When you sit down, you probably don’t check under your seat for a bomb. Even though it could kill you, chances are slim that it’s there.

A similar view of risk led bankers, their regulators and other government officials to overlook dangerous investments and business models that contributed to the global credit crisis, according to speakers at the annual financial risk roundtable held by the Wharton Financial Institutions Center and the Oliver Wyman Institute, a management consulting firm.

Northern Rock may be a little-known name in the United States, but the collapse of the British bank mirrors the failed analysis of risk that contributed to problems at companies such as Citigroup, Bear Stearns and Merrill Lynch. The giant British mortgage lender was considered a “star performer” just months before it failed and was taken over by the government last year, said David T. Llewellyn, professor of banking and finance at Loughborough University in England. 

The bank’s loans were doing well and it had plenty of capital. But when the subprime crisis in the United States triggered a global credit crunch, Northern Rock found itself on the verge of disaster in the fall of last year. The bank could no longer borrow what it needed in the wholesale markets, which accounted for about two-thirds of its funding needs. British depositors, who have less insurance than those in the United States, lined up to take their money out. It was a classic run on the bank, the first in Britain in more than 100 years. The British government has since taken it over.

The risks of Northern Rock’s reliance on borrowed money were always known. They just weren’t taken seriously, Llewellyn noted. “They said, ‘We think there’s a low probability that this could happen. How do we know it’s a low probability? Answer: It’s never happened before….’ It’s as if there is a very real possibility that there is a bomb under your seat and yet no one has looked under their seats. This is exactly what Northern Rock did.”

No Middle Man

Northern Rock’s problems did not threaten the entire British banking system, but those at Bear Stearns last spring were a threat to a broad range of major U.S. financial firms. “What happened in March was that at a certain point, everything was so disconnected that the Wall Street mechanism of being the middle man had broken down. There was no middle man,” said David Benson, senior vice president and treasurer for Fannie Mae, a government-sponsored company that provides liquidity to the mortgage market and that has experienced extreme pressure, mostly related to the housing downturn. During the first quarter of this year, Fannie Mae reported a net loss of $2.2 billion, driven by losses related to the deteriorating housing market. It recently raised $2 billion in capital to bolster its balance sheet.

Benson’s team regularly monitors several measures, such as changes in Fannie Mae’s stock price compared to the Standard & Poor’s 500, to gauge market conditions. It also monitors the adequacy of its cash to manage liquidity risk, which can occur when market turmoil makes it difficult to buy and sell securities. For example, Fannie Mae is required to have enough liquidity to meet its cash obligations for at least 90 days without having to issue unsecured debt.

The company periodically tests its ability to access funds through sales and borrowing against collateral. “It’s a plumbing exercise, so we know it works. We know how to get cash in the door. We force ourselves to access markets just to make sure that works,” Benson said.

During “war games” that simulate market crises, Benson relies on what he calls his cookbook, a checklist of everything he needs to do. It exists so that if a real panic should occur, he won’t have to rely on memory. But contingency plans won’t solve all problems, he added. “I truly think that if we saw system problems in capital markets, the best of contingency plans are probably not going to work right” because firms depend so much on each other that problems at one affect many. “You can only control so much.”

At Washington Mutual, one of the country’s largest mortgage lenders, Treasurer Robert J. Williams is also playing defense. During the first quarter of 2008, the company reported a net loss of $1.1 billion, or $1.40 per diluted share, mostly related to allowances for loan losses. Indeed, on June 2, Kerry Killinger who had been the company’s chairman and CEO, was stripped of his chairmanship because of investor criticism of compensation policies and risk-management practices.

Like many other speakers, Williams believes allowances will remain high into next year because of ongoing credit losses. The potential size of the problem is huge, he said. His back-of-the envelope calculation, which takes into account housing related assets, leverage and credit losses, suggests the banking industry will have to raise $100 billion to $200 billion of capital. At 20 to 1 leverage, a measure of debt to equity, this suggests $2 trillion to $4 trillion of reduced lending capacity until the industry rebuilds its capital base. “We went back and stressed models and numbers,” Williams said, “and the numbers were pretty large.”

Washington Mutual, or WaMu for short, estimates losses of $12 billion to $19 billion over the next three to four years from its $190 billion residential loan portfolio. The range accounts for how the portfolio will perform in different economic situations. The company raised $7 billion in capital recently to cope with potential market upset, believing that these new funds give it a $10 billion cushion over what its capital ratios require.

According to Williams, the housing crisis probably will lead to a “massive examination of the regulatory framework,” including a review of the Basel 2 Accord, a set of international recommendations on banking laws and regulations that includes capital requirements.

Troublesome Pay Structures

Other speakers at the roundtable’s first panel, titled “Liquidity at the Firm Level,” agreed that current regulations fail to adequately deal with risks created by current markets. Llewellyn joked that regulators should “make it illegal to use the words, ‘It’s different this time.'” That phrase has surfaced in every bubble. People have used them to justify soaring prices for technology companies that had yet to produce earnings and for home prices that rose beyond what the average family could pay.

He also cited pay structures for bankers as a source of the problem. “If you actually examine incentive structures, it is very rational for people to follow the herd,” he said. People who follow the herd in a hot new investment trend are initially rewarded with, for example, big fees for churning out housing loans to people with questionable credit records. But if “you stand behind the herd and do what you think is the right thing and get it right, you’re not going to get very much credit for it.”

Group thinking also hampers regulators, he suggested. Northern Rock’s success made it hard for regulators to intervene early, even though its business model was risky.

Princeton University economics professor Hyun Song Shin said his research shows that current capital requirements may aggravate booms and busts. Accounting rules that require banks to mark the value of their securities to market prices also encourage companies to expand investments in good times and contract in bad ones. Regulators should shift their focus to standards for liquidity, the ability of a firm to convert its assets into cash quickly without selling at a discount.

Llewellyn pointed out that an emphasis on capital instead of on liquidity also led major ratings agencies, such as Moody’s, to misjudge risk in the mortgage market.

Regulatory liquidity requirements should focus on the composition of assets and liabilities rather than the size of the equity cushion relative to total assets, as current capital standards do, Shin said, adding that today’s financial markets — which feature such strong connections between firms that problems at even a relatively small player like Bear Stearns imperil the whole system — increase the need for focusing on liquidity, he said.

These connections also create conflicts for the parties involved, he noted. When Bear started crumbling during the market turmoil caused by home-loan losses, it needed other companies to avoid panic and not demand payments out of fear that Bear would fail. But that didn’t happen. “Prudent contractions of balance sheets by Bear Stearns’ creditors were a run from the point of view of Bear Stearns.”

One of the ironies is that mortgage-backed securities were supposed to shift risk away from lenders by pooling loans that were sold to investors, but they did not work that way in the crisis. “Risk hasn’t really been shifted as much as we thought,” Llewellyn said. “There is sort of a residual credit risk that is left with the bank.”

That’s because the contracts underlying the securities allowed investors to shift some responsibility back to individual institutions threatening them with insolvency, according to Joseph Mason, professor of finance at Drexel University’s LeBow College of Business. What’s interesting about this world and interesting about the business world in general is that contracts are made to be amended, if not broken,” he said. “This was part of what investors were counting on….We’re nowhere near the end here. We just have this lull. Some might call it a dead-cat bounce. I would say it’s still the same cat.”

But he also said the severity of the current crisis depends on one’s perspective. His research shows that even homeowners who bought at the peak before housing prices fell in the 1990s would have earned a seven percent return yearly on that investment. That assumes, however, that the homeowner had cash to weather the crisis.

Age also affects opinions. By historical standards, the current economy is hardly suffering. Unemployment remains high, and GDP is still growing a little. “I used to say that you have to be older than 37 to remember living through a real recession,” Mason added. “Some of my colleagues say to me, 1991 wasn’t a real recession. You have to go back to the 1970s. Now I think you have to be about 57.”