Risk management failures

Gordon Crovitz:

In the early 1950s, when young Harry Markowitz was looking for an area of economics to pursue, a chance encounter with a stockbroker in Chicago led him to apply a new logic about risk to what had been an investment industry based on touting individual stocks. He revolutionized the investing world by showing how to create diversified portfolios that reduce risk and maximize return.

Our current credit crisis arose from an imbalance of risk and return in portfolios of mortgage-backed and other debt securities, so it seems timely to ask the father of modern finance what went wrong and what to do about it.

Now 81 and still teaching and advising funds, Mr. Markowitz has good news and bad news. The bad news is that bailouts to restore liquidity aren't addressing the real problem. The good news is that once we have the information to measure the losses of bad risk-taking, markets will recover.

Mr. Markowitz doesn't excuse the financial engineers who bundled complex mortgage-based and other securities. They violated the first principle of his portfolio theory. "Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero," he says in an interview. "But financial engineers should know that's not true of a portfolio of correlated risks."

In traditional Markowitz-inspired investing, such as mutual funds and index funds, there is a discipline around variables such as asset classes and models of covariance. In contrast, collateralized mortgage obligations and related securities had no such discipline. These risks sank together. "Selling people what sellers and buyers don't understand," he says with understatement, "is not a good thing."

In a now-famous paper on portfolio selection in the Journal of Finance in 1952, Mr. Markowitz wrote that risks that are not correlated with one another work best, while investments that move together -- owning both Ford and GM -- are riskier. This idea, which seems obvious now, was so novel then that when Milton Friedman reviewed Mr. Markowitz's University of Chicago Ph.D. dissertation, he half-joked it couldn't lead to a degree in economics because the topic was not economics. Mr. Markowitz got the degree and in 1990 shared the Nobel Prize in economics for portfolio theory.

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He draws a line between his portfolio theory and its later misapplication. "Not all financial engineering is always bad," he says, "but the layers of financially engineered products of recent years, combined with high levels of leverage, have proved to be too much of a good thing." In contrast, classic investment portfolios such as mutual funds and index funds continue to reduce risk.

In an essay recently posted on the Web site of Index Funds Advisors titled "What to Do About the Financial Transparency Crisis," Mr. Markowitz calls for urgency in addressing the underlying problem of mismatched securities. So long as there is continued "obscurity of billions of dollars of financial instruments," we run the risk of Japan-style stagnation. Banks there, with the support of the Ministry of Finance, refused to mark bad debts to market for a decade.

"Just as with all securities, the fundamental exercise of the analysis and understanding of the trade-off between risk and return has no shortcuts," Mr. Markowitz says. "Arbitrarily assigning expected returns absent an understanding of the risks of the securities is precisely how the economy arrived at this point."

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How to avoid more such crises? Politicians need to learn a lesson. "If the choice is requiring mortgages for people who don't qualify or keeping the banking system sound, we should learn to opt for sound banking every time," he says. Also, since "financial engineers seem to get their necks chopped off periodically," they shouldn't get bailed out when it happens.

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I had no idea I was in such good company with my analysis of the financial crisis. I would add an additional point. There was a serious failure of risk analysis in the mortgaged backed securities market.

I think one reason for this is that the securities were largely traded in institutional accounts and not subjected to the kind of risk analysis that usually goes into crafting of the Risk Factor section of a disclosure document. Whatever the cause of the failure, there can be no doubt that there was a serious failure of risk analysis.

One of those factors involved what I call compound leveraging. That involves taking a highly leveraged investment in real estate and creating highly leveraged securities that are based on that real estate investment. In over 35 years in the investment business one of the things I have learned is that to lose really big money you need leverage.

Without leverage it is hard to go below zero, but with it people are finding that losses can reach levels beyond imagination. While leverage can increase the upside potential the down side risk is greater than the upside. When investment values are going up, it is easy to liquidate, but when they are going down the ride can be swifter and seemingly impossible to get off.