Expert view: Lessons of the sub-prime collapse

A number of finance houses dealing in US sub-prime mortgage debt have got into serious financial trouble recently.

They divided up the debt so that some of it would not default, unless more of the sub-prime mortgage market defaulted than ever before. Unfortunately, default expectations are already past 10 per cent of the total money lent. Concerns that the modelling of other engineered investment products is wrong have poisoned lending models far and wide. 

Not surprisingly, some investors have had a torrid time. Goldman Sachs' chief finance officer described the unusual volatility as "25 standard deviation moves, several days in a row".

The models were hopelessly wrong: they didn't factor in the possibility of a crash. It was ever thus: systemic shocks are always unexpected. To survive them, you need to have a cushion of capital. For charities, this means reserves.

In its CC19 guidance, the Charity Commission says trustees have a general legal duty to apply charity funds within a reasonable time after receiving them. To justify reserves, trustees should have a reserves policy based on a realistic assessment of their charities' best interests. The key considerations are business-plan forecasts for income and expenditure, taking into account uncertainty, possible opportunities and contingencies and the likelihood and impact of not meeting future needs.

Clearly, in planning a reserves requirement, your view of the future needs to be sufficiently long term in relation to your beneficiary. The Children's Society is not a permanent endowment charity or foundation, but some of its commitments have the character of the type of activity carried out by such organisations. Frequently, they last more than five years; sometimes they last as long as 70 years. The commission's CC14 guidance says that all charities with permanent endowments have a duty to be even-handed between the interests of present and future beneficiaries. The longer your beneficiary time horizon, the more important this becomes.

What the events of the past few months in the credit markets illustrate is that, no matter how diligent you are in bottoming your business plans, there are risks that you cannot fathom. So when you next consider your reserves policy, don't rely on what has happened in your own recent history. Look to other examples: 25 standard deviation events are products of models, not reality. Reality is worse. As the scouting movement would put it, be prepared to go beyond modelling the familiar.

- Charles Nall is corporate services director at the Children's Society and chair of the Charity Finance Directors' Group.

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