Question 9: (a) The international financial crisis beginning in 2007 originated
ID: 2584798 • Letter: Q
Question
Question 9: (a) The international financial crisis beginning in 2007 originated in the US subprime market. Explain how an asset-backed security (ABS) is designed and briefly explain how these products eventually led to the deterioration of the US and European real economies. [14 marks] (b) There have multiple cases of trader-related fraud over the past twenty years. Through investigation of the cases relating to John Rusnack (AIB), Jerome Kerviel (SocGen) and Nick Lesson (Barings Bank), please identify some of the common characteristics that have been identified. Your answer should consider what internal company procedures may have mitigated the substantial risks or indeed may have deterred the trader's selected action in each case. What actions have international regulators taken to reduce the probability of rogue traders?Explanation / Answer
9a. Asset backed securities (ABS) are designed as financial securities that are backed by any of the following – either a loan, or a lease, or receivables against assets. Thus the assets that back the ABS are loans, leases, different type of debts like credit card debts etc. Mortgage loans are not included in the assets that back ABS. The designing of ABS consists of selling of pool of loans by financial institutions to a special purpose vehicle (SPV). The SPV then buys these assets with the sole purpose of securitizing them. ABS have three tranches – class A,B, and C. Class A is the senior tranche and is also the largest. Class B has lower credit quality than class A and class C has the lowest credit rating.
Products like ABS led to the deterioration of US and European real economies as these products lured investors due to their higher interest rates and yield. The rate of default was higher and majority of the investors were not aware of the risks associated with such products. The bubble burst when real prices began falling and this exposed the risk of such products and investors incurred large losses. Real economic growth was spurred prior to the 2007-2008 crisis as ABS provided investment opportunities to participants that was previously unavailable. But once prices started falling the cost of borrowing increased and ABS were no longer able to make more capital available and facilitate real economic activity.
b. Some of the common characteristics that were present in the John Rusnack, Jerome Kerviel, and Nick Lesson’s fraud case were that there was an absence of internal control systems that could have prevented such frauds. Internal control is a process which helps an organization achieve its objectives toward operational efficiency and effectiveness. The components of the internal control process are: (1) The control Environment (2) Risk Assessment (3) Control activities (4) Information and Communication and (5) Monitoring.
For example in the John Rusnack case he was able to enter false options in the system so as to create a false impression that yen positions were well hedged, but in reality the position had led to substantial losses. There was an absence of control environment, control activities and monitoring.
In order to ensure that the risks are mitigated the organizations in all these cases should have strong control environment through its policies and practices, robust control activities, and lastly monitoring through periodic assessment of the quality of internal control process.
To reduce the probability of rouge trading international regulators can make it mandatory to implement oversight audits (through use of advanced and sophisticated software) by trading firms. When oversight audit is performed regularly then traders will not be able to indulge in speculative trades without the knowledge of the management. Secondly regulations can be introduced to prohibit the use of personal deposit monies for the purpose of speculative trades. Thirdly the power of financial institutions to trade within their own accounts should be curtailed.