Thursday, June 21, 2012

Sell-side stands in the way of recovery of the securitization market

An International Financing Review article describes why this should be the best of times for the securitization market.
[Securitization] is still ... one of the best ways to connect the capital markets to real economy assets, particularly credit-starved households and SMEs. 
To the industry, which can see banks deleveraging, credit conditions tightening, and investors crying out for yield, some sort of regulatory encouragement for securitisation seems like a no-brainer.
All that stands in the way of reaching this nirvana is the sell-side.

Regular readers know that the role of regulators in the global financial system is to ensure that all market participants have access to all the useful, relevant information in an appropriate, timely manner so that investors can independently assess this information and make a fully informed investment decision.

In short, regulators are there to ensure there is transparency.

The sell-side, however, has been fighting tooth-and-nail against transparency.

For example, when the European Commission was considering Article 122a as an amendment to the Capital Requirements Directive, the amount of lobbying against the principle of 'know what you own' was the most that Brussels had ever seen.

For example, when the Committee of European Bank Supervisors, the predecesor to the European Banking Authority, conducted a public consultation, 18 of the 19 respondents were related to the sell-side.  Not surprisingly, each of these respondents asserted that the same disclosure practices that were associated with opaque, toxic sub-prime mortgage-backed securities were adequate to 'know what you own'.

The reason that sub-prime mortgage-backed securities were known as opaque is that the disclosure provided by these securities prevents investors from 'knowing what they own'.

Your humble blogger has easily shown that investors are prevented from 'knowing what they own' by using a brown paper bag to model a structured finance security featuring current industry disclosure practices with standardized data and a Prime Collateralized Securities label.

I could go on and talk about many other examples of the sell-side fighting against transparency (see ECB ABS data warehouse, Prime Collateralized Securities, Project Restart, ....), however, this is unnecessary as readers already know the sell-side is going to keep fighting against transparency because it makes money off of opacity.

It is well known in the industry that observable event based reporting is needed if investors are to have the current information they need to 'know what they own'.  I showed this at an industry conference in 2009 using a clear plastic bag.

By fighting observable event based reporting, the sell-side has in fact decreased the likelihood of securitization recovering anytime in the foreseeable future.

What the sell-side has managed to achieve by fighting for opacity is the opportunity for regulators to make structured finance securities economically unattractive as either an investment or as a source of funding.

For example, by fighting transparency, the sell-side managed to get the regulators to adopt a 5% retention requirement.  This requirement decreases the economic attractiveness of issuing structured finance securities while at the same time doing nothing for investors as they still need observable event based reporting to know what they own.

If the sell-side weren't committed to pursuing opacity to the end of the structured finance market, it would champion offering observable event based reporting.

With observable event based reporting, a 5% retention requirement is unnecessary as the investor has all the information they need to independently assess the underlying collateral.

With observable event based reporting, banks and insurance companies that invest in these securities should not have to hold capital against the illiquidity of these securities.  There should be an active secondary market as potential investors have current information with which to value the securities.

I continue to be surprised that the sell-side stands in the way of providing observable event based reporting as they would benefit from a capital market characterized by frequent security issuance and active secondary market trading.

Finally, so long as the sell-side refuses to champion observable event based reporting, there is no reason for the regulators to back down off of any of their proposed regulations.  These regulations exist as a result of opacity in structured finance.

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