“Our ability to trade complex assets has completely surpassed our ability to understand those assets,” says Philip Moyer, CEO of Edgar Online. But an answer to the problem of valuing complex derivatives, especially asset-backed securities, is not far out of reach, he says: It lies in the use of free writing prospectuses. “Free writing prospectuses provide you with data about every single loan that sits inside an asset-backed security,” Moyer says. “They’re issued two or three weeks before an asset-backed security is priced.” By contrast, the first detailed database for an asset-backed security comes out two to three months after the security is priced, when the underlying loans have already gone into servicing. With the mandatory use of FWPs and standard formatting for the information in them, buyers can know what’s inside the derivatives they’re buying and set about valuing them.

As defined in Securities Act Rule 405, free writing prospectuses are written communications, including electronic communications, that constitute an offer to sell or solicitation to buy securities in a registered offering by means other than the statutory prospectus. The free writing prospectus may include information that is not included in the registration statement, but it cannot conflict with information in the filed registration statement, including any prospectus and any Exchange Act reports incorporated by reference. Free writing prospectuses tend to be very long documents. (Here’s an example from Merrill Lynch.)

“Most people in the industry don’t know these things exist,” Moyer says. But FWPs provide many revealing details about the loans a security is based on – for instance, in the case of a mortgage, the appraised value of the house, the down payment, and proof of income (in the case of a subprime mortgage, these last two fields might be blank).

Instead of asset managers scrutinizing FWPs to understand asset-backed securities before buying them, typically the FWP data provided by originators of asset-backed products gets sent to the servicers of the loans, which use different data models, including disparate loan identifiers.

“Just being able to get that kind of basic information about these assets has been tough for a single asset-backed security,” Moyer says. “When you go across multiple asset-backed securities, you’re able to do wide-scale analysis that lets you do apples to apples comparisons.” With that data available, it’s possible to apply economic models to the products, for instance, to estimate the possibility of the loans foreclosing.

Moyer expects the government to start requiring derivative originators to provide free writing prospectuses, as well as to start adhering to a common data model for them, including a single type of loan identifier. He predicts the SEC and industry organizations will work together to build a common data specification for mortgage-backed securities.

Having this detailed data available will help even the market for complex collateralized debt obligations that tend to be sliced up into junior and senior tranches, Moyer says. “Your goal is to find out the underlying value sitting in that asset -- what’s the likelihood of a piece of that defaulting?” he says. “At the end of the day, this traces back to somebody not paying his mortgage and you have to determine the likelihood of that. Has the person missed a payment? What’s the money down? What’s the borrower’s credit history? If you can track that mortgage back to the source and see its status, regardless of how many slices there are, you can get a sense of the likelihood of default.”

SEC commissioners including Chairman Cox have been urging companies to file reports using interactive data. The SEC released a GAAP taxonomy in December that provides labels and definitions for about 12,000 data elements. Providing a standard data scheme for mortgage-backed securities would require labels and definitions for about 100-200 elements. “We’re not talking about complexity,” Moyer says. “We’re really talking about the basics of getting flowing data as opposed to documents. People have this information in their systems, it’s just a matter of getting everybody to agree on what to call the down payment, what to call the interest rate.”