Uncontrolled Risk

The credit crisis that exploded in 2008 affected people across the planet, but few of us understand what happened to cause it all. Risk management expert Mark T. Williams wrote the book Uncontrolled Risk that tells the story of Lehman Brothers’ fall and more generally the events leading to the credit crisis. More than just a chronology, Williams explains why events unfolded as they did and why Canada’s banking system survived largely unscathed.

Taking on too much risk in mortgage-backed securities led to the downfall of Lehman Brothers, a 158-year-old financial institution. With increased risk comes higher profit, but also greater chance of total failure. Lehman lost the gamble that in the case of imminent failure the U.S. government would judge it to be “too big to fail”.

Here are a few parts of the book that I particularly liked:

CEOs with too much control

In the last couple of decades “shareholders became less hands-on and showed displeasure not by voting out directors but rather by selling stock. As shareholders became more removed from deciding how companies were structured and run, CEOs enjoyed more latitude in their decisions.”

“Unfortunately, some boards have developed into an extension of a CEO’s friendship network instead of an independent governing body that ensures shareholder interests are put first.”

Change that led to the crisis

When banks made decisions about granting mortgages, they used to have to live with those decisions for up to 30 years. But mortgage-back securities “allowed lenders to package and sell their loans, severing the accountability between those who created the risk and those who assumed it. Banks and other lenders could pass the risk down the line to further removed and often less-informed investors.”

Risk measurement

One measure of risk level is called value-at-risk (VaR). This measure has been criticized as a measure that is only accurate when markets are calm. David Einhorn, a short-seller of Lehman Brothers’ stock, is quoted as saying that VaR is like “an airbag that works all the time, except when you have a car accident.”

Two-faced banks

Banks that accepted government bailout money “continue to express public support for re-regulation of the financial markets while their paid lobbyists attempt to defeat or weaken any new regulation.”

The book concludes with ten recommendations along with strong praise for Canada’s banking system and its regulatory body. Overall, this book is a must-read for anyone with a strong interest in the causes behind our recent financial turmoil.