As mentioned in an earlier article, rating agencies have taken a huge hit to their reputations because they have been very slow to react to the market and have been outright wrong about their "opinions" as to ratings. So if there is so much dependency that financial institutions have soldered into the rating agencies disclaimed opinions (see how little they trust even themselves), what else can be done to come up with better and more timely quotes for market participants. There's been a lot of press relating to how UN-transparent the market in ABS and mortgage backed securities has been and how this has contributed to the problem. Today's rant is not so much of a rant as a series of things that can be done to provide varying degrees of market transparency and thereby add liquidity to the business of offering prices for ABS securities:
1. Use the CDS on ABS market as a proxy for quotes on cash. Sure, there will be some "basis" (difference between the quotes on ABS CDS and the underlying quotes on cash instruments), but as in the Corporate Bond market, CDS quotes go a very long way to giving one and all a pretty good feel for what the market perceives is the riskiness of these securities. The CDS market is so far ahead of the rating agencies as an indicator as to make the rating agencies almost "redundant" (I'm using the British meaning of the word here). In fact they're so bad, I'd be hesitant to even include them at all, except as perhaps the very "tip of the iceberg" with a big warning sign all over it: "use at risk to your own investment health."
2. Additionally, use the ABX Index market as a secondary proxy. If there are no quotes available for the "single name CDA on ABS" from 1 above, then it's quite possible to find the ABX tranche that the specific bond is "most like" and use that as an approximation of the price. See http://www.markit.com/ for more information on ABX pricing.
3. Use actual trade prices. For all corporate bond trades in the US, it is required that no more than fifteen minutes after a trade, it be entered into the NASD TRACE (trade reporting and compliance engine) system. The counterparties to the trades are anonymous, but you can see the date and time of the trade, the price, the yield and most sizes of transactions. Make it a requirement that all ABS trades (and even ABX trades) be entered into TRACE and published broadly. Just this step alone would increase transparency greatly.
4. Make it a requirement for all dealers to submit daily indicative pricing for all Cusips that they have traded within the last 6-12 months. These need not be "firm" prices, but should obviously be as real as possible and as close to where a firm would trade if required. If all dealers were required to submit pricing daily, then the "bad prices" would be able to be weeded out. Each dealer can be "scored" in some way so as to ascertain the general quality of its routine pricing and these scoring tables could also be kept up to date. Again, http://www.markit.com/ would be an obvious candidate for managing something like this as they're already the "arbiter" for ABX products as well as, to a lesser extent, single name CDS on ABS.
5. To continue further along the "transparency curve", given a dealer, in the absence of known marks from the first three sources above, should be able to search through its database of "bid lists" and "color" data. Doing this for a single bond or retrieving the data for comparable bonds can go far towards assisting with working out what the price should be. This, of course, assumes that each trading desk has had the foresight to actually create and maintain a database of quotes and color historically. I've seen some where the primary source of bid list and related histories are gigantic Excel spreadsheets. These do function, but are very difficult to share amongst the participants of an individual trading desk. Better yet is to provide simple programs for dealing desks to save their quotes away to a real database for use by whoever is permissioned to see those quotes. If you don't have a database already, you're basically still in grade school at this point.
6. Use Bloomberg. Bloomberg has got several very useful functions to assist in calculating price based on spread and vice versa. If a firm doesn't want to commit to a single price/yield, then give a range of prices and yields to as to give at least an idea of price. To make this more detailed, the more information that is given will result in higher quality prices for example, if the CPR rate was disclosed along with the quote. Attribution should be given to indicate that the pricing comes from Bloomberg.
7. Use Intex. Intex has an "applications programmer's interface" which can be utilized to produce a wide range of complex scenarios. Some of the ways these can be analyzed are as follows:
-CPR's
-CDR's
-Loss Severities
-Collateral can be "bucketed-up" into various groupings such as "Fixed", "ARM" and further into "2/28", "3/27" and further still with "2/28 with a 2 year preempt penalty", etc. Each of these collateral groupings can have separate CPR, CDR and Loss Severity curves applied to them.
-Interest Rate stresses
Creating standard ways of stressing the above and providing matrixes of results for "Px/Yield" tables could go far towards assisting with determining the variability of any given bond to a wide variety of scenarios. The Intex API is quite complex but with some effort and education, the above can be made into a valid means of providing quotes to clients and to the public. Bottom line is that the above presents a fairly wide range of options for giving quotes in the market place. To the degree all of them are used determines the quality of any single dealer. The dealers should be scored according to their ability to not only do the above, but publish the above with the necessary information for other market participants to see how the results were arrived at. So what's all this about lack of transparency? With the above raft of solutions things should get quite a bit clearer. Let's hope it's not too late.
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Jack Broad is the CEO of Thetica, LLC. Thetica's ABS Trader Tools allows you to price bonds faster and easier. You can analyze data across many deals at once, from multiple vendors and run many scenarios at the same time with rapid results. Integrated into your own systems for easy and fast customizable access to the data you need.
Source: www.theticasystems.com
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