Wednesday, June 13, 2012

With PCS, ECB and EBA show they are either intellectually captured or incompetent

The European Central Bank and the European Banking Authority showed either they have been completely intellectually captured by the banks or they are incompetent by committing the cardinal sin of endorsing an investment product.

Regular readers know that since the 1930s the global financial system has been based on the philosophy of disclosure.

Under this philosophy, governments are responsible for ensuring that all market participants have access to all the useful, relevant information on an investment in an appropriate, timely manner.  Market participants know that access to this information makes them solely responsible for all gains and losses on an investment and therefore they have an incentive to use the disclosed information.

As a result of the responsibility to ensure access to all useful, relevant information, governments and regulators face the type of bright yellow line favored by Paul Volcker.  This bright yellow line that governments and regulators are never, never ever suppose to cross is being seen as endorsing an investment product.

There is a very simple reason that governments and regulators should not endorse an investment product.  This endorsement creates a moral hazard.  It obligates the government to bailout any investor who relied on the government's endorsement from potential losses (so much for the investor being responsible for losses...).

As reported by Reuters,
Europe's investment banks launched a best-practice label for complex debt instruments that were at the heart of the credit crisis, as the capital markets industry fights back to kick-start a once important source of income.
Please note that this is a sell-side effort.
The banks, represented by two lobby groups, also hope that revitalising the market for so-called securitised instruments will make it easier for them to raise funds.
The reason the market needs to be restarted is that the buyers are on strike.
Crucially, the project - which will involve setting up a secretariat - has received the backing from both the European Central Bank and the European Banking Authority, which groups together Europe's bank watchdogs. 
"The European Central Bank welcomes the initiative, which aims at increasing the attractiveness of asset-backed securities among investors and originating banks," ECB President Mario Draghi was quoted as saying in a press release....
Despite the bright yellow line, led by economists armed with PhD's who know nothing about how the financial system actually works (if they did, they would have taken the necessary steps to prevent the financial crisis and the freezing of the structured finance market in the first place), the regulators offer up an explicit endorsement.

In case anyone thinks I am holding economists to an impossibly high standard (given their training, for economists it probably is), it is a standard that I have publicly met (but then, I didn't have to overcome a PhD in economics).
Only securitisations based on safe asset classes would be awarded the Prime Collateralised Securities (PCS) label, the Association for Financial Markets in Europe (AFME) and the European Financial Services Round Table groups said. 
Among those were auto loans and leases, residential mortgage loans, loans to small and medium enterprises, consumer loans and credit card receivables, the two groups said....
For those, like two finance professors in New Haven, who missed the start of the financial crisis on August 9, 2007, BNP Paribas announced that it could not value sub-prime mortgage-backed securities.  Sub-prime mortgages are a form of residential mortgage loan, which the sell-side's lobbying groups see as a safe asset class.

Subsequently, the buy-side realized it could not value any private labeled mortgage-backed security regardless of the quality of the underlying assets.  Investors could not do this because these securities do not provide current performance information on the underlying collateral.

Investors and EU policymakers realized that buying these securities is the equivalent of blindly betting on the contents of a brown paper bag.  As a result, the buyers went on strike and the EU policymakers passed Article 122a of the European Capital Requirements Directive requiring that investors know what they own and issuers provide them with this data.

Of course the sell-side and its lobbyists fought against passage of this legislation.  They lost.

However, this did not stop the sell-side and its lobbyists.  They simply turn to the regulators.

It has been no contest.

Either the regulators are prone to being intellectually captured by the sell-side banks or they are incompetent.  Regardless, the EBA (then known as the Committee of European Bank Supervisors; also, known as the regulators who ran stress tests that passed three banks weeks prior to their needing to be nationalised) blessed the same disclosure frequency that BNP Paribas said did not allow it to value sub-prime mortgage-backed securities and said it was adequate to know what you own.

Not to be outdone, the ECB jumped into the fray and promoted the development of an ABS data warehouse that features less frequent disclosure than sub-prime mortgage-backed securities provided.
The new brand is designed to polish the image of the assets that could be used by the European Central Bank as security - a stamp of approval that would reassure investors.
I can understand why the sell-side has championed this labeling idea.  By getting the explicit endorsement of the ECB and EBA, they can go to investors and say "don't worry about any losses on these securities as the explicit endorsement means that taxpayers will bail you out".

If investors really are muppets, they would believe this and end their buyers' strike.

However, investors are not muppets and they realize that this implicit guarantee is really debt that should be counted as part of each country's outstanding debt (after all, presumably the taxpayers will have to pay it off when the government has to make good on its moral hazard obligation).

With this realization, national policymakers will quickly see that the sell-side has managed to usurp their fiscal authority and effectively started issuing debt guaranteed by the country for their own benefit.  Policymakers will react by explicitly saying it will not bailout structured finance investors.

At which point, without implicit access to a government bailout, the label becomes completely worthless.
Credit Suisse, Deutsche Bank, JPMorgan , UBS, BNPParibas and Bank of New York Mellon : are among the funding members of PCS.
The fact that they would spend millions of euros on a labeling gimmick shows everyone how valuable opacity in structured finance securities is to these banks.

As your humble blogger has said repeatedly, the only way to end the buyers' strike without some form of government guarantee is to require each structured finance securities to provide observable event based reporting.  Whenever there is an activity like a payment, delinquency, default or modification it is reported to investors before the beginning of the next business day.

With current information on the underlying collateral's performance, market participants can value the structured finance security.

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