Friday, December 31, 2010

European Bank Supervisors Save Structured Finance Reform

Just when it appeared that structured finance reform might be gutted, on December 31, 2010, the Committee of European Bank Supervisors published effective January 1, 2011  Guidelines to Article 122a of the Capital Requirements Directive.

Article 122a of the European Capital Requirements Directive is legislation that requires that European credit institutions, whether investing for their own accounts or in a fiduciary capacity, "know what they own" when investing in structured finance transactions.  If these credit institutions do not know what they own, then each structured finance position they invest in has a 100% capital requirement.

The critical guideline is paragraph 79 on page 36.
... credit institutions as investors should make their decision to invest only after conducting thorough due diligence. To make such a decision, credit institutions as investors need adequate information about the securitisation; therefore, credit institutions should not invest in securitisations where they determine that they do not have, and will not be able to receive, adequate information to undertake thorough due diligence and satisfy the requirements of the Directive.
In the accompanying feedback document, clause 68 on page 24 removes any ambiguity about the credit institution's responsibility as an investor.

Potential investors should decide what information they need to inform their investment decision; if that is not available or provided they should not invest. There is existing text that covers the fact that there is no need to provide information that breaches regulatory or legal requirements; this is deemed to be sufficient.

Please re-read these paragraphs again as they place on credit institutions as investors the obligation to not invest in the absence of adequate information to undertake thorough due diligence both before investing in and while having an investment in a structured finance transaction.

With this obligation comes the need for regulatory compliance and the potential for legal liability.  The potential for legal liability arises because as an investor, particularly when the credit institution is acting in a fiduciary capacity, it is holding itself out as 'knowing what it owns'.

In the event of a loss on a structured finance security investment, common sense dictates that the credit institution must be able to defend this representation that it 'knows what it owns' by proving that it had adequate information to undertake thorough due diligence and on-going investment monitoring.  This is a far higher standard than bank regulators might choose to enforce.

There are two components to adequate information: when it is disclosed and what is disclosed.

Having data on the underlying collateral performance disclosed at the right frequency is a "material necessity" if credit institutions are going to be able to show that they "know what they own" for both due diligence and portfolio monitoring.

Paragraph 79 addresses 'when' the information is disclosed.  For these guidelines, information must be disclosed on an observable event basis otherwise credit institutions will not have, nor will they be able to receive adequate information to undertake due diligence or monitor their structured finance investments.

What is an observable event?

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.

Even with relaxed compliance enforcement by regulators, how do we know that structured finance information must be disclosed on an observable event basis?

First, in September 2007,  the rating agencies testified before the U.S. Congress that current once-per-month or less frequently reported data was inadequate for monitoring structured finance securities and making timely changes to the ratings of these securities.  By itself, this testimony is sufficient to disqualify current once-per-month or less frequently reported data for the purpose of  'knowing what you own' or for its use by credit institutions to make them less dependent on rating agencies.

If the current data reporting frequency is inadequate for 'knowing what you rate', it is also inadequate for 'knowing what you own'.

It is common sense that if it is inadequate for 'knowing what you rate' it is also inadequate for using for due diligence purposes to buy a structured finance security in the secondary market or for monitoring structured finance securities purchased in the primary market.

Second, before the credit crisis, Wall Street found once-per-month or less frequent data inadequate for its own trading operations.  Wall Street gained an informational advantage for these trading operations by purchasing firms handling the servicing of the underlying collateral.  The information edge provided by the servicing firms was observable event based information on the underlying collateral performance.  Wall Street knew what was going to be in the once-per-month or less frequent reports provided to investors before the investors.  Since structured finance securities have no insiders, Wall Street could legally use what was effectively "inside information" in the form of observable event based reporting in its trading operations to take advantage of investors who received only once per month or less frequent reports.

Third, The Brown Paper Bag Challenge shows definitively that in the absence of information on an observable event basis, investors are blindly betting when they purchase a structured finance security using once-per-month or less frequent collateral performance reports. 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 Brown Paper Bag Challenge also highlights the fact that while other buy-side firms might be blindly betting when they purchase structured finance securities it does not mean that a credit institution using once-per-month or less frequent collateral performance reports 'knows what it owns' when it buys a structured finance security.

Based on the three facts stated above, it is difficult to see how a credit institution can claim that it 'knows what it owns' for either Article 122a or when it is investing for others in a fiduciary capacity if it uses once-per-month or less frequent collateral performance reports.

Ultimately, the Brown Paper Bag Challenge sets the common sense, legally defendable standard for 'when' asset-level performance data must be disclosed for structured finance so credit institutions can 'know what they own'.  
If asset-level data is available on an observable event basis, it is the equivalent of doing due diligence on the contents of a clear plastic bag.  If asset-level data is available on a once-per-month or less frequent basis, it is the equivalent of doing due diligence sight unseen on the contents of a brown paper bag.  Credit institutions 'know what they own' when buying the contents of a clear plastic bag.  Credit institutions do not 'know what they own' when buying sight unseen the contents of a brown paper bag.

Finally, if credit institutions or buy-side firms cannot access asset-level performance data that meets the Brown Paper Bag Challenge standard for 'knowing what they own', do they have to disclose that they are blindly betting? Is it prudent for credit institutions or buy-side firms to buy structured finance securities if they cannot access asset-level performance data that meets the Brown Paper Bag Challenge standard?

Paragraphs 125 and 128 describe 'what' should be disclosed.  For these guidelines, what should be disclosed is loan-level performance data for the individual assets that back each security.
125. Originators and sponsors are also required to provide to investors such information as is necessary to conduct comprehensive and well-informed stress tests on the cash flows and collateral values supporting the underlying exposures. To the extent that there are (for example) standardised reporting and disclosure templates, generally accepted by market participants, that fulfil these requirements adequately, they can be used if the information
disclosed therein is sufficient to fulfil these requirements. 
128. The term “individual underlying exposures”, for which relevant data must be provided by credit institutions as sponsors or originators, will typically mean that such data should be provided on an individual exposure (or “loan-level”) basis, as opposed to on a collective basis. However, it is recognised that there may be circumstances in which such loan-level disclosure is not appropriate; for instance, securitisations with a large volume of exposures that are highly granular. On the other hand, in many circumstances loan-level disclosure is a material necessity for the due diligence process; for instance, securitisations with large concentrations of non-granular exposures.  In determining whether such information should be provided on an individual or aggregate basis, a credit institution, when acting as originator or sponsor, should consider the information that a credit institution when acting as investor would need in order to fulfil its requirements under Paragraphs 4 and 5.
Paragraph 127 addresses 'how' the asset-level data should be made available.  For these guidelines, the focus is on minimizing the cost of accessing and using the data by the investor.
127. The term “readily available” means that gaining access to the information should not be overly prohibitive (in terms of search, accessibility, usage, cost and other factors that might impede availability), so that fulfilling their due diligence requirements is not overly burdensome on investors. 

Thursday, December 30, 2010

Home Prices Are Still Too High

The Wall Street Journal ran an interesting editorial discussing current home prices versus the prices houses would have been expected to sell for if the residential real estate bubble had not occurred.
...By all accounts, the home price boom that began in January 1998, when the previous 1989 peak was finally surpassed, and topped out in June 2006 was extraordinary. The 173% gain in the Case-Shiller 10-City Index (the only monthly data metric that predates the year 2000) in those nine years averaged an eye-popping 19.2% per year. 
...If we assume the bubble was artificial, we can instead imagine that home prices should have followed a more traditional path during that time. In stock-market terms, prices should have followed a trend line. When you do these extrapolations..., a sobering picture emerges. In his book "Irrational Exuberance," Yale economist Robert Shiller (co-creator of the Case-Shiller indices along with economists Karl Case and Allan Weiss), determined that in the 100 years between 1900 and 2000, home prices in the U.S. increased an average 3.35% per year, just a tad above the average rate of inflation. This period includes the Great Depression when home prices sank significantly, but it also includes the frothy postwar years of the 1950s and '60s, as well as the strong market of the early-to-mid 1980s, and the surge in the late '90s.
In January 1998 the 10-City Index was at 82.7. If home prices had followed the 3.35% annual 100 year trend line, then the index would have arrived at 126.7 in October 2010. This week, Case-Shiller announced that figure to be 159.0. This would suggest that the index would need to decline an additional 20.3% from current levels just to get back to the trend line.
An alternative way to look at this data is to ask how many years before the trend line index reaches the current index level.  It would take approximately 7 years to close the gap (126.7*(1.0335)^y = 159.0). 
How has the market found the strength to stop its descent? No one is making the case that fundamentals have improved. Instead, there is widespread agreement that government intervention stopped the free fall. The home buyer's tax credit, record low interest rates, government mortgage-assistance programs, and the increased presence of Fannie Mae, Freddie Mac and the Federal Housing Administration in the mortgage-buying business have, for now, put something of a floor under house prices. Without these artificial props, prices would have likely continued to fall.
There were two ways that Fannie Mae, Freddie Mac and the Federal housing Administration have increased their presence in the mortgage buying business.  First, Congress mandated that they increase the size of the mortgage that was eligible as a conforming mortgage.  This increase in size was designed to prop up property prices as it was (is?) difficult to get a jumbo mortgage.  Second, with the demise of the private residential mortgage backed securities market, agency backed mortgages became the only alternative.
Where would prices go if these props were removed? Given the current conditions in the real-estate market, with bloated inventories, 9.8% unemployment, a dysfunctional mortgage industry and shattered illusions of real-estate riches, does it makes sense that prices should simply fall back to the trend line? I would argue that they should overshoot on the downside.
With a bleak economic prospect stretching far out into the future, I feel that a 10% dip below the 100-year trend line is a reasonable expectation within the next five years, particularly if mortgage rates rise to more typical levels of 6%. That would put the index at 114.02, or prices 28.3% below where we are now. Even a 5% dip would put us at 120.36, or 24.32% below current prices. If rates stay low, price dips may be less severe, but inflation will be higher.
If house prices without all the government props would currently be 10% below the trend line, an index value of 114.02, it would take 11 years at trend line growth to reach the index value of house prices with all the government props, 159.

Is the government willing to pursue policies to artificially prop up house prices for the next decade?  Does the US have the financial wherewithal to prop up house prices for the next decade?
From my perspective, homes are still overvalued not just because of these long-term price trends, but from a sober analysis of the current economy. The country is overly indebted, savings-depleted and underemployed. Without government guarantees no private lenders would be active in the mortgage market, and without ridiculously low interest rates from the Federal Reserve any available credit would cost home buyers much more. These are not conditions that inspire confidence for a recovery in prices.
As pointed out by the columnist earlier, the underlying trend of prices increasing by 3.35% per year occurred through both good and bad times (including the Great Depression).   Presumably it should still be continuing.
In trying to maintain artificial prices, government policies are keeping new buyers from entering the market, exposing taxpayers to untold trillions in liabilities and delaying a real recovery. We should recognize this reality and not pin our hopes on a return to price normalcy that never was that normal to begin with.
The conclusion from the analysis is that the US government is exposing taxpayers to considerable risk by artificially propping up house prices.  The risk is not that house prices will continue to correct.  The columnist identifies a number of factors that support an ongoing correction.  Left off the list is demographics.  What is going to happen to all the houses that the baby boomers have and want to sell as they go into retirement?  

The risk is that the US government will spend a significant amount of its resources and have little left to fight another economic downturn.

Wednesday, December 29, 2010

To Calm Investors, Spain to Open Its Books? No

The Bank of Spain has clarified what opening its books means.  As reported by Reuters,
The central bank has told the country's banks to give detailed quarterly reports which include exposure to property developers and bad loan ratios, and to outline financing plans.
"We believe market perception is much worse than reality," a Bank of Spain official said at a recent press briefing.
The central bank officials may believe market perception is much worse than reality, but they are unwilling to make the loan-level data available that would allow the credit market analysts the ability to independently confirm the accuracy of this belief.

Instead of loan-level data, the central bank officials plan to offer quarterly reports with bad loan ratios.  As every credit market analyst knows, the problem with bad loan ratios is in the definition of "what" is included in the total for bad loans.

Do the "Newly Built Ghost Towns" reported in the NY Times get included in the bad loan totals?  Does the other real estate mentioned in the article get included in the bad loan totals?
Still, skeptics abound. One is Jesús Encinar, the founder of Spain’s most popular property Web site, He says that the Spanish authorities are striving to engineer a soft landing of the housing market that would give more time to offload surplus housing at reasonable prices.
But he believes prices still have a long way to fall, by 30 or 40 percent, maybe more. “Some people who said there was no housing bubble are now saying we are at the bottom,” Mr. Encinar said. “But I say we have several years to go.”
He is not alone in scoffing at some of Spain’s numbers. In a report last April, the French bank Société Générale dismissed many of the assertions made by Spain’s banks, pointing out that Spain had one of the fastest rates of expansion in construction, had the largest number of mortgages per capita and was the most overbuilt among its peers. Yet prices had fallen the least. “We find it impossible to reconcile the banks’ claims of asset quality stability and the macro facts,” the report said.
...There is, however, broad agreement that many of Spain’s empty units are in areas where there is little demand for them, particularly along the southern coastal areas where hills have disappeared under vast housing developments. Practically overnight, Spain’s banks have been forced to begin managing vast real estate portfolios, a role most were ill equipped to take on.
“They do not know how to take care of this housing stock or how to rehab properties,” said Raúl García García, from Tinsa.
While some banks have set up networks to sell property, many others are floundering, having trouble just keeping track of the keys. “They take the old guys who are sitting around and say: ‘Hey, you are in charge of real estate now,’ ” Mr. Encinar of said. “Some are not even answering the phone.”
Experts say that whatever is on the market now is only a piece of what is in the pipeline from distressed homeowners and developers. Mr. Encinar says the banks are holding back on putting property on sale, afraid to bring prices crashing down.
Fernando Acuña, co-founder of, a Web site that sells housing on behalf of the banks, said as many as 100,000 repossessed units were now for sale in Spain, a number that “could double or triple.”
Still, eager to begin getting some of the property off their balance sheets, some banks have been offering deep discounts and special mortgage rates.
Experts say the banks are being slightly more choosy these days about who lend to. But the new loans — almost all of which are at variable rates — could create a second wave of defaults down the road when interest rates rise. Next year may produce a new round of defaults from developers as well. In the early days of the crisis, many banks renegotiated their loans. But experts say many of those deals will expire next year, and without any significant change in the economy, most developers will be no better off.
The tension between banks and developers, once happy accomplices in a booming business, is palpable. Mr. Galindo says that the banks are not lending to developers who have half-built projects and that they are favoring customers who want to buy bank-owned property when giving out mortgages.
The biggest challenge for the banks is that they are likely to end up owners of vast amounts of undeveloped land. José Luis Suárez, an expert on real estate at the IESE business school, said 65 percent of bank lending to developers is tied up in land, enough to build 758,000 more housing units. “That gives you an idea of how long it could take for the market to digest all this,” he said.
Using quarterly reports is a risky strategy.
  • What happens if loans that are excluded from the bad loan total in the first quarter are included in the second quarter?  The credit markets know that this is a distinct possibility - remember that the Irish government went through their banks three times trying to identify and remove all the bad loans.  
  • What happens if the credit markets do not believe the bad loan total shown in the first quarter?  Articles like the NY Times piece suggest that the credit markets are assuming a bad loan ratio that exceeds 50% for real estate. 
As mentioned in the Reuters article, there is a downside to not making loan-level data available and instead relying on reports that may subsequently be seen as overly optimistic.
Ireland's experience had shown that waiting too long to restore confidence in the banking sector's credit quality leads to heightened pressure from the interbank markets to inject capital.
A rising tide of bad property loans eventually forced Dublin to seek outside help in managing its finances, and bailing out lenders there could end up costing taxpayers up to 85 billion euros, or over half of annual GDP.
Is this the fate which awaits Spain? 

Tuesday, December 28, 2010

It is Time to Address Solvency

What will it take to get the global financial policy makers to directly address the global banking system's solvency problem and stop injecting liquidity and pretending the solvency issue will go away?

Thanks to WikiLeaks, we know that by March 2008, Mervyn King recognized and tried to explain to the global financial policy makers that:
  • The global financial system was facing a solvency crisis that required recapitalization of the banking system; and
  • While liquidity was necessary to keep the credit markets functioning, it was not a replacement for risk capital.
Furthermore, he realized that illiquid structured finance securities, including mortgage backed securities, needed to be valued if the issue of solvency was going to be addressed.

The pursuit of a valuation mechanism for the illiquid securities and addressing the issue of solvency was interrupted, in September 2008, when liquidity throughout the credit and capital markets disappeared.

Why did liquidity disappear then?  

Investors saw what happened to Lehman Brothers.  Lehman Brothers succumbed to a liquidity problem brought on by questions about its solvency.  

Credit market analysts looked at Lehman Brothers' then current disclosed exposure to illiquid securities.  They then applied a worse case loss assumption to these securities.  The analysis showed that Lehman Brothers was insolvent.  Naturally, investors wanted their money returned.  This "run on Lehman Brothers" created the liquidity problem.

It was a small step for the credit market analysts to then apply this solvency analysis to other large, global financial institutions.  The conclusion was that few, if any, of these institutions were solvent.  Faced with insolvency, there was a global "run on the bank" as investors, which included banks that lent funds to other banks, raced to withdraw their funds.

The disappearance of liquidity created a problem for the global financial policy makers.  How could they provide enough liquidity to the credit and capital markets to buy time so that the solvency issue could be addressed?

This point bears repeating.  By the time Lehman Brothers went bankrupt, Mervyn King and all the global financial policy makers knew:
  • There was a solvency problem involving most, if not all, of the large, global financial institutions;
  • Liquidity by itself would not fix the problem; and
  • Solvency needed to be addressed if the policy makers were going to be able to permanently exit all the programs put in place to inject liquidity into the financial system.
If the global financial policy makers knew that solvency needed to be addressed, why did they default to their traditional policy of injecting liquidity and publicly denying a solvency problem?

By September 2008, the global financial policy makers were already well aware that their traditional policy creates its own problems and does not cure the underlying solvency issue.
  • The traditional policy has alway created moral hazard.  Rather than make the existing risk capital investors (equity and debt holders) take a haircut when the credit markets first recognize a solvency problem, regulators give them a free pass.  
  • The traditional policy has always failed to cure the solvency issue.  
    • It failed when U.S. regulators tried it at the beginning of the Savings & Loan Crisis in the 1980s.  It failed when Japan applied it after its credit bubble burst in the 1990s.  Ironically, the U.S. financial policy makers told the Japanese financial policy makers that injecting liquidity and publicly denying a solvency problem would not work.  The U.S. financial policy makers' recommendation was to recognize the losses.
Perhaps the choice of this failed traditional policy is driven by the hope that somehow the insolvent financial institution can be force fed enough earnings so that the financial institution can absorb all the losses on its balance sheet.  

While this is true in theory, there is a wee problem with implementing this policy in practice.  

Force feeding earnings into an insolvent financial institution fails when the financial policy makers refuse to publicly acknowledge that the financial institution is insolvent.  Without this public acknowledgement, current employees and owners see "record earnings" for the financial institution and take out the earnings as bonuses and dividends.

Presumably, the reason that financial policy makers do not want to publicly acknowledge that a financial institution is insolvent is fear of sparking a "run on the" financial institution.

However, as was shown in the Savings & Loan crisis, the Japan credit crisis and the current credit crisis, investors are willing to fund an insolvent credit institution so long as the government is protecting the investors against the losses on the financial institution's balance sheet.  

It is when that protection disappears that investors want no part of the financial institution.  This is not surprising as the issue of solvency for the financial institution was never addressed!

Pursuing the traditional policy also raises the issue of who is going to absorb the losses when the solvency issue is finally addressed.  After all, no investor would buy the losses on financial institution balance sheets knowing that they exist.

That a policy of liquidity injections and public denial of solvency problems would not address the solvency issue should not be a surprise to readers of this blog and its companion web site,  Readers knew in 2007 that in the absence of access to loan-level information on an observable event basis for these illiquid structured finance securities that:
  • Once the devaluation process on these securities began, there was no logical stopping point in the downward price spiral other than zero;
  • The few Wall Street firms which did have access to this current loan performance information preferred to keep the information for themselves so they could trade against their "clients".
  • Injecting capital directly, through investments, or indirectly, through earnings, would not answer the question of whether a financial institution was solvent.  Since the illiquid securities could still not be independently valued by the credit market, it would still be impossible to determine whether a financial institution had enough capital to cover the losses on these securities and related credit exposures.
There is a reason your humble blogger refers to a downward spiral.  The first loop of the spiral was focused on the banks and their solvency.  When the governments stepped in and protected the senior investors, which were frequently their country's banks, they transferred the issue of solvency to their balance sheets.  This created the conditions for the second downward loop in the spiral.

So let's review where we are at after three years of pursuing a policy of injecting liquidity and publicly denying the solvency problem.
  • The illiquid structured finance securities can still not be valued.
    • Existing once-per-month or less frequent loan-level disclosure practices leave investors blindly betting on the value of the securities (for more on why this is true, please see the Brown Paper Bag Challenge).
    • The sell-side of the structured finance industry, through the trade associations that it dominates, is blocking regulatory efforts in Europe and the U.S. to provide investors with the current loan-level information that investors need to value the securities.  
      • The sell-side opposition reflects its desire to preserve its informational advantage from servicing the underlying assets and using this information to profit from trading against their clients.  
    • Buyers of structured finance securities are aware that the sell-side has the equivalent of "insider information" that it uses in its trading against them (see the experience of the buyers with securities like Abacus).  There is a buyers' strike until the buy-side receives the same information at the same time as the sell-side.
  • The private RMBS mortgage market is still frozen and the other consumer backed securities markets are faltering.
    • Neither direct bribes, through programs like TALF and PPIP, or indirect bribes, through implementation of zero interest rate policies to encourage investors to chase higher yields, has resulted in sustainable liquidity returning to the market for existing structured finance securities. 
      • If there were sustainable liquidity in the market for existing structured finance securities [where sustainable liquidity equals active trading], then the regulators would have pushed to restore mark-to-market accounting and eliminated mark-to-myth accounting for financial institutions.
    • Issuance of consumer backed structured finance securities are becoming less frequent.  This is a direct result of the Fed providing zero cost funds to the banks and crushing the economic attractiveness of issuing structured finance securities.
  • Banks still have a portfolio of illiquid structured finance securities that cannot be valued as well as other residual exposures to the credit bubble (like commercial and second mortgages).  
  • Without an active secondary market for the current outstanding structured finance securities and the return of mark-to-market accounting, investors still do know know which, if any, of the large, global financial institutions is solvent.  
    • The size of these institutions' exposure to the illiquid securities and therefore the potential losses on the balance sheet dwarfs the capital base of the financial institutions.
  • Governments are explicitly or implicitly guaranteeing all unsecured investments in these financial institutions while publicly denying there is a solvency problem by asserting that the financial institutions are solvent.
    • The European stress tests are confirmation of the extent of public denial of a solvency problem.  
      • First, there are two banks in Ireland that needed to be recapitalized but 'passed' the stress test. 
      • Second, there are only five cajas, a real estate oriented bank, in Spain that failed the stress test when a reasonable expectation given the size of the decline in real estate valuations since the peak of the Spanish real estate bubble would have been only a few of cajas passing.
  • The solvency of individual countries is being questioned as credit market analysts question the financial strength backing up the guarantees of the financial institutions' debt.
    • Credit market analysts are performing a Lehman Brothers' solvency analysis on each European government.  At its peak before the credit crisis, the global illiquid structured finance market exceeded $15 trillion dollars.  The absolute size of the potential losses in each country's banking system calls into question the solvency of each individual country through its bank debt guarantee.
  • Credit market participants are still engaging in "runs" when there is doubt about the solvency of the banks in a country's banking system and the government which supports them.  
    • As Ireland has shown, investors are leaving both a country's banks and its sovereign debt.
  • Governments are adopting austerity in their fiscal policy to 'convince' the credit markets that the governments are solvent after plugging the hole in their banking systems.
    • For this to work, the credit markets have to believe what governments are saying about the size of the hole in their banking systems.  
The morphing of a bank solvency crisis into a sovereign debt crisis and its related austerity measures is a sure sign of the failure of the policy of injecting liquidity and publicly denying the solvency problem.

Despite spending trillions of dollars, the global financial policy makers find themselves facing the same solvency problem as in 2008, but instead of just involving the banking system it has now spread to sovereign debt and involves cutting back on services to the taxpayers.  

Hopefully, while there is still time to halt this downward spiral, the global financial policy makers will abandon the failed policy of injecting liquidity and denying the solvency issue.  

Clinging to this failed policy is the equivalent of telling the capital markets that the financial institutions are insolvent and that the hole in the banking system exceeds the government's ability to fill while remaining solvent itself.  

If the combination of the financial institutions and the government are solvent, there would be nothing to hide.  

In this case, the governments should be leading the way to have the financial institutions provide the current asset level data that would enable the market participants to see for themselves that the combination of government and financial institutions is solvent.  

Ultimately, showing who is or is not solvent is a four step process:
  • Provide current asset level performance on an observable event basis for all illiquid securities and all exposures on financial institution balance sheets to all credit market participants.  
  • With this data, credit market participants can independently analyze each illiquid security using the valuation models of their choice. 
  • Using these independent valuations, investors can then make buy, hold and sell decisions based on the prices being shown by Wall Street and a liquid market created for the previously illiquid securities.  
  • With an active market for the previously illiquid securities and all the assets for each financial institution, it is easy to determine which financial institutions are solvent, which are not solvent and how much capital the insolvent institutions need.  
Once the insolvent institutions have been identified and the amount of capital needed to cure their insolvency determined, regulators can then oversee a resolution of the insolvent financial institutions.

      Monday, December 27, 2010

      Reforming Fannie Mae and Freddie Mac

      2011 is suppose to be the year that Fannie Mae and Freddie Mac are reformed.  The key to the success of this reform is the non-agency RMBS market.  

      So long as the non-agency RMBS market is frozen, the agencies are necessary.  There is not enough capacity on bank balance sheets to replace the agencies.

      However, if the non-agency RMBS market is restarted, then the dependence on the agencies is dramatically reduced.

      Restarting the non-agency RMBS market is a three step process:
      • As has been discussed repeatedly on this blog, current asset level performance on an observable event basis must be made available to all credit market participants.  
      • With this data, all credit market participants can independently analyze each security using the valuation models of their choice. 
      • Using their independent valuations, investors can then make buy, hold and sell decisions based on the prices being shown by Wall Street. 

      Tuesday, December 21, 2010

      Thanks to AFME, Mark-to-Market Returns to Structured Finance Securities on February 1, 2011

      Thanks to the work of the Association for Financial Markets in Europe (AFME), all of the major credit institutions in Europe will be able to begin marking-to-market their structured finance portfolios by February 1, 2011. 

      Thanks to AFME, by the end of the first quarter of 2011, investors will be able to find out which major European credit institutions are solvent and which are insolvent based on their holdings of structured finance securities.

      Why does your humble blogger make these statements?  According to an article in Global Financial Strategy,

      An influential European industry group has backed proposals by the European Central Bank to implement new requirements for providing loan-level information for asset-backed securities.
      The Association for Financial Markets in Europe said in a statement that the move should "enhance transparency" of underlying assets in securitisation pools.
      Richard Hopkin, AFME managing director and a member of the ECB's technical working group, said: "AFME supports measures which have the potential to improve investor confidence in securitisation."
      The ECB guidelines are designed to make information on underlying loans and their performance more timely, widely available and produced in a standardised format.
      "In addition, the industry appreciates the ECB's introduction of an operational phase-in period of 18 months, which is an important factor given the systems changes required of members," added Hopkin.
      Your humble blogger would like to help the reader understand why Mr. Hopkin's comments mean that mark-to-market accounting for structured finance securities will return by February 1, 2011.

      First, Mr. Hopkin would have you believe that it will take 18 months to make all the systems changes required.  As one of the world's leading experts on loan-level disclosure for structured finance securities (I have developed patented information technology in this area), what the ECB is asking the large credit institutions to do can easily be done in a month.  It is a simple data mapping exercise.

      Given that current disclosure practice is to release RMBS loan-level data on a once per month basis, with little effort, the large credit institutions can comply and make the data the ECB is requesting available by February 1, 2011. 

      The failure by any institution to deliver the data by that date can only be attributed to the fact that they have something to hide, namely they are insolvent based on their holdings of structured finance securities that they service.

      Delivering loan-level data is only half the problem.  The second half of the problem is that the data being delivered must also restore "investor confidence".  Without investor confidence, the investors who have gone on a buyers' strike will not return to the securitisation market.

      Clearly, Mr. Hopkin and AFME would have done everything possible to assure that what is being disclosed and when it is being disclosed would restore investor confidence.  Restoring investor confidence means that investors can use this data in the analytic and valuation models of their choice to independently value the securities and then make buy, hold and sell decisions based on the prices shown to them by Wall Street.  

      After all, why would the managing director of a sell-side lobbying firm (it is an affiliate of SIFMA - the sell-side's main lobbying arm) not do everything possible to insure the return of investor confidence and the restarting of the securitisation market?

      Given the intent of all the participants on the ECB technical committee was to restart securitisation by providing the buy-side with the information they want and need on a timely basis, I can only assume that after this information is made available by the end of January, the investors will return to the market.

      Bottom line, if the investors return to the market under the ECB requirement it means the return of mark-to-market accounting for all European credit institutions.

      If the market is not very actively trading with many new offerings being placed with private investors by the end of February, it would suggest that investors were not looking for a perpetuation of current once-per-month or less frequent disclosure practices.  It would also suggest that the focus on standardizing loan-level data, while helpful, is a distraction from the real issue.  It would prove that investors really want to eliminate the "insider information advantage" that Wall Street has because of its role in servicing on a daily basis the underlying collateral.

      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.