Lessons from a former CEO, U.S. Senator, and Governor, on how to avoid risk hurdles

In yesterday's WSJ we saw yet another article regarding MF Global Holdings and its former CEO, Jon Corzine ("MF Probe Targets Back-Office Unit") . This time we learn that just about everyone in the company has been interviewed by federal prosecutors, save for the Honorable former Governor of the great state of New Jersey, and a few other former seniors from the firm.

In the spirit of "full disclosure" I must confess that as a resident of the Garden State, I did not vote for Corzine when he ran for Senator or Governor, and my reasons aren't because he is a Democrat, as I have been known to vote for several Democrats, including the member of the House of Representatives (Rush Holt) who represents my district. It is one thing to persuade lots of people to make significant donations to your campaign, as Barack Obama and many others have done; it's another to spend millions of your own dollars to buy a Senate seat and Governor's position. Perhaps he was fired from Goldman Sachs for a reason. His performance as a U.S. Senator was one with no notable accomplishments, and as Governor, his performance was so bad that this predominantly Democratic state voted him out (something that rarely occurs).

It has been reported that Corzine, when confronted by MF Global's risk officer (who no doubt was paid a sizable amount to guard the firm against taking unnecessary risks) about his desire to invest so much of the company's funds in sovereign debt, said something to the effect of "if you won't let me do this, I'll quit!" At least somewhere in the WSJ I recall reading something to this effect, as incredulous as this may sound.

I am blessed with two beautiful grandsons. But I have confidence that their father (my older son) and their mother (my lovely daughter-in-law), if talked to in a similar fashion, wouldn't budge. But no; not in this case. A CEO who throws the equivalent of a tantrum is told "okay, go ahead."

Risk managers are hired and risk controls are implemented for very good reasons; and one would think that the CEO, who as spent decades on Wall Street, would know as much, respect them, and even serve perhaps as an example in honoring them (so much for the "honorable").

Risk remains a very difficult subject to get our arms around. Risk managers, risk officers, risk controls, risk management rules, etc. are necessary; they must be honored, respected, and ahered to.

Jane Austen's guidance on risk management

Perhaps it might seem odd that one can draw anything from Jane Austen's classic, Pride And Prejudice, in regards to our profession, but alas it is possible, and I believe I have.

The scene occurs at the start of Chapter 5 in Volume 3, shortly after the main character, Elizabeth, has learned that her younger sister, Lydia, has eloped with the once respected, more recently loathed, military officer Wickham. Elizabeth's uncle reflects upon what has occurred: "It appears to me so unlikely that any young man should form such a design against a girl who is by no means unprotected or friendless, and who was actually in his Colone's family, that I am strongly inclined to hope the best. Could he expect that her friends would not step forward? Could he expect to be noticed again by the regiment after such an affront to Colonel Forster? His temptation is not adequate to the risk." (emphasis added) In other words, Surely this man, Wickham, must weigh the risks of his actions and realize that they are such that to put Elizabeth's sister in any jeopardy isn't worth it.

Being aware of the risks is a critical part of investing, whether it's an investment of our money, time, or emotions. Too often investors don't consider the downside of their actions. As is often stated, risk isn't bad, what is bad is not taking the risks into consideration or knowing what those risks portend. One could argue that the gifted Jane Austen was offering some advice which is worth considering, did she not?

Everybody complains about the weather, but ...

You've no doubt heard the expression about the weather and no one doing anything about it. Well, we could apply the same idea to information, especially regarding risk, and how firms measure and manage it. There is great interest in understanding what firms are doing, but how many are willing to participate in the discovery?

Well, to learn you have to give; that is, you have to be willing to explain what you do in order to learn what others do; at least when it comes to the survey that The Spaulding Group has undertaken, along with Capital Market Risk Advisors. But time is running out!

We encourage you to take just a few minutes of your time to complete the online form; this will entitle you to receive a complimentary copy of the results.

"The strange position of risk manager"

I have become used to some of Nassim Taleb's seemingly outlandish remarks, and so was not terribly surprised when reading Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets that he would make such a statement. To try to at least start to bring this statement into context, I should provide a bit more of the section from where it was drawn:

"Corporations and financial institutions have recently created the strange position of risk manger, someone who is supposed to monitor the institution and verify that it is not too deeply involved in the business of playing Russian roulette. Clearly, having been burned a few times, the incentive is there to have someone take a look at the generator, the roulette that produces the profits and losses...The risk managers' job feels strange: As we said, the generator of reality is not observable." (page 40)

I'll leave you the task of pursuing the full and complete context if you so desire. But Taleb does raise (as he often does) an interesting question regarding the appropriateness and value of a risk manager, as well as what his/her duties should actually be and how they might carry them out.

Can risk be managed?, is essentially the question he is asking. And so, can it? Should it? How to do it? If you agree with Taleb, I'd love to hear from you.

The floor is yours...

Risk management in name only?

We spend a great deal of time debating the value of various risk measures, arguing, for example, whether it's appropriate for the Global Investment Performance Standards (GIPS(R)) to require the disclosure of the 3-year annualized standard deviation or whether value at risk has any value. But perhaps more time needs to be spent on the management of risk, as this seems to be what has often led to the crises we've witnessed. In his exceptional treatise, When Genius Failed, on Long-Term Capital Management, Roger Lowenstein discussed how LTCM regularly reviewed their risks but never put the brakes on any of their investing, in spite of the apparent risks they were facing. Seeing the risks, being aware of the risks, but not doing anything about them, shows an institution that is void of risk management.

In a more recent book, The Quants by Scott Patterson, we read that "risk management is about avoiding the mistake of betting so much you can lose it all." Patterson further states that this was "the mistake made by nearly every bank and hedge fund that ran into trouble in 2007 and 2008."

In this past weekend's Financial Times we are presented with a rather abridged version of the recently published 2,200 page exposé on Lehman's actions, that highlights quite a lot. For example, that the firm's risk officer "resisted an increase in the limit [of risk] from $2.3bn to $3.3bn but was overruled." and that "by the end of 2007, it was $4bn." Further, that certain assets, such as a "$2.3bn bridge loan...was never included in the risk usage calculation, although that single transaction [for example] would have put Lehman over its already enlarged risk limit." What exactly was the role of their risk officer? Patterson's claim that "the banks and hedge funds blowing up didn't know how to manage risk" seems, at least in Lehman's case, to be accurate.

The use of derivatives, short sales, and complex models are often cited as contributors to the market disaster that we're slowly making our way out of. However, risk management needs to be fully assessed as it appears that its absence from many of the trading rooms and investment houses surely was a huge factor. Henry Paulson was no doubt unaware of Lehman's risk management issues when he penned On the Brink, though he does speak in a rather disparaging way the (broad) management of AIG, and so not only risk management but management in general needs to be reviewed by those charged with providing oversight.