RMBS data warehouse needed if private investors are to replace Fannie and Freddie

Four years after the beginning of the financial crisis, the US government is finally taking the first steps towards addressing the issue of opaque residential mortgage backed securities.

Specifically, as discussed in a Bloomberg article, the Federal Housing Finance Agency (FHFA) has realized that an RMBS data warehouse must be constructed if investors are going to end their buyers' strike.

It is impossible to shrink Fannie Mae and Freddie Mac without these investors.

The only way that these investors are going to be willing to end their buyers' strike is if they are provided with all the useful, relevant information on the underlying collateral performance in an appropriate, timely manner.

For RMBS deals, this information is observable event based disclosure where an observable event with the underlying collateral that causes the information to market participants to be updated includes, but is not limited to, a payment, delinquency, default or bankruptcy.

It is only with observable event based disclosure that market participants have current information on the assets backing the security.

Without this information, market participants are left with the disclosure practices that exist for opaque, toxic mortgage backed securities.  We know how that turned out.

With no plan from Congress or the Obama administration to shutter Fannie Mae and Freddie Mac, the companies’ regulator told Congress today it will expand its oversight with a strategic plan to develop new systems and standards for home loans. 

The companies, which own or guarantee most of the nation’s mortgages, exist in an extended policy limbo that poses new risks to taxpayers and the housing market, said Edward J. DeMarco, acting director of the Federal Housing Finance Agency. 

The mandate to protect taxpayers must be balanced with the need to invest in staff and infrastructure, he said. 

“Conservatorship can’t go on forever,” DeMarco said today in a telephone interview. “If we want to have a secondary mortgage market in the future without Fannie and Freddie we have to start investing.” 

The companies are “complex financial institutions with complex business processes, information technology structures and important human capital,” he said.

Fannie and Freddie to start providing loan-level data for structured finance deals they guarantee

In an effort to improve transparency, Fannie Mae and Freddie Mac will start to provide loan-level data for the new structured finance securities that they guarantee.

According to Fannie Mae's press release, this data will be updated on a once per month basis.

Regular readers know that once per month is the same frequency that performance data is disclosed for opaque, toxic sub-prime mortgage backed securities and is inadequate for investors to know what they own.

For investors to actually know what they own would require updating the loan-level data on an observable event basis.  An observable event includes a payment is received, the loan becomes delinquent, the borrower defaults or the borrower files for bankruptcy.

With observable event based reporting, investors know what they are buying or selling because they always know the current status of every loan backing the security.

By adopting once per month reporting, Fannie and Freddie are reaffirming the standard for opacity set by sub-prime mortgage backed securities.

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.

FHFA lawsuit against banks over mortgage-backed securities documents Wall Street's informational advantage

The FHFA lawsuit on behalf of Fannie Mae and Freddie Mac memorializes the informational advantage that Wall Street had regarding mortgage-backed securities and how Wall Street used this advantage to the detriment of other market participants.

Regular readers know that Wall Street invested in and purchased sub-prime mortgage originators and servicers to gain an informational advantage over other market participants.  Their investments and acquisitions put Wall Street's traders in the position of having tomorrow's news today while all other market participants had tomorrow's news several days or weeks later.

Your humble blogger has talked about this informational advantage since before the credit crisis.  My focus has always been on the need to eliminate this informational advantage to restore confidence in and attract investors back to the private RMBS market.

It is the FHFA lawsuit that has shown how the informational advantage could be used for fraud.  Courtney Comstock wrote a long post discussing the FHFA lawsuit, Goldman Sachs and Dan Sparks.

And there are two big reasons why the FHFA says Goldman's actions were fraudulent. In short, they are the money it paid to get a window into the mortgage origination process and Dan Sparks. 

Here's the first. From a key sentence in the FHFA lawsuit: 

Because the information that Goldman provided or caused to be provided [to ratings agencies] was false, the ratings were inflated... [and] also that Goldman Sachs knew, or was reckless in not knowing, that it was falsely representing the underlying process and riskiness of the mortgage loans... because Goldman’s longstanding relationships with the problematic originators, and its numerous roles in the securitization chain, made it uniquely positioned to know the originators had abandoned their underwriting guidelines... [and because] as a result, the GSEs paid Defendants inflated prices for purported AAA (or its equivalent) Certificates, unaware that those Certificates actually carried a severe risk of loss and inadequate credit enhancement.

The big thing here is that Goldman funded mortgage originators, who encouraged property appraisers to inflate home values by firing them if they didn't and gave half million dollar loans to people like hairdressers and gardeners.... 

Goldman is also on the hook because it saw the poor quality of the loans it bought from the mortgage originators it funded (the lawsuit says Goldman received daily updates on how many loans were delinquent), retained third-party due diligence providers to analyze those loans that it considered securitizing regardless of the delinquencies (a smart move considering that it might have absolved Goldman of responsibility for any poor-quality loans in the Securitizations) but Goldman didn't listen to the companies' recommendations to exclude a significant number of loans. Goldman included the loans in its Securitizations anyway. Then it got the ratings agencies to rate them attractively. But it stated in offering documents that the loans had generally met the guidelines of the due diligence review.

Please re-read the highlighted section of the lawsuit again.

Your humble blogger has been saying since before the start of the financial crisis that all structured finance market participants should have access to daily updates on all the observable events that occurred involving the underlying loans.  Observable events include payments and non-payments/delinquencies!

Compare and contrast the use by Wall Street of observable event based information to the once-per-month disclosure that the Wall Street dominated industry trade groups (American Securitization Forum and the European Securitisation Forum/Association for Financial Markets in Europe) have argued is adequate to the SEC, ECB, BoE and CEBS - regulators who tried to bring asset-level performance transparency to structured finance.

Clearly, the trade groups are trying to protect Wall Street's informational advantage.  However, with the FHFA lawsuit, Wall Street's informational advantage is over as all market participants will have to have access on an observable event basis.

Accountants call for timely disclosure

A Reuter's article highlighted how accounting experts are frustrated with the frequency of disclosure and are pushing for more timely disclosure.  Regular readers will find their argument for daily disclosure very familiar.

Author and lawyer Michael Young jokes about the days when it took more time to get some companies' financial statements than it did for Columbus to discover America. 

Alas, those days are still here. 

In an age of lightning-fast stock trades and instant communications, yearly and quarterly financial reports seem stuck on an industrial-era pace that some say was obsolete decades ago. 

"Financial reporting technology allows all sorts of possibilities about which we could not even fantasize back in the Great Depression when our periodic system was put in place," said Young, a partner at law firm Willkie Farr & Gallagher. 

Young and other accounting experts have long called for a move to real-time, online reports in lieu of quarterly earnings statements that investors now use to decide whether to buy stocks. 

An example of the the information that could be reported for financial institutions are their current assets and liability-level data.

Cheap computing power has made real-time reports more technically feasible, but advocates still struggle to draw wide support for the idea....

"Almost any company with rational management tracks its performance daily and makes critical business decisions on the basis of data and trends that should be distilled and published for public consumption," said Harvey Pitt, former chairman of the Securities and Exchange Commission. 

This is particularly true of financial institutions.  

... Free, open-source software has allowed even much smaller companies to construct dashboard-like digital displays that continuously track sales, orders and other key figures. 

That kind of data could help make the stock market much more transparent, said Paul Miller, a University of Colorado accounting professor. 

"If I'm an investor, why can't I go on the Web and see what the Wal-Mart sales are today?" Miller asked. 

Instead, investors have to wait to find out what happened months ago. 

"It's a constant state of incomplete information and the consequence of that incompleteness is discounted stock prices, which means a higher cost of capital," he added. 

For financial institutions, the consequence of incompleteness is no one knows who is solvent and who is not solvent.

... Eventually, some companies may embrace real-time disclosures to build more trust in the capital markets, said W. David Stephenson, a homeland security expert and author of Data Dynamite, a book about data sharing. 

"I do think that quarterly reporting is going to become an artifact at some point and that it's going to start with some companies -- maybe banks -- that have a particular credibility problem," he said. 

Please reread Mr. Stephenson's quote as he makes the point that more and better disclosure is directly related to more and better credibility in the capital markets.

..."It would obviously be a headache for investors to try to process financial information on a daily basis, but what a real-time system would allow investors to do is step back and say to themselves: 'What period of analysis for this particular company makes sense?'" said Young, the lawyer at Willkie Farr. 

Actually, it is not difficult for investors to try to process financial information on a daily basis.  They do this all the time - think security prices.

More importantly, investors would let their computers do the processing (computers do not get a headache) and highlight the information that is relevant for the investor to look at.

More real-time reporting might also result in smaller gyrations in a company's share price because investors could adjust their expectations each day, he said. 

This is another critical point.  With daily reporting, markets can adjust over time and not in a short time period.