Will the SEC Give the Buy Side What It Needs?

While the Obama initiative for restoring financial stability will come under Congressional scrutiny for most of its regulatory overhaul, the portion dealing with securitization will likely be buried in the depths of the Securities and Exchange Commission.

In a fitting win for the financial elite, meaningful change in this area most likely will not be forthcoming and the buyers will stubbornly remain on strike.

Unless the EU radically changes the dynamic, securitization is dead. Long live covered bonds . . . when private demand for them returns.

The role of securitization in the formation of the credit bubble and the ensuing bursting of the bubble and resulting global credit contraction has been discussed extensively the past two years.

In simple terms, by August 2007 when the pricing models blew up, the market for these instruments froze solid as the buy side walked away and went on strike.

The significance of this strike should not be understated. Prior to the freezing of the securitization market, banks supplied less than half the credit needs of the United States economy. The non-financial, shadow banking system fed by securitization supplied more than half. Removing the ability to securitize assets and recycle balance sheets produced a growing credit contraction, the effects of which are being felt and will continue to be felt for years to come.

Several attempts have been made to restart securitization here and abroad, but none has worked. In the most basic terms, the securitization market flowed credit from the buyers to the borrowers and the buyers no longer want to purchase the securities.

Some have argued that the reason for the lack of buying is that housing prices remain under pressure. It's a good rationale, but it misses the mark. Several studies of the buy side have ferreted out the real reason. The buy-side strike is over the issue of transparency and all attempts at having them accept some form of the industry standard of month-old remittance reports has been met with continued silence and refusal to re-enter the market.

The buyers' strike is real. In a survey conducted by McKinsey & Co. (pages 39-41 of the report) for industry trade groups and released on December 3, 2008 as part of a joint international initiative to restore investor confidence in securitization, McKinsey & Co. revealed that extensive interviews with the buy side pointed to a lack of sufficient transparency into the collateral underlying the securities as the reason for the strike.

Essentially, what would cause the buy side to return to the market and allow credit to flow through securitization again would be giving them more granular data on a more timely basis so that they could perform their own due diligence and have more trust in the ratings agencies methodologies.

To some extent, the recently passed amendments to the EU Capital Requirements Directive sought to encapsulate the buyers' concerns. The CRD amendments require a 5% "skin in the game" retention as well as a "know what you own" provision that requires financial institutions owning structured finance securities to have granular information sufficient to perform their own due diligence without reliance upon the NRSRO industry.

The initial optimism that accompanied this legislation and the remarks made at the Global ABS conference by Francesco Papadia regarding the need for loan-level detail has given way to concern that little has changed in the U.S.

The Obama plan for financial stability includes the provision that the Securities and Exchange Commission be given the clear authority to establish transparency guidelines for the industry to follow.

Will those guidelines give the buy side what they need to return to the structured finance market? Certainly the SEC has been given a third bite at the apple of disclosure. The first came with the disclosure provisions for Regulation AB of Rule 144. The second came last summer when the FDIC issued its Summer 2008 Supervisory Insights Report including a section on Transparency in Structured Finance:

For example, on September 25, 2007, Moody’s proposed a series of enhancements to the Non-Prime RMBS Securitizations that they believe, if adopted, would improve the transparency and oversight on loans sold into a securitization vehicle. Generally, the Moody’s proposal is intended to address the need for third-party loan reviews, improve representations and warranties, and enhance reporting for increased transparency.

The enhancements proposed by Moody’s would help increase transparency. However, transparency cannot be increased industry wide unless the SEC, as the regulator of NRSROs, endorses proposals such as this as a best practice and factors the standards into its supervisory oversight function. Ideally, all rating agencies would follow and provide more granularity on the underlying exposures in their publicly available presale and surveillance reports so that investors, regulators, and other interested parties can better assess the risks relating to these securities."

The FDIC report does little to absolve the buy side from its role in the credit crisis. Focusing on the lack of due diligence, something that the Presidential Working Group noted in March 2008, the FDIC report states:

Investors need to look beyond the ratings and develop a better awareness of the risks to which they are exposed. They should demand exposure-level information on the performance and
composition of underlying assets as well as on the structural features that can quickly alter the terms of the deal.

Very clearly, the buy side understands the nature of the due diligence requirements now placed upon it and the risks associated with ignoring the due diligence function.

The question is whether the SEC will tailor its disclosure rules with the idea of giving the buy side what it needs to return to the market with sufficient information to conduct suitable due diligence on structured finance securities and to impose market discipline on the sell side.

For, without the restoration of private demand for structured finance securities, it is difficult to see from where the flow of credit will come to provide the U.S. and world with sufficient credit for global growth.

Comments

[Steve in Gr...:]

Thanks, Mr. Greenberg, for the helpful note. Much of it I was already familiar with, but I have a question. Your position is that potential buyers are unwilling to buy given the current inadequate levels of transparency.

"...Essentially, what would cause the buy side to return to the market and allow credit to flow through securitization again would be giving them more granular data on a more timely basis so that they could perform their own due diligence and have more trust in the ratings agencies methodologies..."

Why wouldn't the sellers provide increased transparency on their own in order to get more buyers, better pricing, etc.? Why would the sellers need the SEC to force them to do something that is clearly already in their economic interest to do?

Jun 18 11:27 AM

[Paul Wilkinson:]

Actually, since they were getting gov't help after Lehman (note the AIG conduit to Goldman Sachs et al.) and it was not at all certain that full transparency would result in better prices, the more risk-averse position was to hold and recapitalize and wait rather than go for full transparency. Andrew Butter's article from Tuesday, and its comments, have it right: seekingalpha.com/artic...

Mr. Greenberg is also exactly right:

"Essentially, what would cause the buy side to return to the market and allow credit to flow through securitization again would be giving them more granular data on a more timely basis so that they could perform their own due diligence and have more trust in the ratings agencies methodologies."

See the comments to the Butter article for links to ways to produce that more granular data. The Treasury plan yesterday at least called for disclosure of loan level detail. What it left out was the need to disclose the detail and subsequent data in a format that can be easily analyzed by potential buyers. That format, for which a list of data tags already exists, is XBRL. All that is needed is the leadership to force the sell side to disclose instead of muck around in opacity that's further confused by potential and actual taxpayer subsidies.

Bear Stearns tried to offer some of its junk to the public in 2007 but nixed the deal, presumably when they found out that the transparency required wouldn't get them the price they wanted. Here's a quote from the FT at the time:

"Jack McCleary, head of asset-backed securities syndication at UBS said: 'The market does good job of sniffing out leverage. Dealers will look at funds with similar positions to ensure valuations are appropriate.'" -- www.ft.com/cms/s/0/f7b...

Alas, Mr. McCleary was all too prescient about the ability of the market. Too bad there wasn't more transparency sooner to help it move faster, before opacity exacerbated the bubble.

Jun 18 11:58 PM

[Gary Greenberg:]

Steve,

Your question is essentially the same as asked by Fed economists almost daily. Why would an organization not do something that is in their economic interest?

The answer is that the organization defines economic interest differently, or in this instance, longer term than a single issue. It may also believe that it does not have to give up something to get the result it eventually wants.

1. Wall Street is built on asymmetrical information as Stiglitz showed in his Nobel prize winning research. Opacity is the gravitas of Wall Street profitability. As he and Ken Rogoff of Harvard have mentioned several times in this crisis, the financial elite will fight transparency with every weapon in their arsenal.

2. Wall Street doesn't want to set a precedent that might affect other, future areas of profitability that will rely upon opacity to generate large profits.

3. The buy side history is one of short memory. To this observer, Wall Street has been hoping for collective amnesia to strike the buy side and have them return to the market. That is unlikely to occur given the depth of the losses, the amount of advantage gained from opacity and the recognition that they were unable to perform adequate due diligence previously. That both the President's Working Group on Financial Markets (March 2008) and the European Union excoriated the buy side for not doing sufficient due diligence on their own and for their reliance on the ratings from the NRSRO industry (which also did not have the data they needed according to Moody's Special Report of Sept 25, 2007), is something that has not been lost on the buy side or their legal advisers.



On Jun 18 11:27 AM Steve in Greensboro wrote:

> Thanks, Mr. Greenberg, for the helpful note. Much of it I was already
> familiar with, but I have a question. Your position is that potential
> buyers are unwilling to buy given the current inadequate levels of
> transparency.
>
> "...Essentially, what would cause the buy side to return to the market
> and allow credit to flow through securitization again would be giving
> them more granular data on a more timely basis so that they could
> perform their own due diligence and have more trust in the ratings
> agencies methodologies..."
>
> Why wouldn't the sellers provide increased transparency on their
> own in order to get more buyers, better pricing, etc.? Why would
> the sellers need the SEC to force them to do something that is clearly
> already in their economic interest to do?

Jun 19 07:27 AM

[Gary Greenberg:]

Paul,

Re: Your comment -

"What it left out was the need to disclose the detail and subsequent data in a format that can be easily analyzed by potential buyers. That format, for which a list of data tags already exists, is XBRL. All that is needed is the leadership to force the sell side to disclose instead of muck around in opacity that's further confused by potential and actual taxpayer subsidies."

The solution is a "mother of all databases." See my blog entry: rwbeerdiet.blogspot.co...

The concept proposed by TYI, LLC of Needham, MA is for a centralized, database administered by an independent third party that would collect the relevant data on a daily basis, standardize it, verify and report it the next-day, delivering it to the desktops of investors and regulators around the world so that they could use the analytics of their choice to value and price the securities.

Getting the loan-level information is an issue, as you've stated. A crowbar, hammer or similar instrument of persuasion will likely be necessary. Barring that, legislation or regulation will have to suffice.



On Jun 18 11:58 PM Paul Wilkinson wrote:

> Actually, since they were getting gov't help after Lehman (note the
> AIG conduit to Goldman Sachs et al.) and it was not at all certain
> that full transparency would result in better prices, the more risk-averse
> position was to hold and recapitalize and wait rather than go for
> full transparency. Andrew Butter's article from Tuesday, and its
> comments, have it right: seekingalpha.com/artic...
>
>
> Mr. Greenberg is also exactly right:
>
> "Essentially, what would cause the buy side to return to the market
> and allow credit to flow through securitization again would be giving
> them more granular data on a more timely basis so that they could
> perform their own due diligence and have more trust in the ratings
> agencies methodologies."
>
> See the comments to the Butter article for links to ways to produce
> that more granular data. The Treasury plan yesterday at least called
> for disclosure of loan level detail. What it left out was the need
> to disclose the detail and subsequent data in a format that can be
> easily analyzed by potential buyers. That format, for which a list
> of data tags already exists, is XBRL. All that is needed is the leadership
> to force the sell side to disclose instead of muck around in opacity
> that's further confused by potential and actual taxpayer subsidies.
>
>
> Bear Stearns tried to offer some of its junk to the public in 2007
> but nixed the deal, presumably when they found out that the transparency
> required wouldn't get them the price they wanted. Here's a quote
> from the FT at the time:
>
> "Jack McCleary, head of asset-backed securities syndication at UBS
> said: 'The market does good job of sniffing out leverage. Dealers
> will look at funds with similar positions to ensure valuations are
> appropriate.'" -- www.ft.com/cms/s/0/f7b...
>
>
> Alas, Mr. McCleary was all too prescient about the ability of the
> market. Too bad there wasn't more transparency sooner to help it
> move faster, before opacity exacerbated the bubble.

Jun 19 07:43 AM

[Paul Wilkinson:]

Alas, it surely wouldn't be a $700 billion (or whatever number you want to use) hammer! Check out the RMBS ASCII posted on EDGAR if you haven't had a chance. It is simply astonishing in its uselessness, but Phil Moyer, who commented at the Butter post, has explained how he used the same XBRL technology being used for GAAP and FDIC reports to tag the ASCII RMBS data, which proved quite useful to short sellers before the depth of the current crisis was widely known.

On Jun 19 07:43 AM Gary Greenberg wrote:

> Paul,
>
> Re: Your comment -
>
> "What it left out was the need to disclose the detail and subsequent
> data in a format that can be easily analyzed by potential buyers.
> That format, for which a list of data tags already exists, is XBRL.
> All that is needed is the leadership to force the sell side to disclose
> instead of muck around in opacity that's further confused by potential
> and actual taxpayer subsidies."
>
> The solution is a "mother of all databases." See my blog entry: rwbeerdiet.blogspot.co...
>
>
> The concept proposed by TYI, LLC of Needham, MA is for a centralized,
> database administered by an independent third party that would collect
> the relevant data on a daily basis, standardize it, verify and report
> it the next-day, delivering it to the desktops of investors and regulators
> around the world so that they could use the analytics of their choice
> to value and price the securities.
>
> Getting the loan-level information is an issue, as you've stated.
> A crowbar, hammer or similar instrument of persuasion will likely
> be necessary. Barring that, legislation or regulation will have to
> suffice.
>

Jun 19 11:19 AM