So we have seen some high profile casualties in the subprime triggered credit crunch from both the corporation and personnel perspective and I am sure we will see further cases in the coming weeks and months as more banks write off ever increasing amounts
related to their mortgage business and as the true size of these write offs become clear as half year and full year results are posted.
We take for granted that banks can measure credit risk and ascertain the correct point in the fiscal cycle where the market price for money dips below the bank’s internally-calculated risk-adjusted price.
But can they?
In the case of the subprime credit crunch, surely banks were trying their hardest to measure the economic cost of risk and to differentiate between subprime borrowers – and the problem was that the industry’s models, including rating industry models, did
not work?
Well, yes and no – mainly no. Risk modelers in banks and elsewhere were entirely aware that the subprime sector was new and had not suffered the kind of economic shocks that would yield reliable default and risk factor correlation statistics.
If the subprime industry had behaved in a way that was sensitive to credit risk we would therefore have seen a number of features in the run up to the crisis:
- strong control over origination and due diligence, so that at least the basics of risk measurement were solid
- acknowledgement of the inevitable uncertainty in subprime risk modeling in this cycle, and the relationship between this and funding risk
- emphasis on business line diversification to absorb any shocks arising from uncertainty
- product structures that upfronted credit risks rather than temporarily obscuring them
In fact, we did not see much of this. To the contrary, brokers were disproportionately likely to originate subprime; credit risk data was poorly collected and attached to complex securitized risks and structures; diversification was patchy; and many subprime
borrowers were offered teaser rates followed by sudden rate hikes.
Meanwhile, the poor quality of the fundamental risk information attached to the bundles of loans underlying securitizations is one reason investors panicked, looked for reassurance that could not be given, and turned a credit crunch into a banking industry
liquidity crisis.
It was only two weeks since that Alistair Darling, the UK Chancellor, told the BBC’s Today programme that “we need to get to a far better situation where there is a great deal more transparency, more openness, so people understand the risks to which these
banks have become exposed”.
I think we can all agree that having access to the fundamental risk information is key but firms also need the ability to incorporate it into their risk models and scenarios.
If you've ever bought a home, which I am guessing is the majority of us reading Finextra, then you will be aware of the warnings issued by lenders:
"Your home is at risk if you do not keep up repayments on a mortgage or other loan secured on it."
Taking into account recent events, perhaps we should consider replacing the word 'home' with 'bank' and publishing the warning to all risk managers.