Rich Berg, Chief Executive Officer of Performance Trust Capital Partners, testified today in Washington D.C. as an expert witness before the US House of Representatives' House Sub Committee on Banking. The testimony was delivered during a hearing titled "Exploring the Balance Between Increased Credit Availability and Prudent Lending Standards."
Berg, one of 10 experts who testified, focused his comments on how the "one-size-fits-all" approach to rating securities was labeling securitized assets that were performing and delivering cash flows as toxic assets.
"As Congress and Treasury form plans for removing 'toxic assets' off the books of financial institutions through taxpayer assistance in order to get credit flowing again, we need to correctly define toxic assets," Berg said.
Toxic assets are typically identified by the credit ratings provided by ratings organizations such as Standard & Poor's, Moody's or Fitch. The rating scale ranges from AAA (Triple A), AA (Double A), A (Single A)-all the way down to D (default). BBB (Triple B) is generally considered the lowest rung for investment grade. Corporate bonds below investment grade are referred to as "junk" bonds and mortgage bonds and other securitized debt below investment grade are labeled "toxic."
The current rating approach is primarily geared to evaluating fixed income instruments with a single obligor (loan), but not multiple obligors (a pool of loans). As a result, when the current letter-based credit rating is applied to a multi-obligor security, it effectively treats all obligors in default even if only a small percentage-such as 1 percent-of the pool is not performing. In addition, the current rating approach makes no accommodation for purchasing the security at a price that is below 100 cents on the dollar.
"The systemic effect is huge and significantly contributing to the downward spiral we are now witnessing," he said. Credit ratings are hard-coded into current regulations, capital calculations, counterparty agreements, collateral agreements and investment policies, and a CCC rating may trigger cascading negative actions by accountants, regulators, counterparties and investors. "As an institution creeps closer to mandatory regulatory or policy minimums in these areas, it has less tolerance for any risk taking and will hoard more cash," he said.
Berg recommended establishing a numerical scale rating system for multiple obligor securities because single and multiple obligor securities have very different risks.
"We strongly believe that a critical step to restoring credit markets is a revamp of the rating system for multiple obligor securities like mortgage-backed securities," he said. "Unless a major change is made, it will be very difficult to clean up previously issued securities-those already downgraded, or those feared to be downgraded in the future - and the current discussion involving loan modifications will certainly cause a whole new round of downgrades and create more toxic assets," he said.