TODAY THE SECONDARY MORTGAGE MARKET is facing growing pressure to provide greater transparency to investors.
One of the most telling signs of the new transparency era is the proposed Shays Markey bill in Congress, which would require all of Fannie Mae's and Freddie Mac's securities--including debt and mortgage-backed securities (MBS)--to be registered. With the two agencies' outstanding MBS issuance at nearly $2 trillion, according to the Congressional Budget Office (CBO), such a move would bring an unprecedented level of transparency to the market's bellwether issuers.
What's more, the financial markets have seen a spate of new requirements aimed at heightening overall financial transparency. The Sarbanes-Oxley Act of 2002 requires the inclusion of off balance-sheet transactions, among a host of new disclosures. In 2001, the Financial Accounting Standard Board (FASB) issued FAS 140, which aimed to improve the valuation of residual income resulting from securitization.
Another target of FAS 140 was major mortgage servicers, many of whom have had to take impairment charges on their servicing portfolios, prompted by falling rates and accelerated prepayments that cut into servicing fees.
In today's landscape, issuers that embrace disclosure stand to reap the benefits of lower funding costs, while demonstrating industry leadership in adopting best practices. Issuers slow to adopt more disclosure are seeing their funding options dwindle, thanks to a tiering of the market. Issuers with robust investor reporting can regularly tap the securitization market, issuing deals under their own shelf registrations. However, firms with poor disclosure are increasingly finding their only funding options to be whole-loan sales to agencies or Wall Street dealers.
The move toward more transparency in the MBS market can be seen as part of a trend to raise transparency across America's financial markets that started a decade ago.
Lessons from the past
The Orange County, California, derivatives debacle in 1994 is perhaps the first documented case of how derivative securities can obscure huge financial risks. (A securitization is a derivative transaction on a number of levels--the securitization tranches themselves are derived from the performance of the underlying loans, and many issuers include swaps, options and clean-up calls, only adding to the complexity of analysis.)
The problem Orange County experienced was derivatives held by its highly leveraged pension fund started to implode when interest rates spiked upward that year. With the pension fund facing staggering losses of $1.6 billion, the county was ultimately forced into bankruptcy.
In the late 1990s, Ann Arbor, Michigan--based lender Greentree Financial Corporation ran into trouble over the accounting for the residual income in its securitization deals. Following Greentree's $6 billion acquisition by Indianapolis-based insurer Conseco Finance Corporation in 1998, it came to light that the lender had used highly aggressive accounting in its booking of residual income--the monthly income that an issuer earns in a securitization after other parties, such as the trustee and investors, are paid. Greentree had misjudged the impact on residual income of prepayments and defaults of its underlying loans, which led to a $500 million write-off.
Fast-forward to 2002, and a handful of high-profile deal blow-ups put transparency of asset backed securities (ABS) in the news again. In February, Fort Worth, Texas-based auto lender AmeriCredit Corporation is forced to restate its earnings to reflect an additional $17 million in write-downs. And in October last year, Indianapolis-based Union Acceptance Corporation, another auto lender, declares bankruptcy after taking a residual write-down that resulted in a $30 million charge.
In 2003, Freddie Mac's accounting travails make the headlines. In May, the corporation announces it will restate its earnings for three years by several billion dollars when it is revealed that derivatives on Freddie Mac's books were improperly valued. …