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Blind adherence to risk management controls along the mortgage chain, from origination to securitization, are to blame for the current credit crisis. The public has been quick to place sole responsibility for the crisis on the shoulders of bankers, and their perceived excesses. However in any crisis, be it a Depression, Fraud or Catastrophe such as the Three Mile Island Nuclear incident, it is not any one failure point, or person, that leads to a disaster but a confluence of more minor interlinked breakdowns. A misplaced reliance and faith in mechanical risk models, possessing known flaws and weaknesses, were exploited throughout the mortgage chain. Loan originators were actively encouraged to push high commission, high risk products, such as Adjustable Rate Mortgages, whilst at the same time over-inflating borrowers assets and under-stating borrowers expenses in order to generate mortgage flow for Wall Street. The controls in place designed to mitigate these abuses, such as obtaining substantiating documentation and 3rd party credit checks were often ignored, omitted or seldom verified. Bankers packaged, split and combined these mortgages into Bonds backed by them. These bonds were subsequently securitized into Collateralized Debt Obligations (CDO) and then turned into ever more complex and esoteric products, such as CDO^2. These products were impossible to price given their complexity, lack of historic default & price performance information, thereby making management of the associated risks unattainable. Bankers let the task of independently pricing and rating these securities prior to issuance with Rating Agencies leading to a conflict of interest as Rating agencies were paid for these ratings by the bond issuers. In addition to this moral hazard, Rating Agencies used overly simplistic risk and pricing models that did not take into account systemic risks, risks that the underlying assumptions used in their valuations would be moot due to “extraordinary” market conditions. To protect themselves from unexpected losses on CDOs, sophisticated investors relied upon the purchase of a type of insurance contract, the Credit Default Swap which shared the same fundamental flaws in pricing and risk as the CDOs. Whilst the economic benefit of a CDS is sound in principle, the vast majority of these CDS were written and traded solely as a speculative play. As defaults increased to levels way beyond those used in the initial modeling of price and risk the perceived likelihood that the originating issuers of being burdened with “insurance” payouts that they will be unable to pay further added to market turmoil and systemic risk. Industry regulators, bodies who’s task is to protect investors by maintaining the fairness of Capital Markets, must also bear a portion of the blame for the current crisis. Regulators were under staffed and over lobbied by financial institutions eager to remove rules designed to reduce the level of risk they could take on. In addition regulatory staff working at the coal face were seldom experienced and educated in the fields of risk management and were primarily concerned that the banks were following the rules set by the regulators, rules that possessed loopholes that institutions readily exploited. In the end the credit crisis resulted from failures of many interrelated controls. Moral hazard over the way in which compensation was awarded, controls that were actively avoided, known flaws in risk models which were overlooked and the gatekeepers of the financial market were under funded and over lobbied. Such far ranging failures throughout the entire mortgage process demand a complete rethink on how financial products and markets are modeled, monitored and controlled. About Crest Rider Crest Rider Inc is a Management Consulting firm specializing in developing Risk & Governance solutions in the fields of Capital Markets, Investment Banking and Insurance. For more information, visit www.crestrider.com or contact Julian Fisher at 212 721 1580 or Julian@CrestRider.com Credit Crisis
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