What Do Your Threats Look Like?

Severe and intense threats are usually associated with dramatic weather events, terrorist attacks, earthquakes, nuclear accidents and such like.  When one of these types of threats is thought to be immanent, people will often cooperate with a cooperative ERM scheme, if one is offered.  But when the threat actually happens, there are four possible responses:  cooperation with disaster plan, becoming immobilized and ignoring the disaster, panic and anti-social advantage taking.  Disaster planning sometimes goes no further than developing a path for people with the first response.  A full disaster plan would need to take into account all four reactions.  Plans would be made to deal with the labile and panicked people and to prevent the damage from the anti-social.  In businesses, a business continuity or disaster plan would fall into this category of activity.

When businesses do a first assessment, risks are often displayed in four quadrants: Low Likelihood/Low Severity; Low Likelihood/High Severity; High Likelihood/Low Severity; and High Likelihood/High Severity.  It is extremely difficult to survive if your risks are High Likelihood/High Severity, so few businesses find that they have risks in that quadrant.  So businesses usually only have risks in this category that are Low Likelihood.

Highly Cooperative mode of Risk Management means that everyone is involved in risk management because you need everyone to be looking out for the threats.  This falls apart quickly if your threats are not Severe and Intense because people will question the need for so much vigilance.

Highly Complex threats usually come from the breakdown of a complex system of some sort that you are counting upon.  For an insurer, this usually means that events that they thought had low interdependency end up with a high correlation.  Or else a new source of large losses emerges from an existing area of coverage.  Other complex threats that threaten the life insurance industry include the interplay of financial markets and competing products, such as happened in the 1980’s when money market funds threatened to suck all of the money out of insurers, or in the 1990’s the variable products that decimated the more traditional guaranteed minimum return products.

In addition, financial firms all create their own complex threat situations because they tend to be exposed to a number of different risks.  Keeping track of the magnitude of several different risk types and their interplay is itself a complex task.  Without very complex risk evaluation tools and the help of trained professionals, financial firms would be flying blind.  But these risk evaluation tools themselves create a complex threat.

Highly Organized mode of Risk Management means that there are many very different specialized roles within the risk management process.  May have different teams doing risk assessment, risk mitigation and assurance, for each separate threat.  This can only make sense when the rewards for taking these risks is large because this mode of risk management is very expensive.

Highly Unpredictable Threats are common during times of transition when a system is reorganizing itself.  “Uncertain” has been the word most often used in the past several years to describe the current environment.  We just are not sure what will be hitting us next.  Neither the type of threat, the timing, frequency or severity is known in advance of these unpredictable threats.

Businesses operating in less developed economies will usually see this as their situation.  Governments change, regulations change, the economy dips and weaves, access to resources changes abruptly, wars and terrorism are real threats.

Highly Adaptable mode of Risk Management means that you are ready to shift among the other three modes at any time and operate in a different mode for each threat.  The highly adaptable mode of risk management also allows for quick decisions to abandon the activity that creates the threat at any time.  But taking up new activities with other unique threats is less of a problem under this mode.  Firms operating under the highly adaptive mode usually make sure that their activities do not all lead to a single threat and that they are highly diversified.

Benign Threats are things that will never do more than partially reduce earnings.  Small stuff.  Not good news, but not bad enough to lose any sleep over.

Low Cooperation mode of Risk Management means that individuals within their firm can be separately authorized to undertake activities that expand the threats to the firm.  The individuals will all operate under some rules that put boundaries around their freedom, but most often these firms police these rules after the action, rather than with a process that prevents infractions.  At the extreme of low cooperation mode of risk management, enforcement will be very weak.

For example, many banks have been trying to get by with a low cooperation mode of ERM.  Risk Management is usually separate and adversarial.  The idea is to allow the risk takers the maximum degree of freedom.  After all, they make the profits of the bank.  The idea of VaR is purely to monitor earnings fluctuations.  The risk management systems of banks had not even been looking for any possible Severe and Intense Threats.  As their risk shifted from a simple “Credit” or “Market” to very complex instruments that had elements of both with highly intricate structures there was not enough movement to the highly organized mode of risk management within many banks.  Without the highly organized risk management, the banks were unable to see the shift of those structures from highly complex threats to severe and intense threats. (Or the risk staff saw the problem, but were not empowered to force action.)  The low cooperation mode of risk management was not able to handle those threats and the banks suffered large losses or simply collapsed.

Not About Capital

The reality is that regulatory capital requirements, no matter how much we try to refine them, will always be a blunt tool.  Certainly they should not create the wrong incentives, but we cannot micromanage firm behavior through regulatory capital requirements.  There are diminishing returns to pursuing precision in regulatory capital requirements.

Terri Vaughan, NAIC

These remarks were made in Europe recently by the lead US regulator of the insurance industry.  In Europe, there has never been a regulatory capital requirement that was risk related.  But the Europeans have been making the discussion all about capital for about 10 years now in anticipation of their first risk based capital regime, Solvency II.

The European assumption is that if they follow as closely as possible the regulatory regime that has failed so spectacularly to control the banking system, Basel II, then everything will be under control.

The idea seems to be that if you concentrate, really concentrate, on measuring risk, then insurance company management will really take seriously the idea of managing risk.   Of course, that conclusion is also based upon the assumption that if you really, really concentrate on measuring risk that you will get it right.

But the Law of Risk and Light tells us that our risk taking systems will lead us to avoid the risk in the light and to load up on the risk in the dark.

That means the risks that are properly measured by the risk based capital regulatory system will be managed.

But whatever risks that are not properly measured will come to predominate the system.  The companies that take those risks will grow their business and their profits faster than the companies that do not take those poorly measured risks.

And if everyone is required to use the same expensive risk measurement system, very, very few will invest the additional money to create alternate measures that will see the flaws in the regulatory regime.

The banking system had a flaw.  And many banks concentrated on risks that looked good in the flawed system but that were actually rotten.

What is needed instead is a system that concentrates on risk controlling.  A firm first needs a risk appetite and second needs a system that makes sure that their risks stay within their appetite.

Under a regulatory risk capital system, the most common risk appetite is that a firm will maintain capital above the regulatory requirement.  This represents a transfer of the duty of management and the board onto the regulator.  They never need to say how much risk that they are willing to take.  They say instead that they are in business to satisfy the regulator with regard to their risk taking.

The capital held by the firm should depend upon the firm’s risk appetite.  The capital held should support the risk limits allowed by the board.

And the heart of the risk control system should be the processes that ensure that the risk stays within the limits.

And finally, the limits should not be a part of a game that managers try to beat.  The limits need to be an extremely clear expression of the fundamental way that the firm wants to conduct business.  So any manager that acts in a way that is contrary to the fundamental goals of the firm should not continue to have authority to direct the activities of the firm.

Risk Velocity

By Chris Mandel

Understand the probability of loss, adjusted for the severity of its impact, and you have a sure-fire method for measuring risk.

Sounds familiar and seems on point; but is it? This actuarial construct is useful and adds to our understanding of many types of risk. But if we had these estimates down pat, then how do we explain the financial crisis and its devastating results? The consequences of this failure have been overwhelming.

Enter “risk velocity,” or how quickly risks create loss events. Another way to think about the concept is in terms of “time to impact” a military phrase, a perspective that implies proactively assessing when the objective will be achieved. While relatively new in the risk expert forums I read, I would suggest this is a valuable concept to understand and more so to apply.

It is well and good to know how likely it is that a risk will manifest into a loss. Better yet to understand what the loss will be if it manifests. But perhaps the best way to generate a more comprehensive assessment of risk is to estimate how much time there may be to prepare a response or make some other risk treatment decision about an exposure. This allows you to prioritize more rapidly, developing exposures for action. Dynamic action is at the heart of robust risk management.

After all, expending all of your limited resources on identification and assessment really doesn’t buy you much but awareness. In fact awareness, from a legal perspective, creates another element of risk, one that can be quite costly if reasonable action is not taken in a timely manner. Not every exposure will result in this incremental risk, but a surprising number do.

Right now, there’s a substantial number of actors in the financial services sector who wish they’d understood risk velocity and taken some form of prudent action that could have perhaps altered the course of loss events as they came home to roost; if only.

More at Risk and Insurance

Why the valuation of RMBS holdings needed changing

Post from Michael A Cohen, Principal – Cohen Strategic Consulting

Last November’s decision by the National Association of Insurance Commissioners (NAIC) to appoint PIMCO Advisory to assess the holdings of non-agency residential mortgage-backed securities (RMBS) signaled a marked change in attitude towards the major ratings agencies. This move by the NAIC — the regulatory body for the insurance industry in the US, comprising the insurance commissioners of the 50 states – was aimed at determining the appropriate amount of risk-adjusted capital to be held by US insurers (more than 1,600 companies in both the life and property/casualty segments) for RMBS on their balance sheets.

Why did the NAIC act?

A number of problems had arisen from the way RMBS held by insurers had historically been rated by some rating agencies which are “nationally recognized statistical rating organizations” (NRSROs), though it is important to note that not all rating agencies which are NRSROs had engaged in this particular rating activity.

RMBS had been assigned (much) higher ratings than they seem to have deserved at the time, albeit with the benefit of hindsight. The higher ratings also led to lower capital charges for entities holding these securitizations (insurers, in this example) in determining the risk-adjusted capital they needed to hold for regulatory standards.

Consequently, these insurance organizations were ultimately viewed to be undercapitalized for their collective investment risks. These higher ratings also led to lower prices for the securitizations, which meant that the purchasers were ultimately getting much lower risk-adjusted returns than had been envisaged (and in many cases losses) for their purchases.

The analysis that was performed by the NRSROs has been strenuously called into question by many industry observers during the financial crisis of the past two years, for two primary reasons:

• The level of analytical due diligence was weak and the default statistics used to evaluate these securities did not reflect the actual level of stress in the marketplace; as a consequence ratings were issued at higher levels than the underlying analytics in part to placate the purchasers of the ratings, and a number of industry insiders observed that this was done.
• Once the RMBS marketplace came under extreme stress, the rating agencies subsequently determined that the risk charges for these securities would increase several fold, materially increasing the amount of risk-adjusted capital needed to be held by insurers with RMBS, and ultimately jeopardizing the companies’ financial strength ratings themselves.

Flaws in rating RMBS

Rating agencies have historically been paid for their rating services by those entities to which they assign ratings (that reflect claims paying, debt paying, principal paying, etc. abilities). Industry observers have long viewed this relationship as a potential conflict of interest, but, because insurers and buyers had not been materially harmed by this process until recently, the industry practice of rating agencies assigning ratings to companies who were paying them for the service was not strenuously challenged.

Further, since the rating agencies can increase their profit margins by increasing their overall rating fees while maintaining their expenses in the course of performing rating analysis, it follows that there is an incentive to increase the volume of ratings issued by the staff, which implies less time being spent on a particular analysis. Again, until recently, the rated entities and the purchasers of rated securities and insurance policies did not feel sufficiently harmed to challenge the process.

Risk Management in 2009 – Reflections

Perhaps we will look back at 2009 and recall that it is the turning point year for Risk Management.  The year that boards ans management and regulators all at once embraced ERM and really took it to heart.  The year that many, many firms appointed their first ever Chief Risk Officer.  They year when they finally committed the resources to build the risk capital model of the entire firm.

On the other hand, it might be recalled as the false spring of ERM before its eventual relegation to the scrapyard of those incessant series of new business management fads like Management by Objective, Managerial Grid, TQM, Process Re-engineering and Six Sigma.

The Financial Crisis was in part due to risk management.  Put a helmet on a kid on a bicycle and they go faster down that hill.  And if the kid really doesn’t believe in helmets and they fail to buckle to chin strap and the helmet blows off in the wind, so much the better.  The wind in the hair feels exhilarating.

The true test of whether the top management is ready to actually DO risk management is whether they are expecting to have to vhange some of their decisions based upon what their risk assessment process tells them.

The dashboard metaphor is really a good way of thinking about risk management.  A reasonable person driving a car will look at their dashboard periodically to check on their speed and on the amount of gas that they have in the car.  That information will occasionally cause them to do something different than what they might have otherwise done.

Regulatory concentration on Risk Management is. on the whole, likely to be bad for firms.  While most banks were doing enough risk management to satisfy regulators, that risk management was not relevant to stopping or even slowing down the financial crisis.

Firms will tend to load up on risks that are not featured by their risk assessment system.  A regulatory driven risk management system tends to be fixed, while a real risk management system needs to be nimble.

Compliance based risk management makes as much sense for firms as driving at the speed limit regardless of the weather, road conditions or the conditions of the car’s breaks and steering.

Many have urged that risk management is as much about opportunities as it is about losses.  However, that is then usually followed by focusing on the opportunities and downplaying the importance of loss controlling.

Preventing a dollar of loss is just as valuable to the firm as adding a dollar of revenue.  A risk management loss controlling system provides management with a methodology to make that loss prevention a reliable and repeatable event.  Excess revenue has much more value if it is reliable and repeatable.  Loss control that is reliable and repeatable can have the same value.

Getting the price right for risks is key.  I like to think of the right price as having three components.  Expected losses.  Risk Margin.  Margin for expenses and profits.  The first thing that you have to decide about participating in a market for a particular type of risk is whether the market in sane.  That means that the market is realistically including some positive margin for expenses and profits above a realistic value for the expected losses and risk margin.

Most aspects of the home real estate and mortgage markets were not sane in 2006 and 2007.  Various insurance markets go through periods of low sanity as well.

Risk management needs to be sure to have the tools to identify the insane markets and the access to tell the story to the real decision makers.

Finally, individual risks or trades need to be assessed and priced properly.  That means that the insurance premium needs to provide a positive margin for expenses and profits above the realistic provision for expected losses and a reasonable margin for risk.

There were two big hits to insurers in 2009.  One was the continuing problems to AIG from its financial products unit.  The main lesson from their troubles ought to be TANSTAAFL.  There ain’t no such thing as a free lunch.  Selling far out of the money puts and recording the entire premium as a profit is a business model that will ALWAYS end up in disaster.

The other hit was to the variable annuity writers.  In their case, they were guilty of only pretending to do risk management.  Their risk limits were strange historical artifacts that had very little to do with the actual risk exposures of the firm.  The typical risk limits for a VA writer were very low risk retained from equities if the potential loss was due to an embedded guarantee and no limit whatsoever for equity risk that resulted in drops in basic M&E revenue.  A typical VA hedging program was like a homeowner who insured every item of his possessions from fire risk, but who failed to insure the house!

So insurers should end the year of 2009 thinking about whether they have either of those two problems lurking somewhere in their book of business.

Are there any “far out of the money” risks where no one is appropriately aware of the large loss potential ?

Are there parts of the business where risk limits are based on tradition rather than on risk?

Have a Happy New Year!

Commentary on Timeline of the Global Financial Crisis

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

Non-Linearities and Capacity

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.

RISK USA Conference – October 2009

Many, many good questions and good ideas at the RISK USA conference in New York.  Here is a brief sampling:

• Risk managers are spending more time showing different constituencies that they really are managing risk.
• May want to change the name to “Enterprise Uncertainty Management”
• Two risk managers explained how their firms did withdraw from the mortgage market prior to the crisis and what sort of thinking by their top management supported that strategy
• Now is the moment for risk management – we are being asked for our opinion on a wide range of things – we need to have good answers
• Availability of risk management talent is an issue.  At both the operational level and the board level. 
• Risk managers need to move to doing more explaining after better automating the calculating
• Group think is one of the major barriers of good risk management
• Regulators tend to want to save too many firms.  Need to have a middle path that allows a different sort of resolution of a troubled firm than bankrupcy.
• Collateral will not be a sufficient solution to risks of derivatives.  Collateral covers only 30 – 50% of risk
• No one has ever come up with a theory for the level of capital for financial firms.  Basel II is based upon the idea of keeping capital at about the same level as Basel I. 
• Disclosure of Stress tests of major banks last Spring was a new level of transparency. 
• Banking is risky. 
• Systemic Risk Regulation is impossibly complicated and doomed to failure. 
• Systemic Risk Regulation can be done.  (Two different speakers)
• In Q2 2007, the Fed said that the sub-prime crisis is contained.  (let’s put them in charge)
• Having a very good system for communicating was key to surviving the crisis.  Risk committees met 3 times per day 7 days per week in fall 2008. 
• Should have worked out in advance what do do after environmental changes shifted exposures over limits
• One firm used ratings plus 8 additional metrics to model their credit risk
• Need to look through holdings in financial firms to their underlying risk exposures – one firm got red of all direct exposure to sub prime but retained a large exposure to banks with large sub prime exposure
• Active management of counterparties and information flow to decision makers of the interactions with counter parties provided early warning to problems
• Several speakers said that largest risk right now is regulatory changes
• One speaker said that the largest Black Swan was another major terrorist attack
• Next major systemic risk problem will be driven primarily by regulators/exchanges
• Some of structured markets will never come back (CDO squareds)
• Regret is needed to learn from mistakes
• No one from major firms actually went physically to the hottest real estate markets to get an on the ground sense of what was happening there – it would have made a big difference – Instead of relying solely on models. 

Discussions of these and other ideas from the conference will appear here in the near future.

Coverage and Collateral

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:

1.  Coverage

2.  Collateral

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.

Black Swan Free World (3)

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…

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.

How prescient.

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.

Black Swan Free World (10)

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Another Risk Management Book On The Best–Sellers List…

Guest Post from Ronald Poon Affat

What do these books have in common?

* “The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron”

* “When Genius Failed: The Rise and Fall of Long-Term Capital Management”

* “The Black Swan: The Impact of the Highly Improbable”

* “Against the Gods: The Remarkable Story of Risk”

They are all about risk management and they all rub shoulders with best-selling books widely sold in airports. OK, they haven’t quite made Oprah’s book club as yet… but have patience. I recall when I qualified way back in 1987 no one could have imagined that a book on risk management would venture out of an actuarial reading list. Well, so much for being trained to predict the future.

Sadly, these days one does not have to visit the local Barnes & Noble to gawk at the latest corporate crash sites. The TV reports and newspapers are full of the stuff. Disgraced CEOs, CFOs, CROs and even reinsurance managers are now targets of the paparazzi.

Enoch Powell, the controversial British politician, once remarked, “All political lives end in failure.” Are risk managers destined to suffer the same fate?

My guess is that the fallen CEOs and Boards of Directors felt totally safe in the hands of these responsible looking, well-qualified risk management individuals. The trouble was both that the CEOs and Boards of Directors assumed that the company’s risks were being well-managed and it is quite likely that the risk manager did not have any influence regarding product design or pricing. It’s all too often the case that it is only after the product is on the street and the damage has been done that the risk manager is involved. Then he or she is reminded that the company must “deliver the year end numbers.”

Not too long ago, The Economist questioned, “What’s the single most important price in the world?” The popular answers were the price of oil, American interest rates, and the dollar. However, none of these–The Economist argued–may be as important as the price of Chinese wages. So now that we know what the most important prices are, how do we manage these risks? We don’t! I would like to argue that we can’t truly eliminate risk. We can only measure risks and determine the most effective ways to protect ourselves, either through avoidance (changing our activities) or mitigation (protection, such as reinsurance, hedges, etc.).

The discipline of risk measurement results in the formulation of appropriate risk management policies, which then leads to the establishment of reserves, capital adequacy, risk margins and procedures that aim to both recognize and reduce extreme tail events. Highly rated reinsurers hold huge catastrophic reserves for tail events. Even our most infamous Black Swan event, the World Trade Center, did not bring down reinsurers or insurers. Those recent mark-to-market mega balance sheet write downs on the asset side by the banks and AIG, just did not have a corresponding contingency reserve on the liability side to absorb the financial impact. However, it should be noted that the herd effect of bankers led to lots of simultaneous World Trade Center-sized financial events.

So what are the conclusions? It’s time that the CEO and the Board of Directors realize that this responsibility cannot simply be delegated away and also that the risk management process is as crucial in the opening gambit as it is in the end game. Risk management is here to stay! So fellow actuaries, let’s work together with senior management to make sure our companies and clients stay out of the crash-site books at the Barnes & Noble.

The views expressed in this article are those of the author and are not intended to express the views of his employer.

Ronald Poon-Affat FSA, FIA, MAAA, CFA
http://www.linkedin.com/in/ronaldpoonaffat
poolside06@yahoo.com

How Many Dependencies did you Declare?

Correlation is a statement of historical fact.  The measurement of correlation does not necessarily give any indication of future tendencies unless there is a clear interdependency or lack thereof.  That is especially true when we seek to calculate losses at probability levels that are far outside the size of the historical data set.  (If you want to calculate a 1/200 loss and have 50 years of data, you have 25% of 1 observation)

Using historical correlations in the absence of understand the actual interdependencies could possibly result in drastic problems.

An example is the sub primes.  One of the key differences between what actually happened and the models used prior to the collapse of these markets is that historical correlations were used to drive the models for sub primes.  The correlations were between regions.  Historically, there had been low correlations between mortgage default rates in different regions of the US.  Unfortunately, those correlations were an artifact of regional unemployment driven defaults and unemployment is not the only factor that affects defaults.   The mortgage market had changed drastically from the period over which the defaults were measured.  Mortgage lending practices changed in most of the larger markets.  The prevalence of modified payment mortgages meant that the relationship between mortgages and income was changing as the payments shifted.  In addition, the amount of mortgage granted compared to income also shifted drastically.

So the long term low regional correlations were no longer applicable to the new mortgage market, because the market had changed.  The historical correlation was still a true fact, but is did not have much predictive power.

And it makes some sense to talk about interdependency rising in extreme events.  Just like in the subprime situation, there are drivers of risks that shift into new patterns because systems exceed their carrying capacity.

Everything that is dependent on confidence in the market may not correlate in most times, but that interdependency will show through when confidence is shaken.  In addition to confidence, financial market instruments may also be dependent on the level of liquidity in the markets.  Is confidence in the market a stochastic variable in the risk models?  It should be – it is one of the main drivers of levels of correlation of otherwise unrelated activities.

So before jumping to using correlations, we must seek to understand dependencies.

DISLOCATION

Guest post from Mike Cohen

http://www.cohenstrategicconsulting.com/index.php

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?”

Know your embedded assumptions

An implicit assumption in the way that many practitioners use financial models is that their planned activity is marginal to the market. If you ask the manager of a large mutual find about that assumption and they will generally laugh out loud. They are well aware that their trades must be made carefully to avoid moving the market price. Often they will build up a position over a period of time based upon the normal flow of trading in a security. That is a very micro example of non-marginality. What happened with the sub-prime mortgage market was a drastic shift in activity that was clearly not marginal. When the volume of sub prime mortgages rose 10 fold there were two major changes that occurred. First, the sub prime mortgages were no longer going to a marginally more creditworthy subset of the folks who would technically into the sub prime class, they were going to anyone in that class. Any prior experience factors that were observed of the highly select sub prime folks would not apply to the average sub prime folks. So what was true on the margin is not true in general. The second marginal issue is the change in the real estate market that was driven by the non-marginal amount of new sub prime buyers who came into the market. On the way up, this expansion in the number of folks who could buy houses helped to drive the late stages of the price run up because of that increased demand. That increase in price fed into the confidence of the market participants who were feeding money into the market. Risk managers should always be aware that marginal analysis can produce incorrect results. They should follow my mother’s caution “what if everybody did that?”

Lessons from the Financial Crisis (2)

It must be ok if everyone else is doing it – Banks were unwilling to miss out and not take part of this lucrative idea. In the past insurers have been caught up in this approach to business as well. The presence of a well respected firm in a market does not make that market good for everyone.

THis factor was so strong that one bank CEO suggested that if he did not allow his bank to continue in the lucrative sub prime business, that he would start to lose key employees and eventually would lose his job to someone who would participate in that business.

That must be one of the last stages of a bubble, when markets become so profitable that many feel that they have to participate.

In this case, the very low interest rates and spreads for almost any other type of risk helped to feed the situation. The sub prime market was one of the only place where there was any spread to be had.

And a major flaw with the “everyone is doing it” motivation is that some things only work if a small fraction of the market is doing it and fall apart when everyone jumps on.

Just like the ferry. A few people can stand on the edge looking at the shore, but if everyone on the ferry stands along that same edge and looks, the boat may dip and might even capsize.