Tuesday, March 13, 2012

Quality labels on asset-backed securities is like a skunk with a new name, it still stinks

A Reuters' article discusses how the Eurozone asset-backed security sell-side is trying to roll out a new, rebranded with quality labels asset-backed security.  This new security has all of the fatal flaws that sunk the pre-financial crisis asset-backed securities.

This is like calling a skunk a different name and hoping that it changes the smell of the odor a skunk puts out.
Asset-backed securities, blamed for triggering the financial market chaos that has toppled banks and sucked in countries, are undergoing a brand makeover but they may find it hard to shake off their old image. 
Financial lobby groups are working on a new 'quality label' for bonds secured against bundles of assets including credit card debt and car loans, with the aim of rekindling demand. 
In future, they hope top-notch ABS will be known as PCS, or Prime Collateralised Securities. 
The new brand is designed to polish the image of assets that could be used by the European Central Bank as security - a stamp of approval that would reassure investors who still associate them with the subprime U.S. mortgage loans that sent shockwaves through banks in Europe and beyond after the last five years.
The ECB is willing to use the old, asset backed securities as collateral. Hence, this is not much of a stamp of approval.

Furthermore, the ECB endorsed the creation of a data warehouse so that loan-level data could be made available for each deal.  The ECB did this to revive investor interest in asset-backed securities so that private investors would buy these securities and become the source of funding rather than the ECB.

Unfortunately, in endorsing the data warehouse, the ECB also endorsed the same disclosure practices that made subprime mortgage backed securities toxic in the first place.  These disclosure practices are designed so that investors do not know what they own.

The lesson from the financial crisis is that buying securities where you do not know what you own will result in the loss of most of your investment.
Its architects are optimistic the brand will be seen as low-risk, and have identified almost 1 trillion euros of securitised loans that might qualify for the PCS label. 
That includes more than 750 billion euros of debt backed by mortgages, while some 100 billion euros of small business loan securitisations and a similar volume of securities backed by consumer debt and credit card loans could also qualify. 
"There is a strong commitment to make this happen, including public comments of support from the ECB, European Commission ... and other authorities," said Sebastian Fairhurst, Secretary-General of the European Financial Services Round Table, one of two lobby groups organising the programme. 
"The initiative is expected to bring added quality, transparency and standardisation to the market, with a goal of improving overall liquidity."
Your humble blogger can assure the buy-side that the sell-side has no interest in providing transparency that is useful for independently valuing these securities.
The project inspires both enthusiasm and nervousness among observers. One banker, speaking anonymously, expressed concerns that it could be abused by banks to disguise toxic assets.
No kidding!
With interbank lending still fragile in Europe despite the ECB's recent 1 trillion euro liquidity injection, rejuvenating demand for securitised debt would throw a lifeline to banks. 
The blessing of the ECB, which has already lowered standards for the collateral it accepts in return for providing lenders with funds, is important for the new brand, and its officials are following developments.... 
The central bank considers factors including credit ratings when deciding whether ABS can be used as collateral. It currently accepts those backed by home loans and small-company credit, having lowered the minimum acceptable rating for such securities to single-A from triple-A in December.... 
The PCS project is being organised by a Brussels-based lobby group chaired by Swiss Re chairman Walter Kielholz, the European Financial Services Round Table, and the Association for Financial Markets in Europe, representing investment banks including Deutsche Bank and Goldman Sachs.
The PCS project is being organized by the sell-side.
Banks are also hoping to persuade European regulators to include high-quality securitised debt among the assets they can use in their liquidity buffers. European Union countries are negotiating a framework for bank capital to be finalised in coming months.... 
"There has been a lot of lobbying saying that ABS, particularly European ABS, is not that bad and those lobbyists are finding some favour now among regulators and the ECB," said Dipesh Mehta, an analyst with Barclays Capital. 
"The ECB is showing willingness to accept more ABS as collateral. The PCS initiative might satisfy regulators more and may make it easier to repo (repurchase agreement) bonds at the ECB."...
Of course the regulators controlled by the sell-side will bless PCS.

The problem the sell-side, the ECB and the regulators have is the buy-side is on strike.  It is not returning for a skunk relabeled a black cat.

The buy-side has been explicit that it is not returning until it knows exactly what it is buying and it has disclosure practices that 24/7/365 support their knowing what they own.

Adopting the same disclosure practices as opaque, toxic mortgage backed securities will not end the strike.

Since before the financial crisis, your humble blogger has written a series of white papers on what structured finance 2.0 needs to look like.

To date, the sell-side and the Opacity Protection Team have lobbied successfully against my proposed reforms.

However, for the efforts, they have been rewarded with a number of regulations that make structured finance less attractive.  These include the issuer having skin in the game, the exclusion of structured finance securities from bank liquidity measures and the higher capital requirements.

Now, we have reached a point in time where having a functioning structured finance market would be very useful in the US and Europe.  The key to doing so is for the regulators and the ECB to adopt my ultra transparency based solution.

Many of the regulatory restrictions are no longer required when there is ultra transparency.

For example, with access to current collateral level performance data, market participants will always be able to value these securities (as oppose to the opaque, toxic securities which are impossible to value).  The ability to value is directly related to increased liquidity in the market and hence allowing structured finance 2.0 securities to qualify as a liquid asset for banks.

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