Wall Street Law Blog

The two most important words in financial risk management?

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.

***

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)

* * *

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.

How Wall Street Manipulated the Risk-Reward Tradeoff (updated)

Did The Sheer Complexity of MBS, CDOs, and related "Structured Products" Enable Wall Street to Cheat Investors out of A Reasonable Risk Premium? 

 

 

An impromptu analysis of securities fraud and the mortgage securitization boom that led to the great 21st century Financial Crisis.  

If pressed to identify one factor that made Wall Street's subprime securitization frauds of the last decade so successful (as of this writing, it cannot be credibly argued that these mortgage-based frauds were anything other than an enormous financial success for most of the individuals who ran major investment banks), we would select complexity as that one factor.

In this post, we attempt to explain how we believe the big banks used complexity to disguise risk and con the markets.  

 

Background: Investors bought subprime mortgage bonds for a simple reason. 

For most of the housing bubble era, AAA-rated tranches of nonconforming mortgage bonds (those backed by subprime mortgages and alt-a mortgages) offered investors slightly higher returns than other AAA-rated bonds.

 

Since the risks were ostensibly the same for a mortgage bond carved out of a AAA-rated tranche of an MBS or CDO and other AAA-rated securities, Wall Street knew that most big institutions would choose to buy the higher yielding mortgage bonds.  And this is precisely what happened. 

 

As the housing bubble expanded, investor demand for private label MBS and CDOs seemed insatiable.  Only when market conditions changed enough for the investments to be exposed as the frauds that they always were did investor demand finally disappear.  By that point, however, the personal wealth accumulated by senior management at the major Wall Street banks from securitization and sales of fraudulent mortgage bonds during the 2000s was staggering. 

The housing bubble era was, in sum, a short-term money grab.  Management enriched themselves at the expense of the shareholders they were obligated to serve (not to mention the financial health of most nations on Planet Earth).

 

"Fraud by Complexity": Hiding Risk from Investors.

During the housing bubble era, very bright people designed mind-numbingly complex financial products to conceal risk from investors.

Bear Stearns, Lehman Brothers and the rest of what were the big 5 investment banks (and a group of other powerful financial institutions) knowingly marketed and sold high-risk mortgage bonds to institutional investors all over the world for years as if those risky investments were, instead, extremely safe AAA-quality securities. 

 

Indeed, we believe that complexity is the ultimate x factor that allowed Wall Street to collude with and/or bribe credit rating agencies, which then stamped securitized subprime/Alt-a mortgage bonds with AAA credit ratings.  It was complexity that allowed investment banks and rating agencies to construct formulas and models with bogus inputs and flawed assumptions to "justify" what investors now know were fraudulent credit ratings.

 

It was, of course, the vaunted AAA credit rating that guaranteed a massive market for dodgy (to put it mildly) mortgage bonds for as long as market conditions were such that the true risks of those bonds remained hidden.  When the housing bubble popped and mortgage defaults spiked, firms like Lehman and Bear Stearns kept up the pretense of quality for as long as they could. 

Thus, management at most (though not all) of the big banks squeezed as much personal profit as possible from their fraud factories before mortgage defaults inevitably reached high enough levels, in or around early 2007, to undermine the credibility of previously unquestioned AAA credit ratings. 

When the number of investors who began to doubt the credlt-ratings for mortgage bonds hit a critical mass, the scheme reached a tipping point and the game was up. 

From summer 2007 on, the handwriting was on the wall for the few that, like the big investment banks, were privy to enough information to read it. Soon came the foreseeable, indeed the inevitable, flight to quality that is a core feature of all bond market panics.

 

Flight to Quality

In a flight to quality, investors try to dump everything that is touched by uncertainty and move as much money as possible into investments that they know are safe.  Most often, that means a mass movement of money into Treasuries.  When investors began their flight to quality, demand for mortgage bonds essentially disappeared.  From that point, those on the inside knew, or should have known, that there was no stopping the dominos from toppling.  

 

Concealing Risk; Paying Lower Risk Premiums

Complexity of structured mortgage bonds - from mortgage-backed securities to even more complex CDOs, CDOs-squared, Synthetic CDOs and so on -- was intentionally exploited by Wall Street to hide risk.  By concealing the true risk of these investments, the Bear Stearns and Lehmans of the world manipulated the risk-return tradeoff (from econ 101) so that these financial institutions could profit by paying far less return than is warranted by the risk of these products. 

If a bond issuer uses deception to convince investors to accept a lower risk premium (a lower yield than would be required if the true risks were known to investors), then the issuer fraudulently profits from the difference between the comparitively high risk premium the investment should require and the low yield that is actually paid out.

 

The beauty of this type of scheme, of course, is that -- until the foundation finally caves in -- investors actually believe that they are getting a generous return because the yield is a bit higher than Treasuries and other AAA-rated investments. 

 

The truth, hidden from investors, is that the return on mortgage bonds blessed with bogus AAA-ratings was far too low given the risk of these products.

 

As for those executives who claim they did not understand their own businesses, remember that fraud includes intentional misconduct and wilfull blindness.  

Hiding the true risk of mortgage bonds produced well-documented windfalls for Wall Street's top executives and their lieutenants, even as many of those executives presided over the destruction of the companies they managed on behalf of thousands of public shareholders.  

 

Conclusion: A "AAA-Rating" Does Not (Necessarily) Equal "AAA-Quality"

The fact is that these banks knew the majority of the AAA "private label" mortgage bonds they peddled in the 2000s were high risk, but not high quality.  

 

The banks knew the true risks of subprime MBS and CDOs, but few investors had access to sufficient information to decipher these risks for themselves. 

Instead, investors justifiably relied on the representations of mortgage traders and salespersons and especially on the supposed integrity of credit ratings. Today, we all know what the big banks knew all along -  

AAA is in the eye of the beholder.

 

By Brett Sherman, Wall Street Law Blog

 

Risk, reward and investments: The Harder They Come, the Harder they Fall...

Revised and updated

From the Wall Street Law Blog:  Caution, common sense ahead-

These days, we hear too many people mistakenly describe the risk-reward tradeoff with incomplete, shorthand definitions like "risk equals reward," or "the greater the risk, the greater the reward." 

Investors should use the following definition for market risk: 

Market risk is the chance that an investment in securities might produce an unexpected bad outcome; a/k/a  financial loss.  

This definition for risk applies equally to the actual fact of losing money on any investment - an outcome that is always unexpected to some greater or lessor extent - and also to investments that produce higher magnitude losses than the investor expected.  

To digress for a moment: An expected bad outcome is not really a risk because a company will build expected losses into its business model. For example, suppose a bank assumes that the default-rate on a credit portfolio will be 2 percent. Because the losses are expected, the bank should build a 2 percent loss into its revenue forecasting as a cost of doing business.  

 

Thus, while some investors are enticed to put their money in risky ventures because there is the potential for greater upside for a risky investment than there is for a conservative (safe) investment, the higher upside is far from free.  

Thus, the more risk you take, the more you increase the chance of an unexpected bad outcome.

Which brings us to this pearl of wisdom:  When it comes to risk, it pays to remember the warnings of the great Jimmy Cliff (and the late great Jerry Garcia):  The harder the come, the harder they fall, one and all... 

By Brett Sherman

The Sherman Law Firm

The Fight Was Fixed - Risk Managers had no chance v. CEO's

By Brett Sherman, The Sherman Law Firm

I know it may be hard to remember at this point, but it wasn't so long ago that the sight of drywall and the sound of hammer striking nail was as common as the ubiquitous "For Sale" signs are today.  The economy was was moving forward so quickly that it was sweating.

During the height of the housing bubble, how many of you forgot the lessons of the technology stock implosion?  As a general rule, we tend to ignore/block out/forget the lessons of past financial traumas whenever the markets are humming and money is flowing. Risk managers are paid to disregard that general rule.

While the rest of us enjoy a bull market, risk managers must be corporate police officers.  A vital part of the risk management function is to guard against a business strategy that capable of crippling a company when the boom market cycle ends (and they always end).

During a boom, risk managers are unpopular.  Hardly anyone wants to hear that a sizzling market will eventually burn out.

The unfortunate reality, however, is that market bubbles have always popped.  Not only do economic boom cycles fizzle sooner or later (often abrubtly), but it is nearly always impossible to predict why or when the end will come. The unfortunate truth is that, no matter how strong a bull market may seem, we can never know for sure that disaster isn't lurking around the bend.

The future is now and always will be a mystery. Therefore, corporate risk managers must manage risk by devising strategies to mitigate potential negative consequences in the event of a market downturn.

Consider the last market bubble, the tech-wreck.  Remember how many people were convinced that we were in a new age of prosperity, a "new economy" in which the old rules of Wall Street no longer applied?

Remember all the "paper millionaires"? Remember Dow 36,000?  Remember how it all ended?  Of course you do.  And so do Wall Street CEO's (and former Wall Street CEO's) and risk managers.

The tech-wreck is a textbook example of a market bubble.  On its heels (thanks to the Fed's loose monetary policy) came the housing and mortgage boom.  Subprime-based mortgage- backed securities were the perfect investment to sell to unwitting investors.  So don't believe Wall Street investment banks when they tell you that they didn't think the housing boom would eventually end like the tech-wreck and so many other market bubbles.

Wall Street firms reported record profits during the housing boom.  High annual profits meant high annual incentive-based compensation for senior Wall Street executives.  Therefore, the risk management function (protecting investment banks from the risks of business models that could lead to the kind of corporate implosions that will forever mark 2008) was at odds with the interests of senior Wall Street executives, who made more money by maximizing short-term returns.  Guess who won that battle?

As someone once said, the brightest stars burn out the fastest.  With effective risk management, Wall Street profits may not have reached the stratosphere during the housing boom. Then again, former investment banks like Bear Stearns and Lehman Brothers still may still have been profitable and lived to make more money another day.

In this day of ultra-sophisticated engineered securities, risk management is vital to the long-term success of any financial institution. Maybe corporate managers will realize that one day soon.

WALL STREET LAW BLOG WELCOMES YOUR COMMENTS.

 

Christopher Columbus and financial risk management... (encore)

By Brett Sherman

Introduction (a slight bit of revisionist history is ok now and then...)

***

1492:  The Italian explorer sailed his three ships from island to island, staking claims for the Spanish King and Queen throughout the calm, crystal blue waters of what would later be called the Carribean Sea.  His three ships navigated the placid sea for months, and the Italian and his men explored islands we now call Cuba, Puerto Rico, and Jamaica, among many others.   March, April, May, June, July, August, and September passed.  The weather was perfect.  The sea was calm.  These were the best sailing waters in the world proclaimed the Italian.  He had "discovered" paradise. 

Then, in early October, a mild storm came and went.  After so many months of perfect weather, some of the crew were uneasy about the sudden turn in the weather.  Perhaps this was a bad omen?  "Nonsense." Days later, another storm, noticeably stronger than the first.  Aberrations, the Italian insisted.  Even in the calmest sea there must be an occasional storm.  Many of the men, now convinced that their run of good luck was over, urged the Italian to safely anchor the three great ships in one of the many naturally protected harbors on the islands the men had explored.  The Italian was stubborn.  He refused to listen.  He had already compiled an enormous treasure - more gold than he had ever imagined, and he was not about to interrupt his accumulation of treasure because his men were worried about some wind and rain.  

Then came a storm unlike any the explorer or his crew had ever witnessed.  It sunk one of the three ships, nearly destroyed the other two.  Many men drowned.  Nearly all of the gold was lost.  The Italian was ashamed.  He had ignored the warnings of the crew.  Now all was lost.  All of those months of calm seas - the calmest seas the explorer had ever encountered. 

He had seen bad storms in his life.  He had seen men die at sea, ships sink, and treasures lost.  But it he had rarely seen even a cloud for months and months.  Terrible storms had not happened here.  Therefore they could not happen here (though he really did not believe his own words).  

Although he had sailed the Caribbean for nearly a year, this was his first October.  Each October, the hurricanes came to the calm waters.  It was a lesson he could have learned from the safety of a protected harbor - had he not been blinded by greed.

*******

Your turn to play CEO

As an attorney, I'll be the first to admit that hindsight is 20-20.  However, this post (in which I am asking you to imagine that it is December 2006) has nothing whatsoever to do with hindsight.  On the contrary, I want you to pretend that you are winding down the year 2006 as Chief Executive Officer of a major Wall Street investment bank.  There is something you know at that time (hence no hindsight issue) - something quite important.  And you've known it for at least ten years, maybe even two decades.  

Financial Panics

Here is what you know Mr. or Ms. CEO - financial panics have become a fact of life on Wall Street.  The frequency of market bubbles and bursts has increased exponentially during your tenure at or near the pinnacle of your profession.  There were exactly zero true market panics between 1929 and Black Monday 1987.  However, through December 2006, you've lived through at least six "market panics" in twenty years, including 5 in the preceding decade alone (in 1987, 1996, 1997, two or more in 1998, and 2000).    

Maybe not so coincidentally, almost all of Wall Street's investment banks went from private partnership to public corporation during the 1980's, right before the new panic era.   Perhaps Wall Street was just a bit less cautious with its money once the risk of loss shifted from the partners to public shareholders.  What do you think, Mr. or Madame CEO?

Anyway, all of these panics were unexpected to one degree or another (whether in terms of timing, intensity, or even crises that were completely unforeseen).  Each of these panics sent intense shockwaves cascading through markets, sometimes infecting market sectors that were unrelated to the genesis of the panic itself (through the ugly tentacles of "contagion").  

Since you are (for purposes of our exercise) the leader of one of the most important financial institutions in the entire world, you really can't credibly deny that you understand some seriously important concepts from the six major panics that seized markets starting on Black Monday 1987. 

Having been in the thick of the action and privy to lessons learned in the aftermath of these crises, you would have had to have been incompetent for years to miss out on the following wisdom:  Panic in the financial sense means pretty much what panic means in every other sense.  Some event (it could be a major occurrence or a series of smaller tremors that eventually build to a critical mass), triggers a crisis of confidence in a given sector of the world economy (perhaps doubts about a booming U.S. housing market?). Once a crisis of confidence is triggered, animal instinct - herd mentality - takes over and truly frightened human beings (investors and investment professionals) stampede in a bloody fight for self-preservation.  A run on financial markets ensues, feeding on itself in a vicious cycle until hearts stop thumping, collective blood pressure levels out, and panic begins to subside.   

 You also know - based on your experiences with recent panics - thatalthough the timing of triggering events, and even the severity of panics themselves, may have been unforeseen, the strong probability of similar events occurring again - especially during economic "booms" - is entirely foreseeable.  You also know that it is only a matter of time until a company that surfs the biggest wave, wipes out and drowns.

Something is going to happen to derail the gravy train eventually. You know this.  After all, you run a major investment bank.  Since 1987, you know you can only to limit the downside to your company from the next crash is live by one guiding precept - Expect the Unexpected.  Translation - Fail to truly stress the importance of effective risk management at your peril. 

The more experience you gained with panics, you realized, the more you knew you should not play games with trying to predict when the next one might come.  You only knew that it would come.  Therefore, the only protection against disaster - the only true hedge - was to keep an even keel.  You had to manage risk prudently, avoid temptation of easy money, resist the pull of greed.  Even the most prudent risk management, of course, can fail.  But easing up on the reigns of risk management could be truly deadly to any company at any time.  This was the lesson you learned from the panics you lived through.  But you ignored it anyway.  

***

PART TWO: Wall Street CEO Do's and don'ts (since your are the CEO, feel free to disagree)

• Do Prepare for the next crash that you know is all but inevitable by making sure your company manages risk sufficiently to limit potential down-side exposure.

• Don't recklessly manage your publicly-held company for excessive short-term profits at the expense of long-term stability. 

• Do concede that it doesn't do shareholders any good to have your stock shoot to the moon if it crashes back to earth (except for the lucky ones who sold out at lunar levels). 

• Don't tie the fortunes of your company to hard to price mortgage-related products that depend on a dangerous and grossly negligent assumption that the U.S. housing market cannot collapse. 

• Don't let a loss of confidence in your firm by creditors (for whatever reason, rational or irrational) kill you because your company is leveraging its balance sheet at an obscene level of 33 times equity.

• Don't be so irresponsible that you focus on squeezing every penny of profit from the mortgage securities boom today and neglect the potential ramifications of your business strategy for tomorrow.

By Brett D. Sherman

Visit The Sherman Law Firm Website

Corruption or what? CDOs, Treasuries and Credit Ratings...

CDOs and Treasury Bonds - Risk, Return, and Credit Ratings? We aren't economists, but something sure seems wrong.

PLEASE - set us straight if we are off base here...   

OK, if two fixed income investments have the same risk profile, they should offer the same return (or something very close to it).  Right?

If so, then are we right to assume that two classes of fixed income investments stamped with the same credit rating should have very similar risk characteristics?  If one investment offers higher returns with no added risk, common sense (and, we presume, the science of economics) dictates that rational investors will choose the higher yielding investment product.  

So far, so good?  If so, then what in the world were the Credit Rating Agencies doing during the housing bubble?   

A huge volume of mortgage-backed securities (MBS) and related investments like collateralized debt obligations (CDO's) received AAA credit-ratings and offered investors yields that, for several years, were superior to AAA U.S. bonds.  To managers of massive pension funds, sovereign wealth funds, and other investors, a AAA credit-rating means there is virtually zero risk of default (we looked that one up). Therefore, the only logical conclusion is that Moody's, S&P, and Fitch told investors that certain mortgage securities were pretty much impregnable, just like obligations of the United States government.  

It seems kind of clear to us that no fund manager would purchase super safe U.S. government bonds when investments in high-rated tranches of MBS and CDO's carried higher yields with no added risk? Predictably, demand for mortgage-related securities skyrocketed.

In nearly every case, investors relied on credit ratings.  Institutions believed the CDOs were safe.  AAA means AAA, and because financial engineers at places like Bear Stearns and Lehman brothers were able to slice and dice the cash flow from all kinds of mortgages in ways that were too complex for practically anyone to truly understand, even sophisticated investors were unable to do any independent risk assessment.  

Again, it is our understanding that the basic risk-reward principle dictates that two or more AAA-rated fixed income investments issued in the same interest rate environment should produce virtually identical returns.  Is there some basic fact or principle that Wall Street Law blog is missing?  And yet...

Vast quantities of AAA-rated mortgage-backed securities and CDOs consistently promised and, until the credit bubble started to leak, actually delivered significantly higher yields than AAA-rated U.S. Treasury bonds (which are, of course, guaranteed by the full faith and credit of the United States Government). 

All of this leads us to one of two conclusions -

EITHER-  

The science of economics and/or the business of credit ratings are farsical-

-OR- 

Wall Streeters like Merrill Lynch, Lehman Brothers and Bear Stearns colluded with the major credit rating agencies to obtain bogus investment grade ratings (at least for AAA tranches) in order to maximize the universe of potential investors for CDOs.  

If we have this stuff way wrong (and maybe we do), we'd sure like to hear what really happened and where our amateur analysis went awry.      

The Sherman Law Firm