The Campaign Against Transparency: A Rebuttal

The Campaign Against Transparency

The campaign being waged by some against the recently passed amendments to the European Union's Capital Requirements Directive is as much an attempt to influence U.S. initiatives regarding transparency in securitization as to water down the EU requirements.

The lobbyists undoubtedly know that with a global market, the EU's actions become the de facto global standard. Keeping the U.S. from agreeing with the EU or from providing tougher disclosure rules are their likely goals.

The campaign can be broken down into a few, short assertions:

1. Due diligence by the buy side is not practical or necessary;
2. The EU changes will prevent a revival of the securitization market; and
3. Investors will be confused as to how to perform due diligence, thereby causing them to forgo buying securitized assets.

Due Diligence

The need for transparency to permit buy-side due diligence was known by late summer and early fall in 2007. Three major points became widely known to the buy side. First, investors realized that they did not have the necessary loan-level detail to perform adequate due diligence on structured finance securities.

Second, the credit rating agencies (NRSRO industry) did not have the necessary information to perform timely credit quality adjustments to these securities, a fact made public in Moody's Special Report dated September 25, 2007 and referenced in the FDIC Supervisory Insights Report on Transparency in the Summer 2008 issue.

Third, some members of the sell side had the advantage of asymmetrical information as to the performance of subprime securities at a time the buy side did not. This last is the clear implication of the Wall Street Journal, Heard on the Street column of November 9, 2007 (see here).

The regulatory intervention at this time came in the form of a report from the President's Working Group on Financial Markets, dated March 2008, in which it excoriated the buy side for not performing adequate due diligence and for a faulty, over-reliance upon the credit reporting agencies for such due diligence. The implications of this report were not lost on the buy side. No longer could they safely rely upon the NRSRO industry for due diligence. They would have to do their own. Nor was it lost on the European regulators who began working on a response to make certain that the financial crisis would not happen again for similar reasons, while still encouraging the restarting of securitization, albeit in a form with less systemic risk..

The proposals that became the amendments to the CRD were laid out in a speech by Charlie McCreevy in Brussels on October 1, 2008. Charlie McCreevy is the EU commissioner for Internal Markets and Services. According to reports from across the pond, the retention provision and the transparency provision in particular met with ferocious lobbying from the financial services industry. As the Sunday Business Post OnLine stated on October 26, 2008:

"McCreevy also wants a requirement for banks to document the undertaking of detailed due diligence and sensitivity analysis on securitised assets independently of the credit rating agencies. The measure has led to furious lobbying, and one Brussels source said that no topic had generated as much financial services lobbying in Europe over the past five years." [Personal note: one may reasonably assume that the sell side was not lobbying in favor of the disclosure provision.]

It’s nice to know from where push back originates.

Reviving the Securitization Market

A further argument against the transparency provisions is that they will prevent a revival of the securitization market. That comment blithely ignores that there is no private securitization market today precisely because the buy side is on strike over the issue of transparency and has said that it will not return until it receives sufficient loan-level detail to be able to conduct adequate due diligence. The buy side wants the ability to value and price securities based upon real-time, standardized data instead of relying on outmoded data reports and the resulting inferior pricing models.

In the summer of 2008, JP Morgan conducted a survey of the buy side and found that about 60% wanted better loan-level detail as a prerequisite to returning to the market for structured finance. This point was disclosed at the 2008 Global ABS conference in Cannes, France.

The point was driven home by McKinsey & Company's survey included in a report by the Global Joint Initiative to restore confidence in the securitization market.

As pages 39-41 or that report attest, the buy side wants better transparency to return to the market. It is simply stunning that one would attempt to argue that providing increased transparency would prevent the revival of the securitization market when it's precisely that which the buy side has stated it requires to return to the market and to purchase structured finance securities. See this link for an analysis of the McKinsey & Company survey.

Analysis Paralysis

The "analysis paralysis" argument is that the buy side will have too much information to process and will remain away from the securitization market in frustration. This argument is fairly insulting to the buy side and it has not gone anywhere with regulators now that the buy side has begun to express its transparency concerns. The argument is that with too much information (by which I presume it is meant real-time, loan-level data), the buy side will be overwhelmed and unable to make decisions. Better to trust the sell side analysis goes the argument.

That dog won't hunt.

Handled properly, the massive flow of real-time data could be gathered by an independent, third-party database administrator, standardized so that it could be useful in structured finance valuation, reviewed for accuracy of output vs. input, and then distributed on a "next-day" basis around the world to both investors and regulators interested in emerging systemic risk. The key to dissemination would be the distributors who would receive the data at no cost and likely provide some type of valuation and pricing analytics of their own similar to a Bloomberg Fair Value.

Alternatively, many investors receiving the data will commission and pay for their own analytics to be developed. Finally, the availability of this information at no cost to the users will very likely give rise to an emerging third-party pricing industry that could be used by buyers and sellers to engage in price convergence and actual trading of securitized assets.

That scenario is a long cry from the "analysis paralysis" canard.

The FSOC and the Database

Flying under the radar of the political and financial press is the possibility that a real systemic risk regulator may well be formed from the Financial Services Oversight Council being proposed. The Federal Reserve is a lightning rod for those who believe that it failed in its mission earlier and that it cannot be trusted with identifying emerging systemic risk. Thus, the White Paper submitted to Congress is encountering some head winds from those who distrust the Fed in this role.

One solution is to make the FSOC a quasi-independent agency under the Department of Treasury, but with a director appointed and confirmed for a ten-year term similar to the head of the FBI.

The FSOC would have the authority to gather information related to indentifying emerging systemic risk, such as derivative exposure, counter party risk, performance of underlying collateral, and credit default swaps. That information would reside in a massive transparency database, both for analytical purposes as well as for historical reference to identify future emerging trends. The "mother of all financial crises," as Paul Volcker has termed the current situation, requires the "mother of all databases." The FSOC, with the appropriate Congressional authority, can be uniquely qualified for that purpose.

Comments

[Moon Kil Woong:]

There is no real buy side analysis to speak of. I suppose that's why they are protesting that they aren't given adequate tools by the sell side.

Sadly, no matter how much they protest the sell side will never be able to give them what they need which is buy side analysts.

The end result is not too bad. The elaborate and broken securitization market is shrinking and the derivatives market along with it. Although this can put us all the way back into depression, at least we will walk out of there without financial weapons of mass destruction hung around our necks.

After the first nuclear bombs were released people were smart enough not to use them again. I wonder if we will be able to say the same about the toxic financial weapondry that have been peddled around this economic cycle? Until we can say definatively yes, we should not encorage a resumption of mass unregulated securitization.

Jun 24 04:36 AM

[prudentinve...:]

Mass securitisation of loans was a bad idea. The ABS/MBS boom is not coming back, and the future of will look like the past. Banks that originate mortgages or business loans will keep much of them on their books until they mature, just like they did in the boring, logical, successful, stable, pre-bubble banking model.

Given the losses suffered around the world from securitised, dubioulsy rated junk, I doubt that a buy side will return for a pool of mysterious mortgages yielding 5%.

Jun 24 09:34 PM