Hiding behind Writing: Communication in the Offering
Process of Mortgage-Backed Securities
Harold H. Zhang, Feng Zhao, Xiaofei Zhao
University of Texas at Dallas
Second Annual Conference on Financial Market Regulation
May 1, 2015
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
The agenda
Focus on a very important part of the supply-chain for the mortgage securitization
– the offering process
What we do
Analyze written documents in the offering process of private-label RMBS
I
Data – written documents in the offering process from SEC EDGAR
Security Offering Reform in Dec. 2005 made it possible to collect them
I
Empirical strategy – textual analysis
More intensive written communications, especially textual ones (as opposed to
numbers) ⇒ Higher losses of underlying loan pool
These written communications, in the pre-issuance period ⇒ More ambiguous
words in final deal prospectus supplement
A tactic of hedging litigation risk after information withholding in the issuing
process – an indication of hiding behind writing
⇒ Evidence consistent with information withholding of RMBS issuers
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
2 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Motivation
I
Security offering process has been studied in the context of equity IPO
In particular, some papers have tried to understand the impact of offering
document content in IPOs, such as Hanley and Hoberg (2010, 2012), Loughran
and McDonald (2013), etc.
I
Not much has been done for written communications/documents in RMBS
offering process
Many papers on RMBS focus on other important issues in this market: Mian
and Sufi (2009); Nadauld and Sherlund (2009); Keys, Mukherjee, Seru, and Vig
(2010); Keys, Seru, and Vig (2012); Purnanandam (2011); Jiang, Nelson, and
Vytlacil (2014), among others.
I
RMBS/RMBS issuers differ from corporate securities/operating companies
“there is generally no business or management to describe in offering these
securities. Instead, information about the transaction structure and the quality
of the asset pool and servicing is often what is most important to investors.”
I
Information withholding could be an important issue in RMBS offering process
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
3 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Information withholding
I
Growing anecdotal evidence on information withholding in sales of RMBS
“In many ways, mortgage products such as RMBS were ground zero in the
financial crisis. Misrepresentations in connection with the creation and sale of
mortgage securities contributed greatly to the tremendous losses suffered by
investors once the U.S. housing market collapsed.”
Robert Khuzami, former Director of the SEC Enforcement Division and
Co-Chair of the President’s Financial Fraud Enforcement Task Force
RMBS Working Group
Some SEC cases listed in the appendix
I
RMBS provides a nice setting for testing information withholding tendency
Underlying asset value change is observable
Studies in corporate settings reply on stock price reactions to certain events to
infer (adverse) information withholding tendency (for example, Kothari, Shu,
and Wysocki (2009))
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
4 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Communications in RMBS offering process
I
Prior to Securities Offering Reform (SOR) in December 2005, term
sheets are widely used.
I
Post SOR, term sheets are formalized as FWPs and required to be
filed with the SEC.
An FWP, according to the Securities Exchange Commission, is “a
written communication that constitutes an offer to sell or a solicitation
of an offer to buy securities that are or will be the subject of a
registration statement.”
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
5 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Example of SEC filings
ABFC Asset-Backed Certificates, Series 2005-WMC1
ABFC 2006-OPT1 Trust
filetype
filedate
filetype
filedate
424B5
8-K
8-K
8-K
8-K/A
8-K
8-K
8-K/A
15-15D
10-K
8-K/A
9/30/2005
10/17/2005
11/3/2005
12/5/2005
12/20/2005
12/30/2005
1/5/2006
1/26/2006
1/27/2006
3/30/2006
11/13/2006
FWP
FWP
FWP
424B5
8-K
8-K
8-K
10-D
8-K
10-D
10-D
8/4/2006
8/7/2006
8/8/2006
8/10/2006
8/10/2006
8/25/2006
8/31/2006
9/8/2006
9/29/2006
10/5/2006
11/1/2006
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
6 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Hypothesis
I
Issuers’ legal counsels are cautious about using FWPs
“When feasible, issuers and underwriters should structure offering
communications in a form that does not subject a seller to potential
liability under section 12(a)(2) of the Securities Act and/or is not
required to be filed as a free writing prospectus...it is advisable to do so
rather than to disseminate similar information in the form of a free
writing prospectus...” (see page 2-91 of Arnholz and Gainor (2011)).
I
FWP usage may be related to low underlying loan pool quality either
due to the needs to promote the sales of RMBS or demand of
information from investors
Needs to promote sales or demand of information may be stronger
when loan pool quality is lower
RMBS issuers have incentives to hide some adverse information at the
same time to facilitate the sales of RMBS
I
Hypothesis: Ceteris paribus, more FWP usage in the RMBS offering
process is associated with worse mortgage pool performance because
of information withholding.
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
7 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Data
I
Sample consists of private-label RMBS deals that were issued between
2006 and 2007
Not many new deals starting from late 2007
I
Data on deal characteristics: Bloomberg
I
Data on FWPs and deal final prospectuses: EDGAR
Merge Bloomberg and EDGAR information by deal name
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
8 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Key variables
I
Variable for performance measure
Deal performance measure: the cumulative net loss rate measured as
the sum of all losses of principal suffered until December 2010 divided
by the total original balance of all mortgages
I
Variables for FWPs
No. of FWPs and Multiple FWP dummy
FWP content: number of numeric tokens and number of alphabet
tokens
I
Variables for final prospectus
Linguistic complexity
Total number of words in deal final prospectus
Total number of pages in deal final prospectus — alternative measure
Uncertain text
Percentage of uncertain words in deal final prospectus using Loughran
and McDonald (2011) aggregate uncertain words list
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
9 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Correlation matrix
Cumulative net loss
No. of FWPs
Multiple FWPs
FICO
LTV
Second lien
Adjustable rate mortgage
Low documentation
Negative amortization
Purchase loans
Single Family
Owner occupied
High reputation
Original collateral balance
No. of tranches
Zhang, Zhao, and Zhao (UT Dallas)
Cum. net loss
No. of FWPs
Multiple FWPs
1.00
0.41***
0.42***
-0.59***
0.51***
0.41***
0.38***
0.13***
0.06**
-0.04*
0.03
0.02
0.09***
0.21***
-0.12***
1.00
0.78***
-0.35***
0.27***
0.19***
0.15***
-0.03
-0.04*
-0.04*
0.17***
0.09***
0.14***
0.18***
-0.12***
1.00
-0.37***
0.28***
0.24***
0.17***
-0.08***
-0.06***
-0.05**
0.22***
0.12***
0.08***
0.15***
-0.17***
MBS Offering Communications
May 1, 2015
10 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Determinants of FWP Usage
FWP Usage = f (Deal characteristic variables + Fixed effects)
I
FWP Usage: Number of FWPs or Multiplicity of FWPs
I
In general, results consistent with the correlation table. Deals with
lower quality loans tend to use more FWPs (for example, lower FICO,
higher LTV ratio, etc).
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
11 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Empirical results on FWP and loan pool performance
1
Results 1, 2: link loan pool looses to FWP frequency and FWP
content
2
Results 3, 4: link FWP content to final prospectus content
3
Result 5: control for initial pricing variables
4
Result 6: matching sample analysis as robustness check
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
12 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
1/6: Cumulative net loss and FWP Usage
Cumulative net loss = α + β × FWP Usage
+ Deal characteristic variables
+Macro variables + Fixed effects.
I
We expect β to be positive
I
Fixed effects: Year and Lead underwriter fixed effects
I
Standard errors: Clustered by lead underwriter
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
13 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
1/6: Cumulative net loss and FWP Usage
No. of FWPs
1.75***
(11.60)
Multiple FWPs
Adj. R2
N
Deal characteristics
Macro variables
Lead underwriter FE
Year FE
I
0.313
1577
No
Yes
Yes
Yes
0.61***
(6.25)
6.30***
(7.87)
0.306
1577
No
Yes
Yes
Yes
0.688
1450
Yes
Yes
Yes
Yes
2.14***
(4.28)
0.687
1450
Yes
Yes
Yes
Yes
Deals with multiple FWPs have 2.14 percentage points higher losses
— average deal loss is 12 percent
I On deal characteristics: deals with lower loan quality also have higher losses (such as
lower FICO score, higher LTV ratio, more loans with low documentation, second lien, etc)
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
14 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
FWP content
I
Classify FWPs into two types: loantape FWP and textual FWP
Content characteristics of Loantape FWP
No. of alphabet tokens
No. of numeric tokens
Alphabet-number ratio
Mean
St. Dev.
379,006
820,367
0.50
376,664
670,928
0.38
Content characteristics of Textual FWP
No. of alphabet tokens
No. of numeric tokens
Alphabet-number ratio
Zhang, Zhao, and Zhao (UT Dallas)
Mean
St. Dev.
300,890
23,099
51
302,020
23,382
681
MBS Offering Communications
May 1, 2015
15 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
2/6: Cumulative net loss and FWP content
Cumulative net loss = α + β × FWP content
+ Deal characteristic variables
+Macro variables + Fixed effects.
I
I
FWP content: Loantape FWP content and Textual FWP content
Loantape FWP content: Log(No. of alphabet tokens + No. of numeric
tokens for all loantape FWPs) — Log(Loantape FWP)
I
Textual FWP content: Log(No. of alphabet tokens + No. of numeric tokens
for all textual FWPs) — Log(Textual FWP)
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
16 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
2/6: Cumulative net loss and FWP content
Log(Textual FWP)
0.52***
(8.94)
Log(Loantape FWP)
Adj. R2
N
Deal characteristics
Macro variables
Lead underwriter FE
Year FE
0.320
1577
No
Yes
Yes
Yes
0.22***
(6.15)
0.42***
(7.15)
0.288
1577
No
Yes
Yes
Yes
0.694
1450
Yes
Yes
Yes
Yes
0.06
(1.25)
0.677
1450
Yes
Yes
Yes
Yes
0.22***
(5.80)
0.01
(0.20)
0.694
1450
Yes
Yes
Yes
Yes
I
Deals with more textual communications have higher losses
I
Numeric communications have little effect after controlling for textual
communications
⇒ Hiding behind writing
I
Consistent with studies in 10-K setting (Li 2008, Loughran and
McDonald 2014)
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
17 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
3/6: FWP content and Final prospectus supplement content
Log(Textual FWP)
Log(Loantape FWP)
Total no. of words
(1)
(2)
Pct of uncertain words
(3)
(4)
Total no. of pages
(5)
(6)
0.080
(0.58)
-0.118
(-1.35)
0.013***
(5.08)
0.005**
(2.49)
0.007
(0.02)
-0.427
(-1.49)
No. of FWPs
2
Adj. R
N
Deal characteristics
Lead underwriter FE
Year FE
Macro variables
0.356
1536
Yes
Yes
Yes
Yes
0.613*
(2.01)
0.350
1536
Yes
Yes
Yes
Yes
0.352
1536
Yes
Yes
Yes
Yes
0.030***
(3.75)
0.324
1536
Yes
Yes
Yes
Yes
0.416
1317
Yes
Yes
Yes
Yes
1.211
(0.93)
0.415
1317
Yes
Yes
Yes
Yes
I
More FWP content, especially textual content, in pre-issuance period,
relates to more uncertain word usage in final prospectus supplement
I
Among the 2600 words in Loughran-McDonald uncertain word list,
“may” (19%) and “approximately” (6%) account for 25%
I
Use of ambiguous words – an indication of hedging litigation risk
(Rogers, Van Buskirk, and Zechman 2011)
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
18 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
4/6: Cumulative loss, FWP content, and prospectus content
Pct of uncertain words
(1)
(2)
(3)
(4)
(5)
(6)
1.45**
(2.79)
0.49
(0.76)
0.21***
(5.20)
0.02
(0.36)
0.97
(1.64)
1.70***
(3.27)
0.63
(1.09)
0.22***
(4.84)
0.03
(0.46)
1.20**
(2.23)
Log(Textual FWP)
Log(Loantape FWP)
No. of FWPs
Total number of words
0.08***
(3.39)
0.08***
(3.52)
0.56***
(5.58)
0.08***
(3.19)
Total number of pages
Adj. R2
N
Deal & Macro variables
Lead underwriter FE
Year FE
0.680
1426
Yes
Yes
Yes
0.679
1426
Yes
Yes
Yes
0.668
1426
Yes
Yes
Yes
0.54***
(4.22)
0.04***
(4.12)
0.674
1214
Yes
Yes
Yes
0.04***
(4.74)
0.673
1214
Yes
Yes
Yes
0.04***
(4.26)
0.663
1214
Yes
Yes
Yes
After including FWP content
I Coefficient for Pct of uncertain words decreases by more than 60%
I Coefficient for Total number of words (pages) not affected much
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
19 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
5/6: FWP effect controlling for pricing variables
(1)
Log(Textual FWP)
Log(Loantape FWP)
(2)
0.16***
(3.93)
0.00
(0.11)
No. of FWPs
Initial yield spread
Subordination
1.76***
(4.57)
0.20**
(2.25)
I
0.733
1426
Yes
Yes
Yes
(4)
0.15***
(2.96)
0.00
(0.13)
0.42***
(4.61)
1.82***
(4.82)
0.20**
(2.40)
Over-collateralization
Adj. R2
N
Deal & Macro variables
Lead underwriter FE
Year FE
(3)
0.730
1426
Yes
Yes
Yes
(5)
(6)
0.14***
(2.85)
-0.00
(-0.13)
1.79***
(4.53)
0.37***
(3.30)
1.84***
(4.81)
2.69***
(4.95)
0.738
1426
Yes
Yes
Yes
2.81***
(5.42)
0.735
1426
Yes
Yes
Yes
1.68***
(4.74)
0.21**
(2.44)
2.75***
(5.31)
0.744
1426
Yes
Yes
Yes
0.33***
(3.12)
1.73***
(5.00)
0.21**
(2.58)
2.86***
(5.80)
0.741
1426
Yes
Yes
Yes
FWP effect remains strong and economically meaningful
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
20 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
6/6: FWP effect and matching sample approach
I
Address potential mis-specification of the linear models
Difference in Cum Loss
Treatment sample
Control sample
Deal and macro matching
Prospectus content matching
Pricing covariates matching
N
(1)
(2)
(3)
(4)
(5)
3.93***
(7.79)
Multi FWP
Zero or one
FWP
Yes
No
No
1450
4.20***
(8.90)
Multi FWP
Zero or one
FWP
Yes
Yes
No
1426
3.15***
(6.26)
Multi FWP
Zero or one
FWP
Yes
Yes
Yes
1426
4.42***
(7.48)
Textual FWP
Zero or only
loantape FWP
Yes
Yes
Yes
1426
0.62
(1.08)
Loantape FWP
Zero or only
textual FWP
Yes
Yes
Yes
1426
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
21 / 22
Introduction
Hypothesis
FWP and Deal Performance
FWP Usage and Information withholding
Conclusion
Conclusion
I
Our paper represents the first attempt to analyze the written
communications in the RMBS offering process
I
More intensive written communications, especially in textual format,
are related to higher future losses of underlying loan pool
I
More written communications in the pre-issuance period also associate
with more uncertain words in final deal prospectus supplement
An indication of hedging litigation risk after information withholding in
the issuing process
Our findings suggest that RMBS issuers may have withheld some
information in the offering process by hiding behind writing
Zhang, Zhao, and Zhao (UT Dallas)
MBS Offering Communications
May 1, 2015
22 / 22