Monday, 29 September 2008

Pass the radioactive parcel

The ATCA thought piece today quoted the world derivatives' market at $1.14 quadrillion ( that a thousand trillion ) which equates to $190,000 for every person on the planet or 22 times the global GDP.

The unravelling ( unwinding seems far too controlled a word) of such a large market which is based on nothing more than confidence starts to look like a radioactive version of pass the parcel, whereby everyone involved is blighted. Don't expect your $190,000 soon.

Monday, 22 September 2008

Wholely right

The following extract from Berkshire Hathaway's 2002 Annual Letter to Shareholders deserves the widest possible circulation. Warren Buffett should be required reading for all in the risk business. I have not abbreviated the extract - you need to read the whole section.

Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.

Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it
seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.

But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them.

Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but that’s no easy job. For
example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.

The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”

I can assure you that the marking errors in the derivatives business have not been symmetrical.
Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the
Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are
fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large
amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market forweeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of
derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activitiesof major banks, the only thing we understand is that we don’t understand how much risk the institution isrunning.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly
multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerousthey are has already permeated the electricity and gas businesses, in which the eruption of major troublescaused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives businesscontinues to expand unchecked. Central banks and governments have so far found no effective way tocontrol, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our
owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, andthat posture may make us unduly apprehensive about the burgeoning quantities of long-term derivativescontracts and the massive amount of uncollateralized receivables that are growing alongside. In our view,however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Sunday, 21 September 2008

A week is a long time in the markets

Stelios Haji-Iannou remarked that " If you think risk management is expensive, try an accident".

Last week we started to count the cost of not having sufficent risk management is place in the derivatives' market. There is one estimate that this market is 11 times the value of the global GDP . No one knows how long or how painful it will be to extract the leverage out of that market or what the shape of the global financial industry will look like when it is finished.

Warren Buffet told us that derivatives were "weapons of mass destruction" back in 2002 when he reported on what he found when he unravelled General Re's derivative book. No one else comes close as a risk manager in the insurance business.

Saturday, 13 September 2008

The Great Pandemic and the young

90 years ago this month 12,000 died of influenza in the USA. In October a further 195,000 died. American life expectancy dropped in 1918 by 12 years. Eventually 600,000 American citizien would die of the disease which singled out the young and fit and turned their immune systems against them. The estimates for world fatalities runs from 20-50 million. The truth is we just do not know how many and find it difficult to disentangle the effects of World War 1 with those of the pandemic.

Those authorities which swiftly recognised the nature of what they were dealing with, stemmed the mortality rate by limiting movement, by reducing contact between people and by promotingthe use of masks.

Others, such as the US army which had 13 million men register for the draft in September 1918, unwittingly exacerbated its effects.

Risk Managers should study the history of this great pandemic - if it was to occur again we would need to understand what did or didn't work in 1918, plus how we have moved on since those days, especially in terms of mobility and communication.

Young people take their health for granted, they think such a death couldn't happen to them. Sadly it did for my maternal grandmother in 1919, she was only 30 when she died of influenza leaving behind my mother , then a seven month old baby.

Tuesday, 9 September 2008

A head above the parapet

There is a risk in bearing bad news and perhaps an even greater risk in raising risk issues which do not chime with the CEO's world view.

Chris Lajtha of Adageo has sent me the following story from antiquity to illustrate the Risk Manager's Dilemma in the starkest terms:

When Darius, the Persian Emperor, decided to teach Alexander of Macedonia a lesson for invading his empire he assembled an enormous army designed to shock and awe with its size and opulence ( some ideas never go out of fashion).

Alexander did not have support from all Greeks and there were some Greek officers at the court of Darius. One of them, Charidemus, assessed the futility of Darius' approach

"Perhaps," he said, "you may not be pleased with my speaking to you plainly, but if I do not do it now, it will be too late hereafter. This great parade and pomp, and this enormous multitude of men, might be formidable to your Asiatic neighbors; but such sort of preparation will be of little avail against Alexander and his Greeks. Your army is resplendent with purple and gold. No one who had not seen it could conceive of its magnificence; but it will not be of any avail against the terrible energy of the Greeks. Their minds are bent on something very different from idle show. They are intent on securing the substantial excellence of their weapons, and on acquiring the discipline and the hardihood essential for the most efficient use of them. They will despise all your parade of purple and gold. They will not even value it as plunder. They glory in their ability to dispense with all the luxuries and conveniences of life. They live upon the coarsest food. At night they sleep upon the bare ground. By day they are always on the march. They brave hunger, cold, and every species of exposure with pride and pleasure, having the greatest contempt for any thing like softness and effeminacy of character. All this pomp and pageantry, with inefficient weapons, and inefficient men to wield them, will be of no avail against their invincible courage and energy; and the best disposition that you can make of all your gold, and silver, and other treasures, is to send it away and procure good soldiers with it, if indeed gold and silver will procure them."

The Greeks were used to direct speech as well as action, but Charidemus had not recognised how the Persians would react to such a blunt appraisal. Darius was so angry that he ordered him to be executed . "Very well," said Charidemus, "I can die. But my avenger is at hand. My advice is good, and Alexander will soon punish you for not regarding it."

Alexander and his men attacked and , as Charidemus predicted, they destroyed the enormous, unwieldly and polyglot army, forcing Darius to flee, leaving his wife and mother to be captured by Alexander, who treated them well.