Monday, May 3, 2010

The financial debacle ... understanding risk and AIG

Dear Colleagues

As I listen to the media ... especially the financial media ... doing their sound byte analysis of the financial sector, capital markets and economic trends, etc. I keep coming back to the question of risk.

While this may not be the most popular conclusion ... I came away from the Goldman Sach's media frenzy of last week thinking that they seem to know what they are doing, and much of the so-called "sophisticated investor" community does not. At the center of Goldman Sach's success is a clear appreciation of risk and how risk needs to be managed.

Though there was a lot of dialog over the past week about many aspects of the financial market and especially behavior that was characterized as gambling, betting against ones clients, casino, etc. rather little was made of the risk associated with the AIG situation. It is my understanding that almost all the AIG contracts would void or reset ... or do something very damaging to the system ... in the event that AIG defaulted or went into some sort of bankruptcy or receivership. I do not understand the legal details, but my experience with risk management and insurance a long time ago was that in the insurance industry all sorts of bad things happen when there is a financial default.

The relatively large government bail-out of AIG seems to reflect a concern of this sort ... and it is evident that the bail-out of AIG worked exactly as it was meant to because contracts due and payable to others were able to be met by AIG. These moneys went to all sorts of organizations in the USA and around the world settling accounts in the (thankfully) normal order of business. Of course some moneys went overseas ... and some of these money went (or came) to Goldman Sachs ... but this is what had to happen in order for the financial system to start working again.

I learned early in my career that most systems could handle a single bad event ... but few could handle multiple bad events. At some point there is the need for human oversight, and people to be clear about the fundamentals. Risk is not reduced by the process of building derivatives ... it is merely positioned so that it is where it will do less damage. In the case of mortgage backed securities, the risk is built in at the moment the mortgage is created. This part of the process seems to have been flawed in almost every dimension ... and it is amazing that nobody responded to this situation a whole lot sooner. I guess this is explained by the simple idea that profit trumps common sense.

When Goldman Sachs realized they were too much at risk with mortgage backed securities, it appears that they moved rapidly to reduce their long positions with outright sales or short sales. On balance they minimized their losses from the real estate sub-prime debacle ... while many others in the financial sector stayed with high risk securities and paid the price.

In the recent debate there is a view that the community banks on Main Street were good and the Wall Street banks like Goldman Sachs were bad. On the contrary, it was the community banks and the mortgage originating organizations that created the sub-prime instruments at the start of the process ... this is the segment of the financial services industry that set up the financial fiasco, and made good profits in the process. They moved a lot of the risk out of their institutions and it eventually ended up with the capital markets ... and big banks were in trouble. The risk, though, originated with community banks and the mortgage originating organizations ... not to mention a whole range of professional people who failed abysmally to do the work that might reasonably have been expected of them!

I realize this is something of a contrarian view ... but this is what the evidence seems to show. Wall Street and big banks got into all sorts of trouble ... with smaller banks dodging much of the risk from the sub-prime debacle. Smaller banks subsequently have become financially fragile because of the high level of unemployment and the slump in consumer spending and small business activity ... but this is separate from the risk that went wrong in the sub-prime situation that wreaked havoc with global financial markets.

I would appreciate feedback ... what have I got wrong?

Peter Burgess

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