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Risk Management on Wall Street during the housing bubble: Like Crossing the Street With a Don't Walk Signal Flashing.

By Brett Sherman, The Sherman Law Firm

I know this may be hard to remember at this point, but it wasn't so long ago that the sight of drywall and the sound of hammer stiking nail was as common as the ubiquitous "For Sale" signs are today.  The economy was was moving forward so quickly that it was sweating.  

During the height of the housing bubble, how many of you forgot the lessons of the technology stock implosion?  As a general rule, we tend to ignore/block out/forget the lessons of past financial traumas whenever the markets are humming and money is flowing. Risk managers are paid to disregard that general rule. 

While the rest of us enjoy a bull market, risk managers must&nbs... corporate police officers.  A vital part of the risk management function is to guard against a business strategy... capable of crippling a company when the boom market cycle ends (and they always end).  

During a boom, risk managers are unpopular.  Hardly anyone wants to hear that a sizzling market will eventually burn out. 

The unfortunate reality, however, is that market bubbles have always popped.  Not only do economic boom cycles fizzle sooner or later (often abrubtly), but it is nearly always impossible to predict why or when the end will come. The unfortunate truth is that, no matter how strong a bull market may seem, we can never know for sure that disaster isn't lurking around the bend. 

The future is now and always will be a mystery. Therefore, corporate risk managers must manage risk by devising strategies to mitigate ... negative consequences in the event of a market downturn.

Consider the last market bubble, the tech-wreck.  Remember how many people were convinced that we were in a new age of prosperity, a "new economy" in which the old rules of Wall Street no longer applied?  Remember all the "paper millionaires"? Remember Dow 36,000?  Remember how it all ended?  Of course you do.  And so do Wall Street CEO's (and former Wall Street CEO's) and risk managers. 

The tech-wreck is a textbook example of a market bubble.  On its heels (thanks to the Fed's loose monetary policy) came the housing and mortgage boom.  Subprime-based mortgage- backed securities were the perfect investment to sell to unwitting investors.  So don't believe Wall Street investment banks when they tell you that they didn't think the housing boom would eventually end like the tech-wreck and so many other market bubbles. 

Wall Street firms reported record profits during the housing boom.  High annual profits meant high annual incentive-based compensation for senior Wall Street executives.  Therefore, the risk management function (protecting investment banks from the risks of business models that could lead to the kind of corporate implosions that will forever mark 2008) was at odds with the interests of senior Wall Street executives, who made more money by maximizing short-term returns.  Guess who won that battle?

As someone once said, the brightest stars burn out the fastest.  With effective risk management, Wall Street profits may not have reached the stratosphere during the housing boom, but investment banks like Bear Stearns and Lehman Brothers still could have been profitable and lived to make more money another day.

In this day of ultra-sophisticated engineered securities, risk management is vital to the long-term success of any financial institution. Maybe corporate managers will realize that one day soon. 'Disclosure: No positions'