The Effect Of Dodd-Frank On The Middle Market

Tuesday, November 2, 2010 - 01:00

Editor: Please describe your professional background.

Bible: I have spent my 30-year career at a mixture of public accounting firms and industry. I served as a senior financial executive at GTE (now Verizon) and at General Motors before coming to (now) EisnerAmper LLP. The industries have ranged from core manufacturing to sophisticated financial institutions. So I have a pretty deep and wide background.

Editor: In the light of Dodd-Frank, what current advice are you giving your financial institution clients, such as banks, which have hedge funds or private equity funds? Is there a way to bypass Dodd-Frank, such as by setting up separate subsidiaries to own and manage them?

Bible: There are several pieces to the Dodd-Frank Act that affect our client base, such as the tier 1 capital requirements ratio, executive compensation, the whistleblower provision, and even securitizations. It is really multifaceted, so it is difficult to categorize what we are advising our clients because it is such a broad-based bill. It really depends on the individual client. To date, I have not seen a way to navigate through what is known as the Volcker provision, which basically says that banks cannot sponsor, own, participate or have affiliations with hedge funds or derivative trading. I believe that they eventually will have to get out of the derivatives-trading business.

Editor: With a need for banks to have a higher percentage of primary capital in their capital base, how do you anticipate this will affect their lending activities? How are the asset bases now defined for the tier 1 capital requirement?

Bible: One of the unintended consequences of this measure is that it will discourage banks from making riskier loans. Let me give you a short example. What the regulators look at is what is referred to as the "risk adjusted assets to tier 1 capital ratio." Tier 1 capital is essentially common stock and retained earnings. The assets of an organization are what the organization has invested in, be it securities or loans to customers. Let's say that you start a bank with two dollars of capital. Customers give you deposits for 10 dollars, so you have a total of 12 dollars available to invest. You then invest three dollars in treasury bills, and you make a loan to a company for nine dollars. The way that the calculations work is that there are percentages that get assigned to those investments. An investment in treasuries presumably is not risky, so it gets a 100 percent rating. Let's say that the loan of nine dollars gets a 70 percent rating. So, in this example, you have a portion of the loan with a ratio of 6.3, which is 70 percent of nine dollars (70% x $9 = 6.3) added to the treasuries' ratio worth 3.0 (100% x $3 = 3.0) yielding a total of 9.3. Let's also say that the loan requires a write down of $2 as a result of credit concerns, which reduces retained earnings.

So if you assume that you need to maintain capital of at least 10 percent of this 9.3 number, you will need to retain $1 (rounding .93 to 1) of capital to pass the capital ratio test. In this example, the loan would drag down your ratio below one, which is not permitted. You are not going to be eager to make the more risky loans with the capital that was raised, which tend to be loans to the start-up companies and the smaller businesses, which will drag down your tier 1 capital ratio. The Act also limits what can be included in tier 1 capital and phases out the inclusion of Trust Perferred Securities in tier 1 capital. Banks will not necessarily go into certain markets or extend some credits that they historically may have made, which is not going to help the credit crisis. So, this will be one of the bigger, unintended consequences.

Editor: How will the Volcker Rule affect banks' trading activities?

Bible: When a bank could participate essentially in investment banking activities, it added more profit into the tier 1 capital calculation. It was a nice source of a profitable revenue stream for them that allowed them to engage in more lending activities or take on more risk. Now the Volcker Rule has eliminated this profitable activity; it has also eliminated some "head room" in the tier 1 capital asset ratio - again, influencing riskier credit decisions.

Editor: How will Dodd-Frank affect advisors to hedge funds, private equity funds, and real estate funds? What new standards will be imposed on these funds and their advisors?

Bible: First and foremost, these entities, previously referred to as private pools of capital, now have to register with the SEC, requiring them to comply with the SEC rules and regulations. Information about these funds has never been in the public domain before. So the question then becomes - once that information is in the public domain, what attempt at further regulations will result? It is very much a wait-and-see scenario right now because people just don't know the long-term fallout. Previously, that information only was shared with investors and potential investors, and now it is going to be in the public domain.Then you run into the question of whether the Federal Reserve will wish to regulate those entities from a capital requirement standpoint. They currently tend to be passive taxable entities, which means they don't pay income taxes but pass through their earnings directly to the investors in the funds.

Editor: What corporate governance provisions in the new law negatively affect all public companies?

Bible: There are two provisions that really stand out - one is the new rules on executive compensation and the other is the whistleblower provision intended to remunerate people for blowing the whistle. I find this latter provision very troubling because it just creates a distraction at a time when American business has got enough distractions. I'm sure it was written with all the best intentions, but here again it is going to create a behavior that is going to be counterproductive.

Editor: Do you expect to see short-term pain inflicted on participants in the derivatives market with long-term unintended consequences?

Bible: What we are seeing in the mortgage market goes exactly to your question. Mortgage-backed securities created a significant amount of liquidity in the mortgage market, but it went way beyond the pale of resembling an orderly market. Nevertheless, mortgage-backed securities were formed to provide liquidity in the mortgage market, and for a very long time they accomplished that very efficiently. The derivatives market is similar. Derivatives are created to manage risks, not for investment per se, but some people treated them as investments. They were created to be risk management tools. The more people who are in the market and the stronger the counterparties to these trades, the better it is for risk management. But to the extent you constrain that market, which the new provisions will do because they will eliminate some participants, you eliminate highly creditworthy players. Hence, the cost of managing risk goes up. Some people who have used derivatives in the past may choose not to manage risk through derivatives in the future, and that creates more volatility. What was a very efficient, deep, and liquid market for a lot of derivatives is going to become constrained.

Editor: How do you feel about the derivative exchange that is being proposed?

Bible: It actually could be a very good idea, but the key is that the exchange is only as strong as its participants. If banks are limited in their ability to invest in derivatives and to take positions in derivatives, it is like taking the New York Stock Exchange and saying that if you are north of 48th Street, you can't invest in this. All of a sudden you have lost a lot of liquidity, and the New York Stock Exchange, which is the deepest and broadest in the world, may cease to exist. The exchange is a great idea, but you must have free market participation for it to work.

Editor: What provisions of Dodd-Frank will facilitate raising capital for smaller companies? What effect does the law have on companies with less capital than $75 million in terms of their governance by Sarbanes-Oxley?

Bible: Dodd-Frank is actually good news for smaller companies, despite the fact that it is tougher for smaller companies to borrow money now because the banks have a disincentive to lend to them. In fact, just recently the IPO activities have increased because capital is like water in seeking an outlet. It takes a path of least resistance with a lot of companies going to the public markets.

Now the good news is that if your market capitalization is less than $75 million, you no longer have to comply with the 404(b) requirement or the auditor's testing of management assertions on internal controls, which can be a cost saver. It actually encourages more money to flow into the public markets because that hurdle has been removed. Actually the GAO and the SEC are studying the $75 million threshold, and there is hope that it might be increased.

Editor: How do you think that Dodd-Frank will affect American businesses' competitiveness in the global market?

Bible: That is something that I have been looking at for a number of years. If you look at the market capitalization of the world's publicly traded companies and the global gross domestic product (GDP) of the entire world, you will discover that the markets of the New York Stock Exchange and NASDAQ, which represent about $14 trillion of market capitalization, are greater than the U.S.'s share of GDP of the world.The gap between the market for stocks on the New York Stock Exchange and NASDAQ, and U.S. GDP with respect to what all represent for the entire world, has been coming down, but GDP has been coming down faster than the market capital of stocks that trade on the stock exchanges.It is not a good trend. It suggests that a lot of economic growth has occurred overseas, not in the U.S., and a lot of capital has gone where that economic growth is.

But my big concern is that between healthcare being a private sector cost, the level of litigation in the United States, both of which are unique to the U.S., and just the complexity of all the legislation being proposed - these factors suggest a trend indicating that it is a lot easier to make money in countries other than the United States. If that is where the money is being made, then that is where the capital is going to flow. So it shows that for U.S.-based companies and investors in the NYSE and NASDAQ, the United States as an investment destination is not a good story right now.

Please email the interviewee at peter.bible@eisneramper.com with questions about this interview.