Thursday, December 20, 2012

As shown by Basel Committee, regulators know there is something wrong with securitization, but cannot figure it out

As reported by Reuters, the Basel Committee knows there is something wrong with the reform of structured finance to date and has issued a public consultation that has the sell-side howling in protest.

Regular readers know that what the Basel Committee is troubled by, but hasn't put its finger on yet, is that disclosure has two components:  "what" is disclose and "when" it is disclosed.

Since the beginning of the financial crisis, the sell-side has set the agenda at focusing on "what" is disclosed.  This issue of "when" has been completely pushed off the agenda.

As a result of the sell-side's agenda, reform of structured finance appears incomplete.  The regulators sense that it is incomplete and have basically said, its time to restart the process as if we were at the beginning of the crisis and the financial system was collapsing because of opaque, toxic sub-prime mortgage-backed securities.

The key word is opaque.  That is where disclosure comes in.

The public consultation is also a direct rebuke of the European Data Warehouse and the Prime Collateralise Securities initiative.  Clearly, the regulators sense that neither of these is going to satisfactorily address the issue of opacity.
Market participants warned this week that a new consultation launched by the Basel Committee on securitisation fell into the same traps as previous initiatives. 
Securitisations are backed by a huge variety of different claims, but the framework treats everything presented in securitised format as being part of the same asset class. 
The new paper aims to change the amount of capital banks hold against securitisations, despite the fact that current capital levels were only agreed in 2009 and will be further changed when Basel III is implemented. 
Furthermore, it comes as the Financial Services Board aims to look again at securitisation as part of its shadow banking reforms, a project it only started late last year. 
Market participants warned that there was much technical detail contained in the proposed new framework as well as other potential pitfalls. 
"There is also initial concern that once again policymakers may have fallen into the trap of characterising all securitisations with the poor performance of certain markets during the crisis, namely US subprime and CDOs," said Richard Hopkin, a managing director at the Association for Financial Markets in Europe.
Please note that the Association for Financial Markets in Europe is a sell-side dominated lobbying group.  Therefore, it is not surprising that Mr. Hopkin's statement suggests that all securitizations do no contain common elements.

In fact, all securitization transactions do contain common elements.  They are lemons without adequate investor protections.

Common to all securitization transactions is the lack of the most basic investor protection: disclosure.  Everyone knows that the standard for disclosure is that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess each security and make a fully informed investment decision.

For structured finance securities to meet this standard of disclosure, they have to provide observable event based reporting.  Under observable event based reporting, all activities like a payment or delinquency involving the underlying collateral are reported to market participants before the beginning of the next business day.

Without observable event based reporting, investors cannot know what they are buying or after buying know what they own.
One senior securitisation lawyer said: "Outside the securitisation framework, SME risk and mortgage risk are treated completely differently, but once you put them in a securitisation, for regulatory purposes, they become the same."...
In the absence of observable event based reporting and other credible investor protections, the argument that the different asset types perform differently is a red herring argument.

By treating all asset types the same, the Basel Committee is effectively saying that in the absence of observable event based reporting and other credible investor protections, banks don't know what they are buying regardless of what type of underlying assets.  As a result, banks need to hold a lot of capital against these blind bets.

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