"According to the mainstream
view from academia, infact, reducing risk, per se, has no intrinsic
value and brings no benefits to the shareholders...It is because of the
ability of investors to know what individual firms are up to and to
achieve diversification by themselves that managers should simply
concentrate on finding projects...whose return exceeds their
appropriate hurdle rate"
Riccardo Rebonato, Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently, p. 107-108
Rebonato, who heads up quantitative research and analysisfor the Royal
Bank of Scotland, has written a book on financial risk that appears at
an appropriate time. The meltdown in the subprime mortgage market
illustrates a number of the issues with which he grapples.
Rebonato occasionally takes the reader a bit deep into the weeds of
probability theory, he at least points regulators and financial
executives in the right direction. The fundamental problem for
financial intermediaries is to produce summaries that accurately
identify and disclose the risks that a firm is taking. I call this the
Risk Disclosure Problem (RDP).
In notorious examples,
such as Enron, the press highlights the deliberate deception of
financial executives. However, my view is that the RDP is at least as
much internal as external. There may have been a brief window in the
months prior to Enron's collapse where the executives knew more than
Enron's investors. However, the main reason that Enron got into
trouble, I believe, is that for years Enron's executives and its Board
did not understand how it was making its money and the risks involved.
financial intermediation is about enticing investors to buy securities
backed by investments whose risks the investors cannot fully evaluate.
The intermediary, such as a bank, hedge fund, or ordinary corporation,
specializes in evaluating risk. The investor who buys securities from
the intermediary looks to the past performance of the intermediary as
well as to concise summaries of the risk of those securities. The
ratings of "AA" or "A+" by bond rating agencies are just one example of
these concise risk summaries.
intermediation is multi-layered. The mortgage broker knows the specific
characteristics of the house being purchased, as well as the borrower's
financial data and credit history. Mortgage funders funnel funds
through brokers, using only summary statistics such as the borrower's
credit score, the ratio of the loan amount to the appraised value
(LTV), and the broker's historical performance with the funding agency.
Funders then pool loans together. Firms that buy the pools know only
the general characteristics of the pool -- the rangeof credit scores,
the range of LTV's, and so on. These pools may befurther carved up into
"tranches," so that if loans start to default, some investors will take
an immediate loss while others continue to receive full principal and
At each step in the layering process, some of
the detailed information about the underlying risk is ignored. Instead,
investors rely on summary information. It is this use of summary
information that makes these investments liquid -- that is, it enables
them to be bought and sold by many investors. As an intermediary layer
is added, while the amount of detailed risk information is going down,
liquidity is going up. The result of this process is that the ultimate
borrower -- in this instance, the home buyer -- pays a much lower risk
premium than would be the case in the absence of liquidity.
Rebonato puts it this way (p. 8-9):
is nothing special about mortgages: a similarly intricate and
multilayered story could be told about insurance products, the funding
of small or large businesses, credit cards, investment funds, etc. What
all these activities have in common is the redirection, protection
from, concentration, or diversification of some form of
risk...[intermediaries] reshape the one and only true underlying 'entity'
that is ultimately being exchanged in modern financial markets: risk."
there is more. All these pieces of financial wizardry must perform
their magic while ensuring that the resulting pieces of paper that are
exchanged between borrowers and lenders enjoy an elusive but
all-important property: the ability to flow smoothly and without
interruptions among the various players...Very aptly, this all-important
quality is called 'liquidity.'"
Explaining Booms and Busts
intermediaries are in the business of reconfiguring risk, the Risk
Disclosure Problem is inherent to financial intermediation. Most
importantly, the RDP explains the booms and busts to which the economy
is subject, as exemplified by the bank runs of the Great Depression,
the 1996-2000 euphoria/crash of dotcom stocks, and the recent boom and
bust in subprime mortgage lending.
innovations, such as credit scoring for mortgage loans, allow
intermediaries to make better risk decisions. At first, when an
innovation is unproven, few investors are comfortable with it, and the
reduction in risk premium is slight. Over time, investors gain
confidence in the track records and disclosure methods of the
intermediaries, and this lowers the risk premium. Occasionally, a
combination of investor overconfidence and poor disclosure practices
causes this process to overshoot. Risk premiums get too
low, somebody gets burned, and the market corrects. At the point of
correction, the flaws in disclosure practices become evident, and the
market shuts down until new methods are developed and investors recover
their confidence in intermediaries. In the subprime mortgage market
today, investors are still at the "been burned" stage.
I would argue that is in the nature of financial intermediation for
risk premiums to decline with financial innovation, with investors
occasionally becoming overconfident, leading to sharp reversals when
adverse outcomes are realized. The post-crash environment is
necessarily one of caution and retrenchment, because the reputations of
financial intermediaries cannot be restored instantly.
From Mainstream Academia to the Real World
The mainstream academic view that frustrates Rebonato is known as Modigliani-Miller after
two Nobel laureates who received the prize in different years. Because
M-M assumes that investors know everything about the risks undertaken
by any corporation or financial intermediary, it assumes away what I
have been calling the Risk Disclosure Problem. This is one of the big
gaps in mainstream economics today.
Ben Bernanke, the
Chairman of the Federal Reserve, is unusual in that his research has
taken financial intermediation as important, rather than assuming away
all of its interesting aspects. Earlier this year, he gave a speech on Regulation and Financial Innovation. He said,
argue that policymakers should act to make trading in the credit
derivatives market more transparent, on the grounds that the market and
policymakers should know just who is holding the credit risk associated
with a particular issuer. But if transparency about risk-bearing is
important, then consistency seems to imply that full transparency
should be required of credit markets broadly, not just of credit
derivatives. And why stop with credit markets? Do we know exactly who
is bearing the risk in equity markets or foreign exchange markets, for
Bank regulators are caught in the
middle of the Risk Disclosure Problem. The regulators themselves rely
on summary statistics. When these statistics are crude and
inappropriate, as was the case prior to and during the Savings and Loan Crisis, they create perverse incentives. As Rebonato puts it (p. 250),
arbitrage occurs when institutions are able to exploit loopholes to
carry out actions that are within the letter of a given piece of
legislation but run against its grain."
an economist, I worked on the Risk Disclosure Problem for Freddie Mac
in the late 1980's and early 1990's, under its then chairman Leland
Brendsel. In retrospect, and particularly after reading Rebonato'sbook,
I think that Freddie Mac did an admirable job of dealing with the RDP.
of the reports that we developed was something that we called the NPV
Curve. This report gave an estimate of the value of the company if all
assets and liabilities were evaluated at current market prices, and
then estimated how this value would change if interest rates were to
rise or fall by one percentage point, two percentage points, and three
The NPV Curve did two things. First,
it introduced market-value accounting. Standard accounting has mortgage
firms value the mortgages on their books at their original book values,
regardless of market fluctuations. In the case of the Savings and
Loans, their use of standard book-value accounting was a major source
of deception and ultimately loss for the taxpayers.
by showing how our value could vary with interest rates, Freddie Mac
was managing interest rate risk. In fact, our goal was a relatively
"flat" NPV curve, meaning that neither a sharp rise nor a sharp fall in
interest rates would have much effect on our estimated market value. We
believed that other firms in the mortgage industry had frown-shaped NPV
curves, meaning that sharp movements in either direction in interest
rates would have lowered their market values.
Rebonato's terms, companies with frown-shaped NPV curves are "selling
lottery tickets." As long as the environment remains stable, no one
wins the lottery, and the ticket sellers rake in nice, steady profits.
But when there is a big change in interest rates -- or some other key
market factor -- someone wins the prize, the ticket seller has to pay
off, and the ticket-seller's shareholders have to be prepared to take a
I believe that Enron was a seller of lottery
tickets. Its financial structure was such that in normal times, it
could rake in nice profits. But it was unusually sensitive to
adversity. Most importantly, neither the executives nor its
shareholders understood the nature of this lottery-ticket exposure.
There was no equivalent of an NPV curve for either internal or external
consumption. All anyone had to go on was past performance, which
suggested -- until near the very end -- that everything was just fine.
reputable companies, such as property and casualty insurance firms, are
sellers of lottery tickets. It is a perfectly respectable business,
provided that you are disclosing it, setting aside reserves, and
maintaining sufficient capital. The business of selling lottery tickets
is only unsavory when no one knows that is what you are doing.
Mac was in the business of selling lottery tickets with respect to
mortgage default risk. We summarized this risk by using something that
we called the "Moody's scenario." Moody's, one of the bond rating
agencies, created a devastating 10-year path of falling average home
prices, reportedly based on the experience of the Great Depression. We
had to hold enough capital to just barely survive such a scenario.
Rebonato probably would not endorse this approach, because of the
difficulty of estimating the probability of the Moody's
scenario actually occurring. But it did have the virtue of clarity, and
as such I think it was a valuable tool for dealing with the RDP.
effect of the Moody's Scenario was that it created regulatory arbitrage.
Freddie Mac's capital requirements under the Moody's Scenario were
relatively low for high-quality loans. Two decades ago, mortgage loans
with 20 percent down payments were far more common than was the case
recently, and our capital standard allowed us to outcompete other
regulated institutions for these loans. Banks had to maintain higher
capital for low-risk mortgages, based on the requirements of their
On the other hand, the Moody's Scenario
would have inhibited the purchase of mortgages with low down payments.
The capital costs of such loans would have been extremely high, because
they are almost certain to default under the Moody's Scenario. Strict
adherence to capital policy would have kept Freddie Mac from
participating in the subprime mortgage frenzy of the last several years.
However, I do not know if Freddie Mac continued to use the Moody's
Scenario. I left the firm over a decade ago, and Leland Brendsel himself
left before the subprime mortgage boom hit.
were a Hall of Fame for risk management at financial intermediaries,
then Brendsel deserves induction. This is certainly the case if
Rebonato's views of risk management are correct.
In fact, Brendsel's status is a bit different. It's a long story, but what follows is a highly-condensed version.
the 1990's, Freddie Mac, with the approval of its accounting firm,
adopted a "hedge accounting" treatment for some of its
financial transactions, in an attempt to get its accounting earnings to
behave like its NPV curve. The accounting firm happened to be Arthur
Andersen, which imploded after Enron. Freddie's new accounting firm did
not approve "hedge accounting," and this required Freddie to restate
its earnings -- they were higher than originally
reported. Freddie Mac's Board, in full Sarbanes-Oxley ass-covering mode,
launched an assault on management for this "scandal." So today Leland
Brendsel, far from being honored as a risk management guru, is battling
in court with Freddie Mac's regulator, the Office of Housing Enterprise
Oversight, trying to hold on to his fortune and what is left of his
OFHEO is also waging a vendetta against
former Fannie Mae Chairman Franklin Raines. Raines, unlike Brendsel, may
deserve a modest amount of opprobrium. Some of Fannie's accounting moves
were clearly designed to benefit its officers rather than share holders.
But overall, OFHEO appears to me to be ignoring the current risk
disclosure problems posed by Freddie and Fannie while pursuing its
campaign of personal destruction against Brendsel and Raines.
Risk Disclosure Problem is not an easy one to solve. And, if Leland
Brendsel's fate is any indication, those who do a good job of addressing
it will not necessarily be recognized.