The ERM Current™

In this month’s issue of Treasury & Risk Magazine, the dramatic increase in credit risk at financial and non-financial companies is examined.  As strategies to mitigate credit risk become more sophisticated, a paradox ensues.  Rather than lowering the amount of credit risk, the strategies can have the opposite effect because they provide a false sense of security.  Here is what the article concludes.

On a macroeconomic level, the dramatic rise in credit risk is partly a result of the very success of credit risk mitigation tools and strategies, argues Jerry Flum, CEO of CreditRiskMonitor in Valley Cottage, N.Y. “We’ve done a lot to promote stability and off-load risk, but the more risk companies transfer, the more they leverage up. When you hedge credit risk with derivatives, you feel confident in taking on more debt.”

The illusion of safety achieved by theoretically reducing risk has encouraged companies to take steps that increase the consequences of negative developments. “Because the foundation seems stable, you build a skyscraper,” Flum says. “It’s rewarding but catastrophic when it falls.” Whether and how the skyscraper will be rebuilt will be a big issue for treasuries of the future.

The big question is how many skyscrapers with weak foundations are looming out there?  Periodic credit stress tests can help provide a better view of the skyscraper and how their foundations can be strengthened.

This week, the Washington Post revealed that the U.S. Treasury has launched an internal effort to determine the size and nature of credit risk across the U.S. financial system.  The effort is portrayed as the development of a last-ditch plan to understand the full scope of credit risk and where it resides.  Here is how the Post described the effort.

Informally known as Plan C, the internal project is focused on vexing problems such as the distressed commercial real estate markets, the high rate of delinquencies among homeowners, and the struggles of community and regional banks, said government sources familiar with the effort.

Part of the mission is assessing which firms are the most vulnerable and trying to decipher what assets these companies hold and whether they pose a danger to the wider financial system. Plan C is a small-scale, relatively informal approach to a problem the administration hopes to address in the long term by empowering the Federal Reserve to oversee systemic risk.  The creation of Plan C is a sign that the government has moved into a new phase of its response, acting preemptively rather than reacting to emerging crises, officials said.

This revelation is somewhat disturbing and promising at the same time.  It is disturbing that the government is just now beginning to work on an effort such as this, but promising in that they are working to prevent future problems rather than just cleaning-up after the fact.

Some banking regulators are beginning to admit the errors made in the early part of this decade that have resulted in the extreme severity of the current economic downturn.  One area that is rearing its ugly head is the inadequacy of loan loss reserves by the largest financial institutions.  As loans were being made at a frenzied pace, the reserves for the inevitable losses associated with those loans were not increased.  The Wall Street Journal reported yesterday that John Dugan, the U.S. Comptroller of the Currency, made the following admission.

He noted that the record profits of the banking industry at the beginning of this decade weren’t coupled with an appropriate increasing in reserving. Instead, Dugan said, the ratio of loan loss reserves to total loans actually fell even though bank executives had to know that record profits couldn’t last forever.  ”Stated differently, rather than being counter cyclical, loan-loss provisioning has become decidedly pro-cyclical, magnifying the impact of the downturn,” Mr. Dugan said.

Like many American consumers, the banks themselves were guilty of spending freely by making bad loans and not saving for a rainy day – or, in today’s case, saving for the perfect storm.