Many risk managers failed to understand complexity of credit instruments
The economic climate has changed a great deal since David Hensler, partner at Hogan & Hartson, worked in the SEC’s general counsel office in 1967, but the regulatory body is as diligent as ever in cracking down on financial misconduct.
In the move to penalize the culprits behind the latest scandal, the subprime lending crisis, the SEC recently reexamined the leading rating agencies – Fitch, Moody’s and Standard & Poor’s – for conflicts of interest and errors in methodology. It found that the agencies did not keep up with the increasing complexity of subprime residential mortgage-backed securities and collateralized debt obligations. They hadn’t even written procedures for rating them. The SEC is calling for better disclosure, a differentiation of ratings on structured products versus bonds and a clarification of the limits and purposes of credit ratings.
There is little doubt that the rating agencies miscalculated many of the financial risks, allocating AAA ratings to securities backed by risky subprime mortgages, but it would be a gross error to hold them entirely to blame. What about the companies, and the highly paid professional investors, that followed their advice? Hensler offers some valuable insight on where the firms went wrong, and what can be done to prevent another credit crisis.
Ignorance isn’t bliss
‘In many cases, what the firms were doing was ignoring their own in-house expertise and relying on the rating agencies,’ Hensler says. He adds that the divorced nature of the rating agencies’ relationship with businesses left those companies with an insufficient understanding of the processes involved. ‘That just makes no sense whatsoever,’ Hensler concludes.
The SEC is basing much of its argument on a report released by the Senior Supervisors Group (SSG) in March entitled ‘Observations on risk management practices during the recent market turbulence’. The SSG consists of seven financial regulators from five countries: France, Germany, Switzerland, the UK and the US. The detailed 27-page report suggests that some companies applied external assessments such as rating agencies’ views of risk while ignoring some of the more sophisticated internal processes they already maintained to assess the credit risk in other business lines.
To further exacerbate the problem, the key model on which companies based their judgments, namely the ‘value-at-risk’ model, was misused. Value-at-risk takes the amount of money an investment bank has invested in AAA bonds and multiplies that by a factor based on the risk of default presented by AAA bonds. In the case of the subprime crisis, the risk wasn’t properly calculated.
The other glaring problem in the subprime mess was the lack of previous knowledge of risk pertaining to these types of securities. As the report explains, there wasn’t any historical data concerning the default rates on mortgage-backed securities of the type companies began to sell.
Hensler says, ‘The key flaws were that the rating agencies had too little time, too little expertise and a compensation structure that presents concerns.’
To help frame the discussion of compensation’s role in stimulating the credit crisis, look at the example of Charles Prince. His base salary for running Citi in 2006 was $1 million. His cash bonus: $13.2 million. Bonuses motivated by higher gains forced companies to take on a lot of leverage, says Hensler, recalling comments he made on a panel at a May ABA conference. Co-panelist Nell Minow, editor of the Corporate Library, agreed, cautioning against compensation that ‘provide[s] an incentive for volume of transactions, not value of transactions.’ At some stricken companies, she elaborated, ‘a percentage of the gross revenues would make up the bonus pool.’
Hensler argues that many financial firms get this balance wrong and in many cases, the misaligned incentives directly contributed to poor decision-making.
The return-on-equity bonus arrangement at Merrill Lynch resulted in the company spending $9 billion in the couple of years after the arrangement went into effect to buy back stock, reducing its equity liquidity. Since the credit crisis is essentially a liquidity crisis, the company was increasing its risk profile.
Hensler provides a solution: ‘One way of compensating executives with stock, but that gives them the same risk as other shareholders, is to use restricted stock – stock that they can only sell under certain circumstances, for example.’ That way there would be both upside and downside risk, and the process would be less performance-driven.
It’s the board’s responsibility to reexamine compensation structures, Hensler says: ‘The board has to appreciate the risk presented by excessive performance-driven compensation because it does encourage much riskier behavior by executives.’
Righting your own ship
Like the SEC, Hensler considers the SSG’s report a key resource for understanding the complex rationales made by these firms. To enable companies to better understand risks, the SSG advises including people ‘with expertise in a range of risks’ and the creation of risk management committees that confer on risk exposures in different areas of the business, with input from executive and senior leaders such as the CFO and senior legal managers.
When it comes to in-house expertise, Hensler illuminates a fascinating characteristic: ‘Every one of these financial institutions that was packaging mortgage-backed securities had an entity that was part of the same corporate structure that originated loans.’ Though the packagers may not have known what was in the packages, they could have contacted the relevant person within the company to discover what the underwriting standards for the loans were, and determine stated income versus verified income, stated assets versus verified assets.
Hensler notes the awkwardness of this process, but points to the SSG’s report, which puts it more succinctly: ‘Firms that avoided losses noted the mortgage underwriting standards had deteriorated.’
He also emphasizes putting ‘more of the risk on the people who package the loans. On Wall Street people tend to get rewarded for success, but you don’t often hear about people getting penalized for failure.’
While this may be outside the direct remit of the general counsel’s or corporate secretary’s office, bringing sound suggestions for remedial or preventative measures to the board and senior management may go a long way to ensuring the correct processes are in place to avoid similar problems.
Above all, it’s the tone at the top that ensures a company’s strength. Going forward, strong corporate ethics can help prevent another ratings debacle.
