The complexity of asset-backed securities (ABS) and collateralized-mortgage obligations (CMOs) has played a major role in Wall Street's current difficulties valuing the assets, and it has also created processing complexities resulting in operational and potential reputation risks as well as millions of dollars in unnecessary costs.
The Depository Trust & Clearing Corp., which processes the vast majority of securities transactions in the U.S., outlined these issues in a recently published third installment of white papers about the growing problem of processing structured transactions. The white paper also describes a series of steps the New York-based industry utility is taking-some requiring Securities and Exchange Commission approval-to limit problematic transactions. One of those steps could significantly hike up processing fees for the transactions' underwriters.
James Balbo, a managing director at DTCC, who along with vice president Peter Gleeson wrote the white paper titled "Transforming Structured Securities Processing," described the deals' top complicating factor as "having many hands in the pie," followed by the way they are structured.
A full 14.9% of existing CMO and ABS issues fail to have their rate information delivered to the DTCC prior to the payable dates established in the contracts between the DTCC, issuers and paying agents. That disrupts the DTCC's timely credits or payments to investors holding the securities. As a result, the DTCC adjusted 7,502 payments in 2006, or 0.56% of the total. Balbo noted that the percentage of adjustments remained nearly the same from the year before, but the number of adjustments jumped 40% because the market for those securities has grown so fast. "It's the same percentage of a bigger pie, but more and more issues are getting into trouble, so it's leading to more payment problems overall," Balbo said.
That creates headaches for investors in ABS and CMOs. When payments from the DTCC arrive one or more days late, they can miss out on the float and experience cash flow problems. A paying agent paying an incorrectly low rate results in obvious problems, especially if the investor has already invested the money anticipated to arrive elsewhere. The DTCC also found an inconsistent approach to dealing with overpayments. Balbo said broker-dealers, with their reputations in mind, may be hesitant to seek repayments from customers who were paid too much, and so simply write off those overpayments.
"From the broker-dealer side, you have to have additional staff doing processing and reconciliation, working nights, to make sure everything is correct. The same is true for the DTCC," Balbo said.
Balbo added that the DTCC was unable to estimate the industry costs stemming from late and incorrect payments, but based on its own history it has extrapolated 2008 costs to DTCC participants holding the securities will reach $15 million. "That would be a small fraction of the overall costs," Balbo said.
Given that the DTCC's payable adjustment rate for all other issue types it processed in 2006 was 0.16%, or less than a third the rate for ABS and CMOs, the processing utility has decided to take steps to lessen the damage. That may not be easy. Brad Bailey, an analyst at Boston-based Aite Group, a consultancy to the securities industry, noted that in light of the instruments' complexity, "It's unsurprising you would have more adjustments."
The structured-products market's phenomenal growth in recent years, however, may make improved processing a necessity. Bailey noted that European companies and even retail investors are increasingly investing in structured products. And for the structured-products market to continue its growth in the U.S.-especially given recent concerns around valuing the instruments-improved processing is important. "To help the market go to another level, it would help to have the proper infrastructure in place, so people feel comfortable looking at these investments and they're not concerned about payment mismatches or incorrect operational functions," Bailey said.
Carrots and Sticks
To move in that direction, the DTCC is proposing both carrots and sticks. On the carrot side, the industry utility is extending the deadline to submit payment rate information the day prior to the payable date, rather than two to five days prior. The processor is also extending its cut-off times on those days to 11:30 p.m. from the current 7 p.m., and Balbo said the firm is considering giving West Coast firms until 1 a.m. Pacific time.
On the stick side, the DTCC is creating conforming and nonconforming categories for the securities. The DTCC, along with a working group of industry participants and trade groups, determined that a subset of structured securities hold features, such as swaps, caps and corridors, likely will never permit paying agents to deliver rates on time. In order to distribute structured securities through the DTCC, both the paying agent and managing underwriter will be required to attest to being able to comply with their operational agreements with the utility. That means reviewing each Cusip, or the specific underwritten security, in the issuance and determining whether it contains features that will prohibit the servicers and agents from submitting timely rate information. Paying agents will then be asked to sign a written statement indicating the reason for non-compliance.
If the managing underwriter agrees with the statement, it will be assessed a new fee by the DTCC. "It is the DTCC's belief that the exception processing fee should be assessed not to the processing entities in the chain but added as a new underwriting fee, since it is the underwriter community that produces" the nonconforming operational-agreement issues, the white paper notes.
Today, the DTCC assesses securities underwriters a base cost of $415, and close to $1,500 for underwriters who don't deliver rate information in a timely matter," Balbo said. The DTCC estimates the new fee in 2008-based on the costs to investment managers holding the securities on behalf of customers-will be $4,200 per Cusip, and an ABS or CMO issuance can have many Cusips.
"The purpose of this is to raise awareness, so that hopefully fewer of these nonconforming securities types are created," Balbo said, adding, "We should be able to lower our costs, participants will see lower costs, and there will be higher investor satisfaction.
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