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Comment: The return of risk management

In a recent interview, Merrill Lynch’s newly anointed chief executive, John Thain, revealed that the financial institution’s risk management system had ceased to function properly during the sub-prime crisis. That comment raised some eyebrows and provoked speculation about the possibility that Merrill’s particular black box might have been switched off.

Merrill would not have been the only bank to override or even ignore the warnings its risk managers and their systems were giving. Only six months ago, covenant-lite and high-loan-to-value ratio transactions were the rule rather than the exception and the property market was ticking along nicely.

Now bankers and investors are listening to their risk management teams and business has slowed to a snail’s pace. Talk to real estate bankers in London and New York and they will tell you they’re open for business. Loans are being made and deals are getting done. And they are, but in much reduced circumstances.

London-based property lawyers report that deals that were only awaiting signatures on final documentation have been pulled at the last minute. Who killed the deals? Banks’ risk management divisions – a deal might have been perfectly sound, only to be called off when the risk managers pointed out that it would breach concentration limits.

Some property funds have also felt the pinch of the liquidity crunch. A handful of funds active in the UK property market have warned investors that it could take up to a year to redeem units. Again, this is the direct result of the slowdown in deal volumes because of the difficulty in securing financing as the risk managers bring some sanity to a market that some believe was out of control.

However, while bankers and investors in London and New York are tearing their hair out, their colleagues active in emerging markets, particularly the Bric countries – Brazil, Russia, India and China – are thriving. New funds targeting these countries are being launched on a weekly basis and the globe’s most influential real estate players are vying for deals giving them access to double-digit returns. Even beleaguered Merrill has got into the game with its $377 million joint venture with India’s largest developer, DLF.

But no matter how attractive these markets might be from a yield perspective, those with experience warn newcomers to proceed with caution. Strong local relationships and patience are only part of what is needed to succeed. Again, risk management plays an important role. As AIG Global Real Estate’s president, Kevin Fitzpatrick, remarks in this issue’s cover story, emerging markets can offer attractive returns without superior risk, but only if that risk is managed properly.