Bob's Daily Buzzword: `Wrong Way Risk'

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July 16 (Bloomberg) -- Bob Rice, general managing partner with Tangent Capital Partners LLC, explains "Wrong Way Risk." (Source: Bloomberg)

From capital partners, ron, we know that you, as bank regulators, want to impose new regulations, so with that in mind, what is this?

It is a very difficult risk, a very dangerous risk as we saw in 2008, and subsequently, and it refers to the quality of a counterparty.

It goes down while your exposure to that particular counter party is going up, so both things are moving the wrong way at the same time.

During a crisis, aig and the housing meltdown, can we pull out an example?

That is the classic, a classic example.

What is happening is these investors are sitting on them, and on the one hand, there is a guarantee.

When they look at the guarantee, two things are to about it.

They say, a, it has got a fantastic credit rating, so we do not have to worry about it, and, b, they had an underlying asset, so they did not think they had any risk there.

But then the underlying risk starts to come in.

You need that guarantee, and suddenly, you have a big exposure to the guarantor's, and their risk is increasing precisely for that same reason.

So that exposure and risk of default both moving higher at the same time.

Exactly, and almost all of these risk models treat these as independent variables.

You have got one bucket that says a and one bucket that says b, but they are not looking at them blowing up together.

When this really tends to bite you is when things like that happen, when very highly rated institutions lose their credit rating, or highly secured traunch as.of debt instruments start to get into trouble.

What are regulators trying to do to mitigate some of the risk?

One of the things that has really exacerbated the risk is the development and expansion of the derivatives market, so one of the things that is helpful is to have these clearing houses that are sitting in the middle.

That is one idea.

And another thing we talked about earlier this week is to get away from this idea that you have your risk adjusted levels of capital inside of the banks.

Instead of looking at every risk by the type of risk, go to a more simple model that takes all of your risks into account at the same time.

This brings up this bigger picture issue of how hard it is to manage or at least to evaluate the risk.

What this really proves is nobody has developed an algorithm to see the future yet, and we cannot model all of the possible risks just by looking backwards at the previous history.

It will happen, as bill gates said, carbon based pets.

Thank you very much, bob, as always.

This text has been automatically generated. It may not be 100% accurate.

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