If there's one lesson from the failure of Lehman Brothers, et al, it's that ignorance is not bliss and what you don't know can hurt you. This seems especially true when you're handling financial weapons of mass destruction. Because playing with WMDs is risky business, and miscalculating the risks can bring a multi-billion dollar business to its knees.
At the heart of the Wall Street woes is a basic failure to measure and manage risk. It started with subprime mortgage lending where banks and brokers sold mortgages on the back of very patchy data about the creditworthiness of the borrowers and their capacity repay. The flames of risky lending were fanned by mortgage-backed securities which brought more investors and fresh capital into the market. Investors may have known at a high level that these loans were risky, but with limited visibility into the details of the underlying loans the risks became more opaque. And then it went nuclear with derivatives.
Thanks to OTC derivatives such as credit default swaps (CDS), investors holding risky investments could shift the risk of default to someone else. And with attractive fees on offer for taking on those risks, the CDS market proliferated. It was a nice little earner, as long as you understood and managed the underlying risk. The problem was, many didn't.
And now, with about $62 trillion worth of credit default swaps sloshing around the market in a complex web of private contracts, the scale of the risk and where it falls is shrouded in a deep fog. Counterparties to Lehman CDS contracts are scrambling to understand the scale of their exposure and how to unravel the mess.
All of which begs the question. If players across the market had taken more care to capture reliable risk data, would the current mess have been averted? If lenders had tracked and monitored better data about their borrowers (was their salary verified or were they stretching themselves thin to flip a 2nd home), would they have avoided widespread mortgage defaults? If investors had better visibility into the quality of loans underlying mortgage-backed securities (did they all have zip codes in a bubble market like Florida) would they have avoided the junk and managed their exposure? If CDS players had better visibility into their rights and remedies across their portfolio of derivative contracts (what are the bankruptcy or termination triggers in every contract with Lehman) could they move more quickly in a time of crisis to manage and stem their counterparty risk?
In each case, the answer is yes.
But how do you get the visibility? One solution is to apply the magic of XML to portfolios of contracts. The basic mission of XML is that it can make whole documents visible and meaningful to machines. And not just a snapshot of high-level data. XML allows you to tag documents with meaning, right down to the fine print on page 42. Which means that you can tell a computer to crunch through a collection of contracts and find every non-standard termination clause or definition of "Event of Default" where Lehman Brothers is a counterparty. And computers can do this much faster than humans.
A similar desire for data visibility sits behind the SEC's requirement for large companies to submit financial reports using XBRL. Once again, XML provides the solution to a visibility problem.
Expect to hear much more about the need for visibility and transparency as the "nuclear winter" of the current financial crisis settles in. And don't be surprised if XML is at the heart of many new systems designed to lift the fog of financial risk.
Related Post: Bankers: Forget the Regulators, Focus on Risk