Monday, December 20, 2010

Asset Level Data is Nice in Theory, But...

The time has come to step back from discussing the theoretical benefits of providing asset level data on an observable event basis to focus on the practical issue of implementation.

What is an observable event for a loan, receivable or investment?

An “observable event” means any of the following:  1) payment (and the amount thereof) by the obligor; 2) failure by the obligor to make payment in full on the due date for such payment; 3) amendment or other modification with respect to such asset; 4) the billing and collecting party becomes aware that such obligor has become subject to a bankruptcy or insolvency proceeding; or 5) for a structured finance transaction a repurchase request is asserted, fulfilled or denied.  

Observable events should be disclosed on the day the observable event occurs or as promptly thereafter as is possible.

Currently, is it technically possible to provide this data to all market participants?

Yes!  The databases used by credit institutions are based on tracking observable events.

In case you have any doubts that these databases work this way, 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 each asset.

What are the objections by credit institutions to observable event based asset level reporting?

1.    Existing reporting is sufficient.  For structured finance securities, 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 for structured finance securities 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.  It is an attempt to create a picture of an individual sitting at their desk with a pile of loans in front of them.  Imagine how big the pile of a million loans would be.  

The reality is that since the information is in a database, the individual sitting at their desk could have their computer look at the individual loans and investments.

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 asset-level data and they are willing to use third parties when necessary, providing asset-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. 
Investors have computers to process asset-level data.  To the extent that investors are unable to analyze asset-level data, they have a history of relying on third parties with computers who can analyze asset-level data for them.
3.    Implementing observable event based reporting would require significant changes to computer systems.  
Existing databases used by credit institutions already track observable events such as payments on a loan-by-loan basis.  As a result, asset-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 asset.

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 credit institutions to report this data.  This objection is specified in terms of the complexity or the ability of the issuer 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.    The information has already been disclosed to third parties like rating services and regulators, 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 and regulators.  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.
7.    The cost of compliance with asset-level disclosure is too high.  It will adversely affect the economic attractiveness of making loans or securitization and this will 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.

8.    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.
9. Sell-side has been talking with investors and the sell-side claims it knows what information investors need
It may be true that the sell-side believes that it understands what investors need, however, it is equally clear that under current reporting standards investors are not receiving the information necessary to analyze individual banks or ABS securities.  

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.
10. 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.
11. 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.

No comments: