Friday, May 14, 2010

Remove Credit Rating Agencies From Financial Institution Regulatory Oversight Process

A comment I posted on "Find the Mistake" by Robert Waldmann on Angry Bear blog.
CDOs (including synthetics) and other combinations of mortgage securities and indices of mortgage securities used models to determine their pricing and expected returns. All models contain a finite set of explicit and implicit assumptions. No set of assumptions will reflect real world events under all future scenarios. CDOs in addition to normal market price risk of expected cashflows also have modeling risk. All pricing based on models will contain modeling risk. No pricing model will accurately predict outcomes under all circumstances.

Traded securities prices reflect investor cashflow expectations of those who think it is fair valued, over valued and under valued. Private placement underwritings, such as CDOs, do not have a trading market price. A potential investor who thinks a CDO underwriting is too risky or overpriced will walk away from the deal, not participate, and have little if any effect on valuation. In a trading scenario some overvalue investor will sell their holdings or find ways to short and will affect valuations.

In a trading market, there is a tension between investors who believe a security is over or under valued. In CDOs, the tension between over and under value investors did not exist and all pricing relied on a single valuation model. Investors, who believed they were overvalued or too risky, did not participate in the deals and did not influence the pricing of the deals.

It does not take a PhD in math or structured finance to understand that it is naïve to rely solely on models of future real world events. Investors in CDOs failed to account for modeling risk of the pricing and expected return.

One of the reasons that investors overlooked modeling risk was the desire to invest in highly credit rated securities. Regulators (Basel capital requirements among others) created the appetite for safe credit rated securities. The regulators embedded the credit ratings in their oversight criteria for capital, solvency and safety of financial institutions.

While many are blaming the credit rating agencies, the credit raters also will use models and under some set of scenarios, their models will fail.

The solution is not to blame the model of CDOs or that credit raters fail to accurately rate the securities. The solution is to remove credit raters from the regulatory process of overseeing financial institutions. Removal of the credit raters from the regulatory process would have reduced the appetite for these securities by financial institutions. A lower appetite would mean fewer CDOs, fewer loans with poor credit scores, and a reduced investor appetite in general for home mortgages

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