Corporate Governance versus Risk Management

The news that the former risk manager for Bear Stearns, Michael Alix, is now working for the New York Federal Reserve in a senior risk-management role has inspired some negative commentary.  An Associated Press story carried this quote:  ''That's incredible,'' said James Cox, whom the AP describes as "a Duke University law professor and securities law expert." "This is not reassuring."

What blew up the Bear, though, was not bad risk management, but bad corporate governance.  The hedge funds that brought Bear down were allowed to lever themselves up to speculate on risky debt, all the while retaining a claim on Bear's balance sheet yet being otherwise separated from Bear's own supervision.  Behind that decision is a tangle of org-chart choices, bonus structures, and decisions about what corporate entities to create -- stuff beyond the math and computers of risk management, and in the realm of corporate governance.

We'll hear a lot about how hedge funds are to blame for the collapse of markets and banking systems around the world and for the looming recession.  This is only half true.  The original concept of a hedge fund was a pool of investors' money, managed privately, and walled off from other financial actors -- free to speculate, free to take potentially big risks, and free to fail with no harm to anyone but the investors and the fund managers themselves, who would go out of business, suffering the risk that corresponds to the rewards.  A nice business for those with strong stomachs and deep pockets.

That original concept is sound and reasonable: nobody gets hurt except the people prepared to take the pain.  What happened -- and this is the corporate governance part -- was that public corporations, specifically big investment banks, decided that they also needed to be in the hedge fund business.  They first entered it by operating on-balance-sheet "prime brokerage" businesses -- lending hedgies the money to multiply their bets several-fold.  That meant they were underwriting some of the risk in the hedge fund business.  This is why a bank consortium had to rescue Long Term Capital Management -- because, had LTCM gone under, and sold all their assets to pay off their borrowing, the lending banks would have lost a lot of money, much more than they stood to lose from an orderly unwinding.  A scary moment, but lesson learned -- watch your prime brokerage clients like hawks, carefully manage your total exposure to that business, and include in your risk model the "unwind" scenario -- the series of events that might occur after a failure, when assets must be promptly liquidated to meet claims.

So what happened next?  The boards of the big banks focused on the excess returns available to hedge funds, and not on the "you go out of business if you fail" part.  Not only that, they figured that -- with their strong skills at trading and analyzing -- they ought to be able to beat the independent hedge funds at their own game, and do even better.  So they put their money and their people to work, and conveniently relegated that awkward "out of business" detail to a footnote (probably in a Powerpoint presentation).  The rest is history.