Confessions of a risk manager is a classic article in Economist published around Aug 2007 before all the hell broke loose. This is my second reading of the article after it was published. Looking back now the risk manager’s concerns seem to be justified.

CDOs sat uncomfortably between credit and market risk. In the end no one took ownership for the risks. Credit risk department thought they should be part of market risk as the CDOs sit in trading books. Market risk department thought it should be part of credit risk as they were basically loan instruments.

Risk managers assumed that there is no risk in AAA and AA rated instruments. Their focus had always been on non-investment-grade instruments. They allowed the business managers to hold the investment-grade instruments in their books but insisted that all lower rated instruments are sold to third parties. In the end even the AAA rating was not good enough.

Liquidity is assumed to be always there. Risk managers always thought that should some CDOs be downgraded they can always be sold.

Rating agencies were trusted to be the best at assessing risks and no one doubted their ratings.

Risk managers and the business managers were always at odds. There were often culture clashes. Risk managers were seen as spoilsports. There is constant pressure from the business managers to “let the deals happen”. Often risk managers themselves aspired to traders and that exacerbated the problem.

Finally the bank’s balance sheets started carrying huge CDO positions. Even slight change in prices could create large mark-to-market losses. That was what finally happened in September 2008.