This is easily shown using a brown paper bag and a clear plastic bag.
A bag is the physical model of a structured finance security.
When the security is issued, specific loans are placed in a trust for the benefit of the investors (for covered bonds, the loans are identified and assigned to the covered loan pool). Subsequently, among its other duties, the trustee generates reports on the performance of the loans.
Under existing disclosure practices, these reports are generated once-per-month or less frequently. Investors do not have current information and therefore cannot see what is currently happening with the loans.
It is the equivalent of putting the loans into a brown paper bag.
In an effort to revive the business, backers of the business have been working together to develop a new label which issuers can attain if they meet certain levels of quality, transparency, simplicity and standardization.As shown with the Brown Paper Bag Challenge, a structured finance security is only transparent if it provides disclosure on an observable event basis. Under observable event based reporting, every time there is an activity like a payment or delinquency involving the underlying collateral, this activity is reported to investors by the beginning of the next business day.
If the structured finance security does not provide observable event based reporting, the label should read "Sub-Prime Collateralized Security".
After years in the making, the new “Prime Collateralised Securities” label was launched this month. The sponsors are the European Financial Services Round Table, representing chief executives or chairmen of several European banks and insurance companies, and the Association for Financial Markets in Europe, a bank lobby group.Prime Collateralized Securities is a sell-side effort.
A PCS secretariat will grant the new quality label to issues on the basis of the judgment of a panel made up of people from inside and outside the business.
It won’t be until later this year that the first label is expected to be granted, and even then it won’t be clear if the rebranding will be successful.
Particularly critical will be how financial regulators react.Actually, this is not that critical from an investor's point of view. What an investor cares about is that the investor has the current information the investor needs to independently assess and value the individual structured finance securities.
Without this information, the investor is blindly betting on the contents of a brown paper bag and most assuredly does not know what they own.
“The Prime Collateralized Securities initiative could bolster investor confidence in European securitization, particularly if it helps securitized debt achieve more favorable treatment under capital and liquidity rules,” Fitch Ratings says.
The rules set by the Basel Committee on Banking Supervision on how much capital banks must hold against securities that they buy and how liquid those securities are considered to be, and the Solvency II rules that will apply to insurers, will make it much less attractive to invest in the asset class if they are implemented as currently envisaged.
Right now, there is no preferential treatment for quality-labelled securitizations under Basel III and Solvency II.There shouldn't be preferential capital and solvency treatment for sticking a label on a brown paper bag.
There should be preferential treatment if the structured finance security provides observable event based reporting and is the equivalent of valuing the contents of a clear plastic bag.