PIMCO shocked by prices paid to gamble on toxic RMBS

Bloomberg reports that JP Morgan is trying to bring a non-agency backed residential mortgage-backed security to market and PIMCO is shocked by the terms that gamblers are willing to accept to place their wager on these securities.

As everyone knows, residential mortgage-backed securities are opaque.  Therefore, buying these securities is simply blindly betting on the contents of a brown paper bag.

Leading up to the financial crisis, buying these securities was a losing bet for the gamblers and selling these securities was a winning bet for Wall Street.

Since nothing has changed, most notably these securities still do not offer observable event based reporting under which all activities like a payment or default on the underlying assets are reported before the beginning of the next business day so market participants can know what they are buying or know what they own, there is no reason to believe the gamblers won't lose again.

Which is precisely why PIMCO cannot believe the prices paid by the gamblers.

JPMorgan Chase & Co. is seeking to sell securities tied to new U.S. home loans without government backing in its first offering since the financial crisis that the debt helped trigger. 

The deal may close this month, according to a person familiar with the discussions. 

Servicers of the underlying loans may include the New York-based lender, First Republic Bank and Johnson Bank, said the person, who asked not to be identified because terms aren’t set. 

The market for so-called non-agency mortgage securities is reviving as the Federal Reserve’s $85 billion a month of bond purchases help push investors to seek potentially higher returns. 

As deals accelerate, Pacific Investment Management Co. is questioning the prices paid. 

At the same time, a weakening of contract clauses that offer protection to investors if the loans don’t match their promised quality is stoking debate, said Kroll Bond Rating Agency analyst Glenn Costello. 

“There’s a pretty heavy dialogue going on right now between all participants in the market about what makes sense,” Costello, who is based in New York, said last week in a telephone interview....

What makes sense is that the deals provide observable event based reporting.

JPMorgan is telling investors its deal’s terms may allow some of the so-called representations and warranties about the mortgages from originators or itself to expire after 36 months to 60 months, the person said. Such contract clauses, which can be used to force loan repurchases, have led to billions of dollars of costs for banks on debt made during the housing boom. 

After Credit Suisse included so-called sunsets of 36 months on certain buyback promises in a November deal, Standard & Poor’s, the only grader to rate the bonds, said in a statement that the move didn’t affect its view of the debt’s risks. The ratings firm cited the “exceptionally high credit quality” of the loans and that all of them had been reviewed by third-party firms before being packaged into the securities.

Interesting to note the use of third-party firms to review the mortgages and the reluctance of the issuers to provide the data on the mortgages to all market participants so that investors can do their own independent assessment.

As everyone knows, one of the weak spots in securitization is the reliance on third parties making representations about the quality of the underlying collateral and the deal.  A prime example of this was the rating firms.

Yet, here is Wall Street trying to repackage and sell the same snake oil.

Rivals including Fitch Ratings, which publicly called S&P’s grades too high, are taking a more skeptical view. Changes such as sunset provisions and clauses that void loan-quality warranties if borrowers default after events such as job losses or illness generally should require greater so-called credit enhancement, said Rui Pereira, a managing director at Fitch. 

Credit enhancement can include some bonds taking losses before others, cash reserves or payments from the underlying assets that exceed coupons on the securities created. 

“Less investor-friendly provisions are something we need to take into account,” Pereira said last week in a telephone interview.

Issuers are seeking to move past a framework for representations and warranties provided by Redwood that represented a “gold standard,”Kathryn Kelbaugh, a senior analyst at Moody’s Investors Service, said last month during a panel discussion at a securitization conference in Las Vegas. 

In Redwood’s latest deal, it may sell a top-rated class as large as $561.2 million with a 2.5 percent coupon at about 102 cents on the dollar, a person familiar with that offering said today, asking not to be named because terms aren’t set. 

That compares with current prices of about 99 cents on the dollar for Fannie Mae-guaranteed 2.5 percent securities, according to Bloomberg data. 

Bonds issued in recent months by Redwood have been “insanely expensive” by comparison with Fannie Mae debt, Pimco’s Scott Simonsaid in an interview yesterday. 

“I can’t believe someone would pay anywhere near where they have sold them,” said Simon, the mortgage-bond head at Newport Beach, California-based Pimco, manager of the world’s largest mutual fund.

 It is hard to argue with Mr. Simon's observation about the Redwood deal or the prices gamblers are paying for other opaque residential mortgage-backed securities.

Trial could set precedent allowing investors to recover under subprime bond reps and warranties

Reuters reports that a case is moving forward that could set a precedent that would allow investors to recover their losses on subprime securities under the reps and warranties made by the issuer.

This might not sound like a big deal, but it is because the banks have been successful to date at not paying out for any misrepresentation that were made concerning the loans backing the individual deals.

A Michigan bank accused of misstating the quality of home loans it repackaged into mortgage-backed securities is set to go to trial on Wednesday, in a case that could affect pending lawsuits against some of Wall Street's biggest firms. 

The lawsuit against Flagstar Bancorp Inc of Troy, Michigan, is one of the first to go to trial over claims that a lender misrepresented loans pooled into mortgage-backed offerings. 

Flagstar was sued in 2011 by bond insurer Assured Guaranty Ltd, which had guaranteed $900 million of securities and was on the hook to pay investors when the investment plummeted in value in the housing market meltdown. 

While Assured is seeking only $108 million in its breach-of-contract case -- a relatively small sum in financial industry litigation -- Wall Street will be watching the Manhattan federal court trial closely. ... 

Leading up to the lawsuit, Assured had demanded Flagstar repurchase some of the loans, and Flagstar refused, according to the insurer's complaint. Flagstar has countered that Assured is a sophisticated party that extensively reviewed the securities before agreeing to insure them.... 

The Flagstar lawsuit is one of many cases over mortgage practices when the housing market was booming. 

In February, Flagstar agreed to a $132.8 million settlement to resolve civil fraud claims by the U.S. Department of Justice that the bank had improperly approved thousands of home mortgages for government insurance....

The Flagstar case has progressed swiftly to trial thanks in part to the presiding judge, Jed Rakoff, who is known for trying to get cases to move along quickly. ... 

The Flagstar trial is expected to focus heavily on why certain loans were included in mortgage-backed securities, an issue at the heart of the lawsuits brought by the bond insurers. 

The question is whether lenders misrepresented details of the loans, such as homeowners' credit scores and their debt-to-income ratios, painting a false picture of the default risks of mortgages underlying the securities. The insurers point to underwriting guidelines that required all the loans in the securities to meet standards. 

Assured has accused Flagstar of falsely representing the quality and characteristics of loans packaged into two offerings issued in 2005 and 2006. An analysis of 800 loans found 610 instances of misrepresentations, according to Assured's lawsuit. 

The trial could also test bond insurers' ability to recover damages using evidence from so-called "statistical sampling." Insurers say they should be able to rely on a sample of the multitude of loans underlying a mortgage pool, rather than have to go loan by loan to prove their case as the defendants have sought.

Jeff Connaughton: Why Wall Street always wins

ZeroHedge carried excerpts from Jeff Connaughton's book, The Payoff:  Why Wall Street Always Wins.

In the book excerpts, Mr. Conaughton discusses one aspect of the Financial, Regulatory, Academic Complex (FRAC).  He specifically focuses on how FRAC goes about maintaining a status quo where complicated regulations and regulatory supervision has replaced transparency and market discipline.

The Blob (it’s really called that) refers to the government entities that regulate the finance industry—like the Banking Committee, Treasury Department, and SEC—and the army of Wall Street representatives and lobbyists that continuously surrounds and permeates them. 

The Blob moves together. Its members are in constant contact by e-mail and phone. They dine, drink, and take vacations together. Not surprisingly, they frequently intermarry. 

Indeed, a good way to maximize your family income in DC is to specialize in financial issues and marry someone in The Blob. Ideally, you and your spouse take turns: One of you works for a bank, insurance company, or lobbying firm while the other works for a government entity that regulates, or enacts legislation for, the financial industry. 

Every few years, you reverse roles: “Sally Striver, staffer on the Senate Banking Committee,” so might read a typical notice in Roll Call, “today announced her departure to work for the Financial Services Roundtable”; inevitably, she’s replaced with someone from the financial industry because, so runs the justification, the committee needs people familiar with the issues. 

What you and your spouse do all the time is share information. After all, no lobbying restrictions yet promulgated can prevent pillow talk between Blob spouses. 

Actually, marrying The Blob isn’t even necessary. A Blob member can simply take his or her non-Blob spouse to Blob parties—convivial gatherings of lobbyists and Wall street emissaries, SEC and Treasury Department officials—to help gather and disseminate intelligence. It’s a weekly, and sometimes nightly, occurrence in Washington. 

Ted and I quickly learned that, when you take on Wall Street in Washington, you take on The Blob....

Please take the time to re-read the description of the Blob keeping in mind the Dodd-Frank Act.

Regular readers know that your humble blogger views the Dodd-Frank Act as written by and for the financial industry with the exception of the Volcker Rule and the Consumer Financial Protection Bureau.

The Act is 2,000+ pages calling for an enormous expansion in complicated regulation and regulatory supervision of the financial sector.  This is undoubtedly good for the Blob.

However, if the last 50 years have shown anything, it has shown that a financial system that is dependent on complicated regulations and regulatory supervision is an inherently unstable financial system prone to collapsing like it did in 2007.

The reason for this instability is that complicated regulations and regulatory supervision create opacity.  Where there is opacity, market participants cannot properly assess risk.  When risk is mis-priced, too much of it is created.

The Bank of England's Andrew Haldane used Basel capital requirements to make the point about creating opacity.  He points out that under Basel I, capital ratio could be calculated on an envelope and under Basel III, capital ratios require 19 million assumptions and a computer to calculate.

While I like this analysis, Mr. Haldane needs to go back one step further.  Why did we have Basel I?  We created Basel I to hide the fact that banks were increasing their leverage (this was sold to regulators as banks need a higher ROE if they are going to attract equity investors).

Why do I know this?  I worked on Basel I.

In August 2009, then Senator Kaufman wrote SEC Chairman Mary Schapiro to urge her to study how dramatic changes in our stock markets in only a few years time had led to an explosive growth in computerized trading. 

Ted's letter to Chairman Schapiro helped draw the media's attention to dark pools and HFT, which began to receive extensive (and concerned) coverage in the financial press. 

The letter also transformed Ted from a virtually unknown Senate newcomer into a brightly flashing blip on Wall Street's radar screen. 

In response, Wall Street scrambled an entire air wing of bankers and lobbyists to buzz Capitol Hill. Soon, squadrons were swooping into our office, anxious to thwart new regulations following the financial crisis and, particularly, to prevent a crackdown on HFT.  

They were numerous (we typically met with five high-level Wall Street executives at a time) and unanimous. 

Whether a megabank, broker-dealer, or a hedge fund, they all said they believed that the stock market had never functioned better. "Competition has driven down the costs of trading," said one. "The spread between a stock's asking price and offer price has never been so narrow," said another. "There's always enough liquidity -- even during times of market stress -- to ensure that trades will almost certainly be executed," said a third. The refrain "mom-and-pop investors have never had it so good" was intoned by nearly all of them. 

As a former lobbyist, I almost had to admire the way they unswervingly stayed on message. And the message was that the status quo was good for everyone and that Ted and I were wasting our time exploring whether market changes might call for statutory and regulatory changes. 

It would've been easy, and quite understandable, for us to be convinced by Wall Street's unanimous message....

I have had a very similar experience trying to bring transparency to banks and structured finance securities.

For example, I like to point out the 19 responses received by Committee of European Bank Supervisors (CEBS) on Article 122a of the European Capital Requirements Directive.  Article 122a requires commercial and investment banks to 'know what they own' when they purchase structured finance securities.

As confirmed by the NAIC white paper, in order to know what you own, structured finance securities need to provide observable event based reporting and before the next business day disclose any activities like payments or defaults involving the underlying collateral.

This compares to current reporting practices where activities involving the underlying collateral are reported once per month or less frequently.  An example of a security that reports once per month is the opaque, toxic subprime mortgage backed security.... hence its first name: opaque.

18 of the 19 responses came from the Blob and made the case that current reporting practices were adequate for knowing what you own.  Not only did they make this argument, but they showed that modern word processing does a terrific job at cut and paste as most of them used the same words to make the argument.

Our top priority was to get the SEC to identify (or, to use the industry term: tag) high-frequency traders and collect data about their trades. Under current rules, such data weren’t collected. So it’s impossible to track an order as it wends its way—if “wend” can apply to a journey that takes a microsecond—through the electronic trading labyrinth and is executed. 

In fact, the entire reporting system for the execution of trades is antiquated. The SEC doesn’t even monitor brokers to ensure they execute trades fairly. Oversight in this area has been outsourced to the Financial Industry Regulatory Authority (FINRA), of which Schapiro was the chairman and CEO from 2006 to 2008. A self-regulatory organization for broker-dealers, FINRA has often been criticized for being lax in policing the industry and generous in compensating its executives (Schapiro’s regular compensation for 2008 was $3.5 million).... 

For our part, we were determined to prove that a workable monitoring solution was possible. So we threw ourselves into composing another letter to the SEC. Attached was a five-page memorandum that detailed the obsolescence of the current reporting requirements and offered specific suggestions, gleaned from some of the top experts in the field, on how to update them. 

Meanwhile, the pushback from Wall Street was intense and multi-pronged. The Blob oozed through the halls of government, seeking, through its glutinous embrace, to immobilize the legislative and regulatory apparatus, thereby preserving the status quo. The executive jets of the Wall Street air force flew sortie after sortie, transporting high-ranking emissaries from new York to Washington to meet with the SEC, [Senator Chris] Dodd and [Senator Richard] Shelby staff, and the staff of other senators on the Banking Committee.... 

The research companies and market experts Wall Street employs also raised their voices against us. ...
 
Just like with derivatives, which blew up and nearly sank the country, we’ve got the same formula with HFT. I call it the Kaufman Formula. Whenever you’ve got a lot of change, a lot of money, no transparency, and therefore no effective regulation—watch out. Because the next thing you could hear is “boom.” 

There’s been a lot of change. The stock markets have transformed dramatically in only a few years time. There’s a lot of money. The daily market volume by high-frequency traders is now over 60 percent. And they’re making billions of dollars a year. 

There’s no transparency. The SEC has admitted you’re not collecting any data and you have almost no baseline understanding of HFT. And therefore we have a rapidly expanding market that’s operating completely in the dark, with no effective regulation. I’m very worried that this is a prescription for another disaster.... 

Please note that high frequency trading like structured finance and black box banks is simply a variant of Wall Street using opacity to make money even as it puts the entire financial system at risk.

On the other hand, we were well aware of the three main impediments to the SEC taking meaningful action. 

First, nearly all the data, evidence, and analysis the SEC uses to monitor the financial industry come from the industry itself, creating a temptation for the industry to spin the data in its favor (as we’d seen with the naked-short-selling data provided by Goldman Sachs). 

Second, The Blob oozes endlessly in and out of the revolving door of public service. According to the Project on Government Oversight, 219 former SEC staff members filed 789 “post employment statements indicating their intent to represent an outside client before the commission” between 2006 and 2010. In other words, 219 former government officials were representing Wall street clients on matters before the SEC. 

Third, because the SEC has been so slow to start collecting data about HFT, it’s still years away from being able to propose HFT regulatory rules that it can empirically justify based on hard data (as the federal courts will require it to do)....

When it comes to bringing transparency to banks and structured finance securities, the SEC no longer has to rely on Wall Street for evidence and analysis.

It is very well documented, see Financial Crisis Inquiry Commission for example, that market participants did not have adequate transparency to be able to value either banks or structured finance securities.

It has been empirically justified based on hard data with the benefit of bringing transparency to banks and structured finance securities starting at $2 trillion and increasing from there.

UK "Funding for Lending" scheme shows how desperate regulators are to restart structured finance

Desperation for restarting securitization has set in across the EU.

In the UK, the Treasury and the Bank of England are pursuing a 'funding for lending' scheme while the Financial Policy Committee is considering reducing bank liquidity requirements.  The involvement of the Bank of England in the 'funding for lending' scheme is occurring despite Mervyn King's objection to taking credit risk onto the central bank's balance sheet.

Meanwhile, the ECB is endorsing an ABS data warehouse that has indicated it will provide loan level performance disclosure less frequently than is available on opaque sub-prime mortgage backed securities.  This less frequent disclosure is the equivalent of changing the challenge from valuing the contents of a brown paper bag with a label on it to valuing the contents of a black box with a label on it.  In either case, buying the contents is blindly betting.

The ECB confirmed that it is being driven to take desperate acts like endorsing the ABS data warehouse by reducing the rating a structured finance security needs to qualify as collateral in an effort to increase funding to the banks.

Why is it so important to restart securitization?

Because securitization was the source of funding for loans to small and medium size enterprises and individuals with less than perfect credit prior to the beginning of the financial crisis and the precipitous decline in the securitization market.  These loans are necessary for economic growth.

Who is funding the loans now in the absence of the securitization market?

Since the beginning of the financial crisis, the only balance sheet that has been willing to fund these loans has been the central banks.  The ECB has taken on considerable exposure through both covered bonds and pledges of retained securitization transactions.

Bank balance sheets are not available to absorb these loans as the EU financial regulators have been pursuing a 9% Tier I capital requirement.

What does it take to restart the securitization market?

That each deal provide observable event based reporting on its underlying collateral.  Any activity like a payment or delinquency involving the underlying collateral should be reported before the beginning of the business day after it occurs.

How come your humble blogger is the only one calling for observable event based reporting?

The sell-side doesn't want observable event based reporting as it benefits from opacity and the fact that the buy-side cannot value the securities.

The few investors left in the market cannot call for observable event based reporting as it puts their jobs at risk.  Calling for observable event based reporting focuses attention on the fact that they are currently blindly betting and have no way to know what they own (see brown paper bag above).  If the investors who provided them with funds realized this, they would undoubtedly want their money back and hence the asset management related jobs would disappear.

What that leaves is your humble blogger up against Wall Street.  It really is an unfair fight.  A guy with a non-verbal learning disability that makes it difficult to communicate with family members pitted against the highest paid salesforce in the world.

As I see it, I have all the advantages.  With the brown paper bag and the clear plastic bag to show what is currently wrong with the industry and what it takes to fix it, I have an solution that a 5 year old understands.

By factoring in the 'opacity of risk' into its ratings, did Moody's just call for ultra transparency?

According to a Bloomberg article, in reviewing banks and securities firms, Moody's is now factoring in the 'opacity of risk' into its ratings.

Regular readers have long known that it is impossible to assess the risk of banks and securities firms that do not provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposures.

The Bank of England's Andrew Haldane refers to banks and securities firms that do not provide ultra transparency as 'black boxes'.

The lack of disclosure by these banks is similar to the lack of disclosure by the subprime structured finance securities.

By acknowledging the 'opacity of risk', Moody's is saying that, similar to the subprime structured finance securities, their ratings are not based on what is actually happening at these firms, but are assumption driven guesses of their best clients financial strength.

Said slightly differently, if there is going to be a realistic assessment of these firm's risk and financial strength, these firms are going to have to provide ultra transparency.

UBS AG (UBSN), Credit Suisse Group AG (CSGN) and Morgan Stanley (MS)’s ratings may be lowered by as many as three levels by Moody’s Investors Service, which is reviewing banks and securities firms with global capital markets operations. 

Goldman Sachs Group Inc. (GS), Deutsche Bank AG (DBK), JPMorgan Chase & Co. (JPM) and Citigroup Inc. (C) are among companies that may be downgraded by two grades, Moody’s said in a statement, adding that the “guidance is indicative only.” 

Credit-rating downgrades can raise a company’s borrowing costs, and for securities firms they can also affect business by obliging them to provide more collateral on trades. 

Banks worldwide are facing risks stemming from higher funding costs, investor confidence roiled by Europe’s sovereign debt woes, and increased regulation following the 2008 global financial crisis. 

“Capital markets firms are confronting evolving challenges, such as more fragile funding conditions, wider credit spreads, increased regulatory burdens and more difficult operating conditions,” Moody’s said. “These difficulties, together with inherent vulnerabilities such as confidence- sensitivity, interconnectedness, and opacity of risk, have diminished the longer term profitability and growth prospects of these firms.”

ECB to recover most of its Lehman loans

In yet another example of how central banks are not like other investors, the NY Times Dealbook carried an article discussing how the ECB was going to recover most of its Lehman loans.

For most investors, recovering most of the money they lent out would imply recognition of a loss.  Not so with central banks like the ECB.

The determination of whether the ECB made or lost money is done by comparing how much money the ECB lent to Lehman versus the total of how much the ECB collected in both interest and principal repayment on the loan.

It is this unique characteristic of central banks that offers the potential for a 'free lunch' in the rebuilding of the financial system.

Some investors and creditors may have lost billions when Lehman Brothers went bankrupt in 2008, but it looks as if theEuropean Central Bank will get most of its money back. 

An effort of more than three years to unwind Lehman assets will recover almost all the 8.5 billion euros, or $11 billion, that the central bank stood to lose, Joachim Nagel, a member of the executive board of the German central bank, the Bundesbank, said Thursday. 

The Bundesbank has managed the disposal of assets that the failed investment bank used as collateral for European Central Bank loans. The Bundesbank said Thursday that it was close to selling one of the last remaining assets, a complex package of real estate loans known as Excalibur. 

“When we’re all done, we will come close,” Mr. Nagel told reporters at a briefing. 

Lehman’s German unit had used 33 securities as collateral to borrow the money from the European Central Bank before its collapse in September 2008. Afterward, the European Central Bank — or strictly speaking, the so-called Eurosystem network of euro zone central banks — was stuck with the assets. 

Initially, the Bundesbank estimated the probable losses at 5.7 billion euros, but continuously reduced that figure as markets for the assets recovered and they could be sold for more than expected. In addition, some of the holdings continued to pay interest or dividends. 

Of the 33 Lehman securities, 28 have been sold. The largest remaining asset is Excalibur, a package of loans and derivatives based on European commercial real estate mortgages. Lehman constructed Excalibur in 2008 and used it to borrow 2.16 billion euros from the European Central Bank, the Bundesbank said.... 

Mr. Nagel conceded that central bankers might not have scrutinized the assets closely enough when accepting them as collateral. Standards have since been tightened, he said. 

“It went well,” Mr. Nagel said of the asset sales, “but should remain the exception.”

Will adding a label indicating minimum standards entice investors to buy European ABS deals? No!

A Bloomberg article reports that European issuers of ABS securities and a broker/dealer controlled lobbying group, the Association for Financial Markets in Europe, want to introduce a label indicating that the assets backing a structured finance deal meet a minimum standard.  According to the article, they are doing so to make the ABS securities more attractive to buyers.

There is zero chance that labeling the ABS securities will make them more attractive to investors.  This is just another attempt by the issuers and Wall Street to avoid having to disclose the current performance of the underlying collateral.

Why will this label not make the securities more attractive?

• The minimum standards for the underlying assets are already covered by the representations and warranties made in the deal documentation.  Since the information is already in the deal documentation, the label offers absolutely zero new information.

• The fact that the underlying assets met the minimum standards at one point in time does not mean that they still meet this standard at a future point in time.  For example, look at the decline in performance for so-called Prime mortgages in the US.  A label conveys zero useful information for valuing a deal in the secondary market.  Without current performance data, investors in the secondary market are blindly betting on the contents of a brown paper bag.

Disclosure of current performance data for the underlying collateral is the only way to entice investors to buy ABS securities.  It is only when investors know what they own that they will return.

The Association for Financial Markets in Europe and European Financial Services Round Table lobby groups are working on plans to label asset-backed notes that reach certain standards as Prime Collateralized Securities, according to two people familiar with the matter. 

A PCS working group, which also comprises investors, is scheduled to meet today to discuss the timing for the project and how to get better regulatory treatment for the debt, said the people, who declined to be identified because the discussions are private. 

The industry groups are working on the quality-assured brand after issuance in the asset-backed securities market in Europe tumbled by more than 80 percent since its pre-credit crunch heyday. Sales stalled in 2008 after bonds linked to U.S. subprime debt slumped, prompting investors to shun the hard-to- value securities. 

“In principle it’s a good initiative, but the implementation is very complex because of the different market practices in each European country,” said Alexander Batchvarov, the London-based head of structured finance research at Bank of America Corp. 

The PCS label would be designed to take account of new and existing regulation, said the people. Deals would need at least two triple-A credit ratings and reveal enough information about the underlying loans to be eligible for the liquidity operations of the European Central Bank and Bank of England, the people said. The ECB, BOE and European Investment Bank have been consulted on the plan, according to the people. 

As this blog has previously documented, the ECB and BoE have disclosure requirements for the underlying loan performance information that are inadequate for complying with Article 122a of the European Capital Requirement Directive.  Both Moody's and S&P have testified before Congress that these disclosure requirements are not adequate for timely rating (the equivalent of valuation) of the securities.

The inclusion of two triple-A credit ratings does not make ABS securities more attractive.  Investors learned from the sub-prime/CDO debacle to not rely on the credit ratings when it comes to valuing and investing in structured finance securities.

... The quality tag will be available for bonds backed by residential mortgages, small- and medium-sized company loans and consumer loans, the people said. 

“To make this initiative work it’s key to get the ECB and BOE to give the labelled issues better treatment in their liquidity operations, or to persuade the European Commission to require less capital for banks and insurance companies that buy these bonds,” Bank of America’s Batchvarov said.

Since September 2008, the ECB and BoE have been the major "buyer" for these securities. These securities are "purchased" by being eligible to be pledged to the ECB and BoE for their liquidity operations.

The goal of the ECB and BoE is to bring private investors back to the market so that they do not have to fund these securities.

Simply slapping a label on these deals will not work to attract investors.  The ECB and BoE know that it will take disclosure of current performance data for the underlying assets.

SEC looks at S&P use of 'dummy' assets in rating CDO

The Wall Street Journal reported that the SEC is looking at S&P and its use of 'dummy' assets in rating CDOs.

Whether or not the SEC pursues this case against S&P, the use of 'dummy' assets makes the case for asset level (loan-level) disclosure for all structured finance securities.  Simply put, the SEC is looking at the issue of how can you value/rate a security when you do not even know what is in the security.

Your humble blogger has been making this point about the need for current asset-level disclosure for structured finance securities since before the credit crisis.  Without this disclosure, market participants do not have all the useful, relevant information in an appropriate, timely manner.

It is nice that the US government in the form of the SEC has come out and formally agreed with me on the need for current asset-level disclosure for structured finance securities.

U.S. securities regulators are zeroing in on the use by Standard & Poor's of fictitious "dummy" assets when it assigned a triple-A credit rating to a $1.6 billion mortgage-bond deal that imploded during the financial crisis, according to a person familiar with the matter. 

S&P's parent company, McGraw-Hill Cos., said Monday that it had received a so-called Wells notice from the Securities and Exchange Commission. A Wells notice is the agency's warning to financial institutions that they could face civil charges. McGraw-Hill said the SEC is weighing civil enforcement action against the firm for its ratings on a collateralized debt obligation called Delphinus CDO 2007-1 issued in July 2007 as the housing market was taking a turn for the worse. 

The SEC is alleging violations of federal securities laws, McGraw-Hill said in a news release. The company said S&P has been cooperating with the regulator on its probe into Delphinus. A spokesman for the SEC declined to comment.

Lawmakers, regulators and investors have trained their cross hairs on S&P and its peers for assigning rosy ratings to thousands of complex securities that were later downgraded within the span of a few months, deepening the crisis. 

The S&P investigation is one of a number of probes by the SEC's enforcement division, headed by Robert Khuzami, into the complex mortgage-bond deals known as collateralized debt obligations. 

CDOs, which are pools of subprime mortgages and other assets that were sold in slices to investors, had emerged before the crisis as popular and profitable products on Wall Street. But the housing market's collapse exposed both the banks and their investors to billions of dollars in losses and left in its wake a raft of legal and regulatory headaches. 

S&P originally assigned its highest rating to the deal based on "dummy," or hypothetical, assets, then maintained that triple-A rating even though bankers had replaced them with lower-quality assets that didn't meet the firm's ratings standards, according to emails among S&P analysts that were disclosed in congressional testimony. 

Jack Chen, a former Moody's analyst who now runs his own consulting firm, said it isn't uncommon for credit-rating firms to use "dummy" assets to determine a final rating for a CDO, because some of the deals may have assets traded in later. 

What is problematic with S&P's rating of Delphinus is that the assets that replaced the "dummy" assets were of a lower quality than those hypothetical assets S&P had used to issue the ratings, said Mr. Chen, who has reviewed the S&P emails that were released. 

Frank Raiter, a former S&P managing director who had retired by the time Delphinus was rated, told lawmakers in April 2010 that S&P's dependence on fictitious assets that were later replaced by lower-quality securities "looks like a bait and switch."

Had the investors had current asset-level data, it would not have been possible to do a bait and switch.  Investors would have been easily able to see that the assets did not meet the quality standards that were represented in the offering documents and would not have purchased the deal.

Fixing the credit-rating system

Francesco Guerrera wrote a column for the Wall Street Journal in which he discussed what to do with the rating agencies.  His column closely parallels this blog's discussion on this topic under the FDR Framework.

Regular readers know that this is a non-issue under the FDR Framework.

Under the FDR Framework, governments are suppose to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.  For their part, market participants have an incentive to analyze this information because, under caveat emptor, they absorb the loss if an investment loses money.

Please note, market participants do not have to do this analysis themselves.  They can hire third parties to do it for them.  A practice that is very common today - for example, mutual funds.

In a perfect world, Standard & Poor's wouldn't ... exist. And neither would its rivals Moody's Investors Service and Fitch Ratings Ltd. At least not in their current roles as global judges and juries of corporate and government bonds. 

The historic decision taken by S&P on Aug. 5 is the culmination of 75 years of policy mistakes that ended up delegating a key regulatory function to three for-profit entities. 

75 years ago, the information technology did not exist for fully implementing the FDR Framework.  For example, it would have been impossible to make a bank's current asset and liability-level data available.  So there was a need for a small group of entities with access to information that the rest of the market did not have.

That was 75 years ago.

Today, the information technology exists to provide all the useful, relevant information in an appropriate, timely manner to all market participants.

... The issues highlighted by S&P's action and the markets' panicky reaction can only be resolved by removing rating firms from the heart of the financial system and by encouraging bond buyers to take on more responsibility for assessing the risk of their portfolios.

Under the FDR Framework, bond buyers are given the incentive, because they are responsible for all losses on their investments under caveat emptor, to assess the risk of each individual security.  Ending the global policy of bailing out investors in bank bonds would reinforce this incentive.

First, some history: Unlike most other markets, in fixed income, investors and companies have been able to outsource their brains. 

Since 1936, when bank regulators forbade lenders from buying "speculative investment securities" as defined in "recognized rating manuals," a handful of raters have enjoyed a cozy oligopoly of the "truth" about bonds. 

Their central role was further hard-wired into the financial architecture as insurance regulators, pension watchdogs, the Securities and Exchange Commission and, eventually, the European authorities, ordered their charges to rely on rating firms' opinions before buying bonds. 

The result, as Lawrence J. White, an economics professor at New York University's Stern School of Business, put it in a paper last year, was that financial groups "could satisfy the safety requirements of their regulators by just heeding the ratings, rather than their own evaluations of the risks of the bonds." 

In short, rather than focus on ensuring disclosure under the FDR Framework, regulators focused on eliminating caveat emptor.

The reason why such a patently imperfect arrangement endured is that it benefits all parties involved. 

Bond buyers don't have to do any work other than reading the "Big Three" reports. 

Regulators can sleep easy as long as their subjects comply with the letters of the law—namely As and Bs, the seals of "investment grade" quality. 

Corporate and government borrowers can count on demand for securities with certain ratings. And the rating firms reap annuity-like earnings from being an indispensable cog of the financial machine. 

This web of vested interests came under the spotlight after the disastrous errors committed by large raters during the securitization bubble (triple-A collateralized debt obligations, anyone?).

The arrangement was also a glaring example of regulators gambling with financial stability.  Under the FDR Framework, the analytical resources of the market are applied as oppose to the analytical resources of a few firms that might have a conflict of interest in the results.

The Dodd-Frank law passed in the aftermath of the financial meltdown calls for references to credit ratings in regulations for financial groups to be eliminated and replaced with different ways of gauging a bond's riskiness.  

The rating firms actually support this approach. "It wouldn't undermine our business," Paul Taylor, Fitch's president told me. "If regulatory references were to go away for us as an industry, there would still be strong demand for our product."

Please reread Mr. Taylor's quote as this is a very important point that your humble blogger has made many times.

Demand for analytical services would increase.  We know that when demand increases, so too does supply if there are no constraints on supply.

In the case of bonds, both structured finance and bank related, there is a constraint on supply.  That constraint is the absence of disclosure of all the useful, relevant information in an appropriate, timely manner.

In the presence of disclosure as recommended under the FDR Framework, many firms would offer analytical services.  This includes the large financial institutions.

In a surreal twist, however, it is the regulators and financial institutions that oppose the Dodd-Frank law's laudable and logical aim. They argue that alternatives to the absolute rule of the Big Three would be too costly and put U.S. companies at a disadvantage to foreign rivals. 

Regulators and systemically important financial institutions would have to give up a mutually beneficial relationship.

Regulators would have to give up their information monopoly and the market's reliance on them to properly analyze this information.

Systemically important financial institutions would have to give up their monopoly on explaining to the regulators how to analyze their firm's information.

David K. Wilson, the chief national bank examiner at the Office of the Comptroller of the Currency, told a recent congressional hearing that Dodd-Frank "goes further than is reasonably necessary." 

Mr. Wilson pointed out that, when regulators canvassed financial groups, the general response was that "developing a suitable alternative to credit ratings would be impossible without creating undue regulatory burden." 

Any change that goes from box-ticking to financial analysis would increase costs and impose a "regulatory burden." 

The question is whether it would be worth it. 

There must be room for improvement in a system that vests so much power in so few hands and is easily gamed by both bond sellers, which lobby to get the best possible ranking, and buyers, which shop around for the highest yielding bond within a rating category (the key reason why triple-A CDOs were so alluring). 

Over the last 75 years, where it has been fully implemented, the FDR Framework has shown that it is worth it.

Fully implementing the FDR Framework in fixed income would result in dramatic improvements.

• It would end the market's reliance on a few analytical services.

• It would encourage buyers, particularly institutional buyers with a fiduciary duty, to do their own homework and assess the risk of each investment.

• It would remove, as was FDR's original intention, the government from evaluating the merits of an investment (saying that an investment has to be rated investment grade is the equivalent of evaluating the merits). 

• It would increase financial stability as fear of the unknown would be replaced with the analysis of facts.

Asset managers reduce reliance on rating agencies

As predicted under the FDR Framework, a Reuters article describes how asset managers are using disclosure to reduce their reliance on rating agencies.

Regular readers know that this blog has recommended that disclosure is the key ingredient for replacing rating agencies in financial regulations.  If there is disclosure, market participants can do their own homework and not rely on the rating agencies.

Some of the world's largest asset managers are cutting ties to credit rating agencies, potentially signalling the beginning of the end of their grip on global financial markets. 

Managers responsible for billions of euros of fixed income investments are reviewing relationships with the likes of Fitch Ratings, Standard & Poor's and Moody's Investors Service, whose calls on Portugal, Ireland and the United States have roiled central banks desperate to avert a collapse of the Euro zone. 

Fund firms contacted by Reuters said rating agency research tended to be backward-looking and superficial, and often encouraged the kind of speculation that has recently dragged down Italy, one of the world's largest government bond issuers. 

"We have cancelled our subscriptions to two of them and they haven't left us alone since. It has been very irritating," the head of sovereign debt investment at one large European bond investor told Reuters on condition of anonymity. 

"It would be naive to blame the agencies for everything that went wrong during the financial crisis but anyone who relies on a third party to form their investment opinions is headed for trouble ... clients pay us to make those decisions, it would be completely wrong of us to abdicate that responsibility." 

Investors say they have steadily reduced reliance on external research providers ever since rating agencies slapped high ratings on complex structured financial investment products such as collateralised debt obligations (CDOs) which later turned out to be far riskier than initially assessed. 

A broad push for development of proprietary research teams shows credit ratings agencies have never fully regained the trust of some of their most important buy-side clients, some of whom are still counting the costs of belated warnings of a change in the risk profile of debt issuers...

"Ultimately, we believe that the research which we produce 'in-house' is more detailed, more forward looking and timelier than that of the agencies," Garrett Walsh, head of credit research, Europe and Asia at Pioneer Investments told Reuters. 

Pre-crisis, Pimco, the world's largest bond investor, used to limit its own internal ratings to private corporations. In 2008 it extended this to Western sovereign credits and now runs its own internal ratings system for all issuers of debt. 

"We will compare our rating to the external ratings but we try to make our decision independent of what the major rating agencies are saying and that has certainly accelerated," Andrew Bosomworth, head of portfolio management in Germany at Pimco, told Reuters. 

"We know what's inside what we rate," he added. 

Daniel Noonan, a New York-based spokesman at Fitch said his company advised investors to use its ratings and commentary alongside a range of inputs when making investment decisions. 

"We think over-reliance on any single input, including a credit rating, is unwise. We continue to see strong demand for our opinions and products, and as a result our business is growing," he said. 

"Investors are undoubtedly doing more of their own research, which we think is appropriate. However, they still need benchmarks to support their research efforts," added Michael Privitera, a member of S&P's Valuation and Risk Strategies team. 

While credit rating agencies may be losing influence on the investment decisions of the world's largest asset managers, sudden ratings calls can still trigger massive sell-offs from passively-managed funds which track an index whose composition is shaped by the ratings given by the credit agencies. 

When a country's debt is downgraded below investment grade it is pushed out of an index, forcing passive investors to sell their holdings and crystallize hefty losses that could shrink when the immediate rush for the exit subsides.... 

Some investors say credit default swap prices -- the cost of insuring debt against default -- are a much better measure of risk than credit ratings....

"Our approach seems to have quite a high correlation to 5-year CDS index which is a decent measure of value in bond markets and a much greater correlation than rating agencies have. In general markets tend to move ahead of rating agencies," BlackRock's Ewen Cameron Watt said.