Wednesday, February 06, 2008

Setting an Example

What a difference an e.g. makes.

In the risk factors section of its 2006 10-K, filed about a year ago, Morgan Stanley included what then seemed a snoreworthy statement about its risk management practices: “Some of our methods of managing risk are based upon our use of observed historical market behavior. As a result, these methods may not predict future risk exposures, which could be significantly greater than the historical measures indicate.”

The same words appeared in Morgan’s 2007 10-K, filed last week, but the firm tacked on at the end this parenthetical: “(e.g., recent events in the U.S. subprime residential mortgage market).”

I’m kind of an example lover, myself; I find many concepts easier to understand when someone gives me a “for instance.” So thank you, subprime meltdown, for serving as a “for instance” that has added immeasurably to the world’s understanding of the art of risk management. (Risk management was, of course, named Oxymoron of the Year here at Proxyland.)

The crash of subprime-linked debt, Morgan explains in a spanky new section in this year's 10-K, has been “among the most significant market shocks ever realized… Events of this magnitude are outside of the loss estimates forecast by VaR models and are more commonly measured by alternative risk measures such as stress tests and scenario analyses. However, the market moves associated with the subprime events of 2007 were significantly greater than those included in the Company's stress tests and scenario analyses at that time.”

So we’ve now learned - by example - that the models, stress tests and scenario analyses financial firms use to measure risk are, well, models, stress tests and scenario analyses. Such educated guesses may miss the mark even when made by highly credentialed, nicely dressed folks like those who work at Morgan Stanley. Morgan's risk managers perhaps envisioned a kinder world than the one we live in, a place where mortgages would be repaid even when borrowers lacked the means to make payments. In that world, Amy Winehouse never smoked crack, Kate Hudson did not wear this dress, and my plumber did NOT charge me $350 to replace a stupid bathroom sink. Just for instance.

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