Friday, August 8, 2008

Squeals over rating scales strangled by velvet rope

(FT) The protests and squeals of pain from the global securities industry over talk of changing credit ratings scales for complex debt products have probably turned into slack-jawed silence in the wake of “Corrigan III”.

The strongest motivation for those pushing a new ratings scale for mortgage-backed bonds and similar assets, I believe, is that it would show publicly that regulators had forced investment managers to reassess their mandates and set new rules on exposure to such products, as distinct from other rated debt.

However, such concerns have been overtaken by this week’s third in a series of reports into systemic risk from the study team led by Gerald Corrigan, Goldman Sachs grandee and former New York Fed chief.

The report proposes the financial industry put up a metaphorical velvet rope, separating a tightly restricted club of initiates, who would be the only institutions allowed to dabble in – the phraseology is crucial – “high-risk complex financial instruments”.

Mr Corrigan is open in saying that questions about both what constitutes the instruments concerned and who can join the club are a “subtle and complex” business.

In the case of the “standards of sophistication” for investors, the bar seems high. The “characteristics” that ought to be assessed in deciding entry to this club must be “guided by the overriding principle that all participants should be capable of assessing and managing the risk of their positions”.

These would include the capability not only to understand the risk and return traits of a specific product but also to price and run stress tests on the instrument. Further, each investor must have “authorisation from the highest levels of management” in their company.

In the case of the products themselves, the report underlines (literally) “not all complex financial instruments are necessarily high-risk”. There are three critical features that, nevertheless, do not provide a complete test of what belongs in the class and what does not.

The most important is leverage, and particularly embedded leverage, which is what tripped up many investors in structured finance. Embedded leverage arises through the slicing, or tranching, of risk in securitisations. Unlike leverage through borrowing, investors are never at risk of losing more than their original investment with embedded leverage. However, what it does is multiply the risk that investors will lose their money and, more importantly, the speed with which a losing scenario can appear.

Such risks have proved obscure and hard to assess, in part because they are often based on assumptions about the performance of the underlying mortgages or loans – assumptions that proved in recent times to be way off mark. With multi-layered securitisations, these risks are multiplied in difficult to fathom ways and become even more obscure.

The other main traits are risk of sharply reduced liquidity and a general lack of price transparency.

In this analysis, even supposedly safest, triple A-rated tranches of collateralised debt obligations that ultimately reference subprime mortgages fit the profile. But lower-rated tranches of the most liquid, prime mortgage-backed bonds might escape.

What stands out immediately is that this approach would concentrate the trickiest risks in fewer hands – the only definite advantage being that, at least, regulators would have a better idea of where such risks reside.

The big question is whether banks can comprehend and cope with those risks, and here is one of the most striking themes of Corrigan III. The report proposes that banks pay far greater heed to – and, by implication, take responsibility for – systemic risks in the financial world. With counterparty risk for example, a firm must evaluate not only its own exposure but also its counterparty’s exposures to others in terms of size and direction.

This seems an effort to support overstretched regulators and central banks while forestalling the need for tighter supervision. Given the widespread and manifest recent risk failures and uncertainties about the raw technical capabilities of banks’ risk systems, such laudable aims are still far from reality.

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