RISK & Other Four Letter Words - RHLF · 2015-07-09 · RISK & Other Four Letter Words An Alternative View On The Real Reasons Behind The Global Financial Crisis Presented By: M I

RISK & Other Four Letter Words

An Alternative View On The Real Reasons Behind

The Global Financial Crisis

Presented By: M I Henderson

October 2010

X-ergy ConsultingPeople Process Technology

Who Are We?

Multi-disciplinary organisational & people effectiveness consulting

Focus on practical solutions to common business problems

Consultants are a network of subject-matter experts

Clients industries mostly: Financial and business services

Telecoms

Consulting industry

South Africa, SADC and East & West Africa

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Topics

An Alternative View On The Real

Reasons Behind The Global

Financial Crisis

What really went wrong?

What was driving the problem?

What is likely to happen from

here?

The impact on credit granting in

South African

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Disclaimers and Rules of

Engagement

4

Today is not going to ‘politically correct’

Not a repetition of the conventional

explanations

Look at things differently - that does not

mean that the conventional view is

wrong … just perhaps that it is more

complex that we at first thought

Largely international examples – draw

your own local parallels.

X-ergy ConsultingPeople Process Technology5

Why It Will Not Be the Same Again“SCUMDOG MILLIONAIRES”

Dumb, Dumber and Dumbest?

Pass the plate …….

Pleading poverty from the steps of the corporate jet

“The culture of entitlement and greed

which was fostered and entrenched

by the 1996 Class Project within state

owned entities and organs.”

Who wants to

be a banker

these days?

“Watching an industry commit political

suicide is not a pretty sight” …Economist Oct 2009


The Events


The Result?

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Public opinion:It must be someone’s fault ….

Someone has to pay ……….…

It must not happen again ……

(PS. …..its also a vote winner!)


Scapegoats ….Its Payback Time

The greed-driven banking CEO’s

Inadequate legislation and regulation

Boards that were carried along with

the tide

The whole capitalist process?


What Got Us Here & What Went Wrong?(the ‘Conventional’ View)

Inadequate financial regulation- Too much de-regulation?

Political interference in lending (Fannie Mae, Freddie Mac … + nearly SA Banking Charter)

Mark-to-market accounting rules

Executive greed and short-termism

Structure of financial incentives -especially share options:

- Not tied enough to performance- Too much- Too easy- Weak accounting and tax rules

Lack of moral leadership

Corporate governance failures

Some just too big to fail?


All The Signs Were ThereEven if you have never read any economic history

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The Consequences

Cost US taxpayers more than 2.5 x real cost of WWII


So What Really Went Wrong?

Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society

ComplexityIrrational Exuberance

Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

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Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

13


Risk Management

Many never worked in a recession - --- ‘Confused brains with a bull market’.

Risk assessment became a box-ticking exercise.

The ‘deal-makers’ had more glamour & organisational standing

The Madness of Crowds’ and ‘Peer Pressure’

…………….Citi CEO .. “When the music plays you gotta get up and dance”

Tone was set from the top ….. t/o growth, EPS, M&A

High gearing (> 30x) + reliance on short-term debt to fund long-term assets

Given a smart sanitised name ….. Sub-prime (aka Ninja Loans)

Too much reliance on rating agencies …….. (paid by the debt issuers)

The spectacular rise of credit insurance …….. insure what you can’t measure

The search for the silver bullet lead to complexity

Many banks IT systems could not cope and aggregate (mostly counterparty) risk

across borrowers or across the bank



Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

15


Complexity

“The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.”

“Against The Gods” – Paul Bernstein – 1996

Mid-1970’s Black-Scholes model for pricing derivatives (Chicago’s Options market)

1990’s … Bankers Trust and JP Morgan – started to develop thinking around “value-at-risk” (VAR - how much you could expect to lose under a variety of scenarios)

Mid-1990’s onwards --- banks hired lawyers, engineers and mathematicians – the more Phd’s the better - to build models that measured risk to 5 decimal places

………………….But typically the models only used 3 to 5 years of data

Mid-2000’s +/- 25% of graduates at the top universities came from finance

Financial engineering was born

CDO, CDO-squared, SPV, SIV, CDS, automated computer driven trading etc

Weapons of financial mass destruction …….. Warren Buffett (2003)


The Man That Caused It All?

David X. Li (born in China in the 1960s)

is a quantitative analyst and an actuary

who in the early 2000s pioneered the

use of Gaussian copula models for the

pricing of collateralised debt obligations

(CDOs).

The Financial Times called him "the

world’s most influential actuary,"

In the aftermath of the Global financial

crisis of his model has been called a

"recipe for disaster".

Like blaming Einstein for Hiroshima?


Complexity

“The over-50s did not know what the

under-30s were doing.” ………Johann Rupert

“We fell in love with the quantitive

methodology underpinning the new

instruments”

. .....Dr. Laura D. Tyson

The sociology of markets: “Heavy use

of models may change the markets

they are supposed to map”

……Prof Donald MacKenzie

“Quants love to over-engineer ….. you

may need a plumber but you get a

professor of fluid dynamics”



Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

19


Governance Failings

Debt sold off but still a contingent liability …. Not measured or recorded

Complexity and new techniques made it difficult for non-execs

Quarterly meetings do not encourage understanding

The ‘sociology’ of big company boards – dissenting voices not

appreciated

Bank boards typically very large – accentuates this

Board duties and responsibilities not clearly spelt out

Too few unconnected non-executive directors

Performance measured by benchmarking to peer groups

…………... What if they are all doing the wrong things?

Correlation between dysfunctional systems - and growth and takeovers


Governance Failings:The Cult of The CEO

Autocratic bosses who walk on water – don’t expect to be told bad news:

Chuck Prince at Citi only told Sept 2007 that they had $43 billion toxic assets

Empire builders not managers …. Let alone leaders

The pitfalls of benchmarking - lets all do the wrong things together

Exceptions ….. Jamie Dimon (JP Morgan Chase) started to back off in

2006 and got flayed by analysts and shareholders

Bottom line is that many boards failed:

To identify and assess risk

To set appropriate goals and objectives

To structure reward correctly

Loading top people with shares can be an aid to corporate governance

but not a substitute for it



Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

22


Irrational Exuberance

Drivers who slow down at an accident but then accelerate afterwards – only cautious for a short while

The warning signs were there:

The failure of Long-Term Capital Management in 1998

The Asian, Japanese and Russian banking crisis

The dotcom bubble

Enron, WorldCom etc (AAA according to the rating agencies )

Rising loan : value ratios in housing

Aggressive selling resulting in multiple credit cards per consumer

Rising consumer debt levels

Rising PE’s despite periodic market attempts to correct in mid-2000’s

Economic history has lots of parallels



Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

24


Regulatory Failings

Many of the new instruments were just too complex to understand: Typical securitised CDO bundle of loans would run to 30 000 pages

Faith in the new technology lead to Basel II – which relied heavily on banks internal models

A belief that markets can be largely left to police themselves

Did not fully understand level of inter-connectivity: Everything is connected to everything else …………… Lenin

Systemic failure …….a financial death spiral in which firms suck one another into the abyss.

Could not see the Black Swans for the trees?

When greed exceeds fear, trouble follows.



Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

26


Asymmetric Incentives

Years of cheap money led to the under-pricing of risk

Negative / very low interest rates fuelled consumer

demand

Misguided policies to promote home ownership

Securitisation and mortgage origination fees were paid up-

front …..Originate, flog and forget

Too big to fail – too many relied on the Greenspan Put

And then there was the pay issue ………………


Asymmetric Incentives

Not what you may expect to find ………

Did financial institutions really run into trouble because they were over-paying their executives?

Better decisions if they had say, 85% of their personal wealth in company shares rather than, say, 80%?

Lehman, Bear Stearns and AIG had very wide-spread employee share ownership – staff lost everything

But generally, it was better to be an employee than a shareholder

Often mis-aligned or poorly thought-out incentive metrics

Rewarding failure ….. moral hazard ?

Complexity: The real problem was deal-maker and dealer incentives -not execs



Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

29


Societal Changes - 1

What about the impact of organisational culture and staff selection – we

measure and value:

Performance (esp. compared to peer group)

Stretch targets

Growth, increased market share – even in mature markets

Creativity and innovation (does this sound like risk taking?)

The ‘Up or Out’ approach to career progression

Competitive people will hit their numbers.

Aiming to be #2 or #3 in your strategic plan is likely to be career

limiting

Most execs did what they thought was expected and/or what they thought

the performance metrics required. Was it their fault that there was an

asymmetric risk-reward structure?

Is it really all just about money?


Societal Changes – 2The problem With Young People Today

Few had seen – none had worked – in a downturn

They grew up with (invented?) technology

They are difficult to intimidate and generally free of

fear. Failure doesn’t frighten them

Life is a computer game – just press the reset button

Money motivated

Tend to have problems getting on with boomers


“How were we supposed to

know that people who lied

about their income and

assets would walk away

from mortgages on houses

in which they had no

equity?

That wasn't in our computer

model.

It's not our fault”

Societal Changes – 2The problem With Young People Today



Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

33


Jack Welch’s Legacy

“ The dumbest idea in the world …. It is a result not a strategy”

…….. Jack himself (2009)

Nailed to the cross of shareholder value:

Slaves to the analysts

Measured by quarterly earnings reporting

Share price and EPS was all that it was about

Benchmarking substituted for strategy

Thinking and focus became very short-term

Often mutates into CEO cult worship

But … Shareholders are not the only stakeholders

And …. do CEO’s really influence events …. What about markets & customers & competitors?

m



Judgement

Failures

Risk Management

Asymmetric

Incentives

Changing Society


Failed Regulation

Governance Failures

Shareholder Value

Paradigm

Leadership

Failures

35


Leadership Failures

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Massive amount spent on

leadership development in last

20 years

Management is not the same as

leadership

More to leadership than just the

metrics


Conclusions - 1

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“It has cost us a lot to learn how

little we really knew”

In fragile financial markets,

Black Swans (extreme events)

happen a lot more frequently

than probability models suggest

Meltdowns happen twice as

frequently as before WW1

- 7 major ones in 20th century


Conclusions - 2

Adam Smith was right – 240 years ago - wrote about the Agency Problem

Managing risk is as much about judgement as about numbers

Don’t reject high-tech finance tools – just understand their limitations

Basel III?………. likely to focus on increased capital and liquidity

Legislation:

Limit pay and bonuses?

Hedge funds, derivatives & structured products?

The Volker Rules?

Regulate non-bank banks?

The loan origination chain has to better managed – needs checks and balances

Better staffed and more powerful risk functions

Regulators have already become much more aggressive and demanding

e.g. SA’s new Companies Act

Re-write shareholder value text book

Need for a culture change ……...Integrity? … Now that’s something I’ll pay for!

Financial Engineers? … It is better to be roughly right than exactly wrong … Keynes


The Future?

Trouble ahead

What started as an Anglo-

American risk management

failure has focused minds on

Euro-land weakness

Euro zone

UK & USA

SA

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Acropolis Now ?

Paying for the public sector

Demographics – the future of

pensions & a welfare state Median age increase from 38 to

52 by 2050

OECD estimate (2003) that only

39% of Europeans 55 – 65 work

Generally low birth rates from

‘old’ Europe

North – South split?

Austerity measures have not

started to bite yet

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UK & USA?

Painful adjustments being made

UK public sector spending being cut 25% to 40%

Currencies and interest rates UK -not ‘straight-jacketed’ by ECB

A culture of biting the bullet when required

China has too much to loose?

US$ a ‘safe haven’

$ strengthened and US stock market outperformed BRICmarkets!

Both have young and growing populations

A generational process

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South Africa ?

Euro zone & UK problems - find new markets

Positive demographics - Young (if unskilled) population

Basel III = 3 x capital holding + increased liquidity Fewer loans

Less risk

Higher prices

Being sheltered from the storm may not have been helpful in the long-term

We’ve addressed some of the issues but not all Teach financial history

Demographics & generation theory

Behavioural economics

Risk management challenges Unforeseen NCA impact

50% of consumers are in arrears

200 000 are flagged for debt counselling

Affordability requirements will slow credit growth

Makes credit – esp. housing – difficult for young people

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Questions?

Contact: Michael. I. Henderson

+27 (0)82 490 3113

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Documents

RISK & Other Four Letter Words - RHLF · 2015-07-09 · RISK & Other Four Letter Words An Alternative View On The Real Reasons Behind The Global Financial Crisis Presented By: M I