Chapter 17
Case Studies Introduction
INTRODUCTION
This part of this book, which consists of this short introductory chapter and the next five chapters, examines major cases involving some form of operational failure. While success is always preferable to failure, it is often easier to learn important lessons from an examination of failure than from an examination of success. In the following chapters, we will look at a total of eleven cases that have been logically grouped based on some commonality. Specifically, we will look at mortgage case studies, derivatives case studies, fixed income case studies, funds case studies, and credit derivatives cases studies.
At the core of these case studies is the concept of fiduciary duty. Financial institutions are obligated to put client interests above their own. This holds true in both the retail and the institutional sectors and includes the selling of mortgages; providing advice to mutual, pension, and government funds; and executing trades on behalf of others. There is no other industry, with the exception of health care, that is obligated to put a client's interests above its own. For example, when a consumer buys a computer from a computer company, there is no obligation to sell “the best computer at the best price” in the same way that a brokerage is obligated to “execute the best trade at the best price.” It is, of course, good business practice on the part of the computer manufacturer to provide the best computer at a competitive price, but there is no fiduciary duty, as mandated by laws and regulations, to do so.
A variety of operational risk issues surface in the series of case studies we examine, but fiduciary duty as an obligation can be found at the heart of most of them. Countrywide Financial, for example, had a duty to sell the most suitable mortgage to its retail clients at the best interest rate available. Once the firm started relying on securitizing mortgages, however, its business model changed to one that favored volume over creditworthiness. The securitization of its mortgage originations moved the credit risk off the books of Countrywide. Once freed of credit risk, the company then concentrated on initiating a high volume of subprime mortgages that were favored in the secondary markets because they had higher payoffs. As Countrywide financed an ever-growing proportion of its lending business from the securitization market, it no longer placed the interests of its retail clients, and what mortgages were most suitable for them, first.
The board of the state of Florida's money market fund compromised its fiduciary duty to the state and its employees and citizens when it shifted how it compensated portfolio managers. Its money managers were given pay incentives in exchange for bringing in above-average returns. This led the money managers to purchase instruments that would act as kickers in their portfolios—specifically, mortgage-backed securities (MBS). The problem with this strategy is that providing incentives to money managers to increase yield led to investment in riskier securities, while the mandate of the fund was to have cash on hand to finance government business. When the mortgage-backed securities market froze up, the fund no longer had this ready source of cash and the money managers had compromised their mission to manage the funds with a low-risk strategy that afforded ready access to cash.
Unauthorized trading events are often triggered by the behavior of traders who sustain losses from one trade and then find themselves in a downward spiral in an effort to trade their way back to profitability. This behavior, while possibly inherent in the personality profile of traders in general, is able to express itself as a result of control factors that are not functioning properly. Such outsized trading misdeeds often occur in environments that tolerate breaches of trading limits, and where management often does not take a long, hard look at where profits are coming from. This lax control environment, which often exists in organizations that experience such large unauthorized trading events, results in a breach of fiduciary duty to the bank's clients, employees, and, most importantly, shareholders; it is the shareholders who are last in line when an institution suffers a liquidity crisis and who often are left with the largest losses.
The concept of fiduciary duty to shareholders is key in all organizations but becomes especially important in financial organizations. This is because a financial institution must have the courage to resist entering sectors or engaging in practices that could put it at risk for regulatory or client troubles later on. Financial institutions that enter into questionable market practices because of pressure to bring in certain returns also put shareholders at risk if they find themselves with large losses later on, due to conflict of interest, regulatory violations, and a failure to put client interests first. It takes a strong management to say, “We don't like this practice, and we, as an institution, are not going to engage in it,” when such a practice is earning great returns for its competitors. That very same management, however, will be in much better shape to weather the next tide of market practice investigations or market turmoil than its competitors. And it will have much happier shareholders and stakeholders of all types.
Finally, all of the outsized case studies provided have another key element in common: They occurred during periods of market volatility and at the end of periods of exuberance when controls may have become especially lax. The operating environment of financial institutions often becomes more fluid during boom times, and high-risk activities are more readily tolerated. There is a credit risk maxim that says that mistakes are made during good times rather than bad times. All of these cases involve certain control oversights, and a certain amount of hubris, associated with the amount of profits that could be made without regard to the associated risk, which ultimately ended up costing the institutions close to everything they owned. Again, it takes an act of courage for management to take a step back and make sure its controls are functioning during the good times. Markets are cyclical and, ultimately, the goal of a financial institution should be to have the resilience to survive tough times.
ABOUT THE AUTHOR
Penny Cagan is a managing director with the Operational Risk division of Algorithmics/Fitch Group. She has over 25 years’ experience in the field of financial services research. She currently manages the First and Opdata operational risk loss event databases and is head of research for the group. She has published numerous articles on the topic of operational risk in Risk magazine, Operational Risk newsletter, Futures and Options World (FOW), and the John Liner Review. She is a highly regarded and frequently requested speaker on operational risk and has given many keynote presentations on the topic.
Penny developed the case study approach to operational risk based on external events, and was the first person to go to market with an operational risk case study database. She has established the best practice standard for examining and analyzing case studies and has managed the First database for the past seven years under three different owners. Earlier in her career, she served as head of research for Deutsche Bank's North American Business Information Services division and as head of reference services with PaineWebber's investment banking division.
Penny holds an MLS in library science and a BA and MFA in English literature and creative writing.