Transparency Left Gray in FINRA Mortgage Trading

October 25, 2012

By Jody Shenn

Five years after the start of the credit crisis, regulatory efforts to expand transparency in the market for mortgage- and asset-backed securities, where $314 billion trades each day, are only going so far. While the U.S. Securities and Exchange Commission agreed this week to a Financial Industry Regulatory Authority plan to create disclosures of trading information including prices in a corner of the $6.2 trillion market for U.S. home loan bonds, the protocols won't reveal unique identifiers called CUSIPs.

Unlike what's required for corporate bonds, the debt will be referred to only by characteristics such as maturity and coupon. FINRA has been broadening its Trace bond-price reporting system to securitized debt after opacity in mortgage bonds without government backing helped fuel the worst financial crisis since the Great Depression by creating doubt about the health of banks and funds. The non-government regulator agreed to mask CUSIPs after hearing from investors that such disclosures could damage bondholders by revealing trading strategies. "We felt that this was a reasonable step to advance transparency while being sensitive to those concerns," Ola Persson, vice president in FINRA's transparency services division, said in a telephone interview from New York.

Pimco, TCW

Following the SEC's approval on Oct. 23, FINRA, which oversees more than 4,000 brokerages, will have two months to publish an effective date, Persson said. Disclosure would need to start within nine months from then, eventually leading to reports on trades within an hour. Trace started in 2002, providing anyone with Internet access with the first real-time data on most corporate bond trading. A year ago, with the system already widened to securities including government agency debt, FINRA began disclosing daily market-level information culled from data on individual securitized-debt trades it had started collecting.

Investors including Pacific Investment Management Co., manager of the world's largest bond fund, and TCW Group Inc., which oversees $130 billion, endorsed FINRA's approach in its latest step, as did the Securities Industry and Financial Markets Association, Wall Street's largest lobbying group. Limited disclosures are less useful to banks, insurers and funds attempting to assign valuations to holdings, said Joshua Rosner, an analyst at Graham Fisher & Co. in New York. It may also make it harder for regulators and others to gauge the accuracy of prices attached to the securities, he said. "You really don't want this market to remain a black hole," Rosner said in a telephone interview.

Lehman Failure

Record defaults on mortgages made during the U.S. housing boom caused the value of bonds backed by the loans to plummet, leading to the collapse of firms including Lehman Brothers Holdings Inc., more than $2 trillion in writedowns and losses at the world's biggest financial companies and a global recession. FINRA's latest plan to expand securitized-debt disclosure covers government-backed mortgage bonds traded as so-called specified pools, as well as securities tied to Small Business Administration loans. FINRA earlier this year won the right to bring Trace disclosures beginning next month to so-called To Be Announced trades of mortgage bonds backed by government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae. TBA trading is the largest part of the market, totaling $275 billion in face value daily, or 10 times more than corporate-bond volumes, Persson said.

TBA Trades

Investors use specified-pool trades to acquire securities that have less risk of prepaying faster or slower than they want. In TBA trades, forward sales contracts are filled with any bonds matching a broad set of characteristics. Sifma and the Bond Dealers of America, which represents smaller brokerages, objected in comment letters to FINRA's initial plan for specified pools, which called for bonds to be identified by their CUSIPs. The groups said the information would reveal strategy shifts because unlike corporate debt, the individual bonds are often owned by only one holder. FINRA took into account those letters as well as separate conversations "primarily" with investment firms in deciding to adjust its approach, Persson said. Bonds will be described by their product type, amortization type, issuing agency, coupon, original maturity, weighted average coupon, weighted average maturity, weighted average loan age, average loan size, and original loan-to-value ratios, according to the SEC's notice.

"Decrease Liquidity"

"The people who were pushing for more transparency and information basically get everything they were looking for, but not at the expense of the privacy concerns of individual investors," said Bryan Whalen, co-head of mortgage bonds at Los Angeles-based TCW. Trace'market-level disclosures already have made it harder to trade big blocks of debt as dealers grow wary that their positions are exposed, said Scott Simon, Pimco'mortgage head. The Newport Beach, California-based firm's customers could be hurt further if CUSIP-level reporting revealed when it'trying to buy or sell specific types of securities, he said. "While all of this is designed to increase liquidity and transparency, it may increase transparency and decrease liquidity," Simon said. Sifma is also satisfied, Chris Killian, a managing director in New York, said in a telephone interview. FINRA'approach means that investors won't always be able to identify which characteristics of bonds are feeding into their prices, said David Land, a mortgage-bond manager at Advantus Capital Management Inc. For example, the initial list doesn't include whether the underlying loans are all from a certain state, which can command premium pricing, he said.

"Good Start"

"This is a really good start," especially if FINRA makes good on a pledge to revisit the descriptions of bonds, said Land, whose St. Paul, Minnesota-based oversees about $24 billion. FINRA will continue to consider dissemination of trading data for so-called collateralized mortgage obligations and asset-backed securities, Persson said. That debt accounts for the roughly 7 percent of volume in the structured-finance market not tied to agency pass-through mortgage bonds, he said. "It's important to advance transparency but we want to find a model that fits the more complex nature of these instruments," he said, declining to offer a timeline for further actions. Persson signaled FINRA is concerned that revealing too much information about the rest of market may confuse investors. Because of the diversity among structured bonds that appear similar, it can be misleading to try to extrapolate the value of different bonds based on reported trades, he said.

"Informed Decisions"

FINRA should be moving more quickly and release all of the information it's been collecting on securitized-debt trades, said Joseph Fichera, chief executive officer of New York-based financial advisory firm Saber Partners LLC.

Certain large investors are probably focusing less on the benefits of transparency and more on the risk of their strategies being exposed because they dominate some CUSIPS and have more information without help from Trace, he said.

"How is it better for investors to have an opaque, dark market versus a transparent market where they can make more informed decisions?" said Fichera, who proposed in 2007 that Trace be brought to mortgage bonds. "Transparency levels the playing field."

Investors in securitized debt aside from government-backed mortgage bonds may be more open to CUSIP-level disclosures, said Chris Hentemann, chief investment officer at New York-based hedge fund 400 Capital Management LLC. Strategies of betting against specific securities are less common in those markets, leaving them less at risk of traders attempting to force their hands, he said.

"Hot Button"

"Price transparency would be helpful, and there's less of a threat you can squeeze a particular issue" in those markets, said Hentemann, also a former head of global structured products at Bank of America' securities unit. More public information about the prices at which mortgage bonds without government backing trade could help the market draw investors and boost values, said Brad Friedlander, head portfolio manager at Atlanta-based Angel Oak Capital Partners. While the difficulty valuing the securities during the crisis is "a stigma that's probably not true at this point," it's certainly a hot button issue" among potential investors such as endowments and pension funds, he said. FINRA should err on the side of greater disclosure and only avoid publishing information for "good reasons," said Friedlander, who oversees private pools of capital and a $324 million mutual fund that's returned 20.4 percent this year to beat 99 percent of peers, according to Bloomberg data.

For Related News and Information: Structured-finance calendar: MCAL CMO issuance: ICMO Credit markets top page: TOP CM Bloomberg Valuation example: GNR 09-106 MS BVAL Credit markets top page: TOP CM Mortgage columns: NI MTGCOL

--With assistance from Charles Mead, John Parry and Sarika Gangar in New York. Editors: Alan Goldstein, Robert Burgess

To contact the reporter on this story: Jody Shenn in New York at +1-212-617-2380 or jshenn@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at +1-212-617-6186 or agoldstein5@bloomberg.net