The big three credit rating agencies have long made the disclaimer that investors should not use ratings as a substitute for independent judgment. Now regulators want banks to prove they aren't doing that.

Regulators told American Banker they are drafting rules that would require banks to demonstrate they had done their own research to receive the regulatory capital benefits of holding highly rated bonds from securitizations. A regulated institution that relied solely on ratings for evaluating an investment's safety would have to hold loss reserves against the full value of its position, regardless of whether its holdings were rated triple-A or junk.

"If you can't use a rating because you don't want to get all the information, then presumably you won't buy the instrument," said a person familiar with the position of the Federal Deposit Insurance Corp. (FDIC), one of multiple agencies drafting the proposed rules.

The move is a potentially significant step toward reducing bank and examiner dependence on the opinions of officially recognized rating agencies. But the agencies are still haggling with one another over the specific language. And a case can be made that years of credit losses on investment-grade securities have already instilled a healthy respect for the principle of "caveat emptor" among banks.

In no way would the rules preclude more formulaic approaches to regulatory capital; a blanket doubling of the amount of capital banks must hold against resecuritized products is part of pending Basel II enhancements. Still, some regulators and observers see the proposal as putting more of an onus on all parties to reach an independent judgment.

"It's going to take more effort on the part of the regulator" as well as the banks, said Larry White, a professor of finance at New York University's Stern School of Business. "They're going to have to do more in the way of what they do when they're looking at other types of loans in the portfolio."

Representatives of the rating agencies either declined to comment or did not respond to questions about prospective changes in regulators' approach to the use of ratings.
That regulators would support such a process struck some rating agency critics as a healthy development. Some factions in Washington support an even more radical approach that would strip "nationally recognized statistical rating organizations" such as Moody's Corp., Fitch Ratings and Standard & Poor's of any official recognition in regulatory capital requirements. Congress has extensively debated ratings reform but not taken concrete action.

Gene Phillips, a former Moody's analyst and current director at PF2 Securities, a structured finance evaluation firm, said requiring and verifying buyer diligence would be preferable to a general regulatory approach he characterizes as "let's make it impossible for things to be complex." Rating users "ought to be able to prove they are familiar with what's behind the rating," Phillips said.

The actual language on which the requirement will be based was part of the Bank of International Settlements' July 2009 enhancements to the Basel II framework. Part of a policy revamp expected to be finished by yearend, it requires that banks be able to demonstrate a "comprehensive understanding" of a security's risk profile, and have access to current data on the underlying collateral at all times.

For example, "for resecuritisations, banks should have information not only on the underlying securitisation tranches, such as the issuer name and credit quality, but also on the characteristics and performance of the pools underlying the securitisation tranches," the enhancements document states.

Without such data regulators would not recognize the risk weight of a triple-A security under the standard Basel approach (20% for a securitization, and 40% for a resecuritization such as a collateralized debt obligation). In effect, the rating would have no value for determining regulatory capital.

The rules in the works say "you need to be doing the due diligence you should have been doing all along," said the person familiar with the FDIC's thinking. "This is really standard supervisory good banking practice."

It's so basic, some argue, as to be almost useless. The securitization market is still moribund, and most investors aren't inclined to put much confidence in ratings anyway, said Paul Miller of FBR Capital Markets. "The market's not going to buy [home] loans that JPMorgan bought and securitized and got a triple-A rating on," Miller said. "There's no market. The regulators just want to make sure [the rules are] there if the shadow banking system comes back."

Higher capital requirements for resecuritizations would certainly make such products less attractive. But the person familiar with the FDIC's thinking said the agency did not believe the requirement to analyze and monitor underlying collateral would be an insurmountable obstacle to creating complex products. "I don't think it's a problem of getting the data," the person said.

"It's a problem of asking for it, and understanding that you need to be looking at it."
Even if products like private-label home mortgage securitizations are unlikely to be revived anytime soon, there's still some life in other securitization categories, such as credit card receivables. And in resecuritization there's continuing action on the repackaging of real estate mortgage investment conduits. Such "re-Remics" take downgraded bonds and resecuritize them to create investment-grade securities that receive better regulatory capital treatment. These deals demonstrate why a shift to more qualitative approach to regulatory capital is necessary, observers like White and Phillips said.

Wall Street produced more than $40 billion of re-Remics last year, effectively adding a buffer of junior tranches to securitizations whose senior positions had been downgraded. Though it's often considered a transparent form of regulatory capital arbitrage, the approach works fine so long as it creates a sufficiently large "moat" of junior tranches to protect the newly reminted senior positions from the deteriorating collateral.


Unfortunately, the relatively brief track record of re-Remics already has blemishes. Bloomberg News reported last month that some re-Remics that S&P had rated only last year have already deteriorated from triple-A to junk, with similar securities rated by Moody's and Fitch suffering less dramatic downgrades. (According to Fitch, 2% of the 1,600 re-Remic securities it has deemed triple-A since 2008 have fallen below investment-grade.)

That has caused some controversy about re-Remics. Fitch announced this month that it had stopped rating re-Remics backed by alternative-A mortgages or subordinated debt, and that it would no longer confer triple-A ratings on other types of re-Remics. It now declines to give any rating to 90% of the re-Remic deals it is presented with. "We're filtering out transactions that we're uncomfortable with based on performance volatility," said Roelof Slump, managing director of Fitch's residential mortgage-backed securities group.

Put simply, the problem with re-Remics may not be one of perverse incentives or insufficient capital held against them. It's that gauging further losses on resecuritized products composed of shrinking pools of underperforming collateral is extremely hard.

One way to address such a problem, White said, would be simply to boost regulatory capital requirements and forbid certain deals.

"It doesn't bother me that regulators would say, 'Gee, this stuff turned out to be awfully difficult to figure out, so we want super extra safety margin,' " he said. A doubling of capital requirements for resecuritizations, though perhaps overly indiscriminate, would not be unreasonable. "We've been through too much drama."

White said he'd prefer a more nuanced approach that relies on bank and regulator judgment. Requiring banks to do some amount of research internally would be a step toward treating ratings as the opinions they were intended to be.

"That opens up the possibility of new ideas coming along," White said. "If you continue to have this reliance on ratings, you have to define whose ratings and set capital limits. And then you're back to this whole nationally recognized statistical rating organization horror we found ourselves in."

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