Situation:  The European Finance Ministers are moving towards more stringent regulation of the securities market as a means to ensure “this never happens again”. The mantra has been sounded for months, ever since the cracks in the US sub-prime market split and the global financial system was rocked by the subsequent credit squeeze.  The focus of the political and financial community has been on identifying the culprit ever since. There is no doubt in anyone’s mind that the wave of complex security derivatives that drove the financial community for the last year unsettled investors.  The underpinning of these instruments by sub-prime mortgages was an invitation to disaster at some point, but the question now is whether a wholesale change in the system will hurt or help. Attention has focused on rating agencies and on “transparency”.  

The prevailing view is that the rating agencies like Standard and Poor’s or Moody’s were too intent on pleasing their banking customers and provided ratings on these funds that were not justified. The EU is pushing for these companies to be split into a ratings division and a consulting division and that the two not be allowed to coexist. This would be done to prevent a conflict of interest. The assumption is that rating agencies deliberately inflated their ratings in order to win business and that is an assertion these companies vehemently deny.

The EU is also suggesting that there be a limit to the complexity of a given security and that derivatives be strictly controlled to maintain maximum transparency. The overall conclusion is that the collapse of the credit system was due to the lack of good information. It was too hard to determine which institutions were at risk due to their use of complex financial instruments. 

Armada Strategic AssessmentThe temptation to “fix the problem” is always intense after a crisis but there are those who think this effort is going too far and for too little gain. As with the collapse of companies like Enron and WorldCom in the US a few years ago, there was a rush to punish and prevent, but in fact the laws and systems in existence were enough to bring the miscreants to justice. In many respects the current credit crisis was an ordered and natural response to the problems this time.

The security instruments were indeed too complex and it was certainly foolish to place such large bets on something as shaky as sub-prime mortgages. The banks, the hedge funds and the investors all jumped where they should not have been and when the weaknesses were exposed they were burned.  It is useful to note that many other banks and investors steered clear of these schemes and came out ahead. This is the nature of the system. Those who engage in great risk reap big rewards (and many did) but they also risk great failures.

Source:  Courtesy Dr. Chris Kuehl, Armada Corporate Intelligence

BIIA Comments: There was wide speculation in the financial press about the reasons leading to the sub-prime debacle:  For instance shoddy risk assessment by banks and deliberately ignoring the extent of the risk to be acquired since the risk was moved off the balance sheet by means of securitization.   Consumer credit bureau processes that provide adequate monitoring of risk seem to have been disconnected from the rating processes, which are based on different data and methods.   Unfortunately for the rating agencies, the current situation is now being used by the EU to settle age old scores against the uninvited Anglo-Saxon rating agencies.

BIIA Newsletter October 2007 Issue