Sunday, May 16, 2010

Credit Scoring for Wall Street Investments

The recent Goldman Sachs revelations are to say the least troublesome. The position taken by the Wall Street Investment Banks that the trader’s duped, were sophisticated buyers that ought to have done their own due diligence, exposes an unacceptable arrogance. The sale of the Mortgage Backed Securities that brought the financial world to its knees was based on that very same premise… caveat emptor. You make your own investment decision, but we are going to hide and disguise the facts. Further, with each passing day, and revelation, it is becoming clearer that my charge of a vast conspiracy or at the very least misrepresentation by the Wall Street banks in cobbling together and passing off as investment grade, these fraudulent and extremely dangerous products; “guaranteed” by the equally bogus Credit Default Swap (CDS) A.I.G mortgage insurance policies.

In this mid-term election season, congress is going through its usual and customary charade of asking “tough” questions for the media and electorate, and then turning around and asking the Walls Street bankers for their advice on future regulations of their industry! We had Senator Levin asking soft ball questions of Lloyd Blankfein, Goldman Sachs Chairman, and then seeking his advice on crafting legislation!… Does the coyote want the chicken coop gate to swing in, or out!

We need, and want our investment banks, and Wall Street brokerages to offer products that will generate income. Yes, these will always be risk based offerings. By their very nature this will be the case. However, in this computer age, but there MUST be openness, and without the subterfuge that has been the usual and customary business practice of the markets. Had the markets implemented the exact same underwriting criteria that are used in approving real estate loans, this entire economic meltdown probably could not have occurred?

Some 20 plus years ago Fair Isaac's created FICO risk/credit scoring. Each of us has a credit report derived from a scoring model and maintained by the three credit repositories. Borrower’s who have demonstrated strong credit worthiness are rewarded with the highest credit scores, and receive interest rate “bonuses.” EVERY mortgage originator hangs their hat on these scores; and then factor in loan to value as the deciding factor in approving each loan. History has proven that the default rate is directly related to higher the credit scores, and the lower the loan to value. The higher the score, the lower the loan to value, the lower the defaults rate. The converse is true, credit scores under 680 and loan to values exceeding 90%, yield a greater default rate.

A Mortgage Backed Security is, in effect a mutual fund comprised of real estate mortgage loans. The MBS must have an AAA or higher rating to qualify as investment grade sufficient to be offered to pension plans. Insofar as every loan placed in the pools already has credit scoring and a loan to value, the mathematical formula to arrive at a credit score for each MBS is quite simple to achieve.

Originators would be required to enter every credit score and loan to value for each loan into a data base… PRIOR to selling any loan into the secondary markets. Every new entry will result in a new score for the pool. Set a minimum “Investment FICO” score, say 800, to be a minimum for an AAA+ rating, 790 for AAA, 780 for AAA- and so on. Further, an MBS cannot be comprised of loans originated from any single source, further eliminating the chance for collusion. As an additional safeguard, originators MUST be required to either retain a position in every loan sold, or provide lender paid mortgage insurance in every loan sold into the markets. The originator made the loan,and must be required to retain a level of risk. Full transparency as to the quality of the loans in each pool would be guaranteed. This method would still allow a Wall Street bank to cobble together whatever garbage it chooses into lower grade loans into a below investment grade marketable security. No regulations for the Wall Street Banks, no looking over their shoulders, winking at a worthless, inept SEC.

My method would far more open… caveat emptor would still be the name of the game… however, the buyer, with proper advance “warning” would then be in the position to make an informed business decision. Congress has proven to be both incapable and unwilling to implement meaningful Wall Street regulation. The SEC has proven to be nothing more than a federal bureau designed to pay lip service to the public.

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