Subprime mortgages cross risk boundaries

Toronto/London - 5 September 2007

The subprime mortgage crisis is providing ideal real world conditions from which to examine the interplay between credit, market and operational risk. That’s according to the monthly newsletter just released to customers of the Algo FIRST database.

Penny Cagan, a Managing Director at Algorithmics, said, ‘When we last wrote about the subprime lending events in June, we had no idea that what was emerging as a credit risk event, with an underlay of operational risk issues, would grow into such volatile market conditions.

‘Initially it appeared that poor operational risk practices, such as those associated with preparing and reviewing documentation and the due diligence process, errors in servicing loans and models that do not appropriately reflect risk, contributed to the credit problems. However, the ensuing volatility could potentially lead to an increase in operational risk issues, such as processing errors and fraud, leading to an escalating feed-back mechanism.’

A U.S. hedge fund was accused by the SEC of using market volatility as a means for hiding improper practices and potential fraud. This case covers credit, market and operational risk issues with the SEC contending that the fund used market volatility as a ruse for certain alleged improper practices. The fund has been charged with fraudulent conduct and misappropriation of client assets and is now being sued by several of its clients for selling its remaining assets ‘at discounts believed to be up to 30%.’ Its actions had ramifications throughout the system as some of its futures brokerage customers needed immediate access to their funds in order to meet financial commitments.

A bankrupt sub-prime mortgage lender is facing charges that it improperly seized as its own pension assets of former employees. The company’s position is that the deferred compensation contributors are unsecured creditors. The company is still facing a federal investigation into its accounting practices and the legitimacy of its pension plan. It is also likely to face a class action by thousands of workers who were laid off.

A mortgage brokerage is in the process of being liquidated – the end result of multiple factors including the devaluation of its mortgage-backed securities by its clearing broker, the meltdown in the sub-prime mortgage market, margin trading on investor accounts used to purchase the securities and what investors describe as speculative and risky investments by its brokers. The company is blaming the brokerage’s clearing firm for theoretical pricing that was inaccurate whilst investors are saying the companies mis-sold the underlying CMOs as well as allowing investors to purchase them on lower than normal margins.

One of the largest diversified mortgage lenders in the United States is facing a class action lawsuit, contending that it issued ‘materially false and misleading statements regarding the company’s business and financial results’ between the period from January 31, 2006 to August 9, 2007. It issued an earnings alert in July, then faced a ‘run’ in August after announcing it had tapped its entire $11.5 billion line of credit with a group of 40 banks in an effort to ‘navigate’ difficult markets. Movements in the Dow Jones as a result of statements by the CEO demonstrate the power of media commentary from a CEO in influencing the markets. As this case continues to unfold, it is beginning to look more like an operational risk event, with allegations that predatory lending might have been at the heart of the company’s current troubles.

Penny Cagan added, ‘It is currently too soon to know how the current market conditions will impact trends in operational risk losses, and it may take one or two years for patterns associated with the present market conditions to be determined.

‘What does seem clear, however, is that risk types cannot be put into separate silos, and that only truly enterprise-wide risk management can prevent the type of cross-over effect being seen in a number of companies in the present crisis.’

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