Want to buy a pile of second mortgages with a loan-to-equity value of 99 to 1, and scant documentation on borrower qualifications? (By the way, those borrowers might not live in the homes they’re mortgaging.) And, sure, it’s possible the borrowers are lying about their income and job status. (But who cares?)
Today, even considering such a package seems ridiculous. Yet most of these loans, part of a fund sold by a major investment bank in 2006, received top-grade scores from rating agencies and enthusiasm from investors. Perhaps not surprisingly, several of the fund’s tranches are already a complete bust, and the rest are in shambles.
Perhaps the most outrageous aspect of this story is that its ending could have been predicted. Those bundles smelled toxic even in the midst of the bubble — for anybody who bothered to take a sniff. When common sense fails in so spectacular a fashion, it’s not just a gap in basic risk-assessment procedures. It’s a symptom of a systematic and cultural collapse.
How, then, can a financial-services firm, or any other company, adopt a more effective risk management system? The most serious gaps are related not to technology and models — that is, not to the risk management tools used to monitor investments and model equity strategies — but to people’s roles and the firm’s decision-making processes. In a number of institutions in the pre-crisis environment, the strong drive for profit led to veiled but intense pressures on risk departments to approve increasingly dangerous transactions. In turn, these assaults on caution weakened the risk management discipline throughout the company.
The banks that weathered the credit crisis relatively well were generally those whose risk management culture had remained strong. They had sharp and effective lines of defense against taking unnecessary chances, and they demonstrated a commitment to supporting capable individuals who exhibited risk awareness and set an example for others to follow. These companies view risk management as a positive capability, something that should be visible everywhere from the front office to headquarters, rather than viewing it as an obstacle to profits.
Understanding, defining, and actively managing an organization’s risk appetite requires a core of executive directors on the board who possess solid business and risk expertise. This group must appreciate the risks being taken and understand the risk/return trade-offs inherent in the creation of new financial products. Moreover, the board must accept the implications of major decisions on risk. In the mid-2000s, for example, most investment bank boards did not discuss the consequences of acquiring so many questionable mortgage investments and other similar instruments, which led to a huge increase in absolute leverage, nor did they discuss the unintended consequences of some bankers’ seemingly unlimited earning power. Instead, as reported by the New York Times in November 2008, top executives at banks such as Merrill Lynch & Company were allowed to order corporate watchdogs — the more squeamish at these firms and on their boards — to heel.
No individual specialist in a certain asset class, product, or function, whatever it might be, can be solely responsible for identifying and mitigating all possible causes of unacceptable losses. Modern investment banking products involve multiple asset classes that are treated separately but are interdependent; a decline in one can worsen declines in others. This means that at a portfolio level, dangerous correlations can exist among the many positions held both within and outside the firm. The goal is to ensure that no one assumes that risk is not his or her responsibility. One idea is to consistently place risk management executives on the trading floor, where they can offer opinions and recommendations on portfolios and newly planned investments. But only companies in which the authority of these executives is unquestioned, particularly in the front office, would choose to take that step.