By Brett Sherman,The Sherman Law Firm
THESE ARE NOT THE RISKS YOU'RE LOOKING FOR...
True risk management begins with one fundamental concept: Companies must prepare for the fact that outcomes can and do differ from expectations.
- SENIOR MANAGEMENT AT FORMER INDEPENDENT WALL STREET INVESTMENT BANKS LIKE LEHMAN BROTHERS, MERRILL LYNCH, and BEAR STEARNS CHOSE TO MAKE VERY BIG BETS ON THE "CONVENTIONAL WISDOM" THAT HOUSING PRICES DO NOT FALL. THIS IS SOMETHING NO JEDI RISK MANAGER WOULD EVER DO.
- A LONG TIME AGO . . . YODA, OBI WAN AND THE CREW COULD HAVE TOLD YOU THAT THAT THERE ARE INFINITE NUMBER OF FORKS IN THE ROAD TO THE FUTURE. PUT ANOTHER WAY, THE FUTURE IS UNKNOWABLE.
- HOUSING PRICES MAY NOT HAVE FALLEN NATIONALLY FOR MANY YEARS BEFORE THE HOUSING BUBBLE POPPED;
- AND WALL STREET MAY NOT HAVE EXPECTED THEM TO FALL (a topic for a different post);
- BUT WALL STREET CERTAINLY KNEW THAT OUTCOMES CAN AND DO DIFFER FROM EXPECTATIONS. THUS, LEHMAN, MERRILL LYNCH, AND BEAR STEARNS KNEW THAT HOUSING PRICES COULD FALL.
- BECAUSE SENIOR EXECUTIVES AT THESE FIRMS WERE MAKING SO MUCH MONEY FROM BIG BETS THAT ULTIMATELY DEPENDED ON THE CONTINUED (AND UNPRECEDENTED SUCCESS) OF THE U.S. HOUSING MARKET, THE FIRMS EITHER HAD NO ANSWER OR DID NOT ADEQUATELY PREPARE TO ANSWER THE MOST BASIC AND OBVIOUS QUESTION:
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Background: Why the Future is Unknowable
No one can predict the future - even the immediate future - with any certainty. Sometimes, events unfold as anticipated, and so we may fool ourselves into believing that we knew what would happen before it happened.
For example: We predict the Patriots will beat the Jets. The Patriots do beat the Jets. We knew it all along. Well... Not quite.
In reality, we made either an educated guess (we watch the teams a lot and we believe the Patriots are better) or a random guess (we know nothing about football, but we like the Patriots uniforms a lot), and our guess turned out to be correct.
The fact that our prediction was right is mostly a matter of luck. The outcome matched our expectation, but that does not mean our prediction was certain to come true. Not even close. What if Tom Brady had broken his leg in the first five minutes of the game? What if half of the Pats defense was struck down with the swine flu the morning of the game? What if Randy Moss caught a long pass and was running free "certain" to score the winning TD and the ball just squirted out of his hands on the ten yard line as he began to celebrate before he reached the end zone?
Maybe the Patriots win despite this seemingly amazing run of bad luck. Maybe they lose.
The main points are these -
While you may expect an outcome, you never be certain that the outcome will in fact match your expectation.
The impact and interplay of infinite variables can make actual outcomes deviate significantly from expected outcomes.
Thus, certainty comes only after the fact. Until that point, there is always a chance that your expectations will be wrong.
Put another way, it is impossible to eliminate the risk that things will not turn out as expected.
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Some of our favorite variables that can impact outcomes (positively or negatively) include weather, timing, mood, whether or not you accellerate through a yellow light or step on the breaks, sunspots and solar flares, the length of the line at Starbucks, sleeping on a decision or making a snap judgement, whether you run to catch your train to work or walk to the platform, content to wait for the next one, and so on and so on, etc., etc. The point, of course, is that our list of variables could go on for millions of pages and still be nowhere near complete.
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RISK MANAGEMENT AND THE FINANCIAL CRISIS
- For financial institutions, minimizing the impact of unexpected outcomes (losses) is the heart of risk management.
Even assuming for the sake of argument the very dubious proposition that senior management and the best analysts and economists at Lehman Brothers, Merrill Lynch, and Bear Stearns truly believed the housing boom would continue indefinitely would be a responsible (even competent) risk management policy required these financial institutions to build into their business models the very real chance that the views of their best analysts and economists could be wrong. Because the future is unknowable, preparing for unexpected outcomes needs to be priority one for risk managers and top decision makers.
- JEDI RISK MANAGEMENT CONCEPTS: RISK MAGNITUDE is as Important as RISK FREQUENCY.
No amount of risk management can account for every contingency. But effective risk management must account for the fact that unexpected events will happen, and those unexpected events will produce unexpected losses. Losses come with the territory. However, crippling losses can and should be prevented.
THE FORTRESS BALANCE SHEET
Banks can never be too prepared for unforeseen (and unforeseeable) financial shocks. Banks can never have enough capital. Risk managers must be prepared to circle the wagons and withstand a crisis.
Like JP Morgan Chase CEO Jamie Dimon (Wall Street's current Obe Wan Kenobe) preaches - Banks need a "Fortress Balance Sheet."
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A fortress balance sheet - per Mr. Dimon - is a balance sheet strong enough to assure JP Morgan Chase can withstand severe shocks that arise with little or no warning.
The CEO of JP Morgan Chase has become a rock star for many reasons. One of the main reasons surely must be that Jamie Dimon knows what it means to be a Jedi Risk Manager.
Love your content - keep it up Wall Street Law Blog!
Posted by: Phil Toledo | 24 January 2010 at 04:50 PM
Dear Wall Street Law Blog: Big fan of your posts. At least you people show some outside the box analysis. Somehow I missed this post when you published it. Great stuff - Jamie Dimon as Obe Wan Canobe? Is jimmy cayne Darth Vader?
Hugs and kisses -
Genn Genn by Big Ben
London, England
Posted by: Gennifer C. Spanule | 12 February 2010 at 06:34 PM
Excellent article.
As an actuary, I am not sure Mr. Dimon's goal is attainable. I can reserve for reasonable problems I can forsee. I don't see how you can create a fortress.
If everyone shows up at Chase to withdraw their money, what would he do?
Posted by: Colin Thompson | 13 April 2010 at 04:05 PM