Donald Kohn and the BoE's Financial Policy Committee could use a lesson in the FDR Framework

Testifying before British MPs at a confirmation hearing for the Bank of England's new Financial Policy Committee, Mr. Kohn demonstrated why he and other financial regulators could use a lesson in the FDR Framework.

According to a Financial Times article,

Speaking to British MPs at a confirmation hearing on Tuesday, Mr Kohn nevertheless said his experience would be valuable for the Bank of England, where he has been appointed to a new committee with powers to guide UK financial stability. 

“I believe I will not make the same mistake twice,” he said. 

This suggests an acknowledgement of what mistake he made is coming...

Mr Kohn has been appointed to the Bank’s new Financial Policy Committee, which will soon have powers to change system-wide UK financial regulations and even limit borrowing by households and companies if it thinks there are threats to financial stability. 

Having been a strong advocate of the Greenspan doctrine not to burst asset bubbles but to mop up any mess after a crash, Mr Kohn recanted much of his previous view in front of MPs.

Apparently the mistake was in not bursting the asset bubbles but instead waiting to mop up any mess after a crash.

However, the alternative of central bankers and financial regulators popping asset bubbles sooner is a non-starter.

As this blog has gone to great lengths to document (see discussion of the Nyberg Report on Ireland) and explain, there is an institutional reason that central bankers and other financial regulators do not burst asset bubbles sooner.

• First, the regulators have to come to a consensus that there is a bubble.  Some analysts in one part of the regulatory bureaucracy might think that there is, but it is a long way from their belief to convincing the entire regulatory body to share their view and take action. 

• Second, the regulators need evidence that the bubble is harmful.  Without this, politicians are likely to crackdown on the regulators as all that is visible to the politicians is the benefits of the asset bubble.

Returning to the FT article

He said he had “learnt quite a few lessons – unfortunately” from the financial crisis, including that people in markets can get excessively relaxed about risk, that risks are not distributed evenly throughout the financial system, that incentives matter even more than he thought and transparency is more important than he thought. 

And here is where the lesson in the FDR Framework comes in.  These are not separate, but issues that are all linked logically together under the FDR Framework.

As regular readers of this blog know, the FDR Framework makes the financial regulators responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  This is the transparency that he learned is important.

Under the FDR Framework, market participants, particularly investors, are responsible for analyzing this information to assess the risk of any investment knowing that it is buyer beware for any investment they make.

The requirement to ensure transparency is placed on financial regulators because there are market participants who benefit from opacity.  This is where incentives matter comes in.  The way these market participants benefit from opacity is that opacity makes it impossible for investors to properly analyze and price risk.

Similar to Mr Greenspan’s 2008 comment that the former Fed chairman had erred in presuming banks were able to act in their shareholders’ interests, Mr Kohn said: “I placed too much confidence in private market participants to police themselves”.

Actually, the financial crisis did not show that confidence in private market participants to police themselves was misplaced.

What the financial crisis showed was that since the financial regulators have an informational monopoly on all the useful, relevant information for each financial institution, other financial market participants are dependent on the regulators' assessment of the risk of the financial institutions.  When the financial regulators under-estimate the risk of the financial institutions, so do the other market participants. 

As predicted by the FDR Framework, without the useful, relevant information, the other market participants cannot exert any market discipline or police the financial institutions themselves should the risk profile of the financial institution change. 

The former Fed official was willing to offer an apology... 

“I deeply regret the pain that was caused to millions of people in the US and around the world by the financial crisis ... Most of the blame should be on the private sector: the people that bought and sold those securities, on the credit rating agencies that rated them. But I also agree that the cops weren’t on the beat,” he said 

“The regulators were not as alert to the risks as they could have been and, to the extent they saw the risks, were not as forceful in bringing them to the attention of management, or taking actions, as they could have been. All this with 20/20 hindsight obviously.”

Actually, it is a matter of public record that your humble blogger using the FDR Framework saw the problems in the financial system before the financial crisis and recommended steps that would have reduced the severity of the crisis.

Your humble blogger would be willing to sit on or consult with the BoE's Financial Policy Committee as it is clear that the committee could benefit from the insights of the FDR Framework.

The FDR Framework and Ending The Looting of Banks

The other day, Bloomberg ran an interesting column by William Black.  One of the main observations in the column was

Nobel laureate George Akerlof and Paul Romer wrote a classic article in 1993. The title captured their findings: “Looting: the Economic Underworld of Bankruptcy for Profit.” Akerlof and Romer explained how bank CEOs can use accounting fraud to create a “sure thing” in the form of record short- term income, generated by making low-quality loans at a premium yield while making only minimal reserve allowances for losses. While it lasts, this fictional income allows the chief executive officer to loot the bank, which then fails, and walk away wealthy.

The necessary conditions for this fraud to take place are the limited access to the asset-level data made possible by the financial regulators' information monopoly combined with the regulators' inability to effectively analyze the information.



Everyone knows that the first condition exists as financial institutions are not required to disclose their current asset-level data.  For confirmation that the second necessary condition exists, see the WSJ article in which

[A] top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... that ... rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.

As regular readers of this blog know, the FDR Framework would prevent this type of accounting fraud.  Under the FDR Framework, market participants have access to all the useful, relevant information in an appropriate, timely manner.  This is asset-level data for banks.

With access to the asset-level data, market participants, including competitors and credit/equity market analysts and investors, will do their own analysis of the risk of the assets.  It is this analysis that will show that the reserve allowance is not sufficient for the risk of the assets.

This type of accounting fraud is another way that the regulators' monopoly on all the useful, relevant information on financial institutions is harmful to the financial system.

EC Puts Up Stop Sign for the Market Group's Involvement in the ECB's ABS Data Warehouse [Update]

Bloomberg published an article on the European Commission's probe of financial market data vendors who control essential infrastructure.

As discussed previously on this blog (see here), the ECB is acting as a catalyst to spur the creation of a centralized ABS data warehouse.  The data warehouse will process, verify and ultimately distribute standardized loan-level information on all existing and future structured finance deals to all market participants.

In a recent International Asset-Backed Strategy report, an RBS analyst observed of this effort

[W]e would see an ECB-endorsed (even if “non-exclusive”) data provider as an effective market monopoly in the ABS data aggregation business.

Hence, it will be on the European Commission's radar as essential infrastructure.

The report continues

The ECB’s letter of intent states that “To the extent possible, market participants will have the opportunity to use and invest in the Data Warehouse subject to entering into appropriate legal arrangements” – while this statement appears to encourage a ‘market-owned’ data provider, we think the difficult practicalities of creating such a socialised venture will mean that the project likely ends up going to a private firm(s). 

This was in fact directly indicated by a press release issued on April 28th from a group of market participants (originators and investors) stating that they will oversee and manage the selection process for the construction and administration of the Data Warehouse, which according to the press release will allow ABS issuers to submit loan-level data electronically, which will then be verified and audited for compliance with the ECB’s criteria requirements for repo eligibility. 

Every member of this group of market participants, the Market Group, has a conflict of interest.  Another big, red flag for the European Commission.

European Union regulators, who are investigating 16 investment banks over the swaps market, will examine the “control and dissemination” of financial-market data for possible antitrust abuses. 

The European Commission will investigate whether data providers are engaging in abusive behavior by “attempting to leverage privileged access to information,” Joaquin Almunia, the EU’s competition commissioner, said in a London speech today. “I also intend to discuss the legitimate scope of intellectual property rights claims on such data,” Almunia said.

Almunia is increasing the EU regulator’s scrutiny of financial markets. Last month, he announced a probe into whether 16 banks ... colluded by giving data to Markit, a financial information provider.  

The commission is also checking whether nine of the banks struck deals with ICE Clear Europe, a clearinghouse for derivatives, that prevent other clearinghouses from entering the market. 

This should be a stop sign for the ECB and its involvement with and potential endorsement of the Market Group's version of the ABS data warehouse.

“The commission is ramping up antitrust enforcement in the financial services sector,” Suzanne Rab, a lawyer at King & Spalding in London, said in an e-mail “An underlying theme is the transparency of and access to data.” [emphasis added]

Almunia, who is set to examine Deutsche Boerse AG’s bid for NYSE Euronext, said he is opposed to “essential” market infrastructure being controlled by a small number of companies. 

“We should prevent that any one entity or group controls essential infrastructure -- be it a trading platform, a clearing platform or a pre-trading service -- to the benefit of a restricted few,” he said.

This problem is particularly acute if the companies all have conflicts of interest in the control and dissemination of the data.

This problem is mitigated if the firms that construct and operate the ABS Data Warehouse and therefore control the essential infrastructure are verifiably free of conflicts of interest with existing structured finance market participants.

This requires that any firm that is involved in either the day-to-day operation of the ABS Data Warehouse or the Coordinator role should be required to make a full disclosure of all competitive and financial interests in the design of the database, the presentation of the data, the analysis of the data, and the use of the data, including:

• Is the firm engaged in a related business that could gain a competitive advantage from its role? Examples of such related businesses include data distribution, pricing services, trustee services, monitoring, analytic solutions, loan servicing, collection services, consulting, ratings services, investment as a principal or agent or portfolio manager, and underwriting.

• Does the firm have investments that could benefit from its role, such as long or short positions in ABS transactions?

So long as these firms, like your humble blogger's, do not have conflicts of interest with existing market participants, they are motivated to do what is best for the structured finance market.  After all, they make money by seeing that the structured finance industry is successful.

The Bloomberg article highlighted another type of anti-trust concern.

... Standard & Poor’s offered to change its pricing policy in Europe to overcome antitrust concerns over licensing fees for securities identification numbers, the commission said earlier today.

This type of anti-trust concern will not be a problem for the ABS Data Warehouse your humble blogger would operate as the data warehouse will provide loan-level data for free to all market participants.

Update

The following are the highlights from a May 16, 2011 speech by Mr. Almunia, the Vice President of the European Commission responsible for Competition Policy to the Cass Business School in London.

The speech touches on many of the themes addressed on this blog under the FDR Framework.  This includes the need to replace opacity with transparency so that all market participants have access to the useful, relevant in an appropriate, timely manner.  This includes the need to eliminate conflicts of interest so that investors can trust this data.

Let me start by talking about the challenges we are facing. Promoting competition, cross-border integration, and transparency in the financial markets has been part of the European Union’s efforts to build and strengthen the Single Market for many years. The need for EU-wide oversight of the financial sector became apparent in the 1990s as the Union moved towards closer economic integration and the single currency. 

This recognition led to the adoption of the Financial Services Action Plan of 1999, which comprised 42 separate measures on securities, banking, insurance, mortgages and pensions. The plan resulted in major pieces of legislation, including the Capital Requirements Directive, the Markets in Financial Instruments Directive – or MiFID – and the Market Abuse Directive. As our first wave of legislation was being implemented, financial markets were changing fast.

• Technological innovation brought new organisations and practices such as broker crossing networks, systematic internalisers, and algorithmic and high frequency trading.

• Ever more complex financial products and derivative instruments were being introduced, and

• There was a massive rise of over-the-counter trading, which is now estimated at around 40% of all equity trades.

More importantly, the spectacular growth of trade in new financial products took place in a very opaque environment. In that environment, too much risk was being taken, also because risk was being mispriced. In addition, the crisis generated suspicions of market manipulation and abuse which contributed to damage investors’ trust in financial markets – and these suspicions have not dissipated yet. 

The EU has responded to these conditions by launching a comprehensive review of its existing legislation. The goals are to bring more transparency and stability to financial markets and to extend the scope of regulation to new financial instruments and infrastructure. 

Almost three years since the crisis erupted, financial markets are the scene of dramatic consolidation of trading platforms and infrastructure. This is due to a recovering environment for financial trading and to the imperatives of globalisation and technological change. 

... These are some of the current challenges in the financial services industry; now I would like to talk about what the joint action of competition policy and regulation at EU level can do to address them. 

... The regulatory measures taken by the European Commission will shed more light into the way financial markets operate and will prevent a dangerous accumulation of risk. But regulation alone is not enough. Whereas regulation tackles broad structural market failures, you need competition policy to tackle the harmful behaviour of individual market participants. 

Competition control should ensure that the actual evolution of the market does not lead to structures that harm users and legitimate market participants. In particular, we should prevent that any one entity or group controls essential infrastructure – be it a trading platform, a clearing platform or a pre-trading service – to the benefit of a restricted few. 

I am aware of the debate on inter-operability and the question of whether increased competition and the proliferation of market actors can undermine stability, but I cannot see a problem here. I believe that competition and stability are not at odds. If market participants comply with strict prudential requirements, I see no risk in having many of them supplying services to investors. In fact, I see potential gains. The level of concentration in the markets should reflect the search for optimal efficiency; it should not reflect the actions of powerful market players that have excluded potential competitors. 

So, in my view this is not a real danger. Let me tell you what I believe is one of the major problems in wholesale financial markets. Regulatory initiatives have gone a long way to increasing transparency of over-the-counter trade vis-à-vis regulators. But for a market to function well there must also be transparency vis-à-vis all market players. Market data that are necessary for a good appreciation of market conditions and for the efficient supply of information, trading and clearing services are not sufficiently available to market participants for many financial products. 

I think it is time we examined the control and dissemination of market data to establish whether there is abusive behaviour on the part of their owners attempting to leverage privileged access to information to foreclose rivals or distort the market. I also intend to discuss the legitimate scope of intellectual property rights claims on such data. 

... Now I would like to move to the third and final part of my presentation and give you a quick update of our current work in competition enforcement. The first two cases I will mention are those against Standard & Poor’s and Thomson Reuters. These two cases involve financial data or market infrastructure that may be important for the operation of markets. 

Our case against Standard & Poor’s regards the distribution of International Securities Identification Numbers developed by ISO, the International Organisation for Standardisation. S&P holds a monopoly position in the assignment of these ISO numbers to new securities issued in the US and in their distribution to the whole financial community. 

European investors have complained that S&P imposes license agreements and demands fees for the usage of the data even if they are downloaded from other vendors, something which is contrary to ISO rules. 

Our concern is that S&P may be abusing its dominant position by charging excessive prices.  

... The case involving Thomson Reuters is about the restrictions the company imposes on the use of Reuters Instrument Codes – or RICs. For example, customers of Thomson Reuters cannot cross reference them with identifiers of other vendors to retrieve data from them. That makes switching to an alternative data feed vendor costly and difficult. We are concerned that the practice could amount to an abuse of dominant position.

... Finally, I would like to talk about two new antitrust investigations into the markets for Credit Default Swaps; which are the first cases we have opened in the market for derivatives. 

The first case involves 16 investment banks and Markit, the leading provider of financial information in the CDS market. We want to find out if the banks are jointly coordinating the control of the information flow on CDS trade to prevent other providers and data vendors from developing competing services. Our preliminary investigations suggest that Markit may receive de facto exclusive information on the transactions and positions of many of these dealers. In addition, Markit’s licence agreements may be restricting the development of the market. 

The second case involves nine large banks – all of them also part of the first investigation – and the agreements they concluded when a company called The Clearing Corporation was sold to Intercontinental Exchange, or ICE. In this operation, the nine banks gave themselves preferential fees and a profit-sharing mechanism which gives them strong incentives to use ICE’s services with a de facto foreclosure effect on other clearing houses. Finally, we are investigating ICE’s fee structure, which may give an unfair advantage to the nine banks and discriminate against other dealers. If confirmed, this could be an abuse of dominant position to the detriment of potentially efficient competitors. 

... Over the past twenty years or so, the financial services sector has become increasingly larger and complex. No one knows this better than you, given that the wider industry accounts for around 14% of Britain’s GDP. Today, overseeing a few investment banks and specialised traders is simply not enough. We need to extend oversight beyond traders and banks to cover infrastructure owners, intermediaries, information services providers and possibly more. 

Competition enforcement and regulation must not saddle the industry with an unnecessary burden and must not stifle innovation. But we must make sure that the market develops in ways that are compatible with long term stability and efficient growth. We need deep and liquid financial markets. We need a system that gives participants all the information they need to fully understand the risks they are taking when they invest in a product and to fully appreciate the price they are paying. Participants need to know who their counterparties are and what their exposures are. Above all, we need to promote a system that participants can trust. 

I will continue to enforce EU competition law against collusion between firms and the undue influence of powerful players. I will also use every opportunity – such as our meeting today – to remind everyone to play by the rules. This is a responsibility that every player in these markets has towards their competitors, their customers, and towards society at large.

Is Simon Johnson Embracing the FDR Framework?

A couple of months ago, your humble blogger met Professor Johnson at the Boston University hosted State of Financial Reform conference.  At the time, Professor Johnson express reservations about the FDR Framework.  In particular, he was uncomfortable with the idea that governments must ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

In a Bloomberg column, Professor Johnson appears to have begun embracing the FDR Framework and its emphasis on bringing sunshine to all areas of the financial markets.

On the face of it, Glencore International AG doesn’t look too scary. With about $80 billion in assets, the Swiss-based commodities trader is a lightweight in comparison to global megabanks like Goldman Sachs Group Inc. (GS), one of its trading rivals. Goldman has assets more than 10 times Glencore’s, is more leveraged and has less capital. 

So why do executives at Goldman, Citigroup and JPMorgan Chase argue that lightly regulated or unregulated companies operating “in the shadows” -- private equity firms, hedge funds and commodities traders like Glencore -- risk another financial calamity? 

What Glencore’s rivals are really worried about is competitive advantage. It’s about to sell $11 billion in shares through an initial public offering in London and Hong Kong. That fresh capital will allow Glencore to expand at a time when its Wall Street competitors’ hands are tied. Glencore doesn’t face the same limits that banks do in proprietary trading, capital reserves, leverage and compensation. This may be unfair, but it’s not the right reason to subject Glencore to the same tough regulatory regime as banks, nor the right lesson to draw from our recent experiences. 

The real question regulators should ask is this: How much of a risk would Glencore pose to the world’s financial system? To use the terminology proposed by Mervyn King, governor of the Bank of England, is Glencore “too important to fail” -- meaning that its bankruptcy would bring down other significant parts of the financial system or real economy? 

... Today Glencore trades and produces minerals and metals like zinc, aluminum, cobalt and coal, as well as grains, cotton and sugar. It owns refineries and drilling rigs and holds large stakes in other mining companies. 

Glencore also has a large amount of capital and little leverage, judging by its shareholder equity, which is worth 25 percent of assets....

There is little sign that a government would feel the need to save Glencore and protect its creditors if it were on the brink of collapse. A restructuring of its debts should not be disruptive to the world economy. Based on the limited information in Glencore’s 2010 annual report, even its derivatives book seems unlikely to create system-wide risk. 

Still, this could change quickly. Derivatives are the wild card. Glencore almost certainly will qualify for the so-called end-user exemption under the Dodd-Frank financial reform legislation, meaning that it may not have to follow new clearing and margin requirements (although these rules are still under discussion). It would be relatively easy for a firm with Glencore’s balance sheet and insight into the physical side of commodity markets to ramp up its involvement in the financial side of commodities. 

We do not want commodity traders like Glencore, Cargill Inc., Paris-based Louis Dreyfus & Cie., an oil major or any other nonfinancial company to be tempted to take financial risks that are big relative to the size of the system. 

Even supposedly expert financial firms can destroy themselves with the mismanagement of risk -- a process made potentially even more devastating to everyone involved through derivatives. 

Remember that Lehman Brothers Holdings Inc. (LEHMQ) was not a megabank -- its balance sheet was about one-fifth the size of Citigroup’s and the largest European banks’. But Lehman’s web of connections through derivative transactions turned out to pose a system-wide threat -- about which the Treasury Department and the Federal Reserve were completely unaware until the day after Lehman went bankrupt. 

The end-user exemption should be interpreted narrowly and applied evenly. If Glencore or a similar company wants to engage in financial speculation or market-making, those activities should be walled off from their physical operations and legitimate hedging needs, as my MIT colleague John Parsons has been arguing. 

Regulators need as much visibility as possible into derivatives transactions around the world. The major players in these markets -- including firms like Goldman -- do not want transparency, primarily because they don’t want their pricing structure to be widely known.

It was transactions between the big Wall Street firms and largely unregulated mortgage originators that brought us the subprime crisis. The open secret of Wall Street is that the “shadows” are often made possible and profitable by the big banks. [emphasis added] 

One example: structured investment vehicles, the undercapitalized, off-balance-sheet entities that large banks created in 2007 and 2008 to house subprime mortgage investments. 

The Treasury Department has been pressing hard to lighten the transparency requirements on derivatives markets, including most recently with its baffling decision to exempt foreign exchange swaps from clearing requirements. 

The best way to deal with potential shadows is to shine a bright light on all markets.  [emphasis added] 

Restricting who can avail themselves of the end-user exemption is one very good way to ensure that the shadows do not get too dark and that stand-alone commodity traders do not become too important to fail.

US Mortgage Market and the Mother of All Databases

The American Banker ran an interesting article on the need for a database containing all the mortgages in the US.

Your humble blogger has been advocating for this since before the credit crisis in conjunction with a loan-level database for structured finance securities.  Just as the loan-level database is needed if market participants are going to be able to analyze and value structure finance securities with all the useful, relevant information, a national mortgage database is needed by mortgage market participants.

Like the structured finance loan-level database, data in the national mortgage database should be standardized.

Like the structured finance loan-level database, data in the national mortgage database should be made available for free to all market participants.

Europe and in particular the ECB and BoE are leading the way in showing how both the structured finance loan-level database and the national mortgage database can be rapidly built.  Specifically, the central banks are making providing data to the loan-level database an eligibility requirement if a structured finance/covered bond security is to be pledged as collateral at the central bank.

There is no reason that the Federal Reserve could not also do this.  There is no reason why the SEC could not make this a requirement of its revision of Regulation AB.  There is no reason that this requirement could not also be added to the Covered Bond legislation moving through Congress.

Why do some mortgage servicers appear to be modifying a great many more loans than others? How many loans are getting principal reduced, rather than interest rate reductions? How many loans in a given neighborhood are more than 30 days late? 

Answering such questions may be critical to craft effective policy responses to the housing crisis. But it's hard to get definitive answers, because data on mortgage performance is incomplete and often expensive. 

Most of the detailed information on mortgage performance is gathered by the two companies, CoreLogic Inc. and Lender Processing Services Inc., and sold in various forms to regulators for sums that can reach hundreds of thousands of dollars for a particular data set. 

Members of Congress, state banking regulators and academics say they have been regularly stymied in attempts to access the data. In many cases they cannot afford it. Sometimes regulators who have the data cannot share it because of proprietary arrangements with data providers. 

... Proponents of the idea say such a database is long overdue. 

"There are no complete data sources and there is over-reliance on third-party vendors," said Richard Neiman, former New York State banking commissioner and former member of the Congressional Oversight Panel for the Troubled Asset Relief Program, who submitted a proposal for such a database in 2009. "We as regulators and stakeholders should not be relying on third party vendors whose data is incomplete and subject to inaccuracies." 

Neiman, who is expected to join PricewaterhouseCoopers as vice chairman of global regulatory practice, said the forthcoming database could be as valuable as the information
collected under the Home Mortgage Disclosure Act, which is used to evaluate possible discrimination in loan approvals. 

"Having a mortgage performance database would provide a similar window on mortgage servicing," he said. "Just like HMDA was used to identify violations in the origination process, a national mortgage database could provide a similar window on servicing
and modifications." 

CoreLogic and LPS depend on voluntary reporting by servicers. And their data has blind spots: CoreLogic covers about 41 million first-lien loans and 7 million second liens,
out of a total of about 60 million mortgages in the country, while LPS has detailed information on about 40 million first liens. 

LPS says building a system like the one called for by Neiman and Dodd-Frank would be unnecessary because currently the mortgage industry, which uses the data to establish benchmarks, is helping to defray the cost of gathering it. 

"Today anybody can license from LPS or from CoreLogic," said Kyle Lundstedt, a managing director at LPS. "We charge the mortgage industry, which benefits, and it is not like the American public is not getting the benefit too, because the regulators who manage the industry on our behalf are also accessing the data. So it leaves me befuddled when someone says, 'Wait a minute, we need to make that data free.' " 

... Having more comprehensive and reliable data could be helpful in assisting distressed homeowners, said Rep. Brad Miller, D-N.C. "There seems to be guesswork on what works and what doesn't work in regard to modifying mortgages," he said. "In the time I have been in Congress, we really have had to rely upon the industry to tell us what is going on and what they have told us has not been reliable. It has not always been accurate and not complete — sometimes plain not truthful — so having an independent source of information would be an enormous benefit." 

The Office of the Comptroller of the Currency, which, together with the soon-to-be-phased-out Office of Thrift Supervision, gathers data on the servicing operations of nine banks accounting for 34 million loans, has made strides in tracking loan performance. Among other advances, the agency's quarterly Mortgage Metrics Report has helped establish common definitions for such categories as subprime and prime. Before the establishment of Mortgage Metrics, these definitions differed from bank to bank. 

However, the report only covers 63% of the mortgages in the country and it does not cover the substantial holdings of second lien loans on bank balance sheets. 

Alan White, a law professor at Valparaiso University in Indiana who has studied various data on mortgage servicing, said the OCC data that is available publicly does not allow
researchers to get a comprehensive picture. 

"The OCC data is a biased sample," he said. "What you get are summaries. The loan-level data is not available anywhere to the public or to researchers. You can get summary statistics from the Mortgage Bankers [Association] once a quarter and then the OCC and OTS metrics comes out, but they give you the numbers they want to give you." 

Another issue is the need to protect borrowers' privacy. 

"We don't share that data because it is supervisory data and the data at loan level includes privacy information," said an OCC official, who did not want to be identified. 

However, White said it should be possible to have a system that releases detailed loan information without compromising borrowers' personal information. "You wouldn't want public releases that included the names and addresses of borrowers," he said. "But I think that there is also certainly with the bank regulators a lot of concern about protecting bank proprietary information. If you were able to look at what kinds of loss severities resulted from foreclosures and modifications, you might get an idea of which servicers are doing a better or worse job for investors and the timing and severity of losses." 

Your humble blogger developed and patented the information system that Professor White would like to see.  The system protects borrower privacy with the standards that Congress approved for protecting patient privacy under HIPAA.

Researchers can gain access to some databases at the Treasury Department, but that comes with restrictions, according to White. 

"Treasury has been very secretive about their data," he said. Although the agency releases periodic report cards on the Home Affordable Modification Program, "and it is possible to
gain access to some of the proprietary databases, but they have licensing agreements and most of the time the licensing agreements prevent researchers from disclosing information that would hurt the reputations of the subscribers to these services" — the subscribers being the banks. 

Andrea Risotto, a Treasury spokeswoman, said she had no knowledge of special access agreements with academics. "I can only answer for Hamp," she said. "We have a database online that literally has every data element for every homeowner who has ever participated or even submitted one piece of paper to apply for the program." 

Lundstedt at LPS argued that a national database would be expensive.... However, government officials say that licensing agreements with LPS and CoreLogic actually end up costing government agencies unnecessary amounts of money and that the new mortgage database could help resolve what has been an enduring issue. 

"We are buying both LPS and CoreLogic mortgage performance data, and other agencies are doing this as well, so those companies are collecting a lot of money," said a senior HUD
official, who also requested anonymity....  

Some agencies cannot even afford all of the data they say they need to do their job. "A lot of this data is very expensive," Neiman said. When he was New York's banking commissioner, he said, "we had some budget restrictions, so our first thought was can we reach out to some of our federal  counterparts, and they are under contractual restrictions for sharing it." 

And when the department could afford to buy private data, Neiman said, it found inaccuracies. "On a quarterly basis we were having to go back and correct data with regard to foreclosure filings," he said. "It is for that very reason that we established a mandatory requirement within the state that institutions have to file pre-foreclosure information with us as well as the filing of lis pendens" — pending foreclosure actions — "because we were continuously finding inaccuracies and lack of completeness from the private sources of that information." 

There are formidable challenges to establishing the national mortgage performance database.
HUD officials say that it could take several years to build it and that no money has been appropriated for the project. (Dodd-Frank does not set a deadline.) Another question is how
the agency would build the database. Would HUD (which already publishes loan-level performance data for Federal Housing Administration loans on its Neighborhood Watch website) gather the data itself or could it buy the information from vendors like CoreLogic and LPS? 

"A potential barrier is will they agree to sell it to us given what we are supposed to do with the data," the senior HUD official said. "Would we render their products obsolete by
giving away the information at the census tract level Congress asked for?"

Conflicts of Interest and Wall Street's Chinese Walls

The Wall Street Journal ran an interesting article on BlackRock Solutions.  The article provides an example of the types of conflicts of interest that exist on Wall Street.

To deal with these conflicts of interest, Wall Street's favorite solution has been to erect a so-called Chinese Wall between the lines of business that have the conflicts of interest.  Left unanswered is the question "Does Wall Street's version of the Chinese Wall function better than the original Chinese Wall which failed to keep out the Mongol invaders?"

BlackRock Solutions is the risk management division of the money management firm, BlackRock.  If all it did was focus on helping to manage the risk of BlackRock's investment portfolios, there would be no conflicts of interest.

However, that is not all that it does.  It also acts as an advisor to third parties, like the Federal Reserve.  For example, BlackRock Solutions is advising the Federal Reserve on the sale of the assets the Federal Reserve acquired in the Bear, Stearns bankruptcy while at the same time the BlackRock money management arm is also a potential direct or indirect bidder for the assets.

To anyone not working on Wall Street, this looks like a situation with conflicts of interest.

Would the conflicts of interest go away if the money management arm agrees not to bid?  No.  So long as BlackRock manages a portfolio containing similar assets there are conflicts of interest as BlackRock is uniquely position to profit from the pricing information contained in the auction of the Federal Reserve's assets.

In another case, BlackRock Solutions has attempted to help an issuer of asset-backed securities provide loan-level information to the market.  To anyone not working on Wall Street, this too looks like a situation with conflicts of interest given the fact that BlackRock manages a sizable portfolio of similar assets.

Now, the fact that BlackRock and other Wall Street firms have conflicts of interest does not mean that anyone has acted for its benefit on these conflicts of interest.

However, the fact that these conflicts of interest exist raises the question of "why work with a firm that has a conflict of interest if the alternative to work with a firm that does not have a conflict of interest exists?"

This can be easily done.  First, have firms disclose publicly their potential conflicts of interest.  Then, select from the firms that are free of conflicts of interest.

Clearly your humble blogger is not the only one concerned about eliminating unnecessary conflicts of interest.  The European Commission expressed its concern about conflicts of interest with regards to financial information vendors when it announced its investigation of Markit, its shareholders who are also the source of its information and the credit default swap market.

Highlights from the WSJ article:

BlackRock Solutions has emerged as a key adviser in helping the government unwind the troubled assets it accumulated during the financial crisis. ...

Yet with the recent success has come some unwelcome attention over how it handles that business—as well as more competition in risk management. 

With more than $3.6 trillion under management, BlackRock is best known for its bond portfolios, including some that hold the same kinds of securities that BlackRock Solutions is helping the government value and sell. 

BlackRock has gone to considerable lengths over the years to keep its Solutions business separate from its core money-management operation. Solutions' employees are housed on separate floors of the firm's headquarters and are accessible by different elevators than other parts of the firm that could profit from its knowledge. All of their data and computer systems are separate from those of the main company. 

Still, some analysts are raising concerns that the firm's government dealings give BlackRock too much access to market-sensitive information—and too many temptations to use that information to boost its main business. 

"They've combined asset-management and advisory businesses, and it raises some issues of conflicts," says Christopher Whalen, co-founder of risk-management consultant Institutional Risk Analytics. He said he isn't suggesting that there have been problems. 

Mr. Goldstein says BlackRock Solutions has been sensitive to such perceptions since its inception. 

...The Solutions group has found a new market since the financial crisis. Not only are many mortgage-related bonds difficult to value these days, but some investors have lost faith in the big bond-rating firms' credit-scoring capabilities, say analysts. Last year, BlackRock Solutions took on 62 new assignments, up from 48 in 2009. 

During an April 21 conference call with investors, BlackRock Chief ExecutiveLaurence Fink singled out Solutions as a high performer, saying it did "an exceptional job" in helping the Central Bank of Ireland understand the market dynamics affecting its banking system. The central bank rescued many of the country's banks after the country's real-estate bubble burst, leaving lenders saddled with souring loans. 

As was pointed out previously on this blog, the work performed by BlackRock Solutions, while very expensive, has failed to restore confidence in the Irish banking system.

... The firm's secretive valuation process also has raised questions. Since the government owns so many subprime assets, critics contend, taxpayers have a right to know how those assets are being valued. BlackRock doesn't discuss its methods publicly, and the Fed offers only broad disclosures about how values are reached. 

"It should all be open," says Allan H. Meltzer, a professor at the Tepper School of Business at Carnegie Mellon. "They may be doing things honestly and above board, but we won't see that unless we see how they got the numbers.…How they calculate the portfolio of those assets is how we know how much the taxpayers are going to pay."  

... "We spend a very significant amount of time teaching clients what the limitations of the risk models are," BlackRock Solutions' Mr. Goldstein says. 

ECB Needs ABS Data Warehouse to Succeed

The ECB needs the ABS Data Warehouse initiative to succeed and end the buyers' strike in the structured finance market.

According to an article in the IFR,

ABS is now the most common collateral group posted at the ECB’s repo window for the first time, according to the central bank’s 2010 annual report. ABS represented 24% of total collateral, up from 23% in 2009, followed by covered bonds at 21%.

Without an end to the buyers' strike, the ECB will have to continue to fund the banks that put up the structured finance collateral until the collateral matures.  Without an active secondary market for the structured finance collateral, how does the ECB know that it is protected in the event that the bank which put up the structured finance collateral becomes insolvent?

Also, it is interesting to note that the ECB handles providing transparency for structured finance securities separately from providing transparency for covered bonds.

Why?

Covered bonds are a simple form of a structured finance security.  The source for the information on the performance of the assets underlying a covered bond is the same as the source for the information on the performance of the assets underlying a structured finance security.

From a technical perspective, there is no reason that the same asset-level performance information provided for structured finance securities could not also be provided for covered bonds.

ECB ABS Data Warehouse: Will It End the Buyers' Strike?

It is fascinating to watch the battle between the buy-side and the sell-side unfold in the development of the ECB's ABS Data Warehouse.  To date, every known aspect of the ABS Data Warehouse has been decided in the favor of the sell-side.

This observation would not be surprising if the ECB was an impartial observer.  As was recognized in the 1930s, the buy-side has an alternative to fighting with the sell-side over disclosure of all the useful, relevant information in an appropriate, timely manner.  The buy-side can effectively go on strike by taking its money and investing in another part of the capital markets that does offer disclosure of all the useful, relevant information in an appropriate, timely manner.

This observation is surprising because the ECB is not an impartial observer.  Under the FDR Framework, the ECB has the responsibility for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  The ECB also has an incentive to want this type of disclosure as the ECB accepts structured finance securities as collateral.

Ultimately, the question the ECB's ABS Data Warehouse is answering is "will an ABS data warehouse built to sell-side specifications end the buyers' strike?"  Will it provide the buy-side with enough disclosure that the buy-side will return to the ABS market, particularly when the standard for investing in ABS deals has become 'know what you own'?

To make these question more concrete, an examination of the ABS data templates is required.  Why are data templates necessary in the first place?

• If there are going to be many data warehouses, data templates reduce the cost of disclosure to the issuer by providing the issuer with one disclosure standard.  

• However, if there is only going to be one ABS data warehouse and with the ECB's endorsement there will only be one, there is no need for the ECB to develop a data template as the data warehouse will tell the issuer how it wants the data disclosed.

How is this a sell-side versus buy-side issue?  The sell-side favors data templates because it offers the sell-side the opportunity to restrict disclosure of all useful, relevant information by debating what data fields should be disclosed.  Clearly the sell-side does this as the ECB has 20+ fewer data fields in its RMBS template than does the BoE.

The buy-side favors disclosure of all the data fields, while preserving borrower privacy, that the issuer tracks.  This makes sense because the issuer is an expert in the data needed to value the assets backing the ABS security and monitoring these assets performance.  In short, the issuer only tracks data fields that their experience shows them to be relevant.

Having every issuer report all the data fields it tracks to multiple ABS data warehouses would pose significant technical difficulties and costs.  However, when there is only one ABS data warehouse, these technical difficulties and costs go away.  An ABS data warehouse built to buy-side specifications would include all the data fields the issuer tracks (remember, there is useful information in knowing what data fields an issuer does not track).

The questions of more immediate concern are

• Why is the ECB building an ABS data warehouse to sell-side specifications and not to buy-side specifications in the first place?  What happens if an ABS data warehouse built to sell-side specifications does not end the buyers' strike?

• Why is the BoE trying to find some middle ground between the data fields in the ECB's data template and full disclosure of all the data fields the issuers' track?  Do regulators win some prize for finding the fewest data fields required to end the buyers' strike?

• Why should the buyers come back knowing that useful, relevant information is being withheld even under the BoE data template?  Knowing that useful, relevant information is missing, how do European financial institutions prove that they know what they own?

Guide to the ABS Data Warehouse

This guide consolidates the various posts on this blog concerning the ECB's ABS Data Warehouse.  As disclosed previously, your humble blogger has an interest in this data warehouse having originally proposed the idea prior to the credit crisis.

In addition, your humble blogger designed and patented a data warehouse and related information infrastructure that has the flexibility to provide market participants with current asset-level performance information for all types of structured finance securities and covered bonds.

My Idea
The ECB's ABS Data Warehouse was My Idea
Implications for ECB's ABS Data Warehouse of US Government Suing Wall Street Over RMBS Deals
40+ Firms Would Like to Build ABS Data Warehouse, Only My Firm Has

Will It End the Buyers' Strike?
The Choice for Restoring Investor Confidence is Between Current, Free Performance Data or Stale, Costly Performance Data
Why the Sell-Side's Proposed Data Warehouse Will Not Restore Investor Confidence
Will Buyers Return Knowing That Data is Being Withheld?
Buy-side Responsible for Losses under the ECB's ABS Data Warehouse

Data is Worthless if not Trusted!
European Commission Wants Clarity on Lack of Conflicts of Interest in ABS Data Warehouse
European Commission Wants Conflict of Interest Free ABS Data Warehouse
The Data Warehouse is not Valuable if the Data is not Trusted

Three Stikes and Market Group's Version of ECB's ABS data warehouse is out
Why the Market Group's Version of the ABS data warehouse should fail
European Commission Raises Stop Sign for Firms with Conflicts of Interest in Data Warehouse
US SEC confirms once-per-month data is too out of date to be useful
Strike Three or why the issuer always pays for disclosure

As the Only Buyer, ECB Looks for Exit
Given Its Exposure to Structured Finance, ECB Needs Data Warehouse
ECB Wants Transparent, Market-Driven Selection Process for Firm to Build and Manage Data Warehouse

Value of my firm's patent for an ABS Data Warehouse
Sapient Global Markets selected to build ABS Data Warehouse

As Predicted, Without Asset Level Data Investors Not Interested in Investing in Spain's Cajas

The Wall Street Journal published an article that confirms this blog's prediction that in the absence of asset level data, investors would not be interested in recapitalizing Spain's Cajas [savings banks].

The article focused on Spanish regulators' fondness for the good bank/bad bank model for attracting capital.  Under the good bank/bad bank model, all the dud assets are put into the bad bank.  The good bank then turns around and tries to sell equity to investors.

Please note that the good bank/bad bank model tries to send a very explicit message about the quality of the assets.   That message is that an investment in the good bank is safe as the problem credits are in the bad bank.

The fact that the regulators embrace this model and its message is confirmation that the investors had no interest in investing capital into the cajas without asset level data.

There is just one tiny problem with the good bank/bad bank model.  It only works for investors if all troubled assets are truly moved into the bad bank.

Unfortunately, as Ireland showed repeatedly, what bankers and their regulators claim is a good bank may still have a significant amount of bad assets on its balance sheet.  An amount of bad assets that renders an investment worth zero.  Investors are not going to forget this lesson just because the banks are in Spain and not in Ireland.

How are investors to know if all the bad assets have been moved to the bad bank particularly after regulators have been allowing the banks to practice extend and pretend with a number of loans for years?

Ultimately, the only way the banks are going to attract capital is by disclosing asset level data so the investors can analyze this data and decide for themselves the attractiveness of an investment in the good bank.