Thursday, January 24, 2008

Atonement Comes to Wall Street as Exiled Risk Guardians Return

(Bloomberg) -- In August, Keishi Hotsuki went to his boss at Merrill Lynch & Co. to protest. Hotsuki, who was co- head of risk management, said the firm's decision to wager $3 billion on indexes of mortgage-related securities was too big a gamble. He lost the battle, and three months later, he left the company partly because of his objections to the trade, according to people familiar with the matter.

As the subprime crisis has unfolded, spurring at least $133 billion in writedowns and credit losses and claiming the jobs of four chief executive officers, the risk managers charged with preventing those kinds of disasters have largely languished on the sidelines.

Banks, emboldened by three years of record profits, failed to heed warnings of their risk managers or give them enough power and data to do their jobs, says Joseph Mason, a professor of finance at Drexel University in Philadelphia who researches risk management. Merrill Lynch spokeswoman Jessica Oppenheim declined to comment on the details of Hotsuki's departure.

Now, risk managers are back in vogue -- at least for the moment. ``They will get more power as firms make a visible show of assessing their risk management,'' says Samuel Hayes, 72, a professor of investment banking at Harvard Business School in Boston. ``And they will be curtailing risk taking for a while.''

On Jan. 15, after Citigroup Inc. reported a $9.8 billion fourth-quarter loss -- the biggest in its 196-year history --new CEO Vikram Pandit said on a conference call that he would be a ``hands-on participant'' in risk management.

Merrill's Risk Chiefs

Merrill Lynch also posted a record $9.8 billion loss in the period. John Thain, 52, who became CEO in December, created two chief risk officer positions that report to him.

Co-chief Noel Donohoe was hired in January and had served as the head of risk at Goldman Sachs Group Inc. until 2005. Edmond Moriarty, the former head of counterparty risk at Merrill, is the other co-chief.

Morgan Stanley, which has written down $9.4 billion, says risk chief Thomas Daula will answer to the chief financial officer rather than the head of trading.

Bear Stearns Cos. is also considering changes after $2.6 billion of writedowns.

``It's not just risk management but the whole risk culture,'' says Alan Schwartz, who replaced James ``Jimmy'' Cayne as CEO of New York-based Bear Stearns in January. ``We have to make sure our risk management and trading management are working together.''

Misleading Information

Wall Street firms have long viewed risk managers as advisers, not decision makers. They are there to support the bankers and traders who generate revenue. At JPMorgan Chase & Co., which took a $1.3 billion writedown in the fourth quarter, the risk department for investment banking has 700 employees.

Risk managers build sophisticated models to predict potential losses from investments and to set overall trading limits. The bankers and traders are supposed to consider the findings of risk managers in deciding whether to reduce or hedge bets.

It doesn't always work that way.

For one thing, risk managers often rely on traders to give them the data and formulas they need to do their jobs. That's what happened with collateralized debt obligations -- packages of securities that are based on home mortgages and other loans. CDOs, whose values dropped as much as 100 percent from July to December, don't have readily available market prices because they're thinly traded.

In many instances, traders gave risk managers insufficient or misleading information about the pricing models for the securities, making their task more difficult, says Cubillas Ding, an analyst at Boston-based Celent LLC, which advises financial services firms on risk management.

Goldman's Rotation

``The front lines and risk management have to cooperate more, the latest crisis has shown,'' Ding says. ``Chief risk officers need to get the right information.''

Goldman Sachs escaped subprime-related writedowns partly because it insists that risk managers and traders work together. Goldman CEO Lloyd Blankfein said during a November investor conference that the firm rotates people between trading and risk management so they better understand both sides of the business.

``We place a lot of importance on communication between revenue and control areas,'' said Blankfein, who was formerly the head of fixed-income trading at the New York-based firm.

Traders -- even those who rose to superstar status as banks wagered more of their own money -- are also more likely to listen to the warnings of risk chiefs that report directly to CEOs, says Bruce Foerster, who was a managing director at Lehman Brothers Holdings Inc. before starting advisory firm South Beach Capital Markets in Miami.

Smaller Bets

Lehman's new head of risk, former CFO Christopher O'Meara, had been the firm's public face on quarterly earnings calls. He reports to CEO Richard Fuld; the former top risk manager was supervised by the chief administrative officer.

``Risk management should be an independent function that closely interacts with the business at the onset of the transaction,'' O'Meara, 46, says.

Banks that hand more authority to risk officers will likely make smaller bets and hedge more, and that may trim profits, Foerster says. New York-based Morgan Stanley says it's curbing its risk-taking.

``I think we have been sprinting, and I think we are going to be jogging right now for a while,'' CEO John Mack said during a December conference call.

The pause may be temporary. Wall Street will start running bigger risks again once traders find a new source of revenue -- whatever the next new thing is after CDOs, says Charles Geisst, author of ``Wall Street: A History'' (Oxford University Press, 2004).

``When the boom resumes,'' Geisst says, ``attention on risk will recede, too.''

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