Wall Street Law Blog

The two most important words in financial risk management? (encore)

WHAT -and- IF

By Brett Sherman, The Sherman Law Firm                  

Worst Case Scenario Analysis - Management of low frequency / high magnitude risks. 

Companies must have methods for controlling risks inherent in activities with -

(a) a high probability of success, but

(b) can produce catastrophic losses with just one failure.

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The ultimate risk management responsibility for publicly owned corporations is to assure that a company cannot be crippled if a business strategy / model goes horribly wrong.  

 

It is impossible to manage against the risk of high loss magnitude events unless corporate risk managers and senior management agree to start all risk analysis with two words - 

"WHAT" and "IF"

 

FOR EXAMPLE-

What if our hedging strategy fails?

-or- 

What if home prices fall?  (the common sense question that could have prevented the failure of Lehman Brothers, and Bear Stearns - and maybe even the financial crisis)

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So, why weren't these basic questions asked by nearly enough companies during the housing bubble?  

That's right - Because an overloaded money train was pulling into Wall Street and Orange County, California (the epicenter of nonprime lending) on a regular basis, and asking "what if" questions would have yielded (pun intended) answers that lenders and bankers did not want to hear.  This is risk management by denial (also called willful blindness or, more colorfully, burying one's common sense in the sand).

Tell us what you think: Wall Street Law Blog welcomes your comments and your criticism.

Forget Hindsight - Housing bubble was foreseeable (updated)

Wall Street Law Blog responds to FCIC Testimony of Bear Stearns execs and others...

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NOTE TO WALL STREET CEO'S:  FRAUD BY HINDSIGHT? SERIOUSLY?

One of the primary arguments Wall Street executives have been asserting to defend themselves before the Financial Crisis Inquiry Commission goes something like this- 

We could not foresee the collapse of the housing market, and therefore any allegations of fraud are merely impermissible claims of "fraud by hindsight." 

Survey Says? - X (pop culture reference)  Wall Street Law Blog doesn't buy it. 

 

(Brief digression -GO PHILLIES - despite recent inability to score a run, we have faith)

The Fraud by hindsight defense is asserted by defendants in many securities fraud cases.  The meaning of the defense is (as you guessed) that there is no fraud (i.., intentional or reckless misrepresentations or material omissions) if the alleged fraud can only be discerned after the fact.  Hindsight is, as they say, 20/20.  

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Returning to the housing and mortgage markets, and the marketing / sale of mortgage-backed securities, cdo's and related products...

Wall Streeters insist that they did not believe, and could not reasonably foresee, the housing and mortgage bubbles that expanded and ruptured in recent years.  

Umm, let's look at some facts:  

• From 1895 through 1996 home price appreciation very closely corresponded to the rate of inflation (roughly 3% per year).  

• Then, from 1995 through 2006 alone - even after adjusting for inflation - housing prices rose by more than 70%.  
  

How could such an unprecedented increase in the rate of home price appreciation rationally occur without alerting the self-anointed experts on "The Street" to watch out for signs of a massive housing bubble?  

For that matter, how would Wall Street executives and risk managers explain their alleged lack of bubblevision in light of the quite relevant fact that the greatest "boom" in the history of U.S. housing was peaking just a few short years after a little event we like to call the tech-wreck.  Remember the great technology stock bubble that ruptured at about the same time many of us were just recovering from the hoax that was Y2K?    

If their collective memories are so short, what the hell were they doing running our largest financial institutions?  (Rhetorical question)

Come on, Wall Street.  You need to come up with something better than the fraud by hindsight defense.   If you can...