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Credit risk transfer: Where did it all go so wrong?

"A few fundamental tenets of sound financial judgment appear to have been violated."

That's the typically understated view of the Bank for International Settlements, in its first official review of the havoc wreaked on the financial markets by wanton abuse of credit risk transfer instruments.

The central bankers bank first reviewed the CRT market (defined in the context of credit derivative-related transactions) back in March 2005. It observed a market  characterised by significant product innovation, an increasing number of market participants, growth in overall transaction volumes, and perceived continued profit opportunities for financial intermediaries.

It concluded that "continued development of the CRT market offers potential benefits in the form of more liquid and efficient markets for the transfer of credit risk" and finished with a series of recommendations for market participants and supervisors in the areas of risk management, disclosure, and supervisory approaches. 

So where did it all go so badly wrong? 

"The originate-to-distribute model created incentives that resulted, in some cases, in weak origination standards for products such as subprime mortgages," states the BIS in today's review. "Some investors placed excessive reliance on credit rating agency ratings, doing minimal or no in-house due diligence on the CRT products employed. Firms also appear to have had few, if any, risk management processes in place to address risk exposures associated with off-balance sheet entities such as structured investment vehicles (SIVs)."

These are fairly fundamental failings. Unsurprisingly, the BIS has updated its recommendations from a few years back. You can read the full report here.

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