Credit-Crunch Villains Should Own Up, Do Penance: Mark Gilbert

Commentary by Mark Gilbert

Aug. 14 (Bloomberg) -- Psychiatry suggests that people hit by catastrophe begin in denial, become angry, then try to bargain their way out of the dilemma, then get depressed, before finally accepting their misfortune and resuming their lives. One year on, the villains of the credit crunch haven't moved past denial.

In the current edition of the Economist, there's a 2,000- word article by an unidentified risk manager at what the weekly magazine calls a ``large global bank.''

Even though the author is shielded by anonymity, he -- I'll bet you beer for a month that a woman didn't write it -- refuses to take any blame for acquiescing in the hubris that brought the finance industry's most munificent decade to a shuddering, writedown-ridden halt.

I thought risk managers existed to manage risk, acting as a bank's conscience and preventing runaway traders from betting the ranch on dubious intuitions and misinterpreted spreadsheets. How quaint! ``Rubber stamper'' is a more accurate job description.

``Often in meetings, our gut reactions as risk managers were negative,'' the risk manager writes. ``But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started.''

Bean Counting

I had to read that final sentence twice. How on God's green Earth could even the most experienced credit officer be expected to judge the merits of a complex transaction in just 60 minutes? Clearly, the risk department should have demanded more time to decide whether the six beans of profit claimed by the traders were in fact generated by multiplying two beans of revenue by eight beans of risk.

Basic mathematical skills also seem to have been missing in action at the large global bank.

``We had not paid enough attention to the ever-growing mountain of highly rated but potentially illiquid assets,'' the article says. ``We had not fully appreciated that 20 percent of a very large number can inflict far greater losses than 80 percent of a small number.''

Letting traders build piles of complicated debt with insufficient scrutiny is a recipe for creating a bank balance sheet that is opaque, unfathomable and downright dangerous -- which is exactly what has happened. Writedowns around the world have now surpassed $500 billion.

Just Say No

``A banking specialist Ph.D. who has spent 20 years at Bank College studying nothing but banks, and whose every waking second is committed to understanding banks, would struggle to conduct due diligence upon banks consistent with making an informed assessment of the risks they hold and the risk they represent,'' says Tim Price, director of investments at PFP Wealth Management in London.

The Economist's guest writer, however, blames the people who came up with the bonus-boosting transactions, rather than the supine overseers who chose to look the other way. It turns out that the risk manager was just a guy who can't say no.

``Most of the time the business line would simply not take no for an answer, especially if the profits were big enough,'' the author writes. ``This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned toward giving the benefit of the doubt to the risk-takers.''

Asleep at Stopcock

So THAT'S how the world's investment banks found themselves up to their necks in toxic debt; the guys who were supposed to keep the sewers from backing up were asleep at the stopcocks! What possible purpose is served by a risk department with a light that never switches to red from green?

The most amazing revelation in the risk manager's testimony is his disclosure that the guardians of financial stability all heard a clanging alarm bell more than two years before the credit crunch began -- and decided to ignore it.

Most asset-backed debt had links to the creditworthiness of U.S. automakers, because those companies had sold so many bonds. So General Motors Corp.'s loss of its investment-grade rating in May 2005 triggered a dislocation in the structured-credit markets, though not the one the credit analysts anticipated.

``The reverse happened of what we had expected; AAA tranches went down in price and non-investment-grade tranches went up, resulting in losses as we marked the positions to market,'' the risk manager writes. ``This was entirely counterintuitive.''

Tarred and Feathered

You might expect that such a nasty shock might prompt increased vigilance and skepticism about the financial models used to measure risk. You'd be wrong. If the unraveling of those automaker-related trades counts as the first black swan of the credit crunch, it is clear that risk managers decided that someone must have tarred that cygnet's feathers.

``We had failed to draw the correct conclusions,'' the risk manager says. ``We should have insisted that all structured tranches, not just the non-investment-grade ones, be sold. But we did not believe that prices on AAA assets could fall by more than about 1 percent. A 20 percent drop on assets with virtually no default risk seemed inconceivable, though this did eventually occur.''

Until the custodians of finance move beyond the denial stage, recovery is impossible. Unfortunately, the article by the unidentified risk manager suggests that is a forlorn hope -- making an overdue apology from the architects of this financial mess even less likely.

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net