The Dodd-Frank Wall Street Reform and Consumer Protection Act and Its Potential Impact on Commercial Mortgage Financing and Lenders

TASA ID: 1813

On July 21, 2010, President Obama signed into law House of Representatives Bill #4173, commonly known as the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"). It was sponsored as "a bill to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end 'too big to fail,' to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes."

Among other things, the act is supposed to rein in lenders and Wall Street firms. The press and politicians have touted it as imposing "sweeping change," but from an early read it does not appear to do all that much or go far enough.

Much of the Act focuses on consumer protection, residential mortgage companies, "Wall Street" firms and the Federal Reserve. Implementation of the different applications will vary between 6 and 24 months (started July 21, 2010), and finalization and enforcement will be the responsibility of regulators and numerous new boards. Accordingly, it will be some time before it will be possible to understand the Act and have its full impact completely known. Despite this, those in Congress that supported it have already called it the greatest "financial services legislation" since the Great Depression. Based on the fact that lobbyists are already working to reduce, eliminate or minimize its impact on their represented area of interest, and as one six-month waiver has already been granted, it may seem reasonable to assume that the statement is true. The average American may feel good that something dramatic has apparently been done, but has it? A closer look says otherwise.

The SAFE Act

A precursor to the Dodd-Frank Act was the Secure and Fair Enforcement for Mortgage Licensing Act that was initially passed on July 30, 2008. Known as the SAFE Act,it was designed to enhance consumer protection and reduce fraud by establishing registration and licensing minimums for residential mortgage loan officers, originators and mortgage companies. But commercial mortgage loan officers, commercial mortgage companies and residential mortgage loan officers that work for an insured depository (a bank) were originally specifically exempted. In addition, no mortgage expertise or licensing of commercial mortgage loan officers was required at any level; there were no such requirements even for Wall Street investment banking firms or rating agency analysts. Remember that these are the parties that analyze, process, rate and/or sell pools of both residential and commercial mortgages. Their past practices all contributed to the meltdown of the capital markets.

On July 28, 2010, and after the Dodd-Frank Act became law, the agencies responsible for the SAFE Act issued their final rules, which now require residential loan officers of national and state banks, savings and loan associations, Farm Credit System Institutions, credit unions and some of their subsidiaries to meet the registration requirements of the SAFE Act. With exceptions for small institutions and those processing less than 25 mortgages per year,  this basically means that all residential mortgage loan officers of banks, savings and loans and credit unions are now required to be formally registered in a national registry base. However, it does not require residential mortgage loan officers of national banks to demonstrate competency by passing a test to become licensed or take continuing education. The explanation for this exemption is that national banks and their loan portfolios are examined every year by federal regulators. Interestingly though, loan officers of non-Federal Reserve member banks and state- charted banks are subject to registration and are also subject to any licensing requirements of their respective states.

What does registration involve? It involves individual background checks and finger printing. Licensing? It involves passing a test to demonstrate competency. Commercial mortgage loan officers and bankers are still exempt from registration and generally from licensing. Seems to me that if the process of annual examination of national banks had worked prior to the capital markets meltdown, the FDIC would not have needed to close over 250 banks since January 1, 2008, with more to come. In December 2008, I wrote to the heads of the various agencies and sponsors of the Dodd-Frank Act, advocating licensure of all financing industry participants. Based on the final version, it appears that even if they listened, they missed the real point by only partially amending and expanding the SAFE Act requirement. 

The Dodd-Frank Act

The Dodd-Frank Act creates better protections for residential mortgage customers and credit card "borrowers," and it addresses some of the items that the SAFE Act missed. However, how it will affect the commercial mortgage industry and Wall Street's capital markets is the focus of my interest.

It appears as if the act will have the most impact on banks, Wall Street "players" and the all important and massive RMBS/CMBS capital markets source for mortgage financing. Here's why:

• There will be no more taxpayer-funded bailouts of financial institutions.
• Complex derivatives will be regulated.
• New controls to allow the government to seize large failing financial companies are being created.
• Hedge funds will now be required to be registered with the SEC.
• Interest rate "swap" transactions will be required to be publicly disclosed.
• Banking entities' abilities to engage in proprietary trading or to own interests in hedge funds or private equity funds will be limited.
• Banks will be required to have higher capital levels.
• With exceptions already negotiated, the sellers of mortgaged-backed securities products (RMBS/CMBS) will retain a 5 percent partial liability on risky issues.
•  It removes a former major exemption by formally designating the rating agencies (so necessary for RMBS, CMBS and other public debt issues to be rated and sold) as experts, and is designed to make them accept responsibility for their actions by making it easier to successfully sue them for bad ratings.
• For the very first time, it requires analysts at the rating agencies to pass qualifying exams and have continued education.

Let's look more closely at three of the reforms, as they principally affect the all important RMBS/CMBS capital market that "everyone" is pressing for a return, which will happen. The impact of requiring sellers of mortgage securities to retain a minimum 5 percent interest in the securities they sell is designed to require them to have "skin in the game" and be at risk along with the securities buyers for the quality of what they sell. Already, exceptions have been negotiated where "normal" and "low risk" mortgages will be defined, and sellers of securities backed up by such mortgages will not need to retain a 5 percent interest. The FHA, FannieMae and FreddieMac have all at different times imposed similar requirements on their correspondent lender-loan originator-sellers, and that hasn't helped much. Look at the financial difficulties that Fannie and Freddie are currently enduring. Past history has shown that when an originator-seller has had such a low level of skin in the game, it went bankrupt when called upon to absorb its portion of the risk or to repurchase the defaulted loans. I spoke with one company founder who told me that the risk of such loss was far outweighed by the money they made from fees and servicing even though they knew they could never afford to cover any significant losses. It sounds good, but in reality it hasn't proven to be worth much protection to the investors that buy the securities.

What is the impact of formally designating the rating agencies (Standard and Poor's, Moody's, Fitch and others) as experts? In order to understand its potential impact, you need to know that agency ratings are used by (Wall Street) debt issuers and underwriters to indicate the quality of the bond or debt security they are selling. Stated simply, the proposed sale of registered securities requires that an agency rating be formally published on the official offering statement (they usually appear in the upper right hand corner of the first page). While they may choose to show a rating, unregistered or private placement securities are exempt from the requirement. An example of an unregistered, private placement security is a local municipal bond issue. 

There are two levels of ratings - investment grade and non-investment grade. Letters are assigned to indicate the rating. Typically, investment grade ratings run from BBB (the lowest) to AAA (the highest) and are often supplemented with + or - gradations. Non-investment grade ratings range downward from BB to D. Securities with non-investment grade ratings or with no rating are often referred to as "junk bonds" due to their lack of quality in comparison with investment grade rated bonds. Investors substantially rely upon such ratings when deciding to buy the securities and what price and yield they are willing to pay or accept.

In previous writings, I mentioned that the rating agencies were escaping liability for their past ratings actions that contributed to the capital markets meltdown by having lawsuits dismissed. That was basically due to their exemption from being considered as "experts." Their ratings were considered just "opinions" as opposed to "expert opinions." While I think most people always believed that the rating agencies were experts, "buyer beware" appears to have been the unacknowledged watchword for reliance upon such ratings. The capital markets meltdown certainly proved that. Now that the exemption is being removed, they become properly liable for their rating opinions just as an attorney or real estate appraiser is liable for his or her opinion. The removal of the exemption now makes it easier for harmed investors to successfully sue.

It is most interesting to note, however, that immediately upon the President's signing of the Act, the rating agencies publicly notified clients and underwriters that they were withholding permission to allow their ratings to be published on any debt issues. This immediate refusal to stand behind their own ratings effectively shut down the $1.4 billion registered securities debt market (of which CMBS, and RMBS are a part) until, on July 22nd, the SEC gave into pressure from large debt issuers and Wall Street underwriters by promptly providing the rating agencies with a six month waiver, thereby allowing pending and proposed debt issues to proceed. The pressure came from a number of Wall Street firms and debt issuers that had major issues pending.  It often takes months and a significant investment of time and money to structure and assemble large debt issues, and they could not be marketed without agency ratings. For example, Goldman Sachs had a $778.5 million registered issue pending that was comprised of traditional, multi-borrower CMBS. They successfully sold the entire issue on August 2^nd, just 10 days after the waiver was put in place. It is also very important to note that Goldman (with no requirement to register or have specially licensed mortgage loan officers or loan underwriters) originated 69 percent of the portfolio itself. Without the waiver, Goldman's CMBS issue could not have been sold. It was business as usual with no changes imposed by Dodd-Frank from the pre-meltdown days.

So what is the impact?

The words LET THE BUYER BEWARE should continue to apply to any new debt issues rated by these agencies while the waiver is in effect. If an acceptable alternative is not found in six months, the agencies will again withhold their ratings and shut down the market. If the SEC backs down on its expert designation, the Dodd-Frank Act will have done nothing, other than licensing analysts, to reign in the credit rating agencies.

How this plays out will have a major impact on the capital markets, including on future (post waiver period) RMBS and CMBS issues. So what should be done? One solution could be creating a "rating agency insurance fund" in combination with mandated cash reserves and professional liability/malpractice insurance to compensate investors harmed by a bad rating. We have the FDIC insurance to protect bank depositors. Some states have similar funds for parties harmed in real estate transactions. If the idea has merit, it will probably take the federal government or the SEC to help start such a fund.

Concerning the licensure of rating agency analysts, no guidelines have been issued. It is another aspect that requires refinement and completion. Remember that the rating agencies were supposed to be the gatekeepers of the mortgage-backed securities market, and they failed miserably. The lack of worldwide investor confidence in their MBS ratings is the major reason for the capital markets collapse. In my opinion, investors should demand that their analyst's licensure and continuing education requirements include mandatory education about prudent mortgage loan underwriting, as well as a basic understanding of real estate appraising. It may be prudent to create separate licensing and requirements for the analysts responsible for analyzing and rating mortgage-backed securities portfolios. I have sent a letter to SEC Chairman Schapiro advocating such an educational requirement. If you agree, perhaps you'll send a similar letter.

Just for the record, the new administrative boards and agencies and sub-entities to be created by the Dodd-Frank Act include:

• The Consumer Financial Protection Bureau of the Federal Reserve
• The Financial Services Oversight Council
• The Office of Credit Ratings at the SEC
• The Federal Office of Insurance within the Treasury Department
• The Office of Financial Literacy and Research within the Treasury Department
• The Office of  Minority and Women Inclusion
• The Office of Housing Counseling within HUD
• The FDIC's

-  Office of Complex Financial Institutions

-  Division of Depositor and Consumer Protection

In summary, depending upon the outcome of the expert status of the rating agencies and the educational requirement that will or will not be imposed on rating agency analysts, it appears as if not much has changed to reign in Wall Street and its potential impact again on the capital markets as it relates to mortgage-backed securities. It was a multi-billion dollar industry that was initially a secondary market and then became a primary market for all types of real estate financing. Investor confidence was lost, but time and the yields currently available are bringing investors back to the market. Will we see a return of the halcyon days of the mid 2000s?  Not for awhile, but the act's safeguards concentrate on making the individual (residential) mortgage originators and loan officers responsible for doing a better and more prudent job of underwriting mortgage loans than in the past. Not much, however, appears to have been done to prevent the Wall Street firms and underwriters from again becoming overly aggressive and abusing the capital markets source.

Because no real adverse impact has been seen now that the act has been passed, and in anticipation of the much-desired return of the capital markets as a major mortgage financing source, more companies are again planning on selling major amounts of mortgage-backed securities. Cantor Fitzgerald (had major 9-11 employee losses), a traditional bond house with no real mortgage experience, just partnered with CIM Group, a Los Angeles Fund Manager (also apparently with no real mortgage experience), to become mortgage originators and pool assemblers. They have announced a target of creating and selling $5 billion of MBS product. No required registration or licensing of mortgage loan officers and underwriters. Can you see a trend?

History has demonstrated that those who do not learn from its lessons are doomed to repeat them.  Were regulators and legislators really paying attention to history? You decide.

Accordingly, while it should not be, sadly the words let the buyer beware continue to be the best advice for investors.

This article discusses issues of general interest and does not give any specific legal or business advice pertaining to any specific circumstances.  Before acting upon any of its information, you should obtain appropriate advice from a lawyer or other qualified professional.

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