Tuesday, August 6, 2013

Key to GSE reform: disclosure

The key to success for any GSE reform and getting private investors to absorb more of the risk of default on mortgages is information.  Specifically, disclosure of information so that investors can "know what they are buying" and "know what they own".

In the run-up to the financial crisis, we learned that once-per-month or less frequent disclosure was inadequate to know what you were buying or know what you own.  We know this because sub-prime mortgage-backed securities disclosed on a once-per-month basis and they were referred to as "opaque".

It is only disclosure on an observable event basis that allows investors to know what they own or know what they are buying.  

This can be easily shown with a clear plastic bag, which represents observable event based reporting, and a brown paper bag, which represents once-per-month or less frequent disclosure.  Which is easier to value the contents of: paper or plastic?

Under observable event based disclosure, any activity like a payment or delinquency involving the underlying collateral is reported to market participants before the beginning of the next business day.

The National Association of Insurance Commissioners, the only non-conflicted buy-side regulator, thinks highly enough of the need for observable event based reporting that it included it in its future of mortgage financing white paper.

This information is best collected and distributed through a securitization platform.

Please note that both the Senate (Corker, Warner) and House bills call for the creation of this securitization platform.

Based on this, you would expect that Fannie Mae and Freddie Mac would, rather than delay and create their own platform, simply use the exiting securitization platform operating in Europe, the EU Data Warehouse.  

This is particularly true because the EU Data Warehouse's pricing model is to charge enough to break-even.  This pricing model caps what a Fannie Mae and Freddie Mac securitization platform could charge and effectively means that there would be no return on, let alone return of, US taxpayer funds used to build the platform.

The case for not using the EU Data Warehouse is it doesn't provide observable event based reporting.  However, based on disclosures by Fannie Mae and Freddie Mac they are not intending to provide observable event based reporting either.

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