How global financial markets were almost destroyed by operational risk

The US Office of the Comptroller of the Currency has just published working paper by Douglas Robertson entitled "So That's Operational Risk!". The sub-title says it all when it proclaims “How operational risk in mortgage-backed securities almost destroyed the world's financial markets and what we can do about it”.

In his paper Douglas Robertson describe the economic crisis that began in the US mortgage market in late 2006 as a consequence of cascading operational failures linked to the securitization process. These 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, the paper proposes an asset inspection methodology that uses simple random sampling and direct verification of loan-level information.

Credit-rating agencies are urged to 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.

This Working Paper is available from the US Office of the Comptroller of the Currency’s website. To go there – CLICK HERE