Claims And Issues

Bonus Babies Ignore Risk Management.

    Risk Management principles had no place on Wall Street during the boom years.  Bonuses came first.  Bonuses were paid first, before investments performed.  Bigger risks drove bigger bonuses.  Bonuses dwarfed salaries exponentially.  Bonuses drove the risk taking engine, that is, the taking of risks with other people's money drove up the amount the risk takers were paid.  See Louise Story, "Wall St. Profits Were a Mirage, But Huge Bonuses Were Real/Questions on Role of Risk and Pay in Losses" p. A1, col. 1 (New York Tiimes Nat'l Ed., Thursday, December 18, 2008).

    Bonuses are still the exponential multiplier of compensation for Wall Street risk takers.  Id.

    Everything is changing, nothing is new.  Except -- compensation to Wall Street is now coming from you and from me, the Federal Taxpayers.  Return to or learning to apply Risk Management principles is overdue.  Their place on Wall Street should always have been paramount.  So it should be now, especially now.

Update of Friday, December 19, 2008:

The changing but still frequently encountered short-term or so-called "mid-term" focus on performance of investments in order to 'earn' bonuses on Wall Street is examined by Louise Story and Eric Dash, "What Goes Around/At Credit Suisse, Troubled Investments Will be a Factor in Bankers' Bonuses" p. B1, col. 2 (New York Times Nat'l Ed., Business Day Section, Friday, December 19, 2008), published online under the headline, "Banks Try New Ways to Handle Bonuses".

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Bonus Babies Ignore Risk Management.

    Risk Management principles had no place on Wall Street during the boom years.  Bonuses came first.  Bonuses were paid first, before investments performed.  Bigger risks drove bigger bonuses.  Bonuses dwarfed salaries exponentially.  Bonuses drove the risk taking engine, that is, the taking of risks with other people's money drove up the amount the risk takers were paid.  See Louise Story, "Wall St. Profits Were a Mirage, But Huge Bonuses Were Real/Questions on Role of Risk and Pay in Losses" p. A1, col. 1 (New York Tiimes Nat'l Ed., Thursday, December 18, 2008).

    Bonuses are still the exponential multiplier of compensation for Wall Street risk takers.  Id.

    Everything is changing, nothing is new.  Except -- compensation to Wall Street is now coming from you and from me, the Federal Taxpayers.  Return to or learning to apply Risk Management principles is overdue.  Their place on Wall Street should always have been paramount.  So it should be now, especially now.

Update of Friday, December 19, 2008:

The changing but still frequently encountered short-term or so-called "mid-term" focus on performance of investments in order to 'earn' bonuses on Wall Street is examined by Louise Story and Eric Dash, "What Goes Around/At Credit Suisse, Troubled Investments Will be a Factor in Bankers' Bonuses" p. B1, col. 2 (New York Times Nat'l Ed., Business Day Section, Friday, December 19, 2008), published online under the headline, "Banks Try New Ways to Handle Bonuses".

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CDS Unregulated "Insurance": The AK-47 Loose on Wall Street.

This is the beginning, the first post in a pressing occasional series takng a look at the biggest unregulated form of Insurance in the World, the "Credit Default Swap" or "CDS".

    The current credit crisis is a financial failure.  It is not the result of unavoidable events like lightning and thunder.  It is not the result of negligence alone, either.  It is instead the result of a combination of unrecognized ignorance and recklessness.

    The most horrifying thing about this currently cascading failure, aside from the fact that it seems to continually get only worse, not better, is that it is being addressed with the same combination of ignorance and recklessness that brought failure in the first place.

    Through ignorance or intentional disregard of Risk, Reserves and Accounting Regulations some people profited enormously for a short time from Credit Default Swaps or CDS's.  These people did not correctly calculate nor manage the Risk of CDS's.  They intentionally rejected the need for Reserves to back up the obligation of any CDS.  And they manipulated Accounting Regulations after the risk taken on CDS's was transferred to third parties in theory, though not in reality.

    This is the first post in a series that will take a hard look at CDS's and their role as the biggest unregulated "Insurance" in the world since they were made for the first time in 1994.  See also Matthew Philips, "The Monster That Ate Wall Street/How 'Credit Default Swaps'--An Insurance Against Bad Loans--Turned From A Smart Bet Into A Killer" (Newsweek, October 6, 2008); "Securitization," encyclopedia entry on Wikipedia.org.

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Risk Management Once Was Lost, But Now Has Been Found ....

.... Perhaps.  

    What are the causes of the financial failure across the planet?  Relying on outliers like Credit Rating Companies to assess risk in the financial services sector is a recurring observation made by regulators.  See Eric Dash and Julie Creswell, "Citigroup Pays For a Rush to Risk/Bank Saw no Red Flags Even as it Made Bolder Bets" p. 1, col. 2 (New York Times Nat'l Ed., Sunday, November 23, 2008).

    Large commercial banks and large Insurance Groups and Insurance Companies hold themselves out as specialists in rating risks.  They tell their potential and existing customrers that they are experts in risk management.  The current head of the Office of the Comptroller of the Currency, has this to say:  "'There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk.'"  John C. Dugan, quoted in id.

    Self-interest management replaced risk management, it seems clear.  Another quote in the linked newspaper report comes from an anonymous source who reportedly worked with Collateralized Debt Obligations at Citigroup:  "'I just think senior managers got addicted to the revenues and arrogant about the risks they were running.  As long as you could grow revenues, you could keep your bonus growing."

  Drawing from the comprehensive linked newspaper article, here are some of the reported behaviors in the financial services sector in recent years that have not matched settled principles of risk managment:

        Allowing or overlooking, and in any case ignoring, potential conflicts of interest on the part of the risk managers;

        Apparent lack of independence of the risk managers from the marketers or traders;

        Instructions from superiors of both risk managers and sales persons to increase marketing of financial instruments that may become profitable in the short term but never become well known except in the long term, such as collateralized debt obligations or C.D.O.'s;

        Lack of clear lines of reporting, such that risk managers report to a person who is in charge of the people marketing or trading the same products that the risk managers are supposed to keep an eye on.

A related post can be found on www.insuranceclaimsbadfaith.typepad.com.

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Risk Management Lost: Part II.

    This follows a recent previous post about the role of Risk Management in the financial fiasco.  To that previously posted list of ways to have a financial breakdown, including in Insurance, should be added:

       It is not good risk management to silence Risk Managers, even if they appear to be "critics" of a Corporate profit center.

        It is also not good risk management to silence other people whose feedback is essential to the Risk Managers' evaluation of risk, which is one of the things that only Risk Managers do.

See also Gretchen Morgenson, "How the Thundering Herd Faltered and Fell/Merril Lynch Couldn't Escape the Housing Crash" p. 1, col 1 (New York Times Nat'l Ed, SundayBusiness Section, Sunday, November 9, 2008).

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AIG "a systemically important company" -- New Deal for an Old Company.

    Untested claims are apparently the reason for the current Treasury Department, extending more Federal Taxpayer Funds in a better deal for the reclamation of AIG.  No, not "claims" on Insurance Policies.  Claims that AIG cannot raise private capital without a supposed "fire sale."

    Newspaper reports today lead with the language that the previous bailout deal with AIG "was putting too much strain on the company."  Andrew Ross Sorkin and Mary Williams Walsh, "U.S. Provides More Aid to Big Insurer" (New York Times Online, Monday, November 10, 2008).  To like effect describing this as a "strain" on the company, is this report by Carol D. Leonnig, "AIG Close to Getting New, Larger Bailout" (Washington Post.com, Monday, Novermber 10, 2008), reposted as "Government to Grant AIG New, Larger Bailout".  The bailout, otherwise known as the Emergency Economic Stabilization Act of 2008, was never intended to protect AIG from "strain".  The infusion of capital by using Federal Taxpayer Funds was always intended, instead, to protect the national economy from chaos.  There is a difference.

    The new deal negotiated by AIG with the current regime "would help the company".  Andrew Ross Sorkin and Mary Williams Walsh, supra.  But that is not the point.  Not at all.  Will the deal now help the national economy and the Federal Taxpayer, even at the expense of an individual Company, or will it instead help the Company at the expense of the Federal Taxpayer?

    In basic terms, there are currently two (2) ways to raise capital.  One is by using Federal Taxpayer Funds through the current federal government regime, and the other is by raising private capital.  Either way, the purpose is to generate a so-called infusion of capital.   What AIG reportedly tried to do was to raise private capital to finance guarantees it made of toxic Collateralized Debt Obligations or "CDOs".  AIG's CDO guarantees generated calls for collateral.  This means that AIG had to raise cash to pay those calls based on obligations assumed by one among many AIG member companies.  AIG reportedly tried to raise private capital -- cash -- by selling off certain successful Insurance Companies that were not apparently tied to the toxic CDO obligations of AIG. 

    If successful in making those sales, AIG would raise the cash by raising private capital, of course, but AIG would no longer own the successful Insurance Companies that AIG was selling to others.  Many of AIG's member Insurance Companies were and are still very successful.  For a list of AIG Member Companies, go to www.aig.com.  (How hard AIG tried to raise private capital is subject to question by many questioners.)  Essentially, AIG gave up.  AIG and certain shareholders of AIG's deflated stock termed the effort "a fire sale."  See Andrew Ross Sorkin and Mary Williams Walsh, supra; Carol D. Leonnig, supra.

    In the restructured deal with AIG, it is reported on Monday, November 10, 2008 that Federal Taxpayers will spend $30 Billion while AIG offers $5 Billion -- or less than 15% of the total -- to buy up the CDOs.  The purchase price of the CDOs reportedly will be set at 50 cents on the dollar.  The combined $35 Billion will be used to purchase $70 Billion of the Collateralized Debt Obligations foolishly guaranteed by a member company of AIG (a member company which, to say again, is not one of its successful Insurance Companies).  AIG reportedly will incorporate "a new entity" which will hold these previous liabilities, which accountants will remove from AIG's own balance sheet.  See Andrew Ross Sorkkin and Mary Williams Walsh, supra.  Under this new deal, AIG will keep its successful Insurance Companies and not sell them off to gain private capital.

    Federal Taxpayer Funds will not stop there, apparently.  Under the new AIG deal with the current Treasury Department, an additional $22.5 Billion in Federal Taxpayer Funds will be given to AIG for the purpose of also purchasing other financial products that AIG foolishly guaranteed, namely, "residential mortgage-backed securities".  AIG will be asked to contribute $1 Billion or 4.3% of the total in that regard.  See Andrew Ross Sorkin and Mary Williams Walsh, supra.  Once again, accountants will remove losses from AIG's bottom line because again, a new corporation or corporations will purchase and hold these previous liabilities, too.  Also, as with CDO purchases under this new deal negotiated by AIG, AIG will keep its successful Insurance Companies and not sell them off to gain private capital.

    The changes in AIG's new deal are enormous.  In short, the changes negotiated by AIG change the whole intent of the appropriation of Federal Taxpayer Funds.  Rather than using Federal Taxpayer Funds in an emergency to shore up the national economy in a crisis, the current Treasury Department is agreeing in this deal to use Federal Taxpayer Funds to protect AIG in its emergency right now, with any benefits to the national economy to come much later, if at all.  This is not a good change for the Federal Taxpayer.  It is not capitalism.  And it is not wise policy for the use of Federal Taxes.

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Risk Management Run Aground.

    Risk Management seems to have been run into the ground.  Recent months have brought many examples of Insurance failures. They have been part of the overall financial fiasco across the world, to be sure.  But they are real and they are failures.  They are failures that lower the value of many Insurance Companies whose operations have been extended far beyond Insurance Coverage for quantifiable risks.

    Five ways to a breakdown in financial risk management are reportedly analyzed by Rene Stulz in an article to be published in a future Harvard Business Review article.  At this time, they are summarized in a post by David Champion on HBR Editors' Blog, "Lesson From the Crisis:  Risk Management Has Limits" (October 28, 2008):

        1.  "Mismeasuring known risks."

        2.  "Ignoring knowable risks."

        3.  "Failing to communicate risks."

        4.  "Failing to capture changes in risk."

        5.  "Concealing risks."

    Each of these five ways to a breakdown in risk management has led to breakdowns in Insurance Risk Management.  Can Insurance Risk Management find the way back, or perhaps, find the way to the future?  More broadly, can financial risk management in general find the way?

    They have to.  Failure is not an option, not any more.

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