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.