Global meltdown and risk management
As the whole world is experiencing an extraordinary time, many words are flying in the air. Be it 'financial turmoil', 'financial tsunami', 'credit crisis' or 'liquidity crunch', impacts of this crisis are intensifying rapidly and apparently, no concrete solution is in sight.
There are two reasons that are primarily responsible for the acceleration in the financial meltdown -- connectivity and speed. In the present era, financial markets no longer operate in isolation and rather they are intricately connected. Financial data travels around the world at lightning speed and the consequences of economic events are no longer confined to one region, industry or nation. Hence, tomorrow's leaders must be well aware of what may come in their path.
No crisis is created from vacuum. There are always market indications and advance warning signs and it is up to risk managers, traders and market analysts to interpret them correctly. After 2003, home prices in the US began to deviate from historical relationships with inflation, income and productivity. Low interest rates and policies promoting home ownership resulted in a booming demand for housing.
What originated as a simple softening of the US housing market, quickly evolved into a full-blown global credit crisis. There were signs that something was perilously wrong in the US housing market at least six months prior to the eventual market freeze in August 2007. However, several firms did not stop activities until the day the market collapsed. They were of the opinion that bad news was an ephemeral jinx and that things would soon turn around.
Mortgage-backed Securities (MBS), Asset-backed Securities (ABS) and their derivatives like Collateralised Debt Obligations (CDO) or CDO-squared, used to provide relief to institutions seeking higher interest income in the low interest rate environment. These debt securitisation products were perceived as a means to diluting toxic risk by mixing it with good, investment-grade debt. But instead, the bad risk polluted and ultimately froze the entire credit market.
Some of the securities were marketed as AAA-rated instruments when in reality these synthetic AAAs had higher probabilities of default and larger losses at default than true AAAs. Deficient risk management practices failed to assess the true credit quality of repackaged MBS or ABS and paved the way for an impending global crisis.
The crisis had its roots in the following three factors: lack of accountability, leverage and liquidity. In contrast to historical practice, mortgage institutions created mortgage and then sold it to other institutions, instead of holding it. Mortgage originators were compensated on the volume of mortgages created and were not impacted by the end outcome with regard to default.
As a result, on the supply side, decision-making was separated from accountability. The corporations focused more on the absolute return without assessing the inherent risk behind these high returns, particularly in the low-yield environment. The basic rule of finance was discarded in the most advanced markets.
On the demand side, the consumer intent of buying a 'Mortgage' shifted from long-term occupancy to investment strategy. The end effect were 'walk-away' rules, as investors abandoned their interests and walked away when house prices started to plunge.
With regard to leverage, many of the institutions, which guaranteed mortgages, failed to evaluate the potential risk and hold reserves against any material differences from historical default rates. Hence, when there was a downturn in property values, default occurred at historically high rates. A liquidity crisis emerged when organisations that had cash held back their cash, while those without cash sold what they could or else borrowed at high cost.
The credit crisis also exposed the lack of enterprise-wide risk management systems and the failure of risk management techniques. The market worked with the truism - “If it looks like a loan, acts like a loan, and performs like a loan, it is probably a loan.”
The first lesson from the current debacle is that the risk inherent in a financial transaction cannot be bypassed by the simple act of repackaging. Prior to the crisis, it was assumed that rating agencies simply knew best and their overpowering brand image used to overrule judgments of the risk practitioners. The second lesson we learned is that rating agencies cannot be trusted all the time.
Amidst all the negatives, there is at least one positive outcome - now there is greater appreciation for risk management professionals. Yes, it is time to rethink risk. In an article titled 'Confessions of a Risk Manager (The Economist, August 08), a risk manager of a large global bank confessed how the market risk team of his organisation never took ownership of the CDO tranches and other ABS/MBS since they believed them to be primarily credit-risk instruments, whereas the credit risk department thought of them as market-risk and disowned them, since those were booked in the bank's trading book.
To recognise the importance of managing their entire risk landscape, companies need to strengthen the role of the Chief Risk Officer and the entire risk team by having them in the management table and, taking proper cognisance of early warning signals. Risk oversight committees should be formed at the board level with broader scopes. Lastly, a defined risk culture should be established and assessed regularly. Because, at the end, good risk management results from the people doing the right things.
In business schools, we are all taught two things 'maximise shareholders' value' and 'the higher the risk, the greater should be the return'. But if we analyse carefully, the companies that appeared to have sustained the turmoil were the ones who were able to manage their strategic risks, hold sufficient capital and align interests of the shareholders and managers appropriately.
I want to conclude by saying that being business professionals, we are all risk takers. But we must remember that risk management is not only about eliminating or minimising risk, it is about avoiding uncompensated risk.