Understanding the Risks We Take

How do you know what risk you are taking?  That’s the subject of a book by Riccardo Rebonato, Plight of the Fortune Tellers.

The problem is that most people in business really don’t know what could happen if things go south.  So Rebonato’s book enables us to think again about notorious debacles like Enron, writes Arnold Kling.

[T]he main reason that Enron got into trouble, I believe, is that for years Enron’s executives and its Board did not understand how it was making its money and the risks involved.

Of course when things started to go badly wrong, Enron’s management started to cheat, and that’s what everyone remembers.  People do that when they get in a hole.  When Nick Leeson, a trader at Barings Bank, got in a hole trading in Nikkei 225 and Japanese bond derivatives  he made such a mess cheating his way out that he took the entire bank down with losses that exceeded one billion dollars.  And Barings didn’t have a clue what he was doing.  Not until it was too late.

How do you evaluate risks?   That is the problem in all kinds of business activity, including most recently sub-prime mortgage-backed securities business.

In the 1980s and 1990s Arnold Kling worked for Freddie Mac, the government-sponsored mortgage giant.  The problem for Freddie Mac was to evaluate what would happen to their assets and liabilities in interest rates changed.

One of the reports that we developed was something that we called the NPV Curve. This report gave an estimate of the value of the company if all assets and liabilities were evaluated at current market prices, and then estimated how this value would change if interest rates were to rise or fall by one percentage point, two percentage points, and three percentage points.

In fact Freddie Mac set up their assets and liabilities so that they could just about survive a ten-year deflation in housing prices equivalent to the Great Depression.

In real life, of course, the future may be worse than the Great Depression.  But we can hardly conceive of such a dismal future.  But by combining the NPV Curve with a Great Depression scenario an institution can develop a set of rules to understand its risks and manage them.

That’s a tool we all could use.