Thursday, November 15, 2012

Securitization industry tries to put blowing up financial system behind it

The Prime Collateralised Securities initiative, also known as putting lipstick on a pig, is going live in the EU.

The idea behind PCS is to put a label on a structured finance security to indicate that these securities meet standards for transparency, reporting quality and market best practices.

Unfortunately, the standard for transparency that warrants a PCS label is the same standard that opaque, toxic sub-prime mortgage-backed securities met prior to the beginning of the financial crisis.

Wait a second, aren't securities that receive a PCS label suppose to provide standardized reports?


Then how are they the same as the opaque, toxic sub-prime mortgage-backed securities?

Transparency has two elements:  what is disclosed and when it is disclosed.  Securities that qualify for a PCS label have the same reporting frequency, once-per-month, as opaque, toxic sub-prime mortgage-backed securities.

It is "when", in this case once-per-month, that makes these securities opaque (hence, a PCS label is deliberately misleading, but that is what one would expect from a sell-side led initiative). [These securities were "toxic" because opacity made it impossible to assess the true risk of the collateral.]

Why are securities with once-per-month reporting opaque?

Everyone knows that structured finance securities ranging from covered bonds through securitizations involve taking specific assets, like mortgages, and setting them aside for the benefit of the bondholder.  The physical equivalent of this would be to put them into a bag.

Now the question is: "is the bag paper or plastic?"

The bag is paper if as a result of "when" disclosure is made the investor does not know what is in the bag currently.  The bag is plastic if as a result of "when" disclosure is made the investor knows what is in the bag currently.

With once-per-month disclosure, the investor knows what was in the bag at the end of last month, but they have no idea what is in the bag currently.

With observable event based disclosure where all activities like a payment or delinquency involving the underlying collateral are reported before the beginning of the next business day, the investor knows what is in the bag currently (if they wanted to they could look up what was there yesterday or at the beginning of last month).

Why is knowing what is in the bag currently important?

If an investor does not know what is in the bag currently, they cannot independently assess the risk and value the collateral.  This is true whether the bag has a label on it or not.

Without this independent assessment, buying the securities is the equivalent of blindly betting.  And, once the securities are purchased, the investor has no ability to know what they own.

On the other hand, if the investor does know what is in the bag currently, they can independently assess the risk and value the collateral.  The investor "knows what they own".  As a result, they can make an investment decision to buy, hold or sell based on the prices being shown by Wall Street and the City.

Recently, the US National Association of Insurance Commissioners published a white paper on the future of mortgage finance.  In this white paper, they concluded that the amount of capital that an insurer should be required to hold against an investment in a mortgage-backed security should be related to whether the insurer was blindly betting or could know what they own.

Simply put, securities that featured observable event based reporting would require dramatically less capital than securities on which the insurer is blindly betting.

This white paper sets the global standard for the buy-side.

Going forward, any institutional money manager that choses to ignore this standard is going to have to explain to investors beforehand how it is that they can value the contents of a brown paper bag.  Without this explanation, the institutional money manager becomes liable for all losses on these securities in their portfolios.

As reported by Reuters,

An industry initiative to distinguish top quality European securitisations from US subprime RMBS goes live on Wednesday, amid hopes that regulators will make good on their hints to spare these bonds from the most punishing effects of Basel III and Solvency II.
Presumably, the NAIC standard will find its way into Solvency II.
The Prime Collateralized Securities initiative will certify securitisations that meet set standards of transparency, reporting quality and market best practice. 
The initiative has been developed by the Association for Financial Markets in Europe (Afme) and the European Financial Services Roundtable (EFR), two banking and financial services trade bodies, with the aim of distancing high quality European consumer securitisation - with realised losses below 1% - from US subprime mortgages, and demonstrating to regulators and investors that the industry is willing to embrace moves to transparency.
The sell-side is not now nor has it ever been willing to embrace transparency.

PCS is nothing more than putting a label on a brown paper bag.  Putting a label on a brown paper bag doesn't make it more transparent.  Investors still do not know what the contents of the bag currently are.

If investors do not know the current performance of the underlying collateral, they cannot assess the risk or value the underlying collateral.

As a result, they cannot "invest" in these securities.  They are merely blindly betting.
The PCS organization will review the documents and reporting procedures of new ABS issues it receives, granting or refusing its endorsement. It will also monitor securities throughout their life to ensure reporting remains up to standard. 
Some version of the initiative has been under discussion since at least 2009, but was only formally launched at the beginning of the Global ABS conference in Brussels in June this year. A chair, Ian Bell, formerly of S&P, was appointed for the PCS Secretariat, the operational body handling day-to-day operations. 
However, further detail remained to be confirmed - including membership of the PCS Board, the governing body of the initiative, and final criteria for each European asset class. 
PCS Board members will include Francesco Papadia, the Director General for Market Operations at the ECB...
Please remember, the ECB has been the securitization market for the EU since the beginning of the financial crisis and its is desperate to get all these brown paper bag securitization transactions off of its balance sheet.
Key industry figures include Gaelle Viriot, head of ABS at Axa Investment Managers, Gregor Gruber, member of the investment management board at Allianz IM....
Everyone knows what you call an investment manager who admits that they are blindly betting with the investors money: unemployed.

Hence, it is no surprise to find some investors sitting on the PCS board.  They cannot admit that they are blindly betting and retain their job.
The securitisation industry has been focused on the PCS as a potential way of navigating a way out of two initiatives likely to hurt the sector. Exclusion from bank liquid asset buffers under CRD IV was set to squeeze bank treasury investment in securitisations, while the capital charges for securitisations under Solvency II were almost prohibitive for insurance investors.
Please note that the easy way out of these two initiatives would be to provide observable event based reporting.  Wait, that is transparency and the sell-side absolutely refuses to allow transparency.

As part of his interesting post on Credit Slips, Adam Levitin observed
MBS were designed with the assumption that everything worked out hunky-dory. These deals were not designed to deal with problems, be they borrower defaults or large scale non-compliance on underwriting. 
The monoline insurers like MBIA are actually in a better position than the MBS investors who have been generally screwed. 
A large part of the securitization industry still seems in deep denial that anything went wrong. 
Part of this is that the sell-side firms are completely implicated in causing the problems--they can't really admit them. Yes, there's some grudging admission that things didn't work out well, but there hasn't been acceptance that the industry is fundamentally tilted to protect the sell-side at the expense of the buy-side.   
Deal design is really a function of the industry sell-side, but unless the sell-side is willing to redesign deals so that they provide credible protections for investors and insurers--the buy-side--I just don't see this market restarting beyond the rare Redwood deal. 
Maybe this speaks to the need for the buy-side to be much, much more involved in product design.  But the buy-side buys lots of things, not just MBS, so there's no reason to invest in MBS deal design.
Please re-read Mr. Levitin's comments and focus on how PCS does absolutely nothing to provide credible protections for investors.
Bottom line, the private-label residential mortgage securitization industry needs to recognize that it is a lemons market in a bunch of different dimensions:  underwriting, servicing, legal documentation, legal recourse. Lemons markets die. If this market is going to be resurrected--and I think it has social value and should be resurrected--it needs to really clean house and rebalance the interests of sellers and investors. 
I agree and the starting point for cleaning house is for these securities to provide observable event based reporting.

1 comment:

Anonymous said...

"Everyone knows what you call an investment manager who admits that they are blindly betting with the investors money: unemployed.