$1 trillion in operational losses and growing

How could this happen? Did all the smart money go to sleep on Wall Street and let the unthinkable occur, the answer is more complicated than you think. First of all, let's start by asking whether the product of mortgage-backed securities is good for investors. The original idea of "securitization" is a great risk management concept. Package up a diverse pool of mortgages originated across the country or in strong regional locations and re-sell the tranches to institutional and retail clients looking for increased income.

So far so good! The pool of mortgages helps to diversify the risks of default. Bankers and/or loan originators gain liquidity for more mortgages and homeowners get the homes that were increasingly out of reach. The cycle started an economic boom the likes and length America had not experienced before. So what went wrong and why didn't the smartest people on wall street not see it coming.

To describe the concept, I will use a term called the "herding model" to best illustrate what happened. When the early innovators of mortgage backed securities pools began to package and sell these products to sophisticated investors the product worked as advertised. However, once the imitators began to follow the lead of the early innovators into the market the quality of the deals and the margins began to shrink. The "herd" killed the market for these products because of increased competition for deals. The early signals were plenty. Newspapers, conferences, blogs, even Joe Lunch-Bucket saw the end in sight however no one wanted or believed the inevitable would happen. Why? Regulators never stepped in aggressively to put curbs on the practice and market participants continued to crowd the field.

Risk practices across all of Wall Street have a difficult time measuring risks of new phenomena. Modeling the unknown is fraught with inadequate assumptions making predictive models unreliable. Risk models are much better at predicting cycles or patterns that are constant or cyclical. New risks are hard to predict and revenue generating incentives are very difficult to contain. So why did some firms suffer when others did not? Experience, common sense, luck?

All of the above. The few firms who were relatively unscathed never lost there conservative approach to investing and deal making. Money clouds the senses. Common sense told us all that the real estate market and financial boom times could not sustain itself given consumer debt however no one wanted to step off the money train first. The "herd" finds safety in numbers because "everyone can't be wrong, right?" Risk management is the art of seeing through the "herding" model of investing and developing data that gives you directional signal. The ability to have the hard conversation about risks can be politically volatile in many firms because the big producers of revenue do not want the gravy train to stop.

The wealth destruction that is going on today is the result of panic that the economic models really were flawed. The original concepts were valid however! Like most things in business and in life good execution is fundamental to success. The next time that you say to yourself that this feels to good to be true...... remember it probably is.

All things Risk and Compliance

Risk Matters will be devoted to the community of risk management and compliance professionals looking for a way to share best practices, approaches and thoughts on improving risk and compliance programs globally.

Topics will include survival skills for risk and compliance professionals as well as a repository for sharing tricks of the trade and tools that may help others. Because of the diversity of practices in risk and compliance the areas of focus may require specialization and sub-groups over time.

My personal area of specialty includes the broker/dealer and asset management industry. I focus on operational risk for an asset management firm across a broad range of complex financial services and products. However, this site will be equally useful for practitioners in health care, basic industry, manufacturing, insurance, etc. My goal is that this blog becomes a "One-Stop" shop for all Risk Matters. Thus the name.

Please visit the site as often as you like to make suggestions and to add postings yourself. I am new to the blog-o-sphere so any advice and feedback will only make the site better over time. I am so excited about creating a forum for risk and compliance experts around the world.