In a previous blog, I recommend Gillian Tett’s book, Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. In this blog I want to describe a few of the key risk management lessons that I was able to glean from reading the book. We’ll start with the first two here.
Lesson 1: If it sounds too good to be true, it probably is.
Fool’s Gold is a great title for this book. As Tett writes, “For the first time in history, banks would be able to make loans without carrying all, or perhaps even any, of the risk involved themselves. That would, in turn, free up banks to make more loans, as they wouldn’t need to take losses if those loans defaulted.” Doesn’t this sound like a too-good-to-be-true story? It was and the mistakes that financial institutions made nearly brought down the global banking system. As risk managers we need to dig deeper and get to the bottom of “deals” that are too good to be true.
Lesson 2: There are many tools that can help reduce risk, but used inappropriately they can actually increase risk.
Warren Buffet defined prophetically in 2003 that the new financial tool called derivatives were “financial weapons of mass destruction.” The crucial point about derivatives is that they can do two things: help investors reduce risk or create a good deal more risk. Everything depends on how they are used and on the motives and skills of those who trade in them. Some investors like derivatives because they want to control risk, like wheat farmers who prefer to lock in a profitable price. Others want to use them to make high-risk bets in the hope of making windfall profits, kind of like playing the lottery. Credit derivatives were used to manage the risk attached to the loan book of banks and these tools offered a way of controlling risk, but they could also amplify it; it all depended on how they were used. In the subprime CDO market they greatly amplified the risk and the majority of senior managers within the financial services firms did not understand this risk.
Check back tomorrow for the next three lessons from Fool’s Gold.