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Friday, April 29, 2011

SEC VOTES TO REMOVE CREDIT RATING REFERENCES FOR CERTAIN ASSETS

Credit rating agencies caused a great deal of harm to the world economy because of their poor performance in rating the credit worthiness of various securities related to mortgages. Many times these credit rating agencies worked for the companies selling the securities. This might be like having a used car dealer use one of the mechanics they employ to inform customers as to the condition of cars the dealer is selling. In the end the customers of broker/dealers of mortgage backed securities lost a great deal of money because they relied on the ratings of the credit rating agencies. There was of course another element that directly caused the economy to seize up.

The element that placed much of the economy at immediate risk was the inability for broker-dealers to have liquidity because the true credit worthiness of the mortgage backed securities they held was far less than what the credit rating agencies had determined. Because the liquid assets required to be maintained by broker-dealers was determined in part by the value of mortgage related securities when the true value of the mortgage related securities was determined by market forces many institutions became illiquid. The following changes are designed to deal with this issue and others relatng to credit rating agencies. The details below are an excerpt from the SEC web site:

“ Washington, D.C., April 27, 2011 — The Securities and Exchange Commission today voted unanimously to propose amendments that would remove references to credit ratings in several rules under the Exchange Act.
These proposals represent the next step in a series of actions taken under the Dodd-Frank Wall Street Reform and Consumer Protection Act to remove references to credit ratings within agency rules and, where appropriate, replace them with alternative criteria.

Proposed Rule Release No. 34-64352

Under Dodd-Frank, federal agencies must review how their existing regulations rely on credit ratings as an assessment of creditworthiness. At the conclusion of this review, each agency is required to report to Congress on how the agency modified these references to replace them with alternative standards that the agency determined to be appropriate.
Public comments on the rule amendments should be received within 60 days after they are published in the Federal Register.

Credit rating agencies are organizations that rate the credit-worthiness of a company or a financial product, such as a debt security or money market instrument. These credit ratings are often considered by investors evaluating whether to purchase securities.
In passing the Dodd-Frank Act, Congress included a provision in Section 939A that requires every federal agency to review rules that use credit ratings as an assessment of credit-worthiness. At the conclusion of this review, each agency is required to report to Congress on how the agency modified these references and replaced them with alternative standards that the agency determined to be appropriate.
The SEC is one such agency that has adopted rules over the years that reference credit ratings in assessing the credit-worthiness of a security. Among other things, the SEC’s net capital rule requires broker-dealers to maintain certain amounts of liquid assets (net capital) in the event that the broker-dealer fails. In computing this “net capital” amount, existing rules rely on credit ratings to determine the value of certain securities that broker-dealers are holding.
In addition, in Section 939(e) of the Dodd-Frank Act, Congress required credit rating references to be removed from certain sections of the Exchange Act that define the terms “mortgage related security,” and “small business related security.” In place of the credit rating references, Congress added language stating that a mortgage related security and a small business related security instead will need to satisfy “standards of credit-worthiness as established by the Commission.” This replacement language will go into effect on July 21, 2012.
The Commission today proposed rules that would replace such references in certain existing rules and would request comment on how to implement Section 939(e) of the Act.
Earlier this year, the SEC proposed rules that would change existing rules related to money market funds that allowed such funds to only invest in securities that have received one of the two highest categories of short-term credit ratings. Additionally, the SEC proposed amendments to its rules that would remove credit ratings as one of the conditions for companies seeking to use short-form registration when registering securities for public sale.
The Proposals
Removing References to Credit Ratings in the SEC’s Net Capital Rule for Broker-Dealers
Current rule: Rule 15c3-1, the “net capital rule,” requires broker-dealers to maintain specified minimum levels of liquid assets, or net capital. The rule is designed to protect the customers of a broker-dealer from losses upon the broker-dealer’s failure. Among other things, the net capital rule requires that broker-dealers, when computing net capital, apply a lower net capital deduction (or “haircut”) to certain proprietary securities positions in commercial paper, nonconvertible debt, and preferred stock if the securities are rated in higher rating categories by at least two Nationally Recognized Statistical Rating Organizations (NRSROs). That is, broker-dealers do not have to deduct as much from their net capital with respect to these securities because these securities typically are more liquid and less volatile in price than securities that are rated in lower rating categories or are unrated.
Proposed rule: The SEC is proposing to remove from the net capital rule all references to credit ratings and substitute an alternative standard of creditworthiness. Under the proposal, a broker-dealer would be required to take a 15 percent haircut on its proprietary positions in commercial paper, nonconvertible debt, and preferred stock unless the broker-dealer has a process for determining creditworthiness that satisfies the criteria described below. However, as is the requirement in the current rule, if these types of securities do not trade in a ready market as defined in the rule, they would be subject to a 100 percent haircut – meaning that the broker-dealers cannot include the value of these securities in their net capital. The 15 percent haircut is derived from the catchall haircut amount that applies to securities not specifically identified in the net capital rule as having an asset-class specific haircut, provided the security is otherwise deemed to have a ready market. It is also the haircut applicable to most equity securities.
If a broker-dealer establishes, maintains, and enforces written policies and procedures for determining creditworthiness under the proposed amendments, the broker-dealer would be permitted to apply the lesser haircut requirement currently specified in the net capital rule for commercial paper (between zero and ½ of 1 percent), nonconvertible debt (between 2 and 9 percent), and preferred stock (10 percent) when the creditworthiness standard is satisfied. Under this proposal, in order to use these lower haircut percentages for commercial paper, nonconvertible debt, and preferred stock, a broker-dealer would be required to establish, maintain, and enforce written policies and procedures designed to assess the credit and liquidity risks applicable to a security, and based on this process, would have to determine that the investment has only a “minimal amount of credit risk.”
Under the proposed amendments, a broker-dealer could consider the following factors to the extent appropriate when assessing credit risk for purposes of the net capital rule: (1) credit spreads; (2) securities-related research; (3) internal or external credit risk assessments; (4) default statistics; (5) inclusion on an index; (6) priorities and enhancements; (7) price, yield and/or volume; and (8) asset class-specific factors. The range and type of specific factors considered would vary depending on the particular securities that are reviewed.
Each broker-dealer would be required to preserve, for a period of not less than three years, the written policies and procedures that the broker-dealer establishes, maintains, and enforces for assessing credit risk for commercial paper, nonconvertible debt, and preferred stock. Broker-dealers would be subject to this requirement in the SEC’s broker-dealer record retention rule, Exchange Act Rule 17a-4.
Removing References to Credit Ratings in the Definition of “Major Market Foreign Currency”
Current rule: Appendix A to Rule 15c3-1 allows broker-dealers to employ theoretical option pricing models in determining net capital requirements for listed options and related positions. Broker-dealers also may elect a strategy-based methodology. The purpose of Appendix A is to simplify the net capital treatment of options and accurately reflect the risk inherent in options and related positions. Under Appendix A, broker-dealers’ proprietary positions in “major market foreign currency” options receive more favorable treatment than options for all other currencies when using theoretical option pricing models to compute net capital deductions. The term “major market foreign currency” is defined to mean “the currency of a sovereign nation whose short term debt is rated in one of the two highest categories by at least two nationally recognized statistical rating organizations and for which there is a substantial inter-bank forward currency market.”
Proposed rule: With respect to the definition of the term “major market foreign currency,” the SEC is proposing to remove from that definition the phrase “whose short-term debt is rated in one of the two highest categories by at least two nationally recognized statistical rating organizations.” The change would modify the definition of that term to include foreign currencies only “for which there is a substantial inter-bank forward currency market.” The SEC is also proposing to eliminate the specific reference in the rule to the European Currency Unit (ECU), which is identified by the rule as the only major market foreign currency under Appendix A. Because of the establishment of the euro as the official currency of the euro-zone, a specific reference to the ECU is no longer needed. A specific reference to the euro also is not necessary, as it is a foreign currency with a substantial inter-bank forward currency market.
Removing References to Credit Ratings When Determining Net Capital Charges for Credit Risk
Current rule: A broker-dealer may apply to the SEC for authorization to use the alternative method for computing capital (the alternative net capital, or “ANC,” computation) contained in Appendix E to the net capital rule. Under Appendix E, firms that have been determined to have robust internal risk management practices may utilize the mathematical modeling methods they use to manage their own business risk, including value-at-risk (VaR) models and scenario analysis, to compute deductions from net capital for market and credit risks arising from OTC derivatives transactions. OTC derivatives dealers may also apply to the SEC to use VaR models to calculate capital charges for market risk and to take alternative charges for credit risk under Appendix F.
Proposed rule: Under Appendix E and Appendix F to the net capital rule, broker-dealers subject to the ANC computation and OTC derivatives dealers, respectively, are required to deduct from their net capital credit risk charges that take counterparty risk into consideration. This counterparty risk determination is currently based on either NRSRO ratings or a dealer’s internal counterparty credit rating. To comply with Section 939A of the Dodd-Frank Act, the SEC is proposing to remove references to NRSRO ratings from Appendices E and F to Rule 15c3-1 and to make conforming changes to Appendix G and the form that OTC derivatives dealers periodically file with the SEC, Form X-17A-5, Part IIB.
Removing References to Credit Ratings in Rule 15c3-3
Current rule: Rule 15c3-3 under the Exchange Act protects customer funds and securities held by broker-dealers. In general, Rule 15c3-3 has two parts.
The first part requires a broker-dealer to have possession or control of all fully paid and excess margin securities of its customers. In this regard, a broker-dealer must make a daily determination in order to comply with this aspect of the rule.
The second part covers customer funds and requires broker-dealers subject to the rule to make a periodic computation to determine how much money it is holding that is either customer money or money obtained from the use of customer securities (credits). From that figure, the broker-dealer subtracts the amount of money that it is owed by customers or by other broker-dealers relating to customer transactions (debits). If the credits exceed debits after this “reserve formula” computation, the broker-dealer must deposit the excess in a “Special Reserve Bank Account for the Exclusive Benefit of Customers” (a Reserve Account). If the debits exceed credits, no deposit is necessary. Funds deposited in a Reserve Account cannot be withdrawn until the broker-dealer completes another computation that shows that the broker-dealer has on deposit more funds than the reserve formula requires.
Exhibit A to Rule 15c3-3 contains the formula that a broker-dealer must use to determine its reserve requirement.
Under Note G to Exhibit A, a broker-dealer may include required customer margin for transactions in security futures products as a debit in its reserve formula computation if:
That margin is required.
That margin is on deposit at a clearing agency or derivatives clearing organization that either:

Maintains the highest investment-grade rating from an NRSRO.
Maintains security deposits from clearing members in connection with regulated options or futures transactions and assessment power over member firms that equal a combined total of at least $2 billion, at least $500 million of which must be in the form of security deposits.
Maintains at least $3 billion in margin deposits.
Obtains an exemption from the Commission.
Proposed rule: The SEC is proposing to remove the first criterion described above (the highest investment-grade rating from an NRSRO). The criteria are disjunctive and, therefore, a clearing agency or derivatives clearing organization needs to satisfy only one criterion to permit a broker-dealer to treat customer margin as a reserve formula debit. While one potential criterion would be removed, there is only one clearing agency for security futures products (namely, the Options Clearing Corporation) and that clearing agency would continue to qualify under each of the other applicable criteria. If a new registered clearing agency or derivatives clearing organization could not meet one of the remaining criteria, a broker-dealer may request an exemption for the clearing agency or organization under the rule.
Removing References to Credit Ratings in Rules 101 and 102 of Regulation M
Current rule: Regulation M is a set of anti-manipulation rules designed to preserve the integrity of the securities market by prohibiting activities that could artificially influence the market for an offered security. Rules 101 and 102 of Regulation M specifically prohibit certain persons, such as issuers and underwriters from directly or indirectly bidding for, purchasing, or attempting to induce another person to bid for or purchase a “covered security” for a specified period of time. In particular the rules currently include an exception for “investment grade nonconvertible and asset-backed securities.” These exceptions apply to nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities that are rated by at least one NRSRO in one of its generic rating categories that signifies investment grade.
Proposed rule: The SEC’s proposal would instead provide an exception for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities from Rules 101 and 102 if they: (1) are liquid relative to the market for that asset class; (2) trade in relation to general market interest rates and yield spreads; and (3) are relatively fungible with securities of similar characteristics and interest rate yield spreads. The proposed standards are an attempt to identify the subset of trading characteristics of these securities that make them less prone to the type of manipulation that Regulation M seeks to prevent. Under the proposal, a person seeking to rely on the exception would make the determination that the security in question meets the proposed standards. The determination would be required to be made utilizing reasonable factors of evaluation and would be required to be subsequently verified by an independent third party.
Removing References to Credit Ratings in Rule 10b-10
Current rule: Rule 10b-10, the Commission’s customer confirmation rule, generally requires that broker-dealers effecting securities transactions on behalf of customers provide to their customers, at or before completion of the securities transaction, a written notification with certain basic transaction terms. Under Rule 10b-10(a)(8), broker-dealers must disclose to customers in debt security transactions if the debt security is unrated by an NRSRO.
Proposed rule: When paragraph (a)(8) of Rule 10b-10 was adopted in 1994, the SEC indicated that this additional disclosure was not intended to suggest that an unrated security was riskier than a rated security; rather, it was intended to prompt a dialogue between the customer and the broker-dealer in the event that the customer was not aware of the unrated status prior to the transaction. Although the disclosure required by Rule 10b-10(a)(8) may not necessarily come within the mandate of Section 939A, the SEC is proposing to delete this reference in light of the SEC’s prior proposals to do so and because it would be consistent with the broader efforts under the Dodd-Frank Act to reduce direct, and in this case, indirect, reliance on NRSRO ratings.
Requests for Comment on Section 939(e) of the Dodd-Frank Act
Section 939(e) of the Dodd-Frank Act deleted Exchange Act references to credit ratings by NRSROs in Exchange Act Section 3(a)(41), which defines the term “mortgage related security,” and in Exchange Act Section 3(a)(53), which defines the term “small business related security.” The credit rating references in Sections 3(a)(41) and 3(a)(53) effectively exclude from the respective definitions securities that otherwise meet the definitions but are not rated by at least one NRSRO in the top two credit rating categories in the case of mortgage related securities or in the top four credit rating categories in the case of small business related securities.
In place of the credit rating references, Congress added language stating that a mortgage related security and a small business related security will need to satisfy “standards of credit-worthiness as established by the Commission.” This replacement language will go into effect on July 21, 2012. Before that time, the Commission will need to establish a new standard of creditworthiness for each Exchange Act definition. To assist the Commission in considering how to implement Section 939(e) of the Dodd-Frank Act, the Commission is requesting comment on potential “standards of credit-worthiness” for purposes of Sections 3(a)(41) and 3(a)(53)”

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