Society and the Default Put

The idea of the Limited Liability Corporation is one of the innovations that is credited with making capitalism work. The structure allows a person or group to form a business without risking their entire fortune. That is the way that economics textbooks say it. It sounds like all upside.

But wait a minute. Think about it like a risk manager. A real risk manager, not the hucksters who sold the “risk goes away if you split it fine enough” or the “no increase in total risk because of diversification benefits” stories.

A real risk manager knows that a loss is a loss. A dollar (or euro, or pound) is a dollar. Losses do not disappear EVER. Unless you do the work to prevent them.

And limited liability is NOT a loss prevention program. It prevents losses from transmitting to a certain party. The owner of the company. But someone always gets those losses.

Think about it for just a fraction of a second. If a company has obligations that it cannot pay, who has a loss? You figured it out; their counterparties take the loss. It might be customers, suppliers, subcontractors, their bank, or bondholders. The limited liability idea protects only one group – the owners/shareholders. Everyone else has unlimited liability!

What we saw in the crisis, if you owe the bank $100,000 they own you. If you owe the bank $10,000,000 then you own the bank.

This limited liability idea is totally embedded now. Everyone believes that they have the RIGHT to create problems for everyone else that deals with them and JUST WALK AWAY.

In ancient times, the ultimate collateral was the debtor’s personal freedom. A person who defaulted on a debt became an indentured servant of the lender in the case of default. This idea persisted in one form or another until the 1800s when debtors prisons became out of favor. The US was one country that led the way on this movement. The US has always had a much easier attitude to bankruptcy. There has always been much less stigma attached to bankruptcy along with the easier legal climate.

So the system works this way – people and businesses can go bankrupt easily and put their excess losses onto their counterparties. And in reaction to this, counterparties must be careful who they do business with.

That means that Credit Risk Management is a fundamental aspect of the business environment.

However, when you recognize the underlying fundamental reason for that statement, you may question whether the new statistical based Credit Risk Management that has developed over the past 25 years actually satisfies the fundamental need of the system.

Under the statistical approach to CRM, diversification is the key risk management tool. This has replaced the time consuming and labor intensive credit underwriting process.

But it is the underwriting process that works to counter balance the default put that is implicit in the bankruptcy rules.

Without the underwriting, the statistical process will simply not work. It will give totally wrong information. That is because statistics does not work on any old bunch of numbers. Statistics only works on homogeneous sets of numbers.

Let’s review. The default put creates a situation where a person or a firm can take on obligations that they cannot repay AND they will not be held responsible to repay. When people or businesses operate AS IF they were going to pay obligations, then they can receive value from counterparties that is in excess of the value that they will repay. So their counterparties need to police this imbalance.

Statistical CRM means that the lender will make many loans with the expectation that only a few will fail to repay and there will be limited losses from those failures. But once borrowers notice this (or intermediaries who have a better chance to notice) their best outcome is to borrow as much as they can, to leverage up as much as possible. Their upside in the event that everything turns out well is then enormous and they suffer none of the downside.

So statistical CRM leads directly to deterioration in credit quality through excess leverage. No one is actually watching to make sure that the credit risk per loan is staying constant.

And the main risk management tool of diversification fails when the loans themselves become the major source of risk. The correlation between excessive lending and defaults is very high. It is different from the correlation between loans that can be repaid easily.

All this results directly from that default put.  You need to understand the true dynamics of the system if you want to get your risk management right.

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Explore posts in the same categories: Credit Risk, Enterprise Risk Management

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