Hearing on Bank Mergers and Subprime Mortgage Credit Problems

From Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Subcommittee on Domestic Policy Committee on Oversight and Government Reform

United States House of Representatives

Hearing on Bank Mergers and Subprime Mortgage Credit Problems

Cleveland, Ohio May 21, 2007

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The One-Page Mortgage Disclosure Proposal

When considering borrowers in financial trouble, whether from unwise borrowing, not having understood the loan, or even induced into loans by misrepresentation, there is a natural political reaction to try to protect them through credit regulation.

I believe a superior strategy is to equip borrowers to protect themselves by requiring short, simple and clear disclosures of the key mortgage loan terms and their relation to household income. The borrowers can then “underwrite themselves.” They have the natural incentive to do so—we need to add intelligible, practical information.

To help address the shortcomings of the subprime market which have become evident, I believe a new, superior disclosure approach is needed, whether or not we do anything else. The key is to realize that complex, lengthy statements in regulatoryese and legalese do not achieve the goal. Moreover, the simple, clear disclosure should be focused on the financial impact on the borrower, not on the financial instruments.

Thus I propose there should be a required one-page form which gives the essentials of the loan and its monthly cost, which must be given to every mortgage borrower three days before closing. 2

A good mortgage lender wants a borrower who understands how the loan will work, including any possible future interest rate increases and prepayment penalties. The total monthly obligation needs to be put clearly in the context of the borrower’s income.

Current American mortgage loan documents certainly do not achieve this. Most of us have had the experience of being overwhelmed and befuddled by the huge stack of documents full of confusing language in small print presented to us for signature at a mortgage closing. The complexity results from legal and compliance requirements. Ironically, past regulatory attempts to insure full disclosure have made the problem worse. That is because they attempt full, rather than relevant, disclosure.

To achieve an informed borrower, the key information must be simply stated and clear, in regular-sized type: 90% of the relevant information which is clear and understandable is far better than 100% of the details which are complex and hard to read. Trying to describe the details in specific legal and bureaucratic terms results in essentially zero information transfer to the borrower.

The one-page form should include key underwriting concepts, including the borrower’s income and housing expense ratio, as well as principal loan terms. The “housing expense ratio” means the sum of the monthly interest payment, principal payment, property tax, and house insurance premium, expressed as a percent of the borrower’s monthly income. This should be shown for both the initial interest rate and the fully-indexed interest rate. In typical types of subprime loans, the fully-indexed expense ratio can be a remarkably larger burden than the initial or “teaser” rate suggests.

The proposed one-page “Basic Facts About Your Mortgage Loan” form, with accompanying common sense explanations and avuncular advice, is Attachment 1.

One of the deans of mortgage journalists has written of how the one-page proposal is distinct from previous regulations and simplification attempts. His article is also attached.

Whatever else is done or not done, I believe the one-page disclosure would be an important step forward for America’s and Ohio’s mortgage borrowers and housing finance system.

How to Improve the Credit Rating Agency Sector

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Committee on Banking, Housing and Urban Affairs

United States Senate 

Hearing on Assessing the Current Oversight and Operations of Credit Rating Agencies

March 7, 2006

How to Improve the Credit Rating Agency Sector

Good morning, Mr. Chairman, Ranking Member Sarbanes and members of the Committee.  Thank you for the opportunity to testify today.  I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views on the need to reform the credit rating agency sector.

It is important and timely for Congress to address this issue.  There is no doubt that the existing SEC regulation and practice represents a significant anti-competitive barrier to entry in the credit rating business, although this was not intended when the regulation was introduced 30 years ago.  Nonetheless, the actual result of the SEC’s actions, and in recent years, inaction, has been to create what is in effect a government-sponsored cartel.

A few weeks ago Barron’s magazine had this to say about the two leading rating agencies:

     “Moody’s and Standard and Poor’s are among the world’s great businesses.  The firms amount to a duopoly and they have enjoyed huge growth in revenue and profits in the past decade.”

Barron’s continues:

     “Moody’s has a lush operating profit margin of 55%...S&P’s [is] 42%.”

An equity analyst’s investment recommendation from last year explains the reason for this exceptional and enviable profit performance: 

     “Companies are not unlike medieval castles.  The most successful are that boast some sort of economic moat that makes it difficult, if not impossible, for competitors to attack or emulate.  Thanks to the fact that the credit ratings market is heavily regulated by the federal government, rating agencies enjoy a wide economic moat.”  (emphasis added)

This is an accurate assessment. 

I recommend that Congress remove such government-created protection or “economic moat,” and promote instead a truly competitive rating agency sector, with all the advantages to customers that competition will bring, including better prices, more customer choice, more innovation, greater efficiency, and reduced potential conflicts of interest. 

I believe that the time has come for legislation to achieve this. 

Instead of allowing the SEC to protect the dominant firms (in fact, if not on purpose), in my view Congress should mandate an approach which is pro-competitive and pro-market discipline.  Last year the AEI  published an article of mine (attached for the record) entitled, “End the Government-Sponsored Cartel in Credit Ratings”:  I respectfully hope Congress will do so this year. 

The “NRSRO” Issue

In the best theoretical case, not only the designation by the SEC of favored rating agencies, but also the regulatory term “NRSRO” would be eliminated.  The term has produced unintended effects never imagined when it was introduced in 1975, and in theory it is unquestionably time for it to retire.

In its place, the responsibility to choose among rating agencies and their services should belong to investors, financial firms, issuers, creditors and other users of ratings—in short, to the market.  A competitive market test, not a bureaucratic process, will then determine which rating agencies turn out to be “widely accepted by the predominant users of ratings,” and competition will provide its normal benefits.

This is altogether different from the approach taken in proposals by the SEC staff, which in my opinion, are entirely unsatisfactory.

Very much in the right direction is the bill introduced in the House by Congressman Michael Fitzpatrick, HR 2990. 

This bill directly addresses the fact that a major practical obstacle to reform is that the SEC’s “NRSRO” designation has over three decades become enshrined in a very large and complex web of interlocking regulations and statutes affecting thousands of financial actors.  The combined effect is to spread the anti-competitive force of the SEC’s regulation throughout the financial system, with too few customer alternatives, too little price and service competition, and the extremely high profits for the favored firms, as we have already noted.  But how can we untangle this regulatory web?

As you know, HR 2990 does so in what I think is an elegant fashion by keeping the abbreviation “NRSRO,” but completely changing its meaning.  By changing the first “R” from “Recognized” to “Registered,” it moves from a restrictive designation regime, to a pro-competitive disclosure regime.  This change, in my view, is in the best tradition of American financial market theory and practice: competition based on disclosure, with informed investors making their own choices. 

Voluntary Registration 

Becoming an “NRSRO” is now, and would be under a registration approach, an entry into the regulated use of your ratings by regulated financial entities.  Therefore I believe that registration in a new system should be entirely voluntary.  If any rating agency wants to continue as simply a private provider of ratings to customers who make such use of them as they desire, other than regulatory use, it should continue as it is, with no requirement to register.  But if it wants to be an “NRSRO,” the way is plain and open.

I think this voluntary approach entirely removes the First Amendment arguments which have been made against HR 2990. 

Rating Agency Pricing Models

An extremely important advantage of a voluntary registration, as opposed to an SEC designation, regime is that it would allow multiple rating agency pricing models to compete for customer favor.  The model of the dominant agencies is that securities issuers pay for credit ratings.  Some critics argue that this creates a conflict of interest.

The alternative of having investors purchase the credit ratings arguably creates a superior incentive structure.  This was the original historical model for the first 50 years of the rating agency business.  If investors pay, it obviously removes the potential conflict of interest and any tendency toward a “race to the bottom” in ratings quality.

In my view, there should be no regulatory or legal prescription of one model or the other:  the market should use whichever credit rating providers best serve the various needs, including the regulatory needs, of those who use the ratings. 

Transition to a New Regime

The decentralization of decisions entailed by a competitive, disclosure-based regime is wholly positive.  Investors and creditors, as well as multiple regulatory agencies, should have to think about how credit ratings should be used and what related policies they wish to adopt.  They should be expected to make informed judgments, rather than merely following an SEC staff decision about whether somebody is “recognized.”

The worst outcome, to be avoided in any case, would be regulation of actual credit ratings by the SEC, or (what would come to be equivalent) regulation of the process of forming credit ratings.  This would be a worse regime than we have now.

Of course, a fully competitive rating agency market will not happen all at once.  There are significant natural (as well as the SEC’s artificial) barriers to entry in this sector, including the need to establish reputation, reliability, and integrity; the prestige factor involved in the purchase of opinions and judgments; and the inherent conservatism of institutional risk management policies.  Nevertheless, in time, innovation and better products can surmount such barriers, when not prevented by regulation.

Because the desirable transition to a competitive rating agency sector would be evolutionary, I believe any concern about disrupting the fixed income markets is misplaced. 

It is important to remember that no matter what the rating agency regime may be, we simply cannot hope for 100% success in predicting future credit performance.  There will never be a world in which there are no ratings mistakes, any more than in any other endeavor which makes judgments about future risks and uncertainties.  But this fact only emphasizes the importance of a vibrant marketplace of ratings opinions, analysis, ideas, forecasts, and risk assessments. 

On timing, the “NRSRO” issue has been a regulatory issue and discussion for a decade, in what seems to me a dilatory fashion.  My recommendation is that Congress should now settle the issue of competition vs. cartel in this key financial sector, moving to create the best American model of competition and disclosure, rather than prescription and government sponsorship. 

This will bring in time better customer service, more innovation, more customer alternatives, greater price competition, and reduced duopoly profits, and indeed better credit ratings will emerge.

Thank you again for the chance to be here today.