27 March 2008
Investor Due Diligence
I have been writing in recent articles about specific weaknesses that have contributed to the current financial crisis in the developed markets. Apart from the unsatisfactory underwriting standards of the sub-prime mortgage sector and the shortcomings in risk management by financial institutions I wrote about in the last two articles, the third weakness is the lack of due diligence by investors. Here we are talking about not just individuals investing directly in complex financial instruments with risks beyond their ability to understand, let alone manage, but also the institutional investors, including the hedge funds, who really should have been able to exercise proper due diligence before getting involved.
Regrettably, inadequate investor due diligence is a common phenomenon that grows along with the intensification of euphoria in the financial markets, when many market participants, whether on the buy or sell side or as intermediaries, get carried away. Also regrettable is that advice given by the authorities to cool the market is often ignored or even condemned for spoiling the party. And when fear inevitably overtakes greed and a crisis develops, the authorities are often blamed for not taking timely action.
To be fair to all those involved in this current crisis, both the structures of the financial instruments and the dynamics of the markets concerned are highly complex. The alphabet soup (CDO, CLO, ABCP, SIV, VIE, ARS, CDS*) is not exactly consommé. But complexity is not an excuse for not exercising due diligence. The volume of information about an investment instrument is not an excuse for not studying it. If complexity is to be used as an excuse, it should be as an excuse for not getting involved at all.
An alternative is to seek advice from experts, but investor due diligence should also involve being alert to whether the experts providing the advice are interested parties to the investment arrangement. As a rule of thumb, one should always take the advice from the counterparty, such as the institution selling a financial product, with a pinch of salt. Unfortunately many only learn this simple rule from bitter and expensive experience.
In the current crisis, even the expert advice of established institutions specialising in this area - the rating agencies - proved inadequate. Some point to the fact that the rating agencies are remunerated for providing ratings to the structured products and are therefore interested parties. I do not believe that this is a significant factor, for I am sure the rating agencies are acutely aware of the reputation risk associated with their rating standards being seen to have been eroded by business interests, which would put their long-term viability at stake. The possibility that the innovative products and the dynamics of the markets for them were too complex even for the rating agencies is a more likely reason. Investors should therefore take the advice of the rating agencies with caution rather than relying on them mechanically, as was the case in the period leading to the current crisis. Another possible reason for the apparent failure of the rating agencies is that their ratings for structured finance products were misunderstood by investors, who may have mistakenly interpreted them as having adequately taken into account liquidity risk and the behaviour of financial markets under stress.
I am sure important lessons are being learnt and remedies will be applied to clarify the role of the rating agencies, making the ratings they give more meaningful and useful. But investors should be aware that ratings are there only to help them to make independent judgements about the risks and not to replace investor due diligence.
Chief Executive, Hong Kong Monetary Authority
* CDO = Collateralised Debt Obligation; CLO = Collateralised Loan Obligation; ABCP = Asset Backed Commercial Paper; SIV = Structured Investment Vehicle; VIE = Variable Interest Entity; ARS = Auction-Rate Securities; CDS = Credit Default Swap.