[OPE] The human element behind the crisis

In July the IIF http://forecasters.org/index.html issued a document that relates to the human element behind the crisis. The roots of evil were opacity and poor understanding, it concluded. Everybody relied on mathematical models to price risk instead of using common sense when evaluating the assets. The result was that the global capital markets turned into a sort of pyramid scheme: Everybody passed on high-risk assets that nobody thoroughly, fundamentally understood and finally, everybody fell down together.

Following that train of thought, the IIF decided that it should be the responsibility of mortgage lenders to apply the same credit checks on borrowers, whether the lender kept the loan or sold it onward through securitization. One cause of the crisis was that this very basic rule was not followed.

In the same spirit, the IIF ruled that institutional investors around the world had relied too much on the risk ratings of assets. They bought and sold assets relying solely on assessments of credit rating agencies, without checking the merits of the assets themselves. The IIF therefore recommends that institutional investors actually study assets they're thinking of buying, and develop their own risk evaluation models.

Nor does the IIF spare its contempt from the capital market supervisors, who handed down rules and standards that also relied on risk ratings from credit rating agencies, which induced institutional investors to do the same - to rely on the credit rating agencies - without actually analyzing the securities themselves. The IIF recommends that supervisory regulations no longer rely solely on credit ratings.

To sum up, the IIF is saying that risk models shouldn't only be based on statistical models. They should factor in actual underlying risk, the risk of the borrower, on which all these structured notes were based.

And finally, the IIF acknowledges that to restore investor faith in the market, transparency has to return. The public must know what it's buying and why. To achieve that, the IIF suggests improving proper disclosure. That doesn't mean requiring more reports - too much information can be confusing, the IIF says. The whole point is for reports to be relevant and useful, it points out, providing clear qualitative and quantitative information about a company's risk.

It all sounds quite trite, yet it took the umbrella organization of the world's banks and the worst capital market crash in 80 years to remind us that common sense and simple understanding are the only way to run a business properly. http://www.haaretz.com/hasen/spages/1024226.html

Spot the flaws in the argument, and the totalitarian implications!

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Received on Fri Sep 26 20:09:32 2008