"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

Riccardo 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.

Although 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.

Fundamentally, 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.

Modern financial 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 interest.

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):

"There 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."

"But 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

Because 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.

Financial 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.

Thus, 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,

"Some 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 example?"

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),

"Regulatory 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."

My Experience

As 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.

One 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 percentage points.

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.

Second, 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.

In 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 hit.

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.

Many 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.

Freddie 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.

One 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 regulators.

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.

If there 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.

In 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 reputation.

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.

The 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.