The Sell-Side: Implications for Structured Finance Disclosure Regulations

by: Richard Field

The Sell-Side and Its Lobbyist Take On the Brown Paper Bag Challenge: Part 1

The ultimate success of financial reform is in the hands of the regulators. As Timothy Ryan, CEO of the Securities Industry and Financial Markets Association ("SIFMA"), a leading sell-side lobbying organization, said, "the administration and the regulators have a mandate to move forward. Our job is to work with them to try to achieve something that makes sense."

Let us look at how the sell-side and its lobbyists, including sell-side dominated industry trade associations and law firms, have done in working with the regulators on the revision of structured finance disclosure requirements and achieving something that makes sense.

As regular readers of this blog know, TYI, LLC developed the Brown Paper Bag Challenge in early 2008 to demonstrate that current securitization industry disclosure practices do not adequately address the timing of disclosure to investors and prevent investors from valuing individual ABS. This is true even if the collateral performance is reported using current disclosure practices in an industry standard template being advocated by the American Securitization Forum, a former affiliate of SIFMA.

To create an asset-backed security, loans or receivables are placed into a trust for the benefit of the investors. Among its other duties, the trustee provides reports to the investors on the performance of the underlying loans or receivables. Under existing securitization disclosure practices, these reports are provided on a once-per-month or less frequent basis.

A brown paper bag is the physical model that best represents these asset-backed securities. Investors know what loans or receivables went into the bag, but under current reporting practices they do not know what is in the bag, ie how the loans are performing, on a current basis.

The Brown Paper Bag Challenge highlights why knowing what you own, in this case knowing what is in the bag currently, is important for valuing individual asset-backed securities ("ABS").

As part of this challenge, assume that at the start of last month, $100 was placed into a brown paper bag (which is analogous to the loans or receivables being placed in a securitization trust). A report has been issued that indicates at the end of last month there was $75 in the bag (which is analogous to the once-per-month disclosure to investors in securitization transactions in an industry standard template). The Brown Paper Bag Challenge is as follows: what is the value of the contents of the bag today?

In the Brown Paper Bag Challenge, everyone is invited to submit an offer to buy the contents of the brown paper bag. If the price offered is accepted by TYI, then money changes hands. If the price offered is greater than the value of the contents of the bag, then the difference is paid to TYI. If the price offered is less than the value of the contents of the bag, then the difference is paid to the individual submitting the purchase offer.

Potential buyers of the contents of the brown paper bag should be aware of the following fact: in this challenge, TYI, in a role that is similar to the Wall Street firms that invest in or run servicers handling the daily billing and collecting in securitization transactions, has observable event data, in this case withdrawals of money, so it knows what is in the brown paper bag currently.

Based on the once-per-month report, current and potential investors do not know what is in the bag right now. They can only guess at what is a knowable historical fact. The same is true with respect to ABS. Once-per-month reporting blocks investors from knowing what is currently in ABS and limits investor valuation of the contents of ABS to an exercise of blind betting. If investors guess incorrectly, whether buying ABS or taking the Brown Paper Bag Challenge, they lose money.

To date, TYI has been unable to find anyone who is willing to take the Brown Paper Bag Challenge.

However, when a clear plastic bag, which is analogous to providing observable event based reporting, is substituted for the brown paper bag, everyone is willing to make an offer for the contents of the clear plastic bag. This is because the contents of the clear plastic bag can be seen and valued. The same could occur for specific securitization transactions; if current information were provided by observable event based reporting, then investors would be able to make informed buy, hold and sell decisions with respect to ABS.

This simple example using brown paper and clear plastic bags may explain why investors have been reluctant to return to the securitization markets in the absence of observable event based reporting.

Part II of this series looks at the sell-side and its lobbyists objections to providing loan-level performance data on an observable event reporting basis and their arguments for why disclosure that results in investors betting blindly on the contents of a brown paper bag is just fine.

MONDAY, NOVEMBER 8, 2010

The Sell-Side and Its Lobbyists Take on The Brown Paper Bag Challenge: Part II

In Part I of this series, the focus was on how current once-per-month or less frequent disclosure practices are inadequate for valuing individual structured finance securities. They do not provide the investor with the information the investor needs 'when' the investor needs it to make a fully informed buy, hold or sell decision.

Current structured finance disclosure practices are the equivalent of putting the underlying collateral into a brown paper bag. Then asking the investor when the contents have changed, but have not been reported, to guess the value of contents of the brown paper bag. The proposed solution was to put the collateral into the equivalent of a clear plastic bag by providing observable event based reporting. With observable event based reporting, all the changes, like payments or defaults, to the underlying collateral are reported on the day that the changes occur. Investors can see what they are buying and can value the structured finance security.

Has the sell-side and its lobbyists (including sell-side dominated industry trade associations and lawyers), which claim to want sensible regulatory reform, championed the Brown Paper Bag Challenge conclusion that observable event based reporting should be part of the revised structured finance disclosure requirements?

No! In fact, they have gone to extraordinary lengths to try to oppose observable event based reporting and champion the disclosure practices that result in investors blindly betting on the contents of a brown paper bag.

Those opposed to observable event based reporting in securitization transactions have asserted various types of objections. The following briefly summarizes these objections and explains why the objections are not valid:

1. Existing ABS reporting is sufficient. Investors could have done their homework with once-per-month or less frequent data and seen the problems with ABS.

This objection substitutes the ability to recognize a trend for the ability to value a specific security. Clearly, the stale data disclosed in once-per-month reporting allows investors to see trends in the performance of the assets underlying a specific type of asset-backed security. A few investors made a substantial amount of money from recognizing the downward performance trend of subprime mortgages.

However, as demonstrated by the Brown Paper Bag Challenge, once-per-month reporting does not provide investors with the current detailed information that is necessary to value a specific ABS. The gap between the ability to recognize a trend and the ability to value individual ABS cost investors several hundred billion dollars during the financial crisis.

Whereas current ABS reporting practices resemble a brown paper bag, observable event based reporting resembles a clear plastic bag. Observable event based reporting would provide the necessary disclosure so that investors can value specific ABS. Observable event based reporting is necessary for restarting the securitization market and creating deep, liquid secondary markets.

2. This much data will confuse investors. Frequently, this objection is specified in terms of the number of loans. For example, the objection is stated to be that loan-level disclosure makes sense when there are five thousand loans but not when there are fifty million loans. Alternatively, the objection is specified in terms of the volume of data. For example, the objection is stated to be that investors cannot handle billions of individual data points.

No matter how it is specified, this type of objection is false. According to the AFME’s February 26, 2010 response to the European Central Bank’s Public Consultation on Provision of ABS Loan-Level Information, “from an investor perspective, loan-level data could provide a number of benefits: … provision of loan-level data will give investors certain options: either to rely on the level of data that they currently use, or, alternatively, to employ third parties to transform the large amount of data into a more useable and value-added format.” Since investors have the ability to use the loan-level data and they are willing to use third parties when necessary, providing loan-level data on an observable event basis is appropriate.

As discussed in the Association of Mortgage Investors’ March 2010 white paper on reforming the ABS market, it would be both “absurd” and inaccurate to assume that the investors are unable to use (or to engage third parties to help them to use) the loan-level data.

Under observable event based reporting, it is quite likely that there will be daily disclosure for securities backed by large numbers of loans or receivables. Investors who purchase the riskiest tranches will use this disclosure to closely monitor their positions. Other investors might use the information less frequently. For analysts who prefer to guess the contents of the brown paper bag and look at the performance data on the old once-per-month or less frequent basis, this would still be an option.

In addition, without loan-level disclosure on an observable event basis, investors cannot look at the non-performing loans and determine if there are borrower specific problems or systemic problems.

ABS investors have computers to process loan-level data. To the extent that ABS investors are unable to analyze loan-level data, they have a history of relying on third parties with computers who can analyze loan-level data for them.

3. Implementing observable event based reporting would require significant changes to computer systems.

Existing databases used by servicers handling the daily billing and collecting of loans and receivables already track observable events such as payments on a loan-by-loan basis. As a result, loan-level data on observable events can and should be made available to investors on the day the observable event occurs or as soon thereafter as practicable so investors can know the current status of every loan or receivable backing an asset-backed security.

Consider an observable event-based report that can be accessed today by any person who holds a credit card. The individual credit cardholder can, using existing technology, access a web site of the credit card issuer on any day of the month and review all charges and payments that have been made on the credit card on each day during the month. Similarly, the credit card issuer can, using existing technology, on any day of the month review all the charges and payments that have been made on each day during the month on i) all of its credit cards, ii) a subset of credit cards which are collateral for a securitization or iii) an individual credit card. Credit institutions have considerable expertise in observable event-based reporting. This same expertise and the same information systems could be used to support observable event-based reporting for securitizations.

4. The cost of observable event based reporting outweighs the benefits.

The following is a comparison of the costs and benefits of observable event based reporting against the costs and benefits of keeping the existing once-per-month disclosure standard.

· In the TYI, LLC response to the FDIC Safe Harbor Proposal, a discussion of the costs and benefits of observable event based reporting was presented. The response noted that investors such as Goldman Sachs and Morgan Stanley had access to loan-level observable event based data through their investment in or ownership of firms handling the daily billing and collecting of the underlying loans and receivables. By late 2006, Goldman Sachs and Morgan Stanley had concluded that the risk in subprime mortgage backed securities was mispriced. As a result, they not only reduced their exposure to these securities but also shorted these securities.

What would have happened if investors had access to the same loan-level observable event based data as the Wall Street firms? Would they have also concluded the securities were mispriced? If so, they would have avoided several hundred billion dollars in losses by not buying subprime mortgage backed securities originated in the years leading up to the financial crisis.

Based on the cost of comparable information services for securitizations, the cost of a data system to collect, standardize and disseminate observable event based data on a borrower privacy protected loan-level basis to all securitization market participants would be approximately 5 basis points (0.05%) of the principal amount of the loans that are supporting a securitization.

The bottom line to the cost/benefit analysis is that the benefit of not losing several hundred billion dollars far outweighs the cost of providing observable event based loan-level data.

· The alternative timeframe is the existing once-per-month disclosure standard. This disclosure standard neither prevented the credit crisis and the associated several hundred billion dollars in losses nor has it restarted the securitization market.

Based on a comparison of the cost/benefit analyses, observable event based disclosure is far superior to retention of the existing once-per-month disclosure standard.

5. It is too hard for sponsors to report this data. This objection is specified in terms of the complexity or the ability of the sponsor to report loan-level data for all of an issuer’s deals.

It will not be difficult for sponsors to report data on an observable event basis because each loan or receivable is linked in the daily billing and collecting database to a specific deal. If this were not the case, how would anyone know if payments received went to the right deal? It is a simple database query to identify every loan or receivable supporting a specific deal that had an observable event that must be disclosed.

6. Providing loan-level data will require disclosure of internally calculated credit ratings, which will hurt a sponsor’s competitive position.

Observable event based reporting will not require the disclosure of a sponsor’s internally calculated credit ratings. Investors in ABS do not need such internally calculated credit ratings. ABS investors do need all of the data fields that went into calculating the internal credit rating, such as the borrower’s credit score and income, in order to analyze the risk of the loans and receivables supporting the securitization.

This objection is also presented as a reverse engineering argument. If competitors are given all the information that the investor needs to properly analyze the risk of the loans and receivables, competitors can back into how the sponsor prices its financing relative to the borrower’s credit quality. This argument is misleading as competitors already have multiple sources of this information including professionals who move between competitors and borrowers who disclose competitors’ offers in the hopes that someone will them make a better deal. However, so as not to force disclosure of proprietary data, the SEC should refine the disclosure requirement to exempt disclosure of internally calculated credit ratings.

7. The information has already been disclosed to third parties conducting due diligence on the underlying loans or receivables and therefore the investors do not need to see the data.

This objection is another way of saying that investors should rely on the rating agencies. However, reliance by investors on rating agencies who implied they had access to loan-level performance information was one of the primary contributors to the credit crisis. In Europe, under Article 122a, there is a mandate that investors do their own homework so they know what they own. In the US, the President’s Working Group on Financial Markets’ March 2008 Policy Statement on Financial Market Developments also stressed the importance of investors doing their own homework. Global investors need to have access to loan-level observable event data so they can do their own homework regardless of whether third parties have conducted due diligence on the underlying loans or receivables.

8. The cost of compliance with loan-level disclosure is too high. It will adversely affect the economic attractiveness of securitization and reduce the amount of credit available to the economy. The related objection is that after a certain period, say twelve (12) months, investors no longer need disclosure and when this happens, to save costs, disclosure should be discontinued.

As noted above, the cost of observable event based reporting will be minimal. At five basis points (0.05%) or less, the cost of observable event based reporting is significantly less than the illiquidity premium currently built into the securitization market. The “illiquidity premium” refers to the fact that buyers in the primary securitization market know that without effective disclosure they will have to hold the security to maturity as it is unlikely that they will find buyers in the secondary market for the contents of a brown paper bag. As a result, investors in the current once-per-month disclosure environment require a higher yield on ABS than they would if observable event based reporting were available. It can be expected that observable event based reporting would reduce the illiquidity premium charged by ABS investors and that such reduction in the illiquidity premium would more than offset the 5 basis points (0.05%) cost of observable event based reporting. In order to reduce the illiquidity premium over the life of the transaction, observable event based reporting should be required so long as the transaction is outstanding.

9. Protecting obligor privacy requires that the sponsor disclose only a fraction of the data fields that the sponsor tracks.

This objection ignores the ability of observable event based reporting to protect borrower privacy. We would expect that observable event based reporting rules would require borrower privacy to be protected in a manner similar to the protections under HIPAA. If borrower privacy is protected in a manner similar to the protections under HIPAA, there are very few data fields that could not be disclosed to ABS investors.

10. Sell-side has been talking with investors in ABS securities and the sell-side claims it knows what information investors need.

It may be true that the sell-side believes that it understands what ABS investors need, however, it is equally clear that under current reporting standards ABS investors are not receiving the information necessary to analyze individual ABS.

For example, we understand that it takes approximately 300 data fields to run all the standard analyses for CMBS deals. However, fewer than 200 data fields are included in the sell-side dominated trade association template. With observable event based reporting, we would expect this type of problem not to occur. Subject to protecting borrower privacy, all of the data fields that are used by originating, billing and collecting entities would be provided to ABS investors.

11. Asset classes other than RMBS, CMBS and CDO have not experienced significant credit problems, so loan-level disclosure would be inappropriate for such other asset classes.

The fact that some ABS investors have bought the contents of a brown paper bag in the past without sufficient information or without losing their investment, does not mean that ABS investors should continue to blindly place bets or that they will not experience credit problems in the future. Observable event based reporting would allow ABS investors to evaluate ABS and select ABS which meet their investment criteria.

12. In revolving ABS transactions, some assets are not in the pool for very long and therefore it is not worthwhile to provide loan-level disclosure and instead only summary data is needed.

The fact that the pool of assets is not static is even more reason that ABS investors should know what is in the securitization pool. AIG discovered this when the managers of the CDOs insured by AIG replaced lower risk securities with higher risk securities.

Part III of this series looks at the tactics used by the sell-side and its lobbyists to try to offset the deficiencies in its objections to observable event based reporting.

TUESDAY, NOVEMBER 9, 2010

The Sell-Side and Its Lobbyists Take on The Brown Paper Bag Challenge: Part III

In Part I of this series, the focus was on how current once-per-month or less frequent disclosure practices are inadequate for valuing individual structured finance securities. Existing structured finance disclosure practices do not provide the investor with the information the investor needs 'when' the investor needs it to make a fully informed buy, hold and sell decision.

Current structured finance disclosure practices are the equivalent of putting the underlying collateral into a brown paper bag. Then asking the investor when the contents have changed, but have not been reported, to guess the value of contents of the brown paper bag. The proposed solution was to put the collateral into the equivalent of a clear plastic bag by providing observable event based reporting. With observable event based reporting, all the changes, like payments or defaults, to the underlying collateral are reported on the day that the changes occur. Investors can see what they are buying and can value the structured finance security.

In Part II of this series, the focus was on the objections raised by the sell-side and its lobbyists to observable event based reporting and their ongoing support for continuing with disclosure practices that leave investors blindly betting on the contents of a brown paper bag.

Part III of the series focuses on several different tactics the sell-side and its lobbyists, including sell-side dominated industry trade associations and lawyers, have employed to frame the discussion of revising structured finance disclosure requirements and oppose observable event based reporting.

First, there is the "red herring" tactic to divert the attention of global regulators from the real issue of 'when' disclosure is made. This has taken the form of focusing on 'what' is disclosed and calling for data reporting templates as the cure for the disclosure problems afflicting structured finance. The data reporting template push originated before the credit crisis and was led by the European Securitisation Forum, an affiliate of SIFMA. It was subsequently adopted by the American Securitization Forum, at the time an affiliate of SIFMA, under the name "Project Restart".

This tactic allows the sell-side dominated trade associations to claim they are 'working' with the regulators as the associations have numerous committees dedicated to creating data reporting templates. At the same time, this tactic allows the trade associations to delay revision of the disclosure requirements. To the extent that regulators believe data reporting templates are necessary, the regulators are unlikely to issue new requirements without the data reporting templates being finished. There are literally hundreds of potential data fields that are tracked by the originators and the firms that do the daily billing and collecting of the underlying loans and receivable that could be included in the templates. Since it is not their area of expertise, the regulators are not really in a position to judge the appropriateness for analytical purposes of any data field. As a result, the arguments between the buy and sell-side over which data fields to include in the data reporting templates are potentially endless.

The assumption underlying data reporting templates as a cure goes as follows: if only investors had standardized loan-level data, then investors would have made different decisions and the losses incurred would have been avoided. The Brown Paper Bag Challenge puts an end for all time to the idea that standardized data reporting templates by themselves are the cure for the problem afflicting structured finance disclosure. If investors had standardized data reporting templates and existing once-per-month or less frequent reporting, they still would be left in the position of guessing the contents of the brown paper bag. The Brown Paper Bag Challenge highlights that 'when' the disclosure is made is as important as 'what' disclosure is made if the revised structured finance disclosure regulations are going to be effective.

Despite the Brown Paper Bag Challenge and its implications for revising structured finance disclosure, the red herring of data reporting templates has been extraordinarily successful in capturing the time and attention of regulators in both the US and Europe.

That the tactic has greatly influenced and dominates the thinking of the global regulators is not in doubt. Over the last two years, the evolution of the proposals by the global regulators to revise structured finance disclosure has steadily become focused almost entirely on data reporting templates. This culminated in the April 7, 2010 SEC proposed revision to Regulation AB.

This proposed revision to structured finance disclosure requirements runs 188 pages in the Federal Register, which is the equivalent of over 600+ normal typed pages. Needless to say, it is bogged down in the minutia of data reporting templates and manages to devote less than 100 words to the issue of 'when' disclosure should take place. This is an example of regulators losing sight of the goal of creating effective disclosure requirements through the opacity of dealing with the mountain of details involved in developing data reporting templates. After investing all this effort into developing templates, is the SEC likely to adopt observable event based reporting in a data reporting template-based revision of Regulation AB?

If the SEC was using a disclosure framework where eliminating the brown paper bag problem with current disclosure practices was the highest priority, the SEC could dramatically shorten and simplify the revision to the structured finance disclosure requirements by eliminating all the details involved in prescribing data reporting templates.

Instead, the SEC could propose the following requirement:

"With respect to a loan or receivable included in a securitization transaction, that any observable event relating to such loan or receivable should be disclosed on the day the observable event occurs or as promptly thereafter as is possible.

An “observable event” means, with respect to a loan or a receivable that is collateral for a securitization, any of the following: 1) payment (and the amount thereof) by the obligor on such loan or receivable; 2) failure by the obligor to make payment in full on such loan or receivable on the due date for such payment; 3) amendment or other modification with respect to such loan or receivable; 4) the billing and collecting party becomes aware that such obligor has become subject to a bankruptcy or insolvency proceeding; or 5) a repurchase request is asserted, fulfilled or denied.

This loan-level disclosure would include all data fields tracked by the originator and the firm handling the daily billing and collection, but should be implemented in a manner that protects the privacy of individual borrowers consistent with the standards under the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”)."

This requirement is short and sweet. It has the added benefit that it addresses both 'when' and 'what' should be disclosed and cures the problem that afflicts structured finance disclosure.

In Europe, the European Central Bank ("ECB") has taken the lead in establishing disclosure requirements for asset-backed securities. The ECB is setting a disclosure standard that asset-backed securities will have to meet to be eligible to be pledged as collateral to the ECB. Like the SEC, the ECB is working with the trade association on developing data reporting templates to the apparent exclusion of the appropriate timing of 'when' disclosure should take place. The ECB could also adopt the disclosure requirement suggested for the SEC above and wait to rollout data reporting templates. Not only would adopting this disclosure requirement cure the problems with existing structured finance disclosure, it would prevent regulatory arbitrage and it would let the global regulators find out what data fields investors actually use before deciding what data fields should be in a data reporting template.

Second, the sell-side and its lobbyists use the "Ignore the Issue" tactic. In responding to the Committee of European Bank Supervisor's request for public comment on the guidelines for implementing Article 122a and its disclosure requirements, the fifteen (15) responses by the sell-side and its lobbyists never brought up the issue of 'when' disclosure should be made. Perhaps they are hoping that the regulators will not notice that 'when' disclosure is made is as or more important than 'what' is disclosed if the revised structured finance disclosure requirements are going to be effective.

Third, there is the "if we keep repeating something, it must be right" tactic. If they must talk about the timing of disclosure, the sell-side and its lobbyists talk about once-per-month disclosure. For example, for Project Restart, ASF recommends once-per-month disclosure without ever discussing why once-per-month is the right frequency. Perhaps they are hoping that regulators will not noticed that they cannot talk about why once-per-month disclosure is the right frequency because it has been shown to be so fundamentally flawed by the Brown Paper Bag Challenge.

All of these objections and tactics are just an insurance policy. In reality, the sell-side and its lobbyists are probably betting on the regulators themselves to actually not understand or choose to not understand the Brown Paper Bag Challenge and its implications for revising structured finance disclosure regulations.

Unfortunately, this is not an unreasonable bet.

Global regulators have asked for public comment on their proposed revisions to structured finance disclosure regulations. The regulators appear to have paid close attention to those comments submitted that support the agenda the individual regulators wanted to push.

For example, the Bank of England ("BoE") expressed concern about managing the risk of structured finance securities on its balance sheet. It had good reason to be concerned. Despite direct bribes, like PPIP, and massive indirect incentives, like zero interest rate policies, investors are reluctant to return to the structured finance market. This is not surprising considering that they lost hundreds of billions of dollars blindly betting on these securities with their once-per-month or less frequent disclosure. For its part, the BoE recognized that central banks are only suppose to take on good collateral and not lose money.

The BoE issued a Public Consultation in which it discussed the need for enhanced disclosure for structured finance securities if they were to be eligible to be pledged as collateral to the BoE. In the responses to the Public Consultation, the BoE was made aware of the 'when' problem in structured finance disclosure and that once-per-month disclosure also did not appear to satisfy the "Know What You Own" requirements of Article 122a of the European Capital Requirements Directive.

Still, the BoE proceded with its agenda to adopt a policy that requires eligible asset-backed securities to have at least once-per-month disclosure. It rolled out this policy in its July 19, 2010 Market Notice (Expanding Eligible Collateral in the Discount Window Facility and Information Transparency on Asset-Backed Securities). With this Market Notice, the BoE voluntarily took on the 'when' problem with structured finance securities. It now has to contend with the issues of valuing the contents of and managing the risk of a portfolio of brown paper bags.

Finally, there is also a significant credibility hurdle that must be overcome by an individual or firm that the global regulators do not know when responding to the request for comment. If the credibility hurdle is not overcome, the comments from the "unknown" third party will be ignored before they can be seriously considered and acted on.

Conversely, why do global regulators receive multiple virtually identical responses from the sell-side and its lobbyists (both trade groups and law firms) on their request for comment? Does this make the content of these responses somehow more legitimate? For example, do global regulators count up the number of times an issue is raised and conclude that the issues that should be focused on are those that are mentioned most frequently by respondents?

Of course all the objections, tactics and legitimacy hurdles go away if the Brown Paper Bag Challenge is understood by a single senior government or regulatory official who is willing to use their position to cure the disclosure problem afflicting structured finance.

Disclosure: No positions