More on Risk: Details On The Recent Credit Market Turbulence

I had a chance to catch up on reading a lot of Wall Street Journal articles this weekend. Among the pieces on which I focused was one in this past Friday's edition concerning how a German bank, IKB, has crippled itself through injudicious involvement with sub-prime mortgage CDOs.

What amazes me is that so much of this is a rerun of the 1998 LTCM debacle. For instance, the German bank had been encouraged by its regulators to move out of basic corporate lending, its historical area of business, in order to diversify its revenue base. The result was for IKB to play 'investment manager,' creating two separate entities which issued commercial paper, collateralized by investments in CDOs containing, among other things, American sub-prime mortgages. According to the Journal article, the bank's commercial paper program recently won an award from one of that sector's organizations. Like LTCM's eventual demise, due to hedges involving equities, with which it was not historically experienced, IKB has been brought down by a foray into unfamiliar financial market instruments, as well.

Stepping back, however, there is absolutely no obvious economic value-added which IKB provided, or could have provided, to the buyers of its paper. What it was really doing was making a spread between its commercial paper, which enjoyed low rates typical of such instruments, while collecting higher rates on its riskier investments in CDOs.

Unfortunately, these guys didn't even do anything so esoteric as construct complex hedges between, say, equity and debt instruments. They simply got caught holding the risk of, well, riskier instruments, while having promised commercial paper returns which they suddenly could not pay, in light of the severe losses on their mortgage-underpinned CDO holdings.

In the US, the coverage late last week of various "quant," or quantitative hedge funds running into trouble again reminded, once more, of LTCM's troubles. As I discussed with a friend yesterday, it's almost an exact rerun of the Long Term Capital Management dissolution.

Whiz kids at the helm of trading desks and risk management functions assume that various correlations between instruments will always obtain, and that markets for all instruments always function smoothly.

In neither case is the contention true. Unusual debt instruments can simply become unsaleable at any price. Nobody wants the risk. Thus, losing positions cannot be unwound.

Perhaps the more worrisome part of this recent credit market debacle is how much of it seems to be a function of the compensation and promotion practices among elite financial service firms.

When frontline traders and their management reap tens of millions of dollars annually in compensation, they simply no longer really feel any risk from ruining their company, customers, or the financial system. How much trust can you really place in a person who risks your money, but keeps perhaps 90% of his own millions safely out of harms way. He's no longer managing in your interests, as if they were his.

And don't be fooled by the line that they, too, want their bonuses, etc. Just like overpaid CEOs who underperform, these traders and investment managers lose little, financially, if they become unemployed due to wrecking their firm.

Ego damage, yes. But someone like the recently-departed senior executive of Bear Stearns, Warren Spector, will hardly feel any change in his lifestyle due to current unemployment. No, he'll be more affected by the embarrassment of having lost his powerful job at Bear. But not by the loss of income.

This is critical, because we trust these people to manage other people's money with fiduciary care. But now we see they do not do this. The ultimate cost of failure to themselves, which is loss of customer assets and their own positions, is more than sustainable. The upside of taking so much risk is more money, in the form of bonuses and added compensation in subsequent years.

If it were my money, I would not commit substantial capital to any fund or strategy in which the manager was not required to have the bulk of his net worth also invested. Otherwise, it becomes worthwhile for the manager to take higher risks with my capital, on which he is paid for performing well. Losses only affect my capital. The manager doesn't have to return prior compensation.

Thus, it's my belief that until measures are taken to address this mismatch between trader and investment manager compensation and equity participation in their own activities, we will continue to see the type of problems we are witnessing in the buying, trading and holding of sub-prime mortgage-backed instruments for many decades to come.