ESM, Rate Rating Procedures

As of  October 8, 2012 the European Stability Mechanism (ESM) is a fact.

ESM is a European multilateral lending bank that lends money to euro Area Member Countries in order to facilitate them to restructure their debt and financial position.

Please note that the ESM lending is funded by debt only! 

ESM Rating

On October 12, 2012 Fitch Ratings has assigned the ESM a triple-A (AAA) Long-term Issuer Default Rating  and a Short-Term IDR of 'F1+'. The Outlook is Stable.

All Hosanna one would say. Well almost....

At the end of the FitchRatings document two small remarks state the following:

1. The rating is robust to downgrades of 'AAA' shareholders into the 'AA' rating category.
2. However, as Fitch has previously commented, in the event that Greece were to exit from the eurozone, the ratings of all sovereign and sovereign-rated entities in the eurozone, including the ESM, would be placed on Rating Watch Negative as Fitch re-assessed the broader political commitment to the euro and the potential contagion and financial implications of a Greek exit.

Implicitly the first remark implies that if individual AAA countries are downgraded below AA, the Fitch rating is no longer robust. As the probability that such a downgrade might happen, is substantial, it is strange that this 'downgrade risk' is not explicitly valued in the rating procedure.

The second remark implies that a significant risk (1Y default Risk Greece>30%; see also: Default Risk at Risk) as the exit of Greece, has also not been valued in the rating procedure. Not to mention that a possible default risk or exit of Spain has not even come into the mind of the FitchRating scientists. 

Conclusion
From a risk management and valuation perspective, leaving out both risks in an official rating procedure is ridiculous and looks more like a kind of 'lip service' instead of a serious rating procedure. Above all, it places rating procedures in a bad spotlight.
It's about time to rate the ratings agencies an their rating procedures. Who's willing (or dares) to do so?

Perhaps it's also time to fill in the Risk Manager vacancy in the ESM Organization Chart...... ;-)

Sources/Related Links

- ESMs FitchRatings document 2012 
- Presentation ESM
- ESM Organisation Chart

Aftermath European Crises Explained

Too Much of a Good Thing

We all know the expression "Too much of a good thing", but in practice, do we act in line with this life principle ?....... NO

I'll illustrate the fallacy of this "Too Much" principle with regard to two topics: Debt and Risk.

Debt

We all know that when it comes down to setting up a new business or investing in a sustainable development, a loan may help us to start up fast and facilitate growth.

So we might say that a deliberate chosen debt (a loan) stimulates the growth of a company or investment and also stimulates the entrepreneur or investor to take the 'right' decisions.

However when adding more debt (taking up more loans) doesn't generate the intented growth, in most cases a serious profit recovery plan is needed to keep the company a life or the investment profitable.

Unfortunately this is not the way we think in saving our western economy.

We keep adding debt while the growth of our economies keeps slowing down. This development is the main reason why the price of gold keeps rising.

Golden Proof
Although in 'normal' times the relationship between gold and country debt is not substantial, it's clear that in a 'no-growth increasing-debt policy' this relationship becomes clearly visible.

Despite of these clear signs, we keep adding debt-increasing measures, while the last signs op economic growth hope drown in the sea of debt.

When I showed the above slide on a Webinar (= online seminar) , one of the participants stated that investing in gold at this (current) price level would be risky.

I answered that the opposite was in fact true, as in historical perspective the market value of the Federal Reserve's Gold has fallen back to a backing up level of around 20-30% of the balance sheet.

So in fact the Fed has allocated 'too little of a good thing ' to restore trust in the financial markets.

In other words, Gold has still a great upward potential, as seen from a risk perspective.

Without going into 'too much' detail her, in fact, it's the other way around:

The relatively high price of Gold in Dollars,

is an indicator of the default risk of the Dollar. 

Looking at the dollar from this new perspective, it suddenly seems strange that we define the default risk of a country (currency) only with help of a country's (artificial) bond interest rate (more on my Blog: Default Risk at Risk) on basis of an also artificial  'risk free interest rate'.

Why not define the risk of a country's currency in terms of it's value to a neutral 'zero credit risk'  asset class, which gold in fact is.  I challenge you to come up with a new formula for the default risk of a country, based on the price of gold (e.g. London Fix=LF)... 

Default Rate Currency X = D_c = F( London Fix [Currency] )

where Currency=USD, GBP or EUR and F is a function which translates the actual London Fix price of Gold in a specific currency to a default risk. 

If no formula-volunteers step up, I'll come up with formula in one of my next blogs.


Risk
Now let's look from a  "too much of a good thing perspective" at Risk itself.
As we all know, a positive and optimistic look at life increases the probability of success in life. In examining Risk, Risk-Life is different.

When risks are far away and have not yet occurred, risk professionals as well as non-risk-professionals are inclined to underestimate risk. On the other hand, risks that occur now and then are (too) well known and overestimated. Finally unkonwn  hidden risks in the well known high frequency-low-impact risks are again often underestimated.


The Art of Judging Risk

A professional risk manager is more than a good goalkeeper in a professional football (soccer) club. His first responsibility is to identify and assess a potential risk together with his (management) team. Golden rule in this risk assessment process is to estimate risk in such a way in time that you never get into a underestimated position of a specific risk. This implies that when we assess new risks (e.g.  'hedge fund risks' or 'country default risks') we should not start from a zero risk position and adding risk in our models while we are making progress, but rather the other way around. This way of estimating risks will contribute to a much more professional and appreciated working method in the risk work field.

Enjoy exploring risk management. It's an everlasting activity you can't do too much!  Or can you?

Used Sources
- Clipproject.info 

Humor: Penguin Risk Management

Life ain't easy ... sometimes.... Especially not... when you're a risk manager....

Changing Professional Field of Risk

In order to make any kind of progress in our human - penguin like - society, we'll have to take risk...

Part of a risk manager's task is to check regularly whether parties, (e.g.  asset managers)  are acting in line with the defined risk mandates (compliance). 

It's more or less generally accepted that a risk manager's first task is to prevent, control and optimize risks from a mainly defensive point of view.

However.....

we live in a 'risk growing world' where (state) regulators and accounting standard boards increasingly prescribe all kind of risk controlling measures.

In this world it becomes more and more important that a risk manager also advices actively on where and when to take more risk, instead of less risk.

Zero Risk Attitude: Death by Risk Management

Taking less and less risk gradually leads to a zero risk position.

An (on top of)  'zero risk attitude' of a risk manager can therefore become the nail in the coffin of any financial company. As without risk there's no profit, and without profit any financial company is doomed.

So skip any form of 'scary risk management', face risk as it is and changes in time. Moreover, develop and demand a positive, realistic and dynamic risk view of yourself and your professional environment.


Risk, Part of Evolution
History shows that taking major risks is essential in successful exploring new areas.

A few examples:

• Discovering America
  The (re)discovering of America by Columbus took a lot of lives. Shipwrecks, bad weather, diseases and fights took its toll.
• Radioactivity
  Discovering the properties and applications of radioactivity took many lives. Example : Marrie Curie died as a result of prolonged exposure to radiation.
• Exploring Space
  Many astronauts died on the the Gemini, Apollo an shuttle projects About 5% of the astronauts that have been launched, have died.

Future Risk Space Programs: Dream Chasing
At the start of the Shuttle program, NASA managers thought (calculated?) there was only a '1-in-100,000' chance of losing a shuttle and its crew.
Today, engineers believe this probability was in fact closer to 1 in 100. 
NASA’s basic requirement for new commercial crew vehicles is a probability of 1 in 1000 (!).

On basis of these modern risk standards, the original Apollo project back in 1961 would not even have started.

Looking at our 'Exploring Space' ambitions, it's likely that due to higher risk standards, cost of new space programs will increase to a level where no profitable exploitation (at all) is possible.

In other words: Profitable exploitation of future crewed flights to other planets will turn out to be a real 'Dream Chaser'.

Let's be fair, after 1972 we've never been back to the moon. Yet, plans to go to Mars are presented as 'business as usual'....

At the same time risk standards increase and costs explode.
Forget about going to Mars at current risk standards!

Financial Risk Equivalent

Just like in the space industry, risk standards in the financial industry have increased. From old demands, like the 2.5% one year default rate (97.5% confidence level)  of Dutch pension funds to the 1.0% - 0.5% default rate in the insurance and 0.1% - 0.05% in the banking industry.


In general, raising default risk standards by lowering default levels is a dead end street. It's much more effective to tackle other risk topics like controlling 'systemic risk' and 'company size' and accept risk as a fact of life.

Penguin Behavior
Perhaps - regarding risk and size - we can learn from penguin behavior. Although king penguins are highly gregarious at rookery sites, they usually travel in small groups of 5 to 20 individuals.

Just like we humans, penguins have to take risk in order to survive. In our research for risk we have to accept risk, and therefore loss, as a necessary unavoidable part of (financial) life.
Let's learn from penguin Risk management.....

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Conclusion

Let's wrap up with penguin wisdom:
To survive as society on the long term, we need to create smal(ler) companies with a limited exposure to systemic risk and a higher risk attitude.

Risk is a part of life, explore but don't kill it, as it will kill you...


Links & Used Sources:
- Apollo by numbers
- Percentage of fatal space flights
- Analysis: NASA underestimated shuttle dangers 
- Certified Safe (2011)
- Dream Chaser
- POLE Penguins Comic Strip

Aftermath

Mars?  Perhaps in 2525?