Thursday, June 21, 2012

Prime Collateralized Securities are not transparent

Just because the sell-side claims that sticking a Prime Collateralized Securities label on a structured finance security makes it transparent does not make the structured finance security transparent.

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.

TYI's 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 structured finance securities.

For 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 RMBS investors in an industry standard template with a Prime Collateralized Securitization label). 

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.  Wall Street firms, the same ones that are promoting Prime Collateralized Securitization labels, that invest in or run servicers handling the daily billing and collecting for structured finance transactions have similar data.

Based on the once-per-month report, existing and potential investors do not know what is in the bag currently even if the bag has a Prime Collateralized Security label indicating it initially contained safe assets.  They can only guess at what is a knowable historical fact. 

The same is true with respect to structured finance securities.  Once-per-month or less frequent reporting blocks investors from knowing what is currently in structured finance securities and limits investor valuation of the contents of structured finance securities to an exercise of blind betting.  If investors guess incorrectly, whether buying structured finance securities 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 every structured finance transaction.  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 the structured finance security. 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 investors have been reluctant to return to the structured finance markets in the absence of observable event based reporting and why sticking a Prime Collateralized Security label on a structured finance security will not entice investors to return.

As reported by the Wall Street Journal, a Prime Collateralized Securities label is suppose to revive a stigmatized market.
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.

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