope of any reform of the financial sector.  

 

If you have questions, please contact Arthur Owens at 515-246-4515 or aowens@dickinsonlaw.com.

FDIC Forms Advisory Committee to Study Community Banks

The FDIC Board of Directors today approved establishing the FDIC Advisory Committee on Community Banking.  The Committee will provide the FDIC with advice and guidance on a broad range of important policy issues impacting small community banks throughout the country, as well as the local communities they serve, with a focus on rural areas.

"Community banks are the lifeblood of our nation's financial system, supplying much-needed credit to countless individuals, small businesses, nonprofit organizations and other entities in large and small towns around the country," said FDIC Chairman Sheila C. Bair. "Our committee will get direct and frequent input on many issues from a cross-section of community bankers nationwide, which is critically important."

The Advisory Committee is expected to study examination policies and procedures, credit and lending practices, deposit insurance assessments, insurance coverage issues, regulatory compliance matters, and obstacles to the continued growth and ability of community banks to extend financial services in their local markets in the current environment.

False Claims Act Liability and the Economic Stimulus Package

The Federal Deposit Insurance Corporation (the “FDIC”) has received over 400 comment letters on its new program for the purchase of legacy loans (the “Legacy Loans Program”).  A review of several of these comments letters reveals the complexity of the issues that will be involved in the implementation of the Legacy Loans Program.  The comments address a large number of issues, including the role that would be played by the FDIC in making the Legacy Loans Program work. 

 

Some basic terms of the Legacy Loans Program are already rather clear. Under the Legacy Loans Program, the Department of the Treasury (“Treasury”) and private investors would contribute equity capital on a 1-for-1 basis to form Public-Private Investment Funds (“PPIFs”).  A PPIFs would purchase loan pools.  Such purchases would be funded using the PPIF’s equity capital and the proceeds of debt issued by the PPIF.  The PPIF could have a debt to equity leverage ratio of up to 6-to-1 with FDIC approval.  The FDIC would provide various managerial oversight services, including conducting auctions of the loan pools, and would guarantee the debt financing issued by the PPIF.  As currently proposed, the FDIC guarantee would be made on a non-recourse basis (secured only by the PPIF’s assets).  In connection with each completed transaction under the Legacy Loans Program, Treasury would receive warrants and the FDIC would receive an annual guarantee fee.  

 

Encouraging Participation.  A number of suggestions were made concerning the manner in which the FDIC could encourage participation in the Legacy Loans Program.  Some of these suggestions emphasized the importance of (1) promoting clarity and consistency with respect to the manner in which the Legacy Loans Program would operate and avoiding retroactive changes, (2) establishing reserve prices that would both encourage seller participation in auctions and assure potential buyers that if the reserve price were met there would be a commitment to complete the sale, (3) giving private investors as much flexibility as possible in deciding how to operate the PPIFs, (4) avoiding the imposition of executive compensation restrictions on private parties who participate in the Legacy Loans Program,  (5) minimizing certain regulatory issues relating to ERISA and the Investment Company Act of 1940, (6) the resolution of certain tax issues that may arise depending on the structure of each PPIF, and (7) using standardized documents to make participation more attractive to smaller financial institutions.

 

The Auction Process.   Suggestions were made concerning the manner in which the FDIC should conduct auctions for loan pools.  Among these suggestions were (1) requiring assurance that transactions (as opposed to mere pricing exercises) would result from the auctions by use of reserve prices or other means, (2) allowing bidding on separate sub-pools within a loan pool, (3) using an initial round of preliminary indication of interest bidding, (4) using sealed bidding, and (5) considering use of privately negotiated transactions in some situations. 

 

If you have questions, please contact Arthur Owens at 515-246-4515 or aowens@dickinsonlaw.com.