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Counterparty Risk Management: How Could So Many Be So Wrong for So Long?

by: John Jansen August 07, 2008 | about stocks: AIG / C / UBS    

John Jansen

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The FT has a fascinating story about a report of the Counterparty Risk Management Policy Group headed by Gerald Corrigan. He was President of the New York Fed in the 1990s and has been instrumental in molding and formulating risk management policies for derivatives and structured reports.

The latest report became available today and I will link to it. It is voluminous at 176 pages. I have read a very small piece of it and it is insightful. I happen to peruse the section on the origins of the current crisis.

That is a topic which always fascinated me. How could so many people be so wrong? If just UBS (UBS) or Citi (C)or AIG (AIG) had lost significant amounts of money by taking bad risk it would be somewhat understandable. But the bad judgments have been nearly universal.

The section of the report that I read discusses the influence of compensation in risk taking. I think the problem lies in the yearly nature of rewards and payouts. There is no lookback.

I have this theory that in some cases a manager who had been very successful for several years running and who had earned prodigious sums of money had reason to double down on bad bets.

So if a trade was leaking P and L, a trader could double or triple the size of the bet and know that if he erred there was no recourse against him for the monumental error that was being made. He would know that he might lose his job but given past successes he could go home and comfortably clip coupons until the next venture presented itself.

It might be better for shareholders if there were some “lookback” in which a significantly bad bet this year would trigger a return of some portion of past bonuses.

It would be one way to force risk takers to take prudent and sensible risk.

There is one other area in the world of derivatives which always fascinated me. It is an area in which the fox is always guarding the henhouse.

What do I mean? I meant that most of this stuff was so complicated and so esoteric that it was barely understood by any but a very small group of people involved in creating them.

Certainly internal auditors, rating agencies or regulators lacked a clear understanding of the product because if we did we would not be in the current fix. And if the aforementioned watchdogs truly understood the complex nature of the instruments they were studying, they would have given up their role as outsiders and they would have jumped into the field to earn the outsized rewards.

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This article has 3 comments:

  •  
    Aug 07 05:21 AM
    The nature of risk management has been simplified over the years as more and more people and consultancies flood into this field and attempt to create methods which dumb down this important area. Basically, for most "risk managers", risk is segregated into credit risk, where ratings are all important, and market risk, which measures the sensitivities of a trade or portfolio. Since many of the MBS are new products in 2005-2007, they relied simply on historical default rates for pricing (and introduced a high incidence of error as historical data would have been scarce). They then used ratings insurance to qualify these products as AAA. Banks then bought paper based on these AAA ratings without questioning their underlying viability to pay back principal or even interest. This is odd as normally a structured swap would be investigated carefully before issuance but for whatever reason, for MBS, people are happy to buy other issuers' paper based purely on nothing more than the rating, a free lunch and a pat on the back.

    I have always taken a holistic view on risk, and for my bank, I have always advised against taking on these products, as the SUM of the risks (if calculated correctly) causes risk profile to rise exponentially to a point where the paper becomes too expensive to buy. Eg. mortgage default risk, issuer risk, guarantor risk, interest rate risk, economic risk, trend risk. People forgot about all that and just bought AAA paper because they did not do (or want to do) their homework. Or maybe their risk management team did not consider all the factors that go into a proper Monte-Carlo simulation for such products. Why was this not done? That will always puzzle me.

    In short, despite what many people think, risk is not a business area that can be easily standardised, and in my experience, there are far too many "risk" people around who do not understand how to apply the basic management rules for risk, especially for new structured products.
    Reply
  •  
    Aug 07 07:17 AM
    Internal auditors? are you serious? The notion that regulators and internal auditors, bear even a portion of blame on this, is laughable. They operate at too detailed a level to address the potential risk of one of a myriad of products. Maybe, the regulators could have caught it, but given the "sophisticated&qu... or perhaps more correctly, intentionally deceptive design, of the products I doubt it.

    Had they raised such an issue of such exposure, it would have been ignored as chicken little in the face of the piles of money the banks were making, they probably would have been fired. What would that assertion look like "If housing prices fall, Audit Committee, we're in deep kim chee?" You can't present speculation as audit evidence, as a result, that function is always "backward" looking, no matter how hard they try.

    Your assertion exposes an important misconception which is that the governance structure actually works. My friend, the governance structure is completely broken. If such a report ever got to the audit committee, they would not have wanted to hear it either for the very reason of limiting their own potential liability!

    So the CFOs have a dual motivation to prevent this kind of information from coming out 1) to protect themselves, and 2) protect their board members who truly just want to collect their checks, enjoy their meetings and head back to their mansions...

    Until these board members are jailed or lose their life savings, NOTHING will change...and it won't be the internal auditors that make it happen.

    Bottom Line: Chris C above has the right idea, new structured products should require the financial equivalent of FDA approval where these types of scenarios can be vetted independently outside the reach of the bankers, and in the bright light of day, which dims significantly when boards convene.
    Reply
  •  
    Aug 07 07:11 PM
    The bankers have tremendous leverage with issuers.

    Who the hell will underwrite the next muni-etfPreferred-Stud... issue if all major bankers say NO?

    Those who need capital need bankers to raise this capital. I see them falling to bankers pressures next, as now it's not our but bankers money on the line.


    Right now this is our money on the line, after UBS buys ARS they sold fraudulently to us from us, this will be their money and their pressure on the issuers. They'll do fine and make some in refinancing fees.
    Reply
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