April 12, 2010
In this issue of The Institutional Risk Analyst, we feature another perspective on reform of the asset securitization market by Richard Field of TYI LLC, in this case focused on the need to level the disclosure playing field in the ABS markets. Like the principals of IRA, Richard has worked in and out of the government regulatory sphere, and understands the world of SEC disclosure and structured finance at the operational level. And he understand that the big Wall Street banks and hedge funds have an unfair informational advantage over other investors in the ABS markets today. Richard comments about the need for real time disclosure of loan level data to fulfill the SEC's ambitious proposal to reform the world of mortgage finance. As Richard told The IRA last week, "real time" at a bank is the last 24 hours of loan portfolio performance, including what is known as the daily "event of default" or EOD report. Giving investors anything less that daily data on loan portfolio performance is unfair, he argues. And as we've written in The IRA since 2003, the basic tools of machine-to-machine data transfer makes it all possible today, as evidenced by the XML-enabled CALL report submittal system at FDIC. The comments we have been featuring in The IRA over the past several months on structured finance are a reflection of our view that it is vitally important to the global markets to fix the private ABS market. A large portion of the finance raised in markets for commercial and residential real estate depend upon bank sponsored securitizations. More important, accounts receivable and working capital finance for all manner of business is a function of the ABS markets. We spoke about this in our interview with Jerry Flum and Bill Danner from Credit Risk Monitor last October ("So What About the Real Economy? Interview with Credit Risk Monitor"). The crisis situation in trade finance is also why we have been so supportive of the efforts by the FDIC and now the SEC to bring order back to the private ABS marketplace. We hope all of the readers of The IRA will read and respond to the SEC proposal. We are frankly amazed at how far and how well the folks at the SEC took the proposed rule on normative standards for issuing ABS. As you might expect, the representatives of the large dealer banks are already yowling in pain at the idea that they might be required to retain exposure to the deals which they sell to investors. The major banks and their surrogates in the policy world argue that requiring "skin in the game" by retaining 5% of each deal is silly, but we are not so sure that such measures won't be required to restore investor confidence. If you want to see the disorder and chaos that deregulation and a lack of disclosure by Wall Street (aka "innovation") with respect to ABS has created for investors and banks, look no further than the adventure-packed world of the collateralized debt obligation (CDO). The CDO typifies the rape and pillage mentality of many Sell Side banks and dealers, and makes us wonder if requiring skin in the game, while a simplistic prescription, is not a prerequisite for private label MBS in the future. But the SEC should not be distracted by arguments from the banks about "skin in the game." The real policy battleground in ABS reform for the SEC and FDIC is disclosure. Have no doubt that an economic recovery requires a functioning ABS marketplace, and a functioning ABS market requires fair and equal access to all information for all investors. Last week we spoke to Jim Burke of Ramius Capital Group about the situation in the world of CDOs, a market that his firm tracks very closely since they assist in the liquidation of defaulted deals. "There were approx $480 billion of ABS CDOs structured over the years, of which about $410 billion have already triggered an event of default." Burke notes. "I believe a majority of the remaining $70 billion of ABS CDOs will trigger an EOD over the next 1-2 years." Of the $410 billion ABS CDOs that have triggered an EOD, approx $160 billion have been liquidated or are in the process of being liquidated, avers Burke, who notes that the holders of the senior tranches of these deals, mostly the large banks BTW, are forcing liquidation and wind up of these deals. In this case, BTW, "skin in the game" includes effective control over the CDO by the sponsoring bank. Mary Schapiro et al at the SEC please take notice. What is really scary is that most of these CDOs, which are carried by many banks as "Level Three " assets under the FASB fair value rule, are showing virtually no recoveries. Like 5 cents on the dollar for the senior debt and nothing, nada, bupkus for the other tranches. So we wonder: Why aren't the people who created and sold these securities going to jail? The sponsor list in the Ramius report reads like a "who's who" of Wall Street, both the Buy and Sell Side firms. Burke reports that when a mezzanine ABS CDO is liquidated, the senior tranche gets back about 5% on average and the remaining noteholders get nothing. In a typical high-grade ABS CDO, the senior noteholder would get back about 40-45% on average. He observes: "Exact amounts may vary depending on vintage and asset quality." Burke's colleague at Ramius, Woojung Park, adds that "that we've seen some High-Grade ABS CDO liquidations with supersenior recovery in the low-to-mid 20's." Sure looks like the 95 percent loss given default we calculate in the professional version of The IRA Bank Monitor for all FDIC insured banks is not far off the mark. Speaking of reform, Burke says that pricing of ABS is inconsistent at best and that the banks are big offenders when it comes to ignoring event of default in their disclosure. "FINRA is in the process of accumulating data on where ABS CDOs as well as other structured finance assets are trading in the marketplace," Burke tells The IRA. "In the future, these asset classes will be TRACE eligible. Any banks not marking these assets appropriately at this time are at risk of having to write them down in the near future. This applies not only to their ABS CDOs but also other types such as TRUP CDOs, of which regional banks are the big holders." Confirming our view of the fading palliative effect of the Fed's QE exercise and also the change in bank accounting rules, Burke and his colleagues at Ramius believe that the are more than a few banks which will be coughing up losses on CDO exposures -- losses that could approach 100 cents on the dollar. Burke told The IRA that regulators expressed surprise when he recently published a list of banks with significant CDO exposures as yet to be written down. Readers of The IRA should not be surprised. For the past year and more, the Fed and other regulators have been desperately trying to buy time -- but the end game has not been clear, save political expedience and delay. In a recent speech, Fed Chairman Ben Bernanke expressed concern about the low level of interest rates and possible problems low or negative rates may cause. But he did not mention that the zero rate policy imposed by the Fed has done little to either restore private markets or boost the real, non-government sector. We can't think of a better example of the futility of Fed policies like quantitative easing than to see large and regional banks pretending that an ABS or CDO is still worth close to par, when in the secondary markets this paper is being auctioned for almost nothing. The Fed has window dressed the accounting for banks in 2009, while the actual market for this paper sees sponsors forcing acceleration and liquidation of deals. Since last summer, we have been telling the subscribers to The IRA Advisory Service that the fundamentals of the banks as a group do not support current market valuations, especially when you look at these banks on an enterprise basis. No rational buyer wants to pay book value for the average large bank today because most sophisticated M&A professionals know that disclosed loss rates on loans and securities are currently understated. Our guess is that due to poor disclosure, price manipulation by the Fed and regulatory forbearance, current charge-off rates in the US banking industry are understated by 1/3 to 1/2 of the true economic loss. Given the lack of true, private economic activity in the industrial world, at least excluding government stimulus, the prospect of rising interest rates may spell big trouble for equities generally and for the financials in particular in the coming year. Eventually the industrial nations will have to default upon and/or restructure their public sector debts, a deflationary process that suggests a prolonged period of low or no economic growth and more shrinkage among financials. But don't hold your breath waiting for any of the leaders of the G-10 countries to actually admit the true scope of the problem. As one of our more astute colleagues noted recently, in Germany these is Angela Merkel, the spokeswoman for Deutsche Bank, in charge of public policy. In Washington and London, likewise the lobbyists and cronies of the large banks such as Citigroup and Goldman Sachs are firmly in charge. Small wonder then that the scope of financial reform remains so inadequate. But we suspect that in 2010, events will start to again dictate policy, unlike the reverse in 2009, which we should refer to as "the year that wasn't really." Covered Bonds and the Reform of Structured Finance On March 18, 2010, Representative Scott Garrett (R-N.J.) introduced the United States Covered Bond Act of 2010 (the "Act"). His goal was to create an alternative to securitization for financing mortgages and other types of consumer debt. What are Covered Bonds? Covered bonds are the original structured finance security. They share several features with all structured finance securities. First, covered bonds use the cash-flow from a pool of assets to make the bond's principal and interest payments. Second, they give the investors in the bond a perfected security interest in the pool of assets that isolates the assets and insulates the pool should the issuer becoming insolvent. Third, they use over-collateralization in the asset pool as a credit enhancement. These features are where the similarities with other structured finance securities stop. Historically, covered bonds have been fixed rate instruments issued with maturities ranging from two (2) to ten (10) years. They have been structured with periodic interest payments and the repayment of principal at maturity. By design, covered bonds have a recourse requirement. The issuer retains ownership of the assets in the pool. During the life of the bond, if the collateral does not perform as expected whether from prepayments or defaults, the issuer remains on the hook to replace all "non-performing" assets in the collateral pool with performing assets or other acceptable collateral. For some covered bonds, if the issuer becomes insolvent, an investment contract covers any gap between the cash flow on the pool assets and payments on the covered bonds. Unlike securitizations, there is no ambiguity about the loans remaining on the issuer's balance sheet and the need for the issuer to retain capital to support them. Experience with Covered Bonds Covered bonds originated several decades ago in Europe. The European experience has been mixed. As would be expected given its call on the issuer for replacement of non-performing assets, there have been very few, if any, defaults. Unfortunately, this same structural reliance on the issuer to replace non-performing assets results in covered bonds trading based on the perceived solvency of the issuer. This reliance also leads to the market freezing, except for purchases by the European Central Bank, as it did from late 2007 through early 2009 when the solvency of the issuers was called into question. The market for covered bonds has not taken off in the United States. Rep. Garrett tries to address this through the creation of a regulatory structure. The Act that he proposed creates a covered bond regulator in the U.S. Treasury. This regulator has numerous responsibilities including setting over-collateralization levels for specific asset types, maintaining a registry of covered bond programs with information on individual outstanding issues and creating a periodic asset-coverage test to be disclosed to market participants showing if the pool backing the bond exceeds a minimum level of over-collateralization. The Act also subjects covered bonds to securities regulations and requires issuers to submit to the trustee on at least a monthly basis a schedule showing all assets pledged. Obstacles to Market Development While Rep. Garrett's proposals are helpful, they don't go far enough to address the obstacles preventing the widespread use of covered bonds. From an issuer's perspective, one obstacle is the ongoing retention of credit and prepayment risk without receiving any offsetting benefit in the form of liquidity in times of financial stress. From the investor's perspective, one obstacle is an almost total lack of information about the performance of the assets in the pool. Without an ability to assess the risk of the assets in the pool, the investor cannot know how dependent the interest and principal payments are on the issuer's replacing non-performing assets. Therefore, the investor cannot give the issuer any credit for the assets in the pool and the issuer's access to funds reflects the issuer's perceived solvency. As currently proposed, the Act solves these problems for the U.S. covered bond market by basing the market on enhanced moral hazard a la Fannie Mae and Freddie Mac. Under this solution, the attractiveness of covered bonds will be driven by investors assuming the government is on the hook for large bank solvency. The preferred solution to overcome these obstacles is to disclose the loan-level performance of the assets supporting the covered bonds on a daily basis. With the performance data, investors in both the primary and secondary markets can value the underlying assets and assess how dependent the interest and principal payments are to replacement of the non-performing assets. The less dependent, the more the covered bond is priced off the asset quality and not the issuer's perceived solvency. The more the covered bond is priced off asset quality, the more attractive this product becomes as a source of funding because there will be investor demand. The more the covered bond is priced off asset quality, the more robust the primary and secondary markets are and the less likely they are to freeze. Lessons for the Broader Securitization Market The disclosure solution for the covered bond market is also applicable to the broader securitization market. Investors in the securitization market also face the issue of a lack of information on the performance of the assets backing these securities. As recognized by the SEC in its Proposed Rules for Asset-Backed Securities, "information asymmetry" exists between the information that issuers report to investors in asset-backed securities ("ABS") and the information that is needed in order to assess the risk, value and monitor the underlying assets. In order to solve the problem of information asymmetry in the ABS markets, it is necessary to address not only what information is to be provided but also the timing of the disclosure of this information. The section of the Proposed Rules on the specific data points for each asset type backing a structured finance transaction addresses the issues of what information should be disclosed. The Proposed Rules do not however specifically address the timing of the disclosure of this information. In the ABS market, a select few have access to loan-level performance information on a daily basis. Firms such as Goldman Sachs and Morgan Stanley have subsidiaries involved in originating, billing and collecting loans backing ABS. They receive "fresh" loan-level performance data on a daily basis that they can use for trading days, even weeks, before most other market participants receive the information. By contrast, other ABS investors and market participants currently have to wait to receive the "stale" accumulation of daily loan-level performance data in a single periodic report. The periodic report is distributed to investors by trustees, third party data vendors or on a website on a once-per-month or less frequent basis. It follows from the Nobel Prize winning work of Columbia University Professor Joseph Stiglitz that once markets with information asymmetry freeze, they don't unfreeze until the information asymmetry is eliminated. To eliminate information asymmetry in and unfreeze the ABS markets requires that each ABS provide all market participants with fresh performance data on a daily basis on the individual loans that support the ABS. If all market participants receive equal and full information on a daily basis, they can evaluate the risk and return of the ABS in both the primary and secondary markets. Benefit of Receiving Loan-Level Performance Data Daily What would have happened if there had been access to loan-level deal specific data daily and its forced recognition of the deterioration in loan underwriting and performance in the years leading up to the current financial crisis? A significant amount of losses could have been avoided if investors had access to loan-level deal specific data daily and had been able to accurately assess the risk in securitizations. It has been reported that securitization investors like Goldman Sachs and Morgan Stanley who had this data daily recognized that risk was mispriced, stopped buying new securities by late 2006 and in fact went further and shorted the subprime market. According to the Securities Industry and Financial Market Association, over $1.75 trillion in non-agency mortgage backed securities, home equity loan-backed securities and CDOs were issued globally between the time Goldman Sachs and Morgan Stanley decided to stop buying such securities and the beginning of the credit crisis in 2007. Analysts and traders estimate that there were several hundred billion dollars of losses on these thinly traded securities. These losses would have been avoidable if either the other investors had exerted market discipline (based on more up-to-date data) by not providing liquidity for unsustainable origination practices or regulators had noticed that securities firms (such as Goldman Sachs and Morgan Stanley) with access to loan-level performance data daily were placing massive shorts on the market and intervened. In addition, there were other avoidable losses in the financial system as there were loans made during this time period that ended up on the balance sheets of financial institutions both to replace the loans sold into the capital markets and to grow the financial institutions' internal loan portfolios. If market discipline had been exerted in late 2006, these loans might not have been made. These loans have also incurred a significant amount of losses. At a minimum, the benefit to the financial system from providing loan-level deal specific data on a daily basis would be several hundred billion dollars of losses avoided. Benefit Outweighs Cost of Providing Loan-Level Data Daily The annual cost of providing loan-level deal specific data daily for securitization and covered bond transactions will be much lower than the losses described above. In order to provide this data, a new data-handling infrastructure will be needed to collect, store and distribute this information. Based on the cost for comparable information services for securitizations, the on-going annual cost of the infrastructure for loan-level deal specific performance data daily would be approximately 5 basis points (0.05%) of the principal amount of the loans that are supporting a particular securitization or covered bond. By spending 0.05% per year of the amount of the loan collateral, the covered bond and securitization market can avoid repeating the several hundred billion dollars of losses from not being able to accurately assess and price the risk of securitizations. Spending such amount will also restore confidence in and restart the securitization markets. Questions? Comments? info@institutionalriskanalytics.com About IRA Products and Services
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