Key Mistakes Made By the Market

Key Mistakes Made By the Market - Financial institutions...

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Key Mistakes Made By the Market Misperception of risks Default correlation (tendency for borrowers to default at the same time) goes up in stressed market conditions Assuming that housing prices only go up 1
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Need to Align Interests of Originators and Investors There is evidence that mortgage originators used lax lending standards because they knew loans would be securitized. For a rebirth of securitization it is necessary to align the interests of originators and investors. Regulators are insisting that when credit risk is transferred a certain percentage (5% to 10%) of each tranche is retained by the originator. 2
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Role of Compensation Plans Short term compensation (the end-of-year bonus) is the most important part of the compensation for many employees of financial institutions. This creates short term horizons for decision making.
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Unformatted text preview: Financial institutions are now realizing that bonuses should be based on performance over 3 to 5 years. 3 Transparency ABSs and ABS CDOs were complex inter-related products. Once the AAA rated tranches were perceived as risky they became very difficult to trade because investors realized they did not understand the risks. Arguably the onus should be on the creators of the products to provide a way for potential purchasers to assess the risks (e.g., by providing software). 4 Need for Models Most financial institutions did not have models to value the tranches they traded (It appears that they did not follow their own procedures on this). ABS CDOs have the same structure as CDO squareds which traders find difficult to value. Without a valuation model risk management is virtually impossible. 5...
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Key Mistakes Made By the Market - Financial institutions...

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