As readers of this blog know, Article 122a was passed by the European Parliament in May of 2009 as an amendment to the European Capital Requirements Directive. It applies to European credit institutions which are broadly defined to include commercial and investment banks.
Article 122a embodies the sensible notion that investors should "know what they own". If they do not know what they own, the article requires that they not be able to use any leverage to support their purchases of these asset. This too is sensible as it prevents the credit institution from losing more than its equity capital on investments where it is effectively blindly betting.
Why is this an opportunity for European regulators to shine? Under Article 122a, they are left to define what "know what you own" means for the purposes of enforcing Article 122a.
That should not be difficult. How many definitions of "know what you own" could there possibly be?
There are two: one as practiced by the sell-side and one that the industry trade groups and the sell-side are advocating.
What is the definition of "know what you own" that the sell-side actually uses?
The definition can be uncovered by looking at the actions of the sell-side. According to a December 6, 2010 Reuters article discussing Goldman and Litton Loan Servicing,
Banks often bought these kinds of businesses in part because they [Litton] could give an informational edge for mortgage bond trading, according to bankers that helped their institutions evaluate these deals.
What informational advantage for mortgage bond trading could Goldman receive from purchasing loan servicing companies like Litton? This informational advantage takes two forms.
First, there is 'when' information is disclosed.
Firms like Goldman receive observable event based information on the performance of the loans underlying a structured finance security (they see all payments, delinquencies, defaults, and insolvency fillings on the day they occur).
Contrast this to investors who receive this information on a once per month or less frequent basis and have to guess what the current performance of the underlying loans is.
Firms like Goldman enjoy a significant informational advantage for trading as they effectively have inside information without any legal restrictions on how they can use the information. There are a number of ways they can capitalize on this information. Remember the Abacus CDO transaction was a deal put together by traders.
Firms like Goldman receive observable event based information on the performance of the loans underlying a structured finance security (they see all payments, delinquencies, defaults, and insolvency fillings on the day they occur).
Contrast this to investors who receive this information on a once per month or less frequent basis and have to guess what the current performance of the underlying loans is.
Firms like Goldman enjoy a significant informational advantage for trading as they effectively have inside information without any legal restrictions on how they can use the information. There are a number of ways they can capitalize on this information. Remember the Abacus CDO transaction was a deal put together by traders.
Second, there is 'what' information is available.
Firms like Goldman would have access to all the information necessary to monitor and value the underlying loans. By definition, since they are in the business, firms like Litton track all the information necessary to monitor and value the loans.
Compare this to the disclosure templates being discussed by the SEC and other regulators. These disclosure templates would include a small subset of the information tracked by firms like Litton.
Firms like Goldman would have access to all the information necessary to monitor and value the underlying loans. By definition, since they are in the business, firms like Litton track all the information necessary to monitor and value the loans.
Compare this to the disclosure templates being discussed by the SEC and other regulators. These disclosure templates would include a small subset of the information tracked by firms like Litton.
The definition of "know what you own" as practiced by the sell-side is a three step process:
What is the definition of "know what you own" that industry trade groups and the sell-side are advocating?
- Have access to loan-level disclosure on an observable event basis;
- Combine this loan-level information on the underlying collateral with the terms of the deal;
- Use the analytic and cash flow models of choice to value the security.
What is the definition of "know what you own" that industry trade groups and the sell-side are advocating?
The definition of "know what you own" as lobbied for by the industry trade groups and the sell-side is a three step process:
- Have access to loan-level disclosure on a once-per-month basis where the information reported for each loan is a subset of the information available;
- Combine the restricted loan-level disclosure on the underlying collateral with the terms of the deal;
- Use the analytic and cash flow models of choice to value the security.
Not surprisingly, there is nothing in the lobbied for definition of "know what you own" that would eliminate the informational advantage enjoyed by the sell-side. It would also not restart the structured finance market as investors are aware of the informational advantage the sell-side enjoys.
The question is will the European regulators take the opportunity to shine and adopt how the sell-side practices "know what you own" as the definition of "know what you own" they will enforce under Article 122a?
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