The Wall Street Law Journal

Smart investments can produce losses 80% of the time. Here's how...

By Brett Sherman, The Sherman Law Firm

Frequency and Magnitude of Risk

In finance, risk is the chance that an investment decision or strategy will result in loss.  Any analysis of risk must consider two major elements - FREQUENCY OF LOSS;  MAGNITUDE OF LOSS. 

Frequency refers to how often one can expect losses.  Magnitude refers to the size, or severity, of potential losses. 

STRATEGY X

Some risky investments will produce losses more often than others. This is not necessarily bad for the investor. 

Suppose strategy X results in a $10 loss 80% of the time, but a $100  profit 20% of the time.  So, 8 out of every 10 times you attempt the strategy, your expectation is that you will lose $10, for a total loss of $80 dollars.  However, if your expectation holds true, you also will make $100 twice in every ten tries.  

Strategy X, is risky from a frequency standpoint since most of the time, the investor losses money.  However, as long as the investor can afford to take losses and keep investing,  Strategy X is a pretty good gamble since - on average - it can be expected to produce a net profit of $120 for every 10 times the strategy is used.   

STRATEGY Y

By the same token, some investment strategies have a very low risk frequency (they will not lose money very often), but can still be extremely risky. 

Suppose Strategy Y produces a $10 profit 90% of the time.  

A 90% success record sounds really good.  But, if 10% of the time Strategy Y results in a $500 loss, the strategy's risk magnitude (the huge size of infrequent losses) far outweighs the potential upside of its low risk frequency.    On average - it can be expected to produce a net loss of of $990 every 10 times the strategy is attempted.  Strategy Y is a terrible gamble.

Now, suppose that Company Z used Strategy Y for 5 years.  All 5 years were profitable.  This is not surprising, since there is a 90% expectation of success.  The Company proudly points to its record of success each year.  Of course, each year Company Z sticks with this strategy the odds of a $500 loss grow higher. 

In year 6, the Company's luck begins to run out.  It loses $300, not as bad as the expected $500 loss, but enough to put Company Z in serious trouble.  In year 7, the Company decides to stick with Strategy Y.  After all, the investment strategy is almost always successful.  Unfortunately, year 7 is another bad year for Strategy Y - a full $500 loss.  

The size - or magnitude - of the loss is catastrophic.  Company Z cannot recover. The Board of Company Z salvages some value by selling what is left of the Company to Bank of America.

RISK MAGNITUDE - CONCLUSION 

Wall Street investment banks like Lehman and Bear Stearns gambled on a strategy that focused on mortgage-backed securities during the housing bubble. 

The risk magnitude of their strategy was the possibility, and ultimately the reality, of losses so catestrophic thatLehman and Bear Stears are each out of business. 

There was no "perfect storm" needed to bring down Lehman and Bear.  All that had to occur was the very predicable collapse of subprime mortgage industry. 

What does risk really mean anyway?

By Brett Sherman, The Sherman Law Firm

 

Here is a nice compact definition of risk I like:  Risk equals the inherent chance of a bad result from a decision or course of action.

 

Here is a bit more comprehensive explanation: Risk is a foreseeable possibility that an uncertain future will produce an unexpected negative outcome.  The more risk a given action carries, the greater the chance for bad results and/or increased negative consequences.  

  Amazing that more than a year has passed since the Bear Stearns went up in smoke.  Even more amazing are the hundreds of articles that describe Bear Stearns as having a reputation for maintaining one of the saviest risk management operations around.  There is no doubt that risk management was a priority for Bear in decades past, particularly when Bear Stearns was led by former Managing Partner and CEO Ace Greenberg. In fact, Greenberg chaired the Risk Management Committee while he was CEO.  His devotion to that role was the primary reason Bear Stearns gained a reputation for excellent risk management.

 

  After Jimmy Cayne ousted Ace Greenberg from the CEO spot in a bloodless coup in 1993, Greenberg surprised some observers by electing to remain with the company.  One of the roles Greenberg retained was head of the Bear Stearns Risk Management Committee.  Unfortunately, Cayne was a salesman.  The only risks he understood were the risks of failing to do enough business.  And Cayne never thought Bear Stearns did enough business.  

 

  Character reflects leadership.  The character of Bear's risk management function was eroded by the leadership style of CEO Jimmy Cayne.  Risk modeling systems aged and became anachronisms.  Personnel responsible for monitoring risk were not properly trained.  In sum, the decline of risk management at Bear Stearns resembled the fall of the Roman Empire. 

  Even though Ace Greenberg is credited with establishing Bear Stearns so-called strong culture of risk controls, the ever-increasing complexity of investment products on Wall Street during the 1990's and 2000's exposed Greenberg's risk management style as a relic from a simpler era.  The raw truth is that Ace Greenberg was a hopelessly overmatched Risk Committee Chairman.  Nevertheless, he held that job until 2007, when he was 80 years old.  

  By the time mortgage-backed securities became the centerpiece of Bear Stearns's business,  Greenberg continued prominence in Bear's risk management function was an inexcusable and reckless act of gross negligence. During the current decade, the era CDOs, CDSs and equally opaque derivitives, how could anyone argue that Ace Greenberg was even remotely qualified to lead Bear Stearns' Risk Management Committee.  

  Ultimately, CEO Cayne and the Board of Directors had a legal duty to shareholders to pay much more attention to managing Bear's risks.  They cannot justify their repeated decisions to leave Greenberg in charge of risk control.

  Ace Greenberg deserves a lot of credit for Bear's rise.  He was and is well-liked and respected by many on Wall Street.  But he deserves his share of the blame for the collapse of Bear Stearns. 

Bear Stearns, Russian Roulette, and Risk Management

      LESSONS IN RISK MANAGEMENT and BUSINESS STRATEGY

By Brett Sherman, The Sherman Law Firm

Thanks to Nassim Nicholas Taleb and Jim Grant.

 

High Risk Strategies Fail In the Long Run - See, for example, Bear Stearns

1.      The definition of risk is the chance of loss.  If an action carries a chance of loss, it is risky.  The greater the chance of loss, the greater the risk. Risk magnitude refers to the size of potential loss. If the potential loss from a given risk could wipe you out, the magnitude is very high.

2.      Why do high risk strategies threaten long-term survival?  Think of betting your life savings on a game of Russian Roulette.[1] Once a year,  on New Year’s Eve, you hold a cold steel pistol to your temple.  The gun has six chambers, but only one holds a bullet.  You say a little prayer and squeeze the trigger.  Each year your luck holds, you exhale with relief. You have drawn one of the five lucky chambers. Then you jump for joy.  You not only get to live, but you’ve just doubled your money.

3.      Unfortunately, each year that you win the laws of probability and statistics stack up higher and higher against you.  Luck doesn’t last forever, and math never lies. Next year, your luck may run out.  In any event, if you play for too long, you are almost guaranteed to lose. 

4.      Of course, losing at Russian Roulette means losing everything you’ve ever had and everything you ever will have.[2] Therefore, “prudent risk management” (to use the words of former Bear Stearns CEO Jimmy Cayne)  dictates that you shouldn’t be playing the game at all.  The bet is far too risky.  But it is also quite lucrative, and you really like money.  You understand the chance you are taking.  You take it anyway.  You are just like the Executive Committee at Bear Stearns.

5.      The point is this - Frequency of success does not mean anything if the cost of even one failure is too high. Bear Stearns reported record revenues for 5 straight years.  And when the company collapsed, those record years didn’t matter to public shareholders at all (except for those lucky enough to have had a reason to sell BSC long before March 2008). 

6.      The individuals who truly benefitted from each of those five record years were the Executive Committee members. They received windfall bonuses, including many millions in cash payments, for generating positive short-term performance during an unprecedented bull market. 

---

[1] The idea of the Russian Roulette analogy comes from the trader and author Nassim Nicholas Taleb. 

[2]Rough paraphrase of Clint Eastwodd from the film The Unforgiven.

 

Six market panics in twenty years: Proof that Wall Street is to blame for world financial crisis.

(Updated for 2009)

By Brett Sherman

First in a series...

Introduction (a slight bit of revisionist history is ok now and then...)

1492:  The Italian explorer sailed his three ships from island to island, staking claims for the Spanish King and Queen throughout the calm, crystal blue waters of what would later be called the Carribean Sea.  His three ships navigated the placid sea for months, and the Italian and his men explored islands we now call Cuba, Puerto Rico, and Jamaica, among many others.   March, April, May, June, July, August, and September passed.  The weather was perfect.  The sea was calm.  These were the best sailing waters in the world proclaimed the Italian.  He had "discovered" paradise. 

Then, in early October, a mild storm came and went.  After so many months of perfect weather, some of the crew were uneasy about the sudden turn in the weather.  Perhaps this was a bad omen?  "Nonsense." Days later, another storm, noticeably stronger than the first.  Aberrations, the Italian insisted.  Even in the calmest sea there must be an occasional storm.  Many of the men, now convinced that their run of good luck was over, urged the Italian to safely anchor the three great ships in one of the many naturally protected harbors on the islands the men had explored.  The Italian was stubborn.  He refused to listen.  He had already compiled an enormous treasure - more gold than he had ever imagined, and he was not about to interrupt his accumulation of treasure because his men were worried about some wind and rain.  

Then came a storm unlike any the explorer or his crew had ever witnessed.  It sunk one of the three ships, nearly destroyed the other two.  Many men drowned.  Nearly all of the gold was lost.  The Italian was ashamed.  He had ignored the warnings of the crew.  Now all was lost.  All of those months of calm seas - the calmest seas the explorer had ever encountered. 

He had seen bad storms in his life.  He had seen men die at sea, ships sink, and treasures lost.  But it he had rarely seen even a cloud for months and months.  Terrible storms had not happened here.  Therefore they could not happen here (though he really did not believe his own words).  

Although he had sailed the Caribbean for nearly a year, this was his first October.  Each October, the hurricanes came to the calm waters.  It was a lesson he could have learned from the safety of a protected harbor - had he not been blinded by greed.

*******

You are the CEO

As an attorney, I'll be the first to admit that hindsight is 20-20.  However, this post, in which I ask you to imagine that it is December 2006, has nothing whatsoever to do with hindsight.  On the contrary, I want you to pretend that you are winding down the year 2006 as Chief Executive Officer of a major Wall Street investment bank.  There is something you know then (hence no hindsight issue) -something quite important.  And you've known it for at least ten years, maybe even two decades.  

Financial Panics

Here is what you know Mr. or Ms. CEO - financial panics are a fact of life on Wall Street.  In fact, the frequency of market crashes has increased exponentially during your tenure at or near the pinnacle of your profession.  There were exactly zero true market panics between 1929 and Black Monday 1987.  However, through December 2006, you've lived through five "market crashes" in twenty years, including four in the preceding decade alone (in 1987, 1996, 1997, 1998, and 2000).   All of these panics were unexpected to one degree or another (whether in terms of timing, intensity, or even crises that were completely unforeseen).  Each of these panics sent intense shockwaves cascading through markets, sometimes infecting market sectors that were unrelated to the genesis of the panic itself (through the ugly tentacles of "contagion"). 

Since you are (for purposes of our exercise) the leader of one of the most important financial institutions in the entire world, you really can't credibly deny that you understand some seriously important concepts from the six major panics that seized markets starting on Black Monday 1987. 

Having been in the thick of the action and privy to lessons learned in the aftermath of these crises, you would have had to have been incompetent for years to miss out on the following wisdom:  Panic in the financial sense means pretty much what panic means in every other sense.  Some event (it could be a major occurrence or a series of smaller tremors that eventually build to a critical mass), triggers a crisis of confidence in a given sector of the world economy (perhaps doubts about a booming U.S. housing market?). Once a crisis of confidence is triggered, animal instinct - herd mentality - takes over and truly frightened human beings (investors and investment professionals) stampede in a bloody fight for self-preservation.  A run on financial markets ensues, feeding on itself in a vicious cycle until hearts stop thumping, collective blood pressure levels out, and panic begins to subside.   

 You also know - based on your experiences with recent panics - that although the timing of triggering events, and even the severity of panics themselves, may have been unforeseen, the strong probability of similar events occurring again - especially during economic "booms" - is entirely foreseeable.  You also know that it is only a matter of time until a company that surfs the biggest wave, wipes out and drowns.

Something is going to happen to derail the gravy train eventually. You know this.  After all, you run a major investment bank.  Since 1987, you know you can only to limit the downside to your company from the next crash is live by one guiding precept - Expect the Unexpected.  Translation - Fail to truly stress the importance of effective risk management at your peril. 

The more experience you gained with panics, you realized, the lmore you knew you could not play games with trying to predict when the next one might come.  You only knew that it would come.  Therefore, the only protection against disaster - the only true hedge - was to keep an even keel.  You had to manage risk prudently, avoid temptation of easy money, resist the pull of greed.  Even the most prudent risk management, of course, can fail.  But easing up on the reigns of risk management could be truly deadly to any company at any time.  This was the lesson you learned from the panics you lived through.  But you ignored it anyway. 

Wall Street CEO Do's and don'ts (since your are the CEO, feel free to disagree)

• Do Prepare for the next crash that you know is all but inevitable by making sure your company manages risk sufficiently to limit potential down-side exposure.

• Don't recklessly manage your publicly-held company for excessive short-term profits at the expense of long-term stability. 

• Do concede that it doesn't do shareholders any good to have your stock shoot to the moon if it crashes back to earth (except for the lucky ones who sold out at lunar levels). 

• Don't tie the fortunes of your company to hard to price mortgage-related products that depend on a dangerous and grossly negligent assumption that the U.S. housing market cannot collapse. 

• Don't let a loss of confidence in your firm by creditors (for whatever reason, rational or irrational) kill you because your company is leveraging its balance sheet at an obscene level of 33 times equity.

• Don't be so irresponsible that you focus on squeezing every penny of profit from the mortgage securities boom today and neglect the potential ramifications of your business strategy for tomorrow.

Conclusion (of Part I)

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Wall Street CEOs and Risk Managers: Like Oil and Water

By Brett Sherman, The Sherman Law Firm

 

Role of Risk Managers Clashed with Interests of Executives.  The Result was disaster for shareholders of Citigroup, Lehman, Bear Stearns, Merrill Lynch, Goldman Sachs and others.

As a general rule, we tend to ignore the lessons of our financial past whenever the markets are humming and money is flowing.  Risk managers are paid to disregard that general rule. 

While the rest of us enjoy a bull market, risk managers must be corporate police officers.  A vital part of risk management function is to prevent a business strategy that produces huge profits for a company during a bull market from crippling the company when a market cycle ends.  During a boom, risk managers are unpopular.  Hardly anyone wants to hear that a sizzling market will eventually burn out. 

The unfortunate reality, however, is that market bubbles have always popped.  Not only do economic boom cycles fizzle sooner or later (often abrubtly), but it is nearly always impossible to predict why or when the end will come. Perhaps one day a permanent bull market will take hold. Unfortunately, no matter how strong or long lasting a market cycle is, we can never know for sure that disaster isn't lurking around the bend.  Therefore, corporate risk managers must manage risk by devising strategies to mitigate potential negative consequences in the event of a market downturn.

Consider the last market bubble, the tech-wreck.  Remember how many individuals within finance and in the general public were convinced that we were in a new age of prosperity, a "new economy" in which the old rules of Wall Street no longer applied?  Remember all the "paper millionaires"?  Remember Dow 36,000?  Remember how it all ended?  Of course you do.  And so do Wall Street CEO's (and former Wall Street CEO's) and risk managers. 

The tech-wreck is a textbook example of a market bubble.  So don't believe Wall Street investment banks when they tell you that they didn't think the housing boom would eventually end like the tech-wreck and so many other market bubbles. 

Within a few short years of the tech-wreck came the housing boom and related booms in mortgages, mortgage related securities, and various derivatives.  In an admitted oversimplification, Wall Street firms like Merrill Lynch, Lehman Brothers, Bear Stearns, and Citigroup gambled their futures on the housing boom.  Wall Street invested heavily in  mortgage securities and related products, accumulating large inventories for their own proprietary portfolios.  At the same time, these investment banks highly leveraged their balance sheets, leaving them exposed to high loss potential when the bubble in home prices popped.  

Wall Street firms reported record profits during the housing boom.  High annual profits meant high annual incentive-based compensation for senior Wall Street executives.  Therefore, the risk management function (protecting investment banks from the risks of business models that could lead to the kind of corporate implosions that will forever mark 2008) was at odds with the interests of senior Wall Street executives, who made more money by maximizing short-term returns.  Guess who won that battle?

As someone once said, the brightest stars burn out the fastest.  With effective risk management, Wall Street profits may not have reached the stratosphere during the housing boom, but investment banks like Bear Stearns and Lehman Brothers still could have been profitable and lived to make more money another day.