The Death Knell for A Business Model - Because of a Risk Model

As I write this, AIG has been downgraded by Fitch and S&P. So the abridged list of failed financial institutions reads: Bear Sterns, Fannie, Freddie, Lehman, Merrill, and (maybe) AIG - with WaMu ready to follow in IndyMac's footsteps within the week. Some analysts are now predicting that no investment bank will make it out of the crisis as an independent entity - that they will all be swallowed up or bankrupted before we reach more tranquil financial times.

These firms have been some of the pillars of Wall Street. They are sizable, too, Lehman is approximately 10 times the size of Enron when it collapsed 7 years ago. Likewise, from the Wall Street Journal: “[AIG] is such a big player in insuring risk for institutions around the world that its failure could undermine the global financial system.”

For me, the amazing part is not that any one of these firms has fallen on troubled times (certainly, it is possible for any one firm to have a significant negative occurrence - such as Barings Bank) but rather that they ALL have.  It is the industry's vulnerability to systemic risk that is so concerning.  There are two primary reasons why the industry has fallen systemically into this treacherous territory:

1) Over-reliance on a financial model that does not effectively capture the impact of the once-in-ten-years kind of event

2) A lack of appreciation for how much credit exposure would grow if a once in ten years event forced a change in credit ratings

Extreme things happen in financial markets. Without the true wisdom to understand that possible outcomes can vary drastically from possible modeled outcomes, business managers place large bets in particular asset classes or trades (such as mortgages) - in blackjack terms, they "double down".   A good blackjack player knows to double down on an 11 when the dealer has a 6.  Statistically, it is a solid bet.  However, as seen at every casino table, just because an opportunity is statistically solid does not mean that it can't lose. Since last summer, mortgages have been losing bets, and the debt leverage used to enhance returns has created a vulnerabilityof dramatic proportions.

These bad and leveraged bets make banks lose money.  And when companies lose money, the loss shows on their balance sheet. As the balance sheet is tapped to fund the losses associated with bad bets, the balance sheet becomes weaker. When balance sheets get weaker, the overall health of the firm suffers. And the rating agencies are forced to react. They adjust the credit rating of the firm to reflect the firm's newly compromised position. The downgrade reflects a company that has a less healthy financial outlook.

This is where item number two comes in to play. Over-the-counter derivatives are backed by the company that originates them. When a company receives a ratings downgrade, the downgrade may trigger the firm to have to make payments to their trading counterparties to stay in good standing. When a firm has lots of agreements with lots of counterparties, the ability to come up with large margin payments is a real challenge, since the firm is likely already in impaired shape.

Here is the scary part....all those trading instruments - the CDO's and CMO's and derivatives - all are either in the money or out of the money with a counterparty.  In other words, they have either made money or lost money for the counterparty.  If they are "in the money" the customer wants the troubled contract writer to perform, but if they are "out of the money" the customer views the writer's insolvency as a blessing, as the customer is able to re-cover that commitment elsewhere at an advantage to where it was originally struck.  For those companies that are "in the money" - well, you hope that the loss of the money that they had anticipated to make is not a business-threatening occurrence. If it is not, then it is just an unfortunate circumstance and a bad quarter. If it is, then the crisis of Wall Street becomes the crisis of Main Street.

Yes, due to a lack of appreciation for the risks of these trades, an entire segment of our economy is being sacked. Say goodbye to Investment Banking. And maybe we can say "good riddance" to the myopic risk modeling that helped get us to where the market is today.