The new world of financial risk.

• Author: Johnson, Simon
• Position: Cover story

Risk is an ever-present condition of human endeavor and of all financial and business activity. Business-people have been struggling to manage risk for millennia. Insurance contracts date back to multiple ancient civilizations. Contract and tort law developed, in part, as mechanisms for allocating risk. Risk diversification and risk management are among the central pillars of modern finance and investment.

Of course, risk is not all bad. "Nothing ventured, nothing gained" is an ancient principle that was only formalized by modern finance theory. Innovation is necessarily risky; at the very least, there is the risk of wasting time. Developing new products, entering new markets, acquiring companies--these are all risky yet potentially profitable projects.

What is bad, however, is underestimating risk or assuming that you have mastered it. Both of these factors contributed to the current global economic crisis.

The main causes of the crisis are well known, although there are debates about their relative importance. The following will focus on the underestimation or mismanagement of risk.

Risk in the Financial Crisis

The most common place to look for excessive risk is leverage. When it collapsed, Lehman Brothers Holdings Inc. had a leverage ration above 30; its assets were worth more than 30 times its capital. However, simply blaming leverage is not strictly accurate.

First, high leverage is not necessarily risky; it depends on what is done with the borrowed money. For example, borrowing a little money to bet on one number on the roulette wheel is riskier than borrowing a lot money to invest in Treasury bonds.

Second, insolvency is not what killed Lehman, at least not directly. Lehman fell victim to a modern-day bank run, in which financial institutions declined to renew their short-term funding.

For whatever reason (and solvency fears played a part), market participants started worrying that Lehman might not be able to pay off its creditors, and therefore, tried to pull their money out first; as a result, their fears became self-fulfilling.

The precipitating cause of Lehman's failure was not leverage, but liquidity risk--which no one was prepared for. The Lehman bankruptcy itself, and the resulting settlement of hundreds of billions of dollars of credit-default swaps on Lehman debt, did not plunge other large banks into bankruptcy. However, it forced the Reserve Fund to break the buck, freezing money markets.

In addition, seeing a major bank vanish awakened all financial institutions to the reality of counterparty risk--the chance that your counterparty might not be there when needed to close a trade--which was the single biggest reason for the American International Group Inc. Bailout.

AIG was a major trader in credit-default swaps (CDS)--contacts to insure bonds or bond-like securities against default--As the subprime crisis deepened and the likelihood of default increased, AIG's potential obligations increased. When the bond rating agencies downgraded AIG, investors with a CDS contract with AIG started wondering if the firm could pay, and those with CDS contracts with other third parties started wondering if they were dependent on AIG.

As a result, everyone lost confidence in everyone else.

Governments have responded to the financial crisis by taking on risk from financial institutions. Since March, the Federal Reserve allowed investment banks to borrow form the Fed using a wide range of collateral.

The effective nationalization of Fannie Mae and Fred die Mac transferred their assets to the government balance sheet. The Federal Deposit Insurance Corp. has guaranteed new dept issued by banks, and the Citigroup Inc. bailout guranteed assets on Citi's balance sheet.

The basic principle is sound: the U.S. government, with its unmatched ability to raise (or create) money, can absorb far more risk than any bank. However, risk does not simply go away when it is nationalized. CDS spreads on U.S. sovereign (U.S. Treasury) debt had climbed from 6 basis points at the end of April to almost 40 basis points in November.

The problem is much more pronounced for other nations. Obviously, Iceland could not afford to bail out its...