All investors are supposed to mark to market their holdings in any investments, particularly public funds and also private funds, otherwise they will not be able to evaluate their performance.

However the flaw in the system is that

1. most investors have abdicated their due diligence responsibilities and rely on the rating agencies for the ratings.

2. a lot of the CDO’s are OTC and not exchange traded, so there is no liquid market. The price is set by the creators on the basis of the ratings obtained. If the rating agencies do not downgrade then there is no motivation for the traders to change the pricing and so it continues to be held at a unrealistic pricing. When there is a sudden downgrade of ratings by a few notches, by then it is too late.

3.the information on the historical performance of the underlying assets is not publicly available. It is generally available with the banks and who pass it on to the rating agencies . So effectively it is a closed club. If the laws required that all CDO’s be listed like equity so all information becomes transparent and is publicly available.
This will enable the investors and independent third party research organizations to express their opinions as well.

4. investors also need to understand that there is no free ride. When they are getting a huge yield premium over a similar rated corporate credit , it is not without reason.

On the issue of fees you have already seen my comments on the articles.

The regulators need to change the rules

1. offer more transparency by making the default information publicly available
2. require the originator to have skin in the game by keeping a reasonable amount of the issue on its balance sheet to take the first loss, rather than relying on third party credit enhancers who guarantee multiple issues with a relative low capital base. When a perfect storm hits , like it did, this all falls apart.
3.. require investors to reserve upfront , at least a minimum amount reflecting the yield premium they are getting over a similar rated corporate credit .

The following is an extract from a article I wrote for the IFR magazine on the issue or structured or transactional ratings.

“……..The most likely beneficiaries of the new
banking model will be the issuers and
borrowers. As the developing economies of
the world continue to grow, there will be a
continuing need for capital. The dominance
of the US as a fundraising capital for Asian
issuers will continue to be tested by the likes
of London, Hong Kong, Singapore and Dubai.

Rules for securitisation and derivatives
markets will be reviewed and possibly be
rewritten. Regulations enabling greater
transparency in these instruments and
exchange-based trading are the need of the
hour, which will also assist in counterparty
settlements. This also means that there will
be fewer one-off toxic products sold to
investors through private banks.

The role of securitisation has come into the
limelight and there is a critical need to
determine whether the securitisation
instrument should be used as a funding
vehicle or should be based on an ‘originateand-
distribute’ model.

If it is a funding vehicle, then investors in
such instruments should have some recourse
to the originator. If it is based on the ‘originateand-
distribute model’ rating agencies should
reflect the nature of the instrument with a
different set of ratings and accordingly include
“buyer beware” health warnings for investors.

The Bank for International Settlements,
the IMF and the central banks should put in
place systems at both the global and local level
that prevent a repeat of the gridlock in the
interbank markets that froze bank lending
recently. Institutional investors such as
sovereign wealth funds should be allowed to
participate in the short-term money
markets.

Institutions such as the World Bank and the
Asian Development Bank should assist the
local regulators in stepping up the efforts to
develop the local capital markets and to
provide market liquidity, particularly in
critical sectors of the economy. There is also
a need for the World Bank and ADB to be
more proactive and to respond faster with
solutions than they are accustomed to do.
Regulators need to monitor closely the
leverage of the institutional credit enhancers
to ensure appropriate risk relative to their
capital bases.

Rating agencies
Until the regulators find an alternative, the
rating agencies will continue to play a crucial
role, particularly as quite a few banks and
institutional investors have abdicated their
due diligence responsibilities. However, as
has been seen with the accounting firms,
there needs to be some form of separation
between corporate ratings and transaction
ratings, particularly in terms of revenue
recognition.

In structured transactions, one of the ways
to address this is to recognise revenues over
the life of the transaction. If the issue defaults
without a significant ratings downgrade, the
rating agencies’ fees should be put into a
pool for investors. That would help address a
basic conflict of interest: the fact that the
agencies have a vested interest in seeing lots
of structured credit issuance, because they get
paid to rate the stuff.

The auditors need to highlight the
counterparty risks (on both sides) and require
the institutions to report the net exposure if
it exceeds a pre-agreed amount or a certain
percentage of the capital base.

A precedent has already been set with the
bailouts of banks and insurance companies
that are “too big to fail”. Regulators need to
appoint independent parties to do a detailed
study in each country, evaluate the triggers
that resulted in the crisis, and suggest and
implement the recommendations.
Academics from the University of Chicago
and Harvard University recently presented a
paper titled Rethinking Capital Regulation,
which proposed that banks should take out
insurance secured by Treasury bonds held in
an escrow account. Such funds will be released
when capital is required when a bank fails.
The alternative argument was that being
over-capitalised in good times was an
expensive proposition and in difficult times
obtaining equity was impossible.
Another variation of this is for the banks to
issue the equivalent of catastrophe bonds
whereby bond investors, in return for a
higher yield, do not get repaid in the event of
a catastrophe such as a sub-prime crisis.

Having lived through several crises in the
past three decades, I think it is unlikely that
lessons will be learnt. Perhaps market
participants can take a leaf from the Mayo
Clinic in Rochester, Minnesota, one of the best
hospitals in the world, which is said to have
a clinical database that goes back a 100 years.
The global regulators and bankers need to
build up an institutional database like that to
deal with future crises. For those presently in
banking and others who will take it up as a
profession in the future, two quotes are worth
bearing in mind.
• The only perfect hedge is in a Japanese garden.
– Eugene Rothberg, former treasurer of
World Bank
• Those who cannot remember the past are
condemned to repeat it
– George Santayana, Spanish philosopher,
essayist, poet and novelist

(Avi Bindra is a former banker who worked with Citi and
HSBC in Asia for nearly 30 years. Based in India,
he runs a financial software firm called Arx Analytics
and Advisory Private Limited)