ANDREW ROSS SORKIN - ESSAY


IS THERE MORE or less risk on Wall Street today?

If “greed is good” was Wall Street’s unofficial motto of the 1980s, the mantra these days might be “risk is bad.” It’s a calming phrase after a frightening year - but it glosses over several important ideas that make the Street run.

We’ve already seen a world where no one wants to take risks. It was September 2008, when banks stopped lending to other banks for fear they wouldn’t be repaid the next day. Hearing speculation about a potential collapse, clients pulled their money from well-established investment banks, helping to turn rumors of trouble into reality. Commercial paper, the workaday stuff that lets companies make payroll, was suddenly viewed as radioactive - and business activity almost stopped in its tracks.

In a twist of logic, a year after Lehman Brothers tumbled into bankruptcy protection, we should all be rooting, at least to some degree, for financial institutions to become, yes, more risky.

President Obama seemed to acknowledge as much recently in his speech to Wall Street executives, saying, “For a market to function, those who invest and lend in that market must believe that their money is actually at risk.”

Still, Mr. Obama added, “Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall.”

Of course, too much risk is just as bad. Just ask the financial wizards at American International Group who ended up on the wrong side of tens of billions of dollars in financial contracts, almost bringing down the world’s biggest insurer.

But now that the crisis has subsided it’s important to avoid an overly simplistic view of risk and the financial system. After all, the least risky place for money is under a mattress. But economies don’t work well if everyone puts it there.

In conversations with Wall Street chiefs, regulators and economists, a more nuanced view of risk emerges.

What’s the state of risk today? There’s some good news, and some bad.

Without question, the markets have stabilized, and there doesn’t appear to be another Lehman Brothers (or Merrill Lynch or any other bank) on the horizon as a potential trouble spot at the moment. Those that could spell problems - like Citigroup and A.I.G. - have clearly already been identified.

Hedge funds have also been forced to reduce the amount of leverage, or debt, that they use to magnify their profits (or losses) because banks just won’t lend them nearly as much money. Private equity firms have been forced to do the same - preventing them from overpaying, or in some cases, paying at all, for investments, though there are early signs the market may be coming back. Without access to credit, corporate boards too have avoided big, expensive mergers and acquisitions, save for a handful of exceptions.

Simon Johnson, a professor at Sloan School of Management at Massachusetts Institute of Technology, who has made a strong case about excessive risk in the financial system and what he believes is a perverse incentive system, actually thinks Wall Street has become much more prudent, at least for now.

“Back-to-back financial crises are rare; people are more careful,” he said. “We’re in something like 2004-2005 when it comes to risk. But we’ll get back up there.”

Perhaps the greatest measure of risk - and in this context, let’s define it as risk to the entire system - is one word: leverage.

There was just too much debt being piled up on top of bad bets. And that has come down.

But by other measures, there are still parts - actually large areas - of the financial services industry that are still taking risk. Lots of it. More than last year. And often for themselves (as opposed to for consumers and clients).

A brief glance at a metric known as VAR or “value at risk,” which ostensibly measures the amount of money an institution could lose on any given day or week, shows that at some firms that number is way up. At Goldman Sachs, for example, the firm’s value at risk has risen from $240 million in the first quarter to $245 million. But the bigger leap is from February 2007, just a month before Bear Stearns was sold to JPMorgan Chase, when Goldman’s VAR stood at only $127 million. As a result, in part, it has recorded some of its most profitable trades in its history.

Even though Goldman is now a bank holding company, arguably with more regulatory oversight, the firm’s chief financial officer, David Viniar, told Bloomberg News, “Our model really never changed.”

In the immediate term, that may be just fine as Goldman has proved again and again that it appears to know how to “manage risk” better than its peers. But in a business that is somewhat akin to gambling, it is not impossible to believe that the firm’s lucky streak could one day run out.

On the other hand, Morgan Stanley, Goldman’s rival, has gone the opposite direction. The firm drastically scaled back its risk-taking, worried that it could overreach. But, oddly enough, it did so at its own peril. While Goldman was gaining money by taking more risk, Morgan Stanley was losing money by sitting on the sideline.

VAR, by the way, is a horrible way to measure risk, as has been said again and again by economists, because it calculates the risk for only 99 percent of the time.

As Mr. Johnson says, “VAR misses everything that matters when it matters.” Indeed, the VAR metrics obviously missed what led to what now has been dubbed the Great Recession.

Some analysts say that Wall Street has become much more prudent, but risk takers are necessary for the financial system to function.