The credit crisis of 2008, or the Great Recession as it is now famous as, has had many many books written on it. Writers from across the ideological spectrum have written about why the crisis occured and how their brand of ideology could have prevented the crisis. Which is why I was skeptical when I came across this piece which seemed to rehash the story of the collapse of Lehman. I was pleasantly surprised that this article was about one element that has been whispered off and on, but not very convincingly: about risk management based on common sense. (The reader needs to get past the title and the opening blurb, though. The title seems to suggest the credit crisis would have never taken place if Goldman Sachs hadn't spotted the game early enough. That is plain ridiculous. The leveraging of the economy + the decline in lending standards created a ticking time-bomb. But I digress.)
The article is not about having some fancy risk management metrics or why our models are wrong or why we should not trust a Ph.D that offers to build a model for you. (Of course, all of these elements contributed to why the crisis was ignored for all these years.) Instead, the article recounts a real-life meeting that took place in Goldman Sachs at the end of 2006. The meeting was convened by Goldman CFO, David Viniar, based on some seemingly innocuous happenings. The company had been losing money on its mortgage backed securities for 10 days in a row. The resulting deep-dive into the details of the trades pointed to a sense of unease about the mortgage market. Which then caused Goldman to famously back-off from the market.
I'll leave the reading to you to get more details of what happened. But some thoughts on what contribute to effective risk management practices.
- A real-life feel for the business. You can't be just into the models, you need to be savvy enough to understand how the models you build interact with the real world outside. And it is an appreciation of this interaction that cause the hairs to stand at the back of your neck when you encounter something that just doesn't seem right.
- Proper role of risk management in the decision making hierarchy. Effective risk management takes place when the risk governance has the authority to put the brakes on risk takers (i.e., the traders, in this case). In Goldman, there were a number of enablers for this type of interaction to take place effectively. Most importantly, risk management reported to the CFO, i.e. high enough in the corporate heirarchy. Second, investment decisions needed a go-ahead from both the risk takers and risk governance.
- Mutual respect between risk governance and risk takers. Goldman encourages a collaborative style of decision making. This allows multiple conflicting opinions to be present at the table. Minority opinions are encouraged and appreciated. Over time, this fosters a culture that genuinely tolerates dissonance of opinions. This also allows the CFO to be influenced by the comptroller group as much as he typically would by the trading group.
- Finally, a certain intellectual probity to acknowledge what it does not know or understand. During the meeting, the Goldman team was not able to pinpoint what their source of unease was. But they were able to honestly admit that they didn't really understand what was going on, but that it was also most appropriate to bring the ship to harbour, given their blindspot about what they didn't know. It takes courage to back-off from an investing decision, saying "I don't understand this well enough" in the alpha-male investment banking culture.
All in all, a really interesting read.
Showing posts with label Recession. Show all posts
Showing posts with label Recession. Show all posts
Wednesday, September 16, 2009
Monday, June 22, 2009
... the Great Escape? Or the Great Deception?
In an earlier post, I commented on the now famous "Green Shoots" of recovery but the very real long term threats to continued economic growth. It turns out that the "so-called" economic recovery seems to be more of a financial market recovery. Conventional wisdom goes that the financial markets turnaround precedes the real economy turnaround by about 6 months. Early signs did point to this phenomenon. Market indices in both emerging markets and the developed markets showed smart 30%+ growths in the last 3 months. Corporate bond offerings began to surge and even below investment grade offerings jumped up (and were well subscribed) in June.
However, some temperance seem to have set in of late. Emerging market indices like the Sensex and the Hang Seng are at least about 10-15% down from their early June peaks. Likewise with the DJIA. The steady upper trend seen for the best part of the last 8 weeks seems to have been interrupted. The yield on 10-year US treasuries had gone up to nearly 4% but is not trended back down to about 3.5%, basically signalling that everything is not as hunky-dory as we expected. There is still a high demand for quality (the irony of it all is that quality is denoted by US treasuries!). The Economist states that all economic indicators have not magically turned to positive, which is what one would expect if the markets and the media are to be believed. According to the Economist,
The June Empire State survey of manufacturing activity in New York showed a retreat. German export figures for April showed a 4.8% month-on-month fall. The latest figures for American and euro-zone industrial production showed similar dips. American raw domestic steel production is down 47% year on year; railway traffic in May was almost a quarter below its level of a year earlier. Bankers say that chief executives seem a lot less confident about the existence of “green shoots” than markets are.
We shouldn't be either. For a bunch of reasons.
1. Losses are nowhere close to bottoming out. Expectations for large credit defaults amongst corporates is expected to be higher than 11% for 2009 and continue to remain there for 2010.
2. At the individual level, unemployment is showing no signs of abating. There was a good article in the Washington Post today on how the economic recovery seems to be taking place in the absence of jobs. Check this link out. Unemployment is expected to be north of 10% and remain there for a good part of 2009 and into 2010. Unemployment is closely linked with the consumer confidence number and therefore any sluggishness in the job market is going to impact consumer spending and therefore further impact the rate of recovery of the economy.
3. Emerging markets were the promised land for the world economy, not not any longer. The markets don't seem to think so however. Indian economic growth is expected to be the slowest in the past 6 years. With much more fragile safety nets in the Asian economic tigers, these economies are going to be even more careful while navigating out of the downturn.
In short, a long haul seems clear. Also seems clear is a fundamental remaking of industries as a whole. Financial services, automobiles and potentially health-care are industries where a new business model is ripe for discovery. This should create many more opportunities for the data scientist, the topic of my next post.
However, some temperance seem to have set in of late. Emerging market indices like the Sensex and the Hang Seng are at least about 10-15% down from their early June peaks. Likewise with the DJIA. The steady upper trend seen for the best part of the last 8 weeks seems to have been interrupted. The yield on 10-year US treasuries had gone up to nearly 4% but is not trended back down to about 3.5%, basically signalling that everything is not as hunky-dory as we expected. There is still a high demand for quality (the irony of it all is that quality is denoted by US treasuries!). The Economist states that all economic indicators have not magically turned to positive, which is what one would expect if the markets and the media are to be believed. According to the Economist,
The June Empire State survey of manufacturing activity in New York showed a retreat. German export figures for April showed a 4.8% month-on-month fall. The latest figures for American and euro-zone industrial production showed similar dips. American raw domestic steel production is down 47% year on year; railway traffic in May was almost a quarter below its level of a year earlier. Bankers say that chief executives seem a lot less confident about the existence of “green shoots” than markets are.
We shouldn't be either. For a bunch of reasons.
1. Losses are nowhere close to bottoming out. Expectations for large credit defaults amongst corporates is expected to be higher than 11% for 2009 and continue to remain there for 2010.
2. At the individual level, unemployment is showing no signs of abating. There was a good article in the Washington Post today on how the economic recovery seems to be taking place in the absence of jobs. Check this link out. Unemployment is expected to be north of 10% and remain there for a good part of 2009 and into 2010. Unemployment is closely linked with the consumer confidence number and therefore any sluggishness in the job market is going to impact consumer spending and therefore further impact the rate of recovery of the economy.
3. Emerging markets were the promised land for the world economy, not not any longer. The markets don't seem to think so however. Indian economic growth is expected to be the slowest in the past 6 years. With much more fragile safety nets in the Asian economic tigers, these economies are going to be even more careful while navigating out of the downturn.
In short, a long haul seems clear. Also seems clear is a fundamental remaking of industries as a whole. Financial services, automobiles and potentially health-care are industries where a new business model is ripe for discovery. This should create many more opportunities for the data scientist, the topic of my next post.
Tuesday, June 9, 2009
Green shoots ... or bust
Equity markets, both international and US, seem to have taken to heart the signs of bottoming of the world economy and the rebound seen in Asia. The Brazilian, Chinese and Indian stock markets are at least 50% higher than the lows in Q4 2008. The DJIA went down to the 6500 for a while but has since rebounded to gyrating around the 8500 market and has on occasion, flirted with the 9000 level.
The rates of job-loss is falling in the US and despite a glut in world oil supply, crude prices are nearing the $70 mark after crashing down to the $30s only recently. Are we past the worst then? Despite the lingering weakness in W.Europe (something seen arguably since the start of WW II!), the signs of economic recovery seem to be unmistakable.
Is the US consumer then going to go back to his/her free-spending ways? While we seem to have come up a fair bit from the Q4 depths, at least from a consumer confidence standpoint, there could be a few big obstacles to growth.
1. The budget deficit. With the famous American aversion to taxes and the growing burden of entitlements (driven mainly by healthcare costs) as the baby-boomer generation retires, the deficit is only going to get worse.
2. The cost of borrowing to feed the deficit. The US Treasury's place of pride as the investment of the highest quality could be under threat as the domestic debt as a % of GDP grows. The US government will need to increasingly borrow more and pay higher interest rates for the borrowing. The higher interest burden is going to crimp the ability to make productive investments.
3. Finally, with increasing protectionism and government involvement in the economy, the vitality of US business enterprise to identify and capitalize on opportunity looks to be suppressed for the next several years.
A number of prognosticators have made some long-range predictions of the US Economy in this article. An interesting read, as the forecasters have taken a 5-10 year view rather than the 6-12 month view typically taken by realtor types. Another interesting article, about the long term speed limit of the US economy from the Economist. Summarizing the article,
According to Robert Gordon, a productivity guru at Northwestern University, America’s trend rate of growth in 2008 was only 2.5%, the lowest rate in its history, and well below the 3-3.5% that many took for granted a few years ago. Without factoring in the financial crisis, Mr Gordon expects potential growth to fall to 2.35% over the coming years.
The rates of job-loss is falling in the US and despite a glut in world oil supply, crude prices are nearing the $70 mark after crashing down to the $30s only recently. Are we past the worst then? Despite the lingering weakness in W.Europe (something seen arguably since the start of WW II!), the signs of economic recovery seem to be unmistakable.
Is the US consumer then going to go back to his/her free-spending ways? While we seem to have come up a fair bit from the Q4 depths, at least from a consumer confidence standpoint, there could be a few big obstacles to growth.
1. The budget deficit. With the famous American aversion to taxes and the growing burden of entitlements (driven mainly by healthcare costs) as the baby-boomer generation retires, the deficit is only going to get worse.
2. The cost of borrowing to feed the deficit. The US Treasury's place of pride as the investment of the highest quality could be under threat as the domestic debt as a % of GDP grows. The US government will need to increasingly borrow more and pay higher interest rates for the borrowing. The higher interest burden is going to crimp the ability to make productive investments.
3. Finally, with increasing protectionism and government involvement in the economy, the vitality of US business enterprise to identify and capitalize on opportunity looks to be suppressed for the next several years.
A number of prognosticators have made some long-range predictions of the US Economy in this article. An interesting read, as the forecasters have taken a 5-10 year view rather than the 6-12 month view typically taken by realtor types. Another interesting article, about the long term speed limit of the US economy from the Economist. Summarizing the article,
According to Robert Gordon, a productivity guru at Northwestern University, America’s trend rate of growth in 2008 was only 2.5%, the lowest rate in its history, and well below the 3-3.5% that many took for granted a few years ago. Without factoring in the financial crisis, Mr Gordon expects potential growth to fall to 2.35% over the coming years.
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