The Dodd-Frank Act's Section 939A prompts banking regulators to remove any "reference to, or requirements of reliance on, credit ratings" in their regulations and capital requirements. The uncertainty of how regulators will interpret those words has the ABS industry bubbling and proposals emerging.
Like most Dodd-Frank mandates, the outcome is uncertain because the law left much of the interpretation in the hands of regulators, and they have until July to publish new rules.
Gagan Singh, chief investment officer at PNC Bank, spoke on a panel addressing the issue of Section 939A at the American Securitization Forum's (ASF) recent conference in Orlando.
"We think the ratings-based approach is fundamentally flawed for securitized products," Singh said. He added that that's because ratings are based on the probability of default when instead a financial institution's capital should be determined by the losses it anticipates in a stressed market environment.
PNC took a more hard-line approach than many industry participants, who in comment letters submitted last October nearly all agreed that change is necessary in one form or another. Disagreement lay, however, in the pace of change, the extent to which national ratings agencies public ratings should be replaced and what they should be replaced with.
The Pittsburgh-headquartered bank offered one of the more straightforward recommendations. "PNC believes that any new framework should tie regulatory capital to an objective, internal, systematic approach for calculating the expected loss on the securitization exposure." That framework would use internal analytics supplemented by third-party inputs, to determine the regulatory capital for securitization exposures.
Such a move would clearly require banks and other regulated financial institutions to make at least some level of internal changes - perhaps significant ones - depending on what regulators request from them. Some caution that too fast a change could detrimentally impact an already damaged ABS market.
The ASF noted in its comment letter, for example, that the "elimination of credit ratings from the risk-based capital rules could have a significant impact on liquidity in the ABS markets which rely upon the ability of investors to make real-time decisions at the point of initial offering of subsequent secondary market purchase."
Most industry participants submitting comments to the regulators agreed that relying on public ratings was insufficient - even Moody's Investors Service (MIS). "Historically, MIS has supported discontinuing the use of ratings of nationally recognized statistical ratings organizations in regulation," noted Fariza Zarin, managing director for global regulatory affairs at the agency.
Recommendations from Moody's echoed most of the comment letters, opting for incremental change rather than purging public ratings from the regulatory system all at once. "We believe the solution lies in modifying the use of the measurement tools rather than simply substituting one tool for another," Moody's said.
Other commentators suggested that banks apply internally generated credit ratings only to more complex deals, given that smaller financial institutions investing in standard transactions may have inadequate resources to perform in depth internal analysis. And in many cases, they argued, it may simply not be necessary.
Bank of America, for example, called Section 939A too broad, noting that problems during the credit crisis mainly arose in "the area of structured securitizations and more specifically the residential mortgage product." The nation's largest bank also said that other provisions of Dodd-Frank address concerns raised by Section 939A. Section 932, for example, requires the national rating agencies to provide better disclosure of their methodologies and mitigate potential conflicts of interest, while the Securities and Exchange Commission must create an office specifically to protect users of credit ratings and promote ratings' accuracy.
The extent to which the regulators soften the Dodd-Frank Act language remains to be seen. What's more certain is that banks will have to take more responsibility for their ABS credit decisions.
PNC noted that internal credit analysis is common practice for most banks and should be a part of a new framework that institutions apply to understand the underlying risks of securitization exposure. The methodology should reflect changes in the expected performance of the securitization in a timely manner. And, PNC added, there should be a link between regulatory capital and expected loss of an ABS that's based on collateral performance and available credit support.
"So do away with the probability of default and focus on the probability and magnitude of loss," Singh explained.
PNC's approach would rely on two variables to measure ABS risk. One would require the frequent review of cumulative collateral loss (CCL) expectations, verified by a third-party, for the underlying assets. The second would measure the amount of credit enhancement available to absorb losses for a given exposure in the securitization capital structure.
To calculate a loss coverage multiple (LCM) for each securitization exposure, a bank would calculate collateral cash flows based on the CCL expectations, and they would be applied to the securitization structure to calculate the expected loss of the portion held by the bank.
"The LCM measures the structural credit enhancement available to a securitization exposure as a multiple of CCL expectations. The LCM relating to a specific ABS structure would then be used to determine the regulatory capital required for that securitization exposure held by the bank," PNC said in its comment letter. "The higher the LCM the lower the regulatory capital required."