Friday, October 29, 2010

Chairman Volcker's Concerns on Banks Gaming Regulations Applies to Structured Finance Disclosure

Chairman Volcker's concerns about the implementation of the "Volcker Rule" banning proprietary trading in today's Wall Street Journal article, Volcker on his 'Rule' - Keep It Broad, are also relevant for the regulatory efforts to revise disclosure requirements for structured finance securities.

His concern is that narrow or prescriptive rules, like setting the specific data fields that must appear in a structured finance reporting template, invite gamesmanship by the banks that ultimately could allow them to avoid the intent of the rules.

Examples of gamesmanship cited in the article are the efforts of banks and their lobbyists to sway the regulators to write rules in a certain way.  This is an excellent description of the activities of the Association of Financial Markets For Europe (AFME) and the American Securitization Forum (ASF) with regards to structured finance security disclosure.

Particularly susceptible to this form of gamesmanship are Article 122a of the Capital Requirements Directive and SEC Regulation AB.  Article 122a requires European credit institutions that invest in structured finance securities to know what they own and issuers to provide the loan-level performance data so that these investors can do their homework.  Regulation AB establishes disclosure requirements for structured finance securities in the US.

Article 122a and Regulation AB need regulators to define disclosure:  either broadly or with narrow, prescriptive rules.  To be effective for investors, 'what' is disclosed has to be done 'when' it is most relevant.  For example, tender offers for common stock have to be announced when the tender offer is made and not at the end of the month or quarter.

The gamesmanship surrounding Article 122a and Regulation AB has been to focus on 'what' and keep repeating that the current frequency of reporting must be the appropriate 'when' for disclosure since it is the current frequency of reporting.  

As readers of this blog who have taken the Brown Paper Bag Challenge know, investors need current information, what is in the bag right now, if they are going to know what they own and not be blindly betting on the value of the contents of the bag.  Current information, which is only achievable through observable event based reporting, is not the same as existing structured finance reporting practices of once-per-month or less frequently.

For structured finance, the way to keep the structured finance disclosure rules from being gamed is to require issuers to disclose on a borrower privacy protected basis all the loan-level data fields that they track on an observable event basis.  Where observable events include activities like payments, delinquencies, defaults, insolvency and identification, acceptance or denial of representation and warranty claims

Thursday, October 28, 2010

Free Lunch: Part III

There is another way for the Fed to acquire the non-agency residential mortgage backed securities from the bank balance sheets.  It could simply exchange agency RMBS for the non-agency RMBS.

Wednesday, October 27, 2010

The Failure of Models that Predict Failure

Attached is a very interesting article from the academic community.  The key takeaway is that disclosure  regulations for structured finance need to require all variables tracked by the lender be reported to investors.  Otherwise, information that is necessary for analyzing the credit risk is missing.

I added the bold emphasis in the article abstract:

Statistical default models, widely used to assess default risk, are subject to a Lucas critique. We demonstrate this phenomenon using data on securitized subprime mortgages issued in the period 1997--2006. As the level of securitization increases, lenders have an incentive to originate loans that rate high based on characteristics that are reported to investors, even if other unreported variables imply a lower borrower quality. Consistent with this behavior, we find that over time lenders set interest rates only on the basis of variables that are reported to investors, ignoring other credit-relevant information. The change in lender behavior alters the data generating process by transforming the mapping from observables to loan defaults. To illustrate this effect, we show that a statistical default model estimated in a low securitization period breaks down in a high securitization period in a systematic manner: it underpredicts defaults among borrowers for whom soft information is more valuable. Regulations that rely on such models to assess default risk may therefore be undermined by the actions of market participants.


Uday Rajan 
University of Michigan at Ann Arbor - Stephen M. Ross School of Business

Amit Seru 
University of Chicago - Booth School of Business

Vikrant Vig 
London Business School

Clarity is the Purpose of Disclosure

"Disclosure has come to be a dirty word. Disclosure has become like shrubbery, a dense thicket of words that are a good place to hide tricks and traps. Clarity is about emphasizing the key pieces of information that someone needs to know... I have great faith in the capacity of people to make good financial decisions — when they have good information. No one makes great decisions — consumers or businesses — if the relevant information is hidden from view."  Elizabeth Warren

The quote from Mrs. Warren appeared in an interview with the Chicago Tribune in which she was discussing the Consumer Financial Protection Bureau.

This quote could just as easily have been applied in the world of structured finance.  A product that has become synonymous with opacity.  

Currently, there is a global regulatory effort focused on rewriting the disclosure rules for the structured finance industry.  My firm has responded to each regulator when they have requested public comments.  

The responses use a brown paper bag to demonstrate that "when" information is disclosed is as important as "what" information is disclosed for structured finance investors.  The Brown Paper Bag Challenge highlights the difficulty investors have trying to value a specific security based on out of date information.

The responses use a clear plastic bag to demonstrate the solution to the "when" problem is to provide current information.  The way to accomplish this for structured finance is through observable event based reporting.  If you have ever looked at your credit card account over the Internet, you know that observable event based reporting is the way that all firms handling daily billing and collecting track loan-level information.

There has been significant push back from the structured finance industry on addressing "when" in the new disclosure regulations.  The TYI, LLC response on October 21, 2010 to the SEC discusses the objections raised by the industry.

The Free Lunch: Part II

I suspected that my suggestion that the Fed use QE II to purchase the non-agency residential mortgage backed securities would receive a lot of negative feedback.  I was right.  Sorry that I did not have comments turn on so readers could see them, but I am still in the learning phase.

Many commentators were appalled by the wealth transfer to the banks implied in buying these securities at what undoubtedly would be a premium price.  They chose to ignore the other side of the trade.  This is where the Fed steps up and imposes significant regulatory constraints on the banks going forward.

Other commentators took issue with the idea that the Fed was willing to impose significant regulatory constraints on the banks.  They noted that the Fed tends to back off whenever the banks claim that any proposed regulation will reduce the availability of credit.

This raises an interesting question, if the Fed is unwilling to exercise its regulatory authority over banks, does it fall to the Financial Services Oversight Council to do so in its place?

Several commentators looked at inflation and asset bubbles related to QE II.  I do not claim any particular expertise to comment here.  With that disclaimer, clearly there is a correlation between the Fed pushing liquidity into the financial system to try to stimulate growth in the economy and increases in the prices of assets (like stocks, bonds and houses).  However, correlation is not the same as causation.  For example, consumption of soft drinks increases at the same time of the year that there is an increase in the number of cases of polio.  While the increase in consumption and illness are correlated, there is no reason to believe that one causes the other.

My focus in making the suggestion as to how to use QE II was on trying to restore "normal" functioning to the capital markets.  This is an area where I have some expertise and the topic of what is normal functioning will be an entry to this blog in the near future.

Tuesday, October 26, 2010

Maybe there is a free lunch

Almost one and a half years have passed since my last post. Despite repeated claims by the global regulatory community, many parts of the global financial system are not working normally. The only part of the system that is working normally is the bonuses paid by financial institutions have returned to pre-credit crisis levels.

While I have lots of topics to discuss, let me return to my blog by focusing on the latest effort being proposed to get the financial system and the global economy functioning normally again. This is the Fed embarking on Quantitative Easing II (QE II). The simple idea behind QE II is that lowering interest rates stimulates the economy.

Under QE II, the Fed is proposing to buy Treasury securities. In theory, this will drive down the yield on these securities and all of the debt instruments that are priced off these securities. This makes borrowing more attractive and allows borrowers to use money saved from refinancing to buy other goods and services.

However, there might be a fly or two in the ointment.

While true for high interest rate environments , in low interest rate environments, like those that are prevailing today, it is not clear that it will result in a boost to the economy. There are many headwinds to increased economic activity including retirees cutting back on their expenditures rather than spend some of their principal and companies cutting back on investments to fund pension obligations.

It is also not clear that buying Treasury securities will be as effective for stimulating the economy as buying existing structured finance securities.

There would be several advantages to doing this. First, it would immediately drive down the cost of borrowing to consumers and small businesses. Second, it would allow banks to remove from their balance sheet hard to value assets and puts to rest any lingering questions about their solvency. Third, since most of these securities are non-agency residential mortgages, it would allow the government to successfully push mortgage modification over foreclosure. As the owners of the securities, the Fed could instruct the servicers to modify and not foreclose. This in turn would support the current level of house prices.

I can already hear the howls of protest at what on the surface also looks like a bailout of the big banks. It clearly is that. However, it is also the only example I can find of a "free lunch". Since it prints money, by definition the Fed does not have an interest cost that it has to pay to finance the purchase of these securities. The Fed also does not have a balance sheet that needs to be marked-to-market (it can carry the investments at cost).

The howls of protest are getting louder. Let me pose a theoretical question. Does the Fed lose money if the total of the interest and principal payments it receives equals the price at which the Fed purchases the security? I would argue that it and the taxpayer do not lose money.

Why does that work? The free lunch occurs because the Fed, and this would hold true for the Bank of England and the European Central Bank, does not have to pay any interest. For any other government or private investor, there is a cost of financing the position.

But the Fed is likely to overpay for the securities. I agree. As was shown in the Brown Paper Bag Challenge,, valuing these securities without current loan-level performance information is the equivalent of blindly betting. However, as long as the total of interest and principal payments is equal to or greater than the purchase price, the Fed and the taxpayer are not worse off.

What about inflation? Chairman Bernanke has argued that there are many tools in the Fed toolbox for keeping inflation under control.

Isn't this a massive wealth transfer to the bankers? It is a massive wealth transfer to the bankers. I would hope that before engaging in these purchases the Fed would extract a significant amount of concessions for doing this. For example, the Fed might require that large US financial institutions adhere to the same capital requirements as large Swiss financial institutions (namely 10% loss bearing capital and another 5% contingent convertible debt to replace the loss bearing capital).