Wall Street's Governance and Risk Management Crisis

Blogger: Bob Blakley

The current financial crisis is, at bottom, very simple: banks lost a bet and they couldn't pay.

But that's not the interesting part; the interesting part is WHY they lost the bet.  They lost the bet because they didn't understand the odds (the New York Times has a great piece on this here).  And failing to understand the odds was a failure of risk management.

It's worth giving a kind of cartoon sketch of the story.

Banks took my money and promised to give me 7% interest.

To earn that interest, they had to do something with the money that would earn them enough money to pay me the 7% and still leave a profit for themselves.

Since many of their traditional lines of business have been automated and commoditized, they looked for a new way to make money.

What they came up with was the home mortgage market, and specifically "collateralized debt obligations".

Collateralized debt obligations were new and complicated, and financial services executives did not understand them very well.

But down deep, these instruments were basically a bet that home values would continue to go up FOREVER.

As long as home values kept going up, banks didn't need to worry too much about whether home buyers were good credit risks - homeowners didn't have to have any money because the home generated its own money.  The owners could just take out equity loans against the rising value of their houses and use the money to make interest payments to the bank.

This, of course, was a game of musical chairs.

The music stopped.  Home prices stopped going up, and the banks lost their bet.

Now banks are supposed to retain a lot of money to ensure that they can pay their customers even when they lose their bets.  The banks thought they had done this, because they counted not only cash on hand, but also assets.  And collateralized debt obligations are assets - but they're not "liquid" assets.  That means they can't easily be turned into cash - they have to be sold.  And for a sale to happen, the buyer and the seller have to agree on how much the goods are worth.  A big part of the banks' assets were the very same collateralized debt obligations which created the problem in the first place.  Unfortunately, nobody knows what most  CDOs are currently worth (since nobody knows how likely the homeowners are to be able to continue to make payments on their mortgages).  In the worst case, the banks will have to repossess the houses which were bought using the mortgages which have been packaged into CDOs, and then turn around and sell the houses to figure out how much their assets are worth. 

And that takes a long time.

Banks have therefore been left holding a lot of paper of unknown value, with no quick way to turn a big chunk of their assets into cash.

This was OK as long as no one asked them for cash.  But they still owe me money - and not just my 7% interest, but my principal too. 

I noticed that the bank didn't have much ready cash, because they'd gambled it all on home prices going up, and they'd lost, and they'd gotten stuck holding a lot of very confusing paper but not a lot of cash.

So I called and asked for my money before anyone else noticed - because I wanted MY cash.

A bunch of other people did the same thing.  We essentially issued a collective margin call to the bank.  And they couldn't meet the margin call, because they couldn't explain to potential buyers what their assets were worth, so they couldn't sell those assets in time to pay us in cash.

So the bank collapsed.

(When I say "I" called and asked for my money, I'm speaking metaphorically, of course.  In reality the banks did this to each other; money managers at banks started to doubt that other banks had enough cash to cover their inter-bank obligations, and they stopped agreeing to loan each other more cash to cover short-term obligations, and the cash that creates liquidity for everyone stopped moving around.  But the principle is the same.)

What's going on right now is that the US Treasury is going to "fix the problem".  How are they going to fix the problem?  Simple.  They're going to raise my taxes, and use the tax revenues to pay me what the bank owes me.  This, of course, doesn't really fix MY problem, because it essentially means that instead of losing my money to the bank, I lose it to the IRS.

But it fixes the bank's problem, because the bank is off the hook for its debt to me.

In one sense this is better than letting the bank collapse; if the government intervenes, I lose my money, but I can still get a car loan or a mortgage next year because there are still banks to go to.  If the banks fail, I still lose my money, but I also lose my ability to use credit.

In another sense, though, it would be better to let the banks collapse - because if the banks collapse, the surviving bankers might learn something. 

What they might learn is that they should not invest in financial instruments they don't understand.

Nick Leeson spoke to us at Catalyst North America about this.  His story about the collapse of Barings Bank, for which he was responsible, was amazing in many ways, but the thing that struck me most was that nobody in Barings' management understood that the bank was in trouble, even though the signs were there for a long time.  The reason they didn't understand was that they - the senior executives of the corporation - didn't understand their own business well enough to see that they were in trouble.

It would be easy to say they were a bunch of stupid, greedy executives, but that lets US off the hook too easily - and here, by "us", I mean technical and financial risk managers.  We need to have a better conversation with our executives.  To have this conversation, we need to better understand how the business works, and how executives talk about the business.  In other words, the people who are responsible for "governance" need to learn to have a much more effective dialog with the people who are responsible for "risk management" - not just in the financial industry but everywhere else, too. 

The people who are responsible for "compliance" are about to get a bunch of new rules thrown in their laps by government agencies, of course, but this will not solve the problem, because it will only protect us against the previous generation of poorly understood risks.  The next crop of poorly understood risks will do the same thing to us again, unless governance and risk management can get together and work on the problem.

Risk management failures created the current financial crisis, and risk management failures  have also created the personal information disclosure crisis, and the malware crisis, and a bunch of other problems which are not yet crises.  We do risk management poorly in all disciplines.  We do it poorly for a bunch of reasons: executives don't understand their own businesses well enough to understand their risks; risk managers don't know how to talk to executives about risk; incentives favor creating long-term risks in order to accrue short-term profits; the list goes on and on.

We're going to talk about these topics at Catalyst Europe in Prague, starting on October 20.

We'll talk about what governance really is, and how governance needs to reform risk management and compliance to get a better handle on the kinds of things that are currently happening to the finance industry.  And Nick Leeson will tell his story again.  It was compelling the first time around, when all we had to look back on this year was Jerome Kerviel's staggering loss at Societe Generale.  It will be riveting this time, now that  we have Lehman Brothers, Merrill Lynch, AIG, and possibly others as context. 

Listening to Nick (and to our other speakers) won't do anything to fix the current financial crisis.  But if you're a risk manager (or if you employ a risk manager) it might help you avoid creating the next crisis - which might be a privacy crisis, or a liability crisis, or an intellectual property crisis, or an availability crisis, or a data integrity crisis, or even a financial crisis.  If you haven't heard Nick talk about what he did at Barings and why he was able to do it, you should be there.

A final thought.  The financial crisis exists because of a failure of risk management.  There will be a temptation to fix the problem using compliance mandates.  Compliance mandates, however, don't fix risk management problems.  All they do is prevent specific risk management failures from happening over and over again.  Organizations whose risk management is weak will find new ways to fail - and these new ways will circumvent compliance regulations. 

The right way to fix a risk management problem is to do a better job of risk management.  In this sense what the Secretary of the Treasury is proposing (which appears likely to be a mechanism for providing the banks liquidity in exchange for their taking the losses they've earned through poor risk management) is a good thing, because it's a risk management solution.  It lowers financial risk by using government money to buy time; the time is then used to establish values for questionable assets, so that they can be sold at a fair market price instead of a panic-sell-bargain-basement price which bankrupts the sellers.  Congress will undoubtedly pass laws which prevent us from doing this again; those laws will be as expensive as building the Maginot Line, and just as effective.

UPDATE: Steve Adler observes that the currently proposed bailout plan has a hopelessly defective governance structure, and proposes some ways to improve it on his blog.

Comments

[readerweb]

This is a very clear analysis. Thank you for putting this together.

readerweb

[Dave Vital]

Bob,
Saw Hank Greenberg (former CEO of AIG)on Charlie Rose Tuesday. He flat out stated the failure of AIG was a risk management failure. In elaborating, he mentioned counterparty risk from CDS's (credit default swaps) was a major reason AIG needed to be rescued. In researching to understand what a CDS is, I came across this gem which uncovers a much more elaborate scheme. This makes the old ponzi scheme look like childs play.

http://www.moneymorning.com/2008/09/18/credit-default-swaps/

[So in short...]

Summary of the summary:

Greed and stupidity caused the banks to collapse.