When you sit down, you probably don't check under your seat for a bomb. Even though it could kill you, chances are slim that it's there.
A similar view of risk led bankers, their regulators and other government officials to overlook dangerous investments and business models that contributed to the global credit crisis, according to speakers at the annual financial risk roundtable held by the Wharton Financial Institutions Center and the Oliver Wyman Institute, a management consulting firm.
Northern Rock may be a little-known name in the United States, but the collapse of the British bank mirrors the failed analysis of risk that contributed to problems at companies such as
Citigroup (C Quote - Cramer on C - Stock Picks),
Bear Stearns and
Merrill Lynch (MER Quote - Cramer on MER - Stock Picks). The giant British mortgage lender was considered a "star performer" just months before it failed and was taken over by the government last year, said David T. Llewellyn, professor of banking and finance at Loughborough University in England.
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The bank's loans were doing well and it had plenty of capital. But when the subprime crisis in the United States triggered a global credit crunch, Northern Rock found itself on the verge of disaster in the fall of last year. The bank could no longer borrow what it needed in the wholesale markets, which accounted for about two-thirds of its funding needs. British depositors, who have less insurance than those in the United States, lined up to take their money out. It was a classic run on the bank, the first in Britain in more than 100 years. The British government has since taken it over.
The risks of Northern Rock's reliance on borrowed money were always known. They just weren't taken seriously, Llewellyn noted. "They said, 'We think there's a low probability that this could happen. How do we know it's a low probability? Answer: It's never happened before....' It's as if there is a very real possibility that there is a bomb under your seat and yet no one has looked under their seats. This is exactly what Northern Rock did."
No Middle Man
Northern Rock's problems did not threaten the entire British banking system, but those at Bear Stearns last spring were a threat to a broad range of major U.S. financial firms. "What happened in March was that at a certain point, everything was so disconnected that the Wall Street mechanism of being the middle man had broken down. There was no middle man," said David Benson, senior vice president and treasurer for
Fannie Mae (FNM Quote - Cramer on FNM - Stock Picks), a government-sponsored company that provides liquidity to the mortgage market and that has experienced extreme pressure, mostly related to the housing downturn. During the first quarter of this year, Fannie Mae reported a net loss of $2.2 billion, driven by losses related to the deteriorating housing market. It recently raised $2 billion in capital to bolster its balance sheet.
Benson's team regularly monitors several measures, such as changes in Fannie Mae's stock price compared to the
Standard & Poor's 500, to gauge market conditions. It also monitors the adequacy of its cash to manage liquidity risk, which can occur when market turmoil makes it difficult to buy and sell securities. For example, Fannie Mae is required to have enough liquidity to meet its cash obligations for at least 90 days without having to issue unsecured debt.
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