Corporate & Securities Law

By Jim Hamilton

In n some of the more thoughtful remarks on the subprime crisis, the Bank of England director of financial stability said that effective reform of the securitized assets market depends on full transparency. While achieving full disclosure on the securitization process sounds deceptively simple, said Nigel Jenkinson, it will actually be quite difficult. In remarks at a Bank of Australia seminar, he explained that full transparency means that investors must understand both the details of highly complex securitized products and the effects of the interplay between exposures and the products on all the other agents in the process.

It is also very difficult to ascertain the pay-off distribution for these instruments. For example, a collateralized debt obligation tranche might have a payoff that is highly sensitive to minor changes in expected credit conditions. With full transparency, instruments with highly sensitive payoffs should be no more difficult to value than any other, he said, but as known information decreases it becomes more risky. Many investors in CDOs and mortgage-backed securities linked to US subprime mortgages were surprised by the extent to which the performance of the securities fell short of even their worst expectations.

He also observed that information loss is built into the securitization process because of the separation between the originator and the end investor. Many investors also delegated their monitoring duty to credit rating agencies, who themselves were unable to overcome the underlying lack of transparency. Once investors lost confidence in the ratings agencies, he noted, there was a concomitant lack of confidence in the asset-backed securities. In hindsight, too much confidence was placed in the ability of rating agencies to solve the highly complex information problems underlying asset-backed securities.

Inadequate transparency also had a major impact on the market liquidity of innovative securitized products. A lack of information made the valuation of some asset-backed securities extremely uncertain, thereby contributing to the evaporation of secondary market liquidity. The official also noted a fundamental tension between the capability of financial engineering to tailor financial products for individual investors and secondary market liquidity.

The more closely a specific financial product is matched to the risk preferences of an individual investor, he reasoned, the harder it is to find another investor willing to trade that exact instrument in the event of a shock to those risk preferences. Thus, satisfying an investor?s risk profile increases risk within the system. He suggested unbundling complex securitized instruments into standardized components that are likely to be liquid.

Counterparty risk is also corrosive for market liquidity as investors become concerned not only with their immediate counterparties but also with more remote counterparties. Since a lack of transparency makes it unclear which counterparties are affected adversely, investors may limit funds to more counterparties than is necessary.

The central banker urged more transparency in the design and content of less complex securitized products. But he cautioned that increased transparency should not be confused with reams of data. Investors doing due diligence should not be overwhelmed with a barrage of data in the issuing documents of asset-backed securities. Further, echoing the Financial Stability Forum, he said that rating agencies must supply additional information on the risk characteristics of rated securities and the sensitivity and uncertainty attached to their ratings.

Full post as published by Jim Hamilton's World of Securities Regulation on August 08, 2008 (boomark / email).