There was even a rating agency, the Kroll Bond Rating Agency which gave this particular pool an investment grade rating. According to the Wall Street Journal, " (Kroll) said the securities are structured so that half the loans in the pool could default and all the bonds still would be repaid, while the lending company absorbs the losses. The high interest rates on the loans are expected to cover any losses from people defaulting." Through February, approximately 12% of these loans (as well as those of another company called Exeter) were 30 days past due and 1/3 were more than 60 days.

Transparency, Provenance and What A Distributed Ledger Would Look Like

In a previous blog post on subprime mortgages I explained why using a distributed ledger would have helped deter the crisis. I also described data provenance and why I thought it made sense for asset backed securities. In this post I am going to go a step further and describe who I think needs to be a part of the supply chain in order to make a distributed ledger a robust solution for the problems of lack of transparency and tracking audit trails. I will also go through the process of what a typical asset backed transaction looks like and why being able to track and monitor it is necessary for establishing proper audit trails of the supply chain and increases transparency. Transparency is a very good thing.

In order for provenance to work really well, getting the entire ecosystem to agree to protocols and standards (Identity and who can read/write/view) is very important. Also getting all the players on the ledger is necessary so let's map out who needs to be the nodes (in no particular order):

Auto finance companies- (giving loans to people who may or may not be credit worthy)

Banks

Underwriters- selected by the seller to purchase the ABS and resell them to investors. They are supposed to perform due diligence on the assets and the structure of the transaction and confirm that the prospectus and other documentation are accurate. Once they sell, they don't have any more interaction with, or interest in, the transaction.

Lawyers- part of the above process.

Rating Agencies

Private Investors and other Transaction Participants- (those who buy the ABS's from the sellers and can re-sell them)

Servicers- perform duties that are stipulated in the servicing agreement for the transaction investors. Servicers take a fee for performing these obligations. They typically collect all income from the assets, enforce the assets as needed and may perform any evaluations needed to substitute assets. Servicer reports to the security holders information on collections and how the assets are performing. This helps determine the payment streams or losses to investors. Servicers evaluate and approve loan modifications, short sales and other default strategies to mitigate losses. It also takes control in the case of foreclosures to undertake actions in the trustee's name. (The seller and the servicer have more knowledge of the transaction than any other participants.)

Trustees- applies funds delivered and instructed by the servicer and provided in the transaction documents to pay interest and principal on securities, to fund reserve accounts and purchases of additional assets. Trustees act as Asset Custodians, analytics providers and paying agent.

Seller- (the party that sells the ABS)

Independent Accountants

Regulators

A Typical Asset Backed Security Transaction

A seller transfers assets in 2 ways: A trustee receives pass through certificates that show ownership interests in the assets or a Special Purpose Vehicle (SPV) is created. Seller of the assets can sell them through an SPV directly or through underwriters to investors. A pooling and service agreement or something similar forms the basic document which sets forth the relationships between the parties and the assets. (a very long, hard to understand document) The seller along with underwriters and/or private investors, determines the structure, drafts the documents and prices the transaction. The seller selects other participants for the deal including the underwriter, servicer and trustee. (Note: at the beginning of the transaction the seller knows more than any other participant about the assets and the structure of the transaction). Major transparency issues here. Based on agreement type the seller generally has continuing obligations for the pools of assets, such as adding or replacing assets if they drop below certain value thresholds. At other times, they have no obligation and the next party to own them can be the one to perform these functions. (This is where chain of custody (provenance) can become very confusing as assets move in and out of the pool and the tranches in the pool. Not to mention in some of the tranches it is only pieces of an asset that are bundled together, while other pieces of that same asset may be pooled elsewhere.) Over time the securities will change hands as well as what is inside of the pool of assets. So will the credit ratings of these assets.

Following the financial crisis, Regulation AB was strengthened and enhanced to protect investors. This rule sets out to make disclosure requirements, reporting and registration more transparent. While it has been a good step forward, the rule still falls short. Using a distributed ledger for asset backed securities will increase transparency for all parties in the ecosystem.

Distributed Ledgers for Asset Backed Securities

Some of the problems with ABS do not need a distributed ledger to solve them. One example is the long and tedious, hard to read documentation around the transaction. That can be done using artificial intelligence or programmatic algorithms that make sure key terms and conditions are in the documentation. However if this data gets stored on the ledger, it could make for a robust system, especially when certain thresholds are breached things fall out of line or assets are added/removed. If anything in the initial documentation changes or in the original pool of assets (as it changes hands) it will be known by everyone on the ledger at the same time as a message is sent to all the nodes. Think "smart contracts". Another thing which can help is a commitment by all parties to digitization of all records, titles and deeds.

What a distributed ledger could be used for are the things that continue to be a problem for all those involved in a transaction including:

asymmetric information : the sellers, servicers & trustees hold more information about the transaction than any of the other participants in the transaction.

: the sellers, servicers & trustees hold more information about the transaction than any of the other participants in the transaction. trust - based on the above statement, a distributed ledger allows for parties who don't trust each other to make transactions (this includes the rating agencies who were one of the main culprits of the last crisis) and this allows for creating;

- based on the above statement, a distributed ledger allows for parties who don't trust each other to make transactions (this includes the rating agencies who were one of the main culprits of the last crisis) and this allows for creating; real-time audit trails - knowing and tracking exactly what is added to the pools and removed as well as a chain of custody of the ABS changing hands in addition to changing what is in the tranches and pools as it goes from investor to investor. This eventually will lead to

- knowing and tracking exactly what is added to the pools and removed as well as a chain of custody of the ABS changing hands in addition to changing what is in the tranches and pools as it goes from investor to investor. This eventually will lead to disintermediation- of many of the duties of the middlemen involved in the transaction. Particularly servicers, trustees and the rating agencies. A lot of fees change hands for their services. Allowing for much of this work to be put into smart contracts with digital signatures and setting up escrow accounts disintermediates a lot of the obligations of these trusted 3rd parties.

After some time a large amount of real-time data will be generated. This will lead to new ways of modeling credit and risk. This creates views of real time actions and transactions of all the actors involved. In fact, real time modeling can lead to extrapolating out into the future many risks with far more accuracy. Right now most of this data is backward looking, particularly when it comes to credit ratings, defaults and delinquencies. This also applies to data around the borrowers (the poor fool taking out these loans) and their rates of delinquency and default.

Risk changes very fast and real time views of that risk are needed to make proper adjustments particularly when thresholds of defaults and delinquencies fall outside of what was modeled. Finding out weeks and months later only exacerbates a bad situation and allows contagion to spread by keeping credit standards very loose. As a result of using a distributed ledger, ratings agencies can be displaced since a real-time virtual credit bureau can be established between all parties.

The Role of the Trustee Can Be Replaced

In a report entitled "The Trustee's Role In Asset Backed Securities", the role of the trustee is describe as follows:

"In many asset-backed securities transactions, the document may not contemplate any direct check on the performance of the seller or the servicer. Transaction documents virtually never give the trustee any substantive oversight of the seller or the servicer and their activities other than to confirm the timely receipt by the trustee of certain remittances and reports from the servicer, including reports of independent accountants, and certifications in the forms required by the transaction documents. Additional oversight is not explicitly required of trustees and would necessarily be limited to matters that are readily ascertainable and verifiable on a cost and time sensitive basis. Importantly, the trustee typically has no duty under the transaction documents to make investigations on its own for the purpose of detecting defaults, fraud or other breaches. If the servicer becomes insolvent or unable to perform, the trustee may be responsible under the transaction documents for the appointment of a successor servicer. Some transaction documents contain specific provisions relating to ―back-up‖ servicing, i.e., appointing a specified successor servicer from the outset to take over servicing when succession becomes necessary. These provisions range from ―cold‖ back-up servicing, where the trustee agrees in the transaction documents to become the successor servicer (a servicer of last resort) unless another entity (appointed by the trustee when needed) accepts such appointment, to ―hot‖ back-up servicing, where a successor servicer named in the transaction documents agrees to maintain back-up files throughout the transaction. In transactions where the trustee accepts the role of back-up servicer, the trustee typically relies upon arrangements with servicing units within its own institution or with third party providers to pre-arrange succession.

The trustee is not, however, expected to determine that a security interest of such quality has been established or that a ―true sale‖ transfer has occurred. Instead, the trustee is authorized by the transaction documents to rely upon legal opinions or other evidence to establish at closing that what it has been granted conforms to the documents. The trustee is also authorized to rely on future opinions and instructions from others (usually the servicer or the seller) to establish that the assets are being maintained so as to preserve the trustee’s interests in the assets in accordance with the transaction documents.

The trustee may be obligated under the transaction documents to determine from time to time that the aggregate value of the assets bears a prescribed ratio to the amount of the debt outstanding or to perform other analytics on the assets. The documents set forth precise valuation procedures and indices and other methods of valuation and authorize the trustee to rely upon specific sources of information. The trustee will instruct the seller or other responsible party to add assets if needed or may permit assets to be withdrawn if the amount held exceeds requirements. In each case the trustee has authority to rely on specified information as to the value and ownership of assets being added or withdrawn. The trustee may also require the substitution of new conforming assets for existing assets that have ceased to conform to the asset requirements for the transaction upon receiving notice of such failure to conform. Usually the seller or servicer will effect the substitution. The trustee will be authorized to rely upon their representations that the substitute assets meet transaction requirements. In certain transactions there is a constant or periodic flow of assets through the trustee’s custody or security interest."

Does this sound necessary to you if a distributed ledger is being used along with smart contracts between the counterparties of transactions? Breaking it down by paragraph:

Paragraph 1: No additional oversight would be needed as each node will have the same information and data and can make decisions based on that without relying on other parties to provide such information. Additionally, this information will be available on a real-time basis and synchronized so everyone has a "golden record of truth". Direct checks can be made implicitly by being on a ledger and malicious actors can be prosecuted for acts of fraud and breaching the rules and regulations set up. This will also make all parties act in a different way since their identities will be known as well as their actions. It will cause malicious actors to think twice before committing such acts. Permissions management can be set up to appoint the entities responsible for replacing certain parties on the ledger. There will be no need for backup files also as they will live in the cloud based ledger and can be stored in each parties nodes if necessary.

Paragraph 2: No need for trustee to tell anyone if a true sale has happened. Once it occurs everyone will have the ability to view the records for themselves and determine if this is true.

"Instead, the trustee is authorized by the transaction documents to rely upon legal opinions or other evidence to establish at closing that what it has been granted conforms to the documents." Not if smart contracts are put into place. The same goes for relying on future instructions that the assets are being maintained in the transaction documents. This can be done in real time, and changed, as risk changes.

Paragraph 3: "The trustee may be obligated under the transaction documents to determine from time to time that the aggregate value of the assets bears a prescribed ratio to the amount of the debt outstanding or to perform other analytics on the assets. The documents set forth precise valuation procedures and indices and other methods of valuation and authorize the trustee to rely upon specific sources of information." Nope. This information will not be valuable on a ledger as it is backward looking. This can all be modeled in real time as these changes happen. For the regulators this will be invaluable information from a credit risk, systemic risk and economic risk standpoint.

"The trustee may also require the substitution of new conforming assets for existing assets that have ceased to conform to the asset requirements for the transaction upon receiving notice of such failure to conform. Usually the seller or servicer will effect the substitution. The trustee will be authorized to rely upon their representations that the substitute assets meet transaction requirements. In certain transactions there is a constant or periodic flow of assets through the trustee’s custody or security interest." Absolutely no transparency here and this is where a huge amount of risk comes in as the system exists today. This can not be allowed to continue as this imposes huge risks to the entire asset backed securities market.

In order for trust and transparency to be restored in the financial system, use cases like this need to be created and implemented to avoid fraud and financial disaster. For all parties involved in transactions where assets change hands and can be altered without the purview of all interested parties, distributed ledgers are an answer.