Should you overhear two dark-suited executives in a bar whispering about ‘assets’ and ‘surveillance’, you could be forgiven for thinking you’ve stumbled across a meeting between intelligence operatives. Alas, the mundane reality is they’re more likely discussing the management of a portfolio of loans.
Surveillance is a term increasingly being bandied about in financial circles. Since the financial crisis of 2007-08, regulators’ resultant focus on investor protection has placed greater emphasis on the requirement for active surveillance of portfolios of loans or other credits – whether held directly or within asset backed securities (ABSs). But the precise nature of surveillance – in particular, how it differs from monitoring or transparency – is still not consistently understood within the market.
This is of concern because everything in financial regulators’ direction of travel suggests that surveillance is set to become an increasingly important element of compliance and best practice. After all, for ABS investors it is already enshrined in the Solvency II regime, capital regulations requirements (CRR) and the Alternative Investment Fund Managers Directive (AIFMD). So what is it and how does it benefit investors and other holders over and above the more passive forms of portfolio management?
Definition and scope
In a nutshell, surveillance is an ongoing process that allows an investor to remain on top of all risks associated with a portfolio of loans or similar instruments. However, unlike pure monitoring surveillance is based on proactive risk management. When an issue is identified, it is not merely noted, it is addressed – even anticipated.
Residential mortgage-backed securities (RMBS), indeed any ABS, lend themselves particularly well to surveillance as, to a large extent, do loan portfolios. The key is the ability to ring-fence the portfolio, thus minimising the impact of the broader environment. Loan portfolios, for example, have no quixotic or un-quantifiable credit risks; ABSs are single purpose vehicles with no other business activities and exposure to just a single market supported by counterparties with clear, legally-defined roles. These investments in all forms also benefit from comprehensive, regularly-produced performance data capturing all the key drivers of credit and other risk.
At its most fundamental, the greater the degree of control you can exert over a portfolio and the more precise the available data, the greater its suitability for surveillance.
By contrast, a portfolio of equities is vulnerable to too many, often unquantifiable, risks and is unable to produce the empirical data necessary to track performance. Corporate investments are subject to highly unpredictable factors such as management changes, market sentiment and economic fluctuations; financial institutions are similarly vulnerable. Without wishing to be flippant, one of the few ways to stay on top of the risks in these portfolios is to read a wide selection of newspapers.
What is surveillance?
Surveillance examines four broad sets of factors, the first of which relates to the characteristics of the assets in the portfolio itself, asking the questions: what will drive performance over time? What is the loan-to-value (LTV) ratio and how is it moving? How will the seasoning of the loans and changes to the incomes of the individual borrowers affect the portfolio?
Second are micro and macro-economic factors. No-one can anticipate how the economy will evolve, but it’s vital to stay on top of the changes and to understand the impact of different potential scenarios on the portfolio.
Third is the servicing of the assets. Two servicers working on the same portfolio can produce widely differing results; what we want is rigorous and effective servicing that minimises delinquencies and losses. A sometimes overlooked part of the servicer’s role is to ensure compliance with regulation and relevant codes of practice. The impact of failing to do so can result in penalties, reputational damage or even the inability to enforce the loans.
Finally, there are the structural cash flows and the behaviour of counterparties.
Four criteria for successful surveillance
Having established what aspects of a portfolio are encompassed by surveillance, we need to establish what is required to do the job properly. Essentially, there are four key requirements in order to surveil a portfolio: data, tools, process and expertise.
Data – the right data – is paramount. The advantage of a loan portfolio is that you can gain access to very specific data about individual loans, for example where a borrower is with regard to payments or how the value of an underlying property is changing. Too much data can result in the investor being swamped or complacent; too little and vital warning signs may be missed. Having gathered the data – including accurate valuation data, economic data, and data from servicers – you need to know what to do with it, which is where tools and processes enter the picture.
Tools in the form of software and technology enable you to examine the portfolio at the highest level but also create the ability to dive down to extreme levels of granularity – to individual loans. Your tools must enable you to take in multiple data sets on the characteristics and behaviour of the assets and distil them to their core risks, on which you can run stress tests and compare current and projected performance against expectations and market comparables. Sophisticated analytical tools of the type needed are available commercially; large originators may design and build their own.
Frequency of analysis is a matter of choice, hence the need for expertise, driven by your degree of exposure and the position in the economic cycle; it also depends on which part of the portfolio you’re holding. For example, an investor in a senior AAA-rated piece of an RMBS has concerns more likely focused on the implications of a rating downgrade than the holder of an equity/first-loss tranche for whom delinquency and loss levels are more significant. Ideally, the investor will have a series of automated reviews running monthly or quarterly, with triggers set to changes such as a rise in delinquency levels to create alerts.
Data, tools and process, however effective or sophisticated, are not enough without gritty, hands-on understanding of how the assets work and how they should be serviced. Periodic review of servicer operations should ensure you stay ahead of issues on the ground and, when required, have the ability to dive in, inspect individual loans, check the servicer’s performance and take remedial action.
Regulators and surveillance
It’s not surprising that regulators are drawn towards surveillance. While great strides have been made in Europe through measures such as central banks’ ABS loan level data initiatives, there is insufficient evidence to suggest that the European market as a whole has embraced proactive surveillance to the same degree as the US.
At the macro level, surveillance increases investor protection – the key shift in the centre of regulatory gravity since 2007. Yet why should this matter to investors themselves? Whether investing directly in the assets or via ABS, investors perform high levels of up-front analysis and due diligence before they invest – as indeed they should, to ensure that they enter these complex transactions with their eyes wide open.
What is just as critical is that their eyes remain wide open and that those levels are maintained throughout the life of the investment. The shortcomings, for example, of over-reliance on ratings have been clearly articulated and are well understood. Nonetheless, if you’re not going to rely on agencies for surveillance you need to be sure that you have something robust in their place. In summary, investors need to continually treat these risks with the level of respect they deserve.
Effective surveillance enables ongoing, accurate valuation, which:
• allows appropriate pricing
• reduces delinquencies and ultimate losses.
• ensures pre-payment rates can continually be measured against assumptions.
• prevents unpleasant regulatory surprises.
• ensures appropriate capital treatment.
• for an ABS portfolio, allows anticipation of rating changes and potential forced sale.
In Europe, surveillance is not as strong a focus as it should be. Some sophisticated ABS investors and those who had their fingers burned in the 2007-09 financial crisis have invested heavily in data and tools. Yet it’s unclear whether all investors have the same appetite, or whether even the most sophisticated have the capacity to interrogate servicer and asset performance on the ground across varying jurisdictions should need arise.
Nor is it clear whether the data and tools which can be used so effectively for the surveillance of ABS are being applied to whole loan portfolios where they could be equally valuable. European central banks, too, hold ABS and loan portfolios as collateral and there’s an equally clear and crucial need for these portfolios to be surveilled.
These uncertain times make the argument for surveillance all the more compelling. It may not seem the most exciting of functions, but everything suggests it’s going to swing into the regulators’ sights. Investors overlook it at their peril. Should the economy show signs of deterioration, it’s likely that regulators will focus even harder. So having a clear sense of what surveillance is – and what it isn’t – is a positive first step on the road to enhanced investor security.
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