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Transparency is key to Liquidity in the Capital Markets

Liquidity is a word we now are hearing more often than ever before. From news reports to congressional testimonies to casual conversations, there is heightened awareness that liquidity is what the market needs to get the economy back on a path to growth and prosperity.

As the banking industry knows, however, liquidity is created when there is confidence in an efficient and transparent market. When the housing boom officially went bust in 2007 and the credit markets collapsed in the fall of 2008, market players did not have the available tools to accurately value whole loan and asset-backed securities (ABS) portfolios. The results of this were that; buyers and sellers became paralysed, market confidence evaporated, and liquidity virtually disappeared.

The US government’s launch of the Term Asset-Backed Securities Loan Facility (TALF) and Public Private Investment Partnership (PPIP) programs is designed to revive the securitisation markets by supporting new issuance and unclogging toxic assets from banks’ balance sheets. While the government will assume a substantial share of credit risk for both of these programs in the short term, liquidity will not return in the long term without additional transparency to accurately price and track changes in underlying asset risk for the ABS markets.

Although ABS values depend on the anticipated cash flow from borrowers making payments on underlying loans, until now the market has relied primarily upon security-level information and credit agency ratings for valuation and pricing. Current valuations are not taking into account dynamic consumer information, and the differences among securities can be significant. Two residential mortgage-backed securities with nearly identical current market prices can have vastly different loss projections based on the changes in credit behavior of the underlying consumers.

Dynamic consumer credit information, including payment history on the underlying asset, delinquencies on nonmortgage obligations and credit card utilisation, can be holistically evaluated to help predict prepayment and default probabilities at the aggregated security and pool levels. More importantly, consumer credit data can be applied to securities on a monthly, weekly and even daily basis to provide insights into current ABS values.

For example, Experian took an actual ABS with multiple tranche ratings and linked the underlying assets to consumer data for analysis. By merely determining the average VantageScore® (a credit risk score developed by Experian, Equifax and TransUnion) for consumers paying obligations on the underlying assets of the ABS and comparing those scores to the security’s tranche ratings in the same period (Q1 2005 to Q3 2008), Experian found that the decline in the VantageScore preceded a decline in ratings by two years. In addition, the probability of default on the security as measured by a VantageScore analysis on all the underlying consumers worsened by 30 percent between Q1 2005 and Q4 2005.

An analysis of underlying consumer behavior would have provided an early warning of significant credit deterioration in the security and given holders the ability to make prudent credit risk-management and hedging decisions in a more timely fashion. Instead, it was two years later that the rating agencies suddenly downgraded this ABS from investment-grade to junk status, creating the type of market disruption that occurs when investors work desperately to sell assets. Essentially, this reflects a loss of confidence in the markets and the subsequent evaporation of liquidity.

If the case for utilising underlying consumer transparency is compelling, how can the markets begin to incorporate easily accessible, secure and dynamic data into the valuation process?

Initially, the federal government can mandate the use of dynamic consumer credit information in both the TALF and PPIP programs and establish its usage as a market standard. By incorporating consumer data and analytics into the structuring and pricing of ABS issues, issuers can more effectively price securities, and the government will be assured greater accountability in the deployment of taxpayer funds. Perhaps most important for the longer term, investors will be given the lens they need to make accurate ABS valuations.

The 2008 financial crisis will not be forgotten soon, nor should its lessons. We have learned that greater transparency provided by consumer data and analytics is essential for the health of the structured finance markets. The result is renewed investor confidence, the return of liquidity and, ultimately, enhanced credit flow to consumers and small businesses — the very backbone of the American economy. By focusing on transparency, we all benefit.

Kerry Williams
Group President
Credit Services and Decision Analytics
Experian

American Banker, 8th May 2009

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