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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Apr 24

Written by: Donald van Deventer
4/24/2009 11:37 AM 

Twice a year, 20 to 30 of the best risk managers in North America gather to compare notes on the state of the risk business.  These experts have 20 to 30 years experience each, typically 10-15 years more experience than the miscreants who securitized subprime mortgages and mispriced collateralized debt obligations.  They care about the shareholders and depositors of their institutions, not their next bonus. The ground rules of the session are simple--it's a peer to peer exchange with nothing for attribution.  In that spirit, on a no names basis, we pass on some of their thoughts in this post.

Who's to blame in the current crisis?  These senior bankers combine experience, quantitative skills and political savvy.  In today's comments, many blamed the fools who made the decision to make 100% loan to value loans, option ARMS, pay option mortgages, and so called NINJA loans ("no income, no assets") without understanding how the very nature of these structures guaranteed a higher level of default never seen before.  They also blame special purpose vehicles that transferred no risk off balance sheet but allowed bankers to avoid holding the assets for regulatory capital purposes.

Flawed models.  The bankers couldn't believe the naivete of their younger brethren in derivatives groups who uncritically took up models that, by the very nature of their assumptions, couldn't possibly be accurate.  See related blog posts on "Is Your Value at Risk because of Value-at-Risk" and "Using the Copula Approach for CDO Valuation: A Post Mortem."  The veteran risk experts saw the users of these models take them up for fashion, not for substance and accuracy.  They were shocked at the lack of due diligence on the quality of these models, given that many of them have been doing much more complex multiperiod monte carlo simulations for more than 20 years.

Stress testing.  The risk experts are glad to see a return to stress testing, a tried and true technique that was a little too frumpy for younger analysts who craved the normal distribution and Excel spreadsheets over accuracy.

Basel II: For Whom the Bell Tolls: Many of these experts hear the funeral bells tolling for Basel II, which has proven useless in the current crisis--a risk measure with no ability to predict who would fail and who wouldn't.  Many guessed that the U.S. failure to adopt the standard would cripple the move toward complicated but meaningless risk standards.  The risk experts see a strong move by analysts and regulators back to "tangible common equity to assets," a risk ratio used for 30 years, as superior to Basel II and much, much cheaper.

Structured Investment Vehicles: A Concept Whose Time has Gone:  The risk experts felt that these SIV structures were just regulatory arbitrage with no real risk transferred to them. Because of the move toward adoption of International Financial Reporting Standards first in Canada and later in the United States, the risk experts predict the rapid decline in the use of off-balance sheet SIVs and other funding vehicles.

Citigroup and AIG: Too Big, but Not Too Big to Fail.  Most of the risk experts would pull the plug now, sell the good pieces and let the derivatives and structured product groups be liquidated with as little damage as possible.  They feel both institutions in their current form don't meet the "sniff test" for taxpayer support.

Tim Geithner: Your Headhunter Called:  The risk experts aren't expecting a long tenure for Mr. Geithner.

Credit Default Swaps:  Time for Change.  The risk experts are very concerned by the huge concentration of counterparty credit risk in the CDS market and encouraged by the move toward exchange trading with daily margin requirements.

Rating the Raters.  The risk experts laughed each time the phrase "rating agency" was mentioned.  They're moving toward rating agency independence as fast as they can.

Mortgage Relief: A quick poll of the risk experts found not a single one of them had refinanced "up," the common recent phenomenon of taking cash out of the unrealized gains on a house by refinancing  a mortgage loan for a new loan with larger principal.  They feel little sympathy for those who took this cash out, bought common stock with it or European vacations with it, and then couldn't pay.  The moral hazard of this precedent bothers them all.

Structured Products: Simplicity is In: The risk experts see a dramatic return to plain vanilla structures going forward.  The era of a structured product made complex only to more easily rip off investors (spelled C-D-O) is dead until a new, naive generation of investors comes along.

All Pros.  These men and women know their stuff.  They'll clean up the mess left by their younger peers in structured products and CDOs.  If management had listened to these experts in the first place, the current crisis would have been just a modest bump in the road.

Donald R. van Deventer

Kamakura Corporation

Honolulu, April 24, 2009

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