The subprime lending crisis of 2008, which led to significant distress in the financial markets, was a disaster of mega proportions. Its root causes are many, making it systemic in nature as opposed to a one-off situation in a specific company. Loan originators brokered financing of houses without regard to credit quality so they could get their up-front fees, take a walk and leave the inevitable consequences in a bag to be passed downstream to someone else. There was a significant erosion of market discipline by those involved in the securitization process, including underwriters, credit rating agencies, investment firms, hedge firms and other global investors. This erosion resulted from breakdowns in underwriting standards, failures to provide or obtain adequate disclosures, and flaws in rating agency assessments of structured products, among other things. Why were such time-tested practices disregarded? Perhaps too many people were having a good time making a lot of money. However, those left standing when the music stopped without the proverbial chair to sit in paid the penalty. And it could have been a lot worse for a number of reasons we lack the space to elaborate upon here.
Why look back 10 years when all of us are coping with a changing world and looking forward? A question I still hear from time to time is: “What separated the financial institutions that had a seat in that proverbial ring when the music stopped from those that didn’t?” In the answer to that question, there are relevant lessons when facing the future.
According to a report issued in 2009 by a group of European and U.S. regulators – the so-called Senior Supervisors Group (SSG) – four enterprisewide practices differentiated performance in the subprime lending market:
- Effective firmwide risk identification and analysis – The performers who reported fewer losses from subprime lending shared quantitative and qualitative information more effectively across the organization. In fact, according to the SSG report, some firms identified “the sources of significant risk as early as mid-2006” and “had as much as a year to evaluate the magnitude of the risks and to implement plans to reduce exposures or hedge risks while it was still practical and not prohibitively expensive.” This is what being an early mover is all about.
- Consistent application of independent and rigorous valuation practices across the firm – The best performers deployed “rigorous internal processes requiring critical judgment and discipline in the valuation of potentially illiquid securities.” Skeptical of rating agency assessments, these firms developed their own in-house expertise to assess credit quality, and even tested their assessments by selling a small percentage of assets in selected residential housing markets to obtain pricing data points to ascertain whether the applicable markets were deteriorating.
- Effective management of funding liquidity, capital and the balance sheet – The firms that avoided the significant challenges faced by their less fortunate peers in the subprime market established more discipline from a liquidity and capital standpoint by charging business lines for building contingent liability exposures so that they bear the cost of obtaining liquidity in a difficult market environment. They also aligned treasury activities more closely with risk management and took an end-to-end enterprisewide view to managing global liquidity risk.
- Information and responsive risk measurement and risk management reporting practices – The best performers had more effective management information systems and tools, meaning executive management was more aware of the speed and severity of changes in the fundamental variables driving the market. These capabilities included stress testing, sensitivity analysis and scenario analysis by a function independent of the business lines that could review and interpret the results objectively and report them to executive management and the board. While value-at-risk techniques were used, the firms recognized the limitations of such measures in terms of evaluating the degree of market volatility they may face looking forward. By combining quantitative rigor with qualitative assessments, these firms were able to apply the brakes and reduce exposures when they determined the portfolio risks outweighed the expected rewards.
All firms participating in the subprime market, including the “better performing” ones, took a hit. How much of a hit depended on how well they identified and managed the risk and, more specifically, how timely they acted on their knowledge of the risks. Those firms that danced until the music stopped were hit the hardest.
Another key lesson is recognizing that risk management processes are not bulletproof. In a March 2008 op-ed, Alan Greenspan noted that the financial risk-valuation system failed under stress. He stated:
“Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioral responses as non-rational. But forecasters’ concerns should be not whether human response is rational or irrational, only that it is observable and systematic.”
Mr. Greenspan’s point is deceptively simple. No matter how hard we try, it is difficult to model the future perfectly. There always will be uncertainty, and human behavior is part of the equation. Therefore, if certain business activities are generating unusually high rates of return, directors and executive management must understand why. When the accounting rules are not black and white, or the nature of certain transactions and activities is very complex, directors and management must insist on clarity. The subprime lending debacle is a clear example of how obscurity, complexity and confusion are a breeding ground for uneconomic activity driven by smart people who can “game the system,” with the masses left unaware until it is too late. Just because someone is generating significantly superior returns does not mean what they are doing is sustainable. If no one understands it, someone has to take a step back and ask, “What are we doing and why are we doing it?” My advice: If you don’t understand the risks, ask the necessary questions until you do.
Another lesson: It is the responsibility of senior management to provide the proper incentives and controls to counter the potential for individuals to discount risks to the broader organization. When executives have the benefit of “heads I win, tails you lose” compensation structures, there is no skin in the game. Accordingly, executive management and the board should understand the consequences of providing an overweight of short-term and one-sided incentives in an executive’s compensation package. This is why, subsequent to the crisis, the Securities and Exchange Commission required boards to disclose in their companies’ proxy statements how they review compensation plans to ensure there is an absence of risk-taking incentives that can affect the company’s risk profile and management of risk.
One last lesson from the crisis (and, of course, there are others I haven’t mentioned) pertains to the importance of a risk-informed culture. Such a culture encourages managers to portray realistically the potential outcomes of prospective transactions, deals, investments, projects and budgeting decisions. The irony of such a culture is that robust and transparent dialogue about risk can lead the organization to take on more risk, not less. Increased understanding improves risk management capabilities and reduces uncertainty. An effective risk management oversight function, coupled with an ongoing enterprisewide risk assessment process, will help create an environment where risk is embraced in a positive, proactive manner at all levels of the organization, enabling issues to be brought out into the open and escalated to the top.