Morningstar warns on social risk in structured credit
Morningstar DBRS has warned that some structured credit transactions may come with a higher environmental social and governance (ESG) risk, as the ‘social’ element of ESG comes under scrutiny.
In a new commentary, the ratings agency laid out the social factors which might affect structured credit transactions. These include operational risks, and the risk of lending to the underserved.
Morningstar said that to ensure that a lender has met the right standards for lending, they must be mindful of ESG issues, including the potential impacts on local communities and working conditions.
“Across Europe, many entities have been taking a more socially responsible approach to lending, either for historical reasons and/or influenced by ESG considerations,” said the Morningstar report.
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“These factors can include community, environment, and social issues. Lenders can use this data to make informed lending decisions as well as to improve the quality of financial services provided to underserved borrowers.”
Morningstar noted that the social impact of some product and service risks could affect its operational risk assessment. These include whether or not the lender is lending prudently to underserved borrowers.
“As these borrowers are underserved, they might have low income/high variability in cash flows and limited to no credit/income track record,” said Morningstar.
“Likewise, originators of new loan products to underserved borrowers likely will not have much historical performance data.
“To ensure that lending to this cohort is prudent, stringent underwriting standards, particularly surrounding borrower affordability, need to be in place. Training and effective procedures on early default resolution are also often needed to mitigate the potential for higher delinquencies from these types of borrowers.”
The agency also said that it looks at unmitigated compliance risks due to lending practices or work-out procedures, as these practices could result in a higher default risk and/or lower recovery expectations for the securitised assets.
Morningstar added that servicers or originators that engage in bad workout procedures could experience increased default risk, while aggressive servicer loss mitigation tactics may lead to litigation and fines that could ultimately be borne by the structured finance issuer and its noteholders.
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“When considering underserved borrowers, our analysis centres on the prudence of lending and how much both the lending and potential workout processes (in the event of arrears) are designed to help this cohort rather than presenting another way for lenders to increase profits or gain publicity,” said the report.
“We believe that the participation of the credit-risk management, quality-control, legal, and compliance departments in the origination, underwriting, and servicing process is important to identify and mitigate operational risks.”
Morningstar noted that lending to underserved borrowers is an inherently riskier practice, and urged all investors to carry out their due diligence and be aware of associated risks such as the possibility of mis-selling, regulatory risk, and compliance risk.
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