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Subprime Crisis Exposes Risk Predicament


The subprime crisis has proved that mutual fund executives should reassess their risk management procedures, according to a Tower Group report called "Multifunctional Integration: The Positive Side of Risk."

"Risk analyses that are siloed' in one area of an institution may exaggerate the danger attached to new products or services, thus leading institutions to stifle innovation and forgo growth opportunities," said Guillermo Kopp, executive director and global research fellow at Tower Group and the author of the report.

The report's thesis is that the subprime crisis has exposed structural deficiencies in the financial system globally, especially in risk management. Many financial institutions cope with change in a reactive way, with their main orientation being the avoidance of threats that may have a negative impact in the future, according to Tower Group. While this is an understandable reaction, institutions should understand and manage risk and financial exposure more holistically, the report said.

Asset management companies should consider the risk in subprime debt and collateralized debt obligations from the perspective of the way any one product interacts with the companies' holdings in their entirety.

In addition to subprime debt and CDOs based on these mortgages, another area of potential vulnerability for the mutual fund industry is the dozen or so money-market mutual funds that are likely to be holding structured investment vehicles (SIVs).

In many cases, SIVs raise money by selling short-term debt and using it to buy longer-term securities that carry higher yields. They have become difficult to sell during the recent market turmoil.

Kopp argued that "poor integration of risk management across an organization masks the interdependence of risk and financial indicators." This may potentially expose financial institutions to severe losses. He goes on to say that many institutions only become aware of their risk management deficiencies once a lapse in controls or unforeseen interdependencies between events causes a major business problem.

Events triggered by the subprime crisis are examples of this type of interdependency. Kopp said the credit crisis that started this summer serves as a harsh reminder that such financial risks as liquidity and credit problems are deeply and globally interdependent.

He suggested that organizations work to integrate the management of financial functions with operational and other risk types such as brand damage, business continuity, disruption of the supply chain and geopolitical unrest. But beyond avoiding trouble, Kopp says this multi-faceted approach to risk management can enhance overall business operations.

He said that leaders of financial institutions must understand the changing variables in today's interconnected world. "Proactive leadership, in which chief financial officers and risk managers play key roles, is critical to achieving integration and sustaining competitive advantage," he said.

A more integrated approach to risk management can drive other businesses and client-centric benefits, including improved quality and transparency of information, Tower Group said. It should also assist in relationship pricing, process simplicity and efficiency, more effective decision-making and overall organization resilience.

One industry expert, Carl Frischling, a partner at the law firm Kramer Levin Naftalis & Frankel, said one outgrowth of the subprime crisis is more discussions at mutual funds' boards and at the Securities and Exchange Commission, to make sure there is increased transparency with respect to valuation. Although Frischling hasn't seen any money market funds in danger of "breaking the buck," he said discussions are ongoing to keep this a remote possibility.

Frischling noted that it is relatively easy to value securities, but less easy to put a price on instruments that are marked to market such as those based on subprime mortgages. It is important for industry players to determine who is ultimately the owner of the security they have invested in, he said.

Another issue for the industry going forward is what is the level of counter-party risk of instruments in their portfolio.

Frischling said one of the lessons for mutual fund companies emerging from the subprime crisis is that principals should worry about what they don't know.

"No one had the foresight to see the subprime problem developing." He said the experience has raised the awareness of other risks that fund managements and boards might encounter.

One other risk boards are more closely evaluating, he said, is the problem in determining what some of a fund's holdings are worth. The process of manufacturing and selling subprime debt led to the creation of a number of financial instruments with misleading credit ratings.

But he pointed out that improved risk management for mutual funds isn't as simple as condemning some of the new products. Frischling argues that it isn't that CDOs are bad, but how they are used that can present risk management challenges.

Lewis Altfest, president of financial advisory firm Altfest, said the next crisis that the asset management industry is likely to face will grow out of its exposure to leveraged buy-out debt purchased during the private equity boom of the last few years. "We're going into an economic downturn, and there will be defaults. It could hit the mutual fund industry as hard as the subprime crisis has," Altfest said.

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