By: Patrick O'Brien
On Monday, I blogged about Gillian Tett’s book, Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. Here are a few more of the key risk management lessons that I was able to glean from reading the book.
Lesson 3: You cannot afford to overlook or underestimate the correlation of risks.
There were two innovations that fueled the growth in the subprime mortgage market. The first was credit derivatives: in its simplest form, a credit derivative is a contract between two parties in which the seller agrees to compensate the buyer if a loan goes into default. The second innovation involved a process called securitization, which traditionally involved lenders selling their loans to an investment bank. The investment bank “bundled” the loans together and sold pieces of the bundle to pension funds and other investors. The original lenders, having offloaded their loans, could make new ones. The investors acquired a slice of the loan bundle and its interest income without having to go to the trouble of meeting and assessing the borrowers.
The innovation was securitizing not just loans but credit derivatives. It was first applied to corporate loans which tend to have very little correlation (correlation is the degree to which the defaults in any given basket of loans might be interconnected). But then it was carried over to mortgages and more importantly subprime mortgages. The financial services sector industrialized the procedure, and began selling securitized debt and derivatives on an extraordinary scale. The fatal mistake was not realizing that subprime mortgages were highly correlated, especially in an economy where interest rates were rising and housing prices were falling nationwide. Moreover, subprime mortgages had intrinsic flaws (such as issuing loans with escalating interest rates to homebuyers with dubious credit ratings) that inevitably resulted in extremely high default rates.
J.P. Morgan opted not to get into this market, a very smart expression of a cautious corporate risk culture that ultimately saved the company from the disasters others suffered. Fool’s Gold gives a great account of how Morgan risk managers struggled to understand how other banks could be making so much money and covering their risks at the same time. To their credit, they did not enter the market because they understood the risk and did not have a way to mitigate it.
Lesson 4: Do not think that models are anything more than a guide or a compass.
Models are useful but they have limits. They are essential for navigating in the world of modern finance, but they are not infallible, no matter how well crafted they are. Models are only as good as the data that is fed into them and the assumptions that underpin their mathematics. The key simplifying assumption on which the credit derivative models rested was that the future was likely to look like the recent past. New financial innovations have no way to be tested relative to their risk level except by means of computer simulations that use historical data. But there are no statistics that truly represent the environment surrounding the new instrument and, as a consequence, no one really fully knows what are the risks associated with the instrument. This is especially true of risks connected with the “correlation” factor. Hence, innovations can always have “surprises” connected with their usage. Remember that models are only tools and should not be used without human intelligence.
Lesson 5: Regulation is not a panacea.
As the crisis unfolded, there was a lot of blame placed on regulators and regulation. Although the Federal Reserve had the legal authority, they did not have the inclination to regulate the behavior by banks that led to the disaster. Alan Greenspan, head of the Fed, admitted that he had made a ‘mistake’ in believing that banks would do what was necessary to protect their shareholders and institutions. This “absence” of the oversight of the bank regulators has resulted in lots of discussion around new regulations, new regulatory agencies and so on. Tett’s book does an especially nice job in explaining how banks worked to get around capital requirements using the new tools and instruments. Part of the problem connected with the absence of the regulators during this period of time was that the banks worked very hard to expand their use of leverage in ways the policy makers could not see. Of course, this came back to haunt them when the collapse occurred. Financial institutions will always attempt to get around regulations in one way or another because it is profitable to do so. In addition, regulators are always behind what is going on in the industry. This is just the nature of the relationship.
Tags: Fool's Gold
