“Wanted: A Counterparty Risk GUT”

In the world of astrophysics, scientists have long pursued a conceptual framework that would finally link the properties and behavior of all bodies and forces throughout the universe. In short, an explanation for how everything connects. The search for a Grand Unified Theory (GUT), as it’s known, has consumed the best and brightest minds for at least four decades. We need a GUT for counterparty risk – and the sooner the better.

One of the chief accelerants that helped ignite the credit crisis, from
which the smoke has yet to clear, was the inability of large financial
institutions (the ones that were too large to fail) to accurately identify
and assess counterparty risk. While the lion’s share of recent attention in the media focuses, understandably, on the forensics of directional bets made by a storied Wall Street institution, the topic of systemic risk remains above the treetops, just out of reach. Yet nowhere was systemic risk more evident than in Wall Street’s inability to accurately identify its counterparty risk.

In its attempt to legislate away any threat of another credit crisis like
the one we’re still wading through, Sen. Chris Dodd’s Senate Committee on Banking has proposed creating something called the Financial Stability Oversight Council, which would in turn create a new Office of Financial Research, within Treasury. The OFR would be staffed with a “highly sophisticated staff of economists, accountants, lawyers, former supervisors, and other
specialists” who would collect financial data and conduct economic analysis with the goal of monitoring emerging risks to the economy. Setting aside the enormity of data aggregation and analysis being proposed, the fact that this information would be made public in “periodic reports and testimony to
Congress every year” underscores the lack of immediacy being brought to bear. The OFR would be looking at much more than CP risk. But the idea of isolating CP exposure alone makes BP’s Gulf oil clean-up look like a case of spilled milk.

Why is it so difficult to identify counterparties, to know who I’m
literally dealing with? (Some 94% of pre-crash structured products were rated AAA!) This was a notable topic during a Q&A at a panel
discussion, “Counterparty Risk Management – The Road Ahead,” hosted by Sybase last month. Nawal Roy, Managing Partner of Shobhit Capital Group, pointed out that institutions in September 2008 mistook the macro picture
for the micro picture.

At ground level (where risk becomes reality) assessing CP risk entails
peering through a dense forest of individual relationships, partial ownerships, and multi-named entities operating in various legal jurisdictions. “When you roll it up, it’s flawed and extremely complicated,” Nawal said. “The number of trading entities at a Lehman or AIG is simply staggering.”

Assigning a quantitative value to systemic risk starts with the quality of the data. We’ll need more than one Einstein to do that.

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