Sub-prime crisis – understand the risks, don’t just treat the symptoms

The International Organisation of Securities Commissions (IOSCO) has come out with a report saying their should be greater regulation of rating agencies (this looks like it will come) and a greater commonality in their regulation (this could be harder given the track records of the regulators). But risk managers have known for 18 months that some ratings are suspect. Surely the risk of inaccurate rating is just another risk and should be built into the calculations?

The SEC has decided that the short sellers in the hedge funds are all to blame for the market turmoil and has brought in a range of measures designed to stop this practice. The UK’s FSA is expected to demand disclosure of short positions. But short selling is a standard practice in a falling market and has been so for some 400 years. Get it wrong and you lose a fortune. Short sellers capitalise on market sentiment and the reputation of the underlying stock issuer. Short sellers are a symptom of the market, not the cause - will a ban on short selling improve lending practices? Risk models need to allow for falling markets and for reputational issues.

Executive remuneration? 30 years ago an analyst told me he had a simple risk formula in assessing companies – divide last year’s profits by the number of expensive cars in the directors’ car park – that was his next year’s profit forecast! The problem is that this does not cater for the current situation of losses, not profits! Greed drives short-term and poor decisions – another risk that can be identified and qualified, if not quantified.

A major issue is that we just do not understand what we are working with. The Chairman of the Investment Management Association, Robert Jenkins, made the following excellent statement earlier this week, "If you don't understand it, don't buy it. If your client doesn't understand it, don't sell it." Good advice, but advice that few directors and risk managers have followed.

Risk management must come out from under its blanket and stand up to be counted. We must stop pretending we have it all under control if only management listened to us. We should admit that we are still in a very new industry which few, let alone risk managers, understand. The models were built on the history of rising markets – let us now improve those models – we have some good new case studies to use. Also, will we stop assuming that the model is everything? Processes that have been in place for centuries need to be unearthed again – processes stop failures, not models. And above all, risk managers need to understand the market in which they operate – fewer mathematics PhDs and more experienced bankers, please. Let’s all go back to school.

Incidentally, why am I still calling it a sub-prime crisis? Simply for elegance in classification. Sub-prime mortgages were just the tip of the iceberg, it should really be the credit crisis, the stupidity crisis, the greed epidemic, or the “we never knew what we were selling” crisis.

[These comments, and all other comments in these bi-weekly columns, contain the views of the editor alone and do not represent any Chase Cooper policy or advice.]