Showing posts with label ABS Data Warehouse. Show all posts
Showing posts with label ABS Data Warehouse. Show all posts

Wednesday, May 15, 2013

Bank of France turns to "super" transparency to restart securitization in EU

Bloomberg reports that the Bank of France is rolling out what it believes is the model for restarting securitization in the EU.

The distinguishing feature of the Bank of France's model is the reliance on making these deals "super transparent" so that market participants can know what they are buying and know what they own.

This is precisely what your humble blogger has been calling for since the earliest days of the financial crisis.

Why would the Bank of France feel the need to roll out deals that are "super transparent" when the ECB has already endorsed the level of transparency provided by the EU DataWarehouse?

Because the Bank of France sees that the EU DataWarehouse doesn't bring transparency that would allow an investor to know what they own or a buyer to know what they are buying.  Rather, the EU DataWarehouse is the industry's effort to retain opacity at the levels associated with opaque, toxic subprime mortgage-backed securities.

Please note, that the Bank of France recognizes that the only way to reduce, if not totally eliminate, the rating firms' role in securitization is to make the deal "super transparent".  When a deal is "super transparent", reliance on rating firms is greatly reduced as investors can do the analysis for themselves or hire a third party expert.

Regular readers know that your humble blogger has defined what it takes for a structured finance deal to be "super transparent".

First, the deal must provide observable event based reporting under which all activities, like a payment or delinquency, involving the underlying collateral are reported to market participants before the beginning of the next business day.

Second, the deal must make available all data fields tracked by the originator of the underlying collateral and the servicer of this collateral.  These firms are experts and would only track data fields that are relevant for valuing or monitoring the underlying collateral.  There is no legitimate business reason for depriving market participants of the right to piggy-back off this expertise.

The Bank of France wants to help banks package loans to businesses into tradable securities with the creation of a special-purpose vehicles, in what could become a template for the euro area. 
As the European Central Bank looks for ways to improve the flow of credit to small and medium-sized enterprises, or SMEs, the project started by the French central bank in July last year could provide one possible solution, the head of its markets division, Alexandre Gautier, said in a telephone interview. 
He’s in talks with the Frankfurt-based ECB and other national central banks on the initiative, which would ideally create securities that qualify as collateral in ECB refinancing operations. While banks can currently securitize SME loans and use them as collateral at the ECB, the process is complicated and not centralized. 
“We want a vehicle that is super simple and super transparent,” Gautier said. “We’d very much like these securities to be eligible in the euro system, but it’s not a condition. We’ll go ahead on our own if we have to to show that it’s doable.”... 
The aim is to make it easier for banks to re-finance existing loans and incentivize them to extend credit to small businesses. That would especially be the case if the new securities were eligible as collateral with the ECB, said Gautier. 
“The banks were very interested but they said that to make it really attractive, any securities should be eligible as collateral for refinancing within the euro system so that they would be liquid in the event of a crisis,” he said. “That’s now what we’re aiming for.” 
ECB President Mario Draghi said on May 2 that policy makers will start consultations with other European institutions on initiatives to promote lending to SMEs in the euro area using asset-backed securities.

Monday, March 4, 2013

Did the US securitization lobby just collapse?

Bloomberg reports that the American Securitization Forum is in disarray and on the brink of collapse after most of its Board of Directors quit.

Regular readers know that ASF is a sell-side dominated lobbying firm (it use to be a "subsidiary" of the sell-side's leading lobbying firm the Securities Industry and Financial Markets Association (SIFMA)).  This is confirmed when one reads the list of members that quit the Board.

The fact that these members quit is a sign that ASF has outlived its usefulness and is now seen even by the financial regulators like the SEC as speaking only for the sell-side.

It is not surprising that the sell-side no longer feels the need to control this lobbying firm.

The few recent structured finance securities that have been sold have been done on terms that make them even more toxic to investors than the opaque, toxic sub-prime mortgage-backed securities at the heart of the financial crisis.

At the same time, a number of sell-side dominated data warehouse initiatives have come on line.  As a result, the sell-side can maintain opacity across the structured finance securities while wrapping themselves in the mantle of providing transparency.

The American Securitization Forum, the leading trade association for the securitization industry, fell into turmoil last week when most of the board resigned ....
The exodus puts the future of the trade group in question, said the people, who spoke on condition of anonymity because the dispute isn’t public. 
Members that quit include Bank of America Corp., JPMorgan Chase & Co. (JPM), Deutsche Bank AG, Citigroup Inc. (C) and law firm Cadwalader, Wickersham & Taft LLP, the people said....
Note: not a buy-side firm or firm beholden to the buy-side on the list.

Wednesday, February 27, 2013

China looking to expand its asset-backed securities market

Bloomberg reports that China is looking to expand its asset-backed securities market.  The big question is how will it do this?

Will it require that asset-backed securities provide observable event based reporting  so investors can know what they are buying and know what they own or will it allow the securities to provide out of date information that leaves buyers and sellers blindly gambling on the contents of a brown paper bag?

China may allow more firms to develop asset-backed securities businesses with the goal of boosting liquidity, the nation’s market regulator said. 
The China Securities Regulatory Commission will lower its threshold for securities companies to undertake such businesses, the CSRC said today on its website. Asset-backed securities could be based on accounts receivable, credit assets, bonds, stocks and commercial properties, it said. 
The CSRC issued draft rules for the asset-backed securities business today and asked for public feedback, according to the statement. 
China Development Bank Corp., the nation’s largest policy bank, sold 9.27 billion yuan ($1.5 billion) of asset-backed securities, the bank said Sept. 7, in the country’s first such sale since 2008. 
The difficulty of assessing risk in bonds that are backed by loans was a major contributor to the 2008 global financial crisis.

Thursday, January 31, 2013

Structured finance investors: current proposed disclosure standards inadequate

A 2012 Q4 survey of investors in asset-backed securities, mortgage-backed securities and structured credit securities by Principia reveals that 59% of these investors think that the proposed loan level disclosure standards will not be sufficient to adequately perform due diligence.

We asked investors whether the current standards for disclosure of loan level data, for example via the European DataWarehouse, Project RESTART, EDGAR or the BoE and ECB templates, will provide sufficient data to adequately perform due diligence on ABS/MBS/CDO investments.... 
59% remain unsure as to whether the new market standards will be sufficient. This is a general finding across all asset classes...
Please re-read the highlighted text and as you are doing so ask yourself what percentage of portfolio managers would say that IBM's disclosures are sufficient to adequately perform due diligence (your humble blogger would expect 90+% as no one refers to IBM as a 'black box').

Regular readers are not surprised by this survey result.  It confirms what your humble blogger has been saying about the sell-side and its lobbyists like ASF, AFME (formerly ESF) derailing efforts to bring greater transparency to structured finance securities.

Regular readers know that there are two aspects to disclosure:  what is disclosed and when it is disclosed.

To date, the sell-side has managed to prevent adequate loan level disclosure standards by focusing the discussion on what is disclosed in the specific data fields in the templates proposed by ESF, Project Restart, EDGAR, the BoE and the ECB.

While very time consuming, this whole discussion of specific data fields to include in the templates ignores a simple relevant fact: the data fields that should be disclosed are all the data fields tracked by the loan originator and servicer that are not borrower privacy protected.

The originator and servicer are experts and as such every field that they track is a field that they feel is important for monitoring and valuing the individual loan.  These experts wouldn't track a data field they didn't think was important because it costs them money.

However, even if the disclosure templates were thrown away and all the data fields tracked by the originators and servicers were provided to investors, this would not be a big enough change in disclosure to get remotely close to 90+% thinking the disclosure was sufficient to adequately perform due diligence.

The simple fact is that investors recognize that 'when' data is disclose is a critical factor in determining if the disclosure is adequate for performing due diligence.

Structured finance securities are created by setting aside specific assets for the benefit of the investors.  The physical equivalent of this would be to put these assets in a bag.

'When' addresses the question of is the bag paper or plastic.

It is a brown paper bag if 'when' is the same reporting frequency as exists for opaque subprime mortgage-backed securities.  This is the frequency that has been adopted by the sell-side and shows up in the European Data Warehouse and Project Restart.

The bag is plastic if 'when' is observable event based reporting under which all activities like a payment or delinquency involving the underlying assets are reported to market participants before the beginning of the next business day.

It is only be adopting observable event based reporting with all the non-borrow privacy protected data fields tracked by the originators and servicers that 90+% of structured finance investors will think the disclosure was sufficient to adequately perform due diligence.

Other Interesting Observations

1) The investors have confessed that when it comes to buying ABS/MBS/CDO securities they are blindly gambling on the contents of a brown paper bag.

59% of investors are saying that the proposed standards are not sufficient to adequately perform due diligence.  If the proposed standards are not sufficient, what does that say about existing disclosure standards?

2) The proposed disclosure standards are unlikely to encourage former or new investors to buy ABS/MBS/CDO securities.

If 59% of existing investors see themselves as blindly gambling on the contents of a brown paper bag because of disclosure is not sufficient to adequately perform due diligence, why would former or new investors want to gamble too?


Tuesday, January 29, 2013

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.

Friday, January 18, 2013

CFPB mortgage servicing rules eliminate excuses not to provide transparency for RMBS

The Consumer Financial Protection Bureau announced its new mortgage servicing rules that eliminate any excuse the structured finance industry has for not providing observable event based reporting on residential mortgage-backed securities.

Under the new rules, mortgage servicers, the firms that manage the loans, will now be required to credit a borrower's account the day a payment is receive.  In addition, the mortgage servicers must provide borrowers with regular statements that show a breakdown of payments by principal, interest, fees, and escrow as well as recent account activity.

For anyone who is familiar with looking up their credit card account on-line, the CFPB has said that mortgage servicing firms need to provide similar information in a timely manner.  From an IT perspective, this is easy to do because both mortgages and credit card databases update whenever there is activity on the account.

I can not stress enough the importance of the CFPB's mortgage servicing rules.  The ability of mortgage servicers to comply with these rules means by definition that observable event based reporting can be provided for all residential mortgage-backed securities.

As regular readers know, observable event based reporting involves reporting all activities like payments or delinquencies involving the underlying collateral to market participants before the next business day.

This is the same information that mortgage servicers need to "report" to borrowers.

As a result, there is no longer any excuse for the structured finance industry to block the provision of observable event based reporting.
To prevent harm to consumers in routine payment processing, our rules also require common-sense policies and procedures. Payments must be promptly credited as of the day they are received.... 
In general, servicers must maintain accurate and accessible documents and records. They must be able to provide accurate and timely information to borrowers, mortgage owners (including investors), and the courts. 
These provisions will prevent the egregious “robo-signing” practices that were rampant from ever happening again. These obligations apply even through transfers of servicing rights between firms; both the transferor and the transferee have the same duties to maintain accurate information about an account. This cuts off yet another frequent source of harm to consumers.

The Fed knew that opacity was the problem in 2007, why hasn't it championed transparency?

From the Fed transcript of the FOMC meeting on August 7, 2007.  Speaker Bill Dudley, then manager of system open market account:
So how does one explain the contagion to corporate credit from the subprime market given the disparity in fundamentals between these two sectors? 
Although the answer is complex, one factor stands out: There has been a loss of confidence among investors in their ability to assess the value of and risks associated with structured products, which has led to a sharp drop in demand for such products. 
The loss of confidence stems from many sources, including the opacity of such products; the infrequency of trades, which makes it more difficult to judge appropriate valuation; the difficulty in forecasting losses and the correlation of losses in the underlying collateral; the sensitivity of returns to the loss rate and the degree of correlation; and the problem that the credit rating focuses mainly on one risk—that of loss from default.  
Please note that it is the opacity of structured finance markets that makes them impossible for market participants to assess their value and risk.

When investors cannot assess the value and risk of an investment due to a lack of transparency, they stop buying or selling said securities.  They stop because they have no way of independently determining the value of the securities and comparing this independent valuation to the prices shown by Wall Street to make a buy, hold or sell decision.

More than five years after this FOMC meeting, the question is:  what has changed about structured finance securities to make them transparent?

The answer is nothing.

These securities will not be transparent until such time as they provide observable event based reporting and all activities like payments and delinquencies on the underlying collateral are reported before the beginning of the next business day.

Without observable event based reporting, buyers or sellers of these securities are simply blindly betting on the contents of brown paper bags.
The CLO and CDO markets have facilitated the transformation of low-rated paper—for which there is a limited investor appetite—into a high proportion of high-grade-rated debt. 
For example, in a typical CLO structure, the underlying loan quality averages a rating of about B. Yet through the magic of structured finance and the corporate rating agencies, the resulting CLO tranches are rated predominately investment grade. 
Exhibit 8 shows the structure for a representative CLO: More than two-thirds is AAA-rated debt, and 87 percent is investment grade. 
The loss of confidence among investors in the ability to assess the value and risks associated with this structured product has led to a sharp drop in CDO and CLO issuance. 
As shown in exhibit 9, CLO and CDO issuance plummeted in July. 
This is very important because the CLO and CDO markets represent the bulk of the demand for non-investment-grade debt. With this demand falling away at a time when the forward supply of high-yield corporate loans and debt exceeds $300 billion by some measures, a huge mismatch between demand and supply has developed. 
The underlying problem is that the depth of the market for non-investment-grade rated loans and debt—excluding CDO and CLO demand—is far shallower than the market for investment-grade products. 
The only way to restore depth to the market is to provide transparency.  Until this is done, the buyers will remain on strike.

Please note that based on the minutes of the FOMC this simple fact was known prior to the beginning of the financial crisis on August 9, 2007.

Yes, in all of the Fed's responses to the financial crisis, the Fed has never addressed making structured finance securities and bank balance sheets transparent.

Update
From the August 10, 2007 Fed conference call, Ben Bernanke speaking:

President Fisher, our goal is to provide liquidity not to support asset prices per se in any way. 
My understanding of the market’s problem is that price discovery has been inhibited by the illiquidity of the subprime-related assets that are not trading, and nobody knows what they’re worth, and so there’s a general freeze-up. 
The market is not operating in a normal way. The idea of providing liquidity is essentially to give the market some ability to do the appropriate repricing it needs to do and to begin to operate more normally. 
So it’s a question of market functioning, not a question of bailing anybody out. That’s really where we are right now. 
Please re-read the highlighted text as within a span of 3 days following the FOMC meeting that said that opacity was making it impossible for market participants to value structured finance securities, Mr. Bernanke has completely forgotten the problem needs to be addressed.

Note that he asserts that the goal is to provide liquidity until the market's problem with price discovery is fixed.

And lo and behold, the Fed has been adding liquidity through programs like quantitative easing ever since.  Of course there is no end in sight for these liquidity programs because no one is working to make these securities transparent!!! 

Update II
Governor Mishkin on August 16, 2007 conference call discussing letting banks pledge structured finance securities at the discount window as a mechanism for unfreezing the frozen subprime mortgage market caused by the buyers' strike,

The issue is that there’s an information problem in the markets, but the banks’ knowing that there’s a backstop and that we’re doing something in terms of the discount window could actually unfreeze the system so that we could have players come into these mortgage markets to replace the players that are now not in the mortgage markets. 
An information problem that can only be solved by bringing transparency to both structured finance securities and bank balance sheets.

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.

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.

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 (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.

Instead,
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.

Thursday, December 6, 2012

Turning lemon mortgage-backed securities to lemonade


The International Organization of Securities Commissions (IOSCO) recently called for  requiring disclosure so that investors can independently assess the creditworthiness of the underlying collateral for each structured finance product.

Let me show you how correctly implementing this simple requirement would turn 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.

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.

Monday, November 19, 2012

Restarting securitization could be helpful for China's banks

The Wall Street Journal reported on how restarting securitization would be helpful for China's banks as it would provide them with liquidity and reduce their need for capital.

True, but who would buy securities backed by their loans without complete disclosure of all the relevant information.  This includes, but is not limited to, observable event based reporting on all activities like payments or delinquencies involving the underlying collateral before the beginning of the next business day.

Without this information, buyers of these securities would be blindly betting.  When buyers did this with sub-prime mortgage backed securities they lost trillions.

The restart of asset securitization, especially loan securitization, will help Chinese banks tackle liquidity challenges under the Chinese version of the Basel III capital requirements that will take effect next year, ICBC Vice President Li Xiaopeng said Sunday. 
Given slowing profit growth this year and weak domestic capital markets, Chinese banks face increasing challenges to meet capital requirements stipulated by regulators and to better serve the real economy, Li said. 
Bank loans have to grow by at least 15% a year to support 8% GDP growth in China, Li said, citing unspecified economists' studies. 
"To realize such a loan growth rate, Chinese banks will have a huge capital gap," he said. 
Asset securitization, especially loan securitization, could be a way to solve the predicament, he added.

IOSCO: banks should be forced to provide "all documents and data relevant to assess ... securitization product"

IOSCO, the International Organization of Securities Commissions, has come out in favor of investors having access to "all documents and data relevant to assess the creditworthiness of each securitization product".

Equally importantly, IOSCO recognizes that banks must be forced to provide this information. They have not done so to date.

The IOSCO requests for "all documents and data relevant to asses the creditworthiness of each securitization product" also means that the proposals of a European Data Warehouse (with monthly data) and the Prime Collateralised Securities label (a sell-side initiative) are inadequate for assessing the creditworthiness.

Regular readers know that the IOSCO statement has two parts:  "what" is disclosed and "when" it is disclosed.
  • The "what" is all the information collected on the underlying collateral on a borrower privacy protected basis.
  • The "when" is on an observable event basis where all activities like a payment or delinquency involving the underlying collateral are reported before the beginning of the next business day.  Without this frequency of reporting, investors don't have all the data they need to assess each securitization.
As reported by Bloomberg,
Banks should be forced to give investors buying securitized debt data for stress tests to gauge its risk, global regulators said as they push to make financial markets safer. 
The International Organization of Securities Commissions said investors should have the same access as credit-ratings companies to “all documents and data relevant to assess creditworthiness of a given securitization product,” as part of a push to improve regulation of the industry. 
The group also said that the EU should work to iron out differences with the U.S. on its rule-making.
“Iosco considers that investors should be able to test whether future cash flows generated from underlying pools” of assets in a securitization will “pay investors in full and on time,” ....

Please re-read the highlighted text again as this is what your humble blogger has been saying since before the financial crisis began.

Regular readers know that leading up to the financial crisis the credit-rating companies "represented" that they had access to information on the underlying collateral performance that allowed them to update their ratings on a timely basis.

In the fall of 2007, the credit-rating companies testified before the US Congress that they actually did not receive data on the performance of the underlying collateral any more frequently than other market participants and this frequency was inadequate for timely ratings updates.

Frequency is a problem because if credit-rating companies cannot do a risk assessment on a timely basis, then neither can investors.  If investors cannot assess the risk of each securitization, they cannot "know what they own".

If investors cannot know what they own, they are blindly betting when they buy a securitization.  The US National Association of Insurance Commissioners white paper on the Future of Mortgage Finance set the global standard for the buy-side and said that blindly betting requires a lot more capital to be held against the position.

In its statement, IOSCO assumes that this frequency problem has been fixed and that the credit-rating companies now have data on an observable event basis.

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?

Yes.

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.

Update
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.

Friday, November 9, 2012

UK Business Secretary Vince Cable looks to restart securitization market

The Telegraph reports that UK Business Secretary Vince Cable is looking to restart the securitization market as it is needed as a source of funding for loans to small and medium size enterprises.

Mr. Cable observed that a number of ways have been tried to restart the securitization market and none of them has been successful.

Regular readers know that the only way to restart the securitization market where investors assume the credit risk on the underlying collateral is to require these securities to provide observable event based reporting.  All activities like a payment or delinquency involving the underlying collateral must be reported before the beginning of the next business day.

It is only with observable event based reporting that investors have the current information they need to satisfy the "know what you own" standard in Article 122a of the European Capital Requirement Directive.

It is only with observable event based reporting that potential investors have the current information they need to independently assess the risk of each security and 'know what they are buying'.

Providing observable event based reporting restarts the securitization market as potential buyers are no longer blindly betting on the contents of a brown paper bag, but instead are making investment decisions on the contents of a clear plastic bag.

Mr. Cable suggested that maybe the way to restart the market is for the UK government to guarantee the debt.  While the government guarantee effectively eliminates the need to know the contents of the brown paper bag, the question is why should the UK taxpayer take on the credit risk for the underlying collateral when by providing observable event based reporting they do not have to?

Business Secretary Vince Cable says that the Government’s £1bn Business Bank will include an agency that parcels up small business debt and sells it on to investors. 
Mr Cable said an agency for business lending is being planned which would package loans into various types of bonds, backed by a state guarantee, which could bring a new source of money into the SME debt market. 
The plan would involve a renaissance for called “securitisation”, which is associated with the kind of financial engineering that led to the economic crisis. 
Mr Cable told The Daily Telegraph that the Government would have to be "very careful" about the design of the agency given the risks associated with securitisation. 
“An agency is part of the current thinking. We’d need to think it through very carefully and decide exactly what role government guarantees and financial support would play. 
“A new version of securitisation does have a future. Various attempts have been made to relaunch it since the financial crisis and none have quite worked. But it’s one of the ways to get money into small businesses and we’ve got to try everything because there is a serious problem of supply of finance, not just demand.”
The primary role for the government is to require that all structured finance securities, broadly defined, must provide observable event based reporting.

This is consistent with the global standard set for the buy-side by the US National Association of Insurance Commissioners in its white paper on the Future of Mortgage Finance.
A Business Bank was announced by Mr Cable in September. It is designed to provide small and medium-sized businesses with an alternative source of finance. 
The £1bn of taxpayers' money will be supported by private partners to provide "£10bn of lending capacity", Mr Cable said. 
"The target market is medium-sized companies that want to borrow for longer than five years. We want to create a facility for companies to access what we call patient capital." 
The bank is expected to support loans on terms of between five and 25 years, with the focus on funding growth....
One of the benefits of observable event based reporting is that it pays for itself.  It pays for itself because it assures there is a secondary market for the securities.

As shown by the current structured finance securities, if there is not observable event based reporting, the secondary market for these securities freezes.  As a result, investors have to charge a premium for this illiquidity.  This premium substantially drives up the cost of the financing.

With observable event based reporting, this illiquidity premium disappears as investors know that other buyers can independently assess and value these securities and as a result, there will always be a buyer should they want to sell.

The savings from eliminating the illiquidity premium pays for the cost of observable event based reporting several times over.
The Business Secretary added that an advisory group is being established which will create a detailed business plan for the bank at the "beginning of 2013".
Your humble blogger would expect to be added to this advisory group.
A feasibility study on the securitisation scheme has been conducted by the Association for Financial Markets in Europe. 
The idea would see existing lenders make loans to small businesses, then sell the debt on to the agency, which would in turn package loans in to bonds which could be sold on to the market. However, banks would have to keep a slice of each loan to avoid them simply passing the poorest quality debt on to the state-backed scheme.
No surprise that with the AFME's involvement the solution is to stick the UK taxpayer with the risk rather than simply provide transparency.

Wednesday, November 7, 2012

Will Obama now bring transparency to all the opaque areas of finance created by Wall Street?

Having won re-election despite Wall Street's overt support of Mitt Romney, will President Obama now embrace bringing transparency to all the opaque corners of the financial system?

With any reflection, President Obama should realize that besides the Consumer Financial Protection Bureau and the Volcker Rule, Dodd-Frank is reform legislation written by and for Wall Street.  It substitutes complex rules/regulations and regulatory oversight, both of which can be gamed by Wall Street, for transparency and market discipline.

Clearly, this is unlikely to meaningfully change Wall Street in a positive manner.

The question is does President Obama want lack of meaningful reform of Wall Street as his legacy.

This question is also linked to his economic policies.  Does President Obama continue to pursue the Japanese Model for handling a bank solvency led financial crisis and protect bank book capital levels and banker bonuses at all cost or does he change and adopt the Swedish Model.

President Obama has 4 years of experience that shows that the US is no different than Japan when it comes to the Japan-style economic slump that results from adoption of the Japanese Model.

Simply put, even with an economy as big and robust as the US economy, the burden of the excess debt in the financial system is too great.  It diverts capital needed for reinvestment and growth to debt service with the result being a stagnant economy if not outright contraction.

President Obama can now chose to adopt the Swedish Model and require the banks to absorb upfront the losses on the excess debt.  This relieves the real economy of the burden of supporting this excess debt and results in the economy growing again.

The decision to adopt the Swedish Model is also a legacy issue.  Does President Obama want to be remembered for putting banker bonuses before the social safety net that protects and takes care of the elderly, the sick, the veterans and the poor?

At the same time, President Obama can also focus on bringing transparency back to all the opaque corners of the financial system.

For banks, he can push to have them required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This has numerous benefits including unfreezing the interbank lending market, preventing future manipulation of interest rates like Libor, enforcing the Volcker Rule prohibition on proprietary trading and reducing in size if not breaking up the Too Big to Fail.

For structured finance securities ranging from covered bonds to securitizations, he can push to have them required to provide observable event based reporting of all activities like payments and delinquencies involving the underlying collateral before the beginning of the next business day.

This has numerous benefits including allowing investors to know what they own and allowing both Fannie Mae and Freddie Mac to be put into runoff mode as the private mortgage-backed finance market restarts.

Tuesday, November 6, 2012

Clifford Rossi: National Mortgage Database faces challenges

In his American Banker column, Clifford Rossi looks at the challenges faced by the National Mortgage Database.

At the top of the list of challenges is distinguishing between this database and the FHFA's platform to support mortgage financing.  While the two databases could be combined, so far, based on public announcements, they have not been.

Mr. Rossi's column does not distinguish between the two databases in discussing the challenges.  Most of the challenges he mentions are actually attributable to the platform to support mortgage financing and have already been addressed in my firm's patented information system.

The CFPB and FHFA's effort to build a comprehensive data repository and identify emerging mortgage lending risks is laudable. However, success will depend on how regulators handle four areas: collaboration, scope, privacy and the regulatory burden. 
The mortgage industry includes numerous participants performing critical functions that touch borrowers at various stages in the home-buying process—and which should be represented in the design of the new mortgage database....
The CFPB and FHFA's decision to join forces is a positive sign, but collaboration must extend beyond these agencies and Experian, the credit bureau they have contracted with to build a database.... 
If a database is going to help regulators understand emerging risks, it needs to be comprehensive. That means including loans from Fannie Mae and Freddie Mac, the Federal Housing Administration and Department of Veterans Affairs, as well as loans that are part of private-label securities in held-for-investment portfolios.
By definition, the National Mortgage Database should include every mortgage. The question is what is the source of data for every mortgage.
Information on credit enhancement and other features of mortgages would provide an even more complete picture of their riskiness. 
Regulators who were armed with an understanding of differences in the risk profiles of loans held for investment and placed into securities, for example, would gain insights into potentially abnormal behavior, such as cherry-picking of loans....
This is also a concern of investors and in theory should be addressed by the database underlying the platform for supporting financing of mortgages.
For the database to be useful in monitoring risk, it must include information at the individual loan level. That means placing into regulators' hands borrowers' credit, employment and income histories, marital status, net worth, and other highly sensitive information. This, unsurprisingly, will give rise to concerns involving regulatory burdens and personal privacy. 
My firm's patented information system was designed to protect personal privacy consistent with the patient privacy standards established under HIPAA.  The protection of personal privacy also meets the standards established in Europe for protecting personal data.
The advantage of collecting such data is that it holds the prospect of improving on analysis of mortgage default behavior, which has traditionally relied on proxies for so-called "trigger events" that prompt defaults.  Ideally, the new database would include information about the events themselves—including divorce, job loss, the death of a spouse and other personal catastrophes. 
Collecting such information and other behavioral characteristics of borrowers is critical in developing more robust risk assessment capabilities, but protecting individuals' privacy is of paramount importance.... 
I know and that is why the information system was designed to protect individual privacy.
From a business perspective it is likewise important to protect portfolio lenders from the release of their proprietary information. 
Again, this was included in the original design of the information system.
The FHFA and CFPB must also be mindful of any additional reporting burdens they place on market participants. Regulators are often criticized for creating excessive regulatory burdens, and the costs of additional regulation could inhibit the industry from overcoming the malaise that has plagued the mortgage market since the crisis. 
Actually, it doesn't cost much to provide the data today and this figure will decline over time.  The reason it will decline is that the cost will be passed through and built into the cost of each mortgage.
The many legitimate concerns aside, the effort to create a National Mortgage Database must go forward. Regulators and the industry have for too long relied on mortgage risk information that has failed to keep pace with the complexity and speed of product development and structured finance. 
If the initiative is to fulfill its potential and become the definitive repository for mortgage risk assessment and monitoring, those in charge must expand collaboration as well as the scope of mortgage activities and the number of participants included in the project. 
Additionally, they must manage the regulatory burden and closely guard private information.