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So That's Operational Risk! (How operational risk in mortgage-backed securities almost destroyed the world's financial markets and what we can do about it)

by Douglas Robertson

March 2011

Abstract

We describe the economic crisis that began in the U.S. mortgage market in late 2006 as a consequence of cascading operational failures linked to the securitization process. 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, we propose an asset inspection methodology that employs simple random sampling and direct verification of loan-level information. We describe how sampling can verify critical asset quality information reported in prospectuses for asset-backed securities, and we demonstrate the sampling procedure with a simulation exercise applied to a mortgage-backed security. We also provide a template for reporting the results from the sampling inspection that should become part of a security’s prospectus.

It is particularly important that credit-rating agencies 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. The sampling methodology proposed here exposes "liar loans" and mortgage fraud; it applies quality assurance supervision to nonbanks seeking access to the securitization channel, and it should help restore confidence in the asset-backed securities market.

Disclaimer

Any whole or partial reproduction of material in this paper should include the following citation: Douglas Robertson, "So That's Operational Risk!" Office of the Comptroller of the Currency, Economics Working Paper 2011-1, March 2011.

Availability

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