Archive for August 2010

Post Pandemic Period

August 31, 2010

10 August 2010 – the WHO declares that the Swine Flu Pandemic has ended.

Or rather they say that we have entered the Post Pandemic Period.

The H1N1 Pandemic is an example of what happens when you do a good job of risk management.  Because of the preparations that were made to develop and distribute vaccines as well as other measures to reduce possible transmission of the virus, and to the fact that the virus did not mutate in a way to become either lethal or resistant to the vaccine, the impact of the Pandemic was not severe.

This is what should happen with good risk management of an emerging risk like that.  Many companies created and/or tested their emergency plans and are now much better prepared for the next emergency.  The plans to prevent systemic failure did go into effect and they worked.

But one of the reactions to effective risk management is disbelief that there ever was a threat.

So it goes.  Do not be discouraged.  Keep up the good fight.

The firms that are run by the skeptics who refuse to take heed of such warnings will at some point get what they haven’t prepared for.

Meanwhile, we now get to learn what Post Pandemic Period means.

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Forget you ever read this

August 30, 2010

I just read a great post that may be a key to understanding both the course of the economy and the public sentiment about government policies.

http://alephblog.com/2010/08/28/queasing-over-quantitative-easing-part-iii/

David Merkel suggests that people are unhappy with the unfairness of government policies.

I would go even further.  People have overwhelmingly come to the conclusion that they need to reduce their own debt.  Many, many people are enduring what they think of as hardship (by ceasing to spend money that they do not have) to bring down their personal debt level.  At the same time, they see the government adding to the public debt.  People are not stupid.  They think of the government debt as THEIR debt.  So they are economizing for naught if for every dollar of debt that they reduce, the government adds a dollar of debt.

Perhaps some day someone will discover a Pelzman effect like mechanism at work with regard to debt.  During the credit bubble that led up to the financial crisis, people where almost totally insensitive to the level of debt.  But now there is a high degree of sensitivity.  So if people feel that there is a right level of debt, then they will take actions to get to that level.  If the government works against that effort, then they will adjust their personal targets so that the aggregate of personal and public debt comes into line with their perceived optimal level of debt.  This may not be because they set a specific target, but because the rising level of public debt makes people uncomfortable and they express that discomfort in the way of looking for more security and less debt.

So maybe the extreme cutting of government spending that is happening in the UK is what is actually needed.  Because the government actions do not exist in some “all things being equal” economics textbook argument.  Government policy and the economy exist in and among the people of the world.

It is widely known that household consumption is a large fraction and major driver of the GDP in the US.  So if we want the GDP to grow, we need to do the things that will get households spending again.  Not in an all things being equal world, but in the real world with real people.

An interesting wrinkle to this is that the Keynesian ideas of using government spending to get out of the Great Depression did not work until the spending for WWII came along and the war spending did the trick.  Some economists have suggested that showed that a larger amount of government spending was needed than was tried prior to WWII.  But the ideas above – that the government spending will not be effective if the people want to save may have kept the earlier spending from working.  The spending for WWII may have worked though BECAUSE people thought of that spending as having its own merits.  WWII spending was necessary.

So perhaps government spending cannot go against the grain of public sentiment to overcome the Paradox of Thrift, unless the public believes that the spending is necessary.

And now to finally link this discussion to risk and risk management…

Perhaps Greenspan is right when he says that he did not know how to pop a bubble.  Maybe that is because he did not believe that he could have changed public opinion about the value of an asset class.  He could take actions that might temporarily hurt the value of an asset class, but it was quite possible that the public attitude would swing right back and keep inflating the bubble in spite of the actions of the Fed.

The same thing certainly has been true within firms.  When the risk manager finds him/her self at odds with the prevailing idea in a firm about a risk, he/she is more likely to lose their job than to change the prevailing opinion.

So in all three cases, in the general economy in severe recession, in an asset bubble and in a company overconfident about a particular risk. the only actions that can be effective will be actions that are not obviously going against the grain.  The actions will need to be designed so that they appear to go with the popular sentiment even when they are really intended to change the fundamentals with regard to that sentiment.

So, I now realize that I need to keep this secret.  So please forget you ever read this.

On The Top of My List

August 28, 2010

I finished a two hour presentation on how to get started with ERM and was asked what were my top 3 things to keep in mind and top 3 things to avoid.

Here’s what I wish I had said:

Top three hings to keep in mind when starting an ERM Program:

  1. ERM must have a clear objective to be successful.  That objective should reflect both the view of management and the board about the amount of risk in the current environment as well as the direction that the company is headed in terms of the future target of risk as compared to capacity.  And finally, the objective for ERM must be compatible with the other objectives of the firm.  It must be reasonably possible to accomplish both the ERM objective and the growth and profit objectives of the firm at the same time.
  2. ERM must have someone who is committed to accomplishing the objective of ERM for the firm.  That person also must have the authority within the firm to resolve most conflicts between the ERM development process and the other objectives of the firm. And they must have access to the CEO to be able to resolve any conflicts that they do not have the authority to resolve personally.
  3. Exactly what you do first is much less important than the fact that you start doing something to develop an ERM program.   Doing something that involves actually managing risk and reporting the activity is a better choice than a long term developmental project.  It is not optimal for the firm to commit to ERM, to identify resources for that process and then to have those people and ERM disappear from  sight for a year or more to develop the ERM system.  Much better to start giving everyone in management of the firm some ideas of what ERM looks and feels like.  Recognize that one product that you are building is confidence in ERM.

Things to Avoid:

  1. Valuing ERM retrospectively taking into account only experienced gains and losses.  (see ERM Value)  A good ERM program changes the likelihood of losses, but in any short period of time actual losses are a matter of chance.  On the other hand, if your ERM programs works to a limit for losses from an individual transaction, then it IS a failure if the firm has losses above that amount for individual transactions.
  2. Starting out on ERM development with the idea that ERM is only correct if it validates existing company decisions.  New risk evaluation systems will almost always find one or more major decisions that expose the company to too much risk in some way. At least they will if the evaluation system is Comprehensive.
  3. Letting ERM routines substitute for critical judgment.  Some of the economic carnage of the Global Financial Crisis was perpetuated by firms where their actions were supported by risk management systems that told them that everything was ok.  But Risk managers need to be humble.

But in fact, I did get some of these out. So next time, I will be prepared.

Changing Risk Tolerance

August 22, 2010

One of the reasons that many firms have not yet set a risk tolerance seems to be that management is afraid that the Risk Tolerance will then take over the company and they will no longer be able to make major decisions because of the risk tolerance.

I imagine the picture of a large sumo wrestler with the name “risk tolerance” sitting in the  corner of the executive conference room.  It would be really smart to avoid making risk tolerance unhappy.

But that is not really the case.  Risk Tolerance is not going to sit on you if you make the wrong decision.  Risk Tolerance is not going to actively insist that you make a decision that you know is wrong.

Risk Tolerance is more like the little brother that tags along behind you.  You know that if you do anything little brother will tell Mom.

Risk Tolerance is a commitment to acting as your own little brother.  Telling on yourself if you take on risk that goes beyond a certain pre-agreed upon point.

Then it is up to you to convince the higher authority that your risk taking was appropriate for whatever reason that you have.

In addition, Risk Tolerance should not be carved in stone.  Risk Tolerance should be written on the white board in Erasable marker.  You should not expect to clean that board every week.  But the option will always be there to walk up to the board and wipe it clean.

That does not mean that every time that it is inconvenient that the Risk Tolerance should be changed.  But it does mean that as the world changes, you should be sure that you Risk Tolerance still means what you intended it to mean when it was set.

Otherwise, you are in danger of having it turn into a Sumo Wrestler in the corner.

Around the Corner Risk

August 19, 2010

That is where the risk manager really earns their money.

The risks that are coming straight down the road, well that is important to pay attention to them.  But those are the obvious risks.  I would not pay very much for help in avoiding serious accidents from those risks.

But those round the corner risks, that would be very valuable, to have someone who can help to make sure that those out of sight risks do not ruin things.

However, what any risk manager who has tried to focus attention on the Around the Corner Risks has learned is that attending to such risks is often seen as spoiling the game.

In the Black Swan, Nassim Taleb talks about the degree to which businesses are in effect selling out of the money puts and pocketing the risk premium as if it is pure profits.

And that is often the case.  Risk managers should extend their view to include analysis of the actual source of profits of the various endeavors of their firms.  Any place where the profits are larger than can be explained is a place where the firm might well be getting paid for selling those puts.

The risk manager needs to be able to take that analysis of sources of profits back to top management to have a frank discussion of those unexplained sources of profits.

In most cases, those situations are risks to the firm, either because they represent risk premium for out of the money puts or because they represent temporary inefficiencies.  The risk from the temporary inefficiencies is that if management mistakenly assumes that those inefficiencies are permanent, then the firm may over-invest in that activity.  That over-investment may then eventually lead to the creation of those our of the money puts as a way to sustain profits when the inefficiencies are extinguished by the market.

An example of this situation is the Variable Annuity market in the US.  In the early 1990’s firms were able to achieve good profits from this business largely because there were too few companies in the market.  Every market participant could show good profits and growth in this new market without resorting to price competition.  This situation attracted many additional insurers into the market, flattening the profitability.  The next phase in the market was to offer additional benefits to customers at prices below market cost.  These additional benefits were in the form of out of the money puts – guarantees against adverse experience of the investments underlying the product.  And the risk premium charged for these benefits was often booked as a profit.

One of the reasons for the confusion between risk premium and profit is the way in which we recognize profits on risks where the period of the risk occurrence is much longer than the period for financial reporting.

The analysis of source of profits can be a powerful tool to help risk managers to both see those around the corner risks and to communicate the possible around the corner risks before them become immanent.

Did you accept your data due to Confirmation Bias?

August 15, 2010

Confirmation bias (also called confirmatory bias or myside bias) is a tendency for people to favor information that confirms their preconceptions or hypotheses regardless of whether the information is true. As a result, people gather evidence and recall information from memory selectively, and interpret it in a biased way. The biases appear in particular for emotionally significant issues and for established beliefs. For example, in reading about gun control, people usually prefer sources that affirm their existing attitudes. They also tend to interpret ambiguous evidence as supporting their existing position. Biased search, interpretation and/or recall have been invoked to explain attitude polarization (when a disagreement becomes more extreme even though the different parties are exposed to the same evidence), belief perseverance (when beliefs persist after the evidence for them is shown to be false), the irrational primacy effect (a stronger weighting for data encountered early in an arbitrary series) and illusory correlation (in which people falsely perceive an association between two events or situations).

From wikipedia

Today’s New York Times tells a story of Japanese longevity data.  Japan has long thought itself to be the home of a large fraction of the world’s oldest people.  The myth of self was that the Japanese lifestyle was healthier than that of any other people and the longevity was a result.

A google search on “The secret of Japanese Longevity” turns up 400,000 web pages that extol the virtues of Japanese diet and lifestyle.  But the news story says that as many as 281 of these extremely old Japanese folks cannot be found.  The efforts to find them revealed numerous cases of fraud and neglect.  This investigation started after they found that the man who had been on their records as the longest lived male had actually been dead for over 20 years!  Someone had been cashing his pension checks for those years and neglecting to report the death.

The secret of Japanese Longevity may well be just bad data.

But the bad data was accepted because it confirmed the going in belief – the belief that Japanese lifestyle was healthier.

The same sort of bad data fed the Sub Prime crisis.  Housing prices were believed to never go down.  So data that confirmed that belief was readily accepted.  Defaults on Sub Prime mortgages were thought to fall within a manageable range and data that confirmed that belief was accepted.

Data that started to appear in late 2006 that indicated that those trends were not going to be permanent and in fact that they were reversing was widely ignored.  One of the most common aspects of confirmation bias is to consider non-confirming data as unusable in some way.

We try to filter out noise and work only with signal.  But sometimes, the noise is a signal all its own.  And a very important signal to risk managers.

An Unusually Uncertain Economy

August 13, 2010

Economists sometimes admit that the economy has different phases.  I think that they are now up to three:  Boom, Bust and Normal.

Most of the Economics literature of the past 30 years relates solely to the Normal environment.

There may be economics literature relating to the Boom phase, but who would know.  No one ever listens to an economist during a boom.

Keynes provided the theories for the Bust phase.  His ideas had been discredited up until they were needed again.  Now many economists are again looking at the Bust phase.

But on July 22, Bernanke said that the recovery was “unusually uncertain”.

There just do not seem to be any economic theories about this “uncertain” environment.  Perhaps that is why no one seems to know what to do.  They have prescriptions that would work if the environment was still in a Bust.  So maybe a double dip recession is needed to take the economy back into a phase where there are economic theories.

What economics needs is a theory of the Uncertain Environment. There are definitely theories in the minds of consumers and business leaders.  Here is one:

In the face of massive uncertainty, hedging your bets and keeping your options open is almost always the right strategy.

Jim Manzi

And that is mostly what we see businesses and individuals doing right now.  Keeping their options open.  Hence the massive buildup of corporate cash and the paydown of individual debt.

I do not have a full economic theory for the Uncertain times, but I can suggest that economists need to start treating this as a true phase of the economy and developing a theory.


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