As regulators search for the roots of the credit crunch, loose underwriting standards and "soft fraud" by originators have been highlighted by the UK's Financial Services Authority.
Tuesday's paper on financial risk criticised the ratings agencies for consistently overlooking these lower standards.
"Ratings agencies have failed to take account of loosening underwriting standards and may have been compromised by potential soft fraud by mortgage originators in disclosing misleading and inaccurate information," said the FSA.
Methodologies must improve to counter these problems, the regulator added. If ratings agencies fail to address these concerns they risk a further loss of confidence in structured finance.
But the FSA does not blame lost investor confidence solely on the ratings agencies. The regulator called for greater investor education – threatening regulation if this is not forthcoming – and managerial education. Many asset managers, it explained, do not understand how the use of derivatives makes a portfolio more risky through increased leverage. And many leave clients in the dark.
"There is a risk of assets managers and clients not being sufficiently aware of how using derivatives changes the risk characteristics of their portfolios. For example, derivatives introduce implicit leverage into portfolios, something which needs to be monitored against mandate restrictions," said the FSA.
Asset managers also don't understand the systems and controls needed, for example, for using credit default swaps in corporate bond-style strategies.
The FSA is also worried about banks' risk management. Many are failing to consider extreme events or not looking far enough into the future in their stress tests, it says.
The regulator also predicts that the credit crunch will persist and that liquidity could diminish further. Banks need to review liquidity, diversify their funding and take further steps to mitigate risk.
"We expect that industry practitioners will be learning lessons from the current episode of market instability to reassess the type of extreme events that might reasonably occur," said the FSA.