Wall Street Law Blog

Loss Frequency v. Loss Magnitude - A Financial Risk Management Lesson

 

By  Brett Sherman

The Sherman Law Firm

In finance, risk is the chance that an investment decision or strategy will result in loss.  Any analysis of risk must consider two major elements

- FREQUENCY OF LOSS and MAGNITUDE OF LOSS. 

 

First, defining terms:

Frequency refers to how often an investing or trading strategy generates losses. 

Magnitude refers to the size, or severity, of potential losses. 

 

  A profitable strategy that generates losses most of the time?  Sure.

  

Some really good investing or trading strategies result in losses more often than profits. Suppose, for example, that hyothetical Plan X results in a $10 loss 80% of the time, but a $100 profit 20% of the time.  So, 8 out of every 10 times you attempt the strategy, your expectation is that you will lose $10, for a total loss of $80 dollars.  However, if your expectation holds true, you also will make $100 two out of every ten times the strategy is executed.  

Thus, Plan X is risky from a frequency standpoint because you will lose money most of the time.  However, as long as you can afford to take losses and keep pursuing the strategy, Plan X is still a pretty good gamble because your expectation is that it will pay off over time, generating - on average - a net profit of $120 for every 10 times the strategy is used.   

 

 A strategy that is almost always profitable can still wipe you out.

 Some investment or trading strategies are extremely risky even though they rarely produce losses. Take, for example hypothetical Plan Y, which - on average - produces a $10 profit 90% of the time.  

A 90% success record sure sounds good.  But, if Plan Y results in losses of at least $500 roughly 10% of the time, then the strategy's risk magnitude (potential for large losses) makes it a bad long-term bet.  Why?  Because, for each ten times you execute Plan Y, you expect to suffer a net loss of $990 or more.  

 

Of Short-term Genius and Long-term Disaster

Now, suppose that Trading Desk A1A follows Plan Y for 5 years.  In each of the five years, the Trading Desk A1A makes money for its parent company.  This is no surprise, because Plan Y is profitable 90% of the time.

After five great years, the Company proudly points to its track record of superior performance.  To the investing public (which is ignorant of the fact that Plan Y will eventually generate high  losses), the Company seems to be thriving.

In year 6, the Company's luck begins to run out.  It loses $300, not as bad as the expected loss of at least $500, but still a big enough loss to put the Company on shaky ground.  In year 7, the Company decides to allow Trading Desk A1A to stick with Plan Y.  After all, the investment strategy is almost always successful.  Unfortunately, year 7 is another bad year.  This time, the Company takes a $500 loss.

For the Company, the size (magnitude) of the losses in years 6 and 7 proves to be  catastrophic.  The Company avoids bankruptcy only because JPMorgan Chase agrees to buy the Company for $2 a share.

Disclaimer- this is a hypothetical situation, any similarities to real world events are purely coincidental! 

 

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Lessons in liquidity, insolvency, mark to market accounting, risk management, and the big difference between luck and skill.

Liquidity, Insolvency, and the financial crisis - 

By "Executive" Analogy...

***

Deep in the heart of Texas:

Your neighbor, George, recently lost his job.  

One Saturday morning at nine o'clock, George knocks on your door.   "Morning neighbor, he says.  Want to watch some of them hunting and fishing shows on ESPN 2?

You say ok, and invite him in.  George has been away a while, and besides, he has always been good for a few laughs.  

George pulls a can of Schlitz from his pocket, pops the tab, and takes a few big gulps.  He narrows his eyes.  "Heck, you're one of thos economist fellas, aint ya? "  You respond that you are indeed an economist.  "Riddle me this, then," he says.

Curious, you take the bait, "I'll try."

"Tell me about this mortgage, financial crisis, subprime..."

"You want me to explain the financial crisis to you?"

"Bingo!" 

You can see he is serious.  Well, George, we need to start with a few concepts first."

"Great.  I'm a concept guy. Know what I mean?"  He smiles; punches you in the arm.  "Call me Doubayuh.  George is my daddy."  He giggles.

You clear your throat.  "Ok, uh, Doubayuh.  Well, at the most basic level, I think we need to start with liquidity, then maybe insolvency, risk management maybe - then we'll take it from there."

"Sweet."  He guzzles his Schlitz.

You take a deep breath.  "Ok, well, absent umm government price regulation, the value of any asset is generally set by supply and demand - which basiscally comes down to how many people want it and how bad do they want it." 

Your neighbor interrupts - "Right, right... Supply and demand.  Heard of it.  Go on, Professor."  

You continue.  "Well, if demand is high, you should be able to convert whatever you are selling into cash rather easily.  In other words, you can liquidate your asset for real money.  So that is they mean when they talk about liquidity."

Your neighbor smiles at you.  Then he squints and nods his head.  "That's what who, means, err - I'm afraid you lost me there Professeroooney."  He punches your arm playfully.

"You can call me Mike, sir."  

Course I can call you Mike.  But I like nicknames, if you get me, err, get my drift."  He chuckles. "You know, like Brownie."

"Yes, whatever you want George.  So, I was talking about the folks who set monetary policy.  You asked me who they were."

"Go on, Brownie.  Just kidding.  Go ahead Mike."

"I was talking about the Secretary of the Treasury, the Fed Chairman, bankers, the guys on CNBC..."

"Treasury.  Wait, that rings a bell.  That Paulsen guy, right?  I call him Goldy, cause he used to work at-"

"Mr. Pre- uh, George.  Hank Paulsen isn't the Secretary anymore."

"Really?  I had no idea. I really liked that guy.  Real strong sense of right and wrong, ya know? Goldy - umm Hank Paulsen - The guy was always talking about how we need to avoid moral hazards.  Great family values..."

"Ok.  We need to back up a little bit here George.  You a football fan?"

"How bout them Cowboys!  Course I am.  This is Texas.  Friday night lights is the best book I ever read.  Ok, I didn't read it.  Hell of a good movie.  Go Panthers!"  George pulls a new can of Schlitz out of his other pocket, pops the tab, and pours in a mouthful.

"Great," you say.  "Let's try this with a football example.  I think you'll have an easier time relating to the concepts."

"Go on."

"Let's say you need to come up with two thousand dollars in 48 hours to pay off your losses from a bad bet on the Dallas Cowboys.  Your bookie, let's call her Tipper, has threatened to break your thumbs if you don't pay up.  No problem, you think to yourself.  You're always telling everyone that your, umm, "stuff",  is worth at least ten thousand bucks.  You decide to have a yard sale.  You put an add in the Dallas Morning News. The next day, your ranch is flooded with potential customers."  You with me, George?"

"Heck yeah."

"Ok.  Now, let's say you get offers below what you had hoped.  You sweat it out, but in the end your proceeds are $2,005."

"My thumb is safe, right?"

"Yes.  Your thumb is safe. Anyway, you've just had a liquidity crisis because your assets weren't worth nearly what you thought.  But the crisis didn't kill you because you ultimately were able to raise the money you needed, if just barely."

"Hey now!"

"On the other hand, if you think your stuff is worth ten grand, and you need at least two to pay Tipper, but you raise less than a thousand dollars, then you have a bunch of problems.  First of all, you have a liquidity problem that has evolved into an insolvency problem.  You have nothing to sell, and not enough money to pay your debt.  You are in the hole, sir, and you may need some bankruptcy protection."

"Ouch."

"I know.  Also, you have some serious accounting issues.  You have apparently been inflating the value of your assets by more than 90%."

"Maybe I did it on purpose." He squints again, and cracks up laughing.  His shoulders bounce up and down under a denim jacket.  "Oh man.  No, seriously, how was I supposed to know what the junk was worth? I never tried to sell it before."

"And that is a very good point.  You don't know what the stuff is worth until you try to liquidate it.  However, you've been strutting around town telling bankers, bookies, and whoever else you know that you have more than ten thousand dollars in liquid assets.  The truth is that you have less than one thousand.  And that is the problem with thinly traded assets like CDOs."

"Thin CD who?"

"Forget it.  That's for another day.  The point is that your actual liquidity was less than 10% what you said it was.  Translation, you bet on the Cowboys with money you don't have.  That, my friend, is bad risk management."

"I'm sorry."

"This is just an illustration, George.  You don't need to apologize." 

"I know.  But role-playing is more fun if you really get into it."  He winks.

"Ok. Well then, unfortunately for you, the Philadelphia Eagles crushed the Cowboys.  Next comes the painful consequences of your high-risk behavior."  

"You mean?"

"Yes George, Tipper is gonna come break your thumb."

"Hah - fat chance - She'll never catch me."

"Probably not, sir.  Now, here is the really interesting part - for me at least.  You could have gotten lucky and won your first bet.  Maybe you accidentally bet on the Eagles or something like that.  Point is, if you won that first bet, you would not have had any reason to liquidate your stuff.  Nobody would know that you overvalued your assets. And nobody would know how poorly you manage risk."

"Now that sounds good to me."

"That's what the banks thought."

"Which banks?"

"Uh, we'll save that for next time too."

"Good."

"All right. So maybe you win the first bet, and then go on a nice streak, winning bets for 6 weeks in a row.  Even better, let's say you let all the winnings ride each week and keep right on winning.  Everyone would be impressed at your obvious skill.  You also would have made a small fortune.  There's no reason to stop, you think.  You are damn good at this football betting.  Its easy money. How bout them Cowboys, indeed."

"Professor, this sounds too good to be true."

"I'm impressed, George.  Ok. So you know you are taking too many risks.  But you do it anyway. You let it all ride on week 7.  The game happens to be a a rematch with Philly.  The Eagles smoke the Cowboys again.  You lose it all.  Every penny.  Nobody thinks you are so smart anymore.  How could you lose so badly.  Haven't you heard of hedging your bets? In the end, people correctly judge you as just another risk-taker that had a lucky streak and blew up."

"Wow."  George finishes his beer and then checks his watch.  "I've got to go Professor.  But that was one wild roller coaster ride.  Thanks for the lesson on liquidity, insolvency, and gambling.  Next time maybe we can talk about the notional value of credit default swaps."  He stands, smiles, and winks.  "Adios amigo." He says.

"Goodbye sir."

By Brett Sherman, The Sherman Law Firm

Lessons in liquidity, insolvency, mark to market accounting, risk management, and the big difference between luck and skill.

Liquidity, Insolvency, and the financial crisis - 

By "Executive" Analogy...

Wall Street Rationale Reviewed...

Wall Street deception revealed by a basic analogy:

The housing market has never collapsed is to 

The housing market cannot collapse                                               

-AS-

I have never been dead is to

I am immortal

By Brett Sherman

Thanks to Nassim Nicholas Taleb and Jim Grant for inspiration.

 

High Risk Strategies Fail In the Long Run - See, for example, Bear Stearns

1.      The definition of risk is the chance of loss.  If an action carries a chance of loss, it is risky.  The greater the chance of loss, the greater the risk. Risk magnitude refers to the size of potential loss. If the potential loss from a given risk could wipe you out, the magnitude is very high.

2.      Why do high risk strategies threaten long-term survival?  Think of betting your life savings on a game of Russian Roulette.[1] Once a year,  on New Year’s Eve, you hold a cold steel pistol to your temple.  The gun has six chambers, but only one holds a bullet.  You say a little prayer and squeeze the trigger.  Each year your luck holds, you exhale with relief. You have drawn one of the five lucky chambers. Then you jump for joy.  You not only get to live, but you’ve just doubled your money.

3.      Unfortunately, each year that you win the laws of probability and statistics stack up higher and higher against you.  Luck doesn’t last forever, and math never lies. Next year, your luck may run out.  In any event, if you play for too long, you are almost guaranteed to lose.

 

4.      Of course, losing at Russian Roulette means losing everything you’ve ever had and everything you ever will have.[2]  Therefore, “prudent risk management” (to use the words of former Bear Stearns CEO Jimmy Cayne)  dictates that you shouldn’t be playing the game at all.  The bet is far too risky.  But it is also quite lucrative, and you really like money.  You understand the chance you are taking.  You take it anyway.  You are just like the Executive Committee at Bear Stearns.

5.      The point is this - Frequency of success does not mean anything if the cost of even one failure is too high. Bear Stearns reported record revenues for 5 straight years.  And when the company collapsed, those record years didn’t matter to public shareholders at all (except for those lucky enough to have had a reason to sell BSC long before March 2008).

 

6.      The individuals who truly benefitted from each of those five record years were the Executive Committee members. They received windfall bonuses, including many millions in cash payments, for generating positive short-term performance during an unprecedented bull market. 

---

[1] The idea of the Russian Roulette analogy comes from the trader and author Nassim Nicholas Taleb. 

[2] Rough paraphrase of Clint Eastwodd from the film The Unforgiven.

 

CASINO CAPITALISM: Accountability Time. (greatest hits collection)

BY BRETT SHERMAN

ARE RESPONSIBILITY AND ACCOUNTABILITY NOT TWO SIDES OF THE SAME COIN?   

 If you "Google" the right keywords and patiently read through hundreds of search results, you will eventually find some senior level Wall Street executives who take some responsibility for wrecking the financial services industry and pushing the entire economy to the brink of, well, [readers - please insert your own hyperbole here].

Jimmy Cayne apologized for the collapse of Bear Stearns.  He even admitted he had no clue what he was doing as Bear struggled through the the summer and fall of 2007 (at the time, however, he talked a very different game). Hell, Cayne has all but labeled Bear's independent directors a gaggle of yes men who did not dare interfere with management or corporate governance at Bear Stearns.  

We've also read scores of interviews with senior managing directors at Lehman and Bear Stearns that give chapter and verse on mismanagement by senior officers like Dick Fuld (CEO of Lehman) and Jimmy Cayne.  

Everyone seems to take it for granted that men like Dick Fuld, Stan O'Neil and Jimmy Cayne are responsible for the demise (or de facto demise) of Lehman Brothers, Merrill Lynch, and Bear Stearns. 

And you know what?  Everyone is right.

However, responsibility doesn't mean a whole lot unless it comes with consequences. The near total absence of meaningful consequences for extreme misconduct by Wall Street executives - the kind of consequences that may actually have a sliver of deterrent value - is, quite frankly, shocking. 

    ****

Motivated by unquenchable thirst for wealth and power, many senior Wall Street executives, at minimum, committed acts of extreme recklessness that manifestly jeopardized the long range prospects of their companies.  Did management intend to destroy their companies?  No. But our society is about instant gratification, not long-term rewards.  

A whole lot of executives were so blinded by greed that they refused to look very far beyond the tremendous windfalls they expected to receive at bonus time.     

Of course, many shareholders suffered large losses when the investment banks went down. Victimized shareholders deserve to be made whole.  After all, If Wall Street executives did not commit "fraud," then the federal securities laws and all other statutes that protect investors should be torn from all law books and fed into shredders.  

Oh, we know all about D&O insurance and indemnification agreements.  We don't care about that stuff. The top dogs on Wall Street killed their companies. So what if the D&O insurers pay? Who cares if Bank of America pays legal costs on behalf of Merrill Lynch executive officers?  Who cares if JPM does the same on behalf of Bear Stearns management?  Whatever. Just make defrauded shareholders whole.

Hey, damaged shareholders-     
 

Drag the men and women responsible for your losses into the muck. Sue them, expose them, take action.  Make sure the history books blame the right individuals for the most severe threat to capitalism since the Great Depression.  

It is time for accountability.  Don't you think?  

Please take the time to share your opinion.  Leave a comment.  Wall Street Law Blog values reader feedback, even the negative kind.

On Housing, Highly Leveraged Assets, and Interest Rate Changes (Greatest Hits Volume 2)

A brief bit of common sense.

Warning. We are not about to offer any earth shattering insights in this short post.  However, when the world of finance reaches levels of complexity and duplicity capable of causing the most significant financial crisis since the Depression, simplicity and common sense are often relegated to the far back burner. So, we decided to pour ourselves a bowl of simple facts about housing.

Specifically:

The housing market is hyper-sensitive to interest rate changes.

For a substantial majority of homeowners, houses are their most leveraged assets.  In other words, most people actually own very little of their houses.  For the most part, the bank or investor that owns our mortgage also owns most of our home.

Interest rate changes so significantly impact housing because interest rate level often determines what type of home a family can afford.  Falling rates lead to refinancings and even downward resets of adjustable rate mortgages.  Most significantly, there is higher demand for homes and, eventually, higher prices.  When credit is cheap and easy to get, homes are more affordable (at least in the short run).  Thus, low interest rates generally equals more homeowners and, by the way, low rates of default and foreclosure.

When rates go up, however, refinancings plummet, home sales (and, eventually, prices) decline because the higher cost of borrowing lowers buyer demand.  Adjustable rate mortgages reset upward.  The segment of the home-owning public that chose adjustable rate mortgages to stretch for houses that may have been unaffordable with traditional fixed rate mortgages can find themselves unable to make their new, higher monthly mortgage payments.  Thus, when interest rates increase, defaults and foreclosures follow suit.

As we said, nothing new here.  All common sense.  Which begs the question - who in their right minds would base an entire industry (subprime lending and, by extension, mortgage backed securities) on the premise that there would not be high default rates on ultra-low interest adjustable rate mortgages to people with poor credit histories succeed after the cycle turned and interest rates climbed back toward historical averages (i.e., when rates started to trend toward the mean)?  Who would make this bet?  Was anyone be surprised that bad credit borrowers would default in droves once their low initial monthly payments increased by hundreds of dollars a month?

These are not hard questions now, and they weren't hard questions in 2002 or 2003 or 2004, 05, 06, or 07 either. Wall Streetdrove the subprime lending explosion. Wall Street understood interest rate cycles. Wall Street knew rates would rise.  Wall Street knew defaults and foreclosures would spike. Wall Street didn't care - the money was rolling in.  The fact that Wall Street itself got so badly burned was the product of greed and knowingly reckless risk-taking.

By Brett Sherman, The Sherman Law Firm.

Wall Street Rationale Reviewed...

Wall Street deception revealed by a basic analogy:

The housing market has never collapsed is to 

The housing market cannot collapse                                               

-AS-

I have never been dead is to

I am immortal

By Brett Sherman

Thanks to Nassim Nicholas Taleb and Jim Grant for inspiration.

 

High Risk Strategies Fail In the Long Run - See, for example, Bear Stearns

1.      The definition of risk is the chance of loss.  If an action carries a chance of loss, it is risky.  The greater the chance of loss, the greater the risk. Risk magnitude refers to the size of potential loss. If the potential loss from a given risk could wipe you out, the magnitude is very high.

2.      Why do high risk strategies threaten long-term survival?  Think of betting your life savings on a game of Russian Roulette.[1] Once a year,  on New Year’s Eve, you hold a cold steel pistol to your temple.  The gun has six chambers, but only one holds a bullet.  You say a little prayer and squeeze the trigger.  Each year your luck holds, you exhale with relief. You have drawn one of the five lucky chambers. Then you jump for joy.  You not only get to live, but you’ve just doubled your money.

3.      Unfortunately, each year that you win the laws of probability and statistics stack up higher and higher against you.  Luck doesn’t last forever, and math never lies. Next year, your luck may run out.  In any event, if you play for too long, you are almost guaranteed to lose.

 

4.      Of course, losing at Russian Roulette means losing everything you’ve ever had and everything you ever will have.[2]  Therefore, “prudent risk management” (to use the words of former Bear Stearns CEO Jimmy Cayne)  dictates that you shouldn’t be playing the game at all.  The bet is far too risky.  But it is also quite lucrative, and you really like money.  You understand the chance you are taking.  You take it anyway.  You are just like the Executive Committee at Bear Stearns.

5.      The point is this - Frequency of success does not mean anything if the cost of even one failure is too high. Bear Stearns reported record revenues for 5 straight years.  And when the company collapsed, those record years didn’t matter to public shareholders at all (except for those lucky enough to have had a reason to sell BSC long before March 2008).

 

6.      The individuals who truly benefitted from each of those five record years were the Executive Committee members. They received windfall bonuses, including many millions in cash payments, for generating positive short-term performance during an unprecedented bull market. 

---

[1] The idea of the Russian Roulette analogy comes from the trader and author Nassim Nicholas Taleb. 

[2] Rough paraphrase of Clint Eastwodd from the film The Unforgiven.