Tuesday, December 11, 2012

Why have the ECB and BoE endorsed a solution that does not bring transparency to structured finance securities?

In attempting to bring transparency to structured finance securities, why have the ECB and BoE endorsed a solution that retains the reporting frequency that makes these securities opaque?

Let's rule out stupidity.  We are dealing with a bunch of PhD economists and a few lawyers.

More likely, we are dealing with regulatory capture.  Not something that you associate with central banks, but that exists none the less.

Reuters carried a fascinating article that helps to answer the question.  The article looks at how the ECB and the BoE used their influence to have the securitization industry build a data warehouse to provide "transparency" into the performance of the underlying collateral.

One way the ECB and BoE used their influence was to bless the data warehouse by saying that any structured finance deal that provides loan-level performance data through this data warehouse qualifies because it is transparent to be pledged as collateral to the central banks.

In addition, the ECB leaned on issuers to fund the project!

What emerged under the influence of the ECB and BoE was the European DataWarehouse.  A data warehouse that will provide loan-level performance data on the same reporting basis as opaque, toxic subprime mortgage-backed securities:  once-per-month.

Regular readers of this blog know that there are two elements to transparency:  what is disclosed and when it is disclosed.

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

Once the mortgages are in the bag, it is important to know what is in the bag currently.


If an investor does not know what is in the bag currently, they cannot take the first step in the investment cycle.

The first step is to independently assess the risk and value the underlying collateral so the investor can know what the investor is buying and, after buying, know what they own (in the eurozone, please see Article 122a of the European Capital Requirements Directive).

The second step is to compare this independent assessment to the prices shown by Wall Street or the City.

The third and final step is to make a buy, hold or sell decision based on the difference between the investor’s independent valuation of the security and the price shown by Wall Street or the City.

Please note that without the ability to know what is in the bag currently, it is impossible to accurately assess what is going to come out of the bag eventually.

The lack of knowing what is in the bag currently prevents investors from performing their own independent assessment and makes meaningless hiring an expert third party to do the assessment for them.  Simply put, without current information of what is in the bag, investors cannot go through the investment cycle.

Buying securities in the absence of an independent assessment is not investing.   Buying securities that cannot be independently assessed is the equivalent of blindly betting on the contents of a brown paper bag.

In case you doubt this, let me show it to you as I have shown both the ECB and BoE using a brown paper bag to hold the underlying collateral.

On the first business day of last month, $100 went into the bag.  On the third business day of this month, a trustee report with granular level data was issued that showed the bag contained $75 at the end of the last month.  This was made up of 3 $20 bills and 3 $5 bills.

So the question is:  what is in the bag currently?

Based on the fact that $25 came out of the bag last month, there are a number of ways of guessing what is in the brown paper bag?  First, we could guess that nothing has been taken out of the bag and it still holds $75. Or a $5 bill has been removed and left $70 in the bag.  Or a $20 bill has been removed and left $55 in the bag?  Or both a $5 bill and a $20 bill have been removed and left $50 in the bag?

By simply asking what is in the brown paper bag currently, I have already created a $25 spread between the $75 a seller might reasonably value the contents of the brown paper bag at and the $50 a buyer might be willing to offer.

Let me assure you that with this wide a spread, the contents of the brown paper bag are not going to sell even if the performance of the underlying collateral had been reported through a data warehouse as there is no transparency into what is being purchased.

The simple solution to unfreezing the market is to allow investors and sellers to know what they are buying and selling by putting the underlying collateral into what is the physical equivalent of a clear plastic bag.

This can be done by providing observable event based reporting.  Under observable event based reporting, all activities like a payment or default on the underlying collateral are reported before the beginning of the next business day.  This way all market participants know exactly what is happening with the collateral so they can independently assess and value the security.
The European Central Bank's loan-level data initiative for structured finance, which should provide detailed loan data to the whole market through the European DataWarehouse (ED), is ready for action. 
The ED was established to ensure the ECB's loan information - which it needs to monitor ABS collateral used for its repo operations - is easily accessible to the whole market. 
The ED will check data that comes in from issuers, ensuring full compliance with the ECB's standard templates, and provide the IT systems for data providers to hook into its systems. 
The project is supposed to "create a central point (or forum) where industries, associations and national agencies can lodge their data and information in an open, transparent and trusted environment". 
The ECB hopes this will boost private sector demand for securitisation - allowing peripheral banks to replace some of their EUR371.7bn of ABS-backed central bank repo funding with transactions placed with third-parties. 
With that much exposure, the ECB has an incredible incentive to push for the creation of a data warehouse.
Issuers wanting their securitisations issues to be ECB-eligible will have to provide this data to the European DataWarehouse....
This certainly gives the ECB a big lever to force the issuers to provide data and invest in the data warehouse.
The data initiative began in 2009, when regulators became convinced that the securitisation industry needed to improve disclosure on the assets which backed the securities if it was to regain investor trust. Transparency became a major part of the drive to re-regulate securitisation....
Please note, that on April 14 2008, your humble blogger wrote a Total Securitization Learning Curve column that laid out why transparency was needed for structured finance securities and that it should be provided through a data warehouse.

I was invited to write this column, because, from the buy side's perspective, I am the independent global expert on transparency and structured finance securities.
Various senior market participants were invited to help draft templates to present loan level data in standard, comparable format across Europe. Each jurisdiction records different data about borrowers - and different information depending on whether they are borrowing via credit card, mortgage, or unsecured loan. This must be anonymous - but be specific enough to be useful.
This exercise was led by the sell-side through its captured industry trade groups (the European Securitisation Forum and its successor AFME) with the explicit goals of delaying transparency as long as possible and assuring that the data being disclosed would be useless.

They have succeeded.

Based on my conversation with several valuation firms that work strictly for the buy side, the data fields that will be disclosed don't allow them to run some of their key analyzes.
Following production of the templates, the ECB decided to encourage the construction of a whole new piece of market infrastructure to provide this data.
One might wonder why the ECB which knew of my existence and the fact that my firm had already designed and held a patent on this new piece of market infrastructure did not talk to me.

Based on the my responses to its public consultation, it was clear to the ECB that my solution was biased to the buy-side.

Paul Burdell of Link Financial, acting as an adviser to the ECB at this time, took on the project, soon dubbed the European DataWarehouse.
Eight institutions drawn from the technical working groups managed the procurement process, picking Sapient Global Markets as constructor.
As I said, regulatory capture?
The ECB maintained an arms-length distance from the project, aiming to present the European DataWarehouse as a market-driven exercise.
Clearly, the ECB did not have an arms-length distance from the project.  It endorsed the European DataWarehouse when there was already a viable solution, my firm's data warehouse, in the market.
Speaking on Thursday in Frankfurt, Peter Praet, chief economist at the ECB, described loan-level data as a classic collective action problem - no individual issuer had an incentive to start making this data available, but official sector organisations could act as catalysts to improve market practice. 
The central bank retained an observer role, since it anticipated being a major user of the resulting data - indeed, it is the only institution so far to have trialled access to the data.
A data warehouse would have been built and made available simply by the ECB and BoE making loan-level data a requirement for eligibility.

It would have been economically attractive to build this data warehouse as there are almost 400 billion euros on the ECB balance sheet that would have needed a data warehouse had the ECB and BoE stuck to making loan-level disclosure an eligibility requirement.

However, the ECB and the BoE did not stop with this simple requirement.  They wanted to choose a winner.  And in choosing a winner they managed to chose a solution that is designed to protect opacity in the structured finance market.
No third party investors in ABS have yet approached the ED about using the data. 
Which shows that these investors are listening to your humble blogger as the data is worthless because it is out of date and does not answer the question of what is in the bag currently.

Investors know that structured finance securities are lemons unless there is observable event based reporting so there is no reason to "pay" for useless data.

Investors also know that under Reg FD (fair disclosure), the information must be disclosed for free to US investors.  Again, no reason to pay.

Finally, money managers know that in the absence of observable event based reporting by ED they have to disclose to their investors that they are blindly betting on the contents of a brown paper bag if they use the data from ED.  Without this disclosure, the money managers and their firms are liable for any losses on investments in these securities.

Of course, this disclosure would also make it impossible for the money managers to buy these securities with ED reporting as investors are not going to give their money to someone to blindly bet on the contents of a brown paper bag.
The project has proved controversial, particularly with some of the large UK issuers, because while the ECB was the main driver of the project, the central bank refused to pay for it, arguing that the industry needed to show willing. 
Again, the central bank didn't need to pay for it.  They simply had to make transparency a criteria for eligibility.  Transparency that addresses both what is disclose and when it is disclosed in a way that places the underlying collateral in the equivalent of a clear plastic bag.
Instead of being a public utility, ED is a profit-making private sector company, paid for by a private share placement to market participants, managed by Perella Weinberg. 
Shareholders get a discount on submitting their data. The idea was a co-operative system, analogous to SWIFT, the payments communication standard owned by its member banks. 
Loading loan-level data into the DataWarehouse is necessary to make ABS central bank eligible, but can only be achieved by paying ED a fee. One senior figure close to the project described it as a toll-booth on the only route to a destination. However, the profit rate is to be limited to 10% and is to be used for reinvestment.
And here we get to the real reason that the sell-side pushed the ECB into promoting the European DataWarehouse.  My firm would have owned the data warehouse and charged a toll.

This way, the sell-side can both minimize the toll and make some money off of the toll.
Initial target funding was EUR20m, though this was subsequently revised to EUR11m. Fundraising for this smaller amount was completed by July 2012, but 15 other institutions have publically committed funds so far, with Dutch institutions also involved, despite reports to the contrary. 
The shareholder list, available on the ED website, is heavily skewed towards peripheral institutions. 
Some firms were initially reluctant to offer financial backing to the project - Executive Board members of the ECB had to use their contacts with senior bank management to encourage them to buy shares. 
Despite this encouragement, some issuer communities decided to only invest under the guise of existing market associations - German banks under the banner of True Sale International and Dutch banks through the newly minted Dutch Securitisation Association.
So much for arms-length or just being an observer.  When a central bank uses their contacts to encourage bank management to buy shares, they have step directly into endorsement mode.

An endorsement that subjects both the ECB and the BoE to public examination.  

When the European DataWarehouse fails to reopen the market for structured finance securities in the first quarter of 2013, Mr. Draghi, the head of the ECB, and Sir Mervyn King, the governor of the BoE, should be held responsible for explaining why they endorsed blindly betting on the contents of a brown paper bag.

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