One particularly opaque corner I have focused on is structured finance.
Regular readers will recall that it was on August 9, 2007 that BNP Paribas issued a press release saying that it could not value subprime mortgage backed securities in 3 funds. Shortly thereafter, these securities were associated with the words opaque and toxic.
So what has happened to bring transparency to structured finance securities in the 5 years after it was publicly recognized that these securities could not be valued because they are opaque?
I have been engaged in a worldwide battle with the sell-side.
A battle in which the global financial regulatory community is a major participant.
But that should be good for bringing transparency to structured finance because, under the FDR Framework, the regulators are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.
The assumption that the regulators involvement is good for transparency rests on the idea that regulators understand structured finance well enough to know what all the useful, relevant information in an appropriate, timely manner is.
The Brown Paper Bag Challenge was developed to help politicians and regulators understand both "what" needs to be disclosed and "when" it needs to be disclosed. As a result, the Brown Paper Bag Challenge has become a test of fitness for purpose for the global regulators.
Either the global regulator passes the Brown Paper Bag Challenge and understands what it takes to bring transparency to securities ranging from covered bonds to structured finance or they do not.
At the five year mark, there is one legislative body and one financial regulator that have passed the Brown Paper Bag Challenge.
The legislative body was the European Parliament which adopted the European Commission's recommendation in Article 122a of the European Capital Requirement Directive that requires
- investors, broadly defined to include banks and institutional investors, need to know what they own when it comes to their holdings of structured finance securities; and
- issuers need to provide the data so that investors can know what they own.
The list of regulators that I have spoken to and have failed includes, but is not limited to:
- in Europe, the ECB and the European Banking Authority (aka, the Committee of European Banking Supervisors);
- in the UK, the Bank of England and the HM Treasury;
- in Australia, the Reserve Bank of Australia and the Australian Securities and Investment Company; and
- in the US, the Federal Reserve, the SEC, Treasury and the FDIC.
A bag is the physical model of an asset backed structured finance security ranging from covered bonds to securitizations. For all of these securities, assets are identified and set aside for the benefit of the investor (as if put into a "bag").
Furthermore, for all of these securities, reports on the performance of the individual assets are provided to the investors. These reports are intended to disclose information that would be useful for the investor in making an investment decision.
So the questions become, "what" is in the reports and "when" are the reports made available. While "what" is an interesting question, "when" is the question addressed by the Brown Paper Bag Challenge.
Please recall that subprime RMBS are called opaque. These securities disclose information on the underlying loan performance once per month. It is easy to prove that it is the once per month frequency of disclosure that causes them to be opaque.
For each global regulator, I offered an individual on the team in charge of bringing transparency to structured finance securities the opportunity to take the Brown Paper Bag Challenge.
The Brown Paper Bag Challenge is simple. I created a structured finance security by putting $100 into a brown paper bag at the beginning of last month. Since that time money has been taken out of the bag. A once per month report has been generated and it shows that there was $75 in the bag at the end of the month.
The question is: what is in the bag currently?
To add some spice to the challenge, I agree to "sell" the regulators the contents of the bag. If the value of the contents of the bag is greater than the sale price, I send them a check for 10 times the difference. If the value of the contents of the bag is less than the sale price, they are to send me a check for 10 times the difference.
100% of the regulators refuse to take the Brown Paper Bag Challenge.
Why? Because as they all say "it would be inappropriate of them to gamble".
This is a great response! It has combines two very important issues.
First, there is the perception that taking the Brown Paper Bag Challenge is a "gamble".
Why do they think it is a "gamble"?
They all reply something along the lines of "because they do not know what is in the brown paper bag right now".
Please re-read that statement. Like everyone else, the regulators know that you are blindly betting when you cannot see the contents of the bag. [They also suspect the challenge is rigged and I will not "sell" them the contents of the brown paper bag unless they owe me money.]
Fortunately, there is a reporting frequency that allows everyone to see the contents of the bag as if they were in a clear plastic bag: observable event based reporting.
Observable event based reporting is the answer to the question of "when" must reports be generated on structured finance securities to end their opacity.
Second, the regulators all understood that it is "inappropriate" to "gamble". As shown with the brown and clear plastic bags, it is inappropriate to buy a structured finance security that does not offer observable event based reporting because this involves gambling as one is blindly betting on the contents.
Ok, so how did the global financial regulators fail the test?
Each of the financial regulators failed the test because it either is willing to let its organization "buy" or it encourages investors to buy structured finance securities that do not provide observable event based reporting.
In the absence of observable event based reporting, even if a data warehouse delivers standardized information on the loan-level performance, investors do not know what is inside the bag currently and would be blindly betting to buy these securities.
Why exactly are the regulators at the Bank of England, the Federal Reserve, the European Central Bank and the Reserve Bank of Australia who wouldn't take the Brown Paper Bag Challenge because it is inappropriate to gamble willing to let their organization gamble with billions of dollars of taxpayer money when they accept structure finance securities which don't provide observable event based reporting as collateral?
Walter Bagehot's number one rule for central banks was to lend against "good" collateral.
In the absence of observable event based reporting, there is simply no way for a central bank to know if it has good collateral when it accepts a structured finance security.