February 13, 2013

The third indicator was a move towards increased leverage that was taking place. It is well known, for example, that leverage levels at Lehman and Bear Stearns were at historically high levels at the time of their demise in 2008. Hedge funds also looked to increase leverage to increase yield to investors for example, Bear Stearns launched an “enhanced leverage” version of its High Grade Credit hedge fund in September 2006. While, the move towards enhanced leverage was encouraged by investors who were looking to enhance their returns, it was also an indicator of rising risk.

[For more on How the Credit Crisis in Sub-Prime Mortgages Affects Hedge Funds, see Ivy Schmerken's related story.]

The fourth risk indicator was reducing market liquidity. When liquidity starts to leave the market, risk increases exponentially for those who hold significant long positions. That is why metrics around liquidity are vital to track. One remembers how between 2008 and 2011, liquidity literally left the building and those investors, banks and investors holding any type of mortgage security could do nothing with them except re-count their losses each month. Monitoring for, and being sensitive to, real time small changes in liquidity levels that suggest larger potential changes is extremely useful.

The fifth indicatoris asymmetric compensation structures: traders who are paid well for good results without any negative consequences for poor results or negative behaviors. OF course, in 2008, the term clawback had barely been coined and clawing back of traders’ profits was a reasonably rare event so this was at best a blunt tool at that time. Such incentive structures though tended to encourage short-term and negative type behaviors and this was no doubt a contributing factor in the increased risk levels and heavy losses from that time. The example of the credit traders at Credit Suisse charged (two since pled guilty, one still faces extradition to the US) with mis-marking their credit portfolio in 2007 to enhance their bonus comes to mind. The increased use of clawbacks has been an encouraging development since that time though a certain level of clarification and consistency regarding their application would be beneficial. Banks who are more consistent with clear guidelines for their application should be better positioned to manage this type of risk.

At a certain point, the securitized mortgage market turned in a most decisive way but nobody could tell you exactly when that tipping point was reached. As the changes in the mortgage market coursed their way to the trading floors of investment banks and hedge funds, Goldman’s risk managers were watching and took actions accordingly when their indicators pointed to changes in market conditions. Others who failed to do so were left holding the bag. This survey of risk indicators, which is hardly exhaustive, does nonetheless highlight the importance of claw backs and the need for risk managers to understand and track risk indicators from each of the major risk disciplines: market, credit and operational. A future column will highlight how banks can strengthen risk management in both these areas.

Andrew Waxman writes on operational risk in capital markets and financial services. Andrew is a consultant in IBM's US financial risk services and compliance group. The views expressed her are ...