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Just when it appeared that structured-finance reform might be gutted, on December 31, 2010, the Committee of European Bank Supervisors published Guidelines to Article 122a of the Capital Requirements Directive.

Article 122a of the European Capital Requirements Directive is legislation that requires that European credit institutions, whether investing for their own accounts or in a fiduciary capacity, "know what they own" when investing in structured-finance transactions. If these credit institutions do not know what they own, then each structured finance position they invest in has a 100% capital requirement.

The critical guideline appears in paragraph 79 on page 36:

... [C]redit institutions as investors should make their decision to invest only after conducting thorough due diligence. To make such a decision, credit institutions as investors need adequate information about the securitisation; therefore, credit institutions should not invest in securitisations where they determine that they do not have, and will not be able to receive, adequate information to undertake thorough due diligence and satisfy the requirements of the Directive.

Please re-read that paragraph again, as it places on credit institutions acting as investors the obligation to not invest in the absence of adequate information to undertake thorough due diligence, both before investing in and while having an investment in a structured finance transaction.

With this obligation comes the need for regulatory compliance and the potential for legal liability. The potential for legal liability arises because as an investor, particularly when the credit institution is acting in a fiduciary capacity, it is holding itself out as "knowing what it owns."

In the event of a loss on a structured-finance security investment, common sense dictates that the credit institution must be able to defend this representation that it "knows what it owns" by proving that it had adequate information to undertake thorough due diligence and ongoing investment monitoring. This is a far higher standard than bank regulators might choose to enforce.

There are two components to adequate information: When it is disclosed and what is disclosed.

Having data on the underlying collateral performance disclosed at the right frequency is a "material necessity" if credit institutions are going to be able to show that they "know what they own" for both due diligence and portfolio monitoring.

Paragraph 79 addresses when the information is disclosed. For these guidelines, information must be disclosed on an observable event basis; otherwise, credit institutions will not have, nor will they be able to receive, adequate information to undertake due diligence or monitor their structured finance investments.

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

Observable events should be disclosed on the day the observable event occurs, or as promptly thereafter as is possible.

Even with relaxed compliance enforcement by regulators, how do we know that structured finance information must be disclosed on an observable event basis?

First, in September 2007, the rating agencies testified before the U.S. Congress that current once-per-month or less frequently reported data was inadequate for monitoring structured-finance securities and making timely changes to the ratings of those securities. By itself, this testimony is sufficient to disqualify current once-per-month or less frequently reported data for the purpose of "knowing what you own" or for its use by credit institutions to make them less dependent on rating agencies.

If the current data reporting frequency is inadequate for "knowing what you rate," it is thus also inadequate for "knowing what you own."

It is common sense that if it is inadequate for "knowing what you rate," it is also inadequate for using for due diligence purposes to buy a structured-finance security in the secondary market or for monitoring structured-finance securities purchased in the primary market.

Second, before the credit crisis, Wall Street found once-per-month or less frequent data inadequate for its own trading operations. Wall Street gained an informational advantage for these trading operations by purchasing firms handling the servicing of the underlying collateral. The information edge provided by the servicing firms was observable, event-based information on the underlying collateral performance. Wall Street knew what was going to be in the once-per-month or less frequent reports provided to investors before the investors did. Since structured finance securities have no insiders, Wall Street could legally use what was effectively "inside information" in the form of observable event-based reporting in its trading operations to take advantage of investors who received only once-per-month or less frequent reports.

Third, The Brown Paper Bag Challenge shows definitively that in the absence of information on an observable event basis, investors are blindly betting when they purchase a structured-finance security using once-per-month or less frequent collateral performance reports. It argues that 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 the bag's contents.

The Brown Paper Bag Challenge also highlights the fact that while other buy-side firms might be blindly betting when they purchase structured-finance securities, it does not mean that a credit institution using once-per-month or less frequent collateral performance reports "knows what it owns" when it buys a structured-finance security.

Based on the three facts stated above, it is difficult to see how a credit institution can claim that it "knows what it owns" for either Article 122a, or when it is investing for others in a fiduciary capacity, if it uses once-per-month or less frequent collateral performance reports.

Ultimately, the Brown Paper Bag Challenge sets the common sense, legally defendable standard for when asset-level performance data must be disclosed for structured finance so credit institutions can "know what they own":

If asset-level data is available on an observable event basis, it is the equivalent of doing due diligence on the contents of a clear plastic bag. If asset-level data is available on a once-per-month or less frequent basis, it is the equivalent of doing due diligence sight unseen on the contents of a brown paper bag. Credit institutions 'know what they own' when buying the contents of a clear plastic bag. Credit institutions do not 'know what they own' when buying sight unseen the contents of a brown paper bag.

Finally, if credit institutions or buy-side firms cannot access asset-level performance data that meets the Brown Paper Bag Challenge standard for "knowing what they own," do they have to disclose that they are blindly betting? Is it prudent for credit institutions or buy-side firms to buy structured-finance securities if they cannot access asset-level performance data that meets the Brown Paper Bag Challenge standard?

Paragraphs 125 and 128 describe what should be disclosed. For these guidelines, what should be disclosed is loan-level performance data for the individual assets that back each security:

125. Originators and sponsors are also required to provide to investors such information as is necessary to conduct comprehensive and well-informed stress tests on the cash flows and collateral values supporting the underlying exposures. To the extent that there are (for example) standardised reporting and disclosure templates, generally accepted by market participants, that fulfil these requirements adequately, they can be used if the information
disclosed therein is sufficient to fulfil these requirements.

128. The term “individual underlying exposures”, for which relevant data must be provided by credit institutions as sponsors or originators, will typically mean that such data should be provided on an individual exposure (or “loan-level”) basis, as opposed to on a collective basis. However, it is recognised that there may be circumstances in which such loan-level disclosure is not appropriate; for instance, securitisations with a large volume of exposures that are highly granular. On the other hand, in many circumstances loan-level disclosure is a material necessity for the due diligence process; for instance, securitisations with large concentrations of non-granular exposures. In determining whether such information should be provided on an individual or aggregate basis, a credit institution, when acting as originator or sponsor, should consider the information that a credit institution when acting as investor would need in order to fulfil its requirements under Paragraphs 4 and 5.

Paragraph 127 addresses how the asset-level data should be made available. For these guidelines, the focus is on minimizing the cost of accessing and using the data by the investor:

127. The term “readily available” means that gaining access to the information should not be overly prohibitive (in terms of search, accessibility, usage, cost and other factors that might impede availability), so that fulfilling their due diligence requirements is not overly burdensome on investors.

Source: Will Structured-Finance Reform Freeze Financials Until They 'Know What They Own'?