Wednesday, April 1, 2009

"We Had No Risk Management"

Great article in New York Magazine by Michael Osinski about his role in the the debt bust. He built computer models that projected how bundles of mortgages would perform, creating a false sense of security across Wall Street. Trading these instruments was so lucrative that everyone had to get in on the game, and to get in on the game, you had to buy his software. He made a lot of money, as many on (and off) Wall Street did.

I loved the article as a stand-alone piece, but I especially loved this quote:

The economy improved. The Feds raised rates. Kidder was in trouble. We had no risk management. According to an internal report, there were management deficiencies across the board. If I remember correctly, one top executive had a contract stipulating that he would only work one day a week for his seven-figure wage. So Kidder was in bad shape when it was hit by the scandal involving the infamous Joseph Jett, who allegedly fabricated hundreds of millions of dollars in trades, more or less taking down the whole firm. Back then, a major Wall Street failure didn’t panic the entire country. Kidder may have handled a fifth of the country’s mortgage-backed securities, but in the wake of its demise, the American economy did not wither. Though securitization slowed to a crawl, breadlines weren’t forming. Homeowners made their payments. Bonuses, if you got one, were halved. People stood pat.

The passage on Kidder's risk management structure struck a cord in my academic experience. In 1998, I was in Finance classes at CAL. I love Finance because it combines math, business and human pyschology. I'm fascinated by how our base human instincts are reflexed in markets, and I was lucky to be learning about it at one of the best undergraduate programs in the country.

My Financial Markets class was TA-ed by an older guy, probably 30 to 35. Most TA's are in their mid-20's. It was a small class and pretty dorky stuff, so if you were in this class, you loved Finance. One day towards the end of the semester he asked us if we wanted to know why he was such an old TA. We nodded and he launched into his story about how he had been one of the risk modelers on mortgage backed securities at a place called Kidder Peabody. He had built elaborate models and was confident in their ability to forecast prepayment risk and duration, the two most important variables in mortgage backed security prices. But his bosses got involved because the models were tying their hands too much. A tweak here, an adjustment there and a year later, Kidder Peabody was bankrupt because of mortgage backed security losses.

The TA's anger was palpable. He was so disgusted with his bosses that he decided to go into academia. This story was probably the most important thing I heard all semester. It cemented my appreciation for risk in financial markets, for career risk if you didn't stand up to your bosses, and it taught me there was no free lunch. I avoided the entire debt meltdown because when Greenspan started artificially pushing down rates and the public reacted by reaching for higher priced houses at variable interest rates on interest only loans, I knew what would eventually happen. That story was worth the price of my education, and this article reminded me of it one more time.

(Note: Not an April's Fools Joke)