So That's Operational Risk! (How operational risk in mortgage-backed securities almost destroyed the world's financial markets and what we can do about it) (WP 2011-1)

Abstract

We describe the economic crisis that began in the U.S. mortgage market in late 2006 as a consequence of cascading operational failures linked to the securitization process. Operational risks including mortgage fraud, negligent underwriting standards and failed due diligence combined with modern finance to initiate a nearly catastrophic crisis in financial markets and a painful recession.

To avoid a repetition of such a crisis, we propose an asset inspection methodology that employs simple random sampling and direct verification of loan-level information. We describe how sampling can verify critical asset quality information reported in prospectuses for asset-backed securities, and we demonstrate the sampling procedure with a simulation exercise applied to a mortgage-backed security. We also provide a template for reporting the results from the sampling inspection that should become part of a security's prospectus.

It is particularly important that credit-rating agencies adopt the inspection methodology to address a fundamental flaw in their credit-rating process for structured finance, namely, a lack of due diligence regarding asset-backed security vintage verification. The sampling methodology proposed here exposes "liar loans" and mortgage fraud; it applies quality assurance supervision to nonbanks seeking access to the securitization channel, and it should help restore confidence in the asset-backed securities market.

Author

Douglas Robertson