Bankers Still Oblivious to the Concept of Risk

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Five years after Countrywide, one of the nation's largest subprime lenders, hemorrhaged losses and was fire-sold to Bank of America , former CEO Angelo Mozilo remains charismatic, confident, and mostly clueless. 

"I have no regrets about how Countrywide was run ... we were a world-class company in every respect," Mozilo allegedly stated under oath last year, according to Bloomberg. He went on (quoting from Bloomberg): The crisis was "not caused by an act of Countrywide," said Mozilo, 73, according to a transcript of the deposition.

This is all about an unprecedented, cataclysmic situation, unprecedented in the history of this country. Values in this country dropped by 50 percent.

Angelo, buddy. Can we talk about risk for a second?


You're right that we experienced an event "unprecedented in the history of this country." But that applies to more than the collapse in housing prices. It also describes the absurdity of housing prices during the bubble, when Countrywide was lending money hand over fist.

Yale economist Robert Shiller began tracking nationwide home prices years before the housing bubble burst. Better yet, he created an index of inflation-adjusted home prices going back to the 19th century, which he included in his 2004 book Irrational Exuberance. Here's how that index looked up until 2006:

How curious it is, Angelo, that you are so attuned to the historic significance of the housing crash, but didn't seem to notice the equally historic housing bubble last decade. Funny how perspective and insight tends to be different when your paycheck is attached to loan growth.

Now, let's assume the housing bubble wasn't obvious. (It was, but let's assume). How does that change your culpability as a lender who made loans to people who couldn't pay them back?

Not one bit.

There are two elements to risk: The odds of an event occurring, and the consequences of that event. If an event is very rare but extremely destructive, you have to multiply those two forces together so that the risk is still taken seriously, even if you think it's unlikely to occur. If I offered you $1 million to play Russian Roulette with a gun that had nine empty chambers and one bullet, you would probably refuse to play. Even though the odds of death are just 10 percent, death is such a serious event that it's not worth the risk.

It's the same with banking risk. Even if the odds of a 50% slide in home prices were low, the impact on your business -- failure -- was so severe, that you couldn't ignore it. Yet, you did.

There's a long history of this ignorance of tail risks. Nassim Taleb recently told The Motley Fool:

All of these people end up blowing up. They say, "Oh, I only lost money once!" Like CitiBank in 1982. They blew up, lost everything made in the history of banking, but they said "You know, we only had one down quarter!" And it happens to them again, of course, in 2007 and 2008.

Or, as Robert Rubin put it in his 2003 memoir:

There is one type of financial risk, the risk of remote contingencies -- which, if they occur, can be devastating -- that market participants of all kinds almost always systematically underestimate. The list of firms and individuals who have gone broke by failing to focus on remote risks is a long one.

Angelo, you've been added to that list. (Rubin was, as well, coincidentally.) That you continue to deny it only proves your tendency toward willful blindness to reality. Which actually explains a lot about Countrywide's fate. 

The article Bankers Still Oblivious to the Concept of Risk originally appeared on Fool.com.

Fool contributor Morgan Housel has no position in any stocks mentioned. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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