Banks became loan originators not loan holders and Credit Default Swaps grew from $631 billion in 2001 to $54.6 trillion in 2008

Risk and the capitulation of capital
Commentary: The simple solution to the crisis is hard to execute
By Hernán T. Narea
Last update: 5:38 a.m. EST Dec. 31, 2008Comments: 13NEW YORK (MarketWatch) -- I was at yet another, sparser-than-usual reception of bankers in Manhattan the other day. Foregoing some sad looking canapés, I embarked on an informal survey. The mood? Decidedly resigned to the prospect of more failures to come.

Anyone whose business card had a valid email, held it like gold bullion, judiciously traded only with others who had the same ingots, in case they were next on the chopping block.

And the blame for our economic ills, running the gamut from eviscerated 401-Ks to sports car fire-sales in Palm Beach? Without exception, everyone wanted to throw a Ferragamo lace up or Blahnik heel at the likes of Bernard Madoff, sub-prime mortgages and the entire regulatory universe. But I think they're all getting a bum rap. They aren't the real culprits.

The underlying problem is risk; more exactly, the disguising of it. Too many people (let's call them herds), convinced themselves that the era of volatility was fading fast in the rearview mirror and that the super-highway of capital markets we all traveled on had crossed the border into a promised land of zero-risk. However, the only thing crossed was the way real risk was being dressed up to look like a sure bet. Think of it as financial transvestism, except in this show, John Travolta in a dress was no competition for the securitizers of our collective wealth dreams.

Earlier this year, Emilio Botín, chairman of Spain's Santander Group, was quoted giving extremely sound advice as it related to the mortgage crisis, "If you don't understand an instrument, don't buy it. If you wouldn't buy a product for yourself, don't try to sell it. If you don't know your customers well, don't lend them money." Unfortunately, his own bankers didn't heed these warnings, as Santander (STD:banco) revealed this month they had placed up to $3.1 billion of investments on behalf of private banking clients with Mr. Madoff. Where many thought there was no risk, there was indeed quite a lot of it.

Disguised risk, and the poor management of it, is at the core of our sleepless nights. In his 1996 bestseller, "Against the Gods," Peter Bernstein aptly described the mastery of risk as "the notion that the future is more than the whim of the gods". The news continues to remind us that we've been at the mercy of unruly risk gods and we're all pretty desperate to get them to behave again, no one more so than Secretary Paulson.

The lasting solution is fairly simple in approach, but much harder to execute. Look risk square in the eye, measure it, understand it, mitigate it as best you can and come to terms with it. You should either live with risk or just walk away. We need to stop obsessing with the output of predictive models and instead focus intellectual energy on the assumptions we stick in them. Hiding risk under some creamy, rating agency sauce won't work either. Also, your vision shouldn't be clouded by pitch-books touting financial products with over-engineered structures and cute acronyms. Clarity and transparency should be everyone's new obsession. Disguised risk can affect all asset classes, but one place to look at how these trends started is lending -- remember those mortgages.

I used to work for one of those mega-galactic banks managing a portfolio of corporate loans. Loans. Not bonds, not equity. Just good ole loans; a borrower on one end and the lender on the other with principal and interest repayment in between. About a decade ago, my boss started throwing around terms usually reserved for the different animal of securities, like 'mark-to-market', 'yields' and 'ratings'. He also developed a knee-jerk reaction to risk that has now been broadly diagnosed as 'credit default swap-itis'; at the mere mention of risk, he rang up the swaps desk plying them for a quote. He shouldn't feel bad, he wasn't the only one. According to the International Swaps & Derivatives Association, the CDS market grew from $631 billion in 2001 to $54.6 trillion this year, an impressive 9,000% growth.

On top of that, my boss required me to sell 90 cents of every dollar we lent. I can't fault him for wanting to ride the wave of financial deregulation and innovation to higher levels of trading fee income, and, ahem, bonuses. But in so doing, we were trying to trick those risk gods by altering the centuries-old structure of loans; one party with excess capital judging the credit-worthiness of another party in need of capital, and importantly, asking those tough questions, until final maturity do them part.

As my boss proved, the minute you whisper 'secondary market' in a lender's ear, you open a Pandora's Box of "Originate-to-Sell." The lender inevitably succumbs to selling his loans and taking that tempting bite of immediate fee income, rather than sticking around to see if that borrower actually pays. After that nibble, he's ready to originate more and more loans for the sole purpose of selling them to third parties. My boss wasn't the only one. Reuters Loan Pricing Corporation tracks the U.S. secondary loan market as growing from a mere $8 billion in 1991 to a healthy $342 billion last year.

With loans off their books, lenders are challenged to maintain the same credit due diligence when it's someone else's capital at risk. You only need to look at the growth of rating agencies' business in corporate loans to understand who was given the task of due diligence; it was the paid evaluators of risk who had no capital skin in the game. By Standard & Poor's count, in 1998, only 20% of U.S. syndicated loans were rated but after only six years, that number approached 80%.

If you lend your own precious capital to a borrower, you will hopefully ask every possible question beforehand, to make sure you're going to get it back. But what if you work in Düsseldorf and the mortgage loan you just bought from your trusted Wall Street counterparty, financed someone's home in Sandusky, Ohio? Well then it's going to be harder to inquire how those house payments are going, or be aware of massive lay-offs in town which will result in a whole slew of mortgages going sour in the next payment cycle. And this isn't just a negative for that Düsseldorf investor. The next wave of pain comes when the Sandusky homeowner finds it difficult to re-negotiate his mortgage with the impatient debt holders on the other end, who turn out to be vast anonymous pools of capital sitting on the banks of the Rhine instead of Lake Erie.

Unquestionably, the innovations of CDS, secondary loan trading and rated loans allowed the loan market to become more efficient and expand by bringing new classes of investors to the party. But unfortunately, it was taken to extremes as these new investors became too reliant on what others were saying, and originators continuously moved on to the next slice of the fee income pie.

Moderating any extreme human behavior isn't easy. Many have called for a stricter financial regulatory environment. Will that help? Yes, of course, but in the long run, not as much as taking stock of our fundamental relationship with risk. A far more lasting, positive impact will be felt if the originators and buyers of risk stop trying to convince each other that it can be eradicated like a disease.

Instead, investors should begin to rely on their own judgment calls, and originators should own a larger risk share on their books to justify keeping their eyes on the ball, call it an 'Originate-to-Partially Sell' strategy.

Is it time for rating agencies to be paid by the buyers, versus the sellers, of risk? Can regulators or market-governing bodies find ways to make sellers' minimum hold positions more transparent to buyers? These are questions that will be bantered over the next months as markets seek normalcy. At the core however, the issue of risk remains. We either embrace it, or you just walk away. The long history of financial panics and manias prove that those pesky risk gods will raise their ugly heads again, each time, when and where we least expect it. There are always Ponzis-in-waiting -- or should we now be calling them Madoffs-in-waiting?

Comments: 13

Apt analysis. The real problem has stemmed from selling risk, as the author states, without transparent linkages to the source of risk. He/she who originates the risk should own more than 10% of it.

- svkris