To Calm Investors, Spain to Open Its Books

As recommended previously on this blog, here and here, Spain has decided to open its books in a bid to restore investor confidence.

The question is how is Spain going to open its books.

• Will it use the gold standard of providing asset level detail for the investment and loan portfolios of its banks so that investors can independently analyze the situation?  

• Will it repeat the Irish government experience?  This involved releasing selective data that makes the situation look better than it is and thereby destroys the government's credibility in the future if the situation turns out to be worse than represented.

The Wall Street Journal reported on Saturday, December 18, 2010, that:

Facing growing pressure from the financial markets, Spanish authorities promised to open the books of two groups of borrowers whose needs for cash are unnerving skittish investors.

Officials pledged to give investors an early peek into the finances of cash-strapped regional governments. Meanwhile, the country's central bank is speeding up plans to force regional savings banks to provide more information on their loans and the amounts they need to borrow. It hopes to quell rising investor fears that the banks might be facing a cash crunch or hiding real-estate losses.

Investors this week drove up Spain's cost of borrowing amid concerns that it could be the next country to need a bailout following Greece and Ireland, and possibly Portugal. In particular, they have worried that Spanish regions, which have a high degree of political autonomy, could derail the country's efforts to slash its budget deficit.

To address those fears, on Monday Spain will make public the finances of the country's regional governments for the first nine months of the year. It had planned to release those figures next year.

This week, Moody's Investors Service warned it might lower Spain's debt rating because of the country's relatively high refinancing needs next year and the possibility that it might have to inject fresh capital into its banks.

..."Ireland's sovereign creditworthiness has suffered from the repeated crystallization of bank-related contingent liabilities on the government's balance sheet," said Dietmar Hornung, vice president, senior credit officer at Moody's.

Spain insists that it isn't in the same situation as Ireland or Greece. It is betting that investors will come around to its view once they can see the inner workings of its banks and regional governments.

In some ways, Spain is an unlikely candidate for a bailout: Its government doesn't have much debt. Even after a generous stimulus plan and an economic slump that blew a big hole in its accounts, Spain's central government debt represented just 46% of its economic output at the end of last year. That compares with 65% for Ireland, 109% for Italy and 138% for Greece.

But Spain's government debt is just the tip of the iceberg. The country's regions, banks, businesses and households also borrowed heavily during the boom years—and history suggests the government could end up shouldering those debts too.

"Spain's problem isn't public debt—it's private debt," says Emilio Ontiveros, a private Spanish economist.

Another problem: Many of those Spanish borrowers will be refinancing their debts next year, at a time when investors are nervous about taking on any European risk. According to Moody's, Spain's central government must raise about €170 billion ($225 billion) in 2011, on top of €30 billion by the country's regional governments.

Spanish banks, whose own ability to raise funds is closely linked to the fortunes of the Spanish government, must refinance about €90 billion of debt next year, it added. The government has also set up a special facility for banks to draw on if needed, with a lending capacity of up to €99 billion. That fund will likely have to issue more government-backed bonds next year.

Some investors worry that so many Spanish borrowers will crowd each other out of the market in ways that could hurt the government's ability to finance itself at reasonable rates. That, they say, raises the chance that Spain will have to turn to the European Union or International Monetary Fund for a bailout.

"We have a sword of Damocles hanging over our heads," said Juan José Toribio, an economist and former IMF official now at the IESE Business School.

The Sell-side Rolls the ECB: The End of Know What You Own for Structured Finance

In May 2009, despite intense opposition form the sell-side lobbyists, the European Parliament passed Article 122a as an amendment to the European Capital Requirements Directive.  It applies to European credit institutions which are broadly defined to include commercial and investment banks.

Article 122a embodies the sensible notion that investors in structured finance securities should "know what they own".  If they do not know what they own, the article requires that they not be able to use any leverage to support their purchases of these asset.  This too is sensible as it prevents the credit institution from losing more than its equity capital on investments where it is effectively blindly betting.


Why would the sell-side lobby against investors knowing what they own?


It implied a change in how information was disclosed to the buyer.

As readers of this blog know, disclosure has two equally important parts:  what is disclosed and when it is disclosed.  

There appears to be little debate about what loan-level information should be disclosed.  The disagreement is over when it should be disclosed.

Your humble blogger has been pushing for observable event based loan-level disclosure for structured finance securities so that all market participants can see the current status of any loan (see here, here, here and here).  As demonstrated using the Brown Paper Bag Challenge, this is the frequency of disclosure that investors need if they are to really know what they own.  

Since the start of the credit crisis, investors have mostly been on a buyers' strike because they are unwilling given current once per month or less frequent disclosure to bet blindly on the value of the security.

Under Article 122a, the bank regulators were left to define what "know what you own" means and then to enforce this definition.

Paul Volcker, Mervyn King, Jean-Claude Trichet and the Group of 30, in the January 2009 report, "Financial Reform:  A Framework for Financial Stability", offered a relevant recommendation to regulators tasked with defining what "know what you own" means (emphasis added):

The appropriate national regulator should, in conjunction with investors, determine what information is material to investors in these products and should consider enhancing existing rules or adopt new rules that ensure disclosure of that information, for both asset-backed and synthetic structured products

It seems entirely reasonable that only investors would know what it would take in the way of disclosure for them to know what they own when it comes to structured finance securities.


In a June 2009 speech in Cambridge, then EU Commissioner for Internal Markets Charlie McCreevy noted the problem for regulators with not adhering to this recommendation when he observed (emphasis added):

It is readily apparent that the Brussels financial services lobby is dominated by the sell side of the market. As regulators, we need to be conscious of this and do everything possible to ensure that the buy side's views are adequately and well represented: 

When I talk about the buy side, I am not so much talking about the retail consumer – who is generally well represented by consumer organizations - : I am talking about the professional "buy side" of the market in areas like, for example, structured products: 

We have become more conscious of this in recent times. That's why I have indicated to the Commission Services that equal weight be given to the views of the buy side and to the representation of the buy side in expert and consultative groups in the future - because by definition the buy side of the market is as important a player as the sell side.

On December 16, 2010, the European Central Bank as part of its ABS loan-level initiative, proposed its definition of "know what you own".

The Governing Council of the European Central Bank (ECB) has decided to establish loan-by-loan information requirements for asset-backed securities (ABSs) in the Eurosystem collateral framework. The Governing Council intends to introduce the loan-by-loan information requirements approximately within the next 18 months, first for retail mortgage-backed securities (RMBSs) and thereafter gradually for other ABSs.

Loan-level data will be provided in accordance with the template which is available on the ECB's website, at least on a quarterly basis on, or within one month of, the interest payment date of the instrument in question. To allow the processing, verification and transmission of the data, the Eurosystem will encourage market participants to establish the necessary data-handling infrastructure. This is expected to facilitate the application of the loan-by-loan information requirements and contribute to further developing transparency in the ABS market.

When the necessary data-handling infrastructure has been established, the provision of loan-by-loan information will become an eligibility requirement for the instruments concerned. The Eurosystem will continue to accept securities not meeting the new information criteria until the obligation to submit loan-level data comes into force.

Why would the ECB adopt the current once-per-month or less frequent disclosure practices?  After all, the European Parliament was aware of these disclosure practices and specifically did not include them as part of Article 122a.

Perhaps the answer lies in the composition of the ABS Technical Working Group that drafted the ECB's position.

Did the ECB follow the recommendation of the Group of 30 and include only investors on the ABS Technical Working Group or any of its subcommittees?  No!

Did the ECB follow the recommendation of Commissioner McCreevy and include an equal number of investors and sell-side participants (lobbyists, investment banking, issuers and rating services)?  No!

A brief look at the composition of the ABS Technical Working Group shows that there are many more sell-side participants than investors.  As noted by Commissioner McCreevy, these sell-side participants have a significant vested interest in not changing the frequency of disclosure from the current practices (for example, think of how much pressure is put onto the rating services business model if all market participants can access current data).

Did the ECB realize that with its adoption of current once per month or less frequent disclosure, the ECB is saying that the current disclosure practices satisfies the "know what you own requirement" of Article 122a?

Probably not!

Your humble blogger suspects that the sell-side used its position on the ABS Technical Working Group to effectively end the "know what you own requirement" of Article 122a and the ECB representatives, who are not experts in disclosure or did not understand the implications for Article 122a, went along with it.

Mervyn King Gets a Second Chance to Save the Global Financial System

Thanks to WikiLeaks, we now know that by March 17, 2008, Mervyn King and the Bank of England realized that they were dealing with a solvency and not a liquidity crisis.


The cable, which was published in the Guardian, follows [emphasis added]:

Summary 

-------

1. (C/NF) Since last summer, the nature of the crisis in financial markets has changed. The problem is now not liquidity in the system but rather a question of systemic solvency, Bank of England (BOE) Governor Mervyn King said at a lunch meeting with Treasury Deputy Secretary Robert Kimmitt and Ambassador Tuttle. King said there are two imperatives. First to find ways for banks to avoid the stigma of selling unwanted paper at distressed prices or going to a central bank for assistance. Second to ensure there's a coordinated effort to possibly recapitalize the global banking system. 

For the first imperative, King suggested developing a pooling and auction process to unblock the large volume of financial investments for which there is currently no market. 

For the second imperative, King suggested that the U.S., UK, Switzerland, and perhaps Japan might form a temporary new group to jointly develop an effort to bring together sources of capital to recapitalize all major banks. END SUMMARY

Systemic Insolvency Is Now The Problem

--------------------------------------

2. (C/NF) King said that liquidity is necessary but not sufficient in the current market crisis because the global banking system is undercapitalized due to being over leveraged. 

He said it is hard to look at the big four UK banks (Royal Bank of Scotland, Barclays, HSBC, and Lloyds TSB) and not think they need more capital. A coordinated effort among central banks and finance ministers may be needed to develop a plan to recapitalize the banking system.

Unblocking Illiquid Mortgage-Backed Securities

--------------------------------------------- -

3. (C/NF) King said it is also imperative to find a way for banks to sell off unwanted illiquid securities, including mortgage backed securities, without resorting to sales at distressed valuations. He said sales at distressed values only serve to lower the floor to which banks must mark down their assets (mark to market), thereby forcing unwarranted additional write downs. 

He said we need to find an auction system where banks could move paper they want to sell without fear of stigma that the market views selling at a low price as a sign that a bank is in trouble. King said, however, he did not yet know how to structure such an auction and that further dialogue was needed. Kimmitt acknowledged the need to find ways to unblock these markets and said we should remain in touch bilaterally as well as in the G-7, the Financial Stability Forum, and the central banks.

A Possible Approach To Recapitalization

---------------------------------------

4. (C/NF) The G-7 is almost dysfunctional on an economic level, said King. Key economies are not included, especially those that have large and growing pools of capital. King said that a new international group was needed to address the issue. It could be a temporary group, and he suggested that perhaps the central banks and finance ministers of the U.S., the UK, and Switzerland could coordinate discussions with other countries that have large pools of capital, including sovereign wealth funds, about recycling dollars to recapitalize banks. King said Japan might not be included because it has little to offer. King noted, though that including the Japanese might force their hand in finally marking to market impaired assets. Kimmitt said that he was cautious about starting new groups in the international financial community because of the inevitable debate around whom to include.

Comment

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5. (C) The King proposals were not casual ideas developed in the course of luncheon conversation. It was clear that his principal objective in the meeting was to outline his outside-the-box thinking for Kimmitt. King included very few details about his proposals and was content to present broad concepts, thereby planting the seeds for future discussion.

As this humble blogger was reading the cable for the fifth time, it served to re-emphasize the fact that Europe and the US have not yet addressed the systemic solvency issue nor have they managed to find a solution for making a market for the illiquid securities.


It is now three years into the credit crisis and, like Japan, banks in Europe and the US are not marking impaired assets to market.


The problem of solvency has not gone away.  Nor has the problem of valuing illiquid securities or impaired assets.  


The question is how to create a market for the illiquid securities and impaired assets!


Mr. King highlights every regulator's concern when it comes to selling illiquid securities and impaired assets for which there is no liquid market.  As discussed in the Looting of the Irish, the problem of not having a liquid market is that Wall Street will be happy to buy the assets for less than they are worth.  This in turn increases the amount of capital the banking system needs from the government and ultimately its taxpayers.


Mr. King suggests the Wall Street auction model which is designed to loot and pillage the banking system and through the recapitalization mechanism, the national treasury. 

Wall Street's basic approach is to share loan-level performance detail on the collateral underlying the illiquid securities and impaired assets with a limited group of prospective buyers.  After the prospective buyers have had a chance to do their due diligence, Wall Street then conducts an "auction" of the illiquid securities and impaired assets complete with competitive bidding to realize the 'best' price.

The aspect that gives rise to looting and pillaging is the absence of an independent "fair" value determined by the credit markets.  Without this value, how do the sellers, which is ultimately the government when banks need to be recapitalized, know if:

• The highest price from Wall Street's "auction" is below, equal to or above fair value?
• They got a good deal or were ripped off?

Fortunately, governments did not pursue this auction strategy.

If not an auction, then what?

Since the beginning of the crisis in 2007, your humble blogger has been advocating a different method for creating a market.  This method is based on the idea that sunlight is both the fundamental building block of the global financial system and the best disinfectant for the opaque auction process.  

Governments should first require the disclosure of current loan-level performance information on the collateral underlying the illiquid securities and impaired assets to all credit market participants.  To insure the information disclosed is always current it should be updated on an observable event basis (observable events include a payment, delinquency, default, or borrower insolvency filing).

This lets the credit market analysts and third party pricing services value these illiquid securities and impaired assets and independently determine what their fair value is.  

Then, and only then, let Wall Street auction the loans to all prospective buyers.

Armed with the fair value of the illiquid securities and impaired assets, governments could see how well Wall Street performed in maximizing the value of the illiquid securities and impaired assets.  Was Wall Street able to justify it fees by auctioning off the illiquid securities and impaired assets for more than the credit market analysts and third party pricing services believed was fair value?


By maximizing the value of the illiquid securities and impaired assets on the banks' balance sheets, governments minimize the amount of capital required to recapitalize the banks.

Europe Gets a Second Chance to Cure Solvency Crisis

As the credit crisis was slowly unfolding in early 2008, European and US central bankers and the national financial officials of their respective countries made the decision that their banking systems must be saved.  Their tools of choice were guarantees, temporary capital injections, suspension of mark-to-market accounting and unlimited liquidity for the commercial banks (call this the "liquidity policy").

Unfortunately, before using any of these tools they failed to:

• Identify all the sources of losses and determine how big the losses actually were for each bank; and
• Agree on who would bear the losses that were in the global banking system.  

By not doing so, they left themselves without an exit strategy for returning the banks to a capital market system where investors have the potential for gains and losses.

Re-introducing banks to this type of capital markets system is virtually impossible given that the liquidity policy does not directly address the issue of solvency.  The policy does not answer the question of what are the losses on each bank's balance sheet.  Who is solvent and who is insolvent?

Investors today do not want to buy the losses that should have been incurred by the investors who were bailed out by the liquidity policy.  The only way investors today are going to be comfortable accepting the possibility of losses is if they can independently determine that they are not buying the old losses.

This point needs to be repeated.

Investors are not compensated for buying someone else's investment losses.  They are not going to buy bank or sovereign debt where they think they are buying losses that have already been incurred but have not been disclosed.

Today, Europe once again is faced with the issue of what to do with the losses in its banking system.  An issue that has now also morphed into a sovereign debt crisis.

Based on the discussions surrounding the European Financial Stability Facility, it appears that European financial officials are responding to the solvency/sovereign debt crisis with the classic definition of insanity - repeating the same thing over and over again and expecting a different result.  

Even though the liquidity policy did not end the solvency crisis that began in 2008, the financial officials are proposing more of the same.  And why is this approach going to produce a different result this time?

Ireland provides a case study in the ongoing failure of this approach to address solvency and why it is unlikely to produce a different result this time.

The bailout is supposed to tide Ireland over for years as it recovers, and give it room to mend its finances until it can borrow in financial markets again.

Yet it is still unclear if the money will be enough. Irish regulators and I.M.F. officials found no new surprises when they pored over the banks’ books recently, and they said they doubted that the banks would need more capital or that mortgage defaults would surge. But if Irish homeowners, who feel particularly duty-bound to make their payments, change their behavior, that could increase defaults and push banks to tap the reserve of 25 billion euros. Regulators will test the banks again in March for any new threats from residential or other mortgages.

Even if the banks pass the latest stress tests, banking experts worry that problems may surface later.

“I reckon 35 billion euros is not going to be enough,” said Alan Dukes, a former finance minister whom the government tapped to unwind Anglo Irish before it was nationalized in January.

“The number that’s there at the moment is based on what we can expect of the commercial property market,” Mr. Dukes said. “I don’t think any assessment has been made of the possible impact of mortgage defaults.”

 As readers of this blog know, the cure for the solvency crisis is:

1. Provide current asset level information to the credit and equity market analysts so they can independently value each bank's assets and therefore each bank's solvency;
2. If a bank is seen as insolvent, then it can either be recapitalized or closed;
3. Banks can be recapitalized either by raising money in the capital markets or government investment.

With this cure, investors know they are not buying someone else's losses and banks can return on their own to the capital markets.

Asset Level Data Key to Viability of Soros' European Bank Bailout Plan

In an editorial in the Financial Times, George Soros argues that Europe should use its limited resources to first bailout its banking system.

The authorities are making at least two mistakes. 

One is that they are determined to avoid defaults or haircuts on currently outstanding sovereign debt for fear of provoking a banking crisis. The bondholders of insolvent banks are being protected at the expense of taxpayers. 

This is politically unacceptable. A new Irish government to be elected next spring is bound to repudiate the current arrangements. Markets recognise this and that is why the Irish rescue brought no relief. 

Second, high interest rates charged on rescue packages make it impossible for the weaker countries to improve their competitiveness vis-à-vis the stronger ones. Divergences will continue to widen and weaker countries will continue to weaken. Mutual resentment between creditors and debtors is liable to grow and there is a real danger that the euro may destroy the political and social cohesion of the EU.

Both mistakes can be corrected. With regard to the first, emergency funds ought to be used to recapitalise banking systems as well as to provide loans to sovereign states. The former would be a more efficient use of funds than the latter. It would leave countries with smaller deficits, and they could regain access to the market sooner if the banking system were properly capitalised. 

It is better to inject equity now rather than later and it is better to do it on a Europe-wide basis than each country acting on its own. That would create a European regulatory regime. Europe-wide regulation of banks interferes with national sovereignty less than European control over fiscal policy. And European control over banks is less amenable to political abuse than national control.

Given the European financial regulators' history, there is a step that is necessary before the banks can be recapitalized.

The necessary step is to release each bank's current asset level data, both investment and lending portfolios, so that credit and equity market analysts can determine independently how solvent or insolvent each bank is.  Knowing what the market expects, the financial authorities can then move forward to recapitalize the banks or have the banks raise money in the capital markets.

[This idea was first discussed in Asset Level Data:  The Firewall to Stop European Contagion and Bailouts, where it was noted that there is not enough capital to recapitalize the European banking system for worse case loss assumptions.  Therefore, the asset level data must be made available so that credit and equity market analysts can independently verify that worse case loss assumptions are too extreme.]

Bank of England Looks to Improve Its Stress Test Capabilities

With little fanfare, Bank of England announced that it is improving its ability to conduct stress tests.

British market watchdogs will rely more heavily on their own stress testing of the nation's banks as part of the U.K. coalition government's overhaul of the country's financial regulators, the head of the Financial Services Authority said.

Regulators will carry out their own investigations rather than rely on banks or their auditors, and are stepping up capacity to be able to make better judgments in-house, added Hector Sants, the FSA's chief executive. He will head a new super-regulator called the Prudential Regulation Authority in 2012.

"Regulators should not rely solely on the judgments made by firms or their auditors," he told a Thomson Reuters conference Monday. "We have to have the capability in-house to make these judgments."

As part of a shake-up of financial regulation proposed by the U.K.'s coalition government, the FSA will be dismantled by 2012. Its responsibilities will be divided between the Prudential Regulation Authority, which will be part of the Bank of England, and the new Consumer Protection and Markets Authority.

Mr. Sants said the authority would make sure banks are sound via "thorough business model and market analysis, close engagement with auditors, and, where necessary, it will conduct its own in-depth stress testing to ensure its judgments are not reliant on firms' own capabilities." The tests will help ensure the stability of the U.K. economy, he added.

Stress tests carried out by the Committee of European Banking Supervisors earlier this year were widely criticized for not making sufficiently pessimistic assumptions about factors that could weaken banks' capital ratios. Only seven of 91 European banks failed.

Mr. Sants said the Prudential Regulation Authority would use about 200 recently hired specialists to carry out the tests, without elaborating. The FSA has historically relied on banks to carry out their own stress testing.

One of the reasons that the authorities relied on the banks to carry out their own stress testing is that the banks have access to the asset level detail that is necessary for conducting the stress tests.

Is the Prudential Regulation Authority going to have access to the asset level detail?  Is the Prudential Regulation Authority going to share this asset level detail with credit and equity market participants so they can do their own stress tests to confirm the findings of the Prudential Regulation Authority? 

RBS Begins to Open Its Kimono

With its latest financial report, RBS has begun to court the credit market by disclosing far more information about its current performance.  This is clearly a movement in the right direction.

However, it is impossible to tell from this disclosure if management actually believes RBS has nothing to hide or management is cynically using more disclosure to highlight areas where RBS looks good.

Ultimately, the only way to know if RBS has nothing to hide is if RBS sets the global standard for disclosure by making it possible for market participants to analyze all of its investment and borrower privacy protected lending positions on a current basis.

If RBS management were to announce that they were going to disclose this current asset level data, then the credit market analysts would know that RBS has nothing to hide and its ability to access funds from the capital market at lower costs would be significantly enhanced.

Will EU Require Irish Banking System to be Looted? (The Looting of the Irish)

Under the terms of the Irish bailout, several banks in the Irish banking system will have to reduce the size of their asset base by shrinking their loan portfolio.

There are two ways to shrink a loan portfolio:  there is the strategy of letting the portfolio wind down as the loans are repaid and there is the strategy of selling portions of the loan portfolio.

European financial officials are pushing for Ireland to adopt the second strategy and have their banks sell portions of their loan portfolios.

There are two ways for the banks to pursue these loan portfolio sales.

First, there is the approach recommended by the investment bankers which is designed to loot and pillage the Irish banking system.

The investment bankers' basic approach is to share loan-level detail with a limited group of prospective buyers.  After the prospective buyers have had a chance to do their due diligence on the loan portfolios, the investment bankers then conduct an "auction" of the loan portfolios complete with competitive bidding to realize the 'best' price.

The aspect that gives rise to looting and pillaging is the absence of an independent "fair" value determined by the credit markets.  Without this value,

• How do the sellers, which is ultimately the Irish government, know if the highest price from the investment banker's "auction" is below, equal to or above fair value?

How do the sellers, which is ultimately the Irish government, know if they got a good deal or were ripped off?

Second, there is the alternative method for pursuing the sale of these loans portfolios which involves first disclose current information on the underlying loans to the market.

Let the credit market analysts value these loans and independently determine what their fair value is.  Then, and only then, let the investment bankers sell the loans to their prospective buyers.

Armed with the fair value of the loans, the Irish government and its banking system can see how well the investment bankers performed in maximizing the value of the loans.  Were the investment bankers able to justify their fees by auctioning off the loans for more than the credit market analysts believed was fair value?

It is hard to imagine that the EU would push the Irish government to go through a process that would minimize the proceeds to the Irish banking system from the loan sale.  Disclosing the loan-level information to the markets first still results in shrinking the banking system.  Disclosing the loan-level information to the market first just maximizes the value of the loan portfolios and minimizes the time it takes Ireland to repay the bailout funds.

Disclosure Worked To Restore Confidence in the 1930s, Will it Work in 2011?

This blog has spent a considerable amount of time focused on how using disclosure could solve at low cost a number of problems (see here, here, here and here, for example).  It is time to backup a little bit and present a primer on disclosure and how disclosure is actually used in the marketplace.


The following brief history of disclosure for public securities is presented with the author's permission:

In his 2007 book, The Defining Moment, Jonathan Alter describes the FDR “Brain Trust” in glowing terms. It included brilliant luminaries such as Adolf Berle and Rexford Tugwell who were to help design the solutions to the problems that would face the President.

Included in this inner circle of advisers was one Charles Taussig, the president of the American Molasses Company. With no college education and no economics training, this “amusing hanger-on,” according to Alter, had an access to FDR that left the other members of the Brain Trust resentful and wondering why he was there.

Perhaps we will never know precisely what it was that appealed to FDR about Charles Taussig. But we do know that Taussig was an early advocate of restoring the country’s shattered confidence by implementing transparency in the securities industry. This advocacy of a transparency solutions found its way into the Securities Act of 1933 and became the cornerstone of Franklin Roosevelt’s process to restore trust and confidence to a nation that had suffered a terrible loss of confidence and which was foundering on fear.

As the Congressional Oversight Panel’s Special Report on Regulatory Reform (2009) states: 

“From the time they were introduced at the federal level in the early 1930s, disclosure and reporting requirements have constituted a defining feature of American securities regulation (and of American financial regulation more generally). President Franklin Roosevelt himself explained in April 1933 that although the federal government should never be seen as endorsing or promoting a private security, there was ―’an obligation upon us to insist that every issue of new securities to be sold in interstate commerce be accompanied by full publicity and information and that no essentially important element attending the issue shall be concealed from the buying public.’ ”

Please note that as designed in the 1930s,

• Disclosure was based on the idea of providing the investor with access to all the information they need at the time of their investment to make a fully informed investment decision.  
• Of equal importance, no burden was placed on an investor to use this disclosure!

How does the market for an individual security (stock, bond, structured finance product) work if investors are not required to look at the information disclosed?

The fact that all investors are not required to look at the disclosed information does not mean that all investors will not look at the disclosed information.  

It is the investors who look at the information who are likely to understand how to use it in the analytic and valuation models of their choice to independently value the security.  These investors are also likely to add stability to the price of the security by being buyers when the price is below their valuation and sellers when the price is above their valuation.  

In the absence of investors who look at the disclosed information, prices for securities make movements similar to what occurred for structured finance securities in 2008 - one day the price is par and the next it is 20% of par.

For purposes of full disclosure, this humble blogger has been advocating for providing loan-level disclosure on an observable event basis for structured finance securities since before the credit crisis began.  

The bank/sell-side dominated lobby has pushed back strongly against this type of disclosure.  

One of their leading argument against providing loan-level disclosure on an observable event basis has been that providing this much data would confuse investors.

Frankly, Joe Six-pack cannot analyze or value structured finance securities.  However, Joe Six-pack is not likely to buy these securities directly.  He is likely to invest through a mutual fund or hedge fund with a professional portfolio manager.  The portfolio manager can choose to use the loan-level disclosure to value structured finance securities or they can hire an independent pricing service that is capable of valuing the securities using loan-level disclosure.

Let me repeat that, Joe Six-pack cannot analyze or value opaque structured finance securities.  So, he hires a professional portfolio manager.  That manager and his firm either have the ability to analyze and value the structured finance securities using loan-level data or the firm hires an independent third party service to do so.

Returning to the narrative on disclosure:

The transparency requirements in the securities industry have withstood the test of time as they restored trust and confidence in the financial system when paired with the appropriate government guarantees such as FDIC insurance and safety nets such as Social Security. For the next 75 years, we benefitted from the economic growth that the functioning capital markets helped to promote. However, with the advent of increasingly complicated and opaque structured finance securities, the wheels began to come off.

As we search for solutions to today’s “mother of all financial crises, it is time to reach back to 1933 and ask the question of whether the solution to restoring the “catastrophic loss of confidence” mentioned by Treasury Secretary Geithner is in fact, the very old, very tested balm of transparency.

The toxic assets clogging the arteries of finance may be complex, but the real sin is that they were designed to be as opaque as possible. There is no observable event based transparency for investors into the cash flows of the loans that serve as the collateral for these securities. Because of that opacity, the market cannot value or price the securities. When this became clear to everyone in August 2007, the entire $15 trillion securitization market became frozen and with it, the great credit contraction began.

Understanding the linkage between opacity, the securitization market and the resulting global credit contraction is vital to fashioning a comprehensive solution to the crisis. If Charles Taussig were in President Obama’s inner circle of advisers, he would undoubtedly advocate that the opacity afflicting the marketplace be washed aside by a torrent of transparency, so that investors would once again have confidence and trust in the financial system and trading in structured finance would restart. Coincidentally, in a January [2009] report on restoring financial stability, the Group of Thirty Steering Committee, led by Paul Volcker and Jacob Frenkel, advocated precisely that approach in their Core Recommendation IV.

Article 122a: An Opportunity for European Regulators to Shine

Article 122a represents an opportunity for European regulators to shine.  It is a chance for these regulators to show that they can develop regulations that would restart a deep, liquid structured finance market.

As readers of this blog know, Article 122a was passed by the European Parliament in May of 2009 as an amendment to the European Capital Requirements Directive.  It applies to European credit institutions which are broadly defined to include commercial and investment banks.

Article 122a embodies the sensible notion that investors should "know what they own".  If they do not know what they own, the article requires that they not be able to use any leverage to support their purchases of these asset.  This too is sensible as it prevents the credit institution from losing more than its equity capital on investments where it is effectively blindly betting.

Why is this an opportunity for European regulators to shine?  Under Article 122a, they are left to define what "know what you own" means for the purposes of enforcing Article 122a.

That should not be difficult.  How many definitions of "know what you own" could there possibly be?

There are two:  one as practiced by the sell-side and one that the industry trade groups and the sell-side are advocating.

What is the definition of "know what you own" that the sell-side actually uses?

The definition can be uncovered by looking at the actions of the sell-side.  According to a December 6, 2010 Reuters article discussing Goldman and Litton Loan Servicing,

Banks often bought these kinds of businesses in part because they [Litton] could give an informational edge for mortgage bond trading, according to bankers that helped their institutions evaluate these deals. 

What informational advantage for mortgage bond trading could Goldman receive from purchasing loan servicing companies like Litton?  This informational advantage takes two forms.  

First, there is 'when' information is disclosed.  


Firms like Goldman receive observable event based information on the performance of the loans underlying a structured finance security (they see all payments, delinquencies, defaults, and insolvency fillings on the day they occur).


Contrast this to investors who receive this information on a once per month or less frequent basis and have to guess what the current performance of the underlying loans is.  


Firms like Goldman enjoy a significant informational advantage for trading as they effectively have inside information without any legal restrictions on how they can use the information.  There are a number of ways they can capitalize on this information.  Remember the Abacus CDO transaction was a deal put together by traders.

Second, there is 'what' information is available.  


Firms like Goldman would have access to all the information necessary to monitor and value the underlying loans.  By definition, since they are in the business, firms like Litton track all the information necessary to monitor and value the loans.  


Compare this to the disclosure templates being discussed by the SEC and other regulators.  These disclosure templates would include a small subset of the information tracked by firms like Litton.

The definition of "know what you own" as practiced by the sell-side is a three step process: 

1. Have access to loan-level disclosure on an observable event basis;  
2. Combine this loan-level information on the underlying collateral with the terms of the deal;
3. Use the analytic and cash flow models of choice to value the security.

What is the definition of "know what you own" that industry trade groups and the sell-side are advocating?

The definition of "know what you own" as lobbied for by the industry trade groups and the sell-side is a three step process:

1. Have access to loan-level disclosure on a once-per-month basis where the information reported for each loan is a subset of the information available;
2. Combine the restricted loan-level disclosure on the underlying collateral with the terms of the deal;
3. Use the analytic and cash flow models of choice to value the security.

Not surprisingly, there is nothing in the lobbied for definition of "know what you own" that would eliminate the informational advantage enjoyed by the sell-side.  It would also not restart the structured finance market as investors are aware of the informational advantage the sell-side enjoys.

The question is will the European regulators take the opportunity to shine and adopt how the sell-side practices "know what you own" as the definition of "know what you own" they will enforce under Article 122a?