Beware of Risk Everywhere: An Important Lesson from the Current Credit Crisis

Our current credit crisis is a result of the misunderstanding and mismanagement of risk. Exploring the tradeoff between risk and reward has been at the heart of the modem financial theories that have come to dominate our markets. As the capital markets introduced more and more complexity and innovation, most expected that the study of risk management and risk allocation was keeping pace, ensuring our ability to control and limit risk while maximizing reward. In this Article, the author addresses some of the fundamental misunderstandings of risk that have become deeply ingrained in our markets and have brought about the greatest economic downturn since the Great Depression.

The author discusses our general understanding of risk, including its limitations and explains the simplicity and complacency that came to characterize our risk models and risk managers. After exploring the limitations of linear models, including the Value at Risk model, and lamenting the lessons that market participants failed to learn following the Long Term Capital Management debacle, the Article highlights the miscalculations and missteps of Bear Stearns and other market participants. Finally, the author offers a warning for the legal profession. Groupthink and rigid adherence to formulae must give way-with a vigilance and a dogged determination to understand and measure client risks in their place.