Gary Greenberg's  Instablog

After digesting the latest salvo in the transparency wars, I find myself in the unusual and uncomfortable position of criticizing the FDIC. I do so with great regret. I am a fan of Ms. Bair as she has effectively navigated through the minefields of this continuing credit crisis.

One week ago, the FDIC waded knee-deep into the one of these minefields with the intention of striking "a middle ground" between "those who want to eliminate securitization completely and those who want little change." [Bloomberg, FDIC Seeks to Toughen Rules on Banks' Securitizations, December 15, 2009] Ms. Bair is further quoted as saying that she "look[s] forward to eventually finalizing strong, common-sense standards."

Common-sense isn't easy, especially where enormous profits are involved.

To some extent, Chairman Bair mischaracterizes the battle being waged over securitization. The battle is not between elimination of securitization and rules that merely codify the industry's self-serving Project Restart, which has failed to restart securitization. The real battle is between the sell-side industry and the buy-side investors, the latter remaining on strike and refusing to meaningfully restart the securitization market.

Regulators around the world have been moving heaven and earth, as well as spending trillions in taxpayer money, to address the problem of restarting securitization. However, as almost every policy maker has admitted, restarting securitization has proven exceedingly difficult and has required massive government intervention for the little that has occurred.

Obviously, there is a problem to restarting securitization that has evaded ASF, the Treasury, the Fed and the ECB. To Bair's credit, she has figured out that Paul Volcker was right in recommending last January that the systemic risk regulator meet with investors (the buy-side) to find out what they need to return to the marketplace for securitized products. Thus, she has said that FDIC will consider with particular focus the thoughts of the "buy-side community" in drafting the rules.

That would be a welcome change, a change that appears to have been led by the European Union and the European Central Bank. The EU passed their amendments to the Capital Requirements Directive last May, which included two major provisions: a 5% "skin-in-the-game" part and a "know-what-you-own" requirement that appears to apply to securitizations on a daily basis.

Indeed, the Governing Council of the European Central Bank (ECB) is now calling for public consultation on the issue of loan-level data in asset-backed securities. [Dec 17, 2009]. Restarting securitization is a primary goal of policy makers and regulators across the globe as its demise has been central to overly tight credit conditions. Ending securitization is not an option. Restarting it is becoming a main policy concern.

So, what battle should Bair have openly acknowledged?

The answer is very simple: Opacity vs. Transparency

As mentioned prominently by EU minister for internal markets and services, Charlie McCreevy, the banking industry has been lobbying forcefully to retain as many elements of opacity in securitization as possible while fighting strongly against the desire of the buy side to have more complete and timelier data with which to value and price securities. While that battle, which I call the Transparency Wars, has not been widely discussed in the U.S. press, it has been credibly reported in the European media.

Unfortunately, the FDIC has waded into this battle, stacking the deck against the buy side. The proposed rules regarding disclosure applicable to all securitizations contains the following language:

Prior to issuance of obligations and monthly while obligations are outstanding, information about the obligations and the securitized financial assets shall be disclosed to all potential investors at the financial asset, pool, and security-level sufficient to permit evaluation and analysis of the credit risk and performance of the obligations and financial assets. [italics and bold type added]

Essentially, the FDIC has adopted as its safe harbor the industry standard of monthly data for securitizations, even though that level of data disclosure has proven worthless to either prevent the credit crisis or to restart securitization.

What it boils down to, quite simply, is that Wall Street enjoys so much of an information advantage in structured finance that the buy side will no longer trade with it, fearing it will be handed large losses once again.

The buy side is on strike. It wants the information advantage enjoyed by Wall Street (who in many instances have access to much more timely data, a sizable asymmetrical information advantage as written in the Wall Street Journal, Heard on the Street, November 9, 2007) significantly reduced or completely eliminated through the release of daily, loan-level data, available to all.

By seeking comment on the monthly data provision instead of simply asking for comment on what level of data disclosure best meets the needs of investors and regulators, the FDIC has stacked the deck against those who believe that the best disinfectant is plenty of sunshine, every day (not like the weather in a sleepy Northwestern city, where sunshine is at at premium).

By stacking the deck in this manner, the FDIC has at a minimum, required the buy side to come groveling for daily data and to make a burdensome, affirmative case to change the monthly data format favored by the sell side.

This is the unintended consequence of adopting current practices as the starting point for rulemaking.

The question now becomes: How quickly can the buy-side organize and do they recognize that their desire for timelier, daily data is not only possible, but also the solution to the credit crisis.

Disclosure: No stocks mentioned

When Paul Volcker challenged a room of bankers to provide a single shred of unbiased evidence that financial innovation has led to economic growth, he gave a powerful voice outside the U.S. administration to a concept that is gaining credence throughout the world.

Eight months ago, Charlie McCreevy as the EU commissioner for internal market and services stated in a New York Times interview that "there is no doubt that some of the so-called innovation in financial products was more about opaqueness and about trying to turbo-charge risk to deliver maximum returns for the seller while transferring concealed layers of risk to the buyer." [emphasis added]

Financial innovation seeks to shroud a product in opacity so as to maximize the profitability to the seller and Wall Street trader.

The question a systemic risk regulator needs to ask is, "How do we slow the pace of financial innovation so that regulation can effectively protect us from the disastrous effects when financial innovation fails miserably?"

Richard Field of the structured finance consulting firm, TYI, LLC, believes that the most effective means of slowing financial reform so that regulators can effectively discharge their duty to protect the public is to require that a financial product should not be approved for sale until the back office can effectively transmit granular data on a daily basis to a central database administered for the government by an independent, third party. As long as the product is opaque to regulators and the back office is unable to produce such granular level data for the systemic risk regulator, the product should not be permitted by the systemic risk regulator to be sold or purchased by regulated entities. The financial innovation machinery will be slowed down to a pace that regulators will be able to handle.

A transparency database is not a new concept, by the way. As early as August 2007, former Treasury official Phillip Swagel propounded the idea that such a database could help to alleviate the incipient credit crisis by giving regulators [and ultimately investors] access to granular level data as to the loans underlying securitized assets.

Unfortunately, that idea was not embraced by bankers, regulators or central banks.

As Mark Gilbert wrote yesterday for Bloomberg:

"The financial authorities appear to have missed a golden opportunity to force transparency on the securitization market, where different kinds of debt are bundled together in packages that can be sliced, diced and resold.

Central banks have been the only buyers of such debt for months, after the subprime crisis revealed the toxicity of what lay beneath the misguided AAA ratings slapped on many asset- backed securities. As lenders of last resort, the Federal Reserve, the European Central Bank and the Bank of England could have forced the banks they funded to start giving granular detail on every individual loan being securitized." [emphasis in bold added]

The opportunity to protect investors, save taxpayers' money and insulate the economy from failed financial innovations should not be squandered.

Disclosure: No stocks mentioned

In a Bloomberg interview yesterday, FDIC Chairman Sheila Bair warned that consumer debt structured finance securities will continue to require government assistance until there are effective measures in place to protect the purchasers.

"Nobody has any confidence in the securities," said Bair. The statement should not come as any surprise to the readers of this blog entry from January 2009. According to the Bloomberg article by Dawn Kopecki, the structured finance securities backed by consumer debt "had been relying on a Federal Reserve funding program for the bulk of investor interest since March.

Bair does focus on the main issue when she says, "It's all about whether there's confidence in the assets that back the securitization." Restoring investor confidence in securitization has been central to ending the credit crisis from the beginning.

But one cannot restore confidence simply by asking the originators to maintain "skin in the game." There are simply too many ways to game the system, including being in on the writing of the legislation. Restoring investor confidence in the securitization market requires eliminating the information gap that currently exists between Wall Street and the marketplace. That conclusion not only speaks from the McKinsey & Co. report linked above, but also from Joseph Stiglitz' Nobel prize work on the effects of asymmetrical information in the marketplace.

Given the powerful interests of opacity, I suspect that we will have to go through the latest iteration of "confidence" building to see if it succeeds in restoring confidence in securitization without eliminating the information gap.

But, at least it comforting to know that Phillip Swagel's solution of a transparency database, offered as early as August 2007, remains the most viable means of eliminating the information gap and restoring investor confidence in securitization.


Disclosure: None Mentioned