Tuesday, November 9, 2010

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.  

No comments: