Friday, November 5, 2010

The Sell-Side and Its Lobbyist Take On the Brown Paper Bag Challenge: Part 1

The ultimate success of financial reform is in the hands of the regulators.  As Timothy Ryan, CEO of the Securities Industry and Financial Markets Association ("SIFMA"), a leading sell-side lobbying organization, said, "the administration and the regulators have a mandate to move forward.  Our job is to work with them to try to achieve something that makes sense."

Let us look at how the sell-side and its lobbyists, including sell-side dominated industry trade associations and law firms, have done in working with the regulators on the revision of structured finance disclosure requirements and achieving something that makes sense.

As regular readers of this blog know, TYI, LLC developed the Brown Paper Bag Challenge in early 2008 to demonstrate that current securitization industry disclosure practices do not adequately address the timing of disclosure to investors and prevent investors from valuing individual ABS.  This is true even if the collateral performance is reported using current disclosure practices in an industry standard template being advocated by the American Securitization Forum, a former affiliate of SIFMA.

To create an asset-backed security, loans or receivables are placed into a trust for the benefit of the investors.  Among its other duties, the trustee provides reports to the investors on the performance of the underlying loans or receivables.  Under existing securitization disclosure practices, these reports are provided on a once-per-month or less frequent basis. 

A brown paper bag is the physical model that best represents these asset-backed securities.  Investors know what loans or receivables went into the bag, but under current reporting practices they do not know what is in the bag, ie how the loans are performing, on a current basis.

The Brown Paper Bag Challenge highlights why knowing what you own, in this case knowing what is in the bag currently, is important for valuing individual asset-backed securities ("ABS").  

As part of this challenge, assume that at the start of last month, $100 was placed into a brown paper bag (which is analogous to the loans or receivables being placed in a securitization trust).  A report has been issued that indicates at the end of last month there was $75 in the bag (which is analogous to the once-per-month disclosure to investors in securitization transactions in an industry standard template).  The Brown Paper Bag Challenge is as follows: what is the value of the contents of the bag today? 

In the Brown Paper Bag Challenge, everyone is invited to submit an offer to buy the contents of the brown paper bag.  If the price offered is accepted by TYI, then money changes hands.  If the price offered is greater than the value of the contents of the bag, then the difference is paid to TYI.  If the price offered is less than the value of the contents of the bag, then the difference is paid to the individual submitting the purchase offer.  

Potential buyers of the contents of the brown paper bag should be aware of the following fact:  in this challenge, TYI, in a role that is similar to the Wall Street firms that invest in or run servicers handling the daily billing and collecting in securitization transactions, has observable event data, in this case withdrawals of money, so it knows what is in the brown paper bag currently.

Based on the once-per-month report, current and potential investors do not know what is in the bag right now.  They can only guess at what is a knowable historical fact.  The same is true with respect to ABS.  Once-per-month reporting blocks investors from knowing what is currently in ABS and limits investor valuation of the contents of ABS to an exercise of blind betting.  If investors guess incorrectly, whether buying ABS or taking the Brown Paper Bag Challenge, they lose money.

To date, TYI has been unable to find anyone who is willing to take the Brown Paper Bag Challenge. 

However, when a clear plastic bag, which is analogous to providing observable event based reporting, is substituted for the brown paper bag, everyone is willing to make an offer for the contents of the clear plastic bag.  This is because the contents of the clear plastic bag can be seen and valued.  The same could occur for specific securitization transactions; if current information were provided by observable event based reporting, then investors would be able to make informed buy, hold and sell decisions with respect to ABS.

This simple example using brown paper and clear plastic bags may explain why investors have been reluctant to return to the securitization markets in the absence of observable event based reporting.

Part II of this series looks at the sell-side and its lobbyists objections to providing loan-level performance data on an observable event reporting basis and their arguments for why disclosure that results in investors betting blindly on the contents of a brown paper bag is just fine.

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