Lessons from the abyss: the credit market meltdown and risk management; As the subprime mortgage malaise and related woes continue to roil the credit markets, issues of risk management and regulation are getting new attention. Hard lessons will be learned, many of which are just now beginning to be understood.

• Author: Marshall, Jeffrey
• Position: Cover story - Company overview

Stocks fell sharply on Friday morning, March 14, as they often have in recent months. But the cause of the tumble wasn't another snowball in the avalanche of bad news from the mortgage and credit markets. It was that venerable Wall Street firm Bear, Stearns & Co. found that its cash position had cratered in the previous 24 hours and it needed emergency financing.

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That quickly came when JPMorgan Chase & Co. and the Federal Reserve Bank of New York stepped in to provide a financial life raft to Bear Stearns, the fifth-largest U.S. investment bank. That was a Friday. By Sunday afternoon, Bear Stearns had been sold to Morgan in a fire sale for just $2 a share; it had closed Friday at $30, off 47 percent on the day. Following a furor over the sale price, it was later upgraded.

Bear Stearns' meltdown was just the most recent in a hornet's nest of problems besetting financial firms, which has morphed into what some are calling the biggest financial crisis since the Depression. What has stood out to many in the market is the players' continuing inability to sense how serious the problems are (or their ability to wish them into manageability) or where the bottom might actually be. Predictably, the blame is falling heavily on the firms themselves.

"The [Bear Stearns] CFO yesterday said fears of liquidity concerns are overblown," Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, N.J., lamented to Reuters on Friday morning. "What happened in 24 hours that they didn't know 24 hours ago? But overnight, the company needed a government bailout."

It was just a day earlier, March 13, when Secretary of the Treasury Henry M. Paulson stood at a lectern at the National Press Club in Washington and spoke to a just-released report, "The Policy Statement on Financial Market Developments." Looking around the room as he spoke, he said, "We are working to get through the current period of market turmoil while minimizing its impact on the economy."

Unfortunately, for financial firms and their investors, the stock markets in general and now the overall economy, "the current period of market turmoil" seems unending. The trend since last summer has been a sickening slide, marked by sharp volatility, triggered by a credit crisis with roots in the mortgage market and the securities tied to it.

The Federal Reserve has practically tripped over itself in recent months in its rush to inject capital into a credit-starved marketplace, slashing interest rates and implementing unprecedented liquidity policies. But, as the events have unfolded across both public and private markets--hedge funds and private equity players also have suffered tremendously--it has become clear that no agency can rein in the forces of markets run amok. A mighty river of woe has washed over the credit markets, and when or how they can recover--especially when security price implosions keep raining on the market and a recession is baring its fangs--is utterly unpredictable.

Books will be written on the 2007-8 credit meltdown, and how the housing bubble and subprime mortgage excess helped create and prolong it. The depth of the crisis sparks larger questions about governance and risk management at time when--viewed from a distance, at least--they seemed in short supply at scores of huge financial firms.

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As FEI President and CEO Michael Cangemi wrote recently in a note to FEI members, "Lax credit standards for mortgages, compounded by huge quantities of multi-tier securitizations that were driven by fees and perhaps greed, resulted in significant risks for firms with large volumes and concentrations of these securities. Easy credit also resulted in risky leverage levels. Rather than assessing these risks, business and risk managers convinced themselves that housing prices would always go up."

Put more simply, the fundamental problem is that financial institutions and the investors they sold to broke the first and second commandments of finance: "Remember that there is no return without risk" and "know what risk you are taking."

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Among the key issues that will be explored in coming months:

* Risk modeling, especially of exotic and highly complex instruments;

* Overall risk management and the role of executives and the CFO;

* Transparency, integrity and reputation;

* The herd instinct and chasing yield; and

* The role of regulation and government.

THE FAILURE OF RISK MODELING

Investors put their confidence in a false "science" of finance. The financial industry as a whole relied on highly quantitative risk measurements drawn from the natural sciences. The most widely used is Value at Risk (VAR), which claims to take into account all of the relationships, correlations, co-dependencies and risk profiles of every security and trading position, and come up with a total risk measure.

VAR looks good on paper, but as physicist-turned-banker Riccardo Rebonato points out, the numbers that come out depend on the data that go into the models. Financial risk managers were ignoring the real world and failing to adjust their models for changes that made the data questionable at best.

For example, some used only the last five years of data to calculate risk, even though, in general, interest rates had been falling and home prices rising for considerably longer. The quants also ignored the fact that things work differently in good times than in bad.

As former Federal Reserve Chairman Alan Greenspan noted in a March commentary in The Financial Times: "The essential problem is that our models--both risk models and econometric models--as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality."

According to Bear Stearns' annual report, $29 billion in mortgages and mortgage-backed securities on its books were valued based on computer models "derived from" or "supported by" observable market information. Another $17 billion, however, were valued based on "internally developed models or methodologies utilizing significant inputs that are generally less readily observable"--a sizable understatement.

In severe market disruptions, correlations emerge that may never be seen in normal markets. In the late 1990s, for example, the East Asian financial crisis spread contagion through Latin American and Russia, and the failure of the hedge fund Long Term Capital Management threatened to bring down the entire world financial system.

"When asset prices, rather than offsetting each other's movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued," Greenspan wrote in his article. "Negative correlations among asset classes, so evident during an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk-reward trade-offs through diversification."

Eugene Ludwig, CEO of financial services consultantancy Promontory Financial Group in Washington, D.C., and the Controller of the...