adverse selection greatly increases the risk of credit losses, especially in areas such as small business or mortgage loans where only the originator of the loan can easily understand its quality.
It was precisely for this reason that markets in securitised loans of this type closed in 2007.
The Bank has been working with others to see if the transparency of such instruments could be improved sufficiently to support greater market activity.
But adverse selection remains a deterrent to issuance, and purchases by the public sector would represent a real risk to taxpayers.Regular readers know that blindly betting on the contents of a brown paper bag, which is the equivalent of investing in structured finance securities, is very risky. You don't know what you own and therefore are susceptible to being sold a security backed by collateral selected with an adverse bias.
Regular readers also know that the solution for eliminating adverse selection is, while protecting borrower confidentiality, to provide all the information collected by both the loan originator and servicer on an observable event basis.
This is the data that is necessary so that market participants can independently assess the individual loans. It is the equivalent of putting the loans into a clear plastic bag.
Without observable event based reporting, structured finance securities have no transparency.
Why would investors want to buy opaque, high risk securities when they have other alternatives that are transparent with lower risk?
The simple fact that the structured finance market has been effectively closed since 2007 tells an observer that investors are not interested in buying opaque, high risk securities. If the issuers want the market to reopen, they are going to have to make it transparent and provide observable event based reporting.
It is also interesting that the Bank of England is working with others, not including your humble blogger, to see if transparency can be improved sufficiently to support greater market activity.
This implies an incremental approach to improving transparency hoping that the buyers' strike will end while the sell-side continues to reap the benefits of opacity. All these benefits come down to the sell-side using opacity to take advantage of the buy-side.
This incremental approach to improving transparency also implies that there is some logical stopping point in providing loan-level disclosure between the industry's current once per month or less frequent disclosures and observable event based reporting.
The Brown Paper Bag Challenge easily shows that there is no logical stopping point.