Financial Armageddon

In a commentary for the June issue of Risk Professional, a magazine published by the Global Association of Risk Professionals, I offered up a few thoughts on a subject that is on the minds of many managers nowadays. Here is an excerpt from "Crisis Analysis: Views from a Non-Risk Manager":

To understand their true exposure to risk, firms must rely less on mathematical models and pay more attention to the unpredictable human element.

I am not a risk manager. Moreover, I am not an economist, nor an underwriter, nor the head of a business that regularly engages in risky transactions. Under the circumstances, many people might naturally assume that I am not qualified to advise risk professionals on how to do a better job managing their firm’s exposure.

Maybe they are right. But then again, as a long-time trader and student of markets, history and human psychology, I believe that sort of perspective might explain why so many individuals — including risk managers — were caught off-guard by the biggest financial crisis since the Great Depression.

To be sure, there are plenty of reasons why the financial world, as well as the real economy, was poised to come undone as 2007 unfolded. One major factor, however, was the large number of ill-founded and unquestioned assumptions that managers, policymakers, regulators and others had made — and relied upon — up until that point.

The assumptions came in many shapes and sizes. At the broadest level, there was a widespread belief that, despite mounting evidence that financial institutions around the world were engaging in increasingly dangerous behavior — including operating with ultra-slim margins of error and unprecedented leverage — there was little reason for alarm.

People assumed that the Federal Reserve would step in and prevent things from getting out of hand if anything untoward happened, which cynics had long ago referred to as the “Greenspan put.” Many also believed that Wall Street’s increasing sophistication and the lessons of history meant we had more control over our economic destiny than our predecessors did. According to the conventional wisdom of the time, the business cycle was more-or-less dead, financial crises were history, and the good times could, in theory, go on forever.

This sense of overconfidence — hubris, really — also rested on other dubious assumptions. With Wall Street reaping big rewards from market-related activities, including securitization and proprietary trading, it wasn’t surprising that many insiders placed great faith in the power of markets to help them in other ways if need be. Of course, if they had studied the past, they would have known that the liquidity they were counting on could readily disappear.

In fact, if recent developments have taught us anything, it is that those who are charged with managing risk need to have an exceptionally strong grasp of history, especially economic and financial history. Not just of the period that began at the start of the last bull market, or at the end of World War II, but of the span that extends, say, to the early days of the 17th century tulip mania.

As we’ve witnessed on countless occasions, “this time is different” is only true if you don’t go back far enough.

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