The Art of Managing Risk

Vince Kaminski, a Ph.D. in economics, says the science of risk management has failed. (Andrew Councill - Bloomberg News)

Kaminski offers the example of the flood walls in New Orleans. When they were constructed, he says, hundreds of soil samples were taken and then averaged together before the experts concluded they could support the walls. But when the big one finally hit, it turned out that there was one point at which the configuration of clay and swampy black soil was so different as to allow the water to seep down and push out the wall. And that was it -- one point of weakness and the whole structure collapsed.

But even if the models were better able to predict such calamities, risk management would probably fail, Kaminski says, because risk managers are routinely ignored or overruled.

"Many times I have been sitting across the table from an energy trader and I would say, 'Your portfolio will implode if this specific situation happens.' And the trader would start yelling at me and telling me I'm an idiot, that such a situation would never happen," he says. "The problem is that, on one side, you have a rainmaker who is making lots of money for the company and is treated like a superstar, and on the other side you have an introverted nerd. So who do you think wins?"

As Kaminski sees it, you didn't need elaborate models to see that there was a housing bubble, and a credit bubble, and that things would someday end badly. Indeed, any number of top Wall Street executives conceded as much in the months leading up to the current debacle.

But under pressure to increase earnings, keep up with the competition and retain top talent, these same executives found it almost impossible to pull back from a product or strategy that might be risky but was generating big profit, big bonuses and a rising stock price.

"When the music stops in terms of liquidity, things will be complicated," Chuck Prince, chief executive of Citigroup, told the Financial Times back in July when asked about the flood of cheap credit that was fueling the buyout boom. "But as long as the music is playing, you've got to get up and dance."

Now, of course, Prince has hung up his dancing shoes while his bank, because of its enthusiastic tango with newfangled CDOs and SIVs, has to sell a 4.9 percent stake to the government of Abu Dhabi to raise $7.5 billion in badly needed capital.

Prince and other executives surely understood the risks they were taking by lowering underwriting standards for mortgages and loans of all types. But like the others, he figured he'd be able to get out of the dance hall before too much damage was done.

It's a mind-set Kaminski has seen many times before.

"What matters in terms of managing risk," Kaminski says, "isn't the model -- it's the intuition, judgment and experience to spot the risks as they are developing, and the character to be able to stand up to very aggressive and successful commercial people and say, 'Enough is enough.' "

Risk management is an art, not a science.

And its latest failure is turning out to be an expensive learning experience, not only for Wall Street, but for the rest of us as well.

Certainly it is a failure on the part of executives whose jobs, reputations and fortunes are on the line.

But it is also a failure on the part of bank regulators who have placed excessive faith in risk-management systems, not only to ensure that no individual bank will fail but also to protect against a broader meltdown in the banking system. For years now, I've listened as top regulators have explained to me that it is no longer their role to question banks about certain practices or products or individual loans -- that all that matters is whether the bank has an adequate risk-management system in place. Now that a minor problem with subprime mortgages has led to a full-blown housing crisis and credit crunch that threaten to drag the entire economy into a recession, the shortcomings of that regulatory approach should be obvious.

Steven Pearlstein will host a Web discussion today at 11 a.m. athttp://washingtonpost.com. He can be reached atpearlsteins@washpost.com.