Monday, November 8, 2010

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

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.  They do not provide the investor with the information the investor needs 'when' the investor needs it to make a fully informed buy, hold or 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.

Has the sell-side and its lobbyists (including sell-side dominated industry trade associations and lawyers), which claim to want sensible regulatory reform, championed the Brown Paper Bag Challenge conclusion that observable event based reporting should be part of the revised structured finance disclosure requirements?

No!  In fact, they have gone to extraordinary lengths to try to oppose observable event based reporting and champion the disclosure practices that result in investors blindly betting on the contents of a brown paper bag.

Those opposed to observable event based reporting in securitization transactions have asserted various types of objections.  The following briefly summarizes these objections and explains why the objections are not valid:

1.    Existing ABS reporting is sufficient.  Investors could have done their homework with once-per-month or less frequent data and seen the problems with ABS. 
This objection substitutes the ability to recognize a trend for the ability to value a specific security.  Clearly, the stale data disclosed in once-per-month reporting allows investors to see trends in the performance of the assets underlying a specific type of asset-backed security.  A few investors made a substantial amount of money from recognizing the downward performance trend of subprime mortgages. 
However, as demonstrated by the Brown Paper Bag Challenge, once-per-month reporting does not provide investors with the current detailed information that is necessary to value a specific ABS.  The gap between the ability to recognize a trend and the ability to value individual ABS cost investors several hundred billion dollars during the financial crisis. 
Whereas current ABS reporting practices resemble a brown paper bag, observable event based reporting resembles a clear plastic bag.   Observable event based reporting would provide the necessary disclosure so that investors can value specific ABS.  Observable event based reporting is necessary for restarting the securitization market and creating deep, liquid secondary markets.
2.    This much data will confuse investors.  Frequently, this objection is specified in terms of the number of loans.  For example, the objection is stated to be that loan-level disclosure makes sense when there are five thousand loans but not when there are fifty million loans.  Alternatively, the objection is specified in terms of the volume of data.  For example, the objection is stated to be that investors cannot handle billions of individual data points.
No matter how it is specified, this type of objection is false.  According to the AFME’s February 26, 2010 response to the European Central Bank’s Public Consultation on Provision of ABS Loan-Level Information, “from an investor perspective, loan-level data could provide a number of benefits: … provision of loan-level data will give investors certain options:  either to rely on the level of data that they currently use, or, alternatively, to employ third parties to transform the large amount of data into a more useable and value-added format.”  Since investors have the ability to use the loan-level data and they are willing to use third parties when necessary, providing loan-level data on an observable event basis is appropriate.
As discussed in the Association of Mortgage Investors’ March 2010 white paper on reforming the ABS market, it would be both “absurd” and inaccurate to assume that the investors are unable to use (or to engage third parties to help them to use) the loan-level data.
Under observable event based reporting, it is quite likely that there will be daily disclosure for securities backed by large numbers of loans or receivables. Investors who purchase the riskiest tranches will use this disclosure to closely monitor their positions.  Other investors might use the information less frequently.  For analysts who prefer to guess the contents of the brown paper bag and look at the performance data on the old once-per-month or less frequent basis, this would still be an option.
In addition, without loan-level disclosure on an observable event basis, investors cannot look at the non-performing loans and determine if there are borrower specific problems or systemic problems. 
ABS investors have computers to process loan-level data.  To the extent that ABS investors are unable to analyze loan-level data, they have a history of relying on third parties with computers who can analyze loan-level data for them.
3.    Implementing observable event based reporting would require significant changes to computer systems.  
Existing databases used by servicers handling the daily billing and collecting of loans and receivables already track observable events such as payments on a loan-by-loan basis.  As a result, loan-level data on observable events can and should be made available to investors on the day the observable event occurs or as soon thereafter as practicable so investors can know the current status of every loan or receivable backing an asset-backed security.

Consider an observable event-based report that can be accessed today by any person who holds a credit card.  The individual credit cardholder can, using existing technology, access a web site of the credit card issuer on any day of the month and review all charges and payments that have been made on the credit card on each day during the month.  Similarly, the credit card issuer can, using existing technology, on any day of the month review all the charges and payments that have been made on each day during the month on i) all of its credit cards, ii) a subset of credit cards which are collateral for a securitization or iii) an individual credit card.  Credit institutions have considerable expertise in observable event-based reporting.  This same expertise and the same information systems could be used to support observable event-based reporting for securitizations.
4.    The cost of observable event based reporting outweighs the benefits. 
The following is a comparison of the costs and benefits of observable event based reporting against the costs and benefits of keeping the existing once-per-month disclosure standard. 

·      In the TYI, LLC response to the FDIC Safe Harbor Proposal, a discussion of the costs and benefits of observable event based reporting was presented.  The response noted that investors such as Goldman Sachs and Morgan Stanley had access to loan-level observable event based data through their investment in or ownership of firms handling the daily billing and collecting of the underlying loans and receivables.  By late 2006, Goldman Sachs and Morgan Stanley had concluded that the risk in subprime mortgage backed securities was mispriced.  As a result, they not only reduced their exposure to these securities but also shorted these securities.  

     What would have happened if investors had access to the same loan-level observable event based data as the Wall Street firms?  Would they have also concluded the securities were mispriced?  If so, they would have avoided several hundred billion dollars in losses by not buying subprime mortgage backed securities originated in the years leading up to the financial crisis.  

     Based on the cost of comparable information services for securitizations, the cost of a data system to collect, standardize and disseminate observable event based data on a borrower privacy protected loan-level basis to all securitization market participants would be approximately 5 basis points (0.05%) of the principal amount of the loans that are supporting a securitization.  

     The bottom line to the cost/benefit analysis is that the benefit of not losing several hundred billion dollars far outweighs the cost of providing observable event based loan-level data. 
·      The alternative timeframe is the existing once-per-month disclosure standard.  This disclosure standard neither prevented the credit crisis and the associated several hundred billion dollars in losses nor has it restarted the securitization market.

Based on a comparison of the cost/benefit analyses, observable event based disclosure is far superior to retention of the existing once-per-month disclosure standard.

5.    It is too hard for sponsors to report this data.  This objection is specified in terms of the complexity or the ability of the sponsor to report loan-level data for all of an issuer’s deals. 
It will not be difficult for sponsors to report data on an observable event basis because each loan or receivable is linked in the daily billing and collecting database to a specific deal.  If this were not the case, how would anyone know if payments received went to the right deal?  It is a simple database query to identify every loan or receivable supporting a specific deal that had an observable event that must be disclosed.
6.    Providing loan-level data will require disclosure of internally calculated credit ratings, which will hurt a sponsor’s competitive position. 
Observable event based reporting will not require the disclosure of a sponsor’s internally calculated credit ratings.  Investors in ABS do not need such internally calculated credit ratings.  ABS investors do need all of the data fields that went into calculating the internal credit rating, such as the borrower’s credit score and income, in order to analyze the risk of the loans and receivables supporting the securitization. 
This objection is also presented as a reverse engineering argument.  If competitors are given all the information that the investor needs to properly analyze the risk of the loans and receivables, competitors can back into how the sponsor prices its financing relative to the borrower’s credit quality.  This argument is misleading as competitors already have multiple sources of this information including professionals who move between competitors and borrowers who disclose competitors’ offers in the hopes that someone will them make a better deal.  However, so as not to force disclosure of proprietary data, the SEC should refine the disclosure requirement to exempt disclosure of internally calculated credit ratings.
7.    The information has already been disclosed to third parties conducting due diligence on the underlying loans or receivables and therefore the investors do not need to see the data. 
This objection is another way of saying that investors should rely on the rating agencies.  However, reliance by investors on rating agencies who implied they had access to loan-level performance information was one of the primary contributors to the credit crisis.  In Europe, under Article 122a, there is a mandate that investors do their own homework so they know what they own.  In the US, the President’s Working Group on Financial Markets’ March 2008 Policy Statement on Financial Market Developments also stressed the importance of investors doing their own homework.  Global investors need to have access to loan-level observable event data so they can do their own homework regardless of whether third parties have conducted due diligence on the underlying loans or receivables.
8.    The cost of compliance with loan-level disclosure is too high.  It will adversely affect the economic attractiveness of securitization and reduce the amount of credit available to the economy.  The related objection is that after a certain period, say twelve (12) months, investors no longer need disclosure and when this happens, to save costs, disclosure should be discontinued. 
As noted above, the cost of observable event based reporting will be minimal.  At five basis points (0.05%) or less, the cost of observable event based reporting is significantly less than the illiquidity premium currently built into the securitization market.  The “illiquidity premium” refers to the fact that buyers in the primary securitization market know that without effective disclosure they will have to hold the security to maturity as it is unlikely that they will find buyers in the secondary market for the contents of a brown paper bag.  As a result, investors in the current once-per-month disclosure environment require a higher yield on ABS than they would if observable event based reporting were available.  It can be expected that observable event based reporting would reduce the illiquidity premium charged by ABS investors and that such reduction in the illiquidity premium would more than offset the 5 basis points (0.05%) cost of observable event based reporting.  In order to reduce the illiquidity premium over the life of the transaction, observable event based reporting should be required so long as the transaction is outstanding.

9.    Protecting obligor privacy requires that the sponsor disclose only a fraction of the data fields that the sponsor tracks
This objection ignores the ability of observable event based reporting to protect borrower privacy.  We would expect that observable event based reporting rules would require borrower privacy to be protected in a manner similar to the protections under HIPAA.  If borrower privacy is protected in a manner similar to the protections under HIPAA, there are very few data fields that could not be disclosed to ABS investors.
10. Sell-side has been talking with investors in ABS securities and the sell-side claims it knows what information investors need
It may be true that the sell-side believes that it understands what ABS investors need, however, it is equally clear that under current reporting standards ABS investors are not receiving the information necessary to analyze individual ABS.  

For example, we understand that it takes approximately 300 data fields to run all the standard analyses for CMBS deals.  However, fewer than 200 data fields are included in the sell-side dominated trade association template.  With observable event based reporting, we would expect this type of problem not to occur.  Subject to protecting borrower privacy, all of the data fields that are used by originating, billing and collecting entities would be provided to ABS investors.
11. Asset classes other than RMBS, CMBS and CDO have not experienced significant credit problems, so loan-level disclosure would be inappropriate for such other asset classes
The fact that some ABS investors have bought the contents of a brown paper bag in the past without sufficient information or without losing their investment, does not mean that ABS investors should continue to blindly place bets or that they will not experience credit problems in the future.  Observable event based reporting would allow ABS investors to evaluate ABS and select ABS which meet their investment criteria.
12. In revolving ABS transactions, some assets are not in the pool for very long and therefore it is not worthwhile to provide loan-level disclosure and instead only summary data is needed.
The fact that the pool of assets is not static is even more reason that ABS investors should know what is in the securitization pool.  AIG discovered this when the managers of the CDOs insured by AIG replaced lower risk securities with higher risk securities.

Part III of this series looks at the tactics used by the sell-side and its lobbyists to try to offset the deficiencies in its objections to observable event based reporting. 

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