Friday, April 29, 2016

Too Big to Fail: End Run around a Bank Run

A startling feature of Dodd-Frank is the impression it gives that “Too Big to Fail” - otherwise known as “TBTF” - has been legislatively fixed. The impression is quite misleading. Sort of like the impression that some bank executives are Too Big to Jail! They aren’t; but nobody’s in jail, last time I looked.

Dodd-Frank is a beast that chomps submissively at the rancid remains of a decomposing TBTF bank.  

What is TBTF anyway, but a hypothetical, counterfactual, arbitrary assemblage of somewhat dubious allegations based on the effect of a bank’s failure perpetrated on the entire financial system?

The public screams, “save us from another repeat of the recent financial crisis;” politicians twist and twitch fretfully over a re-occurrence, though they have no idea really how to figure out how big is “Big;” lobbyists for the banks write the legislation that primes the TBTF bizarre spectacle of wondering what metrics to use to quantify systemically explosive financial entities; and Congressman Barney Frank, whose eponymous legislation seems to offer some solace, leaves Congress and rationalizes his decision to join the Board of Signature Bank – appearances be damned!

Maybe there is a tentative solution if we wind up in the midst of a long term financial crisis. Perhaps a proposal, suggested on Tuesday by the FDIC and the OCC, might be worth considering. The proposal would require the biggest banks to retain sufficient assets to be convertible into cash if there is a financial crisis. The tool is known as the “net stable funding ratio.” This ratio requires banks to balance the use of short-term funding sources – the type of sources that come under intense pressure in a financial crisis, such disruption typified by a run on a bank – with more stable funding sources, for instance, deposits and regulatory capital tools, such as equity.

The proposal forces a bank with more than $250 billion in assets and $10 billion in foreign exposures to maintain enough easily convertible capital to allow it to cover any liquidity needs for up to a year. The FRB is also working on a liquidity proposal for banks with between $50 billion and $250 billion in total assets.

The net stable funding ratio, which is often referred to as the NSF, is really a creature of the 2008 financial crisis. As bank failures or near failures abounded, regulators felt that even the then-currently maintained capital levels could be in danger if there were too much reliance on the repo market and other wholesale funding sources. The big fear was that banks would not maintain enough liquid assets to withstand a run on the riskier entries on their balance sheets.

Functionally, the NSF works this way: it requires banks to measure their capital levels along with consumer and small business deposits – traditionally considered stable funding sources - against less stable funding mechanisms. Other assets, such as gold and loans, carry different risk weights in the way they count toward the ratio, based on a Basel Committee release in 2014 involving banking supervision.

So, banks are expected to carry a 100% funding ratio, which means they should be able to handle a short term run by either (A) paying out cash, or (B) quickly converting assets into cash. Hence, the FDIC, FRB, and OCC are devising their own adaptation of the Basel findings. Their NSF endeavors to be consistent with the Basel’s NSF.

Wonk ON!

Now to get a bit wonkish. The proposal would rate a balance sheet’s asset stability on such categories as the type of funding, including regulatory capital, long-term debt and deposits, its maturity horizon and the counterparty to the asset. Insured deposits would be given the highest stability “rating” while short term wholesale funding would be considered significantly less stable.

Tuesday, April 19, 2016

Skating into the Mortgage Meltdown

The mortgage meltdown goes on and on. Like a nuclear explosion that propagates in a gigantic, lethal plume and roils laterally in wave after wave across a huge landscape, leaving death and destruction in the wake, the financial crisis has yet to find its termination point in the mortgage origination world. Litigation is rife with claims and counterclaims. Billions of dollars in judgments, let alone the high cost of attorneys’ fees, continue to blemish banks and Wall Street securitizers. Main Street has yet to recover, although some pockets of residential real estate seem to be stabilizing somewhat. And, of course, almost nobody has gone to jail!

So, the court of public opinion and the court of jurisprudence is where any resolution must find its grounding. Case in point is trustee U.S. Bank’s claim that a UBS unit knowingly sold thousands of bad home loans into securitized trusts, costing investors $2 billion. We get this conundrum courtesy of the rather unprecedented trial that commenced yesterday in New York, at the U.S. District Court. UBS has so much blood on its hands at this point that no bleach is strong enough! At the conclusion of this trial, UBS may wind up paying more than it has paid out altogether since the crisis hit. The bone of contention: mortgage bundling.

Here’s the allegation made by U.S. Bank: it has "overwhelming, irrefutable and largely undisputed" evidence, including emails suggesting UBS Real Estate Securities Inc. knew it was bundling bad loans from “shady originators” in 2006 and 2007.

Those “shady originators” would be the once-upon-a-time premier, illustrious, esteemed originators known as American Home Mortgage Servicing Inc., Countrywide and IndyMac Bank. Did I mention that all three of them failed?

Further, U.S. Bank asserted that “UBS knew of the defects and decided to ignore them or – in some cases – turn[ed] a blind eye to them.” Recognizing that usually motivation precedes the crime, it is alleged that UBS was motivated by a fear that the originators (sic) would give their loans to other banks to bundle, so it declined to hold those originators to high standards even though it “didn't trust them.”

As U.S. Bank says, “UBS constantly disparaged these originators.” Oh for shame!

Emails are given as evidence of UBS’s naughty attitude. For instance, a UBS trader emailed that "HUGE delinquencies" in the securitized trusts, but joked that this was a "big surprise!" [Emphasis in original.]

Or how about a more poignant expression of substance, such as where another UBS trader received an email from a bank colleague that said the originators "run their deals like a sh-- show."

One thing to denigrate the originators, but how about some due diligence here, please? It would seem that UBS allegedly did not investigate ridiculously absurd income claims. A particularly fine specimen of this debt-to-income fiasco is where a “pro skater” claimed to make $12,000 per month but who actually earned $15,000 a year – plus already had two unreported mortgages. Ouch!

Of course, one fraudulent loan does not a litigation make of this magnitude. How about 3,500? Yes, that is the alleged number of possible borrower fraud involving “stated income loans.”

UBS’s defense leaves me breathless: the evidence at trial will show that most of the loans were not materially deficient at the time of their origination. Say what?

I’ll let the judge’s question take the stage: “How did anybody ever think that was a good idea?”

But, says UBS’s defenders at bar, “hindsight is not the standard.” This gambit implies that loans later shown to be defective don't impute liability to UBS. But, if that tactic doesn’t work, how about asserting that those naughty internal UBS communications cited by the plaintiff were “a distraction” and were “taken completely out of context.” 

And, if that tactic doesn’t work, UBS wants to use the old Tu Quoque (you did it too) defense – like when a child fights with his brother and is punished by a parent, and the child says, ‘but he did it, too’! So, in its defense UBS states that it wasn't the only “sophisticated party” (sic) in the transaction and asserted that the trustee, too, knew well of the inherent risks of “stated income” and other loans. Right! That gambit will work – perhaps in a parallel universe.

The court will likely focus on exactly in what instances UBS might bear liability, among other things, for failing to vet obviously false homebuyer income representations – such as the one offered by the “pro skater.”

This is a bench trial and will probably last a few weeks. But it is the first time a trustee has taken such claims to trial.

President & Managing Director
Lenders Compliance Group

Tuesday, April 12, 2016

Going after the Big Cheese (PHH takes on CFPB’s Director)

As many of you know, I have been following the PHH dispute with the CFPB virtually from its inception. Although PHH is a large organization, let’s face it, this is still like a mouse (PHH) squeaking at an elephant (CFPB)! The bite, in this instance, happens to be a $109 million penalty that the CFPB is assessing against PHH.

Reduced to the least common denominator, this is a fight against the authority vested in the Director of the CFPB, or, better said, the authority that the Director presumes to have vested in himself versus a play at arrogating to himself certain authority that he simply does not have.

Going after the Big Cheese himself is no mean feat!

But PHH has assembled a highly skilled and prominent legal team.

And there are amici curiae on both sides.

Let me back up a few steps and give a wider angle. PHH appealed to the DC Circuit Court because the Bureau’s Director Richard Cordray raised a $6 million penalty for mortgage insurance kickbacks - such penalty issued by an administrative law judge - to a whopping $109 million.

To ensure that the information presented at bar was applicable to Dodd-Frank, the hearing judges required the Bureau to provide answers in oral arguments regarding substantive provisions as to the president’s authority to remove the CFPB director only for cause, and, importantly, about how the Court should view an administrative agency led by a single director rather than the more typical commission structure.

Today is the day for those oral arguments!

Here’s one bottom line that may come from the foregoing aspects of the dispute: if the Bureau loses, the Director may find that his authority, presumed or otherwise, will be vitiated.

An access point to the litigation is to challenge the constitutionality of the Bureau itself! Areas of contention, right from the inception, have been the supposed, czarist-like construct of having a single director in charge of the Bureau, plus the view that the CFPB’s funding should come from congressional appropriations rather than from the Federal Reserve’s own budget.

Is it surprising that the DC Circuit recently required the Bureau to be prepared to face questions about whether Dodd-Frank’s provision - stating that the president can remove the CFPB director only for “inefficiency, neglect of duty, or malfeasance in office” - passed constitutional muster? Actually, I don’t think so. After all, the Bureau has been challenged on these issues all along and there is clearly an interest in determining the scope of authorities vested in the Director. If adjudication seems to reach to an unassailable decision, the viability of claims involving the CFPB’s constitutionality may be finally resolved. Or maybe not! The Supreme Court would be the next step along this circuitous path to a decision.

Should we be surprised that the Court is looking for answers about potential remedies for any problems that the applicable provision brings, including potentially removing it from the statute and allowing the president to remove the CFPB director without any specific cause?

Again, I am not surprised. If it turns out that the cures (remedies) are worse than the infection (overreaching authority) and the treatment needs to be changed, the Court will need to determine the extent to which such changes could affect the Director’s authority.

So, even though PHH is challenging Director Cordray’s interpretation of violations under RESPA that allowed him to distend a $6 million penalty handed down by an administrative law judge into an engorged, ballooned penalty of $109 million that the CFPB director handed down when PHH appealed, the fact is the instant arguments are really going quite far beyond that issue.

Here’s a pivot point: whether the Constitution allows Congress to put in restrictions on when the president can fire officials at an administrative agency. Short answer: Yes, it is constitutional if you go by the Supreme Court’s decision in 2010 in Free Enterprise Fund v. 
Public Company Accounting Oversight Board, which affirmed the DC Court’s ruling that such protections were constitutional.

But here’s some drama: Judge Brett M. Kavanaugh, the Circuit judge that leads the impaneled court, happened to cast a dissenting vote in that case. His view was that a president should not have to notify Congress as to why the director of an administrative agency is removed.

Thus, removing that provision from the statute could very well limit the Bureau’s independence – and, mutatis mutandis, limit as well that distinct authority of other administrative agencies for which the statute requires a reason for the dismissal of officials. Put bluntly, the Bureau currently acts independently and does not have to discuss with the White House its decisions regarding enforcement actions. That could change, depending on the Court’s decision.

There are a few moving parts, too. For instance, another case that will be considered is the 1935 Supreme Court’s decision in Humphrey’s Executor v. United States, which allowed for restrictions on the removal of 
Federal Trade Commission commissioners. It will be considered because, among other things, the Bureau itself relied on that case in its filings with the DC Circuit. The CFPB’s lawyers will likely be showered with plenty of questions from the bench about the Humphrey case.

As I have said numerous times in these brief epistles on the CFPB's enforcement tactics, regulating by enforcement deprives judicial review. It may be expedient, from the Bureau’s standpoint, but it leaves us with no judicial precedent.

The role of the Court as finder of fact, thereby vetting the issues, and weighing the claims pursuant to the appropriate statutory framework, should be a viable option to an enforcement by settlement that provides a one-sided interpretation.

Jonathan Foxx
President & Managing Director
Lenders Compliance Group