By Douglas Long, executive vice president of business strategy at Principia
Whether looking at structured finance operations within commercial banks, or the exposure of these portfolios on the wider enterprise, markets or economy, the crisis has demonstrated there is room for improvement for everyone at this time of transition.
The current financial crisis has highlighted many shortcomings in what was an extraordinary period of global economic growth. Investor due diligence, ratings agency models, international accounting rules and the overall governance of the financial markets have been placed under the spotlight. Calls from every direction hint at one thing – greater transparency at every level.
The role of structured finance is at the centre of the debate. The interpretation of transparency takes on a different meaning depending on your perspective or involvement in the day to day management of those operations. Whilst granular detail on the underlying performance of individual deals (such as mortgage delinquency and prepayment rates) is imperative to investors, just having this detail alone has not been sufficient for effective risk oversight. The crisis demonstrated that actually too much information, in many different formats, has made it a challenge at the portfolio management level to interpret collateral information from multiple sources in standardised ways.
In turn, this has made it difficult for bank’s structured finance operations to indicate their overall risk exposures across multiple deals in multiple portfolios efficiently and accurately for the purposes of higher level financial reporting.
The lack of transparency at the operational level meant that it could not be truly reflected at the enterprise, or macroeconomic level either.
At recent industry seminars, discussions with investors have revealed a common concern. Far from stating that there is a dearth of detail about deal or collateral performance information for pools of loans in asset backed securities (ABS) or mortgage backed securities (MBS) assets, most have expressed there is actually information overload.
Pre-crisis however, performing detailed quantitative risk assessments on investments conflicted with the trend of having to invest quickly, often and in quantity to make good returns – at a time when spreads were very tight. The issuer structured the instrument, the rating agencies provided the due diligence and gave it a rating and investors placed trust in the AAA label.
There are a number of well respected, independent data providers of detailed underlying information on ABS, MBS and collateralised debt obligation (CDO) instruments. Players such as Intex, Lewtan, Markit, Trepp and S&P have solid performance, collateral and cash flow modelling capabilities. Even though some may specialise in particular geographies or asset classes, the data has been there for a while from a variety of sources.
Time was a precious commodity in competitive markets. The detailed research required to make sense of all the information available, in all its different forms was a barrier to doing the work and also not seen as a top priority for investors. Finding long term and efficient ways to combine and easily interpret all these tools and data points for comprehensive risk surveillance across the structured finance business was not recognised as a point of pain. Rather, it was seen as a discomfort that could be lived with.
A Standard View
So, until the liquidity crisis hit, market participants were not restricted by a shortage of underlying information on these complex assets per se. The structuring, monitoring and forecasting of structured finance deals was instead hampered by a lack of uniform data formats or standardised content in the transmission or reporting of collateral information. That is not to say that issuers were not distributing the information either. Far from it. They did so regularly, providing lots of detail. Each issuer however, often provided PDF documents that were hundreds of pages long. They used different templates and provided different loan level information. Even two deals from the same issuer could be presented very differently.
Data vendors help to clean and glean the most important detail from issuer reports and present and automate it to help investors collate relevant information. There is still disparity in the presentation and integration of data from each vendor however. Investors now have deal and performance data from different providers, often representing different geographical coverage, alongside the multiple formats provided by issuers. Consolidating all those different data points is a vital step towards clarity.
Having quality data from multiple sources is not sufficient if you can’t efficiently integrate, compare and ‘slice and dice’ that information in the portfolio management, risk oversight, compliance and accounting functions. Having this capability should be at the foundation of accurate, efficient and transparent operations in the future. Gaining control over the application of valuation and performance data across portfolios and throughout their lifecycle is key to ensuring analytical rigor and delivering true transparency.
The International Accounting Standards Board (IASB) recently issued amendments to improve disclosure requirements for illiquid assets. In the US, the Securities and Exchange Commission (SEC) is committed to pushing through a conversion from US Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS) – for banks and hedge funds alike. IFRS influences how securities are valued, what investors will need to know and how results are monitored. As such, portfolio management, risk management, front and back office operations, sales and investor relations will all be affected. Regulatory changes are influencing the new definition of transparency and organisations must be agile enough to adapt.
Industry efforts to facilitate this transparency and to centralise and make available standard valuation and transaction performance data for issuers and investors are ongoing. The American Securitisation Forum (ASF) is working closely with member organisations on Project Restart to develop commonly accepted standards and reporting templates for transparency, disclosure and diligence – particularly for residential mortgage backed securities (RMBS). The European Securitisation Forum (ESF) and Sifma are busy working through a similar initiative in Europe. These efforts are imperative to bringing back confidence in these products and to kick starting secondary markets.
These steps can greatly improve fragmented risk surveillance techniques and provide less onerous means by which to interpret deal information across portfolios. It will also allow investors to better distinguish pools of high quality loans from lesser quality pools and disclose information in standard formats to secondary market players. It goes to the root of some of the problems, ensuring the fundamentals of securitisation are improved and that originators of ABS and MBS do so diligently.
These initiatives take time though. In conjunction with these, structured finance managers need to find better ways of consolidating and utilising performance, risk and deal data across their operations and across all the portfolios they manage.
From The Bottom Up
In a recent survey of the world’s largest banks, entitled “Navigating the Crisis”, Ernst & Young found that only 14% of respondents had a single view of risk across their organisation.
More often there is evidence that asset classes are managed and integrated effectively into banks’ existing treasury management systems. To integrate structured finance effectively there needs to be a different approach. The unique challenges and complexities of structured finance and their associated cash flows and hedging instruments means they are governed by very different operational guidelines and risk oversight functions.
Until this crisis, a large amount of these assets were held in off balance sheet vehicles with purpose built technology and operations in place. As restructuring continues, large quantities of structured finance assets have moved from off balance sheet securities arbitrage conduits and structured investment vehicles (SIVs) back onto the balance sheets of banks.
The intense administrative demands of structured finance portfolios mean that large treasury systems are often limited in their ability to meet the specific stress testing, cash flow monitoring, compliance and reporting requirements of these particular assets. This risk oversight was often carried out with treasury systems, comingled with internally built spreadsheets. This has proved inadequate for accurately monitoring market or operational risk in the current crisis.
Banks will continue to strive to integrate silos and gain an enterprise wide view of risk. Expanding treasury systems to meet the unique and sophisticated operational demands of structured finance is an exercise in papering over the cracks though. Banks should instead consider a dedicated infrastructure that can consolidate, integrate, monitor and control all the portfolios and entities that contribute to the structured finance business.
Being empowered to monitor exposures across portfolios held in different subsidiaries, or on and off balance sheet, should be one of the first steps in being able to effectively deliver overall transparency to the wider organisation.
Silos Within Silos
Silos can themselves be fragmented. Portfolio management’s activities don’t always flow automatically into risk management’s cash flow analysis or risk surveillance; valuation and stress testing information doesn’t always flow into accounting. A dedicated environment for structured finance can consolidate the workflow and use of financial information between these functions and enable stress testing and oversight of the structured finance business. The effect of changing prepayment conditions or increased delinquency rates for example, can be examined both for individual deals and across the entire operation.
Being able to derive this view of risk for the whole structured finance business means that settlement and general ledger accounting functions associated with it can then more easily be carried out by the enterprise treasury management system. From this, operating guidelines, compliance limits and controls can be set at the enterprise level to see how the performance and ongoing risk exposures within the structured finance business apply to the organisation in its entirety.
Structured finance portfolios managed within a dedicated, flexible but robust operating environment will be best positioned to adapt to the changing compliance demands of investors, internal operating guidelines and regulators.
Transparency can only truly be achieved if financial institutions can go beyond just seeing “what is written” and interpret it quickly and easily so it can become something of “worth” – both at the business operating level and to the organisation as a whole.