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Risk Control Management and Sub-prime Mortgage Crisis

The economic environment in which companies compete today has changed dramatically, presenting new challenges and opportunities for executives and managers. As the global marketplace continues to expand, so do exposures risks. With the world business environment changing so rapidly, companies often have an incomplete understanding of the risks they may face.

The strategies and instruments available to help companies manage financial exposures are numerous, but carry their own set of challenges and risks. Companies that are forward thinking in risk management identify and manage financial exposures and provide the necessary reporting and control mechanisms to avoid risk. Well-managed risk programs help put companies on an equal footing with international competitors by reducing exposures associated with constantly changing world.

2.0. Introduction

The underlying premise of risk management is that every entity exists to provide value for its stakeholders. All entities face uncertainty and the challenge for management is to determine how much uncertainty to accept as it strives to grow stakeholder value.

Uncertainty presents both risk and opportunity, with the potential to erode or enhance value. Risk management enables management to effectively deal with uncertainty and associated risk and opportunity, enhancing the capacity to build value.

Value is maximized when management sets strategy and objectives to strike an optimal

balance between growth and return goals and related risks, and efficiently and effective deploys resources in pursuit of the entity’s objectives.

2.1. Explanation of risk

Denenberg defines risk as “uncertainty of loss” this is almost identical to Mehr and Commeck as they said “uncertainty about loss” also Green defines risk as “uncertainty as to occurrence of economic loss”. While Knight defines risk as “measurable uncertainty” The common sense of these definitions is to quite risk with uncertainty.

So we can explain risk the combination of a specific hazard and the likelihood that the hazard occurs (probability)x(hazard) = risk. That likelihood may be expressed as a rate or a probability. For example the risk of an aircraft accident (hazard) can be expressed as one accident per million flights (likelihood).

Risk can be objectively explained so that two people can take the same data and come up with a similar result. Risk can be expressed in many ways, so long as it combines a hazard with likelihood. The concept of risk exists in aviation, finance, human health, and many other areas. One can use the methods of science, engineering, and math in order to define risks.

2.2 Risk can be measure

According to Mathie K,these are a four-step procedure to measure and manage firm’s risk.

1) Standards and Reports

The first step of these measure techniques involves two different conceptual activities, i.e.,

standard setting and financial reporting. They are listed together because they are the sine qua non of any risk management system.

Underwriting standards, risk categorizations, and standards of review are all traditional tools of risk measure. Consistent evaluation and rating of risk is essential for management to understand the true embedded risks in the portfolio, and the extent to which these risks must be mitigated or absorbed.

The standardization of financial reporting is the next ingredient. Obviously, outside audits, regulatory reports, and rating agency evaluations are essential for investors to gauge asset quality and firm-level risk. These reports have long been standardized, for better or worse. However, the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. Such internal reports need similar standardization and much more frequent reporting intervals, with daily or weekly reports substituting for the quarterly GAAP periodicity.

2) Position Limits and Rules

A second step for internal control of active management is the establishment of

position limits. These are imposed to cover exposures to counterparties, credits, and overall position concentrations relative to systematic risks. In general, each person who can commit capital has a well defined limit. This applies to traders, lenders, and portfolio managers. Summary reports to management show counterparty, credit, and capital exposure by business unit on a periodic basis. In large organizations with thousands of positions maintained and transactions done daily, accurate and timely reporting is quite difficult, but perhaps even more essential.

3) Investment Guidelines

Third, investment guidelines and strategies for risk taking in the immediate future are outlined in terms of commitments to particular areas of the market, the extent of asset-liability mismatching or the need to hedge against systematic risk at a particular time. Guidelines offer firm level advice as to the appropriate level of active management – given the state of the market and the willingness of senior management to absorb the risks implied by the aggregate portfolio. Such guidelines lead to hedging and asset-liability matching. In addition, securitization and syndication are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with management’s guidelines. These transactions facilitate asset financing, reduce systematic risk, and allow management to concentrate on customer needs that center more on origination and servicing requirements than funding position.

4) Incentive Schemes

To the extent that management can enter into incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, the need for elaborate and costly controls is lessened. However, such incentive contracts require accurate position valuation and proper cost and capital accounting systems. It involves substantial cost accounting analysis and risk weighting which may take years to put in place. Notwithstanding the difficulty, well designed compensation contracts align the goals of managers with other stakeholders in a most desirable way. In fact, most financial debacles can be traced to the absence of incentive compatibility, as the case of deposit insurance illustrates.

3.0. Factors to be consider in formulating policies for risk control management

As Lancaster (2003) recommended financial institution must consider in formulating policies in their risk control and management:

Systematic risk: is the risk of asset value change associated with systemic factors. As such, it

It cannot be diversified completely away but can be hedged. Therefore, systematic risk can be as undiversifiable risk.

Financial institutions face this risk whenever a assets owned claims issued can change in value as a result of economic conditions. Systematic risk comes in different forms. Example, as interest rates change, different assets have somewhat different and unpredictable value responses. Energy prices affect transportation firms' stock prices and real estate values differently. Large scale weather effects can strongly influence both real and financial asset values for better and worse. These are a few types of systematic risks associated with asset values.

Some financial institutions decompose systematic risk more finely. Institutions that have

Substantial balance sheet reactions to specific systemic changes may try to estimate the impact of these particular systematic risks on performance, attempt to manage them, and thus limit their sensitivity to variation in these undiversifiable factors. Accordingly, many institutions heavily involved in the fixed income market attempt to track interest rate risk closely and more rigorously than those that have little rate risk in their portfolios.

They measure and manage the firm's vulnerability to interest rate variation, even though they cannot do so perfectly.

Credit risk arises from non-performance by a debtor. It may arise from either an inability or

an unwillingness to perform in the pre-committed contracted manner. This can affect the lender who underwrote the contract, other lenders to the creditor, and the debtor's own shareholders. Credit risk is diversifiable but difficult to hedge perfectly. This is because most of the default risk may result, in fact, from the systematic risk outlined above. The idiosyncratic nature of some portion of these losses, however, remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty.

Counterparty risk comes from non-performance of a trading partner. The non-performance

may arise from a counterparty's refusal to perform due to an adverse price movement caused by

systematic factors, or from some other political or legal constraint that was not anticipated by the

principals. Diversification is the major tool for controlling nonsystematic counterparty risk Counterparty risk is like credit risk, but it is generally considered a transient financial risk associated with trading, rather than a standard creditor default risk associated with an investment portfolio.

Operational risk is associated with the problems of accurately processing, settling, and taking

or making delivery on trades in exchange for cash. It also arises in record keeping, computing correct payment amounts, processing system failures and compliance with various regulations. As such, individual operating problems are small probability events for well-run organizations, but they expose a firm to outcomes that may be quite costly.

Legal risks are endemic in financial contracting and are separate from the legal ramifications of credit, counterparty, and operational risks. New statutes, court opinions and regulations can put formerly well established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future. For example, the bankruptcy law enacted in 1979 created new risks for corporate bondholders. Environmental regulations have radically affected real estate values for older properties as well. A second type of legal risk arises from the activities of an institution's management or employees. Fraud, violations of securities laws, and other actions can lead to catastrophic loss, as recent examples have demonstrated.

All financial institutions face these risks to some extent. Non-principal, or agency activity

primarily involves operational risk primarily. Since institutions in this case do not own the underlying assets in which they trade, systematic, credit and counterparty risk accrues directly to the asset holder.

If the latter experiences a financial loss, however, legal recourse against an agent is often attempted. Therefore, institutions engaged in only agency transactions bear some legal risk, if only indirectly.

Principals must weigh both the expected profit and the various risks enumerated above to assure stockholders that the result achieves the stated goal of maximizing shareholder value.

4.0. Sub-prime mortgage crisis and its role in the financial crisis

In early 2007, the term “subprime mortgage crisis” became widely used to describe the deterioration of the U.S. mortgage market, and losses from mortgage backed securities and collateralized debt obligations backed by subprime mortgages.

The United States economy was confronted with many challenges catalyzed by the property bubble bust. The collapse of real estate prices has resulted in unprecedented losses and bankruptcies of hedge funds, mortgage lenders and banks and has led to unnerving uncertainty on Wall Street and global financial markets. The epicentre of this economic weakening are subprime mortgages which are highly risky mortgages issued to borrowers who could not qualify for ordinary or prime mortgages due to low incomes or bad credit history. Most subprime mortgages have adjustable interest rates, with initial fixed low interest rates for two years and then higher rates that are reset every six months based on a benchmark interest rate such as the London Inter-bank Offer Rate (LIBOR). Low interest rates and excessive risk-taking by many weakly supervised financial institutions eager to grant loans largely contributed to a sharp increase in subprime mortgages from 2.4 per cent of total mortgage loans in 2000 to 13.7 per cent in 2006. This, in addition to increased speculative demand, pushed up house prices by 80 per cent during that period, an increase only observed in the immediate post-World War II period.

The rapid appreciation in house prices brought about steep realization of equity from properties which stimulated consumer consumption that makes up a massive 72 per cent of United States GDP. Consequently net equity extraction from residential property spiked from 3per cent of disposable income in 2001 to 9 per cent in 2005.Once interest rates began to reset, mortgage payments increased – in some cases by 30 per cent – to amounts that many borrowers could no longer afford. By January 2008, the rate of delinquency on subprime mortgages had risen to 21 per cent. The drastic increase in housing inventory, followed by sizeable reduction in house prices, gave rise to negative equity for both subprime and prime homeowners. Being the main asset of most households, the collapse of the price of houses has had a significant negative wealth effect, which will undoubtedly reduce consumption significantly.

4.1. The role of sub-prime mortgage in the global financial crisis

Leonnig, Carol D. (June 10, 2008). Stated the immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006.High default rates on "subprime" and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to be a key factor in the global economic crisis, because it drains wealth from consumers and erodes the financial strength of banking institutions.

In the years leading up to the crisis, significant amounts of foreign money flowed into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds combined with low U.S. interest rates from 2002-2004 contributed to easy credit conditions, which fueled both housing and credit bubbles.

5.0. Conclusion

Risk has been part of everyday life for as long as we have been on this world.

While much of the risk humans faced in prehistoric times was physical, the development

of trade and financial markets has allowed for a separation of physical and economic risk.

Investors can risk their money without putting their lives in any danger.

The definitions of risk range the spectrum, with some focusing primarily on the

likelihood of bad events occurring to those that weight in the consequences of those

events to those that look at both upside and downside potential., Consequently, risk provides opportunities while exposing us to outcomes that we may not desire. It is the coupling of risk and reward that lies at the core of the risk definition and the innovations that have been generated in response make risk central to the study of not just finance but to all of business.

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