In terms of the various asset types needed for a successful investment program, it's clear that a real sea change has taken place in the world of institutional investing during the past decade.
Today, a successful program almost must include a substantial portion of asset-backed securities, in addition to the traditional mix of equities, bonds of difference qualities, commercial mortgages, and conventional private placements.
This is a dramatic change from the early 1980s, when asset-backeds were still pretty much a new and unproven type of security and could be found in very few institutional portfolios.
So in the space of just a few years, asset-backeds - or what we at Cigna refer to as structured financings - have made the transition from exotic novelty to a staple of our institutional portfolios. There are several key reasons for the rapidly growing popularity of asset-backeds. Weathering Recessions
Weathering Recessions
Structured financing techniques help to create assets that can withstand periods of recession such as we've been experiencing in this country in recent years.
By combining appropriate third-party credit support with rigorous underwriting of the collateral, structured financings can open up whole new areas of investment opportunities for even the most conservative institutions.
Consistent with the need to seek best relative value, asset-backeds can provide attractive yields while assuring safety of principal.
Tremendous Leverage
Compared with traditional whole-loan buying, securitization provides tremendous leverage and economies of scale. At Cigna, for example, our structured finance unit now manages a portfolio valued at more than $3.3 billion, and we put out some $1.7 billion in new investments in 1991 alone with a staff of just five investment professionals.
A whole-loan operation probably would require a larger staff to handle that type of volume. That's because whole-loan buyers traditionally have more interaction, loan by loan, with the originator-servicer than do the buyers of securitized assets.
The need for more interaction in whole-loan transactions applies both to the original purchase and to the long-term administration of the assets.
Thus, the appeal of asset-backed securities is easy to understand: They combine attractive yields, a high degree of safety, and relatively low overhead costs. They'll represent a growing share of many institutional portfolios in the 1990s, particularly as the variety of securitized products continues to proliferate, thanks to Wall Street's endless creativity.
A Cautionary Note
Against this backdrop of rapid growth, however, I want to sound a cautionary note for all those already involved in, or about to embark on, the purchase of securitized assets.
Even though a securitized asset may be rated A or double-A, and even though the legal documents are quite specific on the duties and responsibilities of the servicer, prudent buyers must be very proactive in terms of assuring ongoing compliance with the pooling and servicing agreement.
Our experience has taught us that it's not enough just to file the agreement and wait for the payments to come in. You must follow up and spend a certain amount of time and effort to assure that the servicer is complying with the terms of the agreement.
When Attention Wanders
Over the course of some seven years of structured-finance activity, we have found many instances where the servicer, for whatever reason, was not being fully attentive to all the details of the legal agreement.
In some cases there seemed to be a lack of communication between the servicer's front office and back office conceming details of the agreement. In others, a degree of inertia or carelessness seemed to have set in after a period of a few years.
Admittedly, some of the servicing shortcomings we've uncovered only involved minor details. For example, while making a sampling of the assets in a mortpge pool, which we do periodically, we may have learned that foreclosure on a delinquent residential mortgage was initiated in 120 days rather than the 90 days specified in the agreement. In itself, this might seem trivial. Unless detected and corrected promptly, however, small problems like that can multiply and could seriously erode the quality of an investment over time.
As an aside, remember that servicers don't earn money on foreclosures, which may help to explain why they are not always as meticulous about such details as we would like them to be.
As mentioned earlier, wholeloan buyers tend to have much more interaction with the servicers and usually will have a dedicated compliance/quality control group within their organization. Buyers of structured securities may not need a fulltime group of this type, but some type of follow-up system must be established.
Cigna's corporate intemal audit staff handles this function for our structured finance group, performing five or six comprehensive audits a year of selected investments.
The auditors, for their part, are eager to do it because it's an interesting change of pace from their regular focus on auditing the various divisions of Cigna.
Selective Audits
Since it would be impossible to audit every servicer every year, how do we decide who will be audited? There are three main criteria:
* The size of our exposure with any individual servicer. Usually we'll schedule an audit once exposure with any given servicer reaches a total of $150 million.
* Awareness of any discrepancy or difficulty, however small, during the course of our normal business dealings with a servicer.
* Our investment in any new asset class. For example, we have owned some securitized boat loans for a period of time, so we'll be auditing the servicers to make sure we have a good understanding of how they conduct their business and asset performance.
A Road to Insights
Audits of this type have a value that far exceeds providing routine information about compliance with the servicing agreement. They give us much more insight into the quality of the people we're dealing with and the latest developments in the marketplace. This, we believe, will help to make us better underwriters of asset-backeds in the future.
Follow-ups and internal audits of servicers obviously lack the glamour of helping to originate some new and innovative structured-finance deal. But they are absolutely essential to investing successfully in this new and exciting asset class over the long term.
Everyone who participates in private structured finance must not lose sight of the need for the follow-up function and must dedicate adequate resources to that function. The unpleasant alternative is to face the risk of trying to explain to senior management some day what went wrong with a seemingly solid investment.
MICHEAL B. STEVENS Managing Director, Private Securities Cigna investment Division Cigna Corp.
Michael B. Stevens is a managing director in the private securities department of the Cigna Coro. investment division.
Mr. Stevens is responsible f or the structured finance investment activities of the private securities department. This includes interest rate and currency swaps, residential mortgage pass-throughs, CMOS, asset-backed securities, secondary private-placement trading, and research and development activities.
Mr. Stevens earned a bachelor of science degree in economics from the University of Florida and a master of science degree in management from the Sloan School of Management at Massachusetts institute of Technology. He holds the Chartered Financial Analyst (CFA) designation.
