A Christmas Wish: Fix Dodd-Frank (Just a Little)

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photo of Rick JonesThe election’s over and elections matter we’re told, albeit most of the denizens of Washington seem to have remained in their seats. The fiscal cliff awaits. We wait, with various levels of trepidation, for a workable compromise or, perhaps, to find out that life goes on regardless of what our elected leaders do. A bit of leadership, perhaps? One hopes that the Congress and the Senate, so mad at each other and so dug in on many issues, will, in the New Year, strive to find areas where compromise and commonality can be found. Indeed, whether the noise about principles and non-negotiable positions has content or is merely the expelling of political gasses, it’s pretty clear both parties better find some place to start agreeing and actually do something for the country if they really want to continue to be honored with the right to engage in public service; e.g., keep their rumps in their elected seats.

Maybe, maybe, one of those somewheres is Dodd-Frank. There has been talk of technical correction to Dodd-Frank almost since the day that nearly unreadable 2,000 pages came off the printer and, like that famous rough beast, slouched into the offices of those who voted for it or against it (many of whom, on both sides, sheepishly or with various levels of bravado, admitted they never read it).

In fact, probably almost nobody read the whole thing in any sort of complete or comprehensive way until the business people, regulators, lawyers and other folk who knew that they would actually have to live with it, do what it says, interpret it, or enforce it, got around to taking a hard look. And what they found is that it cries out for technical correction. Now, as more than one commentator has noticed, one man’s technical correction is another man’s outright repeal. But we’re hearing talk that such a technical correction bill is possible. Whether you broadly support the bill’s aims or see it as unwarranted governmental overreach, a technical correction bill with respect to Dodd-Frank is unleavened good.

The politics may be aligned to get something done. The next election is two years away. The Democrats, having defended the bill and won an election (more or less), may feel more willing to engage. The Republicans, shaken by the reality of the election, may be more prepared to embrace the charms of compromise. Both sides need to show they can get something done.

So, what might get done? Well, part of me says nothing, nada, no way. The Republicans and Democrats may continue to stare at each other across the political divide and refuse to agree on anything. Our little piece of WWI trench warfare. But that would make for a very short article. So I will embrace, I will wallow in, the optimism which, all of a sudden, seems de rigueur for the commercial real estate finance market place, and why not? Worried about the fiscal cliff? Bah Humbug! Cautious and balanced 2013? Party pooper! Where’s the holiday spirit!

So, here’s my Santa’s wish list for technical corrections this Christmas season. (Elected leaders, please feel free to borrow freely from these ideas.)

• Strike the provision requiring banks to disclose protected, privileged information to the Consumer Finance Protection Bureau which has, to date, only been shared with the prudential banking agencies. Such a breach of confidentiality will diminish the willingness of individuals and businesses to work with the banking community and only grow the shadow banking system. Good for some, bad for others, but either way, an unintended consequence of a law designed to help consumers.

• Fix the Volcker Rule. This ambitious effort to roll back the hand of time to a simpler banking world doesn’t work in innumerable ways. It does not provide useful guidance to distinguish risky investments by banks with depositors’ money (e.g., taxpayers’ money) from customary and reasonable banking actions. It has become demonstrably clear that the regulators are unable to ring wall proprietary trading and Congress should give better guidance here or give it up. Remember that prop trading had just about nothing to do with the credit crisis. Moreover, the blanket and unthoughtful restrictions on bank investment funds and other vehicles is not supported by risk and loss data and is damaging capital formation.

• Fix the Qualified Residential Mortgage definition for residential lending and the Qualified CRE Loan definitions for commercial mortgages, to make them functioning modalities for risk mediation. Right now, the CFPB has got the bit in its teeth on the residential Qualified Mortgage definition. There is deep and well-founded concern in the industry (which concern is even starting to seep into consumer-oriented groups) that it simply doesn’t work and will materially hurt the banks’ ability to fund residential mortgage loans. In the commercial space, the regulations are, if anything, even worse. Indeed, the regulators have admitted in numerous public forums that the Qualified CRE Loan definition was designed to make sure that it could not be met. Studies have shown that less than one-half of one percent of all commercial mortgages originated for CMBS since its earliest days would qualify. That’s silly. The statutes specifically authorize the regulators to develop various ways to achieve effective risk mediation through risk retention. The regulators shouldn’t scoff at that, but if they will, Congress should clarify what it meant. When the perfect becomes the enemy of the good, we end up with a car with no engine: perfectly safe to drive because it can’t go anywhere.

• Fix Risk Retention. Let’s do the easy one first. Kill off that noxious nostrum called the Premium Recapture Cash Reserve Account (PRCRA). As those who follow this corner of the regulatory world know, PRCRA, the brainchild of the New York Fed, would have required securitizers to subordinate any income made in the securitization to all losses on the bonds. As all pools of mortgage loans, no matter how well underwritten and structured, suffer losses, it, as a matter of dead nuts, certainly would wipe out the profitability of securitization. Funny thing about capitalism, no profit, no deal, no capital. There is some indication that this wacky idea is finally, indeed, dead, but it has shown incredible regulatory resilience and seems to continue to crawl out of its coffin no matter how often it’s buried. Let’s simply agree the regulators can’t get this right and fix it with technical corrections. In fact, there is a bill in the hopper to do just that sponsored by Senators Crapo and Hagan. And remember, premium recapture was not part of the Dodd-Frank Act at all. It was birthed, full blown out of the fertile minds of the regulatory constituencies. When PRCRA started to look a non-starter, the regulatory community embraced a second bad idea, as a rear guard action against loss of PRCRA. This is to require a B-piece buyer to hold 5% by value as opposed to by bond balance. If the B-buyer must hold 5% of the value of all the loans, it will be buying up into the capital stack towards investment grade and doing something which is wildly inconsistent with the B buyer’s business plan. Look, we need these investors to make CMBS work by hoovering up the risky bits. To be a bit repetitive here, when held to maturity, some mortgage loans, no matter how well structured or underwritten, fail. It’s just the nature of the beast. Because of this, the bottom of the capital stack will be bought at a discount. The whole notion of risk retention was not to stick issuers and originators with liability to make mortgage loan investing into something it’s not, a riskless investment, but to encourage the making of good loans. The B-buyer imposes this discipline. Risk is priced. Let the market mechanisms work.

• And we’re not done. The current exposure draft of the regs requires the B-piece holder to hold the paper on an unlevered basis to maturity. Again, there is no B-piece buyer in the market for which that is a viable business model. It makes no sense. The whole notion of holding risk in the deal is to make sure that bad stuff is not put into the structures. Bad stuff fails quickly. Requiring the B-piece holder to hold to maturity makes the B-holder a guarantor of a promise that is neither commercially reasonable not anticipated by anyone in the commercial real estate space: that mortgage loans do not default. They do. Risk is tranched and priced. That’s what CMBS does so brilliantly well. That’s why it works.

• Finally, the whole notion of risk retention makes no sense whatsoever in very low loan to value deals. If all the bonds are investment grade bonds, what in the world is the concept of risk retention have to add to that equation? The Act invites the regulators to address risk in a variety of ways. It is both easy and rational to conclude low LTV pools don’t need further risk retention.

• Eliminate Senator Franken’s amendment which required all federal regulations to expunge references to rating agencies. The regulatory agencies have not found a way to create implementing regulations for this for the single reason that they cannot. This week, the SEC Staff released a well thought out, well written, and reasoned report discussing the feasibility of expunging references to rating agencies. After 70 plus pages, a couple hundred erudite footnotes and a compilation of all competing ideas in the market place, the report concluded that, at the end of the day, the Staff has no real conviction that a different approach to the rating process would be better (Churchill and democracy redux). We need to recognize that rating agencies are with us and address issues about rating agency performance in other ways.

• While they’re at it, how about just resetting the effective date of the 237 Dodd-Frank regulatory initiatives whose delivery dates have already been missed? Don’t get me wrong, I’m glad that some of the regulatory constituencies are taking their time with the regulations, because they are complex, but it is a little silly.

Some of the problems above could be fixed by regulation, but, in some cases, the regulators would have to meaningfully torque the plain words of the statute to get to reasonable outcomes, and that’s not good policy. In some cases, the regulators need a nudge in the direction of reasonable regulations. In some case, the regulators have to be reminded of what Congress intended in the first instance. Moreover, the possibility that a technical corrections bill will be seriously considered by Congress should motivate the regulatory community to engage with the regulated community and get some of these regulatory initiatives done. That, in and of itself, would be a good thing. So if the Congress wants to find something to do where they can get together and do something good for the country and do something good for capital formation, tackle technical corrections. Let’s see if Democrats have the courage to open this Pandora’s box and the Republicans have the discipline not to turn it into a circus in pursuit of outright repeal.

Finally, let’s get out and help this process along. Let’s work with our trade organizations, our elected officials, and constituencies to get a Dodd-Frank technical corrections act done. Get what has to be tolerated done and what can be fixed fixed. The process will go quicker if we’re engaged. Ultimate uncertainty around the inability to predict the outcomes of some of these regulatory initiatives is a horrible tax on transactional efficiency in and of itself. Time to put the shoulder to the wheel and hope that our elected officials feel there is a place for an effective compromise on a workable set of rules under which capital formation can continue.

 

Topics:  CFPB, Dodd-Frank, Mortgages, Rating Agencies, Volcker Rule

Published In: Administrative Agency Updates, General Business Updates, Elections & Politics Updates, Finance & Banking Updates, Residential Real Estate Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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