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

Includes: AIG, C, UBS
by: John Jansen

The FT has a fascinating story about a report of the Counterparty Risk Management Policy Group headed by Gerald Corrigan. He was President of the New York Fed in the 1990s and has been instrumental in molding and formulating risk management policies for derivatives and structured reports.

The latest report became available today and I will link to it. It is voluminous at 176 pages. I have read a very small piece of it and it is insightful. I happen to peruse the section on the origins of the current crisis.

That is a topic which always fascinated me. How could so many people be so wrong? If just UBS (NYSE:UBS) or Citi (NYSE:C)or AIG (NYSE:AIG) had lost significant amounts of money by taking bad risk it would be somewhat understandable. But the bad judgments have been nearly universal.

The section of the report that I read discusses the influence of compensation in risk taking. I think the problem lies in the yearly nature of rewards and payouts. There is no lookback.

I have this theory that in some cases a manager who had been very successful for several years running and who had earned prodigious sums of money had reason to double down on bad bets.

So if a trade was leaking P and L, a trader could double or triple the size of the bet and know that if he erred there was no recourse against him for the monumental error that was being made. He would know that he might lose his job but given past successes he could go home and comfortably clip coupons until the next venture presented itself.

It might be better for shareholders if there were some “lookback” in which a significantly bad bet this year would trigger a return of some portion of past bonuses.

It would be one way to force risk takers to take prudent and sensible risk.

There is one other area in the world of derivatives which always fascinated me. It is an area in which the fox is always guarding the henhouse.

What do I mean? I meant that most of this stuff was so complicated and so esoteric that it was barely understood by any but a very small group of people involved in creating them.

Certainly internal auditors, rating agencies or regulators lacked a clear understanding of the product because if we did we would not be in the current fix. And if the aforementioned watchdogs truly understood the complex nature of the instruments they were studying, they would have given up their role as outsiders and they would have jumped into the field to earn the outsized rewards.