by Robert D. Kugel CFA |
10/27/2008 | Article ID: V08-40 | Article Type: VentanaView
Summary
An asset-backed security (ABS) is a type of debt instrument that represents a pool of assets or is collateralized by cash flows from a specified pool of underlying assets. These securities have improved the overall efficiency of the credit markets by making small loans and other financial assets more liquid and more readily available to those wanting financial assets with those specific characteristics. Unfortunately, as currently structured ABSs have a serious flaw: limited transparency into the current state of the underlying assets. The current stress on the credit markets (and the home mortgage sector in particular) points to the need for having up-to-date detailed information about the specific asset pools behind each certificate. Using eXtensible Business Reporting Language (XBRL) to capture key information about these underlying assets would give owners, buyers and sellers a clearer picture of the value of any certificate at any given time. When credit markets are stressed (as they are today), this information would help reduce uncertainty and therefore could improve liquidity. In its proposed takeover of the Federal National Mortgage Association (FNMA or “Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), as well as in the overall financial rescue package, the United States Treasury would do well to enhance the marketability of mortgage-backed securities these entities hold by retrofitting XBRL tags on their existing securities. We expect this tagging would enhance the liquidity of these markets by resolving much of the uncertainty hanging over their securities. In the longer term, XBRL tagging of all ABSs would improve the liquidity and enhance the resiliency of these markets.
View
Asset-backed securities were invented to enable the issuer of them to transform a group of smaller, illiquid investments (such as home mortgage loans) into a larger, tradable and more diversified investment. Home mortgages and automobile loans are the two largest types of ABS, but they can be structured from almost any type of obligation. Historically, the process of “securitization” has improved the efficiency of the credit markets, in part by making these assets available to a broader set of investors. However, as they are currently structured, ABSs lack transparency into the current state of the underlying assets. This flaw can be addressed using XBRL to capture key information about the underlying obligations and thus make it easy to determine their value at any point – even years after the security was issued. Rather than relying on prospective credit judgments, each ABS certificate can be “marked to market” in terms of credit quality.
In periods of low economic stress and smoothly functioning credit markets, limited information about the current state of the underlying assets is of little concern. However, in today’s risk-averse environment, this lack of transparency has diminished liquidity and may have produced a systemic undervaluation of these securities. In the past, buyers of mortgage-backed securities relied on extensive due diligence performed at the time the loan was made and on the rating agencies for an assessment of the credit’s quality. The difficulties in today’s ABS markets stem partly from a notable lack of quality control that developed in the mortgage origination process and, in our judgment, the failure of rating agencies to detect this shift. Before the age of securitization, the company that originated a mortgage loan or other collateralized debt held onto the obligation. Since it would be “holding the bag,” it took pains to ensure the creditworthiness of the borrower and the soundness of the collateral. Because it also serviced the obligation and had a general idea of market trends that affected the value of the underlying assets and the ability of the borrowers to make their payments, the company also was able to monitor the ongoing soundness of the credit. With securitization, these pieces (origination, servicing and holding the credit) were split up. This made the up-front quality control in the origination process all the more important because it drove the credit rating of the obligation. The arrangement worked at first, but in recent years the demand for higher yields compromised the process and led us into today’s situation where it’s impossible to know whether or to what degree a given ABS certificate is backed by dud obligations (such as the infamous no-income, no-asset [NINA] loan). Information technology, however, offers a straightforward solution to this problem.
Decades ago, when the ABS first appeared, the cost of tracking the state of each and every piece of the underlying debt was prohibitively high. Today, this is no longer the case. The costs of computer memory and processing speed are fractions of what they were, and the Internet is an ultra-low-cost common network. Even more to the point, XBRL makes it possible to provide anyone with the ability to instantly get information about any aspect of the underlying debt instrument. This information, in conjunction with readily available data sources, would make it possible to characterize the quality of every obligation behind every certificate in nearly real time. For example, the social security number(s) of the debtor(s) (and, if they exist, co-signers), in conjunction with credit-rating databases, would show the current state and trend in the borrowers’ creditworthiness and would provide more insight than the percentage of borrowers who are behind in their payments. In the case of residential mortgages, the address of the property, in conjunction with residential property valuation databases (such as Zillow), would quickly produce an objective, up-to-date loan-to-value ratio.
If credit-rating agencies (such as Fitch, Moody’s and Standard & Poor’s) were to make public the criteria and formulas by which they assign a credit rating (which now is likely, since they need to shore up their reputation), it would be possible to determine the current credit rating of each and every ABS certificate when it came up for sale. (This would be essentially a “mark-to-market” credit rating.) Since they can endlessly “slice and dice” the loans behind the certificates, analysts who make markets in the collateralized debt obligation (CDO) form of ABS would be able to rejigger the pools of underlying mortgages or other assets into more homogenous credit tranches. They could strip out the worthless and low-quality loans and segregate the high and midlevel credits to provide buyers with exactly the risk they can tolerate. This, in turn, would make it possible for the market to price the securities more accurately.
The biggest issue is how to get this process started. In our opinion, now that the federal government has taken over Fannie Mae and Freddie Mac and will play a major role in restructuring the mortgage loan market, it has a substantial incentive to make the true quality of the loans it holds as transparent as possible. We also think that Fannie and Freddie would find it much easier (and more profitable) to liquidate their portfolios of loans should that become necessary. Because of their size and potential market impact, we expect that if Fannie and Freddie were to adopt XBRL tagging for the mortgages and securities they hold, other large holders would fall in line. Although it would not happen overnight, having greater transparency into the quality of the underlying assets would help restore confidence in mortgage-backed securities and other debt instruments in which credit and collateral quality risks exist. These markets have been seriously hobbled by the recent experience. Instituting new methods for measuring and monitoring the securities’ quality would enable these markets to recover faster and foster greater economic efficiency.
Assessment
Ventana Research believes that the Treasury Department should immediately begin to take steps to tag its inventory of mortgages and mortgage-backed securities. First it should begin the process of developing a workable taxonomy for mortgage-backed and other asset-backed securities. The department also should pull together a steering committee that includes representatives of public and private entities (including industry groups) to identify issues, address roadblocks and facilitate the process of adopting XBRL tagging. The need for greater transparency in asset-backed securities is evident, and the technology exists to provide it. The current mortgage crisis provides the incentive to adopt new methods beneficial to everyone involved.
Related Research Notes:
SEC Formally Proposes XBRL Reporting
Largest Companies Would Have To Tag Filings for Calendar Year 2008
XBRL Made Easier
Here Are the First Three Steps for Large Accelerated Filers
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