Where were the regulators on April 26, 2007?

I just read in the Washington Post that the CDO discussed in the suit against Goldman Sachs, ABACUS 2007-AC1, and in which investors lost more than $ 1 billion, was created on April 26, 2007

Just out of curiosity I went back to my blog TeawithFT and found the following letter:

On March 19, 2007: Let us pray the estimates are wrong

Sir, let us pray for that the estimate that 2.2m of American families could lose their homes and that John Gapper mentions in “The wrong way to lend to the poor” is totally wrong. If not, then let us prepare for the worst, as the political consequences of such fallout in the sub-prime mortgage market would by far surpass whatever all other thorny issues such as Iraq and the illegal immigration could all produce, together.

What I miss in this scarily good saddening and scaring article, is some words of how it came about that some 2.2m obviously individual shaky loans could have, when all was said and done, produced the sufficiently good ratings needed to attract so much money. The credit rating agencies sure must have some explaining to do, as has those Bank regulators responsible for giving the credit rating agencies so much power to begin with.

You can find it here http://bit.ly/9clEC9 ... but that’s not all friends;

On April 13 I responded to an article of Gillian Tett in FT titled “Subprime proposals could broaden litigation risk all around” http://bit.ly/d9I0rt

Also on April 13, 2007 I responded to an article in FT by Richard Beales titled “A whiff of double standards” http://bit.ly/d2vopp

And on April 18, 2007 I responded to a comment in FT by Desmond Lachman titled “Housing bubble burst into American elections” http://bit.ly/cxKT3P

And so there obviously has to be so much more to it? Where were the regulators on April 26, 2007?

Credit rating agencies should be free to rate but the markets should also be free from not having to follow them.

Sir, every comment in Richard Beales and Saskia Scholtes´ extensive and detailed “Critical focus turns on rating agencies”, August 16, seems to underline the idea that credit rating agencies can do a better job, while the most important fact we need to realize is that to correctly rate credits is such an impossible thing to do that we should never adjudicate special powers to any agency to influence the market. The first thing we need to do is to start dismantling the system of using credit rating agencies. Of course they are free to rate, but the markets should also be free not to follow them.

I can’t stand the suspense.

Sir, I once saw a balance sheet of a hotel corporation where they had registered on their balance sheet among their fixed assets the cost of building the hotel rooms but since they had also issued user rights valid over a very long period of time for each of those rooms, and were selling these out as timeshares, they also registered as current assets the inventory of unsold timeshares, valued at the price they were selling them at, and all this duly audited by a recognized name. As you can understand, this have your cake and eat it too balance sheet looked extremely solid and paid bonuses to the executives, while it lasted.

This memory came to my mind when reading Richard Beales’ and Gillian Tett’s “Real risks emerge when Pandora’s investment box is opened” June 29. If what I recounted above could happen with open and transparent audited statements (albeit in a developing country) then what limits could there be to what you could hide in black-box algorithmic proprietary trading models. I pity those judges that tomorrow will have to try to understand the issues, as I pity those that though perhaps totally innocent will be sentenced to jail just because they can’t get anyone to understand their models.

Having said that it is clear that we must face the real possibility that all of our economic numbers could be fictitious since we could already have incurred in real big losses but that are mercifully covered by a lot of untested hot air. When those boxes are opened up who will appear? A beautiful girl or someone with a machine-gun… I can’t stand the suspense, though I must admit that the bliss of ignorance has also its attractions.

Investing in people losing their homes?

Sir, June 1 Saskia Scholtes reported of hedge funds' "Fear over a helping hand for home loan defaulters¨ and June 5 Richard Beales says that Fitch ratings could downgrade bonds backed by subprime mortgages if the loan's terms are changed to help borrowers keep their homes. It takes some time for the implications of such news to set in but when it does it really knocks you down. Do they mean that in all the risk diversification (or risk hiding) that has been occurring through derivatives we have now actually created a group of investors with a vested interest in people losing their homes? Sorry, something sounds wrong and this surely must be something more than your regular moral hazard. Can I go long on a nuclear missile index?

Why we should beware of the use of credit rating agencies even if they are superb

Sir, by now you must know that I am one of those who have been most sceptical about the growing role that has been assigned to the credit rating agencies in channelling the financial flows of the world, which is why I commend the financial team of FT for their Failing Grades?, May 17. But, having said that let me briefly give you an example why I think we are on the wrong track even if these agencies were superbly and almost inhuman efficient in their work.

As my MBA, though not that rusty, is from 1974, pre Black-Scholes-Merton model days, I am currently trying to update it by taking the exams for a Certified Financial Advisor (CFA) in the USA, surrounded by thousands of much younger candidates. It is not easy and so that you can better understand how hard it really is, just look at the following question that appears in a CFA mock exam:

Explain whether you agree or disagree with the following statement: “The credit risk of a bond is the risk that the issuer will fail to meet its obligation to make timely payments of interest and principle”

If I had answered the above with a YES, as anyone would have intuitively done, had they not peeked in on the updates, I would have distanced myself further from my CFA certification since the right answer indicated is a “NO”, among others because the (modern) credit risk now includes a “Downgrade risk, which is the risk that an issue will be downgraded by a rating agency”

And so now, instead of having to focus on the true object of the credit risk, we must also focus on the side issue of the opinions of the credit rating agencies, and that Sir, though we might feel all cosily comforted by more knowledge, does not really seem to put the world on a wiser financial track.

I do not mind credit rating agencies but, if we are forced by financial regulators to go by their criteria, then they should be forced to be equally responsible for them. Alternatively, let them hang around, giving their First Amendment protected opinions, but do not force anyone to have to follow them.

The mother of all systemic risks

Sir, when Richard Beales reports (April 2) that “Uproar forces Moody’s into U-turn over bank ratings” he gives compelling evidence to what some of us have been voicing for almost a decade now, namely that to give some few credit rating agencies so much decision power about how the world’s financial flows should be allocated will, sooner or later, implode or explode into a crisis, as that carries within itself the genetically coding for the mother of all the systemic risks. By reading their “theological discussion” of “how to factor into ratings the possibility that some banks were unlikely ever to be allowed to fail even if they appeared financially weak” you surely must conclude that we might have all been placed on a vicious circle that could perhaps only end with the demise of the by then the world’s only remaining bank. On a side issue, can you sue your credit rating agency for the losses caused by the additional market volatility that his change of heart creates?