Mis-Pricing of Asset-Backed Securities

FSA recently fined the UK operations of Credit Suisse (the subsidiaries) £5.6 million for breaching FSA Principles 2 and 3 by failing to conduct their business with due skill, care and diligence and failing to organise and control their business effectively.

Credit Suisse announced its financial results for 2007 on 12 Feb 2008. On 19 Feb 2008, Credit Suisse announced that it had identified mismarking and pricing errors by a small number of traders and that it was repricing certain asset-backed securities. The re-pricing involved a write down of revenues by US$2.65 billion. In relation to the write down, Credit Suisse disclosed in its 2007 Annual report in Mar 2008 that a SOX 404 material weakness had existed in its internal controls over financial reporting as at 31 Dec 2007.

The breaches related to the pricing of certain asset-backed securities held by the Structured Credit Group (SCG) within Credit Suisse's Investment Banking Division. The principal activities of the SCG are structuring and issuing securities based on underlying pools of assets, including CDOs and credit correlation trades. These are often highly complex, high risk, leveraged products. The subsidiaries were responsible for ensuring the adequacy and effective operation of their systems and controls, including those provided in part by other companies within the group.

Credit Suisse's senior management commissioned a detailed review of the causes of the write down which identified serious failings in the design, implementation, operation and management of controls over the SCG. The principal failings identified in that review were set out as follows:

• The systems and controls of the subsidiaries for the supervision of traders in the SCG and for the pricing of highly complex products within the SCG were not effective and were not applied consistently. The systems and controls in place, such as a complex matrix structure for the supervision of traders in the SCG, were too complicated and fragmented. Some individuals within control functions lacked a clear understanding of the responsibilities that had been assigned to them.
• There were failures to respond adequately to a number of warning signals or "red flags" and to translate identified concerns about price testing variances in CDO positions within the SCG into tangible or timely actions.
• Certain personnel within control functions with responsibility for recording or checking prices were overly deferential in challenging certain SCG traders and do not appear to have had sufficient seniority or management support to challenge effectively.
• Undue reliance was placed on the technical ability and revenue contribution of certain front office staff, who were highly influential in down-playing price testing variances and in influencing the price testing methodology used, and did not take appropriate action to control and manage such staff effectively.
• Certain control functions failed to escalate in a timely manner price testing variances that were identified, owing to issues such as the complex booking structure used for the CDO trading business, a lack of effective supervision over price verification processes and an over-reliance on assertions made by certain front office staff.

One of the key lessons learnt from this case is the over-reliance on front office staff because they have more technical knowledge of complex deals than the control function staff. As a matter of risk management, firms may assign some front office staff to work at control functions for a period of time to bridge the knowledge gap. Of course front office staff may not always be willing to sacrifice their high pay to become a "coach", but how about such job rotation is arranged during a bear market (like the present)?