davenerven

Counterparty Risk Management: How Could So Many Be So Wrong for So Long?

The nature of risk management has been simplified over the years as more and more people and consultancies flood into this field and attempt to create methods which dumb down this important area. Basically, for most "risk managers", risk is segregated into credit risk, where ratings are all important, and market risk, which measures the sensitivities of a trade or portfolio. Since many of the MBS are new products in 2005-2007, they relied simply on historical default rates for pricing (and introduced a high incidence of error as historical data would have been scarce). They then used ratings insurance to qualify these products as AAA. Banks then bought paper based on these AAA ratings without questioning their underlying viability to pay back principal or even interest. This is odd as normally a structured swap would be investigated carefully before issuance but for whatever reason, for MBS, people are happy to buy other issuers' paper based purely on nothing more than the rating, a free lunch and a pat on the back.

I have always taken a holistic view on risk, and for my bank, I have always advised against taking on these products, as the SUM of the risks (if calculated correctly) causes risk profile to rise exponentially to a point where the paper becomes too expensive to buy. Eg. mortgage default risk, issuer risk, guarantor risk, interest rate risk, economic risk, trend risk. People forgot about all that and just bought AAA paper because they did not do (or want to do) their homework. Or maybe their risk management team did not consider all the factors that go into a proper Monte-Carlo simulation for such products. Why was this not done? That will always puzzle me.

In short, despite what many people think, risk is not a business area that can be easily standardised, and in my experience, there are far too many "risk" people around who do not understand how to apply the basic management rules for risk, especially for new structured products.