Risk Management in the Financial Industry

Writedowns dominate headlines about the financial industry. Poor management has dominated many of America's premier financial institutions and now they are being forced to drink the poison they concocted. The potent combination of housing price declines and overindulgent subprime lending practices has forced many banks, from Bear Stearns (BSC) to Citigroup (C), to write off billions of dollars in losses. CEO's from some of the biggest institutions have been fired or forced to resign.

Millions of Americans who can no longer afford their flex-rate mortgages are being foreclosed upon. Hundreds of thousands of houses lay dormant and halfway developed. Consumer home values have plunged on average 10% throughout the nation in the last two years, and in some cases by as much as 50%.

This is a major problem that is spreading to all sectors of the U.S. economy. Financial institutions practicing poor risk management are now being forced to turn to the Federal Reserve for help.

Looking back, the traditional way for banks to fund mortgages for homeowners was through the deposits and holdings they received from their customers. This limited the amount of lending they could do. However, in recent years banks have developed a new model where they sell the mortgages in the bonds market. This allowed banks to fund additional borrowing. Because subprime borrowers were willing to pay higher interest rates based on their weaker credit ratings, banks found the additional interest that could be earned to tempting to pass up.

Of course, this was based on the assumption that subprime borrowers would not default on their payments and housing prices would not plummet. As more loans were issued, the housing bubble inflated even more. Housing developments proliferated in every community. By 2005, one in five mortgages was home to subprime borrowers. It was an extension of the American Dream: people who traditionally could not buy housing in the past were now able to purchase their first homes.

But then the bubble burst. The first two years of a subprime loan is at a fixed-rate. After that, the rate becomes dependent on Federal Reserve rates. As interest rates continued to inch upward, homeowners began to fall behind as they could no longer afford the payments. Then the foreclosures began: two million families were evicted from their homes.

It did not end there. With many homes built in anticipation of a continued housing bubble, there were quickly four million unsold homes in the United States.  The value of homes plunged as supply now outweighed demand. This led to bank failures as financial institutions with too much exposure to the subprime crisis found themselves with billions of dollars in valueless mortgage-backed securities.

The most notable example of banking failure due to the subprime crisis has been The Bear Stearns Company. Due to poor risk management, hedge funds ran by the company totaling some $20 billion lost over 60% of their value as the housing crisis grew in the United States.  BSC would bundle all of their subprime mortgages together, creating mortgage-backed securities. They would then buy and sell them in the open market, much like bonds. But as the number of subprime defaults increased, the demand for these securities decreased significantly, reducing their value. Forced to disclose this information, BSC reported the first quarterly loss in its 85 year history in early 2008, close to $4 billion.

As panic increased, rumors of liquidity issues arose. What is known as a "run on the bank" then developed. Combined with a credit rating downgrade, customers, both individual and retail, began to withdraw their funds from the bank. Investors also lost confidence, and sold off their shares in the company. As the panic grew, Bear Stearns was forced to turn to the Federal Reserve for emergency funding to keep the company from becoming insolvent.

The stock price of Bear Stearns, which closed just below $172 in January 2007 and $93 in February 2008, ended the trading day of March 17, 2008 valued at $4.81. Three days later, the company was forced to sign a merger agreement with rival JPMorgan (JPM) valued at only $2 per share (later changed to $10). Shareholders and employees saw their retirement savings, much of it tied to company stock, destroyed. It is estimated that over 8,000 jobs will be lost when the merger is done, adding to the 50,000 the industry will lose as a whole.

Other financial banks that have become victims of the mortgage meltdown include Bank of America (BAC), ING Group (ING) and Wachovia Bank (WB). Even companies outside the industry have reported large quarterly writedowns due to subprime exposure, including H&R Block Tax Services (HRB) and E-Trade Financial (ETFC), which have both reported losses in the hundreds of millions. Government Sponsored Enterprises Freddie Mac (FRE) and Fannie Mae (FNM), which were created to virtually guarantee loans to create continued liquidity in the mortgage markets, have also posted huge writedowns as high as $5 billion due to defaults on subprime mortgages.

On the borrowing side, the largest financial bank in the United States, Citigroup, found itself hit hard by the subprime meltdown. The company was heavily invested in loans to subprime borrowers and collateralized debt obligations (packaged securities like BSC once held).

In the summer of 2007 Citigroup CEO Charles Prince was pressured to resign when the company announced that it would be forced to write down over $18 billion due to devaluation of its subprime investment. Shares of Citigroup have fallen over 55% in the last year, mostly due to poor risk management in the subprime lending arena. It is estimated that the company will layoff close to 24,000 jobs before the end of 2008. Net income at the company fell over 80% in late 2006, largely due to subprime exposure. It is estimated that Citigroup will lose over $125 billion in market capitalization due to its subprime practices when everything is said and done.

The previous example will make you wonder if anyone was using any type of hedging to protect against a worst case scenario.  The fact is, very few companies were.

Goldman Sachs (GS), the world's largest investment bank, actually profited from the subprime downturn. While companies like Bear Stearns and Citigroup were busy buying subprime mortgage securities in the summer of 2007, Goldman Sachs was selling them.

Two floor traders at Goldman Sachs predicted the subprime meltdown was imminent and convinced management to begin selling off most of Goldman's subprime exposure while selling short the securities everyone else was buying. Because the securities were dependent upon homeowners making their mortgage payments, hundreds of billions of dollars was lost when the housing crisis began to run amuck in the United States. It is estimated that the company profited over $40 billion by selling these securities short (betting that the securities will lose value). They were also able to avoid huge writedowns by limiting their exposure to the subprime market.

A key coaching style the company undertakes is rotating its employees from the trading floor to the risk management office. This is likely why the company has emerged unscathed from the mortgage crisis affecting so many of its rivals. The employees learn how to manage risk and minimize exposure in lure of these types of situations. They are then ushered to the trading floor to trade bonds and securities all the while having knowledge and experience of hedging against downside risk.

Another company that has fared well is Wells Fargo (WFC). While the competition was busy giving loans to subprime borrowers, Wells Fargo, acting on the advice of the company's risk management division, decided to stay away from the subprime business. This turned out to be a good long-term strategy. The company stuck with prime and near-prime mortgages (prime borrowers with higher credit scores), which have not experienced the high rate of defaults the subprime market has. They also stayed away from adjustable rate mortgages (option ARMs), which has insulated the company from posting the large losses the rest of the industry is suffering. Wells Fargo employs 158,000 people and has not been forced into making huge layoffs like its competition.

As the economy continues to struggle and the housing market remains in crisis mode, banks are turning to their risk management divisions to help protect them from more billion dollar losses in the future. The role of the risk manager is becoming more involved in everyday affairs and less a tiny voice in the back of the room. As Churchill put it, "those that fail to learn from history, are doomed to repeat it." It is in everyone's interest that the financial industry learns from this if nothing else.

Comments

[User1:]

This a poorly written article which illustrates limited understanding of finance. Unfortunately, this is the same level of understanding that most mainstream media articles on this subject exhibit.

The first chart above equates mortgage securitization with lending to sub-prime borrowers. This is incorrect. Securitization of mortgages has nothing to do with the credit quality of the borrower. Both prime and sub-prime mortgage pools have been securitized. One could argue that securitization created moral hazard in the origination of mortgage loans. That moral hazard impacted both prime and sub-prime loan pools. The severity of the loss on sub-prime pools will be greater due to the characteristics of the sub-prime borrower, but that does not justify the author's equating securitization with sub-prime borrowing.

The author also equates a specific loan structure (adjustable rate) with sub-prime borrowers. This is another fallacy. Both prime and sub-prime borrowers took out adjustable rate mortgages during the run-up to the current credit crisis. The motivations of prime versus sub-prime borrowers in selecting an adjustable rate loan structure may be quite different, and on average, the sub-prime borrower may experience higher default levels than the prime borrower, but that is again due to the characteristics of the borrower, not the loan.

In summary, a financial blogger should be savvy enough to keep in mind that sub-prime refers to the characteristics of the borrower, not the structure of the loan or the subsequent securitization of the loan. Leave the confusion to WSJ.

2008 Jun 11 02:30 PM

[lcd_man:]

User 1 you arent making sense. The reason for the rapid decline in these securities, bundled with prime borrowers or not, was because of the high level of defaults among subprime mortgages.
Therefore, I think its pretty fair to say that subprime is the reason for most of this mess. I have to disagree with you.

2008 Jun 12 05:40 PM