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Page 3 of 4
Ignoring the Warning Signs
To some extent risk management systems in the form of quantitative mathematical models and risk analytical engines might have at least have mitigated some of the CDO risk, but frequently the "buy side" at brokerage houses and investment banks were so enamored by the high yields of these instruments, that they didn't bother with modeling and on occasion paid no heed to risk warnings, consultants and vendors who work in the risk management area on Wall Street told CIOZone as background.
As example, according to a January 24 Bloomberg story, Keishi Hotsuki, the co-head of risk management at Merrill Lynch & Co., warned his boss last August that the firm's decision to invest $3 billion on indexes of mortgage-related securities was a dangerous investment. At the time, Merrill had taken in $800 million in CDO underwriting fees—more than any other firm—since the beginning of 2006, according to Thomson Financial/Freeman, which provides financial information services to corporate customers. Hotsuki's warnings went unheeded. Three months later he left Merrill, which wrote off $7.9 billion in the third quarter and $11.5 billion in the fourth quarter related to CDOs and U.S. subprime residential mortgages outside of the firm's U.S. bank-related investment securities portfolio. Merrill Lynch failed to respond to emails on this matter while CIOZone has been unable to locate Hotsuki.
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Ignoring warnings from risk managers was common while Wall Street was raking in profits of mortgage-related investments. "Traders on the front lines are paid far more than risk managers and have much more power," says the University of Maryland's Kyle. As a result, Kyle explains, risk managers often don't have the necessary clout to keep dicey trading in check.
"You've got a trader who is bringing in enormous profits and probably expects to get millions as an end-of-year bonus being confronted by a risk manager who probably earns one tenth as much," says George Wrenn, a former director of security and technology in the financial sector, and currently a consulting security expert. As a consequence, the traders, the firm's rain makers, often tend to ignore or blow off the risk manager's warning." What Wrenn sometimes did in these situations, he says, was to present the trader with a one page form assessing the particular risk (such forms are called BARFs—the Business Acceptance of Risk Forms) under discussion and have the trader sign it. "That often worked effectively in making the trader or manager realize he was accountable for risk."
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There is also a perception in some financial quarters that risk managers don't "get" the big picture or understand strategy, which impairs their effectiveness. "Risk management types are often overly analytical and statistically oriented," says Kyle of the University of Maryland. "They're trained in technology rather than economics and the market and operate in a narrow box."
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