Lessons To Be Learned From Financial Crisis

One year ago this week, the financial crisis stemming from subprime loan defaults reached global proportions, as several major financial institutions went bust and the world’s then-largest insurer nearly collapsed.

What a difference a year makes. While investment banks Bear Stearns & Co. and Lehman Bros. have disappeared, the Treasury Department came to the rescue of insurer American International Group Inc., and AIG has made plans to sell assets and spin off its core global commercial lines property/casualty business. After two name changes, that business is now known as Chartis Inc.

The name, derived from the Greek word for map, is fitting. We are operating in new territory, with an expanded sense of risk in the global financial system.

Analysis of the subprime loan crisis shows that one of the root causes that almost felled AIG was the failure to monitor aggregate exposure to credit derivative losses. AIG Financial Products for years made lots of money for its holding company parent, and its appetite for writing credit default swaps mushroomed. As the underlying assets on the swaps it wrote plummeted in value, its largely unrealized losses spiraled. The series of massive writedowns triggered calls for increasing amounts of collateral, quickly burning through the company’s liquid assets. Investors, spooked by the spiraling losses, sent the share price almost through the floor, eventually settling well below $1. Unable to halt the freefall, AIG momentarily looked headed for bankruptcy. But a few rounds of federal government financing, the sale of several assets and one reverse stock split later, AIG shares have, to some degree, stabilized.

Through it all, however, and something that remains difficult for some people to understand, AIG’s insurance operations have remained well capitalized and in fact performed in line with their peers. AIG’s woes largely were confined to its Financial Products unit.

In hindsight, few people envisioned the subprime mortgages that backed enormous volumes of securities defaulting on the massive scale they did. Had that risk been considered, perhaps the damage could have been mitigated.

Some observers have questioned whether enterprise risk management was to blame for the financial crisis, as the industry where ERM is most widely practiced is financial services. Others say ERM was not the problem; the real culprit was companies’ failure to use ERM.

I agree with the latter view. Enterprise risk management makes both theoretical and practical sense, but what many people misunderstand is that there is no one-size-fits-all approach to managing risks, be they hazard risks or business risks.

Traditional risk management is concerned with hazard risk—that is, the effects of accidental loss. ERM encompasses hazard risk as well as business risk, which holds the possibility of loss, no loss or gain. ERM also is about maximizing organizational value, which requires viewing risk as both possibility of loss and opportunity.

One of the lessons from the financial crisis is that companies must take a strategic view of risk and manage it so that they can avoid disaster and position themselves to create opportunities, or at least take advantage of ones that arise.