How Wall Street captured US effort to rein in banks’ disclosure rules

Reuters/New YorkIn the aftermath of the 2008 financial crisis, Keith Higgins was certain: Banks weren’t to blame. Higgins, a top attorney at prominent law firm Ropes & Gray, was chairman of an American Bar Association committee on securities regulation. As such, he lobbied strenuously against a rule US regulators were drafting that would require banks to disclose a lot more about asset-backed securities like those that had just torpedoed the economy. In letters to the Securities and Exchange Commission, Higgins argued that divulging more details about the mortgages and other financial products that go into such securities would only confuse investors. And it was investors, with “insufficient understanding and commitment” to their investments, who had been the real cause of the crisis, he argued in a July 2008 letter. Then, in May 2013, as the SEC was still hashing out the rule, Higgins was tapped to lead the very 500-person SEC division that was writing it. When the final version of Reg AB II came out last year, disclosure rules advocated by many within the agency had been stripped out. Of particular concern: Banks could continue to sell asset-backed securities to institutional investors on the private market with no new disclosure requirements. Reg AB II was one of many rules Congress ordered up in the 2010 Dodd-Frank Wall Street Reform Act to fill regulatory holes in the market for asset-backed securities. An unprecedented expansion of this multitrillion-dollar market, in which banks repackage mortgages and other assets into complex securities and sell them to investors, lay at the heart of the financial crisis. But as the evolution of Reg AB II suggests, banks and their advocates have managed to preserve many of the industry’s pre-crisis practices by focusing lobbying efforts on obscure corners of the regulatory world, far from the glare of congressional debate or public scrutiny. Many of these agencies are staffed by appointees from the industry they regulate and return to it when their stints are over. “The banks have done an end run around all the disclosure efforts,” said Thomas Adams, a securitisation lawyer at Paykin Krieg & Adams LLP. Four of the six lawyers now in the leadership of the American Bar Association committee that Higgins chaired have worked for the SEC’s Division of Corp Finance. And between 1993 and 2006, the proportion of financial services veterans on the Financial Accounting Standards Board (FASB) went from zero to 25%, according to a 2012 Harvard Business School study. Higgins declined to comment. SEC Chief of Staff Lona Nallengara said the selection of Higgins to run the division was a reflection of his status as “a respected securities practitioner with 30 years’ experience.” Nallengara, who was acting director of the Division of Corp Finance for seven months before Higgins took over, said the decision to remove disclosure requirements for private offerings from Reg AB II was made before Higgins arrived. “Keith had no influence on that decision,” he said. Like the SEC when it was weighing rules on asset-backed securities, FASB, the private group that sets accounting standards for public companies, came under political pressure to tighten rules blamed for exacerbating the financial crisis. Critics said FASB had made it too easy for banks to stash mountains of securitised loans in off-balance-sheet vehicles based in the Cayman Islands, hiding their exposure to risks that eventually swamped them and the global economy. Here, too, banks pushed back hard. And here, too, their protests reached sympathetic ears. Ultimately, FASB’s rules barely dented the size of banks’ off-book holdings. The practical effect of these lobbying efforts has been obvious. Thanks to the private-market loophole in the SEC’s Reg AB II, banks are selling a greater share of securitised debt than ever on private markets – largely off the radar of regulators and watchdogs. Residential mortgage-backed securities tendered on the private market jumped to 78% of all new offerings last year from 46% in 2013 and just 10% in 2007, according to data obtained by Thomson Reuters. The privately sold share for commercial mortgage-backed securities jumped to 83% from 37% in 2013. The markets for asset-backed securities today are a fraction of what they were in the run-up to the crisis. But they are showing strong signs of revival. What bothers some current and former regulators and industry watchers is that much of the regulatory framework that enabled the crisis remains in place. “What’s playing out is exactly what we were worried about,” said Sheila Bair, former chairwoman of the Federal Deposit Insurance Corp “Most everything is going into these private markets where regulations require little visibility of what’s happening.” With their access to off-balance-sheet entities largely preserved, the banks continue to hold vast sums of securitised loans offshore and off their books. Together, JPMorgan Chase & Co, Bank of America Corp, Citigroup, Wells Fargo & Co, Goldman Sachs Group and Morgan Stanley hold nearly $3.3tn of securitised loans in off-balance-sheet entities. “I still think there is significantly more risk there than is being reflected on banks’ balance sheets,” Bair said. It isn’t just the banks. As hedge funds and private equity funds have ramped up high-risk lending in recent years, their use of off-balance-sheet vehicles has ballooned. For example, KKR & Co LP’s reported exposure to loss from off-balance-sheet entities has risen tenfold since 2010. A KKR spokesperson said less than half of the firm’s off-balance-sheet entities are composed of corporate loans originated by KKR and securitised into collateralised loan obligations, but declined to provide numbers or other information. Robert W Stewart, a spokesman for the Financial Accounting Foundation (FAF), the private-sector body that oversees FASB, said the new rules “resulted in a dramatic increase” of the holdings financial firms and companies in other industries keep on their books. “These standards eliminated long-standing exceptions for securitisations, and that reduced the opportunity for work-arounds,” he said. Even before the crisis, FASB struggled for years with how banks should account for off-balance-sheet entities and the assets held in them. Every additional dollar in assets on a bank’s balance sheet requires holding more idle cash in capital reserves to cover those assets if they drop in value. The increase in reserves means less revenue and earning power and smaller employee bonuses. Off-balance-sheet vehicles free banks to make more loans and build assets without having to add to capital reserves. These assets include all sorts of things: Treasury securities, home and commercial real estate mortgages, auto loans, even “junk” loans used to finance leveraged buyouts. Banks bundle the assets into securities, sell the securities to investors, and then park the assets in separately incorporated off-balance-sheet vehicles. In theory, if one of these vehicles fails because the underlying assets sour – as, for example, when large numbers of homeowners default on their mortgages – the bank does not have to bail it out. In practice, they often do – to preserve their reputations in a lucrative market, and because specific asset-backed securities often carry implicit or explicit guarantees that leave banks legally liable to make investors whole. “Repeatedly, constantly, when the new off-balance-sheet entity got into financial difficulty, the bank bailed out the entity that they supposedly didn’t have any more connection with,” said Halsey Bullen, who was with FASB from 1983 to 2006, much of that time managing financial instruments projects. FASB sought to address the issue several times before the crisis - to no avail. It tightened rules on Special Purpose Entities, the off-balance-sheet vehicles that played a big role in the collapse of Enron Corp in 2001. But banks simply started using alternatives called Qualifying Special Purpose Entities (QSPEs).