Without Asset-Level Data New Round of Stress Tests Will Not Halt European Contagion

European financial officials are considering a new round of stress tests with more stringent criteria to address declining investor confidence in the Euro, European banks and European country solvency.

To be successful at addressing this decline, the stress tests will have to overcome two significant hurdles.

1. Credibility.  As the old saying goes, fool me once shame on you, fool me twice shame on me.  The Irish bank experience shows the first round of European stress tests did not provide an accurate picture of what was actually going on within the Irish banking system.  Why should investors believe a second round of stress tests will produce an accurate picture of what is going on inside the other European banks?
2. Verifiability.  As Ronald Reagan use to say, "Trust, but verify."  Even if the criteria and the results are disclosed, how are investors going to verify the accuracy of the stress tests?

Fortunately, there is a solution that would make the stress tests both credible and verifiable.

The European governments could require the banks to disclose current loan-level performance and their investment positions (this captures sovereign and foreign bank debt exposures).

This would allow market credit analysts to not only verify the results of the stress test, but to run their own stress tests.  This in turn restores trust in the conclusions drawn from the European stress test.

With all market participants knowing which, if any, banks and countries need capital, the situation can be addressed and the decline halted.

Stopping the European Contagion Problem

It is not enough to just predict European contagion as the result of a solvency spiral.  It is necessary to also describe why it is happening now and what it would take to stop it.


Since 2007, many individuals have predicted that the issue of bank solvency would spiral out of control in Europe.


This prediction was based on looking at the capacity of countries to recapitalize their banking system for both direct and indirect losses related to the real estate and credit bubbles.  Like dominoes, countries could be ranked by their relative shortfall in recapitalization capacity if their banks experienced worst case losses.  Under this analysis, no European country could afford to recapitalize their banking system for the direct and indirect losses from their banking system's exposure.

This prediction and its supporting analysis have not been lost on European financial officials.  As reported by GFSNews, Mr. Honohan said [emphasis added]:

"As fears grew that the crisis affecting Ireland might spread to more indebted Eurozone nations, the governor of the country's central bank launched an incendiary attack today on credit analysts who he said 'assume the worst' about the country's banking sector. Governor Patrick Honohan, in an address to a conference of chartered accountants in Dublin, argued that credit analysts do not have enough information about the health of the Irish banking sector and should undergo 'euthanasia'. Honohan said: 'If there is no information, the credit analyst tends to assume the worst. They think, 'if the actual situation were good, would the bank not have been at pains to disclose it. Since it is not disclosed, it must be bad'.

However, it is not enough to predict that there might be an issue of solvency.  It is also necessary to describe the trigger mechanism that set off the solvency spiral in 2010.

As of September, the Irish government was using an independent third party to look at the performance of all the loans on the balance sheets of Irish banks, identify problem loans and value these loans so they could be purchased by a "bad" bank run by the Irish government.  Despite repeated rounds of purchasing bad loans at increasing discounts, the Irish government said that it did not need a bailout.  This position served to anchor investor estimates of the losses on the bad loans and prevented the beginning of the solvency spiral.

The discussion of the Eur 85 billion bailout destroyed the credibility of the valuation of these loans.  The solvency spiral began as investors attempted to come up with a new method for estimating the losses on the bad loans.

Naturally, investors gravitate to the only verifiable information they have, assume the worse and adopt a show me posture.

The original book value of the loans in the Irish banking system exceeds Eur 300 billion.  This is a conservative estimate of the potential size of the hole in the Irish banking system.  Presumably, the loans are worth something, but now the burden is on the government and the banks to show why this estimate of the losses is not accurate.


Unfortunately, the problem with this conservative estimate is the implications for contagion throughout the European Union and the global financial system.

What does this say about the value of the loans on other European banks who syndicated loans with the Irish banks?  What does this say about the value of any direct exposures the European banks have to the Irish banks?

Now that investors are focused on other European banks, another issue emerges.  Investors already have one example of a country that apparently hid the size of its banking problem (this is ironic because the Irish government tried to face up to and put their problem behind them).  Why should investors believe in the absence of any supporting loan-level performance data the pronouncements of other European governments on the issue of the solvency of their financial institutions?

Are the governments in Portugal and Spain trying to hide the problems with their financial institutions?  Investors might easily take the lesson they learned in Ireland and assume the worse case for the assets in these countries banking systems.

Like Ireland, the worse case assumption about the assets in their banking systems implies losses greater than these countries can handle.


Like Ireland, the solution for stopping the solvency spiral in Portugal, Spain and the rest of Europe is to re-anchor the credit analyst estimates of loss to actual performance and not to worse case assumptions.  


In his speech, Governor Honohan provided the solution:  "communicating more [current loan-level performance] information to the market would not only enlist the expertise of market credit analysts in a way helpful to all, but could lower the cost of term borrowing as investors regain confidence." 


Enlisting the expertise of the market credit analysts requires disclosure of current loan-level performance information for all loans on the balance sheets of the banks so that the analysts can independently analyze and value the loans.  


Any government that enlists the expertise of the market credit analysts by requiring disclosure by its banks of current loan-level performance is making an incredibly powerful statement. It is saying emphatically that its banking system is solvent and here is the data to show that fact.


There is one country that has suggested that it is thinking along these lines.  In England, the Bank of England is planning on substituting market discipline for bank examination.  To do so will require having banks disclose current loan-level performance information.

Besides halting the solvency spiral, benefits of adopting current loan-level performance disclosure should include a reduction in the cost of funds to that country's banks, an ability to unwind all government programs that support the credit and banking markets and, most importantly, a restoration of confidence in the country's financial markets. With confidence restored in the financial markets, business and consumer confidence should also return.

Questions Remain After Irish Bailout

As reported by the WSJ, "Prime Minister Brian Cowen at a Dublin news conference Sunday evening said the package 'provides Ireland with vital time and space to address the problems we've been dealing with since this global economic crisis began.'...Under the deal reached Sunday, Ireland will try again what it has tried unsuccessfully for two years: adding more capital to banks to give investors and depositors more confidence in their solidity."


This leaves three major unanswered questions.  First, why should the effort to convince investors and depositors succeed now?  


As discussed here, here and here, in the absence of current loan-level performance information, how does the market know that the Eur35 billion set aside for recapitalizing the Irish banking sector is enough.


The bailout does confirm that the loan-level performance required more resources than Ireland could provide by itself and that the Irish government's previous efforts to remove Eur50 billion in bad loans and inject capital were insufficient to offset the deterioration in the loans in the banking system.

The bailout itself contains no new information as to the actual performance of the loans in the banking system.  

The Irish banking system still holds over Eur300 billion in loans. Under the worse case assumptions being used by analysts (half the loans could be worth nothing), the Eur35 billion set aside under the bailout would appear insufficient to restore solvency to the Irish banking system. 

The second question is how will the Irish regulators use the time that was purchase at such a high cost through the bailout?  

• Will the regulators follow policies similar to what Japan has implemented for the two decades after its real estate crash and hope that the real estate market and financial system will recover?  Injecting capital into the banks and proclaiming that they are solvent without providing the supporting current loan-level performance data would be an example of following similar policies and could be expected to be as effective; or 

• Will the regulators follow the advice of central bank Governor Patrick Honohan and enlist the expertise of the market credit analysts to restore confidence to the market?  Enlisting the expertise of the market credit analysts requires disclosure of current loan-level performance information for all loans on the balance sheets of the Irish banks so that the analysts can independently analyze and value the loans.  Subsequently  Injecting capital into the banks based on where the market perceives a capital shortfall could be expected to be effective in ending the credit crisis.

Third and finally, who would buy Irish or any EU sovereign or bank debt after June 2013 when the debt carries the risk of credit loss?  

In the absence of an ability to evaluate the solvency of banks or countries, why would an investor sign up for the risk of loss?  Under the worse case, analysts would assume that the banking system and/or country is still not solvent.  Their conclusion would be that any buyer of the post June 2013 debt is effectively buying the credit losses that should have been imposed on the investors who held the bank debt and equity at the start of the credit crisis.

If Ireland and/or the EU countries want to sell debt after June 2013 where investors take on the risk of capital losses, they are going to have to make current loan-level performance data available so that credit analysts can determine who is solvent and who is not.  It is only with this independent analysis that investors will feel comfortable taking on the risk of loss from investing in solvent banks and countries.

Is 100 Billion Euros Enough to Solve the Irish Crisis? Part III

Patrick Honohan, governor of the Irish central bank, came out in support of both the analysis and solution presented in this blog to solving the Irish crisis.  The analysis and solution were originally discussed on this blog in the Irish Choice:  Inexpensive Cure or Expensive Bailout.

Part I and Part II of this series presented the idea that investors adopted a worse case assumption about the performance of the assets in the banking sector after the Irish government confirmed by asking for a bailout that its valuation of these assets was not credible.  The series then presented the solution to the crisis: provide investors with the asset-level performance information they needed to independently analyze and value the assets themselves.

As reported by GFSNews, Mr. Honohan said [emphasis added]:

"As fears grew that the crisis affecting Ireland might spread to more indebted Eurozone nations, the governor of the country's central bank launched an incendiary attack today on credit analysts who he said 'assume the worst' about the country's banking sector. Governor Patrick Honohan, in an address to a conference of chartered accountants in Dublin, argued that credit analysts do not have enough information about the health of the Irish banking sector and should undergo 'euthanasia'. Honohan said: 'If there is no information, the credit analyst tends to assume the worst. They think, 'if the actual situation were good, would the bank not have been at pains to disclose it. Since it is not disclosed, it must be bad'. 'As the information flow to the market improves both in quantity and quality, and especially when the economy improves and the news contained in the information is getting better, we will hopefully move towards the euthanasia of the Irish bank credit analyst - though not of course of the accountants!'.... He said that banks should try to boost confidence by disclosing more information to the market, such as on the ageing and migration of loans and status of residential mortgage books.... 'Communicating more information to the market would not only enlist the expertise of market credit analysts in a way helpful to all, but could lower the cost of term borrowing as investors regain confidence. 'We plan to explore this aspect further with the banks - they have much to gain and formal regulation here may not be needed.'" According to the Irish Independent, Mr. Honohan observed "Bottom line: the banks might do well to call in the leading credit analysts and find out what information would be of greatest use to them in identifying tail risks. And then provide it." Hopefully, the banks will voluntarily provide the loan-level data that markets need.  However, given that the Irish government and its people have more to gain than the banks, it is highly likely that regulation will be required.

Is 100 Billion Euros Enough to Solve the Irish Crisis? Part II

The Wall Street Journal noted today that "the Bazooka Theory of financial rescue does not work as advertised."  This comes as no surprise to readers of this blog.

As previously discussed, in the absence of information there is no logical stopping point in the valuation of problem assets other than zero.

Why?  Investors need the performance data on the problem assets if they are going to have anything to independently analyze, value and make informed investment decisions based on.  Without the performance data, investors can only guess.

As of a couple of weeks ago, the Irish government was using an independent third party to look at the performance of all the loans on the balance sheets of Irish banks, identify problem loans and value these loans so they could be purchased by a "bad" bank run by the Irish government.  Despite repeated rounds of purchasing bad loans at increasing discounts, the Irish government said that it did not need a bailout.  This position served to anchor investor estimates of the losses on the bad loans.

The discussion of an 85 billion euro bailout destroys the credibility of the valuation of these loans and casts the investors adrift to come up with a new method for estimating the losses on the bad loans.

Naturally, investors gravitate to the only verifiable information they have, assume the worse and adopt a show me posture.

The original book value of the loans in the Irish banking system exceeds 300 billion euros.  In the absence of loan level information, this is a conservative estimate of the potential size of the hole in the Irish banking system.  Presumably, the loans are worth something, but now the burden is on the government and the banks to show why this estimate of the losses is not accurate.

Unfortunately, the problem with this conservative estimate is the implications for contagion throughout the European Union and the global financial system.

What does this say about the value of the loans on other European banks who syndicated loans with the Irish banks?  What does this say about the value of any direct exposures the European banks have to the Irish banks?

Now that investors are focused on other European banks, another issue emerges.  Investors already have one example of a country that apparently hid the size of its banking problem (this is ironic because the Irish government tried to face up to and put their problem behind them).  Why should investors believe in the absence of any supporting loan-level performance data the pronouncements of other European governments on the issue of the solvency of their financial institutions?

Are the governments in Portugal and Spain trying to hide the problems with their financial institutions?  Investors might easily take the lesson they learned in Ireland and assume the worse case for the assets in these countries banking systems.

Like Ireland, the worse case assumption about the assets in their banking systems implies losses greater than these countries can handle.

Who is next after Portugal and Spain?

The Bazooka Theory of financial rescue fails when investors assume the worse about asset performance.  The size of the losses under the worse case is significantly larger than the financial resources that governments can throw at the problem.

The only way for the European finance ministers to stop contagion is to provide current loan-level performance data on all the underlying assets and let the markets determine the real value of these assets and which, if any, financial institutions require more capital.

Once market values and capital requirements are known, then governments can step in to supply any needed capital.

The Future of Finance: The End of Opacity and The Mother of All Databases

The future of finance is the elimination of opacity throughout the financial system by using 21st century information technology.


This statement is the logical conclusion of the Bank of England's plan to substitute market discipline for bank examination.  As discussed in an earlier blog, Bank of England Adopting 21st Century Oversight of Financial Institutions,  the current model of bank examination does not work.


The current bank examination model, as practiced by regulators like the Financial Services Authority and Federal Reserve, involves sending out large numbers of examiners to look through the banks' books, demanding lots of detailed information for their internal review and asking the banks to run stress tests on assumptions the regulators provide.  A key feature of this model is that no detailed information is shared with the markets.

If this model looks like it parallels how the rating agencies operate, it does.   The parallel in the US goes all the way to the issuance of a CAMELS rating by the regulator.  A CAMELS rating is for regulators eyes only and is a reflection of a bank's overall condition in the areas of capital adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L) and sensitivity to market risk (S).


Just like the ratings produced by the rating agencies, since the markets do not have the information to do their own homework, the markets have to trust that the regulators get their ratings right.  Unfortunately, recent history shows that regulators were just like the rating agencies and they did not always get their ratings right.

According to a WSJ article, "a top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data."

Mr. Haldane identified the flaw in the bank examination model and the reason that regulators need to have banks disclose more information to the markets.

The markets are not overwhelmed by the quantity of data disclosed by financial institutions.  There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.

Andrew Redleaf, a hedge fund manager, takes the idea of banks disclosing data and market participants using this data further.  

He wrote "the late crisis happened not because banks were reckless or regulators incompetent, though both were surely true. It happened because together banks and regulators forged a system that denied citizens and markets the information they needed to respond rationally to events.

Banking has always been too secretive in this country. Banks are quasi-public institutions, performing both private and public functions, including sustaining the credit system that sustains the dollar itself. In return, the big banks especially are granted extraordinary privileges, such as the right to borrow from the Fed virtually for free at times of crisis. Under the circumstances there is no excuse for bank balance sheets to be anything but utterly transparent to the citizens and investors....

Imagine for a moment that in 2004 the government had required every major financial institution in the U.S., any one with the potential for imperiling credit markets, to publish their investment positions. All of them. In detail. Lists of every security or derivative held in their portfolios, along with all data about the underlying mortgage pools, defaults so far, etc.

With such a rule in place, the mortgage crisis likely would never have happened on the scale it did. Most of the worst mortgages, the loans that crashed the system, were written from 2005 through the early days of 2007. Opening the banks' books would have revealed just how near the edge they were playing. The resulting market pressure on bank securities would have forced them to cut back their mortgage books. This would have been a crisis of a sort; the housing bubble would have popped. But popping the bubble two years earlier would have avoided the worst of the damage.

Even if transparency failed to avoid the mortgage crisis, it almost certainly would have prevented the banking crisis and the crash of 2008. Because we would have known. We would have known how much -- or how little -- trouble Bear was in long before March 2008. We would have known, for better or worse, about Lehman, and Morgan, and Goldman, and Citi. Not instantly. It would take time to digest millions of lines of information kept secret for decades. But surely millions of investors poring over the information, including those heroic rag-pickers, of capitalism the vultures and short-sellers would have given us a quicker and better answer than the grand-high-poo-bahs.

The megabanks would hate it....They would scream bloody murder about being forced to let competitors see what they owned. Nonsense. Investors who hold interesting or unusual positions in their portfolios may have something to lose by disclosure. But too-big-to-fail banks have no business taking "interesting" positions. Banks are not supposed to be extra clever, they are supposed to be extra careful."

On February 23, 2009, in a Wired article, Daniel Roth provided the support for Mr. Haldane's observation and solution in much more detail.  


"Even the regulators can't keep up. A Senate study in 2002 found that the SEC had managed to fully review just 16 percent of the nearly 15,000 annual reports that companies submitted in the previous fiscal year; the recently disgraced Enron hadn't been reviewed in a decade. We shouldn't be surprised. While the SEC is staffed by a relatively small group of poorly compensated financial cops, Wall Street bankers get paid millions to create new and ever more complicated investment products. By the time regulators get a handle on one investment class, a slew of new ones have been created. 'This is a cycle that goes on and on—and will continue to get repeated,' says Peter Wysocki, a professor at the MIT Sloan School of Management. 'You can't just make new regulations about the next innovation in financial misreporting.' 


That's why it's not enough to simply give the SEC—or any of its sister regulators—more authority; we need to rethink our entire philosophy of regulation. Instead of assigning oversight responsibility to a finite group of bureaucrats, we should enable every investor to act as a citizen-regulator. We should tap into the massive parallel processing power of people around the world by giving everyone the tools to track, analyze, and publicize financial machinations. The result would be a wave of decentralized innovation that can keep pace with Wall Street and allow the market to regulate itself—naturally punishing companies and investments that don't measure up—more efficiently than the regulators ever could.

Tracking Wall Street's complex inventions may be difficult for regulators, but it's a snap given the right software....When data is kept under lock and key, as mysterious as a temple secret, only the priests can read and interpret it. But place it in the public domain and suddenly it takes on new life. People start playing with the information, reaching strange new conclusions or raising questions that no one else would think to ask. It is impossible to predict who will become obsessed with the data or why—but someone will.

'People care about money,' Tim Bray, director of Web technologies at Sun Microsystems says. 'There's money in money and substantial personal upside to someone who can mine the data and uncover the truth.'"

How can the disclosure pushed by regulators like Haldane and investors like Redleaf actually be implemented?


By creating the "mother of all databases."  This is the database that your humble blogger has been pushing since before the credit crisis (here, here and here) and is necessary if European investors are going to be able to comply with the 'know what you own" provision of Article 122a of the European Capital Requirements Directive.  


This is the database that the Office of Financial Research and Data (OFR) is suppose to develop, but because it is a governmental entity never will.  OFR is fundamentally handicapped because:

1. The current operating philosophy of the regulators is not to share detailed information with the market.  
2. By law it must, where possible, use information collected by other governmental agencies.  What if the frequency that another governmental agencies collects data, say monthly, is not what is required to, as Lloyd Blankfein advised, monitor every position every day?

What is required is an independent third party to run the mother of all databases.  The independent third party must only be in the business of managing this database.  This assures all market participants that the database is free of all conflicts of interest and they can trust the numbers.

Article 122a and the End of Global Securitization

On January 1, 2011, Article 122a of the European Capital Requirements Directive goes into effect.  This article requires European credit institutions, including banks and investment banks, to know what they own when they purchase a structured finance security.  Failure to do so results in the credit institution having to hold at least 100% equity capital against the investment.

Initially, knowing what you own applies to structured finance securities issued on or after January 1, 2011.  By January 1, 2014, knowing what you own applies to all structured finance securities.

What does know what you own mean?

It has been argued on this blog that know what you own for an individual security has three elements:  1) current information on the underlying collateral performance; 2) the terms of the deal; and 3) putting elements 1 and 2 into the analytic and valuation models of the investor's choice to independently value the security.

In the absence of any one of these three elements, an investor does not know what they own.  This point has been repeatedly made when discussing current information on the underlying collateral performance through the use of the Brown Paper Bag Challenge.  In the absence of any one of these three elements, an investor is blindly betting.

Could regulators decide that existing once-per-month disclosure practices are sufficient for knowing what you own?

Of course, but it is highly unlikely after they have taken the Brown Paper Bag Challenge.  Regulators know that 'when' a disclosure is made is as important as 'what' is disclosed.  This does not change even if regulators are buried under the mountain of minutia related to defining 'what' data will be disclosed by the sell-side dominated trade groups.

Why is Article 122a potentially the end of global securitization?

Currently, individual deals are designed to appeal to as many different investor groups as possible.  This includes European investors.

Under Article 122a, the capital charge effectively bars European investors from investing in structured finance securities that do not offer current information and instead offers once-per-month or less frequent reporting.

Without European investors, the market is much less global and the economic attractiveness of issuing the securities decreases.

Is 100 Billion Euros Enough to Solve Irish Crisis?

As the bailout of Ireland and its banks moves forward, it is important to ask the question of 'is 100 billion euros, let alone the 80 billion euros rumored to be in the bailout, enough to solve the Irish crisis'.

Clearly, investors lost confidence in the Irish government and its ability to manage the problem of bad assets in its banking system.

Unlike the rest of Europe and the US, the Irish government made the decision to remove all the bad assets from its banks.  To do this, it used a good bank/bad bank concept.  In theory, the private banks would hold good assets and a government set up bad bank would hold the bad assets.

To be successful, the good bank/bad bank concept required that all the bad assets be identified and transferred in one shot.  Unfortunately, there were three separate rounds of bad asset purchases.  Each round, the bad asset purchases were done at a steeper discount.  The combination of multiple rounds of purchases and the increasing discount on the assets purchased invited an erosion in investor confidence.

Investors began to question both whether the government could get its arms around the problem and what was the actual size of the problem.

Further eroding investor confidence, the Irish government has been claiming for weeks that it did not need a bailout.  Now, under pressure from other European Union finance ministers it is acknowledging it needs a bailout.

But what size bailout is really the right size?

• From the investor's perspective, in the absence of current performance information on the underlying assets so they can independently value the assets, once a devaluation cycle starts, there is no logical stopping place for valuations other than zero.  This suggests a bailout that is approximately equal in size to the current book value of the assets.  Is the current book value of all the bad assets in the Irish banking system approximately 80-100 billion euros?

• If not, how was the size of the bailout arrived at given that there is a potential several hundred billion euro hole in the Irish bank balance sheets?

• What source of information did the finance ministers for the other European countries have access to that supports this size bailout?  How could it support this size bailout if the Irish government also had this same information and claimed they did not need a bailout? 

• Is this the amount that the finance ministers felt investors needed to hear?  Is this revisiting the Hank Paulson Bazooka and trying to convince investors that overwhelming firepower had been made available to deal with the situation?

• Is this all the financial support that the European Union could offer knowing that there are other bailout candidates in the wings?

At the start of the global credit crisis, bailouts were used to allay investors concerns and try to buy time in the hope that the economy would recover and drive up the cost of the underlying assets.  Is this another round of that strategy?  Is there any reason to believe that it will work this time?

Why do governmental officials prefer to throw taxpayer money at this problem rather than provide the information the markets need to determine if there is a problem and if so how big a problem there is?

Bank of England Adopting 21st Century Oversight of Financial Institutions

The Wall Street Journal ran an article on the Bank of England's (BoE) plan to adopt 21st century oversight of financial institutions.  This plan places "a greater emphasis on understanding macroeconomic issues and on requiring the banks to disclose more information to the markets."  


This plan explicitly trades off market discipline for bank examination. 


The plan is in sharp contrast to the current Financial Services Authority and Federal Reserve practice of bank oversight.  Their practice of bank oversight involves sending out large numbers of examiners to look through the banks' books, demanding lots of detailed information for their internal review and asking the banks to run stress tests on assumptions the regulators provide.  A key feature of this practice of bank oversight is that no detailed information is shared with the markets.


If this practice of bank oversight looks like it parallels how the rating agencies operate, it does.     The parallel in the US goes all the way to the issuance of a CAMELS rating by the regulator.  Just like the rating agency business model, since the markets do not have the information to do its own homework, the markets have to trust that the regulators get their bank oversight right.  Unfortunately, recent history shows that regulators do not always get their bank oversight right.


According to the WSJ article, "a top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data." 


Mr. Haldane identified the flaw in the rating agency bank oversight model and the reason that regulators need to have banks disclose more information to the markets.  


The markets are not overwhelmed by the quantity of data disclosed by financial institutions.  There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.


This point bears repeating as it is the key to 21st century oversight of banks.  


The markets are not overwhelmed by the quantity of data disclosed by financial institutions.  There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.


Since the markets can and have an incentive to turn the disclosed data into useful information, the markets are able to bring discipline to the financial system that the regulators with their resources cannot.


For the Bank of England to succeed in replacing examination with market discipline requires using 21st century information technology.  


Specifically it means applying observable event based asset-level performance reporting not just to the loans and receivables underlying structured finance securities, but across the entire asset side of bank balance sheets.  


What is observable event based asset-level performance reporting?  For each individual loan or receivable on the bank balance sheet, it is simply whenever there is a payment, a delinquency, a default, an insolvency filing by the borrower or similar event, it is reported on a borrower privacy protected basis to the market on the day that it occurs.


Observable event based asset-level performance data is the current information markets need to analyze and assess the risk of each individual bank.  It is the current information markets need to bring discipline to the financial system.

There are no technological hurdles that prevent making this data available.  There are no technological hurdles that prevent the market from using this data.  


The cost of providing the data is not a hurdle.  Particularly when this cost is compared to the trillions of dollars of losses that the global financial system suffered in the credit crisis because the market did not have this data.


What has prevented this data from being made available is the lack of a regulator who would champion this approach. 


This approach eliminates reliance on only regulators to detect problems at and curb the risks of a single institution.  This approach eliminates reliance on only regulators to identify systemic problems.  


This approach instead allows the regulators to harness the resources of the market, including ironically, the ability of each financial institution to evaluate its peers.  This approach allows market participants to perform their own stress tests on each financial institution.

During the Great Depression, the decision was made to bring the disinfectant of sunlight to the financial markets through the adoption of disclosure laws.  The belief was that providing investors with access to all the information they needed to make a fully informed investment decision was the best way to restore and maintain confidence in the capital markets.


This belief was rewarded with financial markets that functioned without a slew of government guarantee programs, government loss sharing programs to bribe investors to buy a specific class of securities and government coercion through zero interest rate policies to force investors to buy riskier assets.  


The fundamental problem with using expensive government programs instead of the inexpensive disinfectant of sunlight is that it is not always sustainable.  Markets dependent on government programs collapse if the solvency of the government is called into question.


Now, coming out of the Great Recession, the BoE is proposing to extend the disinfectant of sunlight and the market discipline it brings into the opaque source of the credit crisis, the financial institutions.    


To truly bring in the sunlight and the restoration of confidence in the capital markets will require financial institutions provide asset level disclosure on an observable event basis. 

The Irish Choice: Inexpensive Cure or Expensive Bailout Part III

The New York Times published an article today that confirms the need for providing investors with the loan-level performance information necessary so investors can independently analyze and value the bad assets.


The facts presented in the article support the need for the inexpensive cure to restore the loss of investor confidence: 

1. Investors are operating in fear, as shown by the widening risk premium between Spain and German government bonds, because they having a "growing inability to get a precise read" on the Irish or Spanish losses from the global real estate boom and bust; 
2. Without observable event based performance data on the troubled loans, there is no logical stopping point in the devaluation of these exposures other than zero and as a result there are questions about the solvency of the Irish and Spanish banks and their governments.

The article noted:

"In Ireland, banking troubles lie at the root of what many in Europe are now calling a solvency crisis, reflecting long-term concern over Ireland’s ability to repay its debts, as opposed to the lack of short-term funds that forced the Greek rescue last spring.

“This policy of saving banks at the cost of breaking the back of entire countries is a disaster,” said Daniel Gros, director for the Center for European Policy Studies in Brussels. “Ireland is beyond fiscal plans as long as one cannot see the bottom of the losses in the banking sector,” he said. 


...Ireland is unlikely to let its banks fail, but it has been unable to accurately forecast its banking losses — or say whether bondholders will pay part of the bill.

Irish banking losses are estimated at up to 80 billion euros ($109 billion), depending on the forecast used, or 50 percent of the economy. As long as housing prices continue to fall, these losses cannot be capped."

The Irish Choice: Inexpensive Cure or Expensive Bailout Part II

As Yogi Berra would say, "it is deja vu all over again."


The bond market is sending the message that it is unsure about the solvency of both Ireland and its leading banks.  However, the bond market is not sending the message that the only solution is a bailout?


This was recognized by the Irish government.  Today, in quick succession the Irish government proposed: 1) adding more capital to its banks to address the bond market perception that there might be a solvency problem; 2) accepting the bailout to address any liquidity problems the banks might have; and 3) meeting with EU finance ministers to see what other alternatives might exist to underpin financial and bank stability.

Adding capital and accepting the bailout might temporarily relieve the pressure of increasing interest spreads between Irish and German government bonds, but they do nothing to address the underlying issue of valuing the real estate loans.

Naturally my preference is the selection of an alternative to underpin financial and bank stability - namely provide the bond market with the loan-level performance data.

Announcing the plan to disclose the data on an ongoing basis should have an immediate and permanent impact.


The immediate impact is to stop the fear driven speculation that the situation is worse than the Irish government has reported.  The bond market would assume that the Irish government would not disclose the loan-level data which could be used to check the factual accuracy of the Irish government's statements knowing the severity of the bond market's reaction if reality were significantly different than the statements.


The permanent impact is that Ireland ends up with properly functioning capital markets again as investors are able to independently assess the risk of its banks and its national debt and make fully informed buy, sell and hold decisions without the need for ECB purchases or EU guarantees.

The Irish Choice: Inexpensive Cure or Expensive Bailout

The Irish government faces a choice in how to handle its financial crisis.  It can implement an inexpensive cure and resolve the cause of the crisis or it can implement an expensive bailout and treat the symptoms of the crisis.

At its core, the cause of the Irish financial crisis is the same as the 2007/2008 global credit crisis.  The root cause of the crisis is the inability of investors and other market participants to independently analyze and value commercial and residential real-estate loans.

Unlike most European governments and the US government, the Irish government responded to the global credit crisis by both guaranteeing the solvency of its banks and by deciding to remove all of the 'bad' assets from its banking system.  To do this, the Irish government set up a 'bad bank' to acquire the 'bad' assets.

The intent was to leave behind 'good' banks that were free of 'bad' assets and that could access the capital markets based on their own creditworthiness.  In theory, these 'good' banks could then resume lending and help pull the Irish economy out of its recession.

Unfortunately, the good bank/bad bank idea requires that all of the 'bad' assets are moved to the 'bad' bank when assets are first transferred.  As soon as there is a subsequent round of assets purchased by the 'bad' bank from the 'good' bank, investors are forced to ask the question:  have all the 'bad' assets been transferred now.

The Irish experience has been not one, not two, but three rounds of asset purchases.  After each subsequent round, investors have become increasingly reluctant to conclude that all the 'bad' assets have been transferred.  This limits the 'good' banks access to capital markets and defeats the purpose of removing the 'bad' assets in the first place.

Success of the good bank/bad bank idea also relies on the assumption that the price the 'bad' assets are transferred at reflects a realistic valuation for these assets.  This is particularly an issue when the Irish government is in the position of injecting capital into the good banks to make up for any losses taken on the 'bad' assets.  If the assets are not transferred at a realistic valuation then investors are forced to guess whether the good banks or bad bank benefited.

Compounding the problem of the multiple rounds of asset purchases for the Irish government is the fact that each subsequent round of asset purchases was done at an increasing discount.  Each of these percentage discounts was set by the same independent third party.

Like the Rating Agencies, investors are reliant on the independent third party valuations.  Investors do not have access to the data on the individual 'bad' assets that they need to conduct their own independent analysis and valuation.

Just like the Rating Agencies lost credibility from being wrong in their rating of sub-prime mortgage backed securities, so too has the independent third party in its valuation of the 'bad' assets.

Like the sub-prime mortgaged backed securities, the devaluation cycle on the Irish 'bad' assets appears to have no logical stopping point other than zero.  As a result, investors are questioning the solvency of Ireland.

With the investors' questioning comes an increased reluctance to invest in securities issued by the Irish government or its banks.  This reluctance is reflected in the higher yield of 10-year Irish government bonds over German government bonds.

Seeing the difference in interest rates between these bonds increase, EU officials are encouraging the Irish government to accept a bailout to restore confidence in Ireland's solvency.  The officials hope that this will also stop the spread of financial market turbulence to other euro members.

Naturally, if Ireland accepts a bailout from the EU and the IMF to close the difference in interest rates, it faces both the stigma associated with applying for aid and restrictions on the government and its fiscal policies.  This is a very high price to pay for treating the symptoms of the problem like high interest rate differentials.

There is an inexpensive alternative available to the Irish government which treats and cures the cause of the devaluation cycle of the Irish 'bad' assets.

This success of this alternative is based on the Irish government having identified all the 'bad' assets and properly discounted them.  If so, the Irish government is in a position where it can tell the bond market that the bond market can see for itself the validity of what the Irish government is saying about both the assets and that there is no need for a bailout.  The alternative is to provide all market participants observable event based performance data for all the assets in the 'good' and 'bad' banks.

Investors could use this performance data to independently analyze and value the assets.  Investors could use their choice of analytic tools and valuation models to see for themselves: 

1. Whether or not the 'bad' assets were properly valued;
2. That the exposure of the 'good' banks to bad assets is de minimus; and most importantly,
3. That there is a logical stopping point other than zero for the 'bad' assets and that Ireland is solvent without any need for a bailout.

Based on their own analysis, investors can then set a differential between Irish and German government bonds that reflects the reality of the situation and not fear of how bad the situation could be.

The importance of the solution of observable event based reporting was demonstrated in the Brown Paper Bag Challenge.

Existing disclosure practices do not provide the investor with the information on the performance of the loans, whether backing a security or in the good or bad bank, the investors needs 'when' the investor needs it to make a fully informed buy, hold and sell decision.

Current disclosure practices are the equivalent of putting the loans into a brown paper bag.  Then asking the investor when the contents have changed, but have not been reported, to guess the value of the contents of the brown paper bag.

The proposed solution of providing observable event based reporting puts the loans into the equivalent of a clear plastic bag.  With observable event based reporting, all the changes, like payments or defaults, to the loans are reported on the day that the changes occur.  Investors can see what they are buying and can value the securities or the good or bad banks the loans support.  If investors can value the loans, they can also determine that Ireland is solvent without a bailout.

At the start of the global credit crisis, the US government faced a choice in how to handle its financial crisis:  the inexpensive cure of observable event based reporting or the expensive bailout treatment of the symptoms.  The US government chose expensive bailouts to treat the symptoms.

The expensive bailouts did not prevent the problem of investors not being able to value commercial and residential real estate from recurring in Ireland 2 years later.  It is now the Irish government's time to chose between the inexpensive cure of observable event based reporting or bowing to pressure from the EU and accepting expensive bailouts to treat the symptoms.

Hopefully, the Irish government will set the global standard and select the inexpensive cure of observable event based reporting.

Qualified Residential Mortgages and Structured Finance

In the wake of the credit crisis and the hundreds of billions of dollars of losses on structure finance securities, particularly residential mortgage-backed securities, global legislation has featured the idea of making issuers of these securities retain skin in the game.  The logic behind the retention requirement is that having skin in the game gives the issuer an incentive to do a better job underwriting the loans backing the structured finance security.

Whether this logic is accurate or not is a topic for a different blog entry (hint:  look at the losses the financial institutions suffered on their retained book of business).

What is true though is that skin in the game is complementary to and not a substitute for investors knowing what they own.  As discussed in earlier posts using the Brown Paper Bag Challenge, for investors to have the information that they need 'when' they need it to make a buy, sell or hold decision on an individual structured finance security requires that they are provided with observable event based reporting on the underlying collateral performance.

If a mortgage does not provide observable event based reporting to investors when it is included in a structured finance security, no mortgage should be considered a qualified residential mortgage.

Under the Dodd-Frank Act, regulators have been given the responsibility of defining what is a qualified residential mortgage.  Qualified residential mortgages are exempt from the Dodd-Frank issuer retention requirements when packaged into structured finance securities.

The Wall Street Journal featured an article that describes how both investors and issuers would like the regulators to define qualified residential mortgages.

Investors favor a limited definition of a qualified residential mortgage.  These mortgages would have high down payments, say 20%, and fixed interest rate payments.

Issuers favor a broad definition of a qualified residential mortgage.  These mortgages would have lower down payments and private mortgage insurance.  They could have fixed or variable rates including teaser rates.

However the regulators decide, just because a certain type of mortgage did not perform poorly in the past is no guarantee that it will not perform poorly in the future.  As a result, regulators must require that for a mortgage to qualify as a qualified residential mortgage, it must provide investors with observable event based reporting on its performance when packaged in a structured finance security.

Solving the Toxic Securities Problem Keeps Getting Kicked Down the Road

The failure by the US government to fundamentally resolve the problem of the toxic structured finance securities continues to inflict significant damages to government and central bank balance sheets and the global economy.

On August 9, 2007, BNP Paribas froze three funds because they were unable to value the structured finance assets they contained.

Shortly thereafter, TYI, LLC published a white paper which both described the problem in valuing these securities and how to fix the problem.  It described how existing structured finance disclosure practices do not provide the investor with the information the investors needs 'when' the investor needs it to make a fully informed buy, hold or sell decision for individual securities.  It noted that the result of these disclosure practices would be a security devaluation cycle with no logical stopping point.

The conclusion was inescapable:  the inability to value these securities would effect every part of the financial system until the disclosure practices were corrected.

The inability to value these securities meant that financial institutions that owned these securities could no longer be valued.  In particular, it was impossible for their peers to tell which, if any, financial institutions they dealt with were financially solvent.  In 2008, this doubt about solvency led directly to liquidity problems as global financial firms became reluctant to lend money to each other.

The Bush Administration was faced with the choice of curing the problem with the toxic assets or treating the symptoms.  Unfortunately, it chose to treat the symptoms using a broad range of responses including issuing government guarantees and making TARP funded preferred stock investments.

This left the fundamental problem of valuing the toxic securities and their underlying assets unresolved.  It was kicked down the road to be handled at some future time.

The choice to kick the problem down the road was very unfortunate as it fed the crisis.  It undermined confidence.  It is really hard to have confidence in the prospects for the economy when the government is running around implementing what it describes as heroic and unconventional measures to head off Great Depression II.  As the government scrambled to contain the crisis, it sent the unmistakable message that it did not know what it was doing.

There was a simple, better alternative to kicking the problem down the road.  The alternative was to solve the problem.

The government would have had to acknowledge that the securities could not currently be valued because of the lack of loan-level performance information and announce that the government would cover the cost of making the information available to the market.  This simple tactic would have transformed the issue from being fueled by fear, as in oh my god how bad a problem are the toxic securities, to an issue driven by rational analysis, we will know what the facts are in a fixed period of time.

In 2009, the Obama Administration arrived promising change you can believe in.  The administration promptly adopted the treat the symptoms solution of the Bush Administration.  This was not surprising given that President Obama appointed as the leaders of his economic team individuals who were responsible for developing and implementing the treat the symptoms solution.

Again, the fundamental problem of valuing the toxic securities and their underlying assets was not resolved, but rather was kicked down the road to be handled at some future time.

By late 2009, against a backdrop of significant fiscal stimulus, the Obama Administration declared that the policy of treating the symptoms was successful as a second Great Depression had been avoided and the US economy was recovering.

There was only one small problem with this claim.  The toxic assets still exist, they are still impossible to value and the issue of financial institution solvency has not been ended.  Temporary relieve from the acuteness of the symptoms does not mean that the cause has been cured.

Is there any support for the idea that the issue of solvency has not been ended given the heroic claims by the Treasury Secretary Geithner after the bank stress tests?  Unfortunately, yes.

Before the credit crisis, financial accounting required the banks to mark their investments to market prices.  When the prices of these assets started plunging, the government and the banks urged the financial accounting industry to suspend mark-to-market accounting as the decrease in the market value of the toxic securities was wiping out the capital at these institutions (note: this is a treatment for a symtom of the valuation problem).  Mark-to-market accounting still has not been reinstated.

There could be a number of reasons why mark-to-market accounting has not been reinstated.

One reason is that everyone knows the toxic securities still do not provide the current loan-level information needed to value them.  Without this data, as demonstrated by the Brown Paper Bag Challenge, investors would be blindly betting when it comes to valuing and buying individual securities.

Given the hundreds of billions of dollars of losses they incurred as a result of the inability to value these securities, without the necessary disclosure, investors have been reluctant to return to the structured finance market despite explicit bribes, like PPIP, and forceable coercion, under zero interest rate policies.  This lack of investor activity suggests that the 'market' price for these toxic securities will not be high enough and that reinstating mark-to-market accounting will once again show that the financial institutions have a need for additional capital.

Over the last several months, Yves Smith has been documenting on Naked Capitalism several other reasons that investors might be reluctant to purchase the toxic securities.  Prominent on her list is the possibility that the loans were never properly conveyed to the trusts that were suppose to hold them for the benefit of the structured finance security investors.

The inability to value the toxic securities and their underlying assets continues to weigh down the global economy.

The impact is felt everywhere, but most importantly in the confidence of businesses and individuals to look forward to and act on the idea of a better economy in the future.  It is hard to think the economy is going to improve when the toxic securities are still out there making a return to normal capital market functioning impossible.  At the same time, the programs to treat the symptoms of the toxic securities are themselves becoming toxic (see QE 2 and the rise of commodity prices).

The time to solve the toxic securities problem has come.  Solving the toxic securities program also allows the government to unwind all the programs it put in place to treat the symptoms.

The Sell-Side and Its Lobbyists Take on The Brown Paper Bag Challenge: Part III

In Part I of this series, the focus was on how current once-per-month or less frequent disclosure practices are inadequate for valuing individual structured finance securities.  Existing structured finance disclosure practices do not provide the investor with the information the investor needs 'when' the investor needs it to make a fully informed buy, hold and sell decision.  


Current structured finance disclosure practices are the equivalent of putting the underlying collateral into a brown paper bag.  Then asking the investor when the contents have changed, but have not been reported, to guess the value of contents of the brown paper bag.  The proposed solution was to put the collateral into the equivalent of a clear plastic bag by providing observable event based reporting.  With observable event based reporting, all the changes, like payments or defaults, to the underlying collateral are reported on the day that the changes occur.  Investors can see what they are buying and can value the structured finance security.


In Part II of this series, the focus was on the objections raised by the sell-side and its lobbyists to observable event based reporting and their ongoing support for continuing with disclosure practices that leave investors blindly betting on the contents of a brown paper bag.


Part III of the series focuses on several different tactics the sell-side and its lobbyists, including sell-side dominated industry trade associations and lawyers, have employed to frame the discussion of revising structured finance disclosure requirements and oppose observable event based reporting.

First, there is the "red herring" tactic to divert the attention of global regulators from the real issue of 'when' disclosure is made.  This has taken the form of focusing on 'what' is disclosed and calling for data reporting templates as the cure for the disclosure problems afflicting structured finance.  The data reporting template push originated before the credit crisis and was led by the European Securitisation Forum, an affiliate of SIFMA. It was subsequently adopted by the American Securitization Forum, at the time an affiliate of SIFMA, under the name "Project Restart".  


This tactic allows the sell-side dominated trade associations to claim they are 'working' with the regulators as the associations have numerous committees dedicated to creating data reporting templates.  At the same time, this tactic allows the trade associations to delay revision of the disclosure requirements.  To the extent that regulators believe data reporting templates are necessary, the regulators are unlikely to issue new requirements without the data reporting templates being finished.  There are literally hundreds of potential data fields that are tracked by the originators and the firms that do the daily billing and collecting of the underlying loans and receivable that could be included in the templates.  Since it is not their area of expertise, the regulators are not really in a position to judge the appropriateness for analytical purposes of any data field.  As a result, the arguments between the buy and sell-side over which data fields to include in the data reporting templates are potentially endless.


The assumption underlying data reporting templates as a cure goes as follows:  if only investors had standardized loan-level data, then investors would have made different decisions and the losses incurred would have been avoided.  The Brown Paper Bag Challenge puts an end for all time to the idea that standardized data reporting templates by themselves are the cure for the problem afflicting structured finance disclosure.  If investors had standardized data reporting templates and existing once-per-month or less frequent reporting, they still would be left in the position of guessing the contents of the brown paper bag.  The Brown Paper Bag Challenge highlights that 'when' the disclosure is made is as important as 'what' disclosure is made if the revised structured finance disclosure regulations are going to be effective.  


Despite the Brown Paper Bag Challenge and its implications for revising structured finance disclosure, the red herring of data reporting templates has been extraordinarily successful in capturing the time and attention of regulators in both the US and Europe.  


That the tactic has greatly influenced and dominates the thinking of the global regulators is not in doubt.  Over the last two years, the evolution of the proposals by the global regulators to revise structured finance disclosure has steadily become focused almost entirely on data reporting templates.  This culminated in the April 7, 2010 SEC proposed revision to Regulation AB.  


This proposed revision to structured finance disclosure requirements runs 188 pages in the Federal Register, which is the equivalent of over 600+ normal typed pages.  Needless to say, it is bogged down in the minutia of data reporting templates and manages to devote less than 100 words to the issue of 'when' disclosure should take place.  This is an example of regulators losing sight of the goal of creating effective disclosure requirements through the opacity of dealing with the mountain of details involved in developing data reporting templates.  After investing all this effort into developing templates, is the SEC likely to adopt observable event based reporting in a data reporting template-based revision of Regulation AB?


If the SEC was using a disclosure framework where eliminating the brown paper bag problem with current disclosure practices was the highest priority, the SEC could dramatically shorten and simplify the revision to the structured finance disclosure requirements by eliminating all the details involved in prescribing data reporting templates.  


Instead, the SEC could propose the following requirement:


"With respect to a loan or receivable included in a securitization transaction, that any observable event relating to such loan or receivable should be disclosed on the day the observable event occurs or as promptly thereafter as is possible.

An “observable event” means, with respect to a loan or a receivable that is collateral for a securitization, any of the following:  1) payment (and the amount thereof) by the obligor on such loan or receivable; 2) failure by the obligor to make payment in full on such loan or receivable on the due date for such payment; 3) amendment or other modification with respect to such loan or receivable; 4) the billing and collecting party becomes aware that such obligor has become subject to a bankruptcy or insolvency proceeding; or 5) a repurchase request is asserted, fulfilled or denied.

This loan-level disclosure would include all data fields tracked by the originator and the firm handling the daily billing and collection, but should be implemented in a manner that protects the privacy of individual borrowers consistent with the standards under the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”)."

This requirement is short and sweet.  It has the added benefit that it addresses both 'when' and 'what' should be disclosed and cures the problem that afflicts structured finance disclosure.


In Europe, the European Central Bank ("ECB") has taken the lead in establishing disclosure requirements for asset-backed securities.  The ECB is setting a disclosure standard that asset-backed securities will have to meet to be eligible to be pledged as collateral to the ECB.  Like the SEC, the ECB is working with the trade association on developing data reporting templates to the apparent exclusion of the appropriate timing of 'when' disclosure should take place.  The ECB could also adopt the disclosure requirement suggested for the SEC above and wait to rollout data reporting templates.  Not only would adopting this disclosure requirement cure the problems with existing structured finance disclosure, it would prevent regulatory arbitrage and it would let the global regulators find out what data fields investors actually use before deciding what data fields should be in a data reporting template.

Second, the sell-side and its lobbyists use the "Ignore the Issue" tactic.  In responding to the Committee of European Bank Supervisor's request for public comment on the guidelines for implementing Article 122a and its disclosure requirements, the fifteen (15) responses by the sell-side and its lobbyists never brought up the issue of 'when' disclosure should be made.  Perhaps they are hoping that the regulators will not notice that 'when' disclosure is made is as or more important than 'what' is disclosed if the revised structured finance disclosure requirements are going to be effective.

Third, there is the "if we keep repeating something, it must be right" tactic.  If they must talk about the timing of disclosure, the sell-side and its lobbyists talk about once-per-month disclosure.  For example, for Project Restart, ASF recommends once-per-month disclosure without ever discussing why once-per-month is the right frequency.  Perhaps they are hoping that regulators will not noticed that they cannot talk about why once-per-month disclosure is the right frequency because it has been shown to be so fundamentally flawed by the Brown Paper Bag Challenge.

All of these objections and tactics are just an insurance policy.  In reality, the sell-side and its lobbyists are probably betting on the regulators themselves to actually not understand or choose to not understand the Brown Paper Bag Challenge and its implications for revising structured finance disclosure regulations.  

Unfortunately, this is not an unreasonable bet.  

Global regulators have asked for public comment on their proposed revisions to structured finance disclosure regulations.  The regulators appear to have paid close attention to those comments submitted that support the agenda the individual regulators wanted to push.  

For example, the Bank of England ("BoE") expressed concern about managing the risk of structured finance securities on its balance sheet.  It had good reason to be concerned.  Despite direct bribes, like PPIP, and massive indirect incentives, like zero interest rate policies, investors are reluctant to return to the structured finance market.  This is not surprising considering that they lost hundreds of billions of dollars blindly betting on these securities with their once-per-month or less frequent disclosure.  For its part, the BoE recognized that central banks are only suppose to take on good collateral and not lose money.  


The BoE issued a Public Consultation in which it discussed the need for enhanced disclosure for structured finance securities if they were to be eligible to be pledged as collateral to the BoE.  In the responses to the Public Consultation, the BoE was made aware of the 'when' problem in structured finance disclosure and that once-per-month disclosure also did not appear to satisfy the "Know What You Own" requirements of Article 122a of the European Capital Requirements Directive.  


Still, the BoE proceded with its agenda to adopt a policy that requires eligible asset-backed securities to have at least once-per-month disclosure.  It rolled out this policy in its July 19, 2010 Market Notice (Expanding Eligible Collateral in the Discount Window Facility and Information Transparency on Asset-Backed Securities).  With this Market Notice, the BoE voluntarily took on the 'when' problem with structured finance securities.  It now has to contend with the issues of valuing the contents of and managing the risk of a portfolio of brown paper bags.

Finally, there is also a significant credibility hurdle that must be overcome by an individual or firm that the global regulators do not know when responding to the request for comment.  If the credibility hurdle is not overcome, the comments from the  "unknown" third party will be ignored before they can be seriously considered and acted on.


Conversely, why do global regulators receive multiple virtually identical responses from the sell-side and its lobbyists (both trade groups and law firms) on their request for comment?  Does this make the content of these responses somehow more legitimate?  For example, do global regulators count up the number of times an issue is raised and conclude that the issues that should be focused on are those that are mentioned most frequently by respondents?

Of course all the objections, tactics and legitimacy hurdles go away if the Brown Paper Bag Challenge is understood by a single senior government or regulatory official who is willing to use their position to cure the disclosure problem afflicting structured finance.