Dodd-Frank Requires Removal of References to Credit Rating Agencies from Federal Regulations

Section 939A of the Dodd-Frank Act requires federal agencies to remove references to credit rating agencies (such as Moody’s Standard and Poor’s) from existing regulations and replace them with other appropriate standards for the calculation/measurement of risk. The rule stems from one of the perceived problems that led to the financial crisis: over-reliance on credit-rating agencies. In essence, numerous government regulations have delegated the authority of determining the risk of investments to the major credit-rating agencies and some believe it was the severe underestimation the risks of sub-prime mortgages (combined with both the private and public sector’s reliance on these ratings) that led to financial collapse in 2007/2008.

Some have also questioned the perceived conflict of interest the credit rating agencies have due to the fact that the agencies are paid by the entities/institutions which require assessment.The big three credit rating agencies have not put up much public resistance to these measures, making statements such as that by Standard and Poor’s: “the market – not government mandates – should decide the value of our work”. The rating agencies are also coming under fire in Europe, where EU officials have called for the establishment of new European credit rating agencies to challenge the alleged oligopoly that the U.S.-based agencies have. While these measures do represent justified responses to the clear deficiencies in our financial system’s ability to evaluate and account for risk in investments, establishing a new (more accurate) measure is much easier said than done, particularly given the fact that Moody’s and Standard and Poor’s have spent more than a century building up their reputation amongst market participants.

Bigger than Fannie and Freddie: Defining Qualifying Residential Mortgages

A prominent feature of the Dodd-Frank Act is the risk-retention provision in Title IX (Subtitle D, § 941).  It requires banks that originate mortgages to retain 5 percent of the credit risk in their portfolios.  The risk-retention requirement was created in direct response to the oft-cited lending practice that contributed to the housing bubble where mortgage originators would sell off the securitized loans without retaining any of the credit risk.  A key exception to the provision concern “qualified residential mortgages” (QRM) and loans designated as QRMs are exempt from the risk-retention requirement.