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News Release 2008-22
February 27, 2008
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NEW YORK—Comptroller of the Currency John C. Dugan today outlined steps that should be considered in response to the very large losses incurred by banks and other investors who held tranches of securities that were considered so safe as to be almost impervious to loss.
"These better-than-triple A tranches were supposed to be the least risky parts of the subprime securities pyramid," Mr. Dugan said in a speech to the Global Association of Risk Professionals. "Instead they have generated the clear majority of reported subprime writedowns in capital markets, which in turn have been at the core of several of the worst episodes of the market's disruptions."
The losses came from so-called "super senior" tranches of collateralized debt obligations consisting of securities backed by subprime mortgages, or "subprime ABS CDOs." Because these CDO tranches carried triple A ratings, even risk averse and regulated firms, like banks, insurance companies, and money market mutual funds, felt comfortable investing in these securities, either directly or indirectly through conduits, and some of the firms involved in structuring the securities apparently felt safer in keeping very large concentrations of these assets on their books.
But the systematic weakening in subprime underwriting standards, combined with a significant decline in house price appreciation throughout the country, resulted in a sharp spike in defaults and delinquencies. And that in turn led to rating downgrades and exceptionally large mark-to-market losses on the super-senior tranches of ABS CDOs.
Among the steps that should be considered, Comptroller Dugan said, are improvements in underwriting standards for subprime mortgages.
"While national banks were not the primary originators of subprime mortgages that have gone bust—they originated just 10 percent of such mortgages in 2006, for example, with lower delinquency rates than the national average—the OCC has joined other regulators in raising standards across the board for all banking organizations," the Comptroller said. "The challenge will be to extend these standards in a meaningful way to nonbank lenders and brokers regulated exclusively by the states."
The Comptroller also urged changes in the approach rating agencies take to rating subprime ABS CDOs. While "investors should never rely exclusively on credit ratings in making investment decisions, the plain fact is that triple A credit ratings are a powerful green light for conservative investors all over the world," he said.
One critical characteristic of the triple A tranches of securities that caused so much trouble is that they perform differently from other types of triple A rated securities, including corporate securities. In times of severe stress, they may incur exceptionally large losses.
"At a minimum, I believe that the credit rating agencies need to do a much better job in disclosing the distinctions between the likely performance of triple A-rated structured securities and triple A-rated corporate securities," Mr. Dugan said. "If triple A means different things in different contexts, then we all need to know that."
However, he said, neither investors nor regulators should rely exclusively on credit ratings when evaluating the credit risk in a highly rated tranche of an ABS CDO.
"This may seem obvious to everyone now, but exclusive reliance on ratings has been all too common a practice," he added. "There is really no excuse for institutions that specialize in credit risk assessment—like large commercial banks—to rely solely on credit ratings in assessing credit risk."
The Comptroller also said that packagers of ABS CDOs should not retain large concentrations of super-senior tranches on their balance sheet, no matter how low they perceive the risk to be.
"What most differentiated the companies sustaining the biggest losses from the rest was their willingness to hold exceptionally large positions on their balance sheets – which in turn led to exceptionally large losses," Mr. Dugan said.
Finally, Mr. Dugan said that regulators should reconsider the part of the Basel II capital rules that apply to senior tranches of resecuritized structured credit such as subprime ABS CDOs. "For example, should the securitization provisions of Basel II establish a unique set of higher risk weights for ABS CDOs and other re-securitizations, reflecting the higher vulnerability to systemic risk as evidenced by recent events?" he asked.
The Comptroller said that policy makers and market participants should actively consider whether these and other steps might be necessary to avoid future market disruptions.
"I have only touched upon a few of the questions facing policy makers in the coming months," Comptroller Dugan said. "There are many others, and I believe it is our collective responsibility to learn from the current disruptions and take steps now to help prevent a recurrence of the problems in the future."
Kevin M. Mukri (202) 874-5770