Risk Manager in Chief

One way to view the current economic crisis is as a pervasive failure to manage risk. In fact, bad risk management actually explains a lot of what's gone wrong in recent years. And that realization is one we'd be well advised to bring with us into the voting booth in a few weeks.

One of the main reasons the financial system is seizing up is that too many institutions borrowed beyond their capacity and used the money to make risky bets. Some of those bets took the form of subprime mortgages--loans to people who were credit risks, but would be able to service the debt as long as their new home continued to appreciate at double digit rates. Other bets were in the form of derivatives--many of which also ultimately depended on home prices endlessly defying gravity.

The bubble burst, home prices began to slide, mortgage defaults accelerated, and the extent of overleveraging--borrowing beyond your means--in the financial sector was exposed. The Treasury and the Fed are throwing everything they've got, including a bunch of stuff no one ever knew they had, at the problem, but little is really sticking yet.

What does any of this have to do with risk management? A lot.

When lenders make a loan, they face a risk of not getting paid back. If that risk is kind of high, they're likely to insist on a hefty down payment and set the interest rate on the loan higher than they would otherwise. Remember, that rate is the cost to the borrower of the loan, and if the market is working right, risky borrowers should face higher rates, both to discourage them from getting in over their heads, and to pay the lender a risk premium--a little protection money--for taking a chance.

If the risk is really high, a reasonably savvy lender won't make the loan at all.

But what if both lender and borrower fail to recognize the risks they're taking on? What if the banks think a debt, whether it's a mortgage or a complex derivative, is perfectly likely to be repaid with interest, right on time, when the reality is that it probably won't be. What if borrowers believe they'll be able to finance a loan when in reality, they won't even come close?

And what if a president and defense secretary think they'll be greeted as liberators in a country they've decided to occupy?

The failure to accurately assess risk has been truly epidemic in this country, and the costs have ranged from expensive (and I'm talking trillions here) to fatal.

The key questions are why did these failures occur and which presidential ticket would be best chosen in that regard (okay, question two is a terribly transparent set up, but please read on anyway).

The failure to assess risk in financial markets stems less from greed--that's always been there--than from a combination of "innovative" transactions and lax oversight. The Greenspan Fed not only watched the real estate bubble inflate, they blew into the balloon, touting the wonders of adjustable rate mortgages. Though the Fed is supposed to monitor the subprime market, they ignored internal warnings that large imbalances were forming. As Peter Goodman points out in this must-read article, Greenspan and other top officials blocked initiatives to regulate derivatives, despite the fact that the growing magnitude and interconnectedness of this market meant that their failure threatened the system.

Economists and bankers failed to manage the credit risk that occurs when cheap money and large external (i.e., from other countries) flows of capital finance a spending spree that's not supported by real income growth. In fact, the ability to package and sell that NINJA (no income, no job, no assets) loan you just made to some other dealer, meant that loan originators didn't need to worry about those pesky, old-school underwriting standards.

How did it come to this? The answer has a lot to do with economic ideology. Mainstream economists convinced policy makers that markets were self-disciplining. Oversight, borrowing constraints, the enforcement of lending standards...these would only cuff the invisible hand. Instead, the market would punish those who underpriced risk. Even when key markets were showing clear signs of flying off the hinges, the nation's top economists were reassuring us that these "temporary disequilibriums" were of little concern.

You see how well that has worked out. We very desperately need a new economics that sees market failures--and accurately prices risk--much sooner than the current brand.

But while bad risk management in financial markets is capturing our attention right now, the problem goes much deeper. Faulty intelligence overestimated the risk from WMD's in Iraq, and underestimated the challenges our military would face from the insurgents. In fact, when it comes to risk assessment, economic or otherwise, it is now quite impossible to trust the judgments of our leaders.

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