Government Issuers Should Use Best Structured Finance Disclosure Practices

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 |  Includes: FMCC, FNMA
by: Richard Field

As the debate over new disclosure regulations for structured finance securities goes on, government issuers, including agencies and sponsored entities, are missing the opportunity to lead by example. They should be using best disclosure practices as oppose to the disclosure practices that contributed to the credit crisis.

Prior to the credit crisis, the standard for disclosure of the underlying loan-level performance data was once-per-month or less frequently. This frequency of disclosure did not prevent the structured finance market from freezing at the start of the credit crisis. This frequency of disclosure has not subsequently thawed the structured finance market despite explicit bribes, like PPIP, and implicit investor coercion, like zero interest rate policies.

This frequency of disclosure is great for investing based on performance trends, but terrible for valuing individual securities.

The current once-per-month or less frequent disclosure practice is ideal for placing a macro bet. Look at how much money hedge funds made by noticing there was a gap between the performance on the underlying loans and the assumed performance built into the price.

Unfortunately, current once-per-month or less frequent disclosure is terrible for valuing individual securities. The Brown Paper Bag Challenge shows how once-per-month disclosure leaves investors blindly betting on the value of the loans backing a structured finance security.

Historically, government issuers (like Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), Ginnie Mae and the FDIC in the US) have set the standard for disclosure frequency by reporting once-per-month. Once-per-month reporting is adequate for investors in these securities because the government is guaranteeing and absorbing one hundred percent (100%) of the credit risk of these deals.

Once-per-month reporting is not adequate for investors who are exposed to credit risk. Look how much money was lost by investors who were receiving once-per-month reports on structured finance securities that were guaranteed by financial guarantors like the mono-line insurers.

Once-per-month reporting is not adequate for taxpayers who are ultimately on the hook for the credit losses of government issuers. Notice how Fannie and Freddie's regulator is still scrambling to get its arms around the actual performance of the mortgages these firm's guaranteed and the size of their losses. The regulator's inability to get its arms around the losses has resulted in the US Treasury explicitly stating that it would cover whatever losses are incurred.

There is a best practice for structured finance disclosure. Best practice is to disclose loan-level performance data on an observable event basis. Observable events include payments on the loans, delinquencies, defaults, insolvency filings by the obligors and filing, acceptance or denial of representation and warranty claims.

Can the underlying loan-level performance data be reported on an observable event basis for all structured finance securities? Yes. Financial institutions currently use observable event based reporting to monitor the loans and receivables on their balance sheets. The same systems that support the on-balance sheet loans and receivables are used to support structured finance securities. The data is available, it is only a question of disclosing it.

Would it cost a lot to provide observable event based reporting on the underlying loan-level performance? No. It does not fundamentally alter the economic attractiveness of structured finance from an issuer's perspective. The cost is approximately one-tenth of the cost of billing and collecting the underlying loans or receivables.

If the government is already guaranteeing and absorbing one hundred percent (100%) of the credit risk, what is the benefit of providing observable event based reporting to investors? It sets the standard for reporting for all structured finance securities regardless of their underlying assets or the minimum disclosure requirements required by regulation.

Setting the standard for disclosure by example is a whole lot easier than through the issuance of globally coordinated regulations.

Setting the standard for disclosure by example provides investors with structured finance securities that they can truly know what they own.

Ultimately, if government issuers of structured finance securities can provide observable event based reporting, then all issuers can provide observable event based reporting. The only reason non-governmental issuers would not provide observable event based reporting is because they are trying to hide something.

Should investors really be investing in structured finance securities where issuers are trying to hide something?

Disclosure: No positions