PrefBlog

I’ve run across an extremely interesting paper, Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, written by Joseph R. Mason, an associate professor at Drexel University who has been mentioned here before in connection with his testimony to Congress, and Joshua Rosner, Managing Director of Graham Fisher & Company, a firm that provides “Independent research for institutional investors in financial service assets”.

The primary recommendation for public policy is:

Significant increases in public access to performance reports, CDO and RMBS product standardization, and CDO and RMBS securities ownership registration can help decrease the existing over-reliance on ratings agency inputs to rate and ultimately value the securities and reducing the valuation errors inherent in “marked-to-model” (rather than marked-to-market) portfolios. SEC Regulation AB was a (late) start for ABS and RMBS. Overall, however, the U.S. economy needs an efficient public CDO market that allows transparent openmarket pricing of market risk and outside research into new securities and funding arrangements.

This is a principle with which I can whole-heartedly agree … although I will not guarantee  sweet accord when the details are hammered out! There should be no regulatory restrictions on the flow of information … it should be possible to publish all deal information without fear of adverse regulatory repercussions, but there is often some confusion on this point. The regulators should first make it plain that, while selling the investment to a non-qualified investor may be improper, publishing the advice is encouraged.

After that, let the market and the Prudent Man Rule do its work. I think it would be fairly easy to argue that a Prudent Man would review available information prior to making an investment. At which point we get into further problems … how much review is enough?

Consider a plain and ordinary S&P 500 Index Fund. How much of the fund material do you have to read before you can purchase some on behalf of a client? Do you have to read through and understand the annual reports of all 500 companies?

I suggest that the archetypal Prudent Man need only

• understand what the S&P 500 is attempting to do, and
• verify that the vehicle will track it ‘reasonably’ well, and
• do so at a realistic cost

… but there will be legitimate disagreement over even this simple exposition! My continued vocal support for the primacy of the Prudent Man Rule should not be taken to imply that I believe it will be simple and unambiguous.

This entry was posted on Tuesday, November 6th, 2007 at 3:11 pm and is filed under Interesting External Papers, Regulation, Sub-Prime!. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.