Live Blogging from the Dodd-Frank Symposium: Bank Regulation and Mortgage Market Reform

We’re blogging live from today’s Dodd-Frank Symposium!

Dwight Jaffee from the Haas School of Business kicked off the first set of Securitization and Governance panel presentations with a talk on Bank Regulation and Mortgage Market Reform.Key Highlights from the presentation:

  • Moral Hazard in Securitization is wrong: Jaffee says that the hoopla over securitization causing the mortgage bubble and financial crisis is misplaced and the 5% risk-retention requirement will do nothing but restrict fundamental value of securitization, which is to spread out and segment risks.
  • The private market can fully replace the GSEs: Jaffee thinks the proposals to wind down the GSE are generally a good thing and believes that the private market is more than capable of meeting the credit demand the GSEs currently now provide.  Citing Europe, which Jaffee says has similar rates of homeownership as the U.S., Jaffee says that the GSEs have had minimal if any impact on spurring additional homeownership.
  • Mortgage Contracts will Default to Safe, Low Risk Terms: Jaffee argues that in the absence of GSEs in housing market, the lack of conforming loan standards would nonetheless push borrowers toward the safest, least risky loan terms (i.e., the market would correct itself and move away from costly terms like prepayment penalties.

For a full read of Dwight Jaffee’s ideas, see his working paper on mortgage market reform.

SEC Attempting to Correct Incentives for Risk-taking that Underlie Executive Compensation Structures

The SEC recently proposed a rule that would require greater disclosure of performance-based compensation structures for broker-dealers and investment advisers at companies that manage greater than $1 billion in assets. In addition, the rule would enable SEC regulators to prohibit compensation schemes that it believes promote inappropriate risk-taking and regulators may even require partial deferral of incentive-based compensation for up to three years (for companies managing greater than $50 billion in assets).

This rule is just one of many that the SEC, in collaboration with various other regulatory agencies, has been empowered to implement under the Dodd-Frank Act in order to correct incentive structures which many believe contributed to the recent financial collapse. Many financial institutions (and non-financial institutions, for that matter) pay their employees and executives based on their individual, as well as on the company’s, performance in a given period of time. These compensation structures enable firms to overcome various principal-agent problems that may otherwise exist between shareholders and company executives (as well as between company executives and lower-level employees). The problem with this scheme is that it incentivizes individuals to take risks, particularly risks that pay off in the short term, as the employees stand to benefit tremendously if the risks pay off and yet are not faced with the prospect of personally losing the money that is invested if the risks don’t pay off. The result of this incentive structure is that broker-dealers and investment advisors may end of taking excessive risks, in pursuit of the high yields that fuel their own personal compensation.


Yield-Spread Premiums Prohibited Under New Loan Origination Compensation and Steering Rules

Under Loan Originator Compensation and Steering rules issued by the Federal Reserve, new restrictions on loan originator compensation and steering practices will go into effect on April 1, 2011.  The new rules amend Regulation Z, Federal Reserve rules for implementing provisions of the Truth in Lending Act (TILA), and are consistent with the § 129 TILA provisions in the Dodd-Frank Act (15 U.S.C. 1639(l)(2)).  In particular, the new rules have three major prohibitions:

  • Loan originators compensation must be based on the principal loan amount and cannot be based on any other loan terms or condition, such APR or interest rate.  These new restrictions effectively end the practice of loan originators receiving yield-spread premium compensation from lenders. (more…)

Defining “Swap Execution Facilities”

The SEC to define “swap execution facilities”With the enactment of the Dodd-Frank Act, a new type of regulated marketplace was created known as “swap execution facilities” (“SEFs”) for which the Act established a comprehensive regulatory framework that would require swaps to be executed either on an exchange or on a SEF. The SEFs are defined under Dodd-Frank as a “trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system.” SEFs are a new category of markets, regulated by the Commission, where security-based swaps can be traded.

The SEC, recently, voted unanimously to propose rules defining SEFs and establishing their registration requirements. In a statement by SEC Chairman, Mary L. Schapiro, she explained that the four-part proposal would: 1. Provide a definition for a security-based swap execution facility – outlining what types of markets would meet the definition; 2. Address what it means for a security-based swap to be “made available to trade” on a SEF or an exchange; 3. Implement the 14 core principles detailed in Dodd-Frank (listed below); and 4. Establish a registration process for SEFs that would provide comprehensive information for the Commission to evaluate applications for registration.

The SEFs would be required to:

  1. Comply with the core principles and any requirement the Commission may impose.
  2. Establish and enforce rules governing, among other things, the terms and conditions of security-based swaps traded on their markets; any limitation on access to the facility; trading, trade processing and participation; and the operation of the facility.
  3. Permit trading only in security-based swaps that are not readily susceptible to manipulation.
  4. Establish rules for entering, executing and processing trades and to monitor trading to prevent manipulation, price distortion, and disruptions through surveillance, including real-time trade monitoring and trade reconstructions.
  5. Have systems to capture information necessary to carry out its regulatory responsibilities and share the collected information with the Commission upon request.
  6. Have rules and procedures to ensure the financial integrity of security-based swaps entered on or through the facility, including the clearance and settlement of security-based swaps.
  7. Have rules allowing it to exercise emergency authority, in consultation with the Commission, including the authority to suspend or curtail trading or liquidate or transfer open positions in any security-based swap.
  8. Make public post-trade information (including price, trading volume, and other trading data) in a timely manner to the extent prescribed by the Commission.
  9. Maintain records of activity relating to the facility’s business, including a complete audit, for a period of five years and to report such information to the Commission, upon request.
  10.  Not take any action that imposes any material anticompetitive burden on trading or clearing.
  11. Have rules designed to minimize and resolve conflicts of interest.
  12. Have sufficient financial, operational, and managerial resources to conduct its operations and fulfill its regulatory responsibilities.
  13. Establish a risk analysis and oversight program to identify and minimize sources of operational risk and to establish emergency procedures, backup facilities, and a disaster recovery plan, and to maintain such efforts, including through periodic tests of such resources.
  14. Have a chief compliance officer that performs certain duties relating to the oversight and compliance monitoring of the security-based SEF and that submits annual compliance and financial reports to the Commission.

The SEC has already engaged in several rulemakings related to the derivatives market which include: defining security-based swap terms, establishing reporting rules, rules on data repositories, fraud prevention, swap conflict, and reporting of pre-enactment security-based swaps. Public comments on this recent proposal should be sent to the Commission by April 4, 2011.

Placing More Sparks on Single Stock Circuit Breakers

After the market events of May 6, 2010 that briefly wiped out $862 billion in equity shares before the market recovered, the SEC and CFTC established a Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues to develop recommendations on emerging and ongoing issues of mutual concern to both agencies. The committee is composed of eight members, including Nobel Prize winning Joseph E. Stiglitz; former CFTC chairman, Brooksley E. Born; and former SEC chairman, David Ruder.

The eight-member committee recently advised the SEC in a report, presented during a February 18, 2011 meeting, on various issues including the use of market circuit breakers, restrictions on co-location and direct access, and liquidity enhancement issues.

In the report, the Committee concurred with the steps the SEC has taken to: 1. Create single stock circuit breakers (triggered if the price of a security changes by 10 percent or more within a five-minute period) 2. Establish rules providing clarity as to which trades will be broken when there are multi-stock aberrant price movements, and 3. Implementing minimum quoting requirements to eliminate the ability of market makers to employ “sub quotes.”

However, the Committee stated concerns with the limited applicability of the circuit breakers. The Committee stressed the need for stock specific market “pauses” to be expanded to all but the most inactively traded listed equity securities and ETFs and related derivatives. Specifically, the Committee recommended that the “Commissions require that the pause rules for the exchanges and FINRA be expanded to cover all but the most inactively traded listed equity securities, ETFs, and options and single stock futures on those securities.” The concerns stem from the current length of the “pauses”, which the Committee thinks are unnecessarily lengthy and may, inadvertently, add to the potential market uncertainty.

In a letter addressed to CFTC and SEC, the Committee emphasized that the recommendations are “advisory in nature” – leaving the question open as to how seriously the SEC and CFTC will take the recommendations.

To read more about the Joint Committee’s recommendations and the February 18, 2011 meeting, please visit the SEC’s website

Fed Proposes Definitions for Systemically Important Nonbank Financial Institutions

On February 8th the Fed published a proposed rule that would govern when a company is “predominantly engaged in financial activities” and when it would be considered “systemically important.” Various provisions of the Dodd Frank Act require regulations to be implemented for systemically important financial institutions, including general regulation on activity, as well as reporting and disclosure requirements.

Under the proposed rule, an institution could be considered “financial” if, in either of the past two years, 85% or more of its revenue is related to activities determined to be financial in nature (according to the Bank Holding Company Act). This calculation would include income from equity investments in other institutions that are primarily engaged in financial activities.


Rules are good, but who’s going to enforce them?

Since the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in July, many federal agencies, including the Securities and Exchange Commission, the Federal Reserve Board, and the Office of the Treasury, have been tasked with creating new rules that will govern the future of America’s financial institutions. The Act contains some 300 provisions and may necessitate promulgating upwards of 243 regulations. However, many agencies are now facing an important question: where is the money to properly enforce these new regulations going to come from? Heated debate has raged about appropriate funding for agencies like the SEC and CFTC, whose 2010 funding levels are set to expire March 4.

SEC Chairman Mary Shapiro recently raised the issue before the Senate. Ms. Shapiro has stated that “[t]he real crunch comes after the rules are in place and [the SEC] has to operationalize them. We lack the resources to do that.” Congress’ failure to pass a budget that would have given the SEC an 18% funding increase puts that agency and other regulatory agencies in a bind. If unsuccessful, Shaprio has stated that the SEC will have to cut some 600 employees and would be unable to implement the rules and studies required by the Act.

To help mollify the situation, on January 26, 2011, the Federal Bar Association Securities Law Committee Executive Counsel wrote a letter to members of Congress imploring them to vote for more funding for the SEC. The letter asks Congress for “a substantially increased appropriation for the SEC” through registration fees at no cost to the American taxpayer, and “the adoption for the SEC of the same funding model that Congress has used successfully for decades for the nation’s banking regulators.” In response to the fiscal stalemate, Senator Barney Frank, one of the authors of Dodd-Frank Act, introduced an amendment last week to increase the SEC’s funding by $131 million.


Fed Approves Final Rule to Implement Volcker Rule

On February 9th the Fed approved of the final version of the Volcker Rule, part of the Dodd-Frank Act, which is now scheduled to go into effect on April 1, 2011, though there is a 2 year window in which governed entities will be given to conform their behavior to its regulations. The Volcker Rule prohibits insured depository institutions (hereafter referred to as “banks”) from proprietary trading in securities and financial derivatives, as well as from acquiring a financial or governing interest in hedge funds. Activities by U.S. banks would be governed by the rule, regardless of where their activities take place, however activities by non-U.S. banks would only be governed if they occurred, at least in part, within the U.S.

The definition of activities that constitute proprietary trading is taking positions with the primary purpose of selling shortly thereafter. The ambiguity inherent in this definition is supplemented by the provision that allows government agencies, such as the SEC and CFTC, to implement rules that extend activities governed by the rule to any security or financial instrument that is deemed appropriate.


“Poison Pills” a Plausible Legal Solution for Dealing with External Activist Investors in Proposed Mergers/Acquisitions

It’s not uncommon for one or a few investors to acquire a large stake in a publicly-traded company in order to either force through or interfere with a proposed merger/acquisition. These investors can, on the one hand, engage in “vote no” campaigns, which can lead to large pay-outs (in the form of better terms for the deal) as well as temporary increases in the stock price of the company, but it can also prevent otherwise beneficial and profitable deals from occurring.Today some companies are requiring potential targets to adopt “poison pills” in order to prevent such hold-ups. Case in point: Dell, which insisted that Compellant Technologies implement a poison pill provision before entering into a merger agreement with the company.

There are limits on the legal efficacy awarded to these provisions.  Latham & Watkins recently issued a client alert  highlighting the generally recognized legal limits of poison pill provisions under Delaware state law by reviewing several recent cases.The limits are centered around the existence of a reasonable threat and whether the challenged provision was a proportional response that did not sacrifice the exercise of the franchise by stockholders.One solution that exists to satisfy the last provision (exercise of the franchise) is to require stockholder approval before a poison pill provision kicks in (known as a “chewable pill”).


Bernanke Testifies on Fed’s Commitment to Implementing Dodd-Frank

In a statement before the Committee on Banking, Housing, and Urban Affairs, Ben Bernanke reaffirmed the Federal Reserve’s commitment to working with financial regulatory agencies to implement Dodd-Frank – more than 50 rulemakings and formal guidelines.  According to Bernanke’s statement, the Fed has more than 300 staff members working on implementation projects, and the transfer of the Federal Reserve’s consumer protection responsibilities to the new Bureau of Consumer Financial Protection is well under way.  After delving into a list of ongoing implementation projects, Bernanke concluded his statement by expressing the Fed’s commitment to its “long-standing practice of ensuring that all of its rulemakings are conducted in a fair, open, and transparent manner.”

Click here to read his entire testimony.