Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council

Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council

should undertake a study to identify high risk lending practices at financial institutions, and evaluate the nature and significance of the impacts that these practices may have on U.S. financial systems as a whole.

¶Recommendations on Inflated Credit Ratings

1. Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory authority to rank the Nationally Recognized Statistical Rating Organizations in terms of performance, in particular the accuracy of their ratings.

2. Help Investors Hold CRAs Accountable. The SEC should use its regulatory authority to facilitate the ability of investors to hold credit rating agencies accountable in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or recklessly fails to conduct a reasonable investigation of the rated security.

3. Strengthen CRA Operations. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies institute internal controls, credit rating methodologies, and employee conflict of interest safeguards that advance rating accuracy.

4. Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity, or that rely on assets from parties with a record for issuing poor quality assets.

5. Strengthen Disclosure. The SEC should exercise its authority under the new Section 78o-7(s) of Title 15 to ensure that the credit rating agencies complete the required new ratings forms by the end of the year and that the new forms provide comprehensible, consistent, and useful ratings information to investors, including by testing the proposed forms with actual investors.

6. Reduce Ratings Reliance. Federal regulators should reduce the federal government's reliance on privately issued credit ratings.

¶Recommendations on Investment Bank Abuses

1. Review Structured Finance Transactions. Federal regulators should review the RMBS, CDO, CDS, and ABX activities described in this Report to identify any violations of law and to examine ways to strengthen existing regulatory prohibitions against abusive practices involving structured finance products.

2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on proprietary trading under Section 619, any exceptions to that ban, such as for market-making or risk-mitigating hedging activities, should be strictly limited in the implementing regulations to activities that serve clients or reduce risk.

3. Design Strong Conflict of Interest Prohibitions. Regulators implementing the conflict of interest prohibitions in Sections 619 and 621 should consider the types of conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6) of this Report.

4. Study Bank Use of Structured Finance. Regulators conducting the banking activities study under Section 620 should consider the role of federally insured banks in designing, marketing, and investing in structured finance products with risks that cannot be reliably measured and naked credit default swaps or synthetic financial instruments.

BACKGROUND

¶Understanding the recent financial crisis requires examining how U.S. financial markets have changed in fundamental ways over the past 15 years. The following provides a brief historical overview of some of those changes; explains some of the new financial products and trading strategies in the mortgage area; and provides background on credit ratings, investment banks, government sponsored enterprises, and financial regulators. It also provides a brief timeline of key events in the financial crisis. Two recurrent themes are the increasing amount of risk and conflicts of interest in U.S. financial markets.