The Securities and Exchange Commission has been assailed over the past few years for its failures. It didn't catch the deep problems at some of the investment banks that collapsed. It also missed a few instances of significant fraud, most notably Bernie Madoff's Ponzi scheme. But when the agency does get something right, it deserves credit. One part of its proposed rules for securitization (.pdf) is particularly smart: the SEC suggests requiring issuers to disclose an open source computer program that models each new asset- or mortgage-backed security. This is a great idea.
This computer program would essentially provide certainty to investors about how a deal works and make it easier to evaluate. Some of these deals can be very complicated, and sometimes how the bond payments would work is not crystal clear. But this computer program would make deals more transparent. There won't be any debate about how to create the model through which the assets would pass through to produce cash flows for the asset-backed bonds.
Why It's Good
There are several reasons why this is such a good idea:
First of all, supplying a computer model for investors to evaluate a deal would provide much greater transparency. As mentioned, they wouldn't need to wonder if they were interpreting the prospectus correctly. Any complaints that banks were purposely trying to create overly complex structures to mislead investors would be eliminated. There could be no confusion about how the deal works.
Keep Complexity In Check
On that note, banks would have an incentive to keep deals relatively simple. There really should never be a deal created that can't be modeled through a computer program -- because then you wouldn't be able to price it in the first place. But this proposal would ensure that no such deal could ever exist, because the proof that it can be modeled must be provided.
A More Efficient Market
If investors are provided a computer program as suggested, then the market would be more efficient. Now investors wouldn't have to take the time or spend the money to model these deals themselves, but could just feed their assumptions into the software provided by the issuer and create various scenarios. This means that a deal can be executed quickly.
Reduces Reliance on Rating Agencies
Finally, the rating agencies' role would be muted. Sure, they might still assign ratings, but if each investor -- no matter how big, small, or sophisticated -- could easily see how the deal would perform under various economic shocks, then it could use its own analysis as its primary reason for buying a bond. It would no longer need to use the rating agency's analysis as a crutch.
Of course, no idea is perfect. And some issuers aren't thrilled with this proposal. Here are some objections:
A Burden on the Banks
Ultimately, the quant guys at the investment banks -- not the issuers -- do most of the heavy lifting to create these computer models. As a result, some may complain that this creates a heavy burden in terms of needing to allocate additional resources to create a computer program. This is, no doubt, true. But this extra work can (and would) just be built into the fee structure of the deal. After all, if this is what the industry needs to provide greater transparency, then that additional fee helps to more accurately reflect the true cost of issuing complex securities.
Too Hard To Do
Some issuers could complain that creating a computer program is too hard to do. But that's rubbish. If they don't understand computer programming well enough, then they could contract with a software designer. Surely, they must understand their deal structures well enough to explain to a computer programmer how to model them. Again, any additional burden can just be reflected in higher fees.
To demonstrate that such models aren't, in fact, too hard to create, Bank of New York Mellon put a free sample online. You can download its program here, and watch a few videos explaining how to use it. I tried it, and it appears to work quite well.
Reveals Their Secret Recipe
Another seemingly ridiculous complaint, but likely a very real concern for some bankers that they would only whisper, is that a computer program might provide a little too much disclosure. There may be some on Wall Street who don't want others to fully understand how their deals work. They may believe the complexity of their deals gives them a competitive advantage. If they understand the deals better than investors, then they will likely make more money -- much to those investors' dismay. Obviously, this is not a legitimate concern in the context of wanting to create a safe, robust market for bonds based on consumer debt and other assets. Deals shouldn't be tricky or overly-complex if issuers really intend to use these securities as a legitimate means to obtain more funding.
Unreasonable Liability Criterion
There is, however, one legitimate concern. As currently written, the SEC wishes to hold issuers responsible for any errors in the computer program. This is not a reasonable liability criterion. Perfection in coding has probably never been achieved in a relatively complicated computer program. Computer code commonly has unintended bugs. Issuers can't be held responsible for that, but should instead be held responsible for the program depicting their model as accurately as possible. But if the software itself has flaws, then that should be taken up with a third party vendor that provides the software infrastructure, under the usual sorts of precedent that govern liability stemming from imperfect computer programs. This worry is easily fixable if the SEC tweaks its proposal, however.
Ever since the financial crisis hit, investors lost a great deal of confidence in mortgage- and asset-backed securities. MBS, in particular, have yet to recover, nearly two years later. This regulation could actually help to inspire renewed confidence in the industry. If investors can suddenly create their own scenarios utilizing their own assumptions with a few keystrokes through a computer program provided by issuers, then they will likely become a lot more comfortable buying asset-backed bonds. The SEC's rule would also result in a vast library of publicly available models for the market to use to better understand securitization. The potential this proposal has to jump-start the market is arguably reason enough to adopt it. After all, a little more work for issuers is a small price to pay to reinvigorate an industry so vital to the U.S. economy.
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