Structured credit products could be more vulnerable to rapid changes in the credit cycle, said the Bank of International Settlements (BIS) last week in its annual report. The BIS also said that if investors incur losses on these products in excess of what they anticipate, it could trigger a repricing of risk across all markets.
"Mortgage and asset-backed securities markets are among the largest, fastest growing segments of global securities markets and in recent years have seen a tremendous increase in the range of new products and securitization techniques," the BIS report said. "However, the performance of many of these new products has yet to be tested in an economic downturn."
One source of unexpected losses could be modelling errors. According to the BIS, structured product pricing is far more dependent on quantitative models than corporate bond pricing. Models typically incorporate assumptions to simplify calculations. Under benign market conditions, these estimates for expected losses have little impact, although the BIS warned that it could prove costly should market conditions deteriorate.
Structured products could also experience a surprise loss arising from shortcomings in risk management, the BIS said. An over reliance on credit ratings might lead holders of structured credit products to underestimate the risks which they are exposed to. Although the credit ratings of these products usually experience less fluctuation compared to those of corporate securities, they tend to fall further when downgraded.
The BIS said that in the U.S. mortgage-backed market, for example, subprime mortgage lending has driven growth in recent years. Pricing of these mortgage pools is based on the average rating of the underlying credits. The average credit scoring tends to under predict the default probability, which is calculated from these ratings.
In the U.K., relaxation of lending standards driven by competition and a greater reliance on securitization has led to a significant increase in lending to riskier households. The BIS said that home prices and interest rates are likely to determine the impact of the expected adjustments on these countries where real-estate valuations appear more stretched.
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