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:
WHAT WOULD HAPPEN TO OUR COMPANY IF HOME PRICES PLUNGED?
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.
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."
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.
THE UNIQUE VULNERABILITY OF FINANCIAL INSTITUTIONS TO THE DREADED CONFIDENCE CRISIS
More than any other type of business, financial institutions are vulnerable to crises of confidence. The demise of former powerhouse investment bank Bear Stearns is an ideal example.
First, the financial world lost confidence in Bear's assets, which impaired its access to short-term credit. Then the market lost confidence in Bear Stearns itself. Hedge funds raced to pull their assets out of prime broker accounts at Bear. The cycle repeated itself until Bear's failure was a foregone conclusion
Bear's mortgage assets were an albatross; liquidity of the oversized portfolio dropped like a lead weight in water.
Bear Stearns had a substantial prime brokerage unit. In simple terms, this means that other financial institutions - primarily hedge funds - used Bear Stearns like you and I would use our local bank. Bear was custodian of billions of dollars for these prime brokerage clients. And it was these customers that drove the much talked about "run on the bank" that ate up Bear's insufficient liquidity and forced it into the arms of JP Morgan.
To paraphrase the Corleone men, 'it isn't personal, its only business.' The "run" on Bear Stearns (i.e., hedge funds and other prime brokerage clients pulling their assets out of Bear the week of March 10, 2008) was not only justified, but fund managers would have been incredibly stupid / grossly negligent to leave assets with an investment bank that conceivably could end up filing for bankruptcy.
There was no way customers of Bear Stearns could afford to gamble millions and millions of dollars on the possibility that Bear would solve its nearly insurmountable problems and live happily ever after.
When the market has no more confidence in your bank, the only prudent thing to do, the only smart thing to do, the only thing that makes any sense at all, is to get your cash out of Dodge. Why? For this reason: When doubts arise about the viability of a major financial institution like Bear Stearns, you can bet that there are serious underlying problems at the heart of the matter.
Therefore, any financial institution that suffers a crises of confidence must act swiftly and decisively to restore the market's faith and trust. Failure to do so can mean a death sentence.
Excuses (difficult market conditions, evil short sellers) and denials (we don't need to raise cash, our balance sheet is strong, there is no pressure on our liquidity) only exacerbate a crisis of confidence. That is exactly what happened to Bear Stearns. The executive officers and directors of the fallen investment bank know very well that they can only blame themselves for the demise of Bear Stearns.
There is no question that the crisis of confidence suffered by Bear Stearns was the product of self-inflicted wounds.
For starters, the company had a distinctly undiverse business structure. Bear Stearns was far too dependent on its fixed income businesses, and the firm lacked business units capable of replacing mortgage revenues after the market for mortgage-backed securities (MBS) collapsed.
Lacking reliable replacement streams of revenue was bad enough, but Bear Stearns had also overloaded its own portfolio with, you guessed it, MBS. Bear Stearns drank its own cool-aide, and creditors eventually decided that illiquid (and therefore worthless) MBS were not acceptable collateral.
To complete the trifecta, Bear Stearns buried itself beneath a mountain of debt. Bear was the most leveraged firm on Wall Street, at close to 35:1. In other words, the firm borrowed almost all the money it used to fund its investment activities. Bear Stearns also depended on borrowing more than $50 billion each day in the overnight repo market just to have enough money to cover daily operating expenses.
Bear Stearns was a mess and the markets knew it. Instead of fixing the mess, or even owning up to it, management pretended everything was going to be fine. Bear's strong culture of risk management would see it through some rough times. In October 2007, Bear publicly declared that its businesses were recovering. Bear's reassurance was one of many lies senior executives foisted on the public. Apparently, Bear hoped to stall long enough for market conditions to miraculously reverse and save the firm.
For many months, Bear Stearns navigated dangerous, icy waters. In March 2008, the firm slammed into an iceberg. It took only a few days for the firm to go under.
Jamie Dimon coined the term "fortress balance sheet." By fortress balance sheet, Dimon, the CEO of JP Morgan, means financial institutions must have sufficient liquid capital to survive any shock to their balance sheets.
Bear Stearns ignored this golden rule, and the firm paid the ultimate price.