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5 Risk Indicators that Led to the Mortgage Mess

A civil lawsuit by the Justice Department against Standard & Poor's shines a light on faulty ratings. But savvy traders at Goldman and Paulson & Co. saw early warning signs of the mortgage crisis in 2006 and 2007.

Last week the Justice Department slapped Standard & Poor’s with a civil law suit for fraud, accusing the credit rating agency of inflating the ratings of securitized mortgage products in the years leading up to the 2008 financial crisis. However, the beginnings of the mortgage mess trace back to 2006 and 2007 and some of the key risk indicators that, in retrospect, should have been cause for greater circumspection on the part of some risk managers.

The first indicator of risk back in 2006 was a decrease in asset quality. As has been well documented, the mortgage sales industry had expanded tremendously through the early part of the 2000’s. To maintain production levels and continue to expand the consumer market, the origination of risky mortgage products with adjustable rates in the “sub-prime space” became far more widespread: commentators have estimated that the proportion of sub-prime mortgages grew from historic levels of 8% in 2004 to about 20% in 2006 (M.Simkovich, “Competition and Crisis in Mortgage Securitization”). This trend negatively impacted the underlying quality of the assets being packaged and re-packaged into securitized products by investment banks in 2006 and 2007 making their future cash flows far more vulnerable to changes in underlying market conditions. Risk managers worth their salt took note of the changes in underlying assets and took steps accordingly. Most famously, Goldman Sachs took aggressive steps to hedge their positions with regard to the housing market in 2006. Many risk managers, however, did not take such steps and in fact continued to look for ways to double down on their long positions. Citigroup CEO Charles O. Prince, interviewed by the Financial Times in July 2007, said, “As long as the music is playing, you’ve got to get up and dance,” before adding the punch line, “We’re still dancing.”

[For more on Top Ten Operational Risks, see Andrew Waxman's related story.]

The second indicator of risk was lack of transparency in pricing. These bonds were very complex and the detail behind their underlying assets hard to value. The rating agencies were able to confer value in the marketplace by the ratings they determined. The action just taken by the Department of Justice against S&P underlines the difficulty facing banks. In this context it was important for banks to develop independent means of assessing the value of these securities and of their future prospects. There were several examples of traders who understood that the ratings did not necessarily coincide with market realities – John Paulson, Steve Eisman to name two.

Such traders had developed an independent basis for their assessments of value. It is worth noting that when the market was positive such lack of transparency helped assets of lower quality to attain higher values. When it turned negative, however, that very lack of transparency did not help products that were higher quality: all tended to be tarred with the same brush. Portfolio managers and traders who did detailed analysis of the assets and believed they had a quality portfolio were not necessarily helped if they missed the bigger picture. Andrew Waxman writes on operational risk in capital markets and financial services. Andrew is a consultant in IBM's US financial risk services and compliance group. The views expressed her are those of his own. As an operational risk manager, Andrew has worked at some of the ... View Full Bio

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