The Frank-Dodd Act's regulation of collateralized debt obligations

Frank-Dodd

One of the issues that the Frank-Dodd Act was designed to address was the creation and sales of collateralized debt obligations (CDOs). The inclusion of CDOs in the Frank-Dodd financial reform came about because of the role that these products played in the buildup of the housing bubble that would eventually burst and plunge the U.S. economy into deep recession. The rules were intended to strengthen the regulatory framework governing CDOs in such a way that these instruments would not be able to make that same contribution to the economic landscape again. CDOs were just one type of obligation that made this contribution, and others such as credit default swaps (CDS) were similarly targeted in the legislation (Vasudev, 2012).

CDOs

A collateralized debt obligation is defined as "an investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt" (Investopedia, 2012). CDOs are created by financial institutions as a method of spreading risk. The institution will typically bundle a variety of debt instruments into a single security, which is then brought to market. CDOs are a relatively recent development in the past few decades, and they offer a number of benefits to the financial institution. Most important, the institution uses them to generate profit while diversifying risk. The risk associated with the underlying assets of a CDO lies with its holder, but there are specific problems with these instruments that are not common to other debt instruments.

One problem with CDOs is that it can be difficult to understand the risk profile of a given CDO. It is often difficult to determine the risk characteristics of a CDO given the number and types of underlying assets. One of the problems in the financial crisis was that credit rating agencies misunderstood the risk characteristics, allowing financial institutions to market CDOs at credit ratings that did not accurately reflect the risk of the security. Financial institutions bought CDOs thinking they were safe investments, but ultimately found themselves overleveraged when the true credit quality of the CDO was revealed. This became a political issue when the concept of "too big to fail" was invoked, and the federal government and Federal Reserve needed to pump money into the banking system to maintain its solvency.

The Frank-Dodd Act

The Frank-Dodd Act was designed as a response to a perceived shortfall of regulation in the banking industry. The concept of too big to fail meant that much of the risk in the banking system was actually borne by the taxpayers, so Frank-Dodd was enacted as a means of mitigating that risk, primarily by regulating the riskier instruments and activities in the banking system. The Act did not specifically target CDOs, but rather addressed the more general category of asset-backed securities. Five new requirements with respect to asset-backed securities in Frank-Dodd (SEC, 2012). The first is Section 621, which prohibits conflict of interest. The second, Section 941, is a critical section of the act. Section 941 requires that rules are prescribed to "require that a securitizer retain an economic interest in a material portion of the credit risk for any asset that it transfers, sells, or conveys to a third party" (SEC, 2012). Sections 942 and 943 deal with reporting requirements and representations respectively. Section 945 requires the issuing of "rules requiring an asset-backed issuer in a Securities Act registered transaction to perform a review of the assets underlying the ABS, and disclose the nature of such review." Sections 945 and 941 increase the regulatory, operating and risk burden on the issuers of CDOs by forcing them to hold onto part of the security and to undertake regular reviews of the risk characteristics of the security. It is likely that the latter would be performed anyway if the institution is forced to hold a material portion of that security.

The Volcker Rule

The Volcker Rule holds that banks cannot trade with money from their own accounts (Mattingly, 2012). This was included in the Frank-Dodd Act as a means of reducing the risk level of financial institutions. Several exceptions were included in the final Act. Proprietary trading contributed to the development and the size of the CDO industry. Banks were able to use their own money to purchase parts of CDO deals that proved unmarketable. This allowed the banks to manufacture synthetic CDOs, knowing that if they could not sell the entire thing, they would use house money to buy the remainder (Gandel, 2010). The Volcker Rule was included in Frank-Dodd because of the losses that many banks took both on CDOs purchased from other institutions and on the portion of CDOs that they kept for themselves through proprietary trading.

Effect on CDOs

The Frank-Dodd Act erects several barriers to CDO industry. The Volcker Rule makes the manufacture of synthetic CDOs more difficult, since banks can no longer buy up the unsold portions of these instruments. The banks would need to find other buyers, and the Volcker Rule extends to subsidiaries and other affiliated intermediaries. The Act's risk retention rule also creates a barrier to the manufacture of synthetic CDOs because it fails to adequately address the unique characteristics of these instruments. If banks and buyers do not fully understand their obligations under the Act, they may be hesitant to either create or to purchase synthetic CDOs. The banking industry could seek to overcome these barriers, should it see an economic rationale to do so, but for the time being these barriers are going to challenge the development of all asset-based securities, but especially synthetic CDOs. These instruments will still be created, however, if banks can find ways to place the entire issue, and if the legal framework can be developed to clarify the definitions of securitizer and originator under Frank-Dodd. The risk retention rule, however, because of its vagueness, may be amended to grant an exemption to CDOs or a delay in Frank-Dodd implementation until these definitions can be adequately explained in reference to CDOs.

Recommendations

While the Frank-Dodd Act will inhibit the development of CDOs, the Act essentially creates a framework for a more orderly market in these instruments. Many of the riskier activities surrounding CDOs will be removed under Frank-Dodd. Vasudev (2012) recommends further actions to regulate these instruments. One recommendation is a procedure for screening these instruments prior to their launch. This strategy would allow an external body to pass judgment on the credit quality of the instrument. However, the need to satisfy regulatory approval for each transaction, even if this screening procedure was efficient, would create an additional barrier without any guarantee of addressing the core problem. The philosophy behind Frank-Dodd is to minimize the risk to the taxpayer of trade in these instruments, but this is to be balanced against the needs of the industry. Arguably, however, there is no particular need for synthetic CDOs, so tight regulation that restricts their manufacture and use should be sufficient.

The Frank-Dodd Act imposes significant regulatory burden on synthetic CDOs and the use of credit default swaps to create synthetic CDOs. The full extent of the burden has yet to be defined, in part because the terminology in the risk retention rule has yet to be adapted to these products. Adapting the wording of Section 941 would further regulate and control the use of these instruments. By providing clarity, improved wording would allow regulators to create a tighter framework with fewer loopholes. The regulator would also be able to craft the wording the way it wants, as opposed to having the intent of the law interpreted either in court or by some other body. By closing what could end up as a loophole, the strength of the Frank-Dodd Act would be improved.

Works Cited:

Forrester, J. & Jacobsen, W. (2010). Impact of Frank-Dodd risk-retention requirements on CDOs, CLOs and the loan market. Mayer Brown LLP. Retrieved November 7, 2012 from http://www.martindale.com/finance-law/article_Mayer-Brown-LLP_1106518.htm