Markets for more complex credit risk transfer products may never revive, suggests a new report from the Joint Forum, and it warns that regulators may be no better prepared to prevent future emergencies.

Today’s report was developed in response to a request from the Financial Stability Forum in March 2007 to consider the extent to which the Joint Forum’s March 2005 paper dealing with credit risk transfer required updating as a result of the continued growth and rapid innovation in these markets.

It found that some of the more complex CRT instruments developed since 2004 involve increased leverage, and that this increased complexity, combined with a more diffuse investor base, means that some investors may not fully appreciate the higher-risk nature of these products. This failure to understand some of these risks contributed to the market turmoil of 2007. “A few fundamental tenets of sound financial judgment appear to have been violated,” it noted.

“Despite these shortcomings, the structured credit market is likely to survive, but will remain weak for a period of time,” it said, adding that market participants thought that “one-layer” products, such as collateralized loan obligations or corporate collateralized debt obligations, make economic sense and will continue; but their assessment for “multi-layer” securitizations was less optimistic, and “a common view was that the market for ABS CDOs would either shrink dramatically or disappear.”

The paper reported that supervisors remain concerned about the market’s complexity; valuation issues; liquidity, operational and reputational risks.

It added that, with continued innovation in these markets, the effort and resources that firms and regulators will need to expend to properly understand these instruments increases significantly. “Any future ‘misunderstandings’ of risks involving CRT instruments will probably involve a new and different flavour of products and may be no more likely to be detected in advance, with the current level of supervisory resources,” it concludes. “Nonetheless, there are steps that the industry and regulatory community can take to enhance the robustness of their risk management and oversight of these products.”

The Joint Forum said that it will undertake a review of the recommendations in this paper together with those in the 2005 paper to assess the degree to which they have been effectively implemented. The intention is for this review to take place in one year so that firms and supervisors have time to include necessary changes in their respective processes.