Hints for the Next Economic Crisis: Know Your Risks

by Robert N. Charette, Fellow and Director, Enterprise Risk Management & Governance Practice, Cutter Consortium

The last eight weeks have been fascinating to watch -- at least from a cold-eyed appraisal perspective of how ineffective risk mitigation efforts have been in slowing down -- let alone stopping -- the financial contagion that has spread across the globe.

A large part of the problem has been, of course, the failure to recognize that there was a financial contagion cooking in the Wall Street financial jungle. Like the beginnings of a pandemic that is not recognized, once the contagion started to take hold, it was just too late.

For instance, in late March (doesn't that seem like years ago now?), US Federal Reserve Chairman Ben Bernanke said that the subprime defaults then occurring were "likely to be contained" after the Bears Stearns rescue by the Fed.

However, even as the mortgage situation continued to deteriorate, US Treasury Secretary Henry Paulson said in June that subprime problems "will not affect the economy overall."

More wishful thinking than cold-hearted analysis, that.

As we now know, however, the subprime issues just served as a convenient host to spread the financial contagion to the banking sector in general, then to the insurance markets, credit markets, and on and on until very few industries are unaffected.

We are now somewhere around rescue Plan K, I think. Risk mitigation has been so ineffective that in a recent opinion by economist Russell Roberts published in the Wall Street Journal, he suggests the best risk mitigation strategy right now is to do nothing [1]. Roberts points out that both economists and politicians alike are "clueless" about what to do next, and the actions taken so far are probably making things worse, rather than better.

Good advice. The first principle of risk management, after all is, "Do no harm."

In fact, returning to first principles is the primary decision method that should be followed when facing an uncertain situation.

As the financial detritus continues to pile up, I thought it might be useful to review some additional risk management principles that might prove helpful the next time you find yourself in a messy situation.

1. Know your risks before you act

A Charette risk maxim is, "Risk ignorance begets risk arrogance." As the markets have shown, the risks embedded in the subprime mess were not understood -- even though some very smart financial and government people thought they were. Not only was there ignorance of the risks in individual financial sectors but across financial sectors.

I wrote about how clueless most in the financial industry were to the risks here, but hearing former US Federal Reserve Chairman Alan Greenspan state a few weeks ago that he was in "a state of shocked disbelief" at what has happened truly highlights the depth of the ignorance that existed.

2. Understand your risk context

This goes along with (1) above. The risk context consists of the objectives you are trying to reach, the assumptions that underpin them, and the constraints that can keep you from reaching the objectives.

A favorite risk maxim of mine is, "Assumptions made are risks assumed." Assumptions that are unexamined are problems waiting restlessly to happen. If nothing else, the financial crisis has exposed how poorly -- if at all -- the assumptions underpinning the financial markets were examined and how important assumption analysis is to successfully managing risk. I tell my clients if they can't do anything else, at least do this type of analysis.

Examining constraints is also critical since they are (perceived) barriers to action. I have found it interesting -- again from a professional, not personal, risk management viewpoint at least -- to see how the moral hazard constraint argument that formerly was used by US government officials as an excuse not to intervene in financial markets has gone by the wayside. It is always remarkable to see how supposedly hard constraints are ditched overboard in a crisis.

3. Define completely your criteria for success

There is a raging debate over whether the US government's encouragement to banks to lend to low-income citizens caused the subprime implosion. From the data I have seen, it didn't help, but it is far from certain that this lending by itself was the root of the problem. The government wanted home ownership for this segment of society for a whole host of reasons: home ownership creates individual capital wealth; it helps creates social stability; it helps lower crime; and so on. All these are fine governmental and societal objectives.

Banks and mortgage companies didn't object to the government's encouragement because subprime lending was a source of very profitable fees.

Unfortunately, the success criteria for both the government and the lenders together were not defined -- nor was what it meant to be unsuccessful (i.e., the state we are now in). As a result, each went on to maximize its individual success criteria, to the detriment of the other -- and everyone else directly and indirectly involved, unfortunately.

A better definition of success by both government and lenders might have at least highlighted what "not successful" would have meant -- and served to underline what the real risks were. Another Charette maxim is that, "If you don't know what constitutes success, you sure as heck can't identify the risks that can keep you from achieving it."

4. Understand the behaviors that motivate success

"Greed, greed, greed; politics, politics, politics," explains everything that has happened, according to a Wall Street friend of mine. I think he is probably right.

Success on Wall Street in New York, the City in London, and all the other financial centers of the world was (and still is) measured in stock options and bonuses tied to maximizing short-term financial "performance." If success is measured in that way, expect personal behavior to be maximized to pursue it.

Success in politics is to be reelected -- usually every two years or so. The tried-and-true method for getting reelected is to make sweeping promises and then to "deliver the goods" to your voters.

The subprime mortgage market is where both financial and political behaviors -- even though they were for entirely different reasons -- intersected, aligned, and then became mutually and destructively supportive of one another.

Another Charette maxim is, "Beware intersecting organizational behaviors that create (negative) force multiplier effects."

5. Understand the root causes of risk

The three root causes of risk are: lack of information, lack of control, and lack of time -- in that hierarchical order. Without time, you better have control. Without time and control, you better have information. Without information, you are wandering about the wilderness. Right now, given the lack of information that still exists on how much risk exposure exists in the banks and elsewhere, we are still deep in the financial wilderness.

A corollary to this principle is to understand whether your root causes of risk are tightly or loosely correlated. Another problem this financial crisis has exposed is that many risks that were thought to be uncorrelated were in fact correlated.

Dr. Harry Markowitz, who won the Nobel Prize in economics for portfolio theory, made this point in this week's Wall Street Journal. He said, "Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero. But financial engineers should know that's not true of a portfolio of correlated risks" [2]. Markowitz went on to say, "Selling people what sellers and buyers don't understand is not a good thing."

Furthermore, like behavior force multipliers, highly correlated risks can be extremely dangerous when they create (unknown) negative feedback loops in the system. When this happens, a financial contagion like we are experiencing now can take hold. For example, economist Nouriel Roubini was saying in January that the subprime mess, if not quickly contained, would spill into the near prime then to the prime to consumer credit to auto loans to credit cards to student loans and so on [3].

These risk feedback loops -- and it isn't a single loop but cross-connected loops -- are a major reason why government financial risk mitigation strategies are having such a tough time gaining traction. Taking action to mitigate risk in part of the loop can cause risk to increase in other parts of the loop(s). You have to attack many segments making up the loop simultaneously, which is not easy or inexpensive to do.

A Charette's maxim to remember here is, "Beware risks bringing uninvited friends."

In the next installment, I'll continue discussing further risk management principles that might help keep you from being surprised by risk.

I welcome your comments on this issue of the Cutter Edge and encourage you to send your insights on the market in general to me at rcharette@cutter.com.

Sincerely,
Robert N. Charette, Fellow and Director
Enterprise Risk Management & Governance Practice
E-mail: rcharette@cutter.com

References

1. Roberts, Russell, "Don't Just Do Something. Stand There." Wall Street Journal, 31 October 2008.

2. Crovitz, L. Gordon, "The Father of Portfolio Theory on the Crisis," Wall Street Journal, 3 November 2008.

3. See discussion here.