We have been hearing quite a bit about the ponzi scheme that was created and managed by Bernie Madoff. Almost $50 billion dollars was taken from those that were considered to be sophisticated and definitely not the typical type to be scammed. So, what created the environment that allowed such large sums of money to be lost in such a basic con game as a ponzi scheme? I believe there are a few basic factors that prompted these seemingly sophisticated people to invest in this ill-fated “investment.”
- A strong desire to generate investment returns when the typical channels were not delivering.
- The reputation(s) of the existing client list — If they invested why shouldn’t I?
- The thought that if it paid off with smaller dollar investments, just think what could be made with larger dollars!
Hmmm! Sounds like how we got ourselves into today’s credit situation. Basically, we were distracted by the items noted above and ignored the warning signs.
Putting the items above into credit industry terms it can be summed up as follows:
- We have to continue to grow and we are pressured to find more opportunities. If we go lower in the credit quality spectrum, it can generate immediate volume from the existing application volume.
- Other financial institutions have gone into this type of lending and they aren’t showing any signs of significant distress in their portfolios. We need to do the same. (Everyone in the herd in favor of this action please respond by saying “Moo.”)
- Our test portfolio has performed acceptably, so let’s increase the volume.
Let’s continue the correlation between these two “problems.” In the Madoff ponzi scheme, there were warning signs that cropped up – some earlier than others. These included:
- In 2000, the Securities and Exchange Commission received a letter from an outside money manager which warned of a possible scheme.
- In 2005, the Bostonian submitted an 18-page document to the SEC citing 29 red flags and indicated some level of corruption within Madoff’s investment company.
- The SEC’s own earlier investigation conducted in 1999, included an acknowledgement that they had received “credible allegations” but these allegations were ignored.
So, what were the signs that were in front of us but we simply chose to ignore?
- Were the portfolios turning over so fast that we could not actually gather statistically valid data to support performance?
- Since we were selling off the loans, either individually or in bulk, did we ignore the actual risk that was taken by the industry?
- Were we appropriately monitoring the portfolio growth and performance, utilizing risk reduction and risk avoidance techniques, doing regular rescores and tracking potential behavioral issues?
Whether the signs were visible to us or not, the fact remains that they existed in the past and they will likely exist in the future. As we continue to clean up the mess of our past, we need to consider a few items:
- What we did in the past will no longer be acceptable going forward. We must change. We must improve.
- Regulatory pressures will increase and changes will continue to be made.
- We will not have the luxury of time to respond to these pressures and/or changes. We must act now.
What is a financial institution to do? Well, the worst thing we can do is wait for the regulators to tell us what to do because that is simply too late. We need to act and act now.
- Assess the risk management methods that were employed in the past and determine deficiencies. Note the gaps between the historical tools and data sources compared with the updated credit decisioning tools and sources available in the industry.
- Develop a plan for implementing the new risk reduction methods and tools. Determine the estimated lift and manage/monitor your performance against your estimates.
- Don’t forget about the new additions to the portfolio. Once you have the existing risk identified, you should make the appropriate adjustments to the product risk parameters and terms and conditions to improve the overall quality of the new portfolio.
Overall, the worst thing that we can do is nothing.
“Those who do not remember the past are condemned to repeat it.”
George Santayana, a philosopher, essayist, poet, and novelist