Monday, September 28, 2009

The Riskiness Of Risk

There is tremendous risk in attempting to evaluate and use risk as a metric for evaluating firms, investments and individual financial decisions. Using risk as a dominant feature for decision-making is in and of itself highly risky. The recent financial crisis shows that risk measurement cannot be the premier guide for business and individual actions.

Investors, homeowners, regulators, analysts and financial institution executives learned in the financial crisis that the actual risk of an investment is different from the expected risk. In the financial crisis, the risk and investment losses were much greater than were expected in the worst-case scenarios. Firms and homeowners faced insolvency and the entire landscape of financial firms and homeownership changed.

Institutional investors and financial firms are sophisticated. They are not self-destructive and employees would not knowingly risk their entire careers, their equity in their firms and their firms. Many know how to analyze collateralized mortgage obligations, derivatives and other mortgage related investments. If they do not know how to analyze the risk of these investments, they know they can get an analysis, showing the value of the investment under different economic situations and mortgage default scenarios, from the firms originating and selling the investments. Investors can always buy a US treasury bond as an alternative and are not powerless. Likewise, homeowners would not knowingly risk losing their homes.

Holders take great effort to limit their investments to the acceptable levels within their firms' risk guidelines or risk losing their jobs and careers. Certainly, there are aberrant traders, salespeople and investors, but they are isolated and not system or firm wide. The financial crisis is not the result of a few rogue individuals. The risk affected many firms and most developed countries. There is no easy explanation of past events.

Additionally, for over twenty years, derivative modelers and analysts knew how to value fat tails, otherwise known as black swans or low probability events. They can also model investments where prices break from past behavior, i.e. jump diffusion models. Even without that knowledge, firms have analysts who could run sensitivity analysis for different economic events, even very low probability ones, to accurately gauge how an investment will behave in unlikely scenarios. Brokers would show that truthful information to risk-adverse investors, if needed or requested.

The crisis taught everyone that past investment behavior, modeling, sensitivity analysis, risk expectations and any other decision-making criteria for dealing with risk is in itself very risky.

There is a second order effect. Risk and risk evaluation is risky and using risk criteria for decision making and investment decision entails risk to an institution not captured by the measurement of the investment and product risk.

The riskiness of risk is separate and different from the systemic risk of the interconnectedness of financial institutions.

It is the recognition of the riskiness of risk that has made all of us much more risk adverse. It is showing up in many indicators. Households are paying down debt. They are not making major purchases, such as homes or autos. There are fewer business startups. Employers are hiring many fewer people than in the past, which is the primary cause of the high unemployment numbers and not the layoffs.

The country is placing too much attention on why and how we got into this mess. When we are wiling to accept the recent past, our changed financial and housing landscape, our investment losses, and our and our children's changed career prospects, we will then be ready to move on and economically grow this country again, to start new businesses, develop new ideas and to take the necessary risks to improve the country's future prospects.

If we focus too much on the riskiness of the past, everyone will become risk avoiders and it will only delay strong future economic growth.

It will take awhile and some time separation from the present events for unbiased research to give us a clearer picture of the causes and results of the financial crisis. (See my older post, "Too Bad Financial Regulatory Agencies Do Not Know Coase's Work.")
At that time, we can institute reforms to prevent a reoccurrence. Until then, we should stop looking back and start looking forward at how we can rebuild the great economic growth that this country can achieve.

1 comment :

  1. The post was good, but i personally think it should have been written in a more precise manner.