Market "ignored" pre-subprime warnings: BIS' Knight

PARIS (Reuters) - The financial market ignored warnings that house prices were likely to fall, a top banker said on Thursday, adding the U.S. subprime crisis and ensuing credit squeeze were due to inadequate risk management.

Malcolm Knight, general manager of the Bank of International Settlements (BIS) -- the central banks' bank -- said sectors like securitization and credit rating agencies could not have been unaware of what was happening in the U.S. housing market.

"Participants ignored the possibility of a general decline in housing prices," Knight told a meeting of the International Organisation of Securities Commissions (IOSCO).

"The crisis was not solely the result of bad luck but inadequate risk practices and inadequate due diligence of market practitioners," he said.

IOSCO, other regulatory bodies and governments are in the middle of applying lessons learned from the subprime crisis as fallout from it has begun to damage economic growth.

Knight also said investors should place less reliance on the ratings that credit rating agencies put on structured products.

"Complex engineering led to fundamental illusions among investors," Knight said.

"It was a fallacy that complex instruments could be created tailored to the needs of the investor and at the same time be continuously tradable in the market," he said.

Many complex securitized products were linked to U.S. home loans and when those loans began defaulting last year, the products slumped in value and became untradeable.

Rating agencies gave high ratings on many structured products that turned out to be untradeable.

Banks have been forced to write down over $200 billion in the value of holdings in securitized products such as mortgage backed securities and collateralized debt obligations.

Paul Taylor, group managing director of Fitch, said the rating agency was looking at whether it could have a different ratings system for structured products as IOSCO suggested this week.

Rating agencies accepted there were some failings but providing an indicator of how liquid or tradable a structured product will be was much harder, Taylor added.

The BIS began warning in reports as early as 2004 of the risks associated to some parts of the U.S. housing market.

But the chain reaction that led to a global credit crunch, likened by Knight as the tail wagging the dog, has yet to be fully understood.

Knight said securitization still had a role in financial markets but needed improving through greater attention to risk and transparency.

Rick Watson, managing director of the European Securitization Forum, an industry body, said the forum was working on improving transparency in the complex products in response to demands from the European Commission.

"We see simplification of process going forward," Watson said. "We have to make sure investors understand what they buy."

Knight said there were already signs of improvement as some securitized products had probably vanished forever to be replaced by "plain vanilla" products.

"Perhaps this process can be pushed further with some of the standardized synthetic products taken on exchanges," Knight said.

Regulators remain harsh about the securitization sector and rating agencies, as some lawmakers call for a tough response.

"We are in urgent need of improvement," said Jochen Sanio, head of Germany's market watchdog BaFin.

"A lot of glass has been broken in the international financial system and we are now starting with the necessary repairs," he said.

(Editing by Ingrid Melander and Leika Kihara)