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An Introduction to Derivative Securities, Financial Markets, and Risk ManagementAdvanced Financial Risk Management, 2nd ed.

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In the mid 1980s at First Interstate, I participated in serious discussions about how the Merton model of risky debt could be used to diversify credit risk. In the early 1990s, I actively marketed default probabilities based on the Merton concept in Japan. I wrote two books advocating the model in the 1990s as well. Now my view of the model has completely changed. This blog explains how and why that came about.

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Much of today’s credit crisis can be blamed on mortgage structures where the lender hoped, but had no reason to believe, that losses would be manageable. This blog talks about what changes are needed in “common practice” default modeling to achieve “best practice” in both the short and long term.

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Last week on July 22 and 23, our blog post focused on the issue of which government rescues should constitute a "failed" firm for default modeling and which should not. The view of most of our clients is that FNMA and FHLMC are clear fails, while the rating agencies and a few clients say they are not. The choice one makes has big implications for the accuracy of default modeling. This post shows why.

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Yesterday's blog post on the need to audit rating agencies' self-assessments on ratings accuracy has provoked a lot of comments.  What do you think should be done in the KRIS version 5.0 credit modeling exercise with respect to FNMA and FHLMC? 

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The U.S. Treasury proposed new regulations on the major rating agencies yesterday, and a chorus of critics have attacked the agencies for inaccuracy of both structured products and corporate ratings over the last two years.  One of my great fears has been the moral hazard that the rating agencies have to exaggerate the accuracy of their historical performance in rating corporate bonds.  Today, those fears were realized.  The U.S. Treasury should require an independent audit of rating agency performance in rating bonds and structured products.  This post explains why.

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