Standard and Poor’s Changes Rating Criteria – Downgrades 15 Banking Companies

Sources:

NPR: S&P Downgrades Top U.S. Banks' Credit Ratings

Reuters: S&P Cuts Ratings on Big Banks After Criteria Change

S&P: Standard & Poor's Applies its Revised Bank Criteria to 37 of the Largest Rated Banks and Certain Subsidiaries

WSJ: S&P's New Criteria Prompt Downgrades of BofA, Barclays, Citi

Standard & Poor’s (S&P), one of the ‘big three’ New York City-based credit rating agencies (Fitch and Moody’s round out the trio), announced new rating criteria for banks on November 9, 2011. This week, S&P applied the new criteria to 37 of the world’s largest financial institutions, which resulted in the downgrading of 15 major institutions including Goldman Sachs, Bank of America, UBS, JP Morgan Chase, Citigroup, Morgan Stanley, and The Royal Bank of Scotland.

S&P’s new criteria consist of two key steps. First, S&P evaluates a bank’s financial health and ability to withstand severe or extreme economic stress without reliance on external support and assigns each bank a “stand-alone credit profile.” Second, S&P assesses the degree of extraordinary government or institutional support available to a given bank. These two conclusions are then factored into the broader credit rating methodology, which includes complex risk analysis and assumptions and an overall financial evaluation.

By taking into consideration the degree of external support a bank may have available from central banks or due to its association with a parent group, S&P attempts to create a more accurate credit profile by evaluating the bank not only as an independent financial entity, but also as to the position of the bank within the financial industry as a whole. The new criteria appear promising; however, it may also extend the reach of credit rating agencies and prove controversial. The new criteria allow S&P to consider a bank’s position within the broader context of global finance, governmental support, political climate and economic conditions and to reflect that information in the credit rating. The recent bank downgrades are largely a result of the industry’s susceptibility to such factors and increasing reliance on governments and central banks worldwide.

The new criteria were designed to allow the rating agency more flexibility to respond to rapidly changing market conditions and adjust credit ratings accordingly. Prior to implementing the new criteria, S&P detailed its underlying assumptions and methodologies for rating banks in a series of reports on January 6, February 16, November 1, and November 9, 2011. According to the November 9, 2011 report, “the criteria are designed to improve transparency of bank ratings globally.”

U.S. Sues Big Banks Over $196 Billion in High-Risk Home Loans

Sources:
Fannie Mae
Federal Housing Financial Agency
FT: Banks Sued Over Mortgage Deals
Freddie Mac
NYT: Federal Regulators Sue Big Banks Over Mortgages
WSJ: U.S. Sues Big Banks Over Home Mortgages

Last Friday, the U.S. Federal Housing Finance Agency (FHFA) filed lawsuits against 17 of the world’s largest banks, alleging that they failed to disclose the high-risk nature of some of the home loans contained in $196 billion worth of mortgage-backed securities (MBS) they sold to Fannie Mae and Freddie Mac. The U.S. Congress established Fannie Mae and Freddie Mac (known as government-sponsored entities, or GSEs) to provide liquidity and stability to the U.S. housing market. As the largest source of home financing in the U.S., Fannie Mae and Freddie Mac play an integral role in ensuring that the average American can secure a home loan.

Although Fannie and Freddie do not lend money directly to homeowners, they are the largest purchasers of home loans from banks and other financial institutions that create the mortgages. Thus, they are able to influence what loans the banks issue based on what loans they (Fannie and Freddie) will purchase. The GSEs “securitize” many of the loans they purchase by bundling several loans together and selling them as one financial instrument called a mortgage-backed security or MBS. They also purchased MBSs from banks.

The FHFA lawsuits accuse the banks of making “materially false statements” about how risky the home loans were that the banks securitized and sold to the GSEs to mislead the GSEs into buying these unsafe investments. After the collapse of the U.S. mortgage market in 2008, Fannie Mae and Freddie Mac were left holding billions of dollars of home loans and MBSs that became worthless as homeowners defaulted at an unprecedented pace. Since then, the U.S. Treasury has spent $141 billion taxpayer dollars keeping the GSEs afloat as part of an ongoing effort to stimulate the U.S. housing market. Since 2008, the FHFA has been responsible for overseeing the preservation and conservation of Fannie’s and Freddie’s assets on behalf of U.S. taxpayers. The FHFA filed the lawsuit in keeping with this role.

The controversial lawsuits are the most sweeping governmental action aimed at holding the banks accountable for their role in the financial crisis. In their defense, the banks point to Fannie Mae’s and Freddie Mac’s formidable roles as “major players” in the mortgage market as they purchased, packaged and sold billions of dollars worth of mortgage securities. In July of 2008, just prior to the U.S. government taking control of Fannie and Freddie, the portfolios each GSE held were worth $758 and $798 billion respectively. The banks claim that Fannie and Freddie were, therefore, shrewd and sophisticated market participants with detailed knowledge of the home loans and securities they purchased. Because Fannie and Freddie knew so much about the home mortgage business, the banks argue, the government should not blame the banks for the GSEs’ investing mistakes.

The banks claim that, even if they are at fault, the lawsuits will do more harm than good. After spending the past three years rebalancing their business to address the massive losses they suffered during the financial crisis, the banks fear that the lawsuit creates enormous potential liabilities and uncertainty that threaten their stability. Of the seventeen banks named in the lawsuit, Deutsche Bank, Credit Suisse Holdings USA, Goldman Sachs and Morgan Stanley sold $10 billion or more each in MBSs containing questionable home loans to Fannie and Freddie. J.P. Morgan Chase and Royal Bank of Scotland Group sold over $30 billion each, and the beleaguered Bank of America’s total exceeds $57 billion due to its acquisitions of Countrywide and Merrill Lynch/First Franklin Financial. Although the lawsuit does not specify how much the government hopes to recoup in damages, prior settlements of similar lawsuits indicate that the government could recoup twenty percent (nearly $40 billion) of the total securities sold to the GSEs.

Government critics point to high U.S. unemployment rates, the declining stock market, including the rapid devaluation of bank stocks since the lawsuits were filed, and broad consumer concerns as an indication that the timing and potential consequences of the lawsuit could be bad news for the economy. Bank critics claim that the U.S. government needs to hold the banks accountable for their past reckless practices to prevent future misdeeds. Irrespective of the merits of the lawsuits, the litigation may take years and cost the banks and taxpayers millions of dollars in legal expenses. Most of the banks were in settlement negotiations with the regulators prior to the filing of the lawsuits and observers expect those negotiations to continue.

The Securities and Exchange Commission Considers Revising Some of the Rules on Private-Company Capital Formation in the United States

AP: SEC Weighs New Rules for Private Companies' Stock
FT: SEC to Examine Private Share Trading Rules
WSJ: U.S. Eyes New Stock Rules
NYT: S.E.C. to Study Easing Rules on Shares of Private Companies

Over the past 10 years, the number of initial public offerings (“IPOs”) in the United States has decreased sharply from an average of 530 per year during the 1990s to an average of 130 per year since 2001. During the same period, however, the value of the transactions involving private-company stock has consistently grown. In 2010 alone, their value was $4.6 billion, which is almost twice as much as the corresponding 2009 figure of $2.4 billion. The proliferation of transactions in private-company shares has caught the attention of the Securities and Exchange Commission (the “SEC”). For example, the agency recently launched investigations to determine if certain private-company insiders have traded their private-company shares on the private market by using information which was not available to outside investors.

In the midst of such developments, the SEC is considering relaxing the rules regarding the ways private companies raise capital. The goal of the likely revisions is to reduce the private companies’ cost of regulatory compliance associated with capital formation without sacrificing investor protection. Such an ambitious objective may prove to be a significant challenge for the SEC in light of its shrinking budget and heavy workload related to the enactment of the Dodd-Frank Act.

Some commentators have opined that the SEC is likely to make two changes to the current regulatory regime. First, the agency would probably increase the number of shareholders a private company can have without being forced to make financial disclosures. Currently, this number is 499. Google, Inc.’s recent history provides an example of how this particular rule affects private companies in the U.S. In 2004, the company decided to go public because it could not raise sufficient capital without exceeding 499 shareholders. Second, the SEC is considering relaxing the strict prohibition against publicizing private-company share issues, known as a “general solicitation ban.” This solicitation ban was designed as a tool for protecting ordinary investors because private companies, unlike public ones, are not required to disclose financial information. If private companies were allowed to contact ordinary investors for the purpose of selling them their stock, those investors could be taken advantage of because they would have little or no information to rely on before making their decision.

Critics of the current version of the rules under scrutiny highlight that these rules discourage private companies from issuing shares, which reduces investment and leads to fewer jobs. Other commentators, however, point out that the SEC’s decision to review the relevant regulations may lead to the cancellation of some pending IPOs. Also, if the SEC amends its regulations to allow private companies greater flexibility in raising capital, it will take away the incentive for private companies to go public. Thus, ordinary investors will in effect be denied access to private-company shares, which are usually reserved for wealthy individuals.

Canada Debates Whether to Establish a National Securities Regulator

Sources:
Bloomberg: Canada Needs Single Regulator, IMF’s Hockin Says
Montreal Gazette: Canada Will Suffer Without a Sole Regulator: IMF
The Globe and Mail: Lack of National Regulator Cited as Investment Barrier
CBC News: Banks Call for Single Securities Regulator
The Financial Post: Quebec's Court of Appeals Weighs in on National Securities Regulator Issue

This week, Canada’s executive director at the International Monetary Fund (IMF), Tom Hockin, expressed growing concern over the country’s financial stability. Canada currently does not have a national securities regulator. This is uncommon for a major industrialized country; Canada is the only G7 nation that lacks a federal regulator. Currently, the twelve provinces each have their own capital market regulating body. Critics say the system promotes inconsistent policies and creates problems and complicates the monitoring and assessment of capital flows.

In 2009, the Canadian government appointed a committee to investigate whether the country should create a securities regulator. The committee recommended that an oversight body be established, concluding that a federal regulator would reduce costs and boost the confidence of both investors and issuers. The committee also believed that a federal regulator would be able to manage broad systemic risks better than the current system, enabling the nation to respond better in the event of a financial crisis. The IMF has expressed concern about Canada’s ability to respond to a financial crisis without a federal oversight body. It believes that a single federal regulator would lead to better enforcement of the securities laws and more accountability. Both the committee and the IMF also agree that establishing a federal regulator would attract more international investors in Canada’s capital markets.

The committee’s report prompted Canada’s federal government to advocate for the creation of a national regulating body. Last May, Canadian Finance Minister, Jim Flaherty drafted the Canadian Securities Act, which would establish a federal oversight body. Flaherty then submitted the bill to the nation’s Supreme Court for a ruling on whether it is constitutional. The Supreme Court is expected to start hearing arguments in April on whether the federal government has the authority to create a securities regulatory body.

Three of the twelve provinces, Quebec, Manitoba, and Alberta, have been adamant in their opposition to the creation of such a regulating body. Several other provinces have been non-committal over the federal government’s plan, and only two, Ottawa and Ontario, have been vocal in their support. The opposing provinces argue that the existing regulatory system is effective and warn that allowing the federal government to establish a regulatory would set a dangerous precedent of federal intrusion into the provinces’ jurisdiction. If the Supreme Court rules that the federal government does have jurisdiction to establish a regulatory body, the government would like to have it fully operational by July of 2012.

Discussion:
1. Should Canada establish a securities regulatory body at the federal level?
2. What are some advantages of Canada’s current regulatory system?