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.
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.
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.
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.
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?