Risk management failures

- [Instructor] So, what is risk? Risk is the chance that something bad happens, or what we might describe as a negative event occurring. This event often ends up resulting in a financial loss or another negative outcome, such as a damaged reputation. Risk management is the process of controlling these risky events in order to minimize these negative outcomes. There are lots of different risks that a bank is exposed to, and in Chapter Two, we will provide a fuller definition of risk and describe the spectrum of risks that a bank or financial institution is exposed to. But I wanted to start by looking at a couple of real life examples of where a bank has failed or has been taken over due to not managing risk effectively. Let's start by going back in time to 2008. In January of that year, Lehman Brothers was one of the largest investment banks in the US. The previous year, in 2007, the bank had just booked a record profit of over $4 billion. The bank was deeply invested in mortgage-backed securities, or MBSs. An MBS collects lots of mortgages and pulls them together into something called a special purpose vehicle, or SPV. Investors can then invest in the MBSs and receive payments from the underlying mortgages. The issue in 2008 was that many of the mortgages in the MBSs were made to borrowers with low credit scores, making them much more likely to default and making many MBSs incredibly risky. These mortgages were called subprime mortgages. Lehman Brothers created so many MBSs that they couldn't sell them all and owned billions of dollars worth, which they recorded as assets on their balance sheet. A US housing crash, which started in 2006, but was largely ignored by banks such as Lehman Brothers initially, ultimately led to the value of these MBSs crashing. Banks wanted to avoid doing business with the Lehman Brothers, as its exposure to these subprime mortgages was well-known. As Lehman Brothers had to be able to do business with other banks in order to survive on a day-to-day basis, Lehman Brothers was forced to file for bankruptcy on September the 15th, 2008, with $619 billion in debt. Lehman Brothers had taken on too much risk through its MBS exposures. This excessive risk was enabled by the management team of Lehman Brothers, who encouraged an inappropriate risk-taking culture within the bank. In fact, the chief risk officer for Lehman Brothers between 2000 and 2007 has since been quoted as saying that risk management at the bank was repeatedly overruled. If you can remember that far back, Lehman Brothers wasn't the only banking crisis that year. Its small investment banking rival Bear Stearns in the US and Northern Rock, a savings and mortgage bank in the UK, were also victims of poor risk management. These banking failures were significant contributors to the global financial crisis of 2008, an event that is often referred to as the Great Recession.