More Than One Million Reasons to Lie about Structured Finance

Abstract

Correctly characterizing credit risk is the most important step in structured finance. In particular, detecting fraud in granular portfolio assets leads to market outperformance for portfolio managers who eliminate more fraud than their competitors. Fraud results in varying degrees of permanent value destruction for both fixed income and equity portfolios. Even if no fraud is discovered, the due diligence process eliminates weaker “peer” credits and eliminates overpaying for assets. Fraud discovered in discrete assets is often a leading indicator of gaming in other aspects of securitizations. Despite the contribution of massive securitization fraud to the September 2008 financial crisis, quantitative modeling is still favored at the expense of thorough portfolio due diligence. The financial industry should shift the bulk of time and money to ongoing credit analysis instead of spending most of its resources on quantitative analysis. This is the opposite of current market practice.

TOPICS:CLOs, CDOs, and other structured credit; credit risk management; portfolio management/multi-asset allocation; quantitative methods; financial crises and financial market history