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The risk fallacy, page 4

October 28, 2008: 5:52 AM ET

Ultimately, Wall Street and investors were rolling the dice in a real-life version of Risk - only the "game of global domination," as it has long billed itself, became a game of global diminution. And whether you were Lehman Brothers or a homeowner in Stockton, Calif., the trouble was the same: too much money borrowed against collateral that, suddenly, nobody would buy.

When the music stopped, some 50% of AAA-rated subprime ABS and virtually 100% of all AAA CDOs partially defaulted. (The risk of AAAs defaulting was supposed to be 1 in 10,000 over a ten-year period, according to Moody's.)

Today a high rating or even a low default rate is irrelevant; virtually nobody wants to buy CDOs. That explains why 2008 CDO issuance has shriveled to 10% of its 2007 figure. Says Christopher Flanagan, head of CDO research at J.P. Morgan (JPM, Fortune 500): "The CDO market isn't coming back - not in our lifetimes."

Meanwhile, the effects of those defaults - which once would have been confined to a fairly limited number of banks - were spread to the balance sheets of thousands of institutions around the world.

The final nail in the risk coffin was the banks' lack of capital. Their profligate use of borrowed money left commercial banks with only $1 in equity to support each $20 in debt. That was conservative compared with the investment banks, which the Securities and Exchange Commission in 2004 permitted to have $30 in debt for each dollar of equity.

Meanwhile, the Basel II agreements (which the U.S. has not implemented) permitted European banks to reduce capital by giving them extra credit for highly rated assets (in other words, AAA-rated CDOs - which the European banks bought by the boatload).

"The biggest mistake was the risk-based capital framework depending on ratings," says Flanagan. "If rating agencies got it wrong, which they did, holders would be enormously undercapitalized."

These days, of course, banks are frantically trying to recapitalize. The federal government's $250 billion equity injection will help. And momentum appears to be building for the feds to take a greater role in restructuring the mortgages that underlie the entire mess.

With credit in a deep freeze, it's hard to predict the future of lending and therefore of risk. Certainly necessity dictates stricter lending practices in the short term; the bigger challenge will be creating accountability through the risk chain.

In the meantime Wall Street is likely to assure us that future risk models will take the credit meltdown into account, guaranteeing that we won't be brought down by the same products again. True enough. It'll be another, newer innovative twist that gets us next time.  To top of page

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