Credit Crisis: How Could So Many Be So Wrong?

by: John Jansen posted on: August 07, 2008    
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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 (.pdf) became available today. 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 or Citi or 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 manger 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 hen house.

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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John Jansen

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This article has 7 comments:

  •  
    Alan von
    Altendorf
    Aug 07 04:52 AM
    My Website
    Steve Waldman has an extremely shrewd, surprising explanation why so many got it so wrong, shunning risk. Posted at naked capitalism: feeds.feedburner.com/~r/NakedCapitalism/~3...
  •  
    Alan von
    Altendorf
    Aug 07 04:54 AM
    My Website
    better link to Waldman
    www.nakedcapitalism.co...
  •  
    buyitcheap
    Aug 07 08:53 AM
    Internal auditors? are you serious? The notion that regulators and internal auditors, bear even a portion of blame on this, is way off target. They operate at too detailed a level to address the potential risk of one of a myriad of products and are typically backward looking, meaning, they need actual evidence to look at, not speculation and conjecture.

    This debacle rests of the creators of the product and those above that supported and sold them.

    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! And there would have been overwhelming evidence, some in the form of economist Ph.D's, who would've blown the assertion of a housing bubble bursting causing a collapse of aleveraged product as absurd.

    So the CFOs and myriad Sr. VPs 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.

    Perhaps 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.
  •  
    PastTense
    Aug 07 09:22 AM
    If rating agencies lacked a clear understanding of the product they had no business rating it.
  •  
    ResourceWise
    Aug 07 12:47 PM
    John, your summary highlights the essence of the problem viz., unsustainable risk reward relationship (long term risk vs. short term rewards; also risk held by organization and reward received by employee); and “foxes guarding the henhouse”. There is a fundamental disconnect between the interests of these financial 'wizards' and other stakeholders in the financial services industry. It is only in the financial services businesses where some employees demand and receive a substantial percentage of revenues as incentive compensation/bonus; moreover the revenues aren’t even discounted by the cost of covering risk! In contrast to this largesse, the owners of the business (i.e. shareholders) receive a percentage of net income! How bizarre!

    So even as tax payers’ money is being shovelled at this industry, it is necessary for regulators to examine how incentive compensation particularly to investment bankers was paid over the past few years so that the rotten ‘conventional wisdom’ of this business can be exposed to some sunlight. This knowledge will allow regulators to build rules of the game that address the endemic fault lines that make periodic failure almost inevitable. I believe that this understanding is necessary in order to manage other esoteric bits of the financial industry – private equity funds and hedge funds, which are largely unregulated and capable of enormous damage to the financial well-being of people around the world. Maybe this will be the ‘good’ that emerges from the current crisis.
  •  
    nickgogerty
    Aug 07 01:58 PM
    My Website
    Free money is the beautiful lie. Kindelberger mentions it. We all wanted to believe.
  •  
    nickgogerty
    Aug 07 01:59 PM
    My Website
    Free Money is sometimes called the beautiful lie. We all wanted to believe.
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