SEC Commissioner Troy Paredes: Sophisticated investors better at valuing contents of brown paper bag

In an astonishing report by Securitization Intelligence, in his keynote address at the ASF 2013 conference, SEC Commissioner Troy Paredes offered

his views on Regulation AB II’s requirement that private 144a offerings include elements of disclosure usually limited to publicly registered transactions, saying that he has previously expressed concern “that we were going too far in treating the private market just like the public market, and that, as a consequence of that, we may compromise the value that the private market brings to bear.” 

He added that the thought that the relative lack of legal protections for investors in the private-label market makes such disclosure requirements important is obviated in part by the sophistication of the investors in the space. 

“I remain unpersuaded that the fundamental reason that the securitization market has been struggling in the last few years is because we don’t have a piling on of regulatory demands,” he said. 

“That’s not to say there is not some room for improvement” in disclosure enhancements, but that the SEC could “end up undercutting the objective of trying to move the ball forward when it comes to the securitization market being conditioned to take off again.” 

To which Deutsch replied, on behalf of attendees who received less resolute answers from some regulatory panelists yesterday, “Hallelujah, brother.” [confirming that ASF is a sell-side dominated group and doesn't represent the buy-side's interests.]

As long as Commissioner Paredes brought up the issue, I thought I might describe exactly what disclosure requirements are needed for both publicly registered and private 144a offerings.

From my post, Turning lemon mortgage-backed securities into lemonade

Disclosure has two components:  what is disclosed and when it is disclosed.  I would like to focus on “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. 

 Why? 

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. 

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

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. 

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.  And, once the securities are purchased, the investor has no ability to know what they own. 

In case you doubt this, let me show it to you 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. 

This valuation problem has been shown to be particularly acute for mortgage-backed securities since the beginning of the financial crisis.  At that time, buyers came to doubt the ability of the borrowers to make their future payments.  The more doubt, the more likely the market is to freeze as it is impossible to get buyers, who think that the bag is more likely to have $50, and sellers, who look at last month's performance and think the bag has $75, to agree on price. 

Another way we can approach asking what is currently in this brown paper bag is to use a sophisticated model.  We recognize that last month $25 came out of the bag.  This is roughly $0.85 per day.  So we can value the contents of the brown paper bag by multiplying the day of the month it is today by .85 and subtracting the resulting value from the end of the month value shown in the last trustee report. 

Today is the 6th, so the model suggests a value of $69.90 ($75 minus $5.10).  The price suggested by the model doesn't seem unreasonable if a $5 bill is removed from the bag. 

However, a buyer is significantly overpaying if there has been a sharper decline in the value of collateral in the bag and a $20 bill has been removed.  This is analogous to what happened with sub-prime mortgage-backed securities where there was a rapid decline in the value of the collateral. 

This problem of guessing what is in the bag would go away if we were talking about a clear plastic bag.  The investor would know what is in the bag currently as the contents of the bag can be seen and are a knowable fact. 

This is true whether the investor is Commissioner Paredes' sophisticated investor or not.

As a result, investors could independently assess the risk and value the collateral.  With this assessment, the investor “knows what they are buying” and "knows what they own". With this assessment, the investor can make an investment decision to buy, hold or sell based on the prices being shown by Wall Street. 

So turning the mortgage market from lemons to lemonade simply requires recognizing that it is a choice between “Paper or Plastic”.  With “Paper”, you get lemons.  With “Plastic”, you get lemonade. 

So how can each of the structured finance securities be put into the equivalent of a clear plastic bag? 

This can be easily done as the servicer information systems are designed to track and report on the underlying collateral on an observable event basis. 

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. 

Observable event based disclosure is associated with a clear plastic bag.  All other frequencies of disclosure are associated with a brown paper bag and lemons.