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John Mack wants investors to know he feels their pain. But forget the bonus Mr Mack will forgo. The Morgan Stanley boss is lucky to hang on to his job after the bank disclosed a total writedown of $9.4bn for the quarter and its first ever loss. Yes, Morgan Stanley can point to other bits of the bank that are humming, such as wealth management. But so could Merrill Lynch, whose own mortgage writedown led to Stan O’Neal’s departure.
As for the writedown, it is jaw-dropping, even by subprime standards. A dozen or so traders laid on a position to offset the cost of shorting subprime. Had things worked out, the short could have netted the bank at most about $2bn. Instead, it cost the bank more than $7bn, as the traders’ correct hunch was overwhelmed by a deteriorating long position in top-rated collateralised debt obligation securities. How could that have happened?
There are two failings of risk management. The first is in the stress tests. Taking historical losses, even record ones, and magnifying them does not capture the once-in-a-lifetime crisis. Of course, Morgan Stanley was in good company. The reason it took such a big long position (about $14bn) to defray the costs of shorting was precisely the market’s view that such securities were so low-risk.
For investors, the main issue is the second failing – in the safety nets that can catch disastrous risk-taking in rare moments when models are irrelevant. This is not just about systems and processes. It is about culture and psychology; about when, for instance, you force traders to close out positions and take hits, even though they – and maybe most others – believe the trade will work out with just a bit more time.