The Art of Managing Risk

By Steven Pearlstein
Wednesday, November 28, 2007

Vince Kaminski has seen firsthand how sophisticated companies systematically underestimate and ignore the financial risks they take on until it's too late.

He was at Salomon Brothers when a rogue trader used false bids at Treasury auctions to corner the market in some government bonds, a scandal from which the venerable investment bank never really recovered.

At Enron he was one of the few who tried to warn top management of the financial house of cards created by Andy Fastow's off-book partnerships and the inadequate capital the energy company had to support its extensive trading operations.

So I was curious about what Kaminski might have to say about the unfolding credit crisis engulfing Wall Street's banks and investment houses.

"Let's just say that all the demons of Enron have not been exorcised," Kaminski said from his home in Houston, where he is writing a book and teaching part time at Rice University. "In many ways, it is the same story all over again."

Kaminski hardly fits the mold of the corporate gadfly. He is a careful man with a Ph.D. in economics, an MBA and a nearly completed degree in mathematics. His expertise is in the relatively new field of risk management, in which sophisticated quantitative techniques are used to measure and model a business's risks and what would happen under various unpleasant scenarios. It is this "science" of risk management that supposedly gives management the ability to foresee and prevent the kind of things that brought down Enron and that now befall Citi, Merrill, HSBC and the rest. And it is this "science" that regulators rely on to protect the health of the banking system.

So why doesn't it work?

As Kaminski sees it, the first problem is that the models these systems are based on, while potentially useful, have serious limitations that are too often ignored.

The data that go into them, he says, are so aggregated and "averaged" that they disregard outliers and abnormalities that turn out to be important. There are also risks -- like risk to reputation -- that are ignored because there is no data set by which to quantify them.

Moreover, by relying heavily on past patterns of behavior, they are often useless in dealing with the new products and new markets that are most often the source of the trouble.

Most importantly, Kaminski says, the models have been unable to capture the cascading effect as problems spread, confidence is undermined and people start to act irrationally.

"You cannot model behavior of humans under conditions of extreme stress," Kaminski says.

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.

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