Based on Moody’s updated views on US government support and standalone bank considerations, Moody’s lowered by one notch the senior holding company ratings of Morgan Stanley, Goldman Sachs, JPMorgan, and Bank of New York Mellon.
“We believe that US bank regulators have made substantive progress in establishing a credible framework to resolve a large, failing bank,” said Robert Young, Managing Director. “Rather than relying on public funds to bail-out one of these institutions, we expect that bank holding company creditors will be bailed-in and thereby shoulder much of the burden to help recapitalize a failing bank.”
Posted tagged ‘Financial Crisis’
Excerpted from the 2011 annual report of M&T Bank’s and written by the CEO, Robert Wilmers:
Indeed, it is difficult, for one who has spent more than a generation in the field, to recall a time when banking as a profession has been publicly held in such persistently low esteem. A 2011 Gallup survey found that only a quarter of the American public expressed confidence in the integrity of bankers. We have reached a point at which not only do public demonstrations specifically target
the financial industry but when a leading national newspaper would opine that regulation which might lower bank profits would be “a boon to the broader economy.” What’s worse is that such a view is far from entirely illogical, even if it fails to distinguish between Wall Street banks who, in my view, were central to the financial crisis and continue to distort our economy, and Main Street banks who were often victims of the crisis and are eager, under the right conditions, to extend credit to businesses that need it.
It is no consolation, moreover, to observe that banks and the financial services industry generally were far from alone in sparking the crisis. Nonetheless, it is true, and very much worth keeping in mind, that major institutions in other sectors of the American system – public and private – must be considered complicit, some in ways we are only beginning to learn fully about. As understandable as a search for particular causes, or villains, might be, the truth is that the economic crisis that began in the fall of 2007 implicated a wide range of institutions – not only bankers but their regulators, not only investors but those paid to advise them, not only private finance but its government-sponsored kin. The wide spectrum of the culpable has left the U.S. and the world with a problem which, although related to the financial crisis, transcends it and must be confronted: the decimation of public trust in once-respected institutions and their leaders. This has created a fear among those responsible for forming the rules and standards that shape the American financial services industry. And the outcome of this fear-driven rulemaking is likely to burden the efficiency of the American financial system for years to come and will potentially have broader implications for the overall economy.
Nor can one say with any confidence that we have seen a fundamental change in the big bank business approach which helped lead us into crisis and scandal. The Wall Street banks continue to fight against regulation that would limit their capacity to trade for their own accounts – while enjoying the backing of deposit insurance – and thus seek to keep in place a system which puts taxpayers at high risk. In 2011, the six largest banks spent $31.5 million on lobbying activities. All told, the six firms employed 234 registered lobbyists. Because the Wall Street juggernaut has tarnished the reputation of banking as a whole, it is difficult if not impossible for bankers – who once were viewed as thoughtful stewards of the overall economy – to plausibly play a leadership role today. Inevitably, their ideas and proposals to help right our financial system will be viewed as self-interested, not high-minded.
As noted before, however, the major banks were not the only ones implicated in and tainted by the financial crisis. One can, sadly, go on in this vein to discuss a great many other institutions which have disappointed the American public in similar ways, in the process compromising their own leadership status. They have in common a relationship to the crisis associated with the nation’s housing policies, which were themselves shaped over the course of several generations by many parts of the government and both political parties. Those policies marshaled some of the leading government agencies and enterprises, as well as private financial institutions, in the quest to broaden home ownership. Even apart from the collateral damage this pursuit has caused the financial system, it is worth keeping in mind that it was not remarkably successful on its own terms – particularly when today one finds a higher rate of home ownership in countries such as Hungary, Poland and Portugal, where the per capita GDP on average is 56% lower than that of the United States.
So it is that the crisis was orchestrated by so many who should have, instead, been sounding the alarm – not only bankers but also regulators, rating firms, government agencies, private enterprises and investors. That a former U.S. Senator, Governor and CEO of a big six financial institution was at the helm of MF Global on the eve of its demise due to trading losses, or that the largest-ever Ponzi scheme was run by the former chairman of a major stock exchange will long be remembered by the public. The repercussions have stretched beyond banking, creating an atmosphere of fear affecting and inhibiting those who should be leading us toward a better post-crisis economy.
Fear-Driven Rulemaking and Its Burden:
In this vacuum of credible leadership, not just in the banking industry but all around it, it is entirely understandable that regulators believe they must proceed with an abundance –perhaps over-abundance – of caution. Inevitably, they feel pressure to eliminate, in its entirety, risk that had been rising for far too long. This tension – based in their understanding that steps aimed at ensuring the safety and soundness of the financial system can stifle its vitality and dynamism – naturally weighs on rulemakers and slows the pace of promulgation. They know too, that, in designing regulations, the sort of informal conversations with private institutions and individuals, which were once routine, might now be viewed as suspect, leaving regulators to operate in isolation, without thoughtful guidance as to the overall impact of their actions. When all are suspect, no conversation can be viewed as benign. Ultimately, however, this is neither a recipe to improve public confidence nor a situation likely to facilitate the expeditious design of a regulatory structure which will not hobble the extension of credit. One must be concerned that a lack of leadership and trust, and an overreliance, instead, on the development of policies, procedures and protocols, has created a level of complexity that will decrease the efficiency of the U.S. financial system for years to come – and hamper the flow of trade and commerce for the foreseeable future.
Nor is there any apparent end in sight to the imposition of new directives and rules. The Dodd-Frank Act contains, by one estimate, 400 new rulemaking requirements, only 86 of which were finalized by the start of 2012. It is impossible, of course, to assess our full cost to comply with these rules until they are promulgated. By virtue of having more than $50 billion in assets, a measure of size, with no consideration given to the activities in which we engage nor the merits of our actions, M&T has been deemed to be a “systemically important” financial institution and will be subject to higher capital standards as well as costly new liquidity requirements.
A common feature of many of these new directives is a higher order of complexity than had heretofore been typical, particularly for Main Street banks like M&T which do not engage in excessive risk-taking and rely on fundamental banking services as their primary source of income. Utilization of these opaque and intricate methods as a means to prevent a crisis is at best questionable.
It is no small irony – it is, dare I say, a bitter one – that these costly requirements have been visited on a company such as ours and hundreds, if not thousands, like us who did little or nothing to cause the financial crisis – and were, in fact, in many ways victims of it. And, of course, the higher costs along with higher capital and liquidity requirements will inevitably diminish the availability and increase the cost of credit to business owners, entrepreneurs and innovators of our community. Indeed, one has the sense that little or no thought has been given to the cumulative effect of new directives, both on costs and operations. One wishes, thus far in vain, for a clear, complete, simple and straightforward regulatory regime in which both consumers and banks know what to expect and could proceed accordingly, at reasonable expense.
Broader Impacts and Unintended Consequences:
In this context, one has to be concerned about the accumulated effects of new mandates beyond the narrow terms of how they affect banks. More broadly, there is reason to believe that regulation may provide incentives that distort the allocation of capital in ways that could be harmful to economic recovery. Specifically, there are incentives for commercial banks to divert from their traditional roles – the same sort of activities which helped spark the housing bubble. The proposed Basel III liquidity rules, for instance, call for banks to significantly increase their investments in government securities, leaving less capital for community-based loans which hold the most promise for potential economic progress.
New formulae from the FDIC are likely to have similar inadvertent consequences for the economy. Last spring, the FDIC began assessing insurance premiums based on assets rather than deposits, which it had done since its inception in 1933. As a result, a loan to finance the construction of a company’s new building, an activity that produces jobs, carries insurance premiums that are three to four times as high as for commercial loans extended for unspecified purposes with no need for employment creation – arguably the greatest necessity of the current economy. Even more troubling is the fact that, under this formula, the mere association with real estate deems construction lending more risky regardless of how sturdy one’s underwriting or how much “skin in the game” the entrepreneur is willing to commit.
Nor is the damage from new mandates and regulation merely projected or prospective. Many are already proving to be counterproductive for businesses and consumers alike. The Durbin Amendment, for instance, was supposed to reduce costs for merchants. Instead it has resulted in higher transaction processing fees for some small business owners. According to The Wall Street Journal, many business owners who sell low priced goods like coffee and candy bars are now paying higher rates, when customers use their debit card for transactions that are less than $10. These small merchants now are left with some hard choices, such as raising prices, encouraging customers to pay in cash or dropping card payments altogether.
The breathtakingly rapid pace of changing regulations makes it challenging for banks and regulators alike to understand the changes, let alone react to them in an efficient manner. The fact that there are so many masters to whom banks today report makes it difficult for one hand to know what the other is doing, whether it relates to coordination among the various regulatory bodies or even among the various divisions within a single agency.
Finding a New Way
So it is that the effects of crisis, combined with a void of leadership, weigh on banks such as ours – and encumber the economy. We find ourselves at a point at which, we face not only the question of what approaches are right but how, in light of a leadership vacuum, can we restore our capacity to work together constructively and productively. It is no small task, given the number of agencies involved and the decibel level of politicians and the public at large. We will not, in my own view, be able to make progress absent two key ingredients: trust and leadership. We must again have the sense that leaders, both public and private, will do their best to propose and consider ideas that will serve the general interest, not their own agendas.
To help recognize and preempt emerging new threats, it is crucial that there be an ongoing, at times informal, dialogue among bankers and regulators. Such exchanges would plausibly put focus on rising issues like cyber-crime that has already cost the American banking industry some $15 billion over the last five years. More importantly, these discussions should be premised not on confrontation nor framed by fear but, rather, based on the understanding that a safe and secure financial services system is a prerequisite for a healthy economy –arguably our most important, shared national goal. I know that we would be eager to share our own collective learning with the Federal Reserve and other regulators in order to allow them to understand the extent to which regulatory changes are likely to affect the general well-being of our economy. I am sure other Main Street banks would be eager to do the same. Our goal is not to seek favors or special dispensation – but rather to have the chance to do our part in helping to craft a regulatory regime that does not impede, but rather enables sustainable economic growth.
In reflecting on my years in banking and the situation we confront today, I am mindful of the fact that banks have traditionally played a clear, if limited, role in the economy: to gather savings and to finance industry and commerce. Trading and speculation were nowhere included – nor should they be. Historically, bankers, moreover, were viewed as among the more responsible and ethical members of their communities. In my view, the vast majority still are and have been ill-served by those whose non-traditional approach have caused banks to be the targets of public opprobrium. Such is the case of the British banker who was recently stripped of his knighthood in the wake of his role in the financial crisis. It is time for regulators and, yes, protestors, to understand that all banks have not been equally culpable for the problems we face today. In other words, give us back our good name – and we will do our best to deserve it.
Buttonwood suggests that there are four paths forward from the global debt crisis:
- Grow out of the problem
- Inflate the debt to a more manageable level
- Extended Stagnation
These four paths happen to coincide exactly with the four views of risk from Plural Rationalities.
The Maximizer will be sure that we can just Grow Out of It if the government will just get out of the way and let the market work its magic.
The Managers will believe that a careful process of gradual inflation will bring the economy back into line with the debt. This process will work if the expert government economists who really understand the problem are given their freedom to manage this. In the meantime, they will also want to increase the laws and regulations so that this sort of thing will not happen again.
The Conservators believe that since default is inevitable, then we might as well take our lumps and get it out of the way quickly. They will not be convinced, even after the default that anything has been completely solved and will continue to worry that there is more bad news just around the corner. So they will be preparing for the next shoe to drop. They will probably favor cutting spending to make sure that things come back into balance.
The Pragmatist will believe that there is not really a good way out and that the economy will be stuck in this stage of uncertainty for an extended period. They may even believe that the efforts of the others to try to solve the problems might extend that uncertain period even longer.
Looking back on the 1930′s we see that in various countries at various times during that decade that all four paths were tried by various governments.
What worked then? Well, you can find that there are four different opinions on what was the exact reason that we came out of the depression…..
New movie about 24 hours in the life of a troubled bank at the height of the financial crisis, Margin Call.
Read a review from the point of view of a risk manager here.
Perspective is very important for a risk manager. That is because lack of perspective leads to many of the largest mistakes.in thinking about the cause and likelihood of loss events.
Regarding the US debt ceiling manufactured crisis, there is very interesting perspective on the issue of the US Federal Debt in an article in the NY Times. The story links the current Tea Party movement all the way back to Jefferson and Madison. It seems that the US has always had a major faction strongly opposed to big government and government debt.
However, Riskviews would suggest that some have taken a valid disagreement about the size of government and the level of debt and used that to manufacture a crisis that has the potential to create a second major global recession of the size and scope of the one we have not yet recovered from.
But if you have read the story of the 1930′s history, you will see that is exactly what happened then. Government policy and actions during the 1930′s took several major turns as the economy staggered up and down. To this day, there is no agreement of whether one set of government actions or the movements in the opposite direction were the cause or the solution to the problem.
We seem destined to repeat the same sort of lurching process to find our way out.
In fact, we will never know which really works – spending or austerity – to help with a bad part of the business cycle.
Another great source of perspective on Sovereign Default is the Reinhart, Rogoff book This Time is Different. The book goes through hundreds of years of history and dozens of sovereign defaults. One of their main conclusions is that sovereign default is usually a politically driven event, rather than a financially driven event. The drama in Greece follows the historical patterns described in the book. The involvement of the rest of the EU in the Greece situation is unusual, but not at all unique.
Reinhart and Rogoff make the case that sovereign defaults are mostly political, rather than economic. That is the thinking that seems to motivate S&P in their downgrade decision on the US debt. S&P says that
we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.
But it is unclear to RISKVIEWS whether there is not also a major long term economic problem for most of the G20 economies. The demographic imbalances may prove the downfall of one or several of the major economic powerhouses of the past 50 years.
The GAO last week released a report on Proprietary Trading of banks. The headlines feature a conclusion from the report that the six largest US banks did not make any money our of Prop Trading over the 4.5 years of the study period.
The analysis looks pretty straightforward. But it is difficult to see if the conclusions are quite so obvious.
First and most important for a risk manager to notice is that this is a post facto analysis of a risky decision. Risk Managers should all know that such analysis is really tricky. Results should be compared to expectations. And expectations need to be robust enough to allow proper post facto analysis. That means that expectations need to be of a probability distribution of possible results from the decision.
Most investments had performance that was vaguely similar to the pattern shown above during that time. Is the conclusion really anything more than a 20-20 hindsight that they should have stayed in cash? That is true everytime that there is a downturn. Above is a graph of a steady long position in the S&P.
On the other hand, traders in such situations seem to generally get paid a significant portion of the upside and share in very little, if any of the downside. In this case, the downside cancelled out all of the upside. The good years had gains of over $15.6 B. If the traders were getting the usual hedge fund 20% of the gains, then they were paid 3.9 B for their good work. In the bad years, banks lost $15.8 B. That means that the gains before bonus were $3.7B. Incentives were over 100% of profits.
The one other question is why investors need banks aas intermediaries to do prop trading? Why can’t investors do their own prop trading? Why can’t investors go directly to the hedge funds or mutual funds or private equity funds?
Ultimately, the report says that prop trading was not really significant to bank earnings and not a real diversifier of bank volatility. So in the end, is there any reason for banks to be doing prop trading?
It seems that the banks are reaching that conclusion and exiting the activity.
The US and Global banking regulators have been tasked with regulating systemic risk. One area where they admit that they are unprepared is with the insurance sector. In the recent Global Financial Crisis, several insurance companies played a pivotal role, specifically AIG and the US Financial Guarantee insurers. Most insurers do not consider their activities that helped to build up the bubble and precipitate the crisis to be insurance activities and therefore persist in saying to regulators that insurance is not a systemically important sector. However, the political facts are that AIG and the Financial Guarantors are/were insurers and the idea of leaving insurance completely out of the efforts to prevent a future systemic crisis is simply not a possible.
Last week, the American Academy of Actuaries provided a letter to the US Financial Stability Council titled, “Metrics to Enable FSOC to Monitor Insurance Industry Systemic Risk”. That letter provides a good starting point for discussion of the issues involved in bringing the insurance sector into the discussion. For example, the letter provides the following list of ways that an insurer might have systemically significant risks:
- Risk assumption services provided to the insurance companies through reinsurers, foreign and domestic (e.g. mortality risk in excess of a company’s risk management limit).
- Risk assumption services provided by the non-insurance financial services companies to the insurance industry, (e.g. hedging of financial risk, catastrophe bonds).
- The interconnectedness of the insurance industry when part of a financial services group.
- The interconnectedness of a U.S. insurance company that is owned by a foreign financial services company.
- The insurance industry as a lender to the US economy (e.g. through its purchase of corporate bonds).
- The interconnectedness of risk assumption services external to the insurance industry when part of a financial services group.
Riskviews cautions the participants in this discussion to realize that it is most likely that the next systemic crisis will take a different form than the past crises. So setting up measures and regulatory structures that will prevent a recurrence of past crises is no guarantee of preventing a future crisis.
This letter, with its emphasis on setting down broad principles for Systemic Risk in the insurance industry is a good step in the right direction. Much broad based discussion is needed to take this further to produce a truly dynamic, principles based monitoring and regulating structure that will be imaginative and flexible enough to actually be of future good, not just short term political cover.
Most often when there is a regime change. Many work to change things back to the way that they were. Others simply wait for things to return to normal.
It is often a failure of imagination. People cannot imagine that the world is not going to be what it was.
As many folks are fighting changes that came about as a result of the Global Financial Crisis, they are pushing and pushing for things to go back to the way that they were. They understand that world, they even think that they understand how to prosper in that world. They believe that if you take away the single thing that went sooo bad, the sub prime mortgages, that everything else will go back to being just as it was.
Nothing could be further from the truth. Things will never go back to how they were. Much of how things were was supported by the excess wealth that we all thought that we had because of the inflated values of our homes.
And does going back to the world of 2005 but without sub prime mortgages make any sense anyway? Do we really think that we know which of the many things that happened prior to the Crisis were the actual causes?
Many things changed in the 78 years between Global FInancial Crises. Some of them were the reason for the increases to global wealth and some were the causes of the abrupt reversal of the favorable economic trends.
The changes that are resulting from the 2008 GFC could be the start of the next regime. Or else, we coud go through a start and stop process as the US did in the 1930′s where government policymakers shifted back and forth in their approach to the economy and to financial market and financial market participants. Eventually they settled on a system. The economy went through good growth under that system until the late 1960′s when a new set of major changes were made and a new regime was started. The 1970′s were a period of financial turmoil into the early 1980′s until that regime settled into a stable situation.
A few will adapt quickly and thrive in the new regimes. Others cling to the idea that somehow someway, the good old days will come back.
Take a look at the past experience. It is time for a new regime. It has taken ten years or more for a new regime to settle. We have five or six years to go.
Use your imagination. Imagine a new future regime.
A second series of essays from the actuarial profession about the financial crisis. Download them HERE.
A Tale of Two Density Functions By Dick Joss The Systemic Risk of Risk Capital (Or the "No Matter What" Premise) By C. Frytos &I.Chatzivasiloglou Actuaries and Assumptions By Jonathan Jacobs Managing Financial Crises, Today and Beyond By Vivek Gupta What Did We Learn from the Financial Crisis? By Shibashish Mukherjee Financial Reform: A Legitimate Function of Government By John Wiesner The Economy and Self-Organized Criticality By Matt Wilson Systemic Risk Arising from a Financial System that Required Growth in a World with Limited Oil Supply By Gail Tverberg Managing Systemic Risk in Retirement Systems By Minaz Lalani Worry About Your Own Systemic Risk Exposures By Dave Ingram Systemic Risk as Negative Externality By Rick Gorvette Who Dares Oppose a Boom? By David Merkel Risk Management and the Board of Directors–Suggestions for Reform By Richard Leblanc Victory at All Costs By Tim Cardinal and Jin Li The Financial Crisis: Why Won't We Use the F(raud) Word? By Louise Francis PerfectSunrise–A Warning Before the Perfect Storm By Max Rudolph Strengthening Systemic Risk Regulation By Alfred Weller It's Securitization Stupid By Paul Conlin I Want You to Feel Your Pain By Krzysztof Ostaszewski Federal Reform Bill and the Insurance Industry By David Sherwood
What was the difference between the banks and insurers with high tech risk management programs that did extremely poorly in the GFC from those with equally high tech risk management programs who did less poorly?
One major difference was the degree to which they believed in their models. Some firms used their models to tell them exactly where the edge of the cliff was so that they could race at top speed right at the edge of the cliff. What they did not realie was that they did not know, nor could they know the degree to which the edge of that cliff was sturdy enough to take their weight. Their intense reliance on their models, most often models that focused like a lazer on the most important measure of risk, left other risks in the dark. And those other risks undermined the edge of the cliff.
Others with equally sophisticated models were not quite so willing to believe that it was perfectly safe right at the edge of the cliff. They were aware that there were things that they did not know. Things that they were not able to measure. Risks in the dark. They took the information from their models about the edge of the cliff and they decided to stay a few steps away from that edge.
They left something on the table. They did not seek to maximize their risk adjusted returns. Maximizing risk adjusted return in the ultimate sense involved identifying the opportunity with the highest risk adjusted return and taking advantage of that opportunity to the maximum extent possible, then looking to deploy remaining resources to the second highest risk adjusted return and so on.
The firms who had less losses in the crisis did not seek to maximize their risk adjusted return.
They did not maximize their participation in the opportunity with the highest risk adjusted return. They spread their investments around with a variety of opportunities. Some with the highest risk adjusted return choice and other amounts with lesser but usually acceptable return opportunities.
So when it came to pass that everyone found that their models were totally in error regarding the risk in that previously top opportunity, they were not so concentrated in that possibility.
They left something on the table and therefore had something left at the end of that round of the game.
Michael Thompson often describes the situation where a person or group does not get the experience that they expect as Surprise. I have also heard that called Disappointment.
Probably Surprise is a better term.
What is going on is that people expect one sort of experience and get another.
In a recent published article, Ingram and Thompson describe the expectations of various environments as:
- Boom Environment – High Drift, Low Volatility
- Moderate Environment – Moderate Drift, Moderate Volatility
- Bust Environment – Negative Drift, Low Volatility
- Uncertain Environment – Unpredictable Drift, Unpredictable Volatility
With those descriptions, Surprise/Disappointment is easier to describe. If you believe that the environment is in a Boom and the experience you get is moderate drift and volatility, then you will be surprised and probably disappointed. And similarly, if you expect a Bust environment and you experience high drift, then you will certainly be Surprised, but probably not Disappointed. Unless you were really counting on complaining and are disappointed about good fortune spoiling that.
Surprise is very different for those expecting an Uncertain environment. For them, it is surprising that they are able to notice any pattern, whether it be high, low or moderate drift and volatility. They are expecting unpredictable results, a high volatility as well as a high volatility of volatility. For them, a surprise would be if the experiences did have a reliable volatility.
The Surprise that many of us have been experiencing started out as a Disappointment. We thought that home prices had a large positive drift and low volatility. So as many of us started to count upon that expectation, the system reached its carrying capacity for home real estate. Which is hard to imagine, since with the loans that were over 100% of value, people were being paid by the financial sector to take new homes.
Suddenly, house prices stopped rising. Most stories about the financial crisis do not even try to give any explanation for that happening. But it is easy to picture that everyone who was willing to move had already done so recently. Even in a pay to take, there is a high personal time cost to move. So the hot market encouraged anyone who might be willing to move and move a year or two or three earlier than they would have otherwise. But not enough people were willing to do that year after year. And not enough people were crazy enough to take out mortgages that they had absolutely no chance to pay back. So the turnover faltered. Prices simply stopped rising. And the Surprise hit everyone.
After an extended period of freefall, the market has settled into a much longer period of uncertainty. No discernable pattern to drift or to volatility. There is a large and uneven volume of foreclosed real estate in the system. It comes to market and disrupts prices. Because the real estate market had relied upon a rather primitive price discovery mechanism, the foreclosures are very disruptive to the pricing of non-foreclosed housing. This is a major factor in the level of uncertainty of housing and it ripples through the entire financial system and the entire economy.
With this uncertainty, people who are expecting any of the three other patterns of risk are irregularly Surprised, and often Disappointed. As there are more and more disappointments, more and more people shift their coping strategy to one that makes sense in an Uncertain economy, the strategy of Diversification. That might sound to be a good thing, but in practice, it ends up meaning avoiding any large or lengthy commitments. It means a slow down in basic investment and usually a deferral of any of the major investments that would start to fuel the next positive economic cycle.
This Uncertain cycle will end slowly because of the immense amount of extra home real estate that is still in the foreclosure pipeline.
Such cycles usually end when the flip side of the process described above that drove the stoppage in the real estate boom. What stopped the boom was that people wore out of moving up in housing. What will stop the Uncertain market will be that people will wear out of not changing houses. The people who have had one more child will be fed up with the crowding in their smaller house and the people whose kids have moved away will get fed up with maintaining more house than they need. The people who do well enough to afford a bigger and better house will be fed up with waiting for things to settle down. And when that happens to enough people, the backlog of existing real estate will finally sell down and a new boom will start again.
And people who had adapted to uncertainty will be Surprised, but not disappointed that their house again finally starts to appreciate.
There seems to be various discussions going around about who needs to be considered Systemically important to qualify for “Special Attention” from regulators. Very large money managers are saying that they are not systemically important.
But it seems to me that there are quite a number of considerations. And everyone seems to be arguing solely from the part of that list that exempts them.
When thinking about money managers, I would think of the following:
- How is their liquidity managed? Can they really raise funds fast enough to satisfy a run on the bank?
- If they were to try to liquidate their funds, what would that do to the financial markets?
- How interconnected are they to other financial firms? Do regulators now have information about that?
- What about the future? (Isn’t that our concern, not the past or even the current situation?)
- Could they shift their liquidity practices to become much more illiquid?
- Their argument revolves around leverage, how much could they change their leverage under their current regulations? They can quickly leverage through derivatives as well as borrowing.
- Could they become the center of new risky financial behavior that would endanger the financial sector?
That last point is a major concern of regulators regarding the Insurance industry. And they have history on their side. The insurance industry helped the financial sector to blow the mortgage business up to 4 or 5 times the underlying.
All you need to do that is a big balance sheet and a willingness to take one side of a trade without balancing it with the other side. And the money managers as well as the insurance companies both have exactly those characteristics.
Polling the people who work at the New York banks that were at the center of the financial crisis, people were asked which of the following statements that they agreed with the most:
- We did it and we need to do something differently.
- They did it and they need to do something differently.
- Space Aliens did it and we hope that they do not do it again.
The poll results are in and the findings are:
- No one answered that they agreed with 1.
- The innocent all were able to answer that they agreed with 2.
- Those who were directly involved in the problems that led to the crisis all answered 3.
So the conclusion that you should reach from this survey is that nothing will be different in the future. The financial system will be run mostly the same as it had been run.
Your only protection is to WATCH YOUR OWN WALLET. That is, pay attention yourselves to things that might turn into the next set of systemic risks. Those things will all tend to be very large systematic risks.
So you need to use the emerging risks type process on the largest systematic risks. You need to assess periodically whether your firm’s exposures to these risks might in a crash result in firm ending losses. (Or you can prepare your application for a bailout – good luck on that).
Then you need to have a heart to heart discussion with your board. Stories of the firms that did the worst in the crisis tell that their boards urged them to take more and more risk.
Risk managers need to know whether it is their board’s wishes to be dancing up until the band sinks below the water or to stop perhaps a few songs before and leave the ship ahead of the crash.
In a Oct. 3 FT article, it says that just 30% of 465 executives surveyed said that “they were able to tap risk management programmes to prepare for and minimize the negative outcomes” of the recession.
But I wonder whether minimizing impact of a recession was among the targeted risks of those risk management programs.
And in addition, I wonder whether the risk managers would have been permitted to even think seriously about the impact of a recession as serious as the one that we have (and continue to) experienced.
Financial firms that would have been very well prepared for this recession would have been doing quite a bit more hedging than their peers and the cost of that hedging would have severely reduced earnings prior to the recession.
Non-Financial firms that would have been well prepared would have been running with very low inventories and with loads of unfilled positions, running tons of expensive overtime prior to the flop.
The article also said that “only 44 percent said that they had adequately captured the potential problems before the downturn.
Some of that may be risk managers being slammed for being poor fortune tellers. They did not foresee the size of this recession so they missed it.
I would suggest that these survey results are a case of risk management as scape goat.
Don’t get me wrong. There are times when risk management gets it wrong.
But if you want risk managers to be focused upon minimizing the impact of a once in 75 year recession, then you ought to tell them that before the recession hits, not after.
And if accurate predictions of the economy are required of risk managers, then you ought to completely change your ideas about how much risk managers should be paid.
By the way, if you know now what sort of result you would have wanted from the recession, then that information should be used to set the firm’s risk tolerance – which should be done in advance, not after the fact.
But in fact, 80% of the firms have never agreed on a risk tolerance. Quite often the reason for not picking one is a reluctance of management to have their options restricted by such a limit, to allow the board into decisions that they want to make without the help of the board.
ERM Central to Restoring Capital Adequacy
It is easy to blame CROs (Chief Risk Officers) and ERM (Enterprise Risk Management) for the impact of the crisis on companies, but such blame is often unfair and disingenuous. In few companies did CROs have the power to prevent the execution of strategies that, although fraught with risk, were pursued to deliver on investor profit expectations and management incentive targets.
The primary objective of crisis mitigation must be to realign risk exposures with risk bearing capital and to improve capital adequacy. Realigning exposures with capital (and implied “risk capacity”) enhances insurance strength ratings and the confidence of investors and customers. Without such confidence, a company’s business and franchise would erode rapidly.
In response to the present crisis, many companies improved capital adequacy by (a) cutting expenses, (b) decreasing dividend payments, (c) discontinuing share repurchase programs, and (d) selling assets and non-strategic operating subsidiaries, all to preserve or increase capital. There are few buyers during a crisis, however, and so divestitures and asset sales are at lower prices than in normal times (e.g. sale of HSB Group by AIG) and are therefore very expensive sources of capital.
Realignment strategies also involve retrenchment from businesses with substandard returns on capital. Typical outcomes are: (a) sales of blocks of business and renewal rights, (b) cessation of certain coverage types, (c) sales of entire subsidiaries, (d) changes in underwriting limits, terms, and exclusions, (e) reinsurance strategies, etc. ERM risk analysis models provide a basis for assessing the relationship between capital needs and value contributions of various businesses. Without that assessment, it is hard to align risk exposures with available capital.
Estimates of capital requirements based on risk measures over a one-year horizon (typical of solvency regulations) are not credible during a crisis because they assume that fresh “recovery” capital can be raised. Rating agencies, regulators, and investors, however, know that many solvent companies cannot raise fresh capital during a crisis. Capital is only adequate if it can sustain the company’s operations on a “going concern” basis in the absence of access to recovery capital, but with credit for capital generated internally.
Companies need robust insights from ERM to assess their capital needs (on or off balance sheet, including contingent capital) and to develop effective mitigation strategies. Their ERM must:
- Measure capital consumption by activity and risk type
- Identify the relative value creation of individual businesses, with appropriate recognition for differences in risk
- Demonstrate the impact and future value creation of alternative retrenchment strategies
Through such ERM informed views of capital utilization, capital adequacy, and value creation, insurance companies can chart effective strategies to restore their capital adequacy and mitigate the impact of crises.
Berliet Associates, LLC
According to an AP summary of the negotiated consolidated Financial Reform act of 2010, there are 9 major provisions. These posts will feature commentary on the Risk Management implications of each.
1. OVERSIGHT A 10-member Financial Services Oversight Council made up of the treasury secretary, Federal Reserve chairman, a presidential appointee with insurance expertise, heads of regulatory agencies and a new consumer protection bureau would monitor financial markets and watch for threats.
Does that make you feel safe? An Oversight Council? Not me.
Each of the 10 members will be busy protecting their turf. Any action or proposed action that will damage “their” part of the financial services business more than the rest of the sector will be fought tooth and nail.
Or else, the group will be out to prove that they are really watching. They will protect us from 10 of the next two financial crises.
More protection might seem like a good idea right now, but no one has any idea how disruptive it will be to the economy to have an committee of 10 fighting to be the one who drives the car of the economy.
And in addition, to date there has been no indication that any of these folks will protect us from the NEXT crisis. Instead they will be watching out for a repeat of the last crisis.
The next crisis will come from whatever part of the world economy that they are not paying attention to. Almost by definition.
So my advice is to watch out for yourself. Do not rely on these folks. Do your own homework. Mind your own risks.
How to do that? Start HERE.
The VBM process helps companies compare the value contribution of alternative strategies and select a course that would increase company value,
Weaknesses in its VBM process can prevent an insurance company from restoring its risk capacity through earnings retention or the raising of additional capital. Such weaknesses thereby limit its ability to resume growing and recover from a crisis
Access to capital is a critical strategic advantage during a financial crisis.
Companies with a strong reputation for value creation can raise new “recovery” capital without excessive shareholder dilution (e.g. Goldman Sachs). Others find it more difficult, or impossible, to access the public market. This makes them vulnerable to inroads by competitors or unsolicited tender offers. The primary purpose of VBM frameworks and processes is to ensure that companies consistently meet investor value creation expectations and survive crises.
VBM frameworks help managers compare alternatives, so that they can direct capital towards uses that would support the achievement of a sustainable competitive advantage, and also create value. This is challenging in the insurance industry because competitors can duplicate innovations in product features, service delivery, or operational effectiveness in relatively short times and can redirect capital at the stroke of a pen. Such competitive dynamics call for companies to compete by developing organizational capabilities that (a) are tougher to duplicate by competitors and (b) provide a pricing or cost advantage based on service quality, underwriting insights, investment performance, and risk and capital management
Because risk drives capital utilization in insurance businesses, the integration of ERM and VBM frameworks is required in order to develop strategies and plans that meet value expectations. Integration rests on (a) superior insights into risk exposures and capital consumption and (b) consistent risk metrics at the level of granularity needed to achieve a loss ratio advantage (possibly on the same level of granularity as loss ratios are calculated). In practice, these insights and metrics lead to decisions to reject businesses and strategies that will not create value. They provide a foundation for:
- Measuring capital utilization by line, by market, and in aggregate
- Driving a superior, more disciplined underwriting process
- Optimizing product features
- Maintaining pricing discipline through the underwriting cycle
- Pricing options and guarantees embedded in products fairly
- Controlling risk accumulation, by client and distribution channel
- Managing the composition of the book of business
- Driving marketing and distribution activities
- Optimizing risk and capital management strategies
Achieving superior shareholder returns is critical for a company to earn investor trust and maintain access to affordable capital. Having access to capital during a financial crisis may well be the ultimate indicator of success for a company’s VBM framework.
Anecdotal evidence suggests that insurance companies that consistently trade at significant premiums over book value have such insights about risk and maintain a highly disciplined approach to writing business.
The present crisis has increased the cost of capital dramatically, but not equally for all insurers. Capital remains most affordable to those with a strong record of value creation and adequate capital as a result of good risk management. Conversely, it has become prohibitive for those with a lesser record of value creation and who lost credibility as stewards of shareholders’ interests. The latter are at risk of forced mergers or liquidation, which may be punishment for not integrating ERM and VBM processes more effectively.
Berliet Associates, LLC
There are situations that require collaboration if they are going to be resolved in a manner that produces the largest combined benefit or the smallest combined loss. This is not the “greatest good for the greatest number” objective of socialism – it is simple efficiency. Collaborative results can be greater than competitive results. It is the reason that a sports team where everyone is playing the same strategy does better than the team where each individual seeks to do their personal best regardless of what everyone else is doing.
There are also situations where the application of individual and separate and uncoordinated actions will result in a sub optimal conclusion and where the famous Invisible Hand points in the wrong direction.
You see, the reason why the Invisible Hand ever works is because by the creative destruction of wrong turns, the individual actions find a good way to proceed and eventually all resources are marshaled in following that optimal way of proceeding. But for the Invisible Hand to be efficient, the destruction part of creative destruction needs to be small relative to the creative part. For the Collaborative effort to be efficient, the collaboration needs to result in selection of an efficient approach without the need for destruction through a collaborative decision making process. For the Collaborative effort to be necessary, the total cost of the risk management effort needs to exceed the amount that single firms could afford.
Remember the story of the Iliad. It is the story of armies that worked entirely on the Invisible Hand principle. Each warrior decided on his own what he would do, how and when he would fight. It was the age of Heroes.
The stories of the success of Alexander and later the Roman armies was the success of an army that was collaborative. The age of Heroes was over. The efficiencies of the individual Heroes each finding their own best strategy and tactics was found to be inferior to the collaborative efforts of a group of soldiers who were all using the same strategy and tactics in coordination.
There are many situations in risk management were some sort of collaboration needs to be considered.
The Gulf Oil leak situation seems like it might be one of those. BP is now admitting that it did not have the resources available or even the expertise to do what needs to be done. And perhaps, this leak is a situation where the collective cost of their failure is much higher than society’s tolerance for this sort of loss. But the frequency of this sort of problem has to date been so very low that having BP provide those capabilities may not have made economic sense.
However, there are hundreds of wells in the Gulf. With clear hindsight, the cost of developing and maintaining the capacity to deal with this sort of emergency could have been borne jointly by all of the drillers in the Gulf.
There are many situations in risk management where collaboration would produce much better results than separate actions. Mostly in cases where a common threat faces many where to overcome the threat would take more resources than any one could muster.
Remember the situation with LTCM? No one bank could have helped LTCM alone, they would have gone down with LTCM. But by the forced collaborative action, a large group of banks were able to keep the situation from generating large losses. Now this action rankles many free marketeers, but it is exactly the sort of Radical Collaboration that I am talking about. It did not involve any direct government funding. It used the balance sheets of the group of banks to stabilize the situation and allow for an orderly disposition of LTCMs positions. In the end, I beleive that it was reported that the banks did not end up taking a loss either. (That was mostly an artifact of depressed market prices at the time of the rescue, I would guess.)
The exact same sort of thinking does NOT seem to have been tried with Lehman. If Paulson could not find a single firm to rescue Lehman, he was not going to do anything. But looking back and remembering LTCM, Paulson could have arranged an LTCM style rescue for Lehman. In hindsight, that, even with government guarantees to sweeten the pot would have been better then the financial carnage that ensued.
Perhaps Paulson was one of the free marketeers that hated the LTCM “bailout”. But in the end, he trampled the free market much worse than his predecessors did with LTCM when he bailed out AIG without even giving any thought to terms of the bailout.
Collaboration might have seemed radical to Paulson. But it is sometimes needed for risk management.
In the US, firms are required to disclose their risks. This has led to an exercize that is particularly useless. Firms obviously spend very little time on what they publish under this part of their financial statement. Most firms seem to be using boilerplate language and a list of risks that is as long as possible. It is clearly a totally compliance based CYA activity. The only way that a firm could “lose” under this system is if they fail to disclose something that later creates a major loss. So best to mention everything under the sun. But when you look across a sector at these lists, you find a startling degree to which the risks actually differ. That is because there is absolutely no standard that is applied to tell what is a risk and if something is a risk, how significant is it. The idea of risk severity is totally missing.
What would help would be a common set of terms for Severity of losses from risks. Here is a suggestion of a scale for discussing loss severity for an individual firm:
- A Loss that is a threat to earnings. This level of risk could result in a loss that would seriously impair or eliminate earnings.
- A Loss that could result in a significant reduction to capital. This level of risk would result in a loss that would eliminate earnings and in addition eat into capital, reducing it by 10% to 20%
- A Loss that could result in severe reduction of business activity. For insurers, this would be called “Going into Run-off”. It means that the firm is not insolvent, but it is unable to continue doing new business. This state often lasts for several years as old liabilities of the insurer are slowly paid of as they become due. Usually the firm in this state has some capital, but not enough to make any customers comfortable trusting them for future risks.
- A Loss that would result in the insolvency of the firm.
Then in addition, for an entire sector or sub sector of firms:
- Losses that significantly reduce earnings of the sector. A few firms might have capital reductions.
- Losses that significantly impair capital for the sector. A few firms might be run out of business from these losses.
- Losses that could cause a significant number of firms in the sector to be run out of business. The remainder of the sector still has capacity to pick up the business of the firms that go into run-off. A few firms might be insolvent.
- Losses that are large enough that the sector no longer has the capacity to do the business that it had been doing. There is a forced reduction in activity in the sector until capacity can be replaced, either internally or from outside funds. A large number of firms are either insolvent or will need to go into run-off.
These can be referred to as Class 1, Class 2, Class 3, Class 4 risks for a firm or for a sector.
Class 3 and Class 4 Sector risks are Systemic Risks.
Care should be taken to make sure that everyone understands that risk drivers such as equity markets, or CDS can possibly produce Class 1, Class 2, Class 3 or Class 4 losses for a firm or for a sector in a severe enough scenario. There is no such thing as classifying a risk as always falling into one Class. However, it is possible that at a point in time, a risk may be small enough that it cannot produce a loss that is more than a Class 1 event.
For example, at a point in time (perhaps 2001), US sub prime mortgages were not a large enough class to rise above a Class 1 loss for any firms except those whose sole business was in that area. By 2007, Sub Prime mortgage exposure was large enough that Class 4 losses were created for the banking sector.
Looking at Sub Prime mortgage exposure in 2006, a bank should have been able to determine that sub primes could create a Class 1, Class 2, Class 3 or even Class 4 loss in the future. The banks could have determined the situations that would have led to losses in each Class for their firm and determined the likelihood of each situation, as well as the degree of preparation needed for the situation. This activity would have shown the startling growth of the sub prime mortgage exposure from a Class 1 to a Class 2 through Class 3 to Class 4 in a very short time period.
Similarly, the prudential regulators could theoretically have done the same activity at the sector level. Only in theory, because the banking regulators do not at this time collect the information needed to do such an exercize. There is a proposal that is part of the financial regulation legislation to collect such information. See CE_NIF.
Companies that withstood the crisis and are now poised for continuing success have been disciplined about aligning interests of shareholders and managers
Separation of ownership and control creates conflicts of interests between managers and owners. To mitigate this situation, companies expend much effort to develop and implement incentive compensation systems that align the interests of managers and shareholders. The present crisis demonstrates clearly, however, that such arrangements are imperfect: large incentive payments were made to many people in companies that have performed poorly or even failed. There has been a public outcry.
But there is nothing really new in misalignments of incentives, or weaknesses in incentive designs that produce harmful results: they exist in every company to some degree. In a typical situation, managers are concerned about minimizing financial and career consequences of not achieving their objectives. If the situation requires it, managers will exploit every opportunity to change their operating plans to achieve their targets. They will seek and capitalize on opportunities to convert unreported intangible assets, such as market share, product or service quality, product leadership, plant productivity or customer service responsiveness into current profits by postponing and reducing related expenses. Financial results will look good, and they will be praised for accomplishing their objectives. Actions that they took, however, accelerated uncertain future income to the present period while undermining the company’s competitive capabilities and reducing the sustainability of its performance. This is dangerous. Mitigating this form of moral hazard is difficult because its effects are not readily apparent.
In insurance companies (and banks), business managers have even greater opportunities to “game” incentive plans: they can increase reported business volume and profit in the current period by slightly under-pricing or increasing risks assumed. This approach to “making the numbers” is particularly tempting in lines of coverage in which losses can take many years to emerge and develop; it is also particularly dangerous because losses from mispriced policies, especially in lines with high severity/low frequency loss experience can be devastating. Similarly, investment officers can invest in assets that offer higher yields to increase portfolio performance, while involving risks that can result in significant capital losses later.
Based on these observations, Directors and CEOs of insurance companies need to work with management to:
- Link incentive compensation payments to the ultimate outcome of business written rather than to current profits (especially when fair value accounting standards cause immediate recognition of profits on contracts).
- Establish and empower an internal control and audit function to verify that managers’ actions are aligned with business strategies and plans.
- Verify the integrity of underwriting and investment decisions, in relation to explicitly approved guidelines and processes.
The present crisis has demonstrated how unbundling of risk assumption businesses can increase moral hazard by redistributing risks, gains and potential losses across originators, arrangers of securitization transactions and investors/risk bearers.
Reconstruction of incentive programs and establishment of appropriate oversight and enforcement mechanisms are needed to reduce moral hazard and restore confidence in the financial system, including insurance companies.
©Jean-Pierre Berliet Berliet Associates, LLC (203) 972-0256 firstname.lastname@example.org
Something as massive as the current financial crisis is much too large to have one or two or even three simple drivers. There were many, many mistakes made by many different people.
My mother, who was never employed in the financial world, would have cautioned against many of those mistakes.
When I was 16, I had some fine arguments with my mother about the girls that I was dating. My mother did not want me dating any girls that she did not want me to marry.
That was absolutely silly, I argued. I was years and years away from getting married. That was a concern for another time. My mother knew that in those days, “shotgun marriages” were common, a sudden unexpected change that triggered a long-term commitment. Well, as it happened, even without getting a shotgun involved, five years later I got married to a girl that I started dating when I was 16.
There are two different approaches to risk that firms in the risk-taking business use. One approach is to assume that they can and will always be able to trade away risks at will. The other approach is to assume that any risks will be held by the firm to maturity. If the risk managers of the firms with the risk-trading approach would have listened to their mothers, they would have treated those traded risks as if they might one day hold those risks until maturity. In most cases, the risk traders can easily offload their risks at
will. Using that approach, they can exploit little bits of risk insight to trade ahead of market drops. But when the news reveals a sudden unexpected adverse turn, the trading away option often disappears. In fact, using the trading option will often result in locking in more severe losses than what might eventually occur. And in the most extreme situations, trading just freezes up and there is not even the option to get out with an excessive loss.
So the conclusion here is that, at some level, every entity that handles risks should be assessing what would happen if they ended up owning the risk that they thought they would only have temporarily. This would have a number of consequences. First of all, it could well stop the idea of high speed trading of very, very complex risks. If these risks are too complex to evaluate fully during the intended holding period, then perhaps it would be better for all if the trading just did not happen so very quickly. In the case of the recent subprime-related issues, banks often had very different risk analysis requirements for trading books of risks vs. their banking book of risks. The banking (credit mostly) risks required intense due diligence or underwriting. The trading book only had to be run through models, where the assignment of assumptions was not required to be based upon internal analysis.
From 2008 . . .
Lots more great stuff there. Check it out.
In October 2008, Alan Greenspan had the following exchange during testimony before a Congressional committee:
Representative HENRY WAXMAN (Committee Chairman, Democrat, 30th District of California): You found a flaw in the reality…
Mr. GREENSPAN: Flaw in the model that I perceived is a critical functioning structure that defines how the world works, so to speak.
Rep. WAXMAN: In other words, you found that your view of the world, your ideology was not right. It was not working.
Mr. GREENSPAN: How it – precisely. That’s precisely the reason I was shocked, because I’ve been going for 40 years or more with very considerable evidence that it was working exceptionally well.
One of the things in that model was an assumption that the self interest of the bankers was a more important factor in containing their risks than regulations.
But the evidence that self interest is insufficient to control excessive risk taking is all around us and has been for many, many years. It takes a massive amount of selective blindness to ignore it.
All it takes it to take your car out of the driveway and drive on the roads. Driving involves risk management decision making. For one thing, almost everyone drives a car that is capable of traveling much faster than the speed limit. And the speed limits are only very occasionally enforced. So it is an individual risk management decision of how fast to drive a car.
Now, I happen to live in an area of the New York City suburbs where many of the folks who work on Wall Street firms live. And the evidence is all around. Many drivers do not put long term safety self interest above short term time advantage of speeding. In many cases, they are deliberately trying to take advantage of the folks who are trying to be safe and driving extra recklessly under the assumption that they will not run into someone who is driving as recklessly as they are.
Now it is quite possible that none of the reckless drivers are Wall Street executives. But the reckless drivers are all people. And the readily available evidence with 50 years or more of accident statistics to back up shows that self interest is NOT sufficient motivation for safety.
Perhaps economists and especially central bankers do not own cars.
To the rest of us who do, the theory seems to be from another planet. The people that are risk takers and the people who drive safely are two different sets of people.
is everywhere. I am not sure that I have heard anyone actually explain what should be done or why they are furious, other than the general idea that there were bail-outs.
I can think of two reasons to object to the mega bonuses that can be used to help direct future bonuses:
- There is not any evidence of any claw back being applied in the bonus calculations. It is likely that a significant number of the folks who have the most culpability for the immense losses of the past are no longer there. Doing a claw back from folks who were not involved would as is pointed out by the bankers be counter productive. But they are only partly correct. While many are gone, some do remain. In addition, there are many folks remaining at the bank who were indirectly responsible (or should have been indirectly responsible) who are in the executive ranks and on the board as well. There should be claw backs that apply to everyone who is up the chain of command and in a role with significant corporate wide responsibility. This would be very productive and would send the signal that executives are responsible. It would reduce the degree to which executives are willing to look the other way when a strong business unit manager insists on doing something that might not be in the best interests of the firm. In addition, too little is said of board compensation. Board members of firms that needed to be bailed out should suffer financial consequences. Strong consideration should be given to reducing board fees in a manner that is commensurate with what is done to claw back bonuses for executives.
- For almost two years now, the Fed has been depressing interest rates to levels that flirt with a zero value. They do this to help the banks so that the banks will help the economy. This has created a situation where the banks can operate with a zero cost of good sold. Any business on the planet could show a profit with zero COGS. To the extent that banks are taking earnings that result from these low interest rates and turning around and giving the resulting profits to their employees as bonus they are subverting the purpose of the low rates. This fact has been true for a long time, but the Greenspan Fed that was famous for low interest rates and for ignoring the gross inefficiencies of the approach. The lower interest rates take money from savers and transfers it to debtors and banks and bankers. In this case, the interest rates are being kept low both to bolster bank profits as well as to keep money cheap to spur borrowing to encourage spending. However, credit tightening by the banks has jacked up their effective margins (spread differentials less default losses). So bank profits are soaring because they are (a) paying a trivial amount for funds and (b) not lending as much of the money to as many businesses and people as they had before. In addition, in 2008, the banks were able to obtain debt capital at a rate averaging 0.7% with a government guarantee which is expected to rise to 4.7% (per Reuters). The differential there is purely a gift from the taxpayers, but a gift that was meant to be used to recapitalize the banks to provide funds for loans. And the banks are paying bonuses on these gains, rather than keeping the excess profits to build up balance sheets to be used when they regain the courage to lend. So this is proving to be a very inefficient way to move the economy. The flow of funds through the bankers bonuses back into the economy is just too inefficient of a way to stimulate the economy. Those excess profits that come from both of these interest expense subsidies must be excluded from the bonuses, or else the subsidies must be stopped and the money used in a more efficient manner to stimulate the economy.
So there are probably several alternatives to make this more efficient and less bothersome. We just need to figure out exactly what about it that is bothersome and frame it in a way that can direct policy. Otherwise, we end up with piecemeal solutions aplied in a wack-a-mole approach to problem solving.
Kevin Dowd has written a fine article titled “Moral Hazard and the Financial Crisis” for the Cato Journal. Some of his very well articulated points include:
- Moral Hazard comes from the ability for individuals to benefit from gains without having an equal share in losses. (I would add that that has almost nothing to do with government bailouts. It exists fully in the compensation of most executives of most firms in most economies. )
- Bad risk model (Gaussian). That ignore abnormal market conditions.
- Ignoring the fact that others in the market all have the same risk management strategy and that that strategy does not work for the entire market at once.
- Mark to Model where model is extremely sensitive to assumptions.
- Using models that were not designed for that purpose.
- Assumption of continuously liquid markets.
- Risk management system too rigid, resulting in easy gaming by traders.
- “the more sophisticated the [risk management] system, the more unreliable it might be.”
- Senior management was out of control. (and all CEOs are paid as if they were above average!)
- Fundamental flaw in Limited Liability system. No one has incentive to put a stop to this. Moral Hazard is baked into the system.
Unfortunately, there are two flaws that I see in his paper.
First, he misses the elephant in the room. The actual exposure of the financial system to mortage loan losses in the end was over 400% of the amount of mortgages. So without the multiplication of risk that happened under the guise of risk spreading had not happened, the global financial crisis would have simply been a large loss for the banking sector and other investors. However, with the secret amplification of risk that happened with the CDO/CDS over the counter trades, the mortgage crisis became a depression sized loss, exceeding the capital of many large banks.
So putting all of the transactions out in the open may have gone a long way towards allowing the someone to react intelligently to the situation. Figuring out a way to limit the amount of the synthetic securities would probably be a good idea as well. Moral Hazard is a term from insurance that is important to this situation. Insurable interest in one as well.
The second flaw of the paper is the standard Cato line that regulation should be eliminated. In this case, it is totally outrageous to suggest that the market would have applied any discipline. The market created the situation, operating largely outside of regulations.
So while I liked most of the movie, I hated the ending.
We really do need a Systemic Risk Regulator. And somehow, we need to create a system so that 50 years from now when that person is sitting on a 50 year track record of no market meltdowns, they will still have enough credibility to act against the mega bubble of those days.
From Mike Cohen
“Where do we go from here, and what have we learned to help us arrive there safely and prosperously?” What risk management lessons have been learned?
Dislocations have occurred many times in history, and have occurred in many societal areas, changing many aspects of life profoundly:
- Economy: Agrarian, manufacturing, technology, service
- Military history: Strategies/tactics, weaponry
- Social/family mores: Many, many variations with intensely personal and emotional elements
- Political systems: Capitalism vs. socialism, big vs. small government, government leadership vs. self-determination
Dislocations will, without question, continue to occur in the future, and just as surely manifest themselves in unpredictable ways. Survivors, and ideally ‘thrivers’, will understand when dislocations occur and make the changes necessary to operate well in their new environments.
There are a number of business and societal behaviors that have been culpable in contributing to the interim demise of our socio-economic system:
- Poor analysis
They are not effective, and have eerie parallels to the seven deadly sins.
While many aspects of our personal and business lives have changed, certain themes remain the same. Righting the ship will be driven by adherence to a number of fundamentals that have driven our success over history and will drive our success in the future.
1) Responsibility and trust: Our actions … what we say and what we do … are our legacy. Do we stand behind them in terms of honesty and wisdom?
Kahlil Gibran, in his epic work ‘The Prophet’, said that “You are the bows from which your children as living arrows are sent forth.” Quite so, but we need to make sure our aim is straight and sure. Our children are our most sacred trust, the most important manifestations of our legacy. Our actions are right along side in terms of importance.
2) Be ‘students’ of what we do:
- What is the purpose of our actions? What are we trying to accomplish?
- Are people or institutions going to be hurt by what we are doing?
- What risks are we taking?
- Functions of all kinds … how do they need to be performed?
3) How do our products work? What needs and wants do they satisfy? In life insurance, for example, those needs and wants to be satisfied are:
- Asset accumulation
* Our financial world has never been more complicated and uncertain, and customers (both individuals and corporations) have never had a greater need for guidance
* ‘Caveat emptor’ (let the buyer beware) – Is this too difficult a burden for the consumer of the 21st century?
4) What do corporations need to do to succeed?
- Satisfy their customers’ needs and wants, more effectively and efficiently than their competitors can
- Manage the profit characteristics, for themselves and their customers, well
- Understand the risks in their enterprise, and ensure that they don’t interfere with the interests of their stakeholders
- Operate with integrity and transparency
We have recovered from dislocations in the past; we’re here, aren’t we? Understanding change, that it will always be occurring and how changes have manifested themselves, is critical to our evolution. Not recovery, but evolution. If we forget history, then we are doomed to repeat it. The same is true for understanding history, although the understanding of history is affected by the authors who report it. “How was your vacation?” “I don’t know. I have to wait to see the pictures”
We will solve the major issues confronting our financial system, but we will in all likelihood come out the other end in a very different place.
Link to Detailed Timeline
The events of the past three years are unprecedented in almost all of our lifetimes. One needs to go back and look at how much was happening in such a short time to get an appreciation of how difficult it must have been to be in the hot seats of government, central banks and regulators, especially during the fall of 2008.
On the other hand, it is pretty easy, with 20-20 hindsight, to point to events that should have made it clear that something bad was on its way.
The timeline that is posted here on Riskviews is an amalgam from 5 or 6 different sources, including the BBC, Federal Reserve and Wikipedia. None of them seemed to be very complete. Not that this one is. My personal biases left out some items from all of the sources.
Let us know what was left out that is important. This timeline was created over a one year period and there was little effort to go back and pick up items that did not seem important at the time, but that later were found to be early signals of later big problems.
The reaction that I have had when I used this timeline to make a presentation about the Financial Crisis is that it is pretty unfair to go pointing fingers about actions taken during the fall of 2008. When you look at the daily earth shaking events that were happening, it is really totally overwhelming, even a year later. If the events that occured daily were spread out one per month, then perhaps a case could be made that “they” should ahve done better.
Going back much further, I am not willing to be quite so kind. This crisis was manufactured by collision of two deliberate government policies – home-ownership for all and deregulation of financial markets. That collision was preventable. Neither policy had to be taken to the extreme that it was taken – to what looks now like an absurd extreme in both cases.
And in addition, the financial firms themselves are far from blameless. Greenspan’s belief that the bankers were capable of looking out for their shareholder’s best interest was correct. They were capable.
Read the history. See what happened. Decide for yourself. Let me know what I missed.
Link to Detailed Timeline
Financial markets in the 00s were dominated by the Individualist point of view described in Cultural Theory.
The Cultural Theory idea of four risk views provides some interesting insights regarding the financial crisis.
In Cultural Theory terms what happened to create the crisis was that Individualists were given control over too much of the world’s resources. Meanwhile, Authoritarians and Egalitarians degree of control over Individualists was almost totally eliminated. (Fatalists usually do not control anything for long.)
Hyman Minsky accurately describes what happens to Individualist systems – they go from investment to speculation to Ponzi to collapse.
When Individualists control fewer resources, take for example the 1987 stock market crash, there was not a major impact outside of the highly Individualist financial markets to hurt the “real” economy. When Individualists control moderate amount of resources, their cycle of financial instability ends in a mild recession. With too much resources in the hands of Individualists, a major financial crisis results.
But why did that happen? Why did Individualists get so much of the resources?
As Minsky observed; “Stability is destabilizing”
Cultural Theory makes two similar observations that help to explain what happened.
1. Each of the four views of risk is correct some of the time. (But not all at the same time – so in any period of time 3 out of 4 are incorrect.)
2. With each passing period during which their world risk view is not validated, some people shift their view to the one that has been validated by events.
Allegiances to these four risk views shift over time.
So favorable financial times led more and more people to shift their view to Individualist. The normal Individualist cycle of investment to speculation to Ponzi to crash happened.
The adverse events of the financial crisis are clearly contrary to the Individualist mean reverting idea of risk and will cause many people to now shift away from an Individualist view of risk.
As long as that trend holds, the Teens decade will end up very different from the 00s. We must wait to see whether the Authoritarians or the Egalitarians end up dominating the decade.
The political debate in the US is over whether we must return to an almost purely Individualist system or if we can live in an Egalitarian system.
An interesting aspect of the recent financial market chaos is how innovation plays into the facts. While arguably simply bad lending behavior was at the core of the problem, increasingly complex (i.e innovative) financial instruments such as credit default swaps played a key role as well.
By Christopher E. Mandel
What intrigues me is what some view as the cycle of innovation that produces these bad effects.
I recently heard Mark Cuban say: first there’s innovation, then come the imitators then come the idiots. While there are many examples of this cycle of creativity ending in disaster, few to date are of such magnitude as the current credit crisis. Oftentimes it’s not bad behaviors as much as the way in which initial creativity and its success produces laziness.
Today’s good idea is tomorrow’s exploited idea. New products and services often have short lives. In fact most things have their “season” but creative capitalism drives imitation and as more and more imitators pile in for quick profits, it is all destined to be short lived, absent continuous innovation and improvement.
One of the keys to this cycle is the constant drumbeat for better, faster, cheaper and more. Author Richard Swenson in a book titled “Hurtling Toward Oblivion” makes a compelling case for this phenomenon. First his observations: that we are subject to profusion or the phenomenon of always requiring more of everything, forcing progress.
Continued on Risk & Insurance
I bought my current house 11 years ago. The area where it is located was then in the middle of a long drought. There was never any rain during the summer. Spring rains were slight and winter snow in the mountains that fed the local rivers was well below normal for a number of years in a row. The newspapers started to print stories about the levels of the reservoirs – showing that the water was slightly lower at the end of each succeeding summer. One year they even outlawed watering the lawns and everyone’s grass turned brown.
Then, for no reason that was ever explained, the drought ended. Rainy days in the spring became common and one week it rained for six days straight.
Every system has a capacity. When the capacity of a system is exceeded, there will be a breakdown of the system of some type. The breakdown will be a non-linearity of performance of the system.
For example, the ground around my house has a capacity for absorbing and running off water. When it rained for six days straight, that capacity was exceeded, some of the water showed up in my basement. The first time that happened, I was shocked and surprised. I had lived in the house for 5 years and there had never been a hint of water in the basement. I cleaned up the effects of the water and promptly forgot about it. I put it down to a 1 in 100 year rainstorm. In other parts of town, streets had been flooded. It really was an unusual situation.
When it happened again the very next spring, this time after just 3 days of very, very heavy rain. The flooding in the local area was extreme. People were driven from their homes and they turned the high school gymnasium into a shelter for a week or two.
It appeared that we all had to recalibrate our models of rainfall possibilities. We had to realize that the system we had for dealing with rainfall was being exceeded regularly and that these wetter springs were going to continue to exceed the system. During the years of drought, we had built more and more in low lying areas and in ways that we might not have understood at the time, we altered to overall capacity of the system by paving over ground that would have absorbed the water.
For me, I added a drainage system to my basement. The following spring, I went into my basement during the heaviest rains and listened to the pump taking the water away.
I had increased the capacity of that system. Hopefully the capacity is now higher than the amount of rain that we will experience in the next 20 years while I live here.
Financial firms have capacities. Management generally tries to make sure that the capacity of the firm to absorb losses is not exceeded by losses during their tenure. But just like I underestimated the amount of rain that might fall in my home town, it seems to be common that managers underestimate the severity of the losses that they might experience.
Writers of liability insurance in the US underestimated the degree to which the courts would assign blame for use of a substance that was thought to be largely benign at one time that turned out to be highly dangerous.
In other cases, though it was the system capacity that was misunderstood. Investors miss-estimated the capacity of internet firms to productively absorb new cash from the investors. Just a few years earlier, the capacity of Asian economies to absorb investors cash was over-estimated as well.
Understanding the capacity of large sectors or entire financial systems to absorb additional money and put it to work productively is particularly difficult. There are no rules of thumb to tell what the capacity of a system is in the first place. Then to make it even more difficult, the addition of cash to a system changes the capacity.
Think of it this way, there is a neighborhood in a city where there are very few stores. Given the income and spending of the people living there, an urban planner estimates that there is capacity for 20 stores in that area. So with encouragement of the city government and private investors, a 20 store shopping center is built in an underused property in that neighborhood. What happens next is that those 20 stores employ 150 people and for most of those people, the new job is a substantial increase in income. In addition, everyone in the neighborhood is saving money by not having to travel to do all of their shopping. Some just save money and all save time. A few use that extra time to work longer hours, increasing their income. A new survey by the urban planner a year after the stores open shows that the capacity for stores in the neighborhood is now 22. However, entrepreneurs see the success of the 20 stores and they convert other properties into 10 more stores. The capacity temporarily grows to 25, but eventually, half of the now 30 stores in the neighborhood go out of business.
This sort of simple micro economic story is told every year in university classes.
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It clearly applies to macroeconomics as well – to large systems as well as small. Another word for these situations where system capacity is exceeded is systemic risk. The term is misleading. Systemic risk is not a particular type of risk, like market or credit risk. Systemic risk is the risk that the system will become overloaded and start to behave in severely non-linear manner. One severe non-linear behavior is shutting down. That is what the interbank lending did in 2008.
In 2008, many knew that the capacity of the banking system had been exceeded. They knew that because they knew that their own bank’s capacity had been exceeded. And they knew that the other banks had been involved in the same sort of business as them. There is a name for the risks that hit everyone who is in a market – systematic risks. Systemic risks are usually Systematic risks that grow so large that they exceed the capacity of the system. The third broad category of risk, specific risks, are not an issue, unless a firm with a large amount of specific risk that exceeds their capacity is “too big to fail”. Then suddenly specific risk can become systemic risk.
So everyone just watched when the sub prime systematic risk became a systemic risk to the banking sector. And watch the specific risk to AIG lead to the largest single firm bailout in history.
Many have proposed the establishment of a systemic risk regulator. What that person would be in charge of doing would be to identify growing systematic risks that could become large enough to become systemic problems. THen they are responsible to taking or urging actions that are intended to diffuse the systematic risk before it becomes a systemic risk.
A good risk manager has a systemic risk job as well. THe good risk manager needs to pay attention to the exact same things – to watch out for systematic risks that are growing to a level that might overwhelm the capacity of the system. The risk manager’s responsibility is then to urge their firm to withdraw from holding any of the systematic risk. Stories tell us that happened at JP Morgan and at Goldman. Other stories tell us that didn’t happen at Bear or Lehman.
So the moral of this is that you need to watch not just your own capacity but everyone else’s capacity as well if you do not want stories told about you.
This is the final post in a 10 part series.
On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…
10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.
Of the ten suggestions, this one has the most value by far. Unfortunately, this one may be the suggestion that has the least chance of being taken up. No one is talking about any part of this. We seem to be moving to try to set the world back into the place that is was, or very close to it.
We should be asking “What should be the place of banking in our economy?” This is not a question of allowing the free market to choose. The free market has nothing to do with this. The role of the banking sector is entirely determined by the government. The banking sector had grown to eat up a huge percentage of all of the profits of the entire economy. Does that make any sense to anyone? Banking can be a symbiont with the economy or it can be a parasite or it can be a cancer. Before the crisis, banking had definitely moved beyond the level of parasite to becoming a harmful cancer. Too much of all of the profits of all of business activity in the entire economy were being diverted to the banks and with the pay structure of the banks, into the pockets of a very small number of bankers. Did that make any sense whatsoever? Is there any way that anyone can show that situation makes for a healthy economy? The bubbles that happened twice could be seen as the way that bankers justified their huge take from the economy. If values were growing rapidly, no one seemed to mind that bankers took so much out of the deals.
Source:Evolution of the US Financial Sector Thomas Philippon
However, if the economy and the values of businesses and assets in the economy grow at only a sane pace, and bankers try to go back to the level of take from the economy that they have grown accustomed to, then the amount of total profits left for the rest of the economy are bound to be negative. So unless we re-think things and figure out how to muzzle the banks, then we are headed for more bubbles that will justify their stratospheric incomes.
The financial sector, once it exceeds a certain share of the economy, should be viewed as a tax on the economy. Many protest the taxes that the government imposes because the money is not well spent. Well, the money from this tax goes to personal expenditures of the bankers themselves. There is not even any pretense that this tax will be spent for the common good.
One question that really needs to be answered is how much of this financial “innovation” that is touted as the result is really beneficial to the economy and how much of it is just unnecessary complexity that hides that take of the bankers and hedge funds. The excuse that is always given is that all of this financial innovation helps to provide lubrication for businesses. But that is more like an excuse than a reason. Mostly the financial innovation has fueled bubbles. It has led to the excessive leverage that feeds into one sided deals for hedge fund managers.
More often than not, financial innovation has helped to fuel the extreme fixation on short term gains in the economy. Financial innovation has featured hollowing out companies to maximize short term values. Quite often the companies “helped” by this process turn into worthless shells somewhere along the process. This destroys that productive capacity of the economy to allow for the extraction of the maximum amount of short term profits.
Financial innovation helps to turn corporate assets into profits and to take those profits out of the firm through leverage.
So Taleb’s suggestion that we think through Capitalism 2.0 is a good and timely one. But we need to start asking the right questions to figure out what Capitalism 2.0 will be.
On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…
8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.
George Soros has said that he believes that the GFC is the beginning of the unwinding of a fifty year credit buildup. Clearly there was too much leverage. But does anyone know what the right amount of leverage for a smoothly functioning capitalist system should be?
There is always a problem after a bubble. Many people keep comparing things to how they were at the very height of the bubble. Stock valuations are compared to the height of the market. Employment is compared to the point where the most people had jobs. But these are often not the right comparisons. If in the month of May, for 30 days, I had an outstanding offer for my house of $300,000 and on one day a person flew in from far away and offered $3 million, and if I never made that sale, do I forever after compare the offering price for selling the house to $3 Million?
People talk about a “New Normal”. Possibly, the new normal means nothing more than returning to the long term trend line. Going back to where things would now be if everything had stayed rational.
That may seem sensible, but this new normal may be a very different economy than the overheated and overleveraged one that we had.
Taleb suggests that the only possible transition from excessive debt is cold turkey. If Soros is right and we are going to transition to a new normal that is more like 50 years ago than 5 years ago, there that will be a long bout of DTs.
What we are seeing in the way of debt is the substitution of government debt for private debt. While Taleb is probably too harsh, the Fed does need to be careful. Careful not to go too far with the government debt. The Fed should be acting like the football player who passes ahead of the teammate, not to where they are standing right now. The amount of debt that they should be shooting for is a level that will make sense when the banks fully recover and again take up lending “like normal”. That will keep enough money flowing in the economy to soften the slowdown to the economy from the contraction of bank lending.
However, if the Fed is shooting to put us back where we were at the peak, then we are in trouble and Taleb’s warning holds. I would restate his warning as “Using too much leverage to combat the problem of too much leverage…” But using the right amount of leverage is just what is needed.
But that does mean learning to live with much less leverage. It means that we need to better understand how much leverage is the right amount. And we need to stop blaming the Chinese because they hold so much dollars and want to lend them to us. We need to develop a structural solution to the global imbalance that the Chinese balances are a symptom of.
Like some of our other problems, the purely market based solutions will not work. China is not playing by the market based rule book. They are a mercantilist economy that is taking advantage of the global market economy systems. We need to stop whining about that and develop strategies that work for everyone.
I thought that I must be just woefully old fashioned.
In my mind the real reason for the financial crisis was that bankers lost sight of what it takes to operating a lending business.
There are really only two simple factors that MUST be the first level of screen of borrowers:
And banks stopped looking at both. No surprise that their loan books are going sour. There is no theory on earth that will change those two fundamentals of lending.
The amount of coverage, which means the amount of income available to make the loan payments, is the primary factor in creditworthiness. Someone must have the ability to make the loan payments.
The amount of collateral, which means the assets that the lender can take to offset any loan loss upon failure to repay, is a risk management technique that insulates the lender from “expected” losses.
Thinking has changed over the last 10 – 15 years with the idea that there was no need for collateral, instead the lender could securitize the loan, atomize the risk, thereby spreading the specific risk to many, many parties, thereby making it inconsequential to each party. Instead of collateral, the borrower would be charged for the cost of that securitization process.
Funny thing about accounting. If the lender does something very conservative (in terms of current standards) and requires collateral that would take up the first layer of loss then there will be no impact on P&L of this prudence.
If the lender does not require collateral, then this charge that the borrower pays will be reported as profits! The Banks has taken on more risk and therefore can show more profit!
EXCEPT, in the year(s) when the losses hit!
What this shows is that there is a HUGE problem with how accounting systems treat risks that have a frequency that is longer than the accounting period! In all cases of such risks, the accounting system allows this up and down accounting. Profits are recorded for all periods except when the loss actually hits. This account treatment actually STRONGLY ENCOURAGES taking on risks with a longer frequency.
What I mean by longer frequency risks, is risks that expect to show a loss, say once every 5 years. These risks will all show profits in four years and a loss in the others. Let’s say that the loss every 5 years is expected to be 10% of the loan, then the charge might be 3% per year in place of collateral. So the banks collect the 3% and show results of 3%, 3%, 3%, 3%, (7%). The bank pays out bonuses of about 50% of gains, so they pay 1.5%, 1.5%, 1.5%, 1.5%, 0. The net result to the bank is 1.5%, 1.5%, 1.5%, 1.5%, (7%) for a cumulative result of (1%). And that is when everything goes exactly as planned!
Who is looking out for the shareholders here? Clearly the deck is stacked very well in favor of the employees!
What it took to make this look o.k. was an assumption of independence for the loans. If the losses are atomized and spread around eliminating specific risk, then there would be a small amount of these losses every year, the negative net result that is shown above would NOT happen because every year, the losses would be netted against the gains and the cumulative result would be positive.
Note however, that twice above it says that the SPECIFIC risk is eliminated. That leaves the systematic risk. And the systematic risk has exactly the characteristic shown by the example above. Systematic risk is the underlying correlation of the loans in an adverse economy.
So at the very least, collateral should be resurected and required to the tune of the systematic losses.
Coverage… well that seems so obvious it doed not need discussion. But if you need some, try this.
On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…
7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.
Hyman Minsky’s Financial Instability Hypothesis talks about the financial markets working in three regimes, Hedge, Speculative and Ponzi. Under Hedge financing, investments generally have sufficient cashflow to pay both principle and interest. Under Speculative financing, investments generally have cashflows sufficient to pay interest, but depend upon rolling over financing to continue. Ponzi financing does not have sufficient cashflows to pay either interest or principle. Ponzi financing requires that values will increase enough to pay both principle and interest to repay financing.
Speculative financing requires a belief that the value of the collateral will be stable to justify future refinancing or rolling over of the financing. That belief could be called confidence.
Ponzi financing requires a belief that the value of collateral will grow faster than the interest rate charged. That belief requires a significantly higher amount of confidence.
There are several other levels that a financial business could operate. For example, the value of the collateral could be viewed in terms, not of its current value, but of its value in an adverse scenario. A very conservative lender could then make sure that each investment used that adverse value as the actual amount of collateral granted. In that situation, the investor does not want to rely upon the belief that the asset value will be stable. A significantly more aggressive investor will want to make sure that their portfolio in total adjusts the value of collateral for the possible loss in an adverse situation, allowing for the effects of diversification in the portfolio.
Credit practices in the US have drifted against the path of having the borrower put up cash for that difference between adverse value and current value. Instead, practice has changed so that the lender will hold capital against that adverse scenario and charge the borrowed the cost of holding that capital.
What has changed with that drift, is who will bare the losses in the adverse scenario. That has shifted from the borrower to the lender. So the loan transaction has changed from a simple credit transaction to a combined credit and asset value insurance transaction. (Which makes me wonder if the geniuses who thought of this thought to charge appropriately for the insurance or if they just believed that if the market bought it when they securitized it, then the price must be right.)
This will look different from the former loan business where the borrowed bore the asset value risk because the lender will have fluctuations in their balance sheet when the adverse scenarios hit and the collateral value falls below the loan value. And that is exactly what we are seeing right now.
In addition, as we are seeing now, when there is a extremely severe drop in the value of collateral, having the banks hold the risk of the decline in collateral value, then a drop in the collateral will have a significant impact on bank capital. The impact on bank capital may have a major impact on the bank’s ability to lend which will impact on all of the rest of the economy that had no connection to the impaired asset class.
So to Taleb’s point about confidence, it seems that he is stating that lending practices should revert to their prior level where collateral was valued under an adverse scenario. Then there will be little if any confidence involved in the lending business. And less chance that a steep drop in any one asset class will spill over to the rest of the economy.
So the dividing line would be that the financial firms that could be subject to future government bailouts would need to value collateral pessimistically and to avoid loans that are not fully collateralized.
But here is the problem with that proposal…
If any other firms, outside of that restriction are permitted to lend in the same markets, business will ultimately shift to those institutions. They will be able to offer better loan terms and larger loans for the same collateral AND in most years, they will show much higher profits.
Bad risk management will drive out good. The institutions that take the most optimistic view of risk, those who have the most confidence, will drive the firms with the more pessimistic view (whether that is their own view or the view imposed by the regulators) out of the market.
And then when the next crisis hits, regulators will find that the business has shifted to the non-regulated firms and they they will instead need to bail them out, unless they make it illegal for non-regulated firms to do any of the kinds of finance that is related to a government’s need to bailout.
Then the bank would almost always have real collateral and any drop in confidence could be resolved by assigning that collateral over to someone with cash and settling any needs for cash that the lack of confidence creates.
Taleb is not clear however whether he is referring to banks or the financial system in general or to the government with his statement. The discussion above is about banks.
Trying to think about this idea in the context of the entire financial system, I wonder if he was suggesting a return to the gold standard. When there was a gold standard, there was no need for confidence in the currency. If you stay with the current currency regime, then the confidence idea, I suppose, relates to the question of inflating the currency. If the government does seem to consistently hold the money supply at a reasonable level in proportion to the economy, then there will not be a problem. However, I cannot think of any way of looking at the floating currency system that does not REQUIRE confidence that the government will hold inflation in check.
Applying the idea to the government, I would also say that confidence is required there as well. A government that could be counted on to fund fully for spending programs would instill confidence, but there could be no surity, especially under the US system where the next congress could immediately trample on the good record of a all preceding governments.
6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.
It is my opinion that many bubbles come about after a completely incorrect valuation model or approach becomes widely adopted. Today, we have the advantage over observers from prior decades. In this decade we have experienced two bubbles. In the case of the internet bubble, the valuation model was attributing value to clicks or eyeballs. It had drifted away from there being any connection between free cashflow and value. As valuations soared, people who had internet investments had more to invest in the next sensation driving that part of the bubble. The internet stocks became more and more like Ponzi schemes. In fact, Hyman Minsky described bubbles as Ponzi finance.
In the home real estate bubble, valuation again drifted away from traditional metrics, the archaic and boring loan to value and coverage ratio pair. It was much more sophisticated and modern to use copulas and instead of evaluating the quality of the credit to use credit ratings of a structured securities of loans.
Goerge Soros has said that the current financial crisis might just be the final end of a fifty year mega credit bubble. If he is right, then we will have quite a long slow ride out of the crisis.
There are two aspects of derivatives that I think were ignored in the run up to the crisis. The first is the leverage aspect of derivatives. A CDS is equivalent to a long position in a corporate bond and a short position in a risk free bond. But few observers and even fewer principals considered CDS as containing additional leverage equal to the full notional amount of the bond covered. And leverage magnifies risk. Worse than that.
Leverage takes the cashflows and divides them between reliable cashflows and unreliably cashflows and sells the reliable cashflows to someone else so that more unreliable cashflows can be obtained.
The second misunderstood aspect of the derivatives is the amount of money that can be lost and the speed at which it can be lost. This misunderstanding has caused many including most market participants to believe that posting collateral is a sufficient risk provision. In fact, 999 days out of 1000 the collateral will be sufficient. However, that other day, the collateral is only a small fraction of the money needed. For the institutions that hold large derivative positions, there needs to be a large reserve against that odd really bad day.
So when you look at the two really big, really bad things about derivatives that were ignored by the users, Taleb’s description of children with dynamite seems apt.
But how should we be dealing with the dynamite? Taleb suggests keeping the public away from derivatives. I am not sure I understand how or where the public was exposed directly to derivatives, even in the current crisis.
Indirectly the exposure was through the banks. And I strongly believe that we should be making drastic changes in what different banks are allowed to do and what different capital must be held against derivatives. The capital should reflect the real leverage as well as the real risk. The myth that has been built up that the notional amount of a derivative is not an important statistic and that the market value and movements in market value is the dangerous story that must be eliminated. Derivatives that can be replicated by very large positions in securities must carry the exact same capital as the direct security holdings. Risks that can change overnight to large losses must carry reserves against those losses that are a function of the loss potential, not just a function of benign changes in market values and collateral.
In insurance regulatory accounting, there is a concept called a non-admitted asset. That is something that accountants might call an asset but that is not permitted to be counted by the regulators. Dealings that banks have with unregulated financial operations should be considered non-admitted assets. Transferring something off to the books to an unregulated entity just will not count.
So i would make it extremely expensive for banks to get anywhere near the dynamite. Or to deal with anyone who has any dynamite.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
For many years, money managers were paid out of the revenue from a small management fee charged on assets. The good performing funds attracted more funds and therefore had more gross revenue. Retail mutual funds usually charged a flat rate. Institutional funds charged a sliding scale that went down as a percentage of assets as the amount of assets went up. Since mutual fund expenses were relatively flat, that meant that the larger funds could generate quite substantial profits.
Then hedge funds came along fifty years ago and established the pattern of incentive compensation of 20% of profits fairly early. In addition, the idea of the fund using leverage was an early innovation of hedge funds.
Another innovation was the custom that the hedge fund manager’s gains would stay in the fund so that the incentives were aligned. But think about how that works. The investor puts up $1 million. The fund gains 20%, the manager gets $400k and the investor gets $160k. Then the fund drops 50%, the investor’s account is now worth $580k – he is down $420k. The manager is down to $80k, but still up by that $80k. The investor is creamed but the manager is well ahead. Seems like that incentives need realignment.
Taleb may be thinking of a major issue with hedge funds – valuation of illiquid investments. Hedge funds often make purchases of totally illiquid investments. Each quarter, the manager makes an estimate of what they are worth. The manager gets paid based upon those estimates. However, with the recent downturn, even in funds that have not shown significant losses have had significant redemptions. When these funds have redemptions, the liquid assets are sold to pay off the departing investors. Their shares are determined using the estimated values of the illiquid assets and the remaining fund becomes more and more concentrated in illiquid assets.
If the fund manager had been optimistic about the value of the illiquid assets or simply did not anticipate the shift in demand that has ocurred with the financial crisis, there may well be a major problem brewing for the last investors out the door. The double whammy of depressed prices for the illiquid assets as well as the distribution based upon values for those assets that are now known to be optimistic.
And over payment of the one sided performance bonuses to the manager were supported by the optimistic valuations.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.
Since I cannot claim to have completely clean hands, I will simply point to the writings of Hyman Minsky. His Financial Instability Hypothesis describes how a financial system goes to the extremes of leverage that creates a crash like what we just experienced. He wrote this in the 1980′s and early 1990′s and then did not feel that there was much chance of the extreme part of that cycle happening any time soon. He thought that the Fed had enough of a handle on the financial system to keep things from getting to a blow up state.
However, he did mention that with the advent of sources of debt and leverage and money outside of the traditional financial system, that if those elements grew enough then they could be the source of a severe problem.
In addition to reading what Minsky wrote, we should also be studying the thinking of those who totally avoided the sub prime securities that caused so much problems for so many very large financial institutions or who were in but got out in time to avoid fatal damages.
Those are often the people with the common sense that we should be using as the basis for the way forward.
Risk management programs need to have a deliberate risk learning function, where insights are developed from the firm’s losses and near misses as well as from others losses and near misses.
In this crisis, we should all seek to learn from those who were not enticed into the web of false knowledge about the riskiness of the sub prime securities. One of the most interesting that I hear at the time when the markets were seizing up was that those who had escaped were too unsophisticated to have gotten into that market.
I spoke to one of those severely unsophisticated people on the buy side and he said that he never did spend too much time looking into the CDOs. He said that he knew what the spreads were on straight mortgage backed securities. And he had some idea of how many additional people were getting a slice in the creation of the CDOs. And then he knew that the CDOs were promising higher yields for the same credit rating as the straight mortgage backed securities. At that point, he was sure that something did not add up and he moved on to look at other things where the numbers did add up. I guess he was just too unsophisticated to understand the stochastic calculus needed to explain how 2-1-1-1 = 3.
We need to learn that kind of unsophistication.
2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.
Most assuredly the socialization of losses and privatization of gains is what has anyone outside of the banking sector furious. Within the sector, everyone seems to believe that they earned their share of the gains. Think about what you hear about the bonus scheme at the banks – the investment banks are said to be paying out about 50% of gains before bonus. I imagine that puts them approximately on par with the hedge funds, if the banks profit figure takes out overhead before calculating the 50% ratio. So the bank incentive comp is based upon the hedge fund incentive comp. Amazingly, the hedge fund managers manage to convince investors to give them their money and lenders to advance them funds to leverage without any hint of a bailout ever in their future. The hedge fund managers generally walk away from the fund when things go wrong and they are no longer have a chance for outsized gains.
Do the bank shareholders understand that they are really investing in a highly leveraged hedge fund? The folks getting those bonuses surely understand that.
Is this the worst of capitalism and socialism? Probably so.
How do we get out of this? It seems that rather than limiting compensation, we ought be assuring shareholders and debt holders of any firms that structure their compensation like hedge funds that they should expect to be treated like hedge funds in the event of failure. Goodbye, no regrets.
One way of looking at the compensation issue is to focus on time frame. There are four time frames to consider:
1. The employees – the recipients of the bonuses. Their time frame looks backwards. They want to be paid for the value that they created for the firm. They want to be paid in cash for that value.
2. The Short Term shareholders. Their time frame is in quarters. They are most interested in what will be posted as the next quarterly earnings. They want to be able to cash out their investment at the point where they believe that the next quarter’s earnings will not grow enough to support future price increases.
3. The Long Term shareholders. Their time frame is in years – probably 3 – 5 years. Which is the expected holding period for a long term shareholder. They are looking for growth in value compared to share price and will usually sell when they believe that the intrinsic value of the firm starts to catch up with the market value.
4. The public. Our time frame is our lifetime. We need to have a financial system that works our entire lifetime. The public gets nothing from the changes in value of the financial system but ends up paying off the losses that exceed the capacity of the financial system.
The compensation and prudential capital for banks is a trade-off between the interests of all four of these groups. In the run up to the crisis, the system tilted in the favor of employees and short term investors to the extreme detriment of the long term shareholders and public.
So the solution is likely to be best if the interests of the long term shareholders are made more important. Right now, a large, possibly most of the long term shareholders are index funds. Index funds are extremely unlikely to want to have any say in corporate governance or compensation.
So you could surmise that the compensation aspect of the crisis and the drift of all things corporate to fall under the sway of short term investors is a result of the prevalence of index funds.
From Neil Bodoff
One of the reasons that so many counterparties bought CDS protection [from the same counterparty, precipitating a crisis] was their desire to reduce their regulatory capital requirements. So the regulatory framework had high capital requirements for credit risk, but low capital requirements when the credit risk was hedged. Basically the regulatory framework created a strong incentive for all banks to simultaneously execute the same strategy of hedging risk via CDS. Lessons are:  Whereas individual firms in a competitive market may pursue various strategies, the government’s monopoly on regulation might create a homogenizing effect on firms’ behavior, thus concentrating risk. Thus the regulatory framework itself becomes a systemic risk and thus requires extra scrutiny and care.  For any regulatory framework, the designers ought to choose someone to “roleplay” the part of firms trying to minimize regulatory capital requirements, so as to understand the behaviors and countermeasures the firms might take in response to the regulatory demands.  Beware of unintended consequences.
From Stelios Ioannides (risk manager)
Continuation of earlier post.
Who is to blame?
OK enough, I agree with you: this is an exaggeration of the situation or the situations that we are currently experiencing but reality can be quite close. What happened in the credit sub-prime crisis can only be justified, in my opinion, by such “monkey” logic. At the end of the day, it’s about designing products, valuing (appropriately) risk, and getting on board the “right” clients with a “desirable”, for our purposes profile. Who is doing that? And how? The industry failed spectacularly on that. It allowed to this “monkey” concept to grow and to gain potential.
Who cares about Value at Risk or CTE and the associated graphics, if there is no clue at all on how these “interesting” numbers were derived in the first place? Using a number with out know the source it is like having a map with numbers but with no street names. You do not know where you are, you might know where you are heading (vaguely) but there is absolutely no way you can reach your destination.
Having some well defined risk measures is just a well accepted methodology that justifies capital intensive and risk sensitive decisions at the big scale. So if you are applying it wrongly, things can fail dramatically, at a huge scale, causing chaos. And of course, when things go wrong the funky or the dummy monkeys will be blamed… These are the ones that will loose their jobs. The cheeky ones stay alive and are the ones that will be hiring soon again.
The way forward
Understanding the details and being aware with the fundamentals is crucial is this arena. “Understanding” is about having the right combination of skills and applying these fundamentals. It is also about being able to realize how decisions that might be executed in interrelated contexts like pricing, capital reserving and hedging (just to mention a few) might be derived by ones work.
Knowledge exists, technology exists and in my opinion, it is a pity that people still stick to the old practices. There is strong need to refresh or at least fine tune these well established “ways of doing things”. In no situation, we should act like “robots” that mechanically do things. We need monkeys that are owners and responsible of their piece of work regardless how small that is.
If we fail to do that then the “disease” might propagate in otter industries, and in that case of course, the consequences might scary (at least to say). We spent millions or even billions for initiatives like Basel, but we have to make sure that some basic, common sense and ethical rules are being obeyed at all levels.
Risk industry calls for better quality transparency and people should soon or later realize that sharing knowledge and information and aligning interests and objectives would benefit, in most cases all parties (of the same side) involved in the project or deal. The way assumptions are derived is crucial. At the same time, being able to control the behavior of clients is of paramount importance. How this is achieved? A way is possibly by proper underwriting and classification.
We are working in various dimensions, we are dealing with risk free worlds, real words, real market assumptions, marking to market and so on and so fourth. Concepts like “Stress Testing” are gaining momentum and potential. In our daily work we have to face concepts like implied volatilities, volatility surfaces, “short-selling” (it took me a while to get this right, honestly) and a few even more complicated terms that I do not want to even to mention them here. The list of these complicated terms is endless and growing fast.
In any case, people have the duty to use these concepts in a consistent and ethical way. Sticking to basic and rather simplistic approaches with regards o problem solving is not wise in the fast world we are living.
We have the duty to teach the new generations how to synthesize skills and knowledge and judge impartially and ethically. I personally believe that the future belongs to the people that the have the courage to ask right questions and the patience to apply the fundamentals … it is the duty of each one of us to find out what that really means.
Perhaps, we could elaborate more one that but due to lack to time I cannot. Hopefully this won’t be the case when I will have to deliver a super important risk project in the future. What am I? Well something in between the dummy and the funky monkey (hopefully closer to the later or better the former?)…
From Neil Bodoff
Accounting on the basis of Historical Cost turned out to cause lots of problems in the 1980’s when banks made loans at low interest rates and then interest rates shot up. Ironically, however, the rules requiring Historical Cost were first required after discovering the abuses leading up to the Great Depression; thus there was a consensus to impose the “more conservative” accounting of Historical Cost. So the crusaders who during the 1930s thought they had fixed financial reporting and prevented crises by imposing “more conservative” accounting had, unwittingly, planted the seeds of a banking crisis that would blossom 40 years later. Lesson: be wary of using measurements that are more conservative or more liberal than they ought to be – strive for accuracy. Broader lesson: beware of unintended consequences.
Guest Post from Stelios Ioannides (risk manager)
In the risk management field, various players are being involved; quite a few are more sophisticated, others are more intelligent and some others are being better informed than the rest. It is a fact that each of these players (as it happens besides in a variety of disciplines) has a different vision and understanding on what is meant by “risk management”. Most importantly, few of them might be passionate about pure modeling and quantitative work, and in the other extreme, a few others might even really hate their risk related work: as they view it as a very, very, boring task. They still continue to do it though out of necessity or due to lack to alternative options. As you can understand, the way these different people apply the concepts of risk management is quote different.
In this short piece of opinion, I will try to present the current “crisis” situation, trying to understand how we end up like this; I will focus on mainly three kinds of professionals or alternatively on three “Monkey” beings that are directly or indirectly relayed with this interesting and fast paced arena.
Using Sophisticated Risk Measures…
There has been a debate around on the usage and applicability of metrics like Value at Risk (VaR) and similar risk sensitive measures. Very important people support these measures but on the other side there is a group of equally intelligent and prestigious practitioners and academics that basically scarp such “dump” initiatives. Who is right? And who is wrong?
I think that metrics like VaR etc are quite useful as long as long their user knows the fundamentals, the assumptions and what is essentially happening the behind the senses. If you blindly trust such measures without asking the right questions or without challenging your assumptions, I think you run a high risk for various reasons. Let’s see how our professionals (all “males” monkeys” for simplicity) behave in this complex and chaotic world.
The Dummy Monkey…
This kind of professional, never or rarely asks questions. He blindly trusts the risk software that he is using in order to perform his job. Work can be hectic as he might need to elaborate and complete loads of calculations on a daily basis. He is neither interested or cares on risk management concept or best practices. The important thing for him is to prepare the report with the numbers or the information being asked for and that’s it. The consequences of his work are unknown to him. He is not necessarily aware of the decisions that will be taken (such decisions will be based on the work that HE eventually has produced). In the majority of the cases he is not aware how the models were built or who was involved in the development of the models or software. In that respect, he cannot improve or correct things. He is just capable of typing various inputs into the right, hopefully, boxes and derives some automated reports that in most cases mean nothing to him. So who can build the models then? What is really going on here?!
The Funky Monkey…
The intellectual curiosity of the kind of professional urges him to study and work hard. This monkey is very clever and gifted. He works restless and builds fantastic models. The thing is these models might be wrong and very possibly, these models do not necessarily reflect reality. But who cares? That is fine thought. As long as these “reliable – enough” (who gives the approval, who validates?) financial models, that can be used easily by the dummy (user) monkeys is fine. Who cares about reflecting reality and getting the fundamentals 100% right? The thing is to have more or less an acceptable and an “accurate” tool (or better framework) that behaves as he (the model creator) wishes. But what happens when these “funky” beings are wrong? Because they can get perfectly wrong – they work hard, long hours and alone… – who guarantees that somewhere or somehow a mistake was not made (everybody can get confused every now and then, right?)? Do we have the right, objective and independent control measures in place? What happens if not?
Funky monkeys get hired by the Cheeky Monkeys; they get paid good money…
The Cheeky Monkey…
This “being” is the risk management professional at the very high level. Quite powerful and important, he dedicates loads of time executing risk management decisions. He is not merely interested on how answers are being derived or who derived these answers or even who designed the application, model or framework. As long as a clear and straight forward audit trail (well not necessarily) is accompanying such results, then is perfectly fine. The only thing that matter is that such risk measures are being used as indicators and reference for his performance bonus.
More stuff on this worth examining profile? Well, I cannot say mush as I having reached that level…
(To be Continued)
On April 7 2009, the Financial Times published an article written by Nasim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…
1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.
It does seem safer to that fragile things break when they are small. Unfortunately, what seems to have happened was that big things were permitted to become fragile. So large things need to be encouraged to avoid becoming fragile. It is hard to imagine why such encouragement might be needed. For something to be large, it is usually very valuable. (Unless it is a US auto manufacturer) And most sane people work very hard to protect their valuable possessions. And most of the people who are engaged to run large firms are sane people who would be expected to avoid fragility as well.
So one explanation that fits the facts is that almost everyone did not know that the large firms were fragile.
Which leads to the third sentence. The easy conclusion is that the risks of the big banks were hidden. Some they hid themselves – such as all of the off balance sheet risks. Other risks was hidden even from them.
And fortune favors those with hidden risks because they will hold capital based upon the visible risks and report profits from the actual risks.
So how do we solve the riddle? How do we make sure that large organizations do not become fragile?
The only sensible answer seems to be that there needs to be better risk assessment, probably independent reliable risk assessment.
And because of the extreme complexity of the larger firms, the resources applied to this independent assessment need to be quite substantial.
Time will be required for a thorough risk assessment. It is unlikely that a good job could be done in time for a financial statement, unless the independent assessors are working inside the institutions with full knowledge of positions at all times.
The second sentence suggests that the risk assessments should have a negative size bias- the larger the firm the more risk would be assumed. There seems to be some talk in that direction from the regulators. But the thing that will put that to an abrupt end will be if one or more of the countries with major international banks fails to adopt the same sort of anti-size bias, tilting competition in the favor of their banks.
What can a risk manager take from this? For assessing investment risk, it may make sense for risk models to take a sector, rather than an index or ratings approach to looking at investment risk. The financial sector tends to lead the real economy in timing and severity of downturns. More robust modeling may reveal better strategies for investing that reflect the real risks in financial firms.
And finally, the risk manager should really question whether it ever makes sense to invest in financials unless their risk disclosures become much, much better. There was really no hint to investors that the large banks had built up so much risk. Why, from a risk management point of view, does it make any sense to make an investment that you cannot find out the nature or extent of the underlying risks or any usable information about when that risk materially changes.
From Mike Cohen
Perspective: The life insurance business was a relatively straightforward business from its inception and early growth years in the nineteenth century up until the late 1970’s. Whole life insurance, with a fixed rate of return on its savings component in the 4% range, was sold by career agents who were ‘captive’ to (sold exclusively for) their companies. The business model clearly appeared to be sound. An inside joke at life insurance companies (insurance humor being what it is) was that “All you had to do was turn the lights on” and the business worked.
An unprecedented economic event occurred over a span of 4 1/2 years, from late 1976 until the third quarter of 1981, that changed all that. Interest rates spiked to levels never before seen in the United States. The prime rate rose from a cyclical trough of 6.25% in December, 1976 to unheard of levels of 20% or higher in April, 1980, crossed the 20% threshold again for a two month stretch in December, 1980 through February, 2001, and yet again from May through September, 2001. This shock challenged literally everything about the life insurance business:
1) Guaranteed interest rates offered by whole life products were not (at all) competitive with other investment options consumers could get. Policyholders were borrowing heavily from their policies, as the loan interest rates were well below rates they could earn on their investments. This dynamic spawned the financial strategy known as “buy term and invest the difference”, and drove insurers to develop products that paid competitive (relative to the market) rates, such as Universal Life
2) Bonds values were far ‘under water’ (below cost), as the rates of interest they paid were substantially below what investors could earn on other instruments. Without wanting to realize capital losses on their sale, insurers generally had little choice but to hope for a lower interest rate environment.
3) Given that cash flow was leaving companies in substantial and potentially crippling amounts, many companies made one of two disastrous choices (and often both):
- They paid their producers first year (heaped) commissions to rewrite business already on the books so it wouldn’t surrender, ruining the profitability on that business
- They sold business offering current interest rates (GICs were an egregious example) to raise cash, but they weren’t able to invest the cash at comparable rates, locking in a negative spread, and losses. This dynamic spawned the creation of a critical financial/ actuarial technique, Asset Liability Management.
As companies’ profitability reeled from these and related problems, they looked much closer looks at their profit fundamentals and sought ways to improve results. One area of many came under intense scrutiny … distribution costs. In this new environment, companies across the industry learned that an entirely new distribution model was critical for survival, let alone success.
My company at the time (a life insurer) undertook a major strategic analysis in 1983 … products, markets, distribution were the key areas, but not the only ones. I was a member of the four person team heading this critical project. Overheard in one of our working sessions:
“If we could only come up with a diamond in the rough”, said one of the other members on the project team, a close friend of mine.
“We’ve already had it, and it endured for over 100 years.”, I replied. “We now need to develop significantly different solutions, and more fundamentally focus on entirely new ways to think about our business”.
The life insurance industry had reached a dislocation. All of its strategic dynamics changed, and its companies were forced to change with it in order to survive. It took many years; many industry observers would say more than a decade, but the industry was able to essentially reinvent itself and prosper.
Now, in 2009, the life insurance industry is in the throes of the current dislocation as is the entire financial services industry, and its companies are faced with the challenge of responding to a new set of dynamics.
Guest post from Mike Cohen
Dislocation: dis-lo-ca-tion (\,dis-(,)lō-’ka-shən): a disruption of an established order
The financial world has undergone a dislocation of epic proportions, one that is rivaled by only two such situations in our lifetimes: the Great Depression and to a lesser magnitude the interest spike and related chain of events of the early 1980’s. Financial institutions, and even more profoundly the world financial order, have been found to be standing on foundations of sand, and dynamics/financial behaviors/paradigms/systems that we took for granted are not effective, or at the very least stumbling along in a state of disarray and confusion.
As our ‘rose-colored glasses’ (spawned by over-optimism, greed, laziness, ignorance and unjustified trust) have been taken away and replaced with optical devices fitted with Coke-bottle lenses with Vaseline smeared on them, we are confronted with the critical endeavor of recreating nothing less than our way of life and arguably the most important underpinning of it, our financial system.
Our World Has Changed: This dislocation is different and more troubling than any other in history, in large part because it almost triggered the collapse of the world’s financial system. The crisis we are faced with today was caused by widespread business practices where society’s hard learned lessons were ignored:
- The financial system is based on trust (in people, in the system itself), and the resulting belief that it works; there has been a considerable amount of activity that almost any observer would describe as untrustworthy
- Accurate, objective analysis is critical
- Greed kills, sooner or later
Joseph Schumpeter, the famous Czechoslovakian economist, observed in the 1920’s:
Capitalism moves forward following a process of creative destruction. Inevitable cycles of expansion and retraction are not only survivable but are in fact the secret of capitalism’s extraordinary power to inspire innovation and progress.”
It would be completely inaccurate to describe the financial crisis that has occurred as the result of ‘creative destruction’. The root causes of this crisis are much darker.
How did we get to where we are?
- Unjustifiably easy credit was offered to homebuyers who very logically couldn’t have been expected to be able to service their mortgage loans. A substantial price bubble was created and inevitably burst, as many have before it, but this time the entire American society was hurt badly as opposed to individual investors in past bubbles.
- Asset managers making ambitious claims about investment returns they said they couldn’t possibly achieve, and others committing outright fraud
- Rating analysts not adequately analyzing securities, causing them to be overrated and underpriced
- Investment bankers and others facilitating transactions built on elements that had not been properly vetted, and which have turned out to have crushing levels of risk and unforeseen financial liabilities
Macro Issues Abounded:
- The banking system almost collapsed, and may have had it not been for considerable government intervention, which has raised a host of other profound issues. An enormous amount of bad loans were made as the result of capricious underwriting, leading to huge amounts of bad assets on banks’ books and causing a paralyzing level of fear for making further loans.
- The financial markets ‘froze’. The flow of capital slowed to a trickle because lenders did not believe that borrowers were credit-worthy; ironically, the thought process evolved from lending money to anybody to lending money to no one. The markets are just beginning to thaw, a year later.
- Complicated financial instruments confused and overwhelmed the system, creating enormous risk. Counterparties, partners in transactions, did not understand these vehicles they were buying and selling (and in many cases how their counterparts were managing their own enterprises) … and the risks they were taking on. A certain notorious business operation has long held the notion that “Be close to your friends, and closer to your enemies”.
- The real estate market plunged into its worst cycle in decades, and possibly ever. This collapse was caused by a number of dynamics:
* Selling housing/making loans to individuals or companies whose financial positions were not strong enough to service their financial obligations
- The rating agencies have been called to task over their role in the current situation, and a number of vexing questions have been raised:
* How are they analyzing companies and investment vehicles?
* How are they to be paid for their rating services? Are there conflicts of interest imbedded in their client relationships?
* How will they be operating going forward?
* How will they be regulated?
- Consumer attitudes have been more negative than ever since they began being monitored in the 1960’s, although recently they have improved marginally as economic and financial stabilization is beginning to occur. The widespread view is that the current situation is beyond a cyclical downturn and is perceived as a failure of the system. Uncertainty about the financial system, rising unemployment, restricted credit, and a depressed housing market have all contributed to plummeting consumer sentiment.
- Government responses in the form of rescue programs of various types are beginning to fix the problems within the financial system (banks and insurers) and key industries (automotive), and are gradually beginning to calm fears. Substantial efforts to revise the nation’s financial services regulatory infrastructure are underway, conceived to both address current issues and create a more shock-free system in the future. A number of vexing problems have arisen, however, that will be very difficult to solve:
* Well intentioned programs to interject capital to troubled sectors of the economy have been slow to take effect
* Massive budget deficits are building, which will lead to substantial debt servicing obligations in the future and consequentially depressed economic growth
* The government owns stakes in huge corporations (with the implication of socialistic-type government in the United States, for crying out loud!), and is being perceived as making broad decisions on which corporations will survive or fail.
* Understanding that things that can go wrong (either known or unknown), and making sure the adverse affects do not cause crippling and irreversible harm
* A fundamental question begging to be asked is “how did so many elements of this financial disaster occur that had aspects and implications of risk that no one either understood or quantified anywhere close to properly, or didn’t bother to look at?”