Thursday, June 14, 2012

ECB to require ABS securities disclose loan level data by year-end

Bloomberg reports that starting by year-end, for an ABS security to be eligible to be pledged as collateral to the ECB it must provide loan-level disclosure.

Regular readers know that 'when' is as or more important than 'what' when it comes to disclosure.

Why this is true bears repeating.

TYI, LLC developed the Brown Paper Bag Challenge in early 2008 and presented it to the industry at ABS East to demonstrate that current ABS/RMBS industry disclosure practices do not adequately address the timing of disclosure to investors.  In fact, these practices prevent investors from valuing individual ABS/RMBS.  This is true even if the ECB endorses the reporting of collateral performance using current disclosure practices in an industry standard template.

For example, to create a mortgage-backed security (RMBS), loans are placed into a trust for the benefit of the investors.  Among its other duties, the trustee provides reports to the investors on the performance of the underlying loans.  Under existing RMBS disclosure practices, these reports are provided on a once-per-month or less frequent basis. 

A brown paper bag is the physical model that best represents these mortgage-backed securities.  Investors know what loans went into the bag, but under current reporting practices they do not know what is in the bag on a current basis.

The Brown Paper Bag Challenge highlights why knowing what you own, in this case knowing what is in the bag currently, is important for valuing individual RMBS.

As part of this challenge, assume that at the start of last month, $100 was placed into a brown paper bag (which is analogous to the loans being placed in a securitization trust).  A report has been issued that indicates at the end of last month there was $75 in the bag (which is analogous to the once-per-month disclosure to investors in securitization transactions in an industry standard template).  

The Brown Paper Bag Challenge is as follows: what is the value of the contents of the bag today? 

In the Brown Paper Bag Challenge, everyone is invited to submit an offer to buy the contents of the brown paper bag.  

If the price offered is accepted by TYI, then money changes hands.  If the price offered is greater than the value of the contents of the bag, then the difference is paid to TYI.  If the price offered is less than the value of the contents of the bag, then the difference is paid to the individual submitting the purchase offer.  

Potential buyers of the contents of the brown paper bag are aware of the following fact:  in this challenge, TYI has observable event data so it knows what is in the brown paper bag currently.  TYI receives observable event based reporting which is simply a report of all activity (like a payment or delinquency) involving the underlying collateral that occurred on the previous business day.  

Observable event based reporting is similar to the data available to Wall Street firms that invest in or run servicers handling the daily billing and collecting in RMBS transactions.

Based on a once-per-month or less frequent report, existing and potential investors do not know what is in the bag currently even if the bag has a Prime Collateralised Security label on it.  They can only guess at what is a knowable historical fact.  The same is true with respect to RMBS.  

Once-per-month or less frequent reporting blocks investors from knowing what is currently in RMBS and limits investor valuation of the contents of RMBS to an exercise of blind betting.  If investors guess incorrectly, whether buying RMBS or taking the Brown Paper Bag Challenge, they lose money.

To date, TYI has been unable to find anyone who is willing to take the Brown Paper Bag Challenge. 

However, when a clear plastic bag is substituted for the brown paper bag, everyone is willing to make an offer for the contents of the clear plastic bag.  This is because the contents of the clear plastic bag can be seen and valued.

The same could occur for each RMBS transactions.  If current information were provided by observable event based reporting, then investors would be able to make informed buy, hold and sell decisions with respect to each RMBS. Observable event based reporting has the effect of putting the loans into a clear plastic bag rather than a brown paper bag.

This simple example using brown paper and clear plastic bags explains why when is as or more important than what for disclosure.  This simple example also explains why investors have been reluctant to return to the RMBS markets in the absence of observable event based reporting.

The European Central Bank will start requiring lenders to provide data on the loans in asset-backed securities used as collateral for funding by the end of this year. 
The data requirement will initially cover loans in residential mortgage-backed securities, pending the approval of the ECB’s governing council, said Fernando Gonzalez, the bank’s head of strategy....
Loan-level reporting for commercial mortgage-backed securities and bonds backed by financing to small and medium- sized businesses will start in 2013, he said. Loan reporting for other classes of securities such as bonds backed by car loans will start in 2014. 
The Frankfurt-based central bank is seeking to improve the quality of the assets it takes on as loan security while improving confidence among investors.
To date, the ECB has endorsed an effort by the Market Group to create an ABS data warehouse.  This data warehouse will provide loan level data on a quarterly basis.

This reporting frequency is even worse than the once-per-month reporting that gave rise to the Brown Paper Bag Challenge and that is the frequency of reporting that is used for opaque, toxic sub-prime mortgage-backed securities.

If the ECB ever wants to improve the quality of the assets on its balance sheet, it must require observable event based reporting.  As this is the reporting frequency that is necessary so investors can see the collateral as if it were in a clear plastic bag and know what they own.

Until the ECB requires observable event based reporting, it and the few buyers still left in the market will simply be blindly betting on the value of the ABS securities.

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