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Operational Risk Still a Top Concern for Securitization Professionals (March 10, 2005)

Location: New York
Author: Michael Gutierrez
Date: Thursday, March 10, 2005

The majority of securitization professionals cite operational risk as a leading concern in structured finance transactions, trailing only traditional credit risk as the overriding factor potentially affecting a deal's health, according to the results of Standard & Poor's Ratings Services' recent Structured Finance Market Opinion study.

The survey solicited views from market participants on how to best define, measure, monitor, report, and mitigate operational risk in securitized transactions. The results of the survey, detailed in a recently released commentary titled, "Structured Finance Market Opinion Survey Confirms Operational Risk Remains A Serious Concern For Securitization Professionals," show that more than two-thirds of respondents chose operational risk as one of the top-three most important areas of risk in the market, surpassing other highly touted forms of exposure, such as legal (40%), modeling (39%), interest rate (27%), regulatory (24%), and correlation risk (9%) by a sizable margin. In fact, only credit risk received more votes, with 79% of market players choosing it as one of the most significant factors.

Furthermore, a majority of respondents (78%) identified servicer quality as the most critical element of a transaction's operational risk profile, followed by transaction structure. The inherent serviceability of a particular receivable was in third place, followed closely by deal administration, which includes the work of the trustee and the general level of a transaction's disclosure.

"The single biggest mitigant to operational risk for securitized transactions is an experienced servicer in the relevant asset class," said one survey respondent. "There is a need to focus more specifically on internal controls," commented another, "including the amount of resources dedicated to servicing the securitization and management's involvement in and understanding of the securitization structured and obligations."

According to another survey taker, "Revolving deals must have a way of monitoring any significant changes in underwriting or servicing policies. Smaller servicers, which are more likely to be at risk in times of financial or market stress, must be monitored more closely, as they are more likely to play fast and loose with servicing and reporting to maintain cash flow."

Market participants generally suggested increased or tighter reporting standards and controls as a primary mitigant to operational risks, including "third-party audits of operations," according to one participant.

The SF Market OpinionT respondents also reported that, as expected, they view a company's corporate liquidity and cash flow generation as the most important operational/financial aspect of a seller/servicer (71%). According to one market participant, "Most, but not all of the big disasters in ABS have occurred when the sponsoring corporation had weak cash flow or no other sources of liquidity and put itself (and investors) in a position of moral hazard, ranging from weak servicer performance to fraud."

A company's funding diversity and flexibility was the second most important aspect of a seller/servicer according to respondents, garnering 58% of the vote. Interestingly, in a tie for second, 58% of participants chose breadth of a company's servicing shop as the most critical factor.

"These survey results indicate a sharp turnaround from prior years in which a seller/servicer's financial strength was seen as the paramount factor affecting seller/servicer risk," said Michael Gutierrez, a director and head of Standard & Poor's Structured Finance Servicer Evaluations Group, and co-author of the commentary. In other words, it is possible for a well-funded company to have a flawed servicing operation these days. "Recent industry events, such as the highly publicized regulatory and compliance issues affecting Fairbanks Capital Corp., which had nothing to do with the favorable financial strength of its corporate parents - yet ended up adversely affecting its servicing capabilities - may be a factor in this change."

More than half of the respondents also said that newer or esoteric assets, as well as specialized obligors or industries, are most prone to operational risk, while mortgage/home equity and credit cards were voted least prone.

A total of 197 participants, all of whom were familiar with operational risk in structured finance, completed the survey. Of these, 28% identified themselves as investors, 26% as investment bankers, 20% as issuers, and the remainder represented a mix of other roles in the structured marketplace.

SF Market Opinion is a recurring study covering hot topics pertinent to the structured finance community. It is intended to create valuable discourse and give securitization professionals an opportunity to hear what their peers are saying on critical issues.

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