In light of the number of ìblack swans,î or low probability, high-impact events that decimated the credibility of structured finance models in the recent financial crisis, one of the most important lessons learned by investment managers is that it is critical to prepare for the consequences of such events. In the past, the convention was to run a handful of extreme cashflow scenarios that ignored other possibilities particularly those based on severe unprecedented assumptions where the probability of occurrence was deemed to be extremely low. Not only did the models and assumptions fall short of predicting the current crisis, there was no indication of the sudden illiquidity that was to strangle the structured finance markets. Most assumed that there would be time to sell, even if a small loss had to be taken to exit the position.
Today, the risk of sudden illiquidity coupled with an economy barely on life support demands that investment managers be seriously prepared for the possibility that any structured finance instrument purchased will have to be held through maturity. In the past, it was not market convention to try to negotiate a contingency plan in the event of a catastrophic event. The market for structured finance instruments was so robust that most sellers had a ìtake it or leave it attitude,î leaving very little room for due diligence and negotiation by investors. Few questioned the collateral underlying these securitizations or whether the safeguards in the deals were adequate or enforceable since a quick bid was essential when buying these instruments.
Developing A Contingency Plan
One of the most effective ways to develop a contingency plan against illiquidity risk would be to conduct credit, valuation and liquidity reviews not only prior to purchase but continuously afterwards until the position was closed. In order to be effective, this exercise would need to be customized to each individual deal to ensure that any deal-specific nuances were covered appropriately.
Prior to purchase, it is critical for investment managers to have their own opinions about a securitization or access to the right expertise in order to assess whether an investment fits within their fund's guidelines. Not only does the investment manager need to understand the methodology and assumptions used by third parties to assess the investment, but the investment manager also needs to have the expertise to be able to challenge these opinions. Third-party opinions are a good starting point but should never be the sole justification for purchasing the security.
Proper Analysis Is Key
Structured finance products are unique and due diligence procedures need to be adapted to fit each type of product. A common mistake is to assume that the underlying collateral is similar to the broader asset category because it looks similar or because everyone else has the same assumptions. The assumptions used to analyze residential mortgage-backed securities backed by loans from the 2005-2006 vintage were based on adjustments made to the historical performance of ìsimilar loansî. The problem was, of course, that the new loans were changing rapidly during this period and they were definitely not similar.
Bonds need to be priced based on the results of careful analysis and due diligence. Due diligence should never be an activity performed by the back office whose results are summarized as having been completed like a checklist. If market timing is important, due diligence can be part of the post-closing requirements of the sale subject to timing, re-pricing, put-back and adequacy requirements. In addition, it is critical for the investment manager to understand the roles of each party in the securitization and any inherent conflicts of interest. This would allow them to determine whether ìpiggy-backingî on the due diligence of another party is prudent. In the past, many investment firms have purchased structured finance investments based on the reputation of the offering firm and the ability to put back bonds in case of any problems. Today, the unthinkable is possible and we have precedents that major institutions can disappear overnight.
Know Your Rights
The importance of negotiating catastrophic language at the time of purchase cannot be overemphasized. Investment managers need to know where they stand in the structure of a securitization and what rights they have, if any. It is critical to have a clear understanding about what happens to the tranche in question during stress scenarios and whether any provisions that are documented are easily and actually enforceable. Legal documents need to be carefully reviewed to ensure that provisions not only cover the waterfall but also the payment and change in the role of servicers in distressed situations, for example, in MBS. Language should be included to allow for qualified third parties to perform forensic due diligence on loans that become delinquent and the results need to be available to the investment manager. A process needs to be in place to ensure that breaches of representations and warranties are quickly corrected.
One of the problems in working out deals today is that the language used in past documents, while present, was not clear enough to actually correct the breaches. All loan-level data needs to be provided in a meaningful, useful format so that the data can also be checked for accuracy by third-party vendors.
Investment managers need to ensure that there is sufficient liquidity in the instrument in order to maintain the overall integrity of the portfolio during periods of both normal and extreme redemption. This includes an understanding of who else owns similar bonds, who else might be buying them, what is the market value for the bond and what is the liquidity of the bond.
Conclusion
The management of illiquidity risk is an ongoing process. The initial due diligence on a structured finance instrument helps investment managers determine whether the price paid is appropriate for the level of risk taken. Once the securitization is purchased, the securitization needs to have regular credit, valuation and liquidity reviews so that any changes in the behavior of the instrument can be closely monitored before further deterioration occurs and there is a dramatic drop in market value. While it is extremely difficult to predict black swans, being very well prepared for the possibility of one can put an investment manager well in front of the rest of the pack in terms of managing illiquidity risk.
Lima Ekram is a partner at Phoenix Peak Group, a women- and minority-owned capital markets advisory firm that provides a broad range of structured finance services. Ekram specializes in the credit analysis of residential mortgage-backed securitizations. Her responsibilities include advising customers on MBS risk management strategies.