Declining real estate prices, accompanied by skyrocketing mortgage delinquency and foreclosure rates have illuminated a pattern of flawed risk underwriting in the subprime market, and similar problems have now come to light in the credit card and leveraged debt markets. They will certainly affect the equipment leasing business as well.

Moody’s reports, for instance, that combined “leveraged” bond and loan defaults for January/February were at $7.4 billion, compared to the $4.2 billion and $8.5 billion for all of 2007 and 2006, respectively. Aspects of today’s crisis are reminiscent of factors analyzed in the Alta Group’s 2001 study of leasing industry problems that all occurred simultaneously in the late 1990s, ”The Perfect Storm.”

So far, financial institutions have recognized more than $200 billion in write-downs, with more to come, while the market sharply adjusts its risk/reward equation.

Three major things are happening now: first, recognition of recent underwriting errors; second, a tactical adjustment to risk/reward balance; and third, efforts by regulators to maintain an even keel in the financial markets and economy, while driving changes to prevent future problems.

The news is dominated by multi-billion dollar write-downs, large scale rating downgrades, increasing defaults, failures of financing firms and the exit of senior executives and thousands of less fortunate staff from many financing institutions. The Federal Reserve, U.S. Treasury and other central banking authorities are scrambling mightily, on the one hand, to prevent further damage to the banking system, while on the other hand, they are encouraging banks to continue lending to prevent economic contraction.

Recognition
The “recognition” of underwriting errors will likely continue for another few quarters, and will get lots of media attention — 
witness the $100 billion to $150 billion plus of write-downs announced by such financial giants as Citibank, UBS and Merrill Lynch, often accompanied by announcements of capital replenishment from foreign sources at the expense (dilution) of current shareholders. Effectively bankrupt household names like Bear Stearns and Countrywide are going through painful acquisitions by stronger players. Estimates of total losses for the banking industry range up to $300 billion.

Market Adjustment
The risk/reward adjustment, underway since the third quarter of 2007, involves increasing credit spreads, tightening of terms and the return to tougher standards for weaker credits. Generally, lenders have a reduced appetite for the aggressive credit deal.

In late March, credit spreads [i.e., basis point (bp) difference from comparable duration U.S. Treasury obligations] are up about 300 bp from the end of 2006 for BB credits, and nearly 500 bp for B credits. These spread increases will more than offset base-rate reductions in Fed Funds, LIBOR and Prime.

Furthermore, traditional protective covenants for lenders/lessors are making a comeback, after being severely diluted over the past several years. The Fed’s survey of chief credit officers for fourth quarter 2007 showed a sharp increase in the percentage of banks reporting tighter terms and conditions for their customers.

Regulatory Reaction
Finally, the Fed, Treasury and other central bank authorities have been vigorously pumping liquidity into the system, reducing rates and intervening directly in specific instances to prevent key institutional failures (e.g., Bear Stearns). Beyond protecting the viability of the banking system, regulatory authorities are quite concerned about an overreaction by lenders, now uncertain of the financial terrain and in some cases preoccupied by internal priorities to rapidly get their house in order. They may become too restrictive, choking off credit, even for worthy companies that could otherwise sustain economic growth even in an economic downturn.

What can our industry learn from these events and how can we better protect ourselves in the next cycle? First, some perspective — while the intervals vary, roughly every five to six years there is a significant “debacle” in the credit markets:

Each event had its own story with different sets of contributing factors. However, these episodes all exhibited a common characteristic: the gradual discounting of basic risk management, leading to severe underestimation of potential losses, which in turn drove down risk pricing and conditions.

In the current episode, among the key drivers for this degradation of risk management were:

These factors caused many institutions to reduce the role of risk management in their business: minimizing risk-oriented input into the strategic direction process, under-investing in risk tools, reducing staff and executive development, and isolating senior management from the risk assessment process.

The result: big surprises and big losses!

How Can We Get Ready to Better Handle Risk in the Next Cycle?
First, view risk management as an integral partner in the business, not just a necessary control function to be dialed up and down as the market changes. Successful companies tend to keep risk management in a “fixed” position in its corporate priorities. The function provides constant and credible input to business strategy formulation, is manned by competent and upwardly mobile staff and executives, and is kept high on the priority list for IT investment dollars.

Assure that there is a robust risk infrastructure — credit policies in synch with business direction, well-defined and documented processes, active portfolio management and constant feedback to the business.

As a specific policy point, traditional concentration management for companies, industries and countries should now also include “product” and line of business.

Second, make sure there is direct and detailed involvement by the senior management in the design and operation of the credit function. This must go well beyond the normal adjudication of disagreements between credit and marketing. Assure that senior management knows, in detail, the mechanics and risks of credit products being booked, the profiles of segments and industries being entered, and the financial health of its major customers.

Delegation schedules should force some reasonable percentage of deals up to the top to assure that senior management is “in touch” with deal flow. While it may be old-fashioned, having the top executives of a bank or finance company meet at least weekly to actually review and approve deals (not just ratify) could pay big dividends.

Senior management should also, on a regular basis, step back and look at market conditions, pricing, terms, etc., and make an experienced judgment on whether the risk/reward balance is correct for the business. Financing execs with 15-25 years experience, and who have lived through previous unpleasant episodes might make a different judgment than the three- to ten-year deal manager or executive. Experience is invaluable, but only to the extent it is utilized.

Third, foster an attitude on your team that takes full responsibility for the risks it takes. Recent problems with some major banks and rating agencies are a useful reminder that a lead bank/sponsor or agency rating is simply input to what should be your own organization’s analysis and decision, not a substitute for your own independent understanding of the risk.

Joseph N. Boland is the principal responsible for The Alta Group’s risk management practice and has 38 years of experience in financing and risk management. He has spent 20 years in the banking industry at the Bank of New York and then UBS, and more recently spent 16 years at IBM Corporation as chief credit officer for the company and its financing subsidiary, IBM global Financing. Boland may be contacted at 914-533-7007 or by e-mail at [email protected].

The Alta Group successfully advises clients on effective ways to manage their own risk/reward equations by helping them to building a robust risk-management infrastructure that will prepare them for future challenges. From policy development, process design, portfolio management, systems, controls and executive training, its objective is to increase shareholder value by making risk management an integral part of a business. Alta is involved in the design and implementation of such frameworks to ensure long-term returns.