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Views from the Prairie

January 09

What went wrong on Wall Street?

The "risk managers" at the financial firms were supposed to keep us safe on Wall Street. These are very smart, technically astute people who had fancy computer models that were supposed to keep us from taking too much risk. What went wrong?

Some people say that the top managers at those Wall Street firms leaned on the risk managers to change the models a little. A better case can be made that the whole idea was faulty. It was faulty both in the use of risk models, and in the way that the company was structured.

Risk management is based on financial models. These models, no matter how good they are, all fail because of three reasons. First, they are based on modeling to a specific "assurance level". With any model, there is always a 1%-5% part of reality that does not fit the model. Secondly, disruptive events in the market are always quick events. For example, most of the damage done to a stock happens on one day out of perhaps years of data. Most of the gains that occur happen on just a few days of the year. Models are based on more steady state situations, not disruptive events. Thirdly, the models can not model systemic fraud. Human beings are very creative and that includes those who do fraud. Systemic fraud has always, and will continue to occur outside of everyone's models.

When we blindly use the models, we assume that human beings will follow mathematical rules.

The structure of the companies was at fault also. Simply put, the top managers were not being rewarded for keeping their companies safe. The pay scales, the bonuses, the keeping of the job were all based on how much return they made for their shareholders. There was no consideration of whether or not they were taking excess risk. In such an environment, they delegated the "risk management" to lowly technicians who could not stop the company from any trade. That meant that only returns were considered and not the risk of those investments.

When Toyota decided to make quality their number one priority, they gave the power to stop the production line to the lowest person on that line. That person could stop the line based on the quality level. With such power, quality skyrocketed. On Wall Street, the regulations stated that risk was supposed to be considered, but the power was not handed to those who knew the risk. That means that risk didn't count.

The lesson from this for our own operations is that when there is a significant risk, the people who know how to manage that risk have to have control over it. When something is too important, it should not be left to those who have no power.

Systemic Problems

In business today, we know about fraud. Any business person has had people make them an offer to cheat their company or to invest their time, effort, and resources into "something that might sell if you have it". Most of us know how to avoid those situations. But the real danger is in systemic fraud.

Systemic fraud happens where nobody knows the real risks of a situation. For example, nobody knew the real risks of building a resort in parts of S.E. Asia. So, when the tidal wave came in, nobody was prepared for it.

Enron is a clear example of such a systemic problem. When highly skilled auditors are not able to find the fraud and yet, the fraud is what took down the business. Then, the fraud was not simple fraud, but systemic fraud.

Warren Buffet is said to say that he only wants to invest in companies where he can understand what the company does. When nobody can understand how a company makes money, then we are looking at the probability of systemic fraud. That is how Bernie Madoff was able to build such a massive Ponzi scheme.

We see the same thing in the global "debt swaps" that swept through the banking industry. Nobody knows how much of that was going on. Nobody could tell you the risks were for the banks, the hedge funds, or anyone else. Nobody could tell you if something that was done safely when in minute quantities would be healthy to the system if done in large quantities. Thus, it was a systemic problem.

We see the same thing in dealing with some foreign countries. With some countries, there is no way to verify that what you are buying is what they said it is. In some cases, the fraud results in poisonings and death.

As business people, we need to be aware of the possibility of systemic fraud and plan to mitigate the risks when dealing with such possible situations.

Risky World

In July, the network administrator for the City of San Francisco was arrested for allegedly hijacking the network. When he was arrested, apparently he was the only person who could access the network. The city slowly regained control over their network.


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