The lessons of the losses experienced by Lloyd’s of London in the 1980s were overlooked by banks embroiled in the subprime crisis, who recklessly issued vast amounts of collateralised debt obligations. By Chris Skinner.

With the subprime crisis causing bank foreclosures and jitters around the world, I guess the obvious question is why did the banks not see it coming? My answer is that the spread of collateralised debt obligations (CDOs) hid the risks.

According to a paper written in February by Joseph Mason of Drexel University and Joshua Rosner of Graham Fisher, there were hardly any CDOs in 1995 but their value had risen to more than $500bn by 2006, of which 40% were backed by residential mortgage and almost three-quarters of those were in subprime.

CDOs allowed the banks to lay off more risk to others, and were created specifically as a complex credit derivative to allow greater lending liquidity. As a result, banks could lend excessively and relax their credit risk control measures to a large extent by laying off the risks to other banks and corporates through CDOs.

The fact that these risks were minimised through collateral (a house) that was worth more than the loans meant there was no problem, apart from a housing price boom that did not exist and was fuelled by such lending practices.

This is fool’s folly and we are now seeing the consequences.

And we have seen it all before, as this crisis has great similarities with the Lloyd’s of London insurance losses in the 1980s. The Lloyd’s crisis began because it took on risk and thought it had it covered by reinsuring it out of the markets to others. What Lloyd’s did not know, until disaster hit, was its total exposure across the markets. Then a range of major asbestosis and pollution claims came in from the US, combined with natural disasters such as Hurricane Betsy and Piper Alpha. Lloyd’s suddenly found that its total risk exposure was massive.

What had happened is that each time the market reinsured risk outside, the reinsurance would eventually come back into the market elsewhere. Therefore, whereas Lloyd’s might believe its total exposure to a single risk was small, the pieces of that risk had left the markets and then returned in a different form with a different underwriter. Hence, the whole risk was hidden.

Then several disasters all happened at once, and Lloyd’s realised its exposure was not just for one or two risks, but for several that over-lapped and were inter-related. In other words, Lloyd’s exposures due to these disasters meant that one market was covering virtually the whole world’s risks. That is an awful lot for a small market, and almost meant it collapsed.

But Lloyd’s got through it. A few syndicates collapsed. Others learnt their lessons and now have systems that look at risk across the whole market, rather than on an exposure by exposure basis.

Banks will do the same, eventually.

Banks will realise that moving risk out through their investment desk’s derivatives operations only makes sense if it does not come back in the other door by taking on huge risks backed by those very same derivatives.

The problem for tomorrow will be: how will the banks ever get to the stage of seeing the total risk across all of the markets and all of their operations?Chris Skinner is an independent financial commentator (www.balatroltd.com).

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter