China denounces U.S. banks for 'evil intent' with derivatives

Outside vanilla derivative products their sole function is to flog off hidden risk. The western banks mentioned monitised their cred and died, end of story.

BEIJING -- A senior Chinese official who oversees the country's largest state-owned enterprises has publicly slammed Western investment banks for "maliciously" peddling complicated derivative products that caused huge losses for Chinese companies over the last year.

In Beijing's strongest criticism on the matter to date, Li Wei, vice director of the state-owned Assets Supervision and Administration Commission, singled out Goldman Sachs, Morgan Stanley, Merrill Lynch, and Citigroup in a long and highly critical article in the latest issue of an official Communist party newspaper.

The large losses suffered by Chinese state companies were "closely associated with the intentionally complex and highly leveraged products that were fraudulently peddled by international investment banks with evil intentions," Mr Li asserted. "To a certain extent some international investment banks were the chief criminals and the root of ruin for the Chinese enterprises who encountered this financial derivatives Waterloo."

In his article, Mr Li said 68 of the 130-odd state companies controlled directly by Sasac had been buying derivatives to speculate or hedge against rising commodity prices and fluctuating currencies and interest rates, even though some of them were not authorised to do so.

These 68 companies had booked total combined net losses of Rmb11.4 billion on the Rmb125 billion worth of financial derivatives products they had bought by the end of October 2008, Mr Li said.

The government has not previously revealed the full extent of losses suffered by Chinese companies that made ill-fated bets on over-the-counter, mostly offshore derivatives.

In September, Sasac warned that some of the contracts were illegal and might be invalidated, a move that prompted some Western banks to agree quietly to renegotiate contracts behind closed doors.

Air China, China Eastern Airlines, Cosco, China Railway Engineering Corp., China Railway Construction Corp., and Citic Pacific were among the companies that lost the most from buying complex derivatives.

Some of the biggest losses came from the airlines and shipping companies' purchases of options to hedge against rising oil prices between June and August last year, when oil hit a historic peak of more than $140 a barrel.

When prices fell during the financial crisis, these companies were saddled with large losses, partly because they had chosen riskier -- and cheaper -- derivatives products to hedge against rising prices.

Mr Li said the most important reason for the derivatives losses was unnecessary speculation and attempts at arbitrage by these state companies.

He also cited weak risk management procedures, a lack of expertise, and intentional breaking of rules that restrict most kinds of financial derivatives in China.

But he said China should "not give up eating for fear of choking" and that it was imperative for Chinese companies to keep using financial derivatives.

There is no free lunch and nothing is more risky than "risk free"

On risk...

http://www.financialsense.com/editorials/eckert/2009/0901.html

But, just as the economic concepts of the “Paradox of Thrift” or “Fallacy of Composition” teach us, what is good for an individual household or organization is not necessarily good for the broader economy or nation. As articulated above, we believe that risk-avoidance has stifled business investment and restrained true innovation. And if every individual and organization is trying to lay off or disperse risk, it merely aggregates and mutates elsewhere, making it difficult to identify and mitigate/manage the consequences thereof.

In fact, it is our position that attempts at risk-avoidance only hastened the arrival of those consequences. Each bad SFR or commercial mortgage written in the early 2000s, for instance, no matter how seemingly innocuous—i.e., no matter how much collateral value ostensibly secured the property or what kind of debt service coverage the borrower’s stated income provided—hastened the paralysis in the securitization markets we are now observing. The fact that such loans were available was a testament to the excess liquidity in the secondary mortgage markets. That liquidity created an asset bubble and perverse incentives throughout the mortgage food chain. Soon, notwithstanding the Herculean efforts expended to avoid risk, it became readily apparent that borrowers could not even afford to make the first, teased-rate payment on their mortgages and investors could not rely on agency ratings of securities backed by those mortgages. Shortly thereafter, the truly unthinkable—a certifiable “black swan” event, in our estimation—occurred. Residential real estate value values began to decline and global fixed-income investors had no appetite whatsoever for securities backed by residential real estate loans. But really, this could not have been unexpected. Risk is cumulative. Every incremental exposure brings an individual or organization closer to a day of reckoning. So, once again, trying to avoid risk only intensifies and accelerates the arrival of its consequences. Risk has to be managed, not ignored.

For way too long, America was enjoyed a standard of living it hadn’t earned—at every level of society. Consumers freely spent money they hadn’t worked for, merely borrowing it instead. Corporations reported record profits (and, concomitantly, peak equity market valuations) by stanching the flow of investment into research and capital goods instead of stepping up their commitment to adding true economic and social value. Yet, neither consumers nor corporations felt they were taking any chances. Consumers were confident that sharp increases in the value of their homes and 401ks—after all, housing and stock prices went in only one direction, up—would cushion the blow of any temporary employment setback and provide for both growing debt service requirements and retirement. Businesses saw no need to invest in the future—or any real improvements to existing products—when consumers lapped up current offerings with such zeal. The sentiment seemed to be that introducing genuinely new products would not alter the demand function meaningfully. And, once again, credit intermediaries believed that they did not have to truly underwrite mortgages or price them fully for the associated risk as long as they could sell or securitize them almost immediately. Whatever risks remained—the potential losses on retained interests or loans that would not sell readily—would almost certainly be mitigated by rising home values.

The end result was a country that could only manufacture credit and export jobs—as opposed to value-added goods and services. After all, how much value is created when a dollar passes from doctor to lawyer to insurance agent to mortgage broker (in a refinance) to used car salesman to bartender.. and so forth and so on. The abrupt withdrawal of liquidity and contraction of credit didn’t create the deep recession we are now enduring; they merely exposed a languishing economy bereft of any new ideas and, certainly, any direction or higher purpose; the earlier, rapid expansion of credit—perhaps by design—merely papered over this sorry state of affairs.

The biggest of all risks is taking none. That has been the risk borne by the U.S. populace for most of the last three decades—and, from our point of view, the risk we still bear. Today’s recession and the slow growth it portends in the years ahead are perhaps just a reminder from the global financial markets that there truly is no free lunch.

Didier Sornette and Wei-Xing Zhou had a big crash signal on the S&P500 for 2004/05, but it died under the weight of the credit bubble...like the trade I placed on it... we live and learn.


WITH 20/20 hindsight, financial crashes seem inevitable, yet we never see them coming. Now a team of physicists and financiers have bucked the trend by successfully predicting a steep fall in the Shanghai Stock Exchange.

Their model, which employs concepts from the physics of complex atomic systems, was developed by Didier Sornette of the Financial Crisis Observatory in Zurich, Switzerland, and Wei-Xing Zhou of the East China University of Science and Technology in Shanghai. The idea is that if a plot of the logarithm of the market's value over time deviates upwards from a straight line, it's a clear warning that people are investing simply because the market is rising rather than paying heed to the intrinsic worth of companies. By projecting the trend, the team can predict when growth will become unsustainable and the market will crash.

Sornette, Zhou and colleagues applied their model to the Shanghai Composite Index, which tracks the combined worth of all companies listed on the Shanghai Stock Exchange, the world's second largest. Early this year, the index gained 50 per cent in just four months. In July, the team predicted that the index would start to fall sharply by 10 August (www.arxiv.org/abs/0907.1827). The index duly began to slide on 4 August, falling almost 20 per cent in the subsequent two weeks.

Anyone hoping to exploit the model for profit should think twice. "If enough investors take action based on our predictions, the evolution of prices will probably be affected," says Zhou.

Washington Fiddles as Global Deflation Rages

Raise your glass to the hard working people
Let's drink to the uncounted heads
Let's think of the wavering millions
Who need leaders but get gamblers instead

"Salt of the Earth"
The Rolling Stones

In the latest post on our Picking Nits blog, "Idle Fs: Asset-Rich Operationally Stressed Banks," IRA CEO Dennis Santiago comments on the long-term business model trends visible in the 2008 FDIC data, including disturbing evidence that a number of banks have effectively shut down lending operations. As their portfolios run off, these banks must shrink both in terms of assets and core revenues.

Here is the prepared statement by IRA co-founder Chris Whalen for today's hearing before the Senate Banking Committee, "Modernizing Bank Supervision and Regulation." Riding on the Acela at 6:00AM this morning, we could not help but recall those times we appeared before Chairman Henry B. Gonzalez (D-TX) to discuss some of the very issues that trouble the global markets today. Below follow thoughts and observations on the Geithner/Summers public/private proposal to address toxic assets, at least as we understand it.

The mangers of the private hedge and equity funds would put up 10-20% of the amount of the cost of the assets. Fed would fund the balance at sub-market rates, while the Fed and ultimately the taxpayer would assume the risk of any losses. And the investors look to get most of the profits. You can change the assumptions regarding asset performance or pay out rates, but if asset performance is as officialdom anticipates, then this plan is a monumental give away to the Sell Side dealers. Remember neither the managers nor the private investors are bearing any downside risk. Indeed, the Geithner Plan III represents a very cheap call option on the toxic asset pile.

As economist Dick Alford told The IRA: "The structure as described in the press is nothing more than the Fed, FDIC and Treasury providing some asset managers with calls on the upside--max loss equal to 3% of assets? When was the Fed or the FDIC authorized to sell or give away call options? I suppose that they will try to sell this as a non-recourse loan, but it isn't. It is an option… The investors would in effect be left with sub-market financing and ownership of much of the upside potential. The implied rates of return to the private side are staggering, especially given the absence of any downside risk."

Proponents argue that this plan will allow for "price discovery," but that kind of depends on the price you want to discover. The value of the "priced discovery" is very limited in the world of Washington, in part because the big banks refuse to admit that the true, economic value of many toxic assets is around $0.30 on the $1. Thus the price discovered will be a price premised upon no downside risk and guaranteed sub-market funding, all designed to help the bond holders of these banks avoid a haircut. If this is what Secretary Geithner calls a market based solution, then we may as well nationalize all the banks, flush private property rights and declare The Jubilee.

More troubling, the perception in officialdom is that many toxic assets that have been marked down dramatically ($0.20-0.40 on the $1) will continue to perform, and will thus continue to make timely payments. Secretary Geithner and Fed Chairman Ben Bernanke seem to believe that the economic value of these assets would, in "normal" market conditions, be upwards of $0.80 on the $1 of value. Thus we seemingly have a $0.50 per dollar difference between the theoretical price in the Geithner/Bernanke world and the $0.30 per $1 valuation in the markets today.

Illustrating the popular view that the financial crisis is "only" an accounting issue, an observer named "sourcethree" posted this comment on The Big Picture last week: "The change in the rules wouldn't have influenced the eventual outcome at Lehman, Bear, etc. because those firms did have too much in the way of real toxic assets that still would have overwhelmed whatever 'benefit' this evolution in the m2m rule would have meant to them… but it would help all banks more clearly define those assets that are toxic vs. those that are simply feeling the crunch of overwhelming selling/non-existent demand for non-credit reasons. Bank of New York is an example of what you're looking for - last quarter, they marked down their Alt-A MBS by $1.2 billion - they said even under their worst case scenario, the losses over time from these securities would only be $200 million - they even had a third party do a similar test and they came up with the same result - so, the difference here for just the last quarter was $1 billion and added to their already $6 billion in unrealized losses from prior quarters. Even if you doubt their assumptions used in their 'worst-case' scenario, the difference between the POTENTIAL credit impairment and the m2m loss they were forced to record was a factor of 6 TIMES."

But as we told the clients of IRA's Advisory Service last week, whatever relief that financial institutions and other residents of the hold-to-maturity world believe that they will receive through the modification of fair-value accounting and other official dispensation, they will lose through deteriorating economic fundamentals and falling cash flows supporting these assets as 2009 unfolds.

Or for those colleagues in the insurance world who thought they dodged the OTTI bullet propelled by fair value accounting rules, look for another projectile right behind it driven by economic factors, namely persistent deflation. As our friend Tom Zimmerman said during the last "Deflating Bubble" session hosted by AEI and PRMIA, subprime loss experience has peaked, prime residential loss rates are going to peak later in 2009 and commercial exposures will see loss rates peak in 2010. This Zombie Dance Party is just warming up.

The surprise facing Geithner, Bernanke et al is that by Q3, the true economic deterioration in many toxic assets will be clear for all to see. That $0.30 per $1 of face value bid that Treasury could hit today will be $0.15 per $1 of face value or less. The funds available today to deal with the financial crisis will be further dissipated. The opportunity cost to the Treasury of the Geithner/Bernanke do nothing approach to toxic assets will be enormous.

Speaking of poor fundamentals, when AIG released information about the amounts and recipients of roughly $100 billion of its government loans from September to December 2008, almost utterly unreported was the fact that the staid, boring, heavily regulated insurance businesses managed to run up losses on securities lending requiring $44 billion of government support.

By way of contrast, the credit derivatives widely blamed for bringing down the world's financial system were consuming $27 billion of support; municipal investment agreements (essentially, deposits) made by municipalities with AIG Financial Products took another $12 billion, and maturing debt took $13 billion. We wonder, just which unit of AIG lent the securities? What did AIG purchase with the proceeds of the securities loan? Could it be that the big story at AIG is the unsoundness of the insurer, not the credit default swaps? Why the misdirected coverage?

Our guess is that we are seeing an unholy alliance of insurance and bank regulators, who would rather point the finger at unregulated credit derivatives and support more regulation as the answer to everything. And don't forget the public officials who don't want people to wonder whether other staid, boring insurance companies that don't do credit derivatives might still have huge problems in their core portfolios. Since securities lending lacks the glamor of M&A or international "Master of the Universe" trading, the media is easily distracted.

After all, analysts have been sounding the alarm on AIG for many years, but it is difficult for the truth to penetrate Wall Street's managed version of reality. As we noted in our statement to the SBC, our friend Tim Freestone identified possible instability in the AIG business as early as 2001. AIG threatened to sue Freestone when he published his findings, which were documented at the time by the Economist magazine.

The Economist and Freestone stood their ground and Hank Greenberg and his lawyers eventually went away, but the markets took little notice. Notables such as Henry Kissinger questioned the Economist story and said "I just want you to know that Hank Greenberg has more integrity than any person I have ever known in my life."

http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=349

No Safety in Numbers ~ NYT on Treasuries

By ROGER LOWENSTEIN

Is there such a thing left as a safe investment? Stocks have been massacred, real estate all but wiped out. Each was promoted in its day — as was gold — as safe and secure, appropriate for widows and orphans.

If there is a truly last bastion of safety, it would be, of course, the U.S. Treasury bond, that venerable instrument with the full faith and credit of the United States behind it. Perhaps it is esteemed so highly because we think of it not as an “investment” per se but as an article of faith in Washington and, by extension, the entire country. It is our tax dollars, after all, that stand behind it — the accumulated output of our citizens. And ever since the Wall Street meltdown, as investors have fled from any security carrying a whiff of danger, Treasuries have been in hot demand.

NYT

So it is an eye-opener, and rather depressing, to report that even Treasuries bear risk, in particular, the risk that flows from crowd psychology. Last month, in his annual letter to shareholders (of which I am one), Warren Buffett wrote: “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

Pretty strong words for an investment that has outperformed stocks over the past 25 years and is widely referred to as “riskless.” Yet according to Buffett and other investors of a cautious bent, “risk free” Treasuries of longer maturities are anything but. None other than China’s prime minister, Wen Jiabao, expressed worry about the safety of China’s big stake in U.S. bonds.

Not since World War II has the government borrowed anything close to what it is borrowing now. Because of the economic slowdown, the stimulus package and various financial-relief measures, pundits estimate this year’s federal deficit at $1.75 trillion. To put the figures in (alarming) perspective, over the past half century and regardless of the party in power, federal tax receipts have usually provided 80 to 90 percent of the money needed to fill the budget; thus, the government has had to borrow only the remaining fraction. But this year, it will need to borrow 45 percent, virtually half, of what it is projected to spend. This means that the U.S. government is looking much like a homeowner at the tail end of the boom: too hooked on spending (even if, hopefully, for a worthy cause) to stay within its means.

When you buy a Treasury security, you are actually lending the government money for a set period of time — from 30 days to 30 years — at a fixed rate of interest. Few people worry that Uncle Sam will go the way of a defaulting subprime borrower because the government, unlike other debtors, can always print the money it needs.

But as James Bianco, who runs an eponymous bond-research firm, explains, investors in fixed-income securities face two types of risk. One is credit risk — the risk of default. The other is what bond geeks refer to as “duration” risk. This is the risk that, even if the bonds are paid in full, the promised rate of interest will turn out to be worth less over time.

Inflation destroys bond values. It’s not a big deal over one or two years, but if you hold a long-term bond and inflation takes off, the present value of the security will plummet. Bonds also lose value as interest rates go up. If rates on 30-year U.S. bonds, recently 3 percent, were to rise to, say, 6 percent, the value of bonds issued at the lower rate would fall nearly in half. (The reason is largely intuitive: if the market rate is 6 percent, nobody would be interested in a 3 percent bond, and its price would fall.)

One thing that could make interest rates rise would be an economic recovery that spurred more firms to seek credit. That would be good news for the country, of course, but not for long-term bondholders. And it’s conceivable that rates on Treasuries could rise even without a strong recovery. Government budget deficits always bring a fear of higher rates (interest rates represent the price of credit, and deficits mean that the government will be demanding more of it). And given the looming shortfalls in Social Security and Medicare, it is not clear when the deficits will end.

Granted, Treasury bonds are not quite tulip bulbs or dot-com stocks. Investors purchase them out of fear, not greed. Presumably they are not doubling-down, buying Treasuries with borrowed money to juice profits. But that distinction may not save them.

Think of the yield on Treasuries as a reverse indicator of investor sentiment. The stronger the attachment people have for Treasuries, the more willing they are to accept a low return. Once the Wall Street crisis hit, investors traded what had been a strong attachment to Treasuries for downright love. Naturally enough, given this fearful ardor, the yield touched post-Depression lows.

As with any investment, generalized enthusiasm leads to frothy prices. In seeking safety, global investors pushed Treasuries to a vulnerable level. Bond-market optimists take comfort from the Federal Reserve Board, which has hinted that to keep interest rates from rising, it would be the lender of last resort. But were the Fed to absorb surplus Treasuries, the government would, in fact, merely be “printing money,” says Mohamed El-Erian, chief executive of the bond house Pimco. When the economy rebounds, such a scenario could lead to a textbook case of inflation and devastate the ultimate “safe” investment. And lately, bond rates have begun to rise.

The primary lesson of this crisis is that we, as a nation, took on too much risk — leveraging finite capital on a fantasy that no bet would ever go bad. But there’s another lesson, too. Even safety has its price, and if we overpay for it, we create new risks. Risk, in short, may be something we have to live with.

Software Models Doomed the Markets

After the Crash: How Software Models Doomed the Markets
Overreliance on financial software crafted by physics and math PhDs helped to precipitate the Wall Street collapse

By The Editors


If Hollywood makes a movie about the worst financial crisis since the Great Depression, a basement room in a government building in Washington will serve as the setting for a key scene. There investment bankers from the largest institutions pleaded successfully with Securities and Exchange Commission (SEC) officials during a short meeting in 2004 to lift a rule specifying debt limits and capital reserves needed for a rainy day. This decision, a real event described in the New York Times, freed billions to invest in complex mortgage-backed securities and derivatives that helped to bring about the financial meltdown in September.

In the script, the next scene will be the one in which number-savvy specialists that Wall Street has come to know as quants consult with their superiors about implementing the regulatory change. These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them in its portfolio. Without the formal requirement to maintain debt ceilings and capital reserves, the commission had freed these firms to police themselves using risk tools crafted by cadres of quants.

The software models in question estimate the level of financial risk of a portfolio for a set period at a certain confidence level. As Benoit Mandelbrot, the fractal pioneer who is a longtime critic of mainstream financial theory, wrote in Scientific American in 1999, established modeling techniques presume falsely that radically large market shifts are unlikely and that all price changes are statistically independent; today’s fluctuations have nothing to do with tomorrow’s—and one bank’s portfolio is unrelated to the next’s. Here is where reality and rocket science diverge. Try Googling “financial meltdown,” “contagion” and “2008,” a search that reveals just how wrongheaded these assumptions were.

This modern-day tragedy could be framed not only as a major motion picture but also as a train wreck or plane crash. In aviation, controlled flight into terrain describes the actions of a pilot who, through inattention or incompetence, directs a well-functioning airplane into the side of a mountain. Wall Street’s version stems from the SEC’s decision to allow overreliance on risk software in the middle of a historic housing bubble. The heady environment permitted traders to enter overoptimistic assumptions and faulty data into their models, jiggering the software to avoid setting off alarm bells.

The causes of this fiasco are multifold—the Federal Reserve’s easy-money policy played a big role—but the rocket scientists and geeks also bear their share of the blame. After the crash, the quants and traders they serve need to accept the necessity for a total makeover. The government bailout has already left the U.S. Treasury and Federal Reserve with extraordinary powers. The regulators must ensure that the many lessons of this debacle are not forgotten by the institutions that trade these securities. One important take-home message: capital safety nets (now restored) should never be slashed again, even if a crisis is not looming.

For its part, the quant community needs to undertake a search for better models—perhaps seeking help from behavioral economics, which studies irrationality of investors’ decision making, and from virtual market tools that use “intelligent agents” to mimic more faithfully the ups and downs of the activities of buyers and sellers. These number wizards and their superiors need to study lessons that were never learned during previous market smashups involving intricate financial engineering: risk management models should serve only as aids not substitutes for the critical human factor. Like an airplane, financial models can never be allowed to fly solo.

link

Podcast: Satyajit Das on Late Night Live

A final conversation for the year with LNL's financial crisis analyst. He talks about President-elect Obama's key economic advisers, the likely future of banking, and the effects that have been felt around the world.

Satyajit Das

A familiar swap again; deal risk for systemic risk

The down side of the high life on Planet Finance; the subprime loan, the home equity extraction, bond insurance, the credit default swap was hidden for years and the central weakness was perceived as a strength; it was the elimination of deal risk via insurance. But the dynamic of healthy capitalism is creative distruction; those who pick the wrong side of the risk/reward tradeoff lose and that process of liquidation frees resources that can be employed by the sucessfull.

But risk cannot be eliminated and what was happening was deal risk was being exchanged for systemic risk, the guarantees froze the weightings, the dynamic network hardened and became stiff and unresponsive and was driven to fracture, the rewards paid to the finance sector players was nothing less than the monitisation of the systems capacity for dynamic change.

The final rock of the current order is the dollar system itself and this bailout and stimulus mentality is, I'm afraid, more of the same, the risk of failure of these entities, even though they have been revealed as parasites is being transferred, not eliminated. as this Bloomberg item below reveals, the risks implicit in the bailout are being transferred and at stake is the current geopolitical order and dollar hegemony itself.

That's my take, anyway.

Kevin

Treasury Credit Swaps Soar to Record on New $800 Billion Pledge


By Michael Shanahan and Abigail Moses

Nov. 26 (Bloomberg) -- The cost of hedging against losses on U.S. Treasuries surged to an all-time high after the Federal Reserve’s new $800 billion effort to combat the financial crisis raised concern about how the ballooning debt will be funded.

Benchmark 10-year credit-default swaps on U.S. government bonds jumped six basis points to 56, according to CMA Datavision prices at 12:20 p.m. in London. The contracts have risen from below two basis points at the start of the credit crisis in July 2007.

“There is a lot more money to be spent and it is not clear how it is going to be financed,” said Tim Brunne, a Munich-based credit strategist at UniCredit SpA. “Credit spreads don’t reflect expectation of default, just the uncertainty over the enormous cost to the government.”

The Fed’s new plan to kick-start markets for loans to students, car buyers, credit-card borrowers and small businesses means it will be taking on credit risk by buying debt. The central bank pledged to purchase as much as $500 billion in mortgage-backed securities as well as up to $100 billion in direct debt of Fannie Mae and Freddie Mac, the world’s two largest mortgage buyers, and Federal Home Loan Banks.

“They are loading their balance sheet with credit risk,” Brunne said in a phone interview. “Where does all the money come from?”

Five-Year Contracts

The cost of five-year contracts on Treasuries rose 3 basis points to 50.5, after earlier trading as high as 52, CMA prices show. That’s higher than the debt of Finland, Germany and Norway, according to data compiled by Bloomberg.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.

Contracts on Treasuries are quoted in euros. A basis point on a credit-default swap protecting 10 million euros ($13 million) of debt from default for five years is equivalent to 1,000 euros a year.

The cost of default protection in corporate credit markets was little changed in Europe today. The Markit iTraxx Europe index of 125 companies with investment-grade ratings was unchanged at 168 basis points, JPMorgan Chase & Co. prices show. The Markit iTraxx Crossover Index of 50 companies with mostly high-risk, high-yield credit ratings was rose 2 basis points to 877.

Contracts on the Markit CDX North America Investment Grade Index of 125 companies in the U.S. and Canada declined 12 basis points to 241 at the close of trading in New York, according to Barclays Capital.

Citigroup Saw No Red Flags Even as It Made Bolder Bets ~ NYT

By ERIC DASH and JULIE CRESWELL

“Our job is to set a tone at the top to incent people to do the right thing and to set up safety nets to catch people who make mistakes or do the wrong thing and correct those as quickly as possible. And it is working. It is working.”

Charles O. Prince III, Citigroup’s chief executive, in 2006

In September 2007, with Wall Street confronting a crisis caused by too many souring mortgages, Citigroup executives gathered in a wood-paneled library to assess their own well-being.

There, Citigroup’s chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets. He asked Thomas G. Maheras, who oversaw trading at the bank, whether everything was O.K.

Mr. Maheras told his boss that no big losses were looming, according to people briefed on the meeting who would speak only on the condition that they not be named.

For months, Mr. Maheras’s reassurances to others at Citigroup had quieted internal concerns about the bank’s vulnerabilities. But this time, a risk-management team was dispatched to more rigorously examine Citigroup’s huge mortgage-related holdings. They were too late, however: within several weeks, Citigroup would announce billions of dollars in losses.

Normally, a big bank would never allow the word of just one executive to carry so much weight. Instead, it would have its risk managers aggressively look over any shoulder and guard against trading or lending excesses.

But many Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.

Today, Citigroup, once the nation’s largest and mightiest financial institution, has been brought to its knees by more than $65 billion in losses, write-downs for troubled assets and charges to account for future losses. More than half of that amount stems from mortgage-related securities created by Mr. Maheras’s team — the same products Mr. Prince was briefed on during that 2007 meeting.

Citigroup’s stock has plummeted to its lowest price in more than a decade, closing Friday at $3.77. At that price the company is worth just $20.5 billion, down from $244 billion two years ago. Waves of layoffs have accompanied that slide, with about 75,000 jobs already gone or set to disappear from a work force that numbered about 375,000 a year ago.

Burdened by the losses and a crisis of confidence, Citigroup’s future is so uncertain that regulators in New York and Washington held a series of emergency meetings late last week to discuss ways to help the bank right itself.

And as the credit crisis appears to be entering another treacherous phase despite a $700 billion federal bailout, Citigroup’s woes are emblematic of the haphazard management and rush to riches that enveloped all of Wall Street. All across the banking business, easy profits and a booming housing market led many prominent financiers to overlook the dangers they courted.

While much of the damage inflicted on Citigroup and the broader economy was caused by errant, high-octane trading and lax oversight, critics say, blame also reaches into the highest levels at the bank. Earlier this year, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup.

The bank’s downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.

Citigroup insiders and analysts say that Mr. Prince and Mr. Rubin played pivotal roles in the bank’s current woes, by drafting and blessing a strategy that involved taking greater trading risks to expand its business and reap higher profits. Mr. Prince and Mr. Rubin both declined to comment for this article.

When he was Treasury secretary during the Clinton administration, Mr. Rubin helped loosen Depression-era banking regulations that made the creation of Citigroup possible by allowing banks to expand far beyond their traditional role as lenders and permitting them to profit from a variety of financial activities. During the same period he helped beat back tighter oversight of exotic financial products, a development he had previously said he was helpless to prevent.

And since joining Citigroup in 1999 as a trusted adviser to the bank’s senior executives, Mr. Rubin, who is an economic adviser on the transition team of President-elect Barack Obama, has sat atop a bank that has been roiled by one financial miscue after another.

Citigroup was ensnared in murky financial dealings with the defunct energy company Enron, which drew the attention of federal investigators; it was criticized by law enforcement officials for the role one of its prominent research analysts played during the telecom bubble several years ago; and it found itself in the middle of regulatory violations in Britain and Japan.

For a time, Citigroup’s megabank model paid off handsomely, as it rang up billions in earnings each quarter from credit cards, mortgages, merger advice and trading.

But when Citigroup’s trading machine began churning out billions of dollars in mortgage-related securities, it courted disaster. As it built up that business, it used accounting maneuvers to move billions of dollars of the troubled assets off its books, freeing capital so the bank could grow even larger. Because of pending accounting changes, Citigroup and other banks have been bringing those assets back in-house, raising concerns about a new round of potential losses.

To some, the misery at Citigroup is no surprise. Lynn Turner, a former chief accountant with the Securities and Exchange Commission, said the bank’s balkanized culture and pell-mell management made problems inevitable.

“If you’re an entity of this size,” he said, “if you don’t have controls, if you don’t have the right culture and you don’t have people accountable for the risks that they are taking, you’re Citigroup.”

Questions on Oversight

Though they carry less prestige and are paid less than Wall Street traders and bankers, risk managers can wield significant clout. Their job is to monitor trading floors and inquire about how a bank’s money is being invested, so they can head off potential problems before blow-ups occur. Though risk managers and traders work side by side, they can have an uncomfortable coexistence because the monitors can put a brake on trading.

That is the way it works in theory. But at Citigroup, many say, it was a bit different.

David C. Bushnell was the senior risk officer who, with help from his staff, was supposed to keep an eye on the bank’s bond trading business and its multibillion-dollar portfolio of mortgage-backed securities. Those activities were part of what the bank called its fixed-income business, which Mr. Maheras supervised.

One of Mr. Maheras’s trusted deputies, Randolph H. Barker, helped oversee the huge build-up in mortgage-related securities at Citigroup. But Mr. Bushnell, Mr. Maheras and Mr. Barker were all old friends, having climbed the bank’s corporate ladder together.

It was common in the bank to see Mr. Bushnell waiting patiently — sometimes as long as 45 minutes — outside Mr. Barker’s office so he could drive him home to Short Hills, N.J., where both of their families lived. The two men took occasional fly-fishing trips together; one expedition left them stuck on a lake after their boat ran out of gas.

Because Mr. Bushnell had to monitor traders working for Mr. Barker’s bond desk, their friendship raised eyebrows inside the company among those concerned about its controls.

After all, traders’ livelihoods depended on finding new ways to make money, sometimes using methods that might not be in the bank’s long-term interests. But insufficient boundaries were established in the bank’s fixed-income unit to limit potential conflicts of interest involving Mr. Bushnell and Mr. Barker, people inside the bank say.

Indeed, some at Citigroup say that if traders or bankers wanted to complete a potentially profitable deal, they could sometimes rely on Mr. Barker to convince Mr. Bushnell that it was a risk worth taking.

Risk management “has to be independent, and it wasn’t independent at Citigroup, at least when it came to fixed income,” said one former executive in Mr. Barker’s group who, like many other people interviewed for this article, insisted on anonymity because of pending litigation against the bank or to retain close ties to their colleagues. “We used to say that if we wanted to get a deal done, we needed to convince Randy first because he could get it through.”

Others say that Mr. Bushnell’s friendship with Mr. Maheras may have presented a similar blind spot.

“Because he has such trust and faith in these guys he has worked with for years, he didn’t ask the right questions,” a former senior Citigroup executive said, referring to Mr. Bushnell.

Mr. Bushnell and Mr. Barker did not return repeated phone calls seeking comment. Mr. Maheras declined to comment.

For some time after Sanford I. Weill, an architect of the merger that created Citigroup a decade ago, took control of Citigroup, he toned down the bank’s bond trading. But in late 2002, Mr. Prince, who had been Mr. Weill’s longtime legal counsel, was put in charge of Citigroup’s corporate and investment bank.

According to a former Citigroup executive, Mr. Prince started putting pressure on Mr. Maheras and others to increase earnings in the bank’s trading operations, particularly in the creation of collateralized debt obligations, or C.D.O.’s — securities that packaged mortgages and other forms of debt into bundles for resale to investors.

Because C.D.O.’s included so many forms of bundled debt, gauging their risk was particularly tricky; some parts of the bundle could be sound, while others were vulnerable to default.

“Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process,” a former Citigroup executive said of the bank’s big C.D.O. push. “Chuck was totally new to the job. He didn’t know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You have to take more risk if you want to earn more.’ ”

It appeared to be a good time for building up Citigroup’s C.D.O. business. As the housing market around the country took flight, the C.D.O. market also grew apace as more and more mortgages were pooled together into newfangled securities.

From 2003 to 2005, Citigroup more than tripled its issuing of C.D.O.’s, to more than $20 billion from $6.28 billion, and Mr. Maheras, Mr. Barker and others on the C.D.O. team helped transform Citigroup into one of the industry’s biggest players. Firms issuing the C.D.O.’s generated fees of 0.4 percent to 2.5 percent of the amount sold — meaning Citigroup made up to $500 million in fees from the business in 2005 alone.

Even as Citigroup’s C.D.O. stake was expanding, its top executives wanted more profits from that business. Yet they were not running a bank that was up to all the challenges it faced, including properly overseeing billions of dollars’ worth of exotic products, according to Citigroup insiders and regulators who later criticized the bank.

When Mr. Prince was put in charge in 2003, he presided over a mess of warring business units and operational holes, particularly in critical areas like risk-management and controls.

“He inherited a gobbledygook of companies that were never integrated, and it was never a priority of the company to invest,” said Meredith A. Whitney, a banking analyst who was one of the company’s early critics. “The businesses didn’t communicate with each other. There were dozens of technology systems and dozens of financial ledgers.”

Problems with trading and banking oversight at Citigroup became so dire that the Federal Reserve took the unusual step of telling the bank it could make no more acquisitions until it put its house in order.

In 2005, stung by regulatory rebukes and unable to follow Mr. Weill’s penchant for expanding Citigroup’s holdings through rapid-fire takeovers, Mr. Prince and his board of directors decided to push even more aggressively into trading and other business that would allow Citigroup to continue expanding the bank internally.

One person who helped push Citigroup along this new path was Mr. Rubin.

Pushing Growth

Robert Rubin has moved seamlessly between Wall Street and Washington. After making his millions as a trader and an executive at Goldman Sachs, he joined the Clinton administration.

Mr. Weill, as Citigroup’s chief, wooed Mr. Rubin to join the bank after Mr. Rubin left Washington. Mr. Weill had been involved in the financial services industry’s lobbying to persuade Washington to loosen its regulatory hold on Wall Street.

As chairman of Citigroup’s executive committee, Mr. Rubin was the bank’s resident sage, advising top executives and serving on the board while, he insisted repeatedly, steering clear of daily management issues.

“By the time I finished at Treasury, I decided I never wanted operating responsibility again,” he said in an interview in April. Asked then whether he had made any mistakes during his tenure at Citigroup, he offered a tentative response.

“I’ve thought a lot about that,” he said. “I honestly don’t know. In hindsight, there are a lot of things we’d do differently. But in the context of the facts as I knew them and my role, I’m inclined to think probably not.”

Besides, he said, it was impossible to get a complete handle on Citigroup’s vulnerabilities unless you dealt with the trades daily.

“There is no way you would know what was going on with a risk book unless you’re directly involved with the trading arena,” he said. “We had highly experienced, highly qualified people running the operation.”

But while Mr. Rubin certainly did not have direct responsibility for a Citigroup unit, he was an architect of the bank’s strategy.

In 2005, as Citigroup began its effort to expand from within, Mr. Rubin peppered his colleagues with questions as they formulated the plan. According to current and former colleagues, he believed that Citigroup was falling behind rivals like Morgan Stanley and Goldman, and he pushed to bulk up the bank’s high-growth fixed-income trading, including the C.D.O. business.

Former colleagues said Mr. Rubin also encouraged Mr. Prince to broaden the bank’s appetite for risk, provided that it also upgraded oversight — though the Federal Reserve later would conclude that the bank’s oversight remained inadequate.

Once the strategy was outlined, Mr. Rubin helped Mr. Prince gain the board’s confidence that it would work.

After that, the bank moved even more aggressively into C.D.O.’s. It added to its trading operations and snagged crucial people from competitors. Bonuses doubled and tripled for C.D.O. traders. Mr. Barker drew pay totaling $15 million to $20 million a year, according to former colleagues, and Mr. Maheras became one of Citigroup’s most highly compensated employees, earning as much as $30 million at the peak — far more than top executives like Mr. Bushnell in the risk-management department.

In December 2005, with Citigroup diving into the C.D.O. business, Mr. Prince assured analysts that all was well at his bank.

“Anything based on human endeavor and certainly any business that involves risk-taking, you’re going to have problems from time to time,” he said. “We will run our business in a way where our credibility and our reputation as an institution with the public and with our regulators will be an asset of the company and not a liability.”

Yet as the bank’s C.D.O. machine accelerated, its risk controls fell further behind, according to former Citigroup traders, and risk managers lacked clear lines of reporting. At one point, for instance, risk managers in the fixed-income division reported to both Mr. Maheras and Mr. Bushnell — setting up a potential conflict because that gave Mr. Maheras influence over employees who were supposed to keep an eye on his traders.

C.D.O.’s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup’s business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.

While the sheer size of Citigroup’s C.D.O. position caused concern among some around the trading desk, most say they kept their concerns to themselves.

“I just think senior managers got addicted to the revenues and arrogant about the risks they were running,” said one person who worked in the C.D.O. group. “As long as you could grow revenues, you could keep your bonus growing.”

To make matters worse, Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come, of course, with disastrous consequences for Citigroup and its rivals on Wall Street.

Even as the first shock waves of the subprime mortgage crisis hit Bear Stearns in June 2007, Citigroup’s top executives expressed few concerns about their bank’s exposure to mortgage-linked securities.

In fact, when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.

Later that summer, when the credit markets began seizing up and values of various C.D.O.’s began to plummet, Mr. Maheras, Mr. Barker and Mr. Bushnell participated in a meeting to review Citigroup’s exposure.

The slice of mortgage-related securities held by Citigroup was “viewed by the rating agencies to have an extremely low probability of default (less than .01%),” according to Citigroup slides used at the meeting and reviewed by The New York Times.

Around the same time, Mr. Maheras continued to assure his colleagues that the bank “would never lose a penny,” according to an executive who spoke to him.

In mid-September 2007, Mr. Prince convened the meeting in the small library outside his office to gauge Citigroup’s exposure.

Mr. Maheras assured the group, which included Mr. Rubin and Mr. Bushnell, that Citigroup’s C.D.O. position was safe. Mr. Prince had never questioned the ballooning portfolio before this because no one, including Mr. Maheras and Mr. Bushnell, had warned him.

But as the subprime market plunged further, Citigroup’s position became more dire — even though the firm held onto the belief that its C.D.O.’s were safe.

On Oct. 1, it warned investors that it would write off $1.3 billion in subprime mortgage-related assets. But of the $43 billion in C.D.O.’s it had on its books, it wrote off only about $95 million, according to a person briefed on the situation.

Soon, however, C.D.O. prices began to collapse. Credit-rating agencies downgraded C.D.O.’s, threatening Citigroup’s stockpile. A week later, Merrill Lynch aggressively marked down similar securities, forcing other banks to face reality.

By early November, Citigroup’s anticipated write-downs ballooned to $8 billion to $11 billion. Mr. Barker and Mr. Maheras lost their jobs, as Mr. Bushnell did later on. And on Nov. 4, Mr. Prince told the board that he, too, would resign.

Although Mr. Prince received no severance, he walked away with Citigroup stock valued then at $68 million — along with a cash bonus of about $12.5 million for 2007.

Putting Out Fires

Mr. Prince was replaced last December by Vikram S. Pandit, a former money manager and investment banker whom Mr. Rubin had earlier recruited in a senior role. Since becoming chief executive, Mr. Pandit has been scrambling to put out fires and repair Citigroup’s deficient risk-management systems.

Earlier this year, Federal Reserve examiners quietly presented the bank with a scathing review of its risk-management practices, according to people briefed on the situation.

Citigroup executives responded with a 25-page single-spaced memo outlining a sweeping overhaul of the bank’s risk management.

In May, Brian Leach, Citigroup’s new chief risk officer, told analysts that his bank had greatly improved oversight and installed several new risk managers. He said he wanted to ensure “that Citi takes the lessons learned from recent events and makes critical enhancements to its risk management frameworks. A change in culture is required at Citi.”

Meanwhile, regulators have criticized the banking industry as a whole for relying on outsiders — in particular the ratings agencies — to help them gauge the risk of their investments.

“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year.

But he noted that what caused the largest problem for some banks was that they retained dangerously big positions in certain securities — like C.D.O.’s — rather than selling them off to other investors.

“What most differentiated the companies sustaining the biggest losses from the rest was their willingness to hold exceptionally large positions on their balance sheets which, in turn, led to exceptionally large losses,” he said.

Mr. Dugan did not mention any specific bank by name, but Citigroup is the largest player in the C.D.O. business of any bank the comptroller regulates.

For his part, Mr. Pandit faces the twin challenge of rebuilding investor confidence while trying to fix the company’s myriad problems.

Citigroup has suffered four consecutive quarters of multibillion-dollar losses as it has written down billions of dollars of the mortgage-related assets it held on its books.

But investors worry there is still more to come, and some board members have raised doubts about Mr. Pandit’s leadership, according to people briefed on the situation.

Citigroup still holds $20 billion of mortgage-linked securities on its books, the bulk of which have been marked down to between 21 cents and 41 cents on the dollar. It has billions of dollars of giant buyout and corporate loans. And it also faces a potential flood of losses on auto, mortgage and credit card loans as the global economy plunges into a recession.

Also, hundreds of billions of dollars in dubious assets that Citigroup held off its balance sheet is now starting to be moved back onto its books, setting off yet another potential problem.

The bank has already put more than $55 billion in assets back on its balance sheet. It now says an added $122 billion of assets related to credit cards and possibly billions of dollars of other assets will probably come back on the books.

Even though Citigroup executives insist that the bank can ride out its current difficulties, and that the repatriated assets pose no threat, investors have their doubts. Because analysts do not have a complete grip on the quality of those assets, they are warning that Citigroup may have to set aside billions of dollars to guard against losses.

In fact, some analysts say they believe that the $25 billion that the federal government invested in Citigroup this fall might not be enough to stabilize it.

Others say the fact that such huge amounts have yet to steady the bank is a reflection of the severe damage caused by Citigroup’s appetites.

“They pushed to get earnings, but in doing so, they took on more risk than they probably should have if they are going to be, in the end, a bank subject to regulatory controls,” said Roy Smith, a professor at the Stern School of Business at New York University. “Safe and soundness has to be no less important than growth and profits but that was subordinated by these guys.”

Confessions of a risk manager

Why did banks become so overexposed in the run-up to the credit crunch? A risk manager at a large global bank—someone whose job it was to make sure that the firm did not take unnecessary risks—explains in his own words.

IN JANUARY 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.

As risk managers we were responsible for approving credit requests and transactions submitted to us by the bankers and traders in the front-line. We also monitored and reported the level of risk across the bank’s portfolio and set limits for overall credit and market-risk positions.


The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market—not going out of it. Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets. This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private-equity financings were increasing. “Where is the liquidity crisis supposed to come from?” somebody asked in the meeting. No one could give a good answer.

Looking back on it now we should of course have paid more attention to the first signs of trouble. No crisis comes completely out of the blue; there are always clues and advance warnings if you can only interpret them correctly. It was the hiccup in the structured-credit market in May 2005 which gave the strongest indication of what was to come. In that month bonds of General Motors were marked down by the rating agencies from investment grade to non-investment grade, or “junk”. Because the American carmaker’s bonds were widely held in structured-credit portfolios, the downgrades caused a big dislocation in the market.

Like most banks we owned a portfolio of different tranches of collateralised-debt obligations (CDOs), which are packages of asset-backed securities. Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs; and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero. We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.

In May 2005 we held AAA tranches, expecting them to rise in value, and sold non-investment-grade tranches, expecting them to go down. From a risk-management point of view, this was perfect: have a long position in the low-risk asset, and a short one in the higher-risk one. But the reverse happened of what we had expected: AAA tranches went down in price and non-investment-grade tranches went up, resulting in losses as we marked the positions to market.

This was entirely counter-intuitive. Explanations of why this had happened were confusing and focused on complicated cross-correlations between tranches. In essence it turned out that there had been a short squeeze in non-investment-grade tranches, driving their prices up, and a general selling of all more senior structured tranches, even the very best AAA ones.

That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions. As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold. But we did not believe that prices on AAA assets could fall by more than about 1% in price. A 20% drop on assets with virtually no default risk seemed inconceivable—though this did eventually occur. Liquidity risk was in effect not priced well enough; the market always allowed for it, but at only very small margins prior to the credit crisis.

So how did we get ourselves into a situation where we built up such large trading positions? There were a number of factors. As is often the case, it happened so gradually that it was barely perceptible.
Fighting the last war

The focus of our risk management was on the loan portfolio and classic market risk. Loans were illiquid and accounted for on an accrual basis in the “banking book” rather than on a mark-to-market basis in the “trading book”. Rigorous credit analysis to ensure minimum loan-loss provisions was important. Loan risks and classic market risks were generally well understood and regularly reviewed. Equities, government bonds and foreign exchange, and their derivatives, were well managed in the trading book and monitored on a daily basis.

The gap in our risk management only opened up gradually over the years with the growth of traded credit products such as CDO tranches and other asset-backed securities. These sat uncomfortably between market and credit risk. The market-risk department never really took ownership of them, believing them to be primarily credit-risk instruments, and the credit-risk department thought of them as market risk as they sat in the trading book.

The explosive growth and profitability of the structured-credit market made this an ever greater problem. Our risk-management response was half-hearted. We set portfolio limits on each rating category but otherwise left the trading desks to their own devices. We made two assumptions which would cost us dearly. First, we thought that all mark-to-market positions in the trading book would receive immediate attention when losses occurred, because their profits and losses were published daily. Second, we assumed that, if the market ran into difficulties, we could easily adjust and liquidate our positions, especially on securities rated AAA and AA. Our focus was always on the non-investment-grade part of the portfolio, especially the emerging-markets paper. The previous crises in Russia and Latin America had left a deeply ingrained fear of sudden liquidity shocks and widening credit spreads. Ironically, of course, in the credit crunch the emerging-market bonds have outperformed the Western credit assets.

We also trusted the rating agencies. It is hard to imagine now but the reputation of outside bond ratings was so high that if the risk department had ever assigned a lower rating, our judgment would have been immediately questioned. It was assumed that the rating agencies simply knew best.

We were thus comfortable with investment-grade assets and were struggling with the huge volume of business. We were too slow to sell these better-rated assets. We needed little capital to support them; there was no liquidity charge, very little default risk and a small positive margin, or “carry”, between holding the assets and their financing in the liquid interbank and repo markets. Gradually the structures became more complicated. Since they were held in the trading book, many avoided the rigorous credit process applied to the banking-book assets which might have identified some of the weaknesses.

The pressure on the risk department to keep up and approve transactions was immense. Psychology played a big part. The risk department had a separate reporting line to the board to preserve its independence. This had been reinforced by the regulators who believed it was essential for objective risk analysis and assessment. However, this separation hurt our relationship with the bankers and traders we were supposed to monitor.
Spoilsports

In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.

At the root of it all, however, was—and still is—a deeply ingrained flaw in the decision-making process. In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument. The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.
Gary Neil


Collective common sense suffered as a result. Often in meetings, our gut reactions as risk managers were negative. But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started. In the end, with pressure for earnings and a calm market environment, we reluctantly agreed to marginal transactions.

Over time we accumulated a balance-sheet of traded assets which allowed for very little margin of error. We owned a large portfolio of “very low-risk” assets which turned out to be high-risk. A small price movement on billions of dollars’ worth of securities would translate into large mark-to-market losses. We thought that we had focused correctly on the non-investment-grade paper, of which we held little. We had not paid enough attention to the ever-growing mountain of highly rated but potentially illiquid assets. We had not fully appreciated that 20% of a very large number can inflict far greater losses than 80% of a small number.

Goals and goalkeepers

What have we, both as risk managers and as an industry, to learn from this crisis? A number of thoughts come to mind. One lesson is to go back to basics, to analyse your balance-sheet positions by type, size and complexity both before and after you have hedged them. Do not assume that ratings are always correct and if they are, remember that they can change quickly.

Another lesson is to account properly for liquidity risk in two ways. One is to increase internal and external capital charges for trading-book positions. These are too low relative to banking-book positions and need to be recalibrated. The other is to bring back liquidity reserves. This has received little attention in the industry so far. Over time fair-value accounting practices have disallowed liquidity reserves, as they were deemed to allow for smoothing of earnings. However, in an environment in which an ever-increasing part of the balance-sheet is taken up by trading assets, it would be more sensible to allow liquidity reserves whose size is set in scale to the complexity of the underlying asset. That would be better than questioning the whole principle of mark-to-market accounting, as some banks are doing.

Last but not least, change the perception and standing of risk departments by giving them more prominence. The best way would be to encourage more traders to become risk managers. Unfortunately the trend has been in reverse; good risk managers end up in the front-line and good traders and bankers, once in the front-line, very rarely go the other way. Risk managers need to be perceived like good goalkeepers: always in the game and occasionally absolutely at the heart of it, like in a penalty shoot-out.

This is hard to achieve because the job we do has the risk profile of a short option position with unlimited downside and limited upside. This is the one position that every good risk manager knows he must avoid at all costs. A wise firm will need to bear this in mind when it tries to persuade its best staff to take on such a crucial task.