Verification Risk in Structured Finance
Structured finance markets have long been based on the idea that aggregation and dilution of risk, and the concentration of collateral, enable lenders and investors to benefit from the attributes of the underlying asset classes of the deal structure – receivables, mortgages, equipment, or otherwise. However, the focus of due diligence and risk management in such cases has traditionally been on the characteristics of the collateral itself. This, however, appears to be changing as structured finance products encompass a wider range of asset classes, geographical sources, and deal origination chains.
Verification Risk in Structured Finance
Verification risk, the risk of information regarding the characteristics of deals and underlying assets being inaccurate, appears to be growing in importance relative to other risk categories. This is partially because traditional credit analysis increasingly focuses on the properties of the collateral and its behavior in the case of default, which implicitly assumes that the asset and borrower data provided accurately reflects the true situation
Several factors contribute to this risk being of greater concern:
- Faster deal cycles: As non-bank lenders and fintech players enter the origination fray, the time spent on analyzing each underlying obligor or asset decreases;
- More extended and complex data chains: Structured finance deals often involve aggregation of assets with complex information trails, increasing the likelihood of information becoming muddied or misrepresented at several points;
- A wider range of asset classes: Collateral such as receivables or invoices has less inherent transparency than real assets like equipment or real estate;
- Growing size and complexity of deal structures: This increases the importance of verification as a risk factor;
- Recent high-profile incidents of fraud: Particularly within trade finance and receivables financing, several fraudulent schemes involving falsified collateral have caused significant losses to investors, illustrating the challenge of detecting such misrepresentations even in highly sophisticated capital structures
What Is Meant By Verification Risk?
It is important to define the concept more precisely, as verification risk comprises several categories beyond potential fraud:
Existence risk
is the risk of assets or receivables in a deal structure not being genuine or of the purported value.
Ownership or encumbrance risk
is the risk of assets not being fully owned or pledged by the borrower and/or having been pledged multiple times.
Borrower and counterpart risk
is the risk of the borrower providing inaccurate information about its financial position and operations.
Servicing and reporting risk
finally, is the risk that deal reporting becomes inaccurate post-closing, as servicing of the underlying assets commences.
Any of these factors, individually or together, can cause a deal to perform significantly worse than projected even if the legal and collateral documentation is near-flawless.
Why Is Verification Risk A Growing Concern?
Verification risk is not a new phenomenon – it has always been a part of structured finance transactions. However, there are several reasons why lenders and investors should be especially wary in the current business environment:
- Increased scale of exposure: The size of the deals and the total amount of capital exposed to verification risk is growing;
- Greater overall complexity: Multi-jurisdictional and multi-SPV structures, as well as the mixing of different asset classes within one deal, can contribute to the risk being substantially higher than previously seen;
- Distance from the source of information: Many investors in securitized debt instruments are several degrees removed from the actual collateral, relying on the representations of other market participants.
These trends highlight the fact that traditional mechanisms of mitigating verification risk, namely protections built into the legal documentation as well as third-party enhancements such as ratings and insurance, are insufficient in the case of complex, large-scale deals. They are useful tools but serve more as risk allocation mechanisms, addressing some of the risks that have been identified but doing little to prevent those that have not been properly taken into account.
Moving Toward Enhanced Information Controls
Addressing verification risk requires utilizing complementary processes to the traditional risk management mechanisms used in structured finance. In many cases such measures take the form of ongoing or repeated verification of information provided by deal originators, particularly in cases where asset-specific due diligence is limited. Other potential initiatives include using alternate data sources to verify the accuracy of information, as well as implementing continuous verification processes, especially if material changes to the deal terms or underlying asset pools occur.
Another important area is implementing procedures for addressing concerns that arise from such verification steps. In many cases, discrepancies between the information provided by different parties to a deal obfuscate certain credit risks, masking them behind representations and warranties. However, this practice ultimately causes these risks to resurface later, with investors or lenders only realizing the extent of the issue much later. The key is to implement appropriate transparency and escalation procedures so that concerns can be openly discussed and resolved.
Modern technology plays an important role in the enhanced verification framework, both by helping to ensure that data provided by third parties is consistent with information from other sources and flagging potential discrepancies in a timely manner. Similarly, ongoing data monitoring can help to identify irregularities that might be difficult to detect with traditional tools.
It must be stressed that enhanced information controls are not designed to eliminate verification risk but rather to mitigate it. Verification processes need to be implemented consistently across all relevant aspects of a deal, identifying and addressing both obvious and non-obvious sources of risk. Investors and lenders must understand the limitations of the tools they employ – while third-party credit enhancement mechanisms such as ratings and insurance coverage help to address some of the risks, they typically operate at the level of the entire security structure and are unable to provide sufficient support in cases of misrepresentation or fraud.
The Bottom Line
The collateral is the cornerstone of any structured finance transaction, and few would argue that its value and stability are of primary concern to lenders and investors. However, that information, like any other, is only as reliable as the systems used to collect and analyze it. As deal structures become more complex, asset classes more varied, and lenders more distant from the source of information, ensuring that due diligence procedures are not superficial but truly comprehensive becomes a matter of both competitive advantage and regulatory compliance.
Those who approach verification risk management with a sustained and methodical mindset are likely to find themselves in a stronger position relative to peers who only apply enhanced controls sporadically or at specific points (such as deal closing). In the end, it is about ensuring that risk is accurately priced – both for the investors who purchase securitized bonds and for the originators who take on the responsibility of verifying the information provided by borrowers.
