Getting the House in Order

Financial institution boards will face many issues associated with the current financial crisis, including issues related to the Emergency Economic Stabilization Act of 2008 (EESA), the recently-passed stimulus program, Obama's foreclosure prevention program, and whatever else comes out of the Administration and Congress. Many—perhaps most—decisions will require an understanding of the mortgage-backed securities (MBS) that played such a central role in the deterioration of our largest financial institutions.

Clearly boards must be careful not to undertake the responsibilities of management. Nevertheless, given the mistakes made with respect to MBS, boards will want to subject management at financial services companies to higher scrutiny and oversight regarding their involvement with these and other exotic securities. To do so, they will first need to determine whether there is sufficient expertise on the board and if not they will need to acquire it.

The task is easier said than done. MBS comprise a sophisticated alphabet soup of complex financial instruments, including securities backed by subprime, Alt A, negative amortization, home equity and commercial mortgage loans, as well as collateralized debt obligations (CDOs) backed by asset-backed securities (ABS) , and CDOs squared (which are backed by tranches of CDOs of ABS.) Investment banks leveraged these securities at 35 to 1. Insurance companies bought them to back obligations such as guarantied investment contracts (GICs), annuities and funding agreements. Bond insurers then guarantied and reinsured them, and commercial banks' bought and guarantied them with credit default swaps (CDS).

Defaults on the mortgages underlying these securities triggered steep market value declines, markdowns, capital depletion, rating downgrades, plummeting stock prices, all of which resulted in limitations on the ability to raise needed equity and write loans and insurance products. Yet, an examination of financial institution boards prior to and during the meltdown, and even now, reveals a surprising lack of direct expertise in these securities. And although closer scrutiny and oversight may seem a bit like closing the proverbial barn door, many experts believe that there will be substantially more markdowns of MBS. Indeed, Goldman Sachs, in a February 11, 2009 report stated "We're only halfway through: We forecast $2.1 trillion in losses from U.S. credit this cycle." The current environment will continue to present issues associated with MBS, as well as other issues raised by the financial crisis, that will require increased board oversight and its related expertise.

In fact, in late February, newly appointed Securities and Exchange chairman, Mary Schapiro indicated that she plans to examine whether boards of banks and other financial services firms conducted effective oversight during the period leading up to the financial crisis. At the same time she is considering asking boards to disclose more about directors' backgrounds and skills and their knowledge of risk management, according to a recent article in the Washington Post.

Asset Liability Analysis

Boards, through their Risk Oversight Committees, might want to increase their scrutiny of how assets and liabilities are performing currently: how they performed under the company's stress tests, whether those tests impose enough stress, and the extent to which assets match liabilities, particularly if liabilities are accelerated and assets have to be liquidated to meet them in markets that may become frozen. Boards may also inquire more deeply regarding MBS default projections, the assumptions underlying these projections and the reasonableness of the company's methodology. With respect to CDOs of ABS and CDOs squared, it is important to understand the institution's rights relative to the rights of others. For example the rights of the institution as a holder of a AAA tranche of a CDO squared are subordinate to the rights of the AA holder of the CDO of ABS in which the CDO squared holds the BBB tranche.

Disclosure by companies of additional asset markdowns after they announced that they didn't expect any more has undermined confidence in financial institutions. These markdowns reduced earnings, depleted capital and eroded confidence among equity investors, sending stocks into a tailspin and limiting the company's ability to raise badly needed capital. If the experts who believe that there is more to come turn out to be right, it will be even more important for boards to become comfortable with their companies' mark to market methodologies.

The performance of many liabilities can be even more troublesome. Banks face issues with respect to triggers in their credit default swaps that can result in termination events and the need to post capital in the event of a ratings downgrade. Insurance companies issued GICs and funding agreements that can be accelerated in certain events, such as rating downgrades. "Full flex" GICs can be accelerated under many circumstances—almost at will, and municipal GICs can be accelerated under other circumstances. Annuities have similar considerations. Some funding agreements have short roll-over periods and can be terminated on short notice. Moreover, given the current environment and the likelihood that policy holders will need cash, does the institution have an efficacious methodology of forecasting cash surrenders? Sadly, many of the assets backing these liabilities are MBS, and their liquidation values have plummeted. As a result, which assets does the institution sell to meet their obligations? These and other variables must be clearly modeled out and analyzed—not only for the purpose of avoiding risk, but of understanding them and all the attendant consequences.

The declines in the values of assets backing liabilities that are accelerating raises the need for liquidity. Boards should understand the extent of this need and ensure that management has arranged for multiple sources of robust liquidity that can be depended on during a crisis.

Also, Board's may want to better understand the extent to which a company is at risk of a credit ratings downgrade due to capital adequacy (and other) issues. This is especially important now that rating agencies are downgrading securities backing and backed by financial institution obligations. The agencies are basing these models now on the acceleration of certain liabilities and liquidation values—as opposed to the future cash flows — of the companies' assets. Downgrades not only can accelerate liabilities, require collateral posting and trigger rights to recapture ceded reinsurance, they can also effectively preclude the writing of new business for some institutions.

Under some circumstances, it has been productive for board members to meet directly with rating agencies, particularly if a company has been put on review for a downgrade that will limit the company's ability to do business.

Reserves, too are ripe for renewed focus by board directors. Originally, they were considered the purview of the Audit Committee and informed by the company's auditors as they form a large part the factors in dealing with expected losses and the period over which they will occur. Boards now need a much more comprehensive understanding of how management calculates its reserves and whether its methodology is consistent with statutory, regulatory, GAAP and rating agency requirements, as well as conventional practices.

Boards and Risk Governance

Boards might also want to subject their company's risk tolerance levels to more scrutiny. For example, the boards might inquire more deeply regarding the price volatility of securities in its investment portfolio that may have to be sold to pay claims or other obligations. Boards may also want to question management regarding the correlation risk along references (issuers) and sectors within the corporate CDOs held in the investment portfolio or guarantied through CDS. For example, they'll want to know if the company exposed to the California economy through both its municipal bonds and its MBS holdings? What levels of leverage are acceptable given the price volatility of the securities leveraged?

Moreover, the board should determine that management has a system in place that assures compliance with risk tolerance levels once they are set—a challenge that proved difficult for many financial institutions in the recent past. The board might also want the risk and business functions of the company to be more separate than they are. For instance, analysts who set the company's credit criteria should report to the Chief Risk Officer and the latter should report to both the CEO and the board's Risk Oversight Committee or the full board.

Sell or Hold and TARP

The decision to sell or hold assets, whether to TARP or in negotiated sales to the private sector, involves the need to model future cash flows and assign present values to them. Indeed, a bank may realize more from its MBS by holding to maturity or until future credit losses become more ascertainable than by selling as the massive liquidations of MBS from margin calls have in all likelihood forced prices down beyond the present value of their future cash flows. Moreover, a bank that sells MBS will forego any subsequent markup and its attendant increase in capital (for this reason, a guaranty of MBS under Section 102 of EESA would be preferable). As a result, selling at depressed prices might be the wrong decision and inconsistent with management's and the board's obligations to shareholders. On the other hand, holding MBS will be attended by market uncertainty regarding the extent of future losses. Boards should inquire enough of management to become comfortable with the balancing of these considerations.

The decision to take TARP money or other government funding must be made in light of the government's insistence on lending which can be inconsistent with the board's and management's duties to shareholders to make prudent loans. It also must consider potential dilution of existing shareholders and executive pay limitations that could damage the ability to attract needed talent. Accepting government funds often, maybe always, carries a stigma—a perception that failure is possible.

Government Action and Policy

Boards should be aware of potential legislative and regulatory changes motivated by the financial crisis, how they can impact their companies, whether and how their companies should try to influence their outcomes, and how their companies plan to adjust if these changes are implemented. Perhaps the most visible are the panoply of actions contemplated by the mortgage assistance program, the stimulus package, EESA and the to-be-announced actions to be taken by the federal government in connection with banks. Also, changes are being contemplated by state insurance regulators that are likely to impact insurance and financial guaranty companies.

The notion of removing ratings from the federal, state and international regulatory schemes has been uttered and, if implemented, would change the way capital is calculated for depository institutions, insurance companies, and stock brokers. The elimination of the NRSRO designation—another thought that has been advanced by some — would require changes in state legal investment laws, mutual fund prospectuses and other documents containing investment eligibility criteria (that limit investments to certain rating categories) to allow many institutional investors to continue to purchase debt instruments issued by financial institution (and all other companies).

FASB, the SEC and insurance regulators continually debate whether to allow financial institutions to mark to model instead of to market. Boards will need to understand and become comfortable with the reasonableness of substitute valuation methods and models, how their results might impact the company, and whether they are consistent with their auditors' views.

Some financial institution boards will be faced with the decision whether to become a bank holding company and will have to consider the institution's needs for access to insured deposits as a low cost source of capital, access to the Fed for low-cost liquidity and to exchange illiquid, high beta collateral (e.g. highly rated MBS) for treasuries that can satisfy collateral posting requirements required by CDS and other contracts, and the benefits associated with the imprimatur of government support. On the other hand, boards will have to consider the disadvantages of becoming a bank holding company, such as becoming part of an unprofitable banking system that competes with unsupervised financial firms, lower leverage limits (although investment bank leverage limits are likely to be as low in future), becoming subject to risk-based capital rules (Basel II, for example), increased costs due to the need to install systems necessary to comply with government reporting requirements, increased supervision and regulation attended by additional costs and overhead, and the difficulty in becoming a non-bank holding company if the company chooses to do so in future.

Long vs. Short Term

Finally, some decisions may be in the interests of the institution, at least in the short run, but may be damaging to the economy as a whole and, in the long run, come back to damage the institution and, perhaps the entire sector. For example, lending to less creditworthy borrowers may be above a bank's risk tolerance levels; but if all major banks were not willing to make such loans, funding for businesses could be inadequate to maintain operations, which could result in higher unemployment, a further contraction in consumer spending, more business failures, even higher unemployment and an increase in the velocity and severity of the existing economic downturn.

Also, foreclosure might be preferable to forbearance and mortgage modification (including reducing the principal amount of the mortgage) in order to minimize losses associated with home mortgages. But foreclosure would also add to the massive number of homes on the market, exacerbate the downward spiral of housing prices, result in more markdowns of MBS and, consequently, further deplete bank capital. As importantly, foreclosures prevent a bottoming of home prices, MBS markups and the attendant increase in the availability of home mortgage financing. As a result, home purchases and housing starts, which are the biggest engines to consumer spending, would suffer even more than they do currently. Consequently, because consumer spending constitutes 70 percent of our economy, an early economic recovery would become even less likely.

Because lending to less creditworthy borrowers and forbearance or modification as opposed to foreclosure could have good long-term results only if they were practiced by many large institutions, boards might encourage management to determine whether coordination with federal authorities and other institutions in their sector might be beneficial.

To be sure, boards should not undertake functions that are more appropriately the responsibility of management. Clearly boards should not build their own risk, default or price volatility models, or develop their own reserve methodologies or presentations to rating agencies. Nor should they impose on management a system that, in the board's opinion, ensures compliance with risk tolerance guidelines. But the extent of oversight and scrutiny over these functions should be determined in large part by what is at stake for the company and its shareholders. It would seem that history has taught us that, given the current environment, the decisions discussed above are high stakes decisions that require high levels of board scrutiny and oversight as well as a deep and thorough interaction with management.

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