Spanish Risk Management

Why does Europe support Greece with a bailout? And why will Europe support other PIGS countries when they get into trouble as well?

Greece

It all started with Greece.
After Greece joined the Euro (2001),  it became clear that the Greek government lied about its deficit, the Greeks simply 'cooked their books'.

Unfortunately there's no way back. The Greeks held us by the hand in their 'systemic dance'.  Ancient Greeks always believed that dancing was invented by the Gods. The Spartans not only danced before battles, they also fought with rhythmic movements to the strains of flutes. And so, still it is in the year 2010.

Spain
Let's dive a little deeper and ask ourselves the question why the EU needs to help Spain out, once it gets into trouble.

ING
Just have a look at ING Bank, as a simple example.
In 2010 ING has a € 41.3 billion (total) exposure to Spain. That's 124% of their equity.

It's clear, despite of all effort in explaining and defending an excellent (?) risk policy in their 2009 annual report,

ING Risk Management Fails

Even an amateur in Risk Management and Diversification can tell you blind-sighted, that a single country exposure exceeding ING's total equity is a major and unacceptable risk.



What about the Dutch regulator?
This ING debacle also implies that Dutch supervisor DNB has failed as well. DNB did not notice the 'exposure mismatch' in ING's 'Spanish Risk Management' adventure.

If DNB continues 'checking boxes and formulas' while warning the whole world about every detailed risk, instead of using common sense, keeping an eye on the headlines and demanding adequate actions, the future of Financial Institutions will remain at risk. The control approach and attitude of DNB has to be fundamentally revised.

Other European Banks
Back to the banks. Although 'Exposure Lader Spain', ING turns out not to be the only bank at risk.

Just have a look at Deutsche Bank (DB). At first Deutsche bank stated that the exposure to Greece was 'very limited' and that they had 'no comment on others'.

On May 25, 2010 the DB CEO stated he has 500 million euros exposure to Greece in sovereign loans and debt and DB has no sovereign exposure to Spain and Portugal.

As we can conclude from a EVO Research report, these statements are simply not true.


Conclusion
It's clear that European Banks are not transparent about their exposures. They're hiding and mis-communicating information.

Thanks to the bailout and financial support of the European government, European banks are (temporarily) saved (by the bell).
Key Question: For how long?????

 Related Links / Sources:

- Complete European banks exposure to Spain

- Youtube: Espeluznante cogida a Julio Aparicio en Las Ventas en el cuello 

- Greek debt crisis a hazard for EU 

- Greece : dance history 

-  ING annual report 2009

Bank on the Run

Let's dive into the development of banking failures......

How many banks are on the run?

FDIC
The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress to maintain stability and public confidence in the nation's financial system by (1) insuring deposits, (2) examining and supervising financial institutions for safety and soundness and consumer protection, and (3) managing receiverships.

Just have a look at the reported (half May 2010) FDIC Bank Failures (words don't apply):

Things ain't getting better, I'll leave a 2010 Bank Failure forecast to the imagination of your actuarial mind.

Let's hope for the best...

"Thought of giving it all away
To a registered charity
All I need is a pint a day
If I ever get out of here
If we ever get out of here"

Related Links/ resources:
- The Big Picture: FDIC Bank Failures (5.15.10)
- FDIC Failure Stats

Actuary Professional Test

So you think, because you're an actuary, you must be a top professional....

Well.... Put yourself to the test by taking the next two minute IQ-test.
Remember: Don't cheat!

2 Minute Intelligence Test

Online Murphy Risk Calculator

Risk is like quantum mechanics:

If you think you understand Risk, you don't understand Risk
Maggid after : Feynman

If you are not completely confused by Risk, you do not understand it
Maggid after : John Wheeler

Sure, risk is hard to tackle. The more you learn about risk, the more you become aware of it's sneaky characteristics (clustering, tails, etc).

This is why becoming a qualified actuary takes an incredible amount of time, hard study and many years of experience.  As masters in Risk, actuaries understand the limits in modeling and calculating Risk.

Murphy

Probably one of the more intriguing risk quotes is :

Murphy's Law

"Anything that can go wrong, will go wrong"

by the famous Edwin Murphy.

A quote that keeps an actuary mind busy....  After all, as actuaries it is our duty to quantify and explain uncertainty (as much as is possible) in board rooms and on the accounting table. Not only when decisions have to be taken, but also after things turned out wrong or different from what we thought. This is - to put it mildly - no 'easy task' and it's not getting easier in the near future.....


Just like Murphy, actuaries experienced last decades that (statistic) bad luck often collaborates with bad timing. What drives God (i.e. quantum mechanics or 'Murphy probability') to confront us - (poor) actuaries - with 'fair value volatility', 'longevity explosions', 'subprime defeats', 'imploding real estate market's and 'extraordinary solvency demands by supervisors', all at the same time time?


(Un)Luckily, help is on the way....  In 2004 British Gas commissioned some scientists to create a formula to predict Murphy's Law, also known as Sod's Law.

Murphy's Formula
In a 2005 study, based on a survey of 1,023 adults, Murphy’s Law was shown 'statistically significant'. The final report also supplied a formula for predicting occurrences of Murphy’s Law. Here it is....


Let U, C, I, S, and F be integers between 1 and 9, reflecting respectively comparative levels of Urgency, Complexity, Importance, Skills, and Frequency in a given set of circumstances. Let A, which stands for Aggravation, equal 0.7 (Please, don’t ask why). The likelihood (L) of Murphy’s Law obtaining under those circumstances, on a scale of 0 to 8.6, turns out to be:

L = [((U + C + I) x (10 - S)) / 20] x A x 1 / (1 - sin (F / 10))

Murphy's Formula strikes itself
Unfortunately, Murphy's law suffered from self reference, as one of the  authors, the mathematician Phil Obayda, commented on a 2004 blog that this formula is wrong.

The correct formula according to Phil is:

 P= (((U+C+I) * (1-S))/2) * A * (1/(1-Sin F))

with P = probability of Sod's Law Occuring and U, C, I, S and F values greater than 0 and less than 1, keeping the mysterious A = 0.7.

Murphy's formula simplified
Simplifying this last formula leads to Maggid's formula for the probability (%) of Murphy hitting you, whenever you perform a task:

Although application of this formula is not (yet) an obligated part of the actuary's Code of Professional Conduct, please check this equation anytime you're about to defend an actuarial advice on a Board's table.

How to use Murphy's formula: an Actuarial Example
Let's do a simple exercise to demonstrate the power of Murphy's formula:

You've developed a risk model of the Stock market. In a meeting the Chair of the board asks you how certain you are of your model being right. You know the difference between risk and uncertainty, so you say "one moment please" and pick up your pocket calculator while reflecting: This is a ´U=3, I=9,C=10,F=3´ situation, and I'm a S=9 actuary. That calculates as P=10.4% of Murphy hitting me. Within 20 seconds you (over)confidently answer: I`m about 90% sure of my model!

The Chair of the Board looks desperate... His eyes reflect: ´Is 90% good or bad?` You didn't realize your model was that important to the board.  But.. if that's so, 'Importance' should not be rated at I=9 but at I=10, raising the failure probability to almost 11%. Now you start doubting yourself : What if you overestimated yourself? What if you're only a AA-Actuary (level S=7) instead of a AAA (level S=9)? This would increase the probability of failing to 31.3%. Suddenly you realize you're only one step away from a major personal actuarial meltdown.
You get yourself together, regain your self confidence, realize you're one of the best actuaries in the world (S=10) and full of confidence you reply the questioning eyes of the Chair with: "Sir, I'm almost 100% certain my model is right.

The Board is relieved and content. You're an actuary they can trust. Now they can decide without hesitation.

So next time you want to know the failure probability of a task, use the next Online Murphy Calculater.

Good Luck with Murphy's calculator!

Used sources/Links:
- Sod’s Law: A Proof
- Newyorker: Murphy At the Bat
- The Engineering of Murphy's Law?
- Legend, Inc. Murphy's Laws
- The Stock Market: Risk vs. Uncertainty
- Murphy's Online Calculator

The LORD and Risk Management

The (2010) Louisiana Oil Rig Disaster (LORD) shows that oil industry Risk Management Plans fail.

In general, Risk Management Plans are focusing too much on Risk Control, too little on Risk Prevention and certainly not enough at Damage Control.

The LORD shows us that a sufficient Plan B is missing. The only 'hope'  in the LORD's current Plan B was the Blow-Out Preventer (BOP) at the bottom of the ocean.

Apart from the question whether that BOP has been tested well: what is Plan C if this BOP would fail, as it obvious does?

Plan C ?
Of course not, we don't need a Plan C. All we need is an adequate Plan B. Plan B should simply have included the installing of two other well tested BOPs at an appropriate distance under sea-level.




Supervisors fail as well
It was only after the LORD's appearance, that the House of Representatives began an investigation into "the competency of the companies' risk management and emergency response plans".

This action is a typical case of:

When the steed is stolen, the stable-door is locked

From all this (above) it's clear that not only Risk Managements Plans are failing, but also the preventive control of those plans by national supervisors.

Why care?
As an actuary you might think: BOPs and an exhausting Plan B are perhaps fine regarding the oil industry, but who needs those instruments in the financial industry?

Unfortunately, the financial industry makes the same mistakes as the oil industry. From a long list, in short, two financial examples:

• Only after the dramatic fall of coverage ratios in 2009, Pension Funds started to make recovery plans (Plan Bs)
• Only after Greece's financial crisis and the corresponding decline of the Euro, Europe started thinking whether or not they should help Greece out and developed a Plan B.

Rethinking Risk Management

It's undeniable, we fundamentally need to  rethink and restruct our Risk Management Plans.

Risk Control
First of all we'll have to distinguish more between Risk and Damage. Preventing, reducing and controlling Risk (not just damage!) is key. Testing and supervising (certification!) Risk Management Plans is a must and needs more attention.

Damage Control
Apart from  the probability of a Risk event, Damage Control needs more attention. Here 'Controlling' includes Reducing and definitively Stopping Damage. Both are essential. This implies that a serious Plan B is in place and regularly tested and approved by supervisors. This Plan B should include automatic shut off valves in every line of business and 'triple actions plans' in case a first or second case action plan B unexpectedly fails.

How to deal with Unthinkable Risks?
Moreover, to create effective Risk Management Plans, we have to deal with the issue of "Unthinkable Risks".



No matter how creative you and your organization are, one thing is sure: new 'risks you didn't think of' will always show up . Problem is that - just like the LORD showed us -  you'll only become aware of a new risk after its manifestation; when it's clearly too late.


A Risk Sensitive Mindset
This - however - doesn't mean that you can't deal with unthinkable risks. To manage unthinkable risks you'll have to create a 'Risk Sensitive Mindset' in your organization. It takes employees who are vigilant and empowered to take direct action. Creating such an organization pays off in more than one way, as vigilant employees will also have a nose for new business and sales opportunities.
This way, Risk Management costs are not just unavoidable costs but profitable investments.

The LORD and your own responsibility 

As we seem perfectly capable of managing our own personal life without a fifty-page Risk Management Plan, most likely this type of Employee Risk Attitude Development (ERAD) is the most important (but also most disregarded) part of Effective Risk Management. In this case the LORD can't help us, it'll have to be our own insight and decision to take action to develop risk sensitive and responding employees.

Still not convinced that ERAD is the right way ahead? Imagine what difference we actuaries could have made to the (financial) world if we would have been able to spot and address sub-prime mortgages or the weakness of our ALM models in an early stage.....

Many LORD's blesses and Good Luck with this new view on Risk Management!

Related Links / Resources:
- Government Branches Investigate Louisiana Oil Rig Disaster
- UBC: Case Studies of Engineering Failures
- SKY: Emergency Declared As Oil Approaches US Coast
- Strategic, organisational and risk management context

New Actuarial Ethics

As actuaries we have to act in a complex world. This is no easy task. If we're honest, we have to admit that in this last decade we got ourselves dragged along the road of unrealistic and too optimistic ROI outlooks.

'Good' and mathematically sound advices turned out 'Bad'. Pension Plans are in trouble. New ROI-hope seems to be on our doorstep. With a look of weariness and despair, board members and clients seek our advice.

It's our duty to advice them in this financial jungle. Unfortunately we can not look into our Cristal Ball and predict the future. Moreover, topics like the ROI and longevity outlook become more and more an ethical issue instead of a mathematical exercise in uncertainty.

Yes, it's our responsibility to guide insurance companies, pension funds and other financial institutions through an unsure future. As new age risk managers, we have an enormous responsibility on our shoulders to winnow the Bad from the Good advices. One thing is sure, we have to do better than we did in the past, but how?

E=A-L ?
It's not enough to judge whether a 'one point Equity estimate' keeps the Assets and Liabilities in balance. What's even more clear, there is no one point E, A or L. There are only probabilities and to judge those, our personal ethical principles become even more important than our essential technical skills and experiences.

Our main puzzle is that this decade has shown that observations of the past are no convincing guarantee anymore for predictions of the future. This implies that we have to fall back on other, more ethical, principles in our advice. The good old ethical principles and methods to deal with actuarial dilemmas, need a fresh up.

Genuine Moral Intelligence (GMI)

Main issue is, that the more 'objective' and significant our data get and the more sophisticated our models may become, the more our advice becomes susceptible to unpredictable developments.

On top of all this, more control, increasing data or more advanced models, will only create a false sense of certainty. These old instruments won't  help us anymore en will only reduce the long term returns and aggravate the ultimate volatility. The only way out is to throttle back on our 'risk attitude' on basis of some new ethical principles.

These new ethical principles are not just about 'minimal legal compliance'. Modern actuary ethics goes further than that. In fact ethics is reincarnated as 'Genuine Moral Intelligence' (GMI).


GMI, as defined by Richard E. Thompson, is: Aristotelean decency, vision, purpose, and uncommon sense.

The applicable GMI equation is given by:  

GMI = ER + UPVs + RSI

ER = Ethical Reasoning
Rather than "pick an ethical theory and stay the course," one may ask and answer a series of questions.
Some examples: Who are the stakeholders? What ethical principles apply? How do they apply?

UPVs = Underlying Personal Values.
UPVs are used to answer the above questions.
Some examples:

• As a board member, do you vote for continuing a needed community medical service that is losing money, or for cutting the service to avoid financial problems?
• As a pension board member, to what kind of probability are you willing to increase the pension of the pensioners at the risk of having to raise the contribution of future pension fund members?

Underlying personal values also determine whether we act according to our morally intelligent conclusion, or choose to ignore it.

RSI = Reasonable Self Interest
Ethics only makes sense if we can come up with a sound answer to the question "Why act ethically?"

Here, Aristotle comes in with a helping answer: "To serve one's own self-interest".
Keep in mind there's a difference between self-interest and greed. The wise Aristotle explains: "Love of self is a feeling implanted by nature, but selfishness is rightly censured, because selfishness is not mere love of self but the love of self in excess, like the miser's need for money."

So self-interest is nothing unethical in itself. An example from the famous Adam Smith stresses this:

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest." (reasonable self-interest)

From now on actuarial advice is different!

GMI could be the new key to economic recovery. We have to get back into realistic pension plans. We need to establish the necessary changes (due to aging) in our social security systems. It's our task as actuaries to share and discuss the above principles with our clients and the boards we advice, in order to force the crucial (economic) change that's needed. This is no easy task, as board members are often not used to such transparent en open discussions involving their own underlying personal values, preferences and (reasonable) self-interest.

So from now on, when you discuss an actuarial report or advice on board level, it's different! From now on, we've got New Actuarial Ethics, where GMI is inclusive. 

This new ethical theme, including the communication and discussing techniques, should be incorporated in our actuarial education program....


Used Sources/ Related Links:
- Thompson: Ethics is dead, what do we do next?
- The crystal ball 
- When Bad Things Happen to Good Plans
- Actuarial Ethical Dilemmas(2010,ppt)
- Actuary Duty (Vrystaat)
- Clay Bennett Cartoons

Pension Fund Gambling

The essence of a DB pension fund's risk strategy can be captured in a single graph:

Key issue is that the portfolio duration of a DB-plan's Liabilities varies between 12 and 14 years, whereas the duration of the DB plan’s Assets is generally much shorter, 4.5 to 5 years (Moore 2007).

Secondly, 2008, 2009 and 2010 have proven that investment statistics and models have failed. Sustainable models are nearby dead.

All this implies that, despite all (developed) models, risk strategies, derivatives and experts, ultimately, a Pension Board has to take a decision without a reasonable amount of certainty. In other words they have to gamble.... And to brighten up your day, it's your responsibility as an actuary to advice this pension board!

Read more about this fundamental pension challenge in:

The Prudent Man Standard

Legal and Investing Implications of LDI Safeguards for Pension Risk

Links:
-Public Pension Funds Gamble With Risky Investments
-The Prudent Man Standard

Actuarial Risk Management Humor

During the pause of a Risk Management conference, a professional risk manager, an accountant and an actuary were in the gents room standing at the urinals. The risk manager, who finished first, walked over to the sink to wash his hands. He then proceeded to dry his hands very carefully. He used paper towel after paper towel to ensure that every single spot of water on his hands was dried. Turning to the accountant and actuary, he said, "We risk managers are trained to be extremely thorough to prevent any risk at all."

Then the accountant finished his task at the urinal and proceeded to wash his hands. He used a 'single paper towel' and made sure that he dried his hands using every available portion of the paper towel. He turned and said, "We accountants are not only trained to be extremely thorough in preventing risk, but we are also trained to be extremely efficient in managing and controlling risk as well."

Finally the actuary finished and walked straight for the door, shouting over his shoulder, "We actuaries, we never get our hands dirty"


Links:
- If people think other people are watching them, then they are more likely to wash hands

ABP Pension Fund ROI Travesty

What is a 'good' return on investment?

Dutch Pension Fund ABP, the industry-wide pension fund for employers and employees ( 2.8 million participants) in government and educational institutions in the Netherlands and the world’s third largest pension fund, reported a 20.2% return on investment in 2009.

In the 2nd half 2009 Press Release, ABP qualifies it's own performance as a 'Good Rate of Return'.
Now theologists as well as actuaries are familiar with the risk of calling something 'Good' ....

ABP ROI Stress Test
Let's put the ABP investment strategy to the test.

In the same Press Release,  ABP publishes the long-term rate of return from 1993 to 2009. ABP's average annual rate of return over this period of 17 years is 6.7%.

ABP's 'Signs of Hope Strategy'
To achieve this phenomenal return, ABP has developed a spectacular - every three years changing - Investment Strategy Plan (latest plan is confidently called: 'Signs of Hope') with a strong diversified 'winning' (?)  investment mix in combination with zero transparency or accountability information with regard to 'investment costs'.

Alternative T-Bond Strategy
Alternatively, ABP would have been better of if it would have applied a no-risky defensive European (10 years) Treasury Bond Strategy from the start. In this case the yearly average 1993-2009 ROI would have been around 6.9%.

Take a look at the next chart and decide for yourself. What pension fund would you prefer, Red or Blue?

ABP stated in their objectives that, in order to keep pensions affordable in the future, the return on investments must attain an average of 7% per year. It's clear that this objective will never be met on basis of the developed investment strategies in the past.

ABP's Future perspective?
Let's 'hope' that, after the recent step down of Ed Nijpels, ABP's new to be appointed chairman will have enough power, (pension) experience and time available to resist and combat the opportunistic and risky plans of the headstrong APG investment specialists.
Anyhow, the new chairman should be at least someone who knows how to spell the word 'Risk Management' and is experienced in (ac)counting from 1 to 10.... maybe an actuary?

Solution
Perhaps the best thing to do is to:

• turn the ABP scheme into a "pay as you go system",
  
• transfer the ABP administration to the efficient Dutch Social Insurance Bank,
  
• fire most of the ABP Asset Management Department (APG) (as they are confused about time and cannot tell the difference between Tomorrow and Today anyway) and finally,
  
• use the € 208 billion on assets to reduce most of the Dutch National Debt ( € 375 billion)

Good Luck ABP!

Links
- Top 10 largest pension funds in the world
- ABP Press release 2nd half 2009
- APG: Tomorrow is Today 
- Joshua Maggid: Excel ABP (.xls) 

Actuarial Smurf

Question is whether actuaries are best positioned for the role of Chief Risk Officer (CRO)....

More and more the CRO becomes one of the most important positions at board level to analyze, control and optimize risks in (financial) institutions. Qualified actuaries are pre-eminently positioned to qualify as CRO. After all, managing risk has been their primary task for decades. Rolling out the new Chartered Enterprise Risk Analyst (CERA) credential, actuaries will get better trained and educated than ever before.

CRO Role at Risk
Despite of all this, the CRO role is 'at risk' itself. CRO responsibilities and position are by definition conflicting with certain other stakeholder roles.

This is clearly demonstrated in a graph developed by Professor Emeritus Harry Panjer(Actuarial Science University of Waterloo).

Let's take a look at the slightly adapted graph of Harry Panjer:

• Regulator
  Regulators’ primary responsibility is to protect customers. Thus avoiding downside risk is their focus.
  
• Rating agencies
  Rating agencies focus on both the possibility of large losses as well as the possible gains to shareholders.
  
• Investors
  Investors are interested in both gains and losses and are willing to take the risk of the loss of capital as long as there is compensatory opportunity for gains.
  
• CEO
  The CEO with big stock options, has huge upside potential but little downside risk. Getting fired is one of the embedded options of the CEO's personal strategy.
  
• CFO
  The CFO's first responsibility is to stay 'in control'. The CFO will try to prevent excessive unforeseeable or unexplainable results, whether down- or upward.
  
• Clients
  Clients are primarily interested in value for money, service, quality and the continuity of the (financial) institution. Clients will keep satisfied as long as the financial results of the company remain stable and (average) positive within limits.
  
• CRO
  The CRO is trying to control the downside risk. The CRO is a kind of 'Risk Management Smurf' who only has a big STOP sign to limit the CEO and shareholders in their (short term return) demands. 

It's clear, acting as a CRO is like:

• Walking on eggshells
• Communicating with a silver tongue
• Listening like a fly on the wall
• Looking like a policeman
• Convincing like a missionary
• Calculating like an actuary

Don't wait any longer, become a professional Actuarial Smurf!

Links:
- Panjer: ERM and the Role of Actuaries (2009,pdf)

Return of a U.S. Debt Dollar

Take a (compressed) look at what author and business owner Nathan Martin calls:

The Most Important Chart of the Century!

This chart, based on the latest (March 11, 2010) U.S. Treasury Z1 Flow of Funds report, shows the change in GDP divided by the change in Debt. Or in other words: it illustrates how much extra economic productivity is gained by pumping one extra dollar of debt into our debt backed money system.

As is clear, the economic return of one dollar of 'debt infusion' declined from a positive $ 0.70 in the sixties to a negative $ 0.45 return by the end of 2009!

From a macroeconomic point of view the U.S. economy is fully saturated with debt. Flushing more debt in the U.S. economy will no longer help the economy out. Moreover, it will damage the economic growth!

Interested? Read the full blog of Nathan A. Martin

Links:
- Source: The Most Important Chart of the Century!
- U.S. Treasury Z1 Flow of Funds report (March 11, 2010)

Country Default Probability

National debts are growing worldwide. It seems we're drowning in a sea of debt. Who's gonna survive?


By experience we know that whenever our gut-feeling takes us for a ride, help of statistical models is necessary to rebalance and get sight at the real problem.

Sovereign Risk Monitor
In this case of 'national debt', the help of CMA's Sovereign Risk Monitor comes in. The CMA Sovereign Risk Monitor identifies and ranks the world’s most volatile sovereign debt issuers according to percentage changes in their 5 year CDS. CMA also calculates the Cumulative Probability of Default (CPD), the 5 year probability of a country being unable to honour its debt obligations.

Let's take a look at the world's most risky countries in Q4 2009:




Yet, the 'Default Landscape' is rapidly changing as becomes clear in CMA's interesting daily 19 March 2010 report showing Greece 'Cumulative Probability of Default' rising to 24.27%.

On the other hand we've got the world's best Countries, with Norway on top....

More actual information is available at CMA (registration required).

Latest CMA Update

Let's hope for the best....

Links:
- CMA Sovereign Risk Report for Q4 2009
- Source: CMA
- Latest CMA Update

Hedge Fun

Do you recognize the next situation?

You're at a birthday party or having a social evening. Everybody is having fun, talking to each other and - like usual - discussing the latest financial topics, scandals and solutions.

Suddenly someone turns to you and says: Heee.. you're an actuary, you can tell us what a a hedge fund is!

Of course as born or raised actuaries we all know what a hedge fund is. But when it comes down to explaining what a hedge fund is to clients, board members, friends or family, probably not one of us can explain it better than Paddy Hirsch, Senior Editor at Marketplace, can in the next Youtube video:

Video: What is a Hedgefund?

Now, when a Hedge Fund or a (Lehman)bank 'unexpectedly' gets into trouble, it simply uses the Repo 105 technique to to survive. Paddy Hirsch explains again.....

Video: Repo 105

As professional risk managers we would expect these high risk Hedge Funds to operate under excessively severe capital requirements. Too bad...., this is not the case, as Mr. Timothy Geithner explains in the next video......

Video: Geithner: No Capital Requirements For Hedge Funds

From Mr. Geithner's statements it's clear that Hedge Funds are de facto treated as 'Hedge Fun' until the systemic risk shows up.

However, when this risk becomes manifest, it will be to late to take appropriate measures.

Misunderstanding: Risk management
One of the great public misunderstandings of Risk Management is that most people - obviously including Government -think that Risk management is all about 'Managing Damage' after the corresponding loss has occurred.

As we know, Risk Management is about something else:

I. Identify, Analize & Prevent Risk
About 70% of Risk Management is about constantly identifying, analyzing and preventing risks from happening.

II. Emergency Response Plan
Another 20% is about proactively creating and updating Emergency Response Plans (ERP's) on how to deal with loss and how to limit and reduce that loss in case of the unfortunate event that a risk materializes in a loss.

III. Damage Reduction
Only the last 10% is about 'damage reduction' by executing the ERP's and tackling losses in case a risk - notwithstanding the measures taken - has resulted in a loss.

Perhaps we should offer (one volunteer is worth two pressed men) Mr. Geither a free Risk Management Course from the institute of actuaries.....

Read more about (the regulation of) Hegde Funds in an excellent (2006) paper by Dale A. Oesterle called Regulating Hedge Funds.

It's clear: there's nothing funny about fundy hedge funds....

Corresponding Links:
- Derivatives study center : Hedge Fund
- Regulating Hedge Funds (2006)
- Marketplace videos
- Will Lehman Brothers and Repo 105 allegations bring down Ernst & Young?
- Wikipedia: Repurchase agreement, Repo 105

Magic Banking

Based on an idea as presented in a joshing blog by Henry Blodge, CEO of The Business Insider, here's the slightly changed formula for making thousands of investors happy, becoming a millionaire within months while having a successful career as well.

Become a banker!
All it takes, is to start a new bank. Don't worry, it's simple as will be shown.

This is how it works:

1. Form a cooperative bank called: Cooperative Magic Bank (CMB).
   A cooperative bank is a financial entity which belongs to its members, who are at the same time the owners (shareholders) and the customers of their bank.
2. Appoint yourself CFO together with two of your best friends as Board members. Set your yearly Board Bonus at a modest 10% of CMB's profits.
   
3. Make a business plan (this blog IS the business plan)
   
4. Raise $ 100 million of equity and $ 900 million of deposits, as follows
• Offer your prospects/clients a guaranteed 4.57% guaranteed return on investment.
  
• Offer a 70% yearly profit share. First year return on investment guaranteed 13,35% !
  
• Everybody who wants to join the bank becomes a 'Lucky-Customer-Owner' (LCO)
• Every LCO is obliged to invest 10% of his investment as shareholder capital.
• The other 90% is invested in the CMB-Investment Fund (CMBIF).
• CBMIF guarantees the return (and value) on the LCO's account based on a 30 year Treasury Bond
5. Borrow $3 billion from the Fed at an annual cost (Federal Discount Rate) of x=0.75%.
6. Buy $4 billion of 30-year Treasury Bonds paying y=4.57%
7. Ready! Sit back and enjoy high client satisfaction and your Risk Free career and bonuses as a professional banker!

Magic Banking
Wrapped up in a 'Opening Balance Sheet and a first year ''Income Statement', this is how it looks like:


This is how the FED helps you to become a millionaire. but the party is not yet over.....

Pension Funds and Insurance Companies
If your the owner of a pension fund or an insurance company, starting a 'Magic Bank' could help you achieve a total 'risk free' return of 4,57% with an upward potential of 13,35% as well.

So why should you set up a complex investment model that you don't really see through, to achieve a risky 6% or 8% of return on investment, if you can have more than a 'high school comprehensible' 10% return without any substantial downside risk by starting a Magic Bank instead?

Together with the new Basel and Solvency regulation, this 'magic bank principle' will cause banks to sell their investments in more risky assets like insurance companies. On the other hand, insurance companies and pension funds will probably be interested in starting new banks to profit from the FED's 'free credit lunch'.

Criticasters and Risk
Some criticasters will rightfully point out that the magic bank is not completely risk free. Indeed there are some risks (e.g. the treasury bond volatility), but they can be adequately (low cost) managed by means of stripping or derivatives (e.g. swaptions).

Of course there's also the risk that the Fed will raise the short rates (Federal Discount Rate).In this case, instead of using derivatives upfront, one might simply swap or (temporarily) pay off the FED loan. Yes, your return will temporarily shrink to a somewhat lower level. But who cares?

Moreover, keep in mind that as long as we're in this crisis, the Fed's short money will be cheap. Don't ask why, just profit! By the time the crisis is over and Federal discount rates are more in line again with treasury notes, simply change your strategy again.

And if - regrettably - the federal discount rate and the treasury bond rate rise at the same time, simply book a life time trip to a save sunny island to enjoy your 'early pension' of $ 11.1 million (ore more).

For those of you who still doubt and for all of you who like a humorous crash course in investment banking, just click on the next video by Bird & Fortune....

Banking crash course

Let's get serious
Although for us actuaries it's clear that because of the Asset Liability Mismatch, the magical bank is a running gag, the principles and consequences of the situation as described above are bad for the economy.

Financial Health Management
Banks and financial institutions in general are discouraged to act in their primary role as risk transfer institutes by performing on bases of professional calculated risk.

Why would they take any additional (credit) risk if they can generate their revenues almost 'risk free' with help of the Fed?

We all know that without risk, there's no economic added value either. Continuing this Fed policy will lead to Bob hopes:

A bank is a place that will lend you money, if you can prove that you don't need it.

Maintaining the current Fed policy keeps the banks alive, but ill.

What's needed is a new Federal Financial Health policy.

Over the last decades the relative equity (equity in % of assets) of Banks deteriorated from a 20% level to a 3-5% level in this last decade.

Banks need to be stimulated to take appropriate healthy risks again, while maintaining a sound individual calculated 'equity to assets ratio', increased with an all over (additional) 5% risk margin.

The Fed should therefore act decisively and:

• stop the ridicule and seducing leverage risk levels
  Redefine the Capital Adequacy Ratio (CAR). The new Basel III leverage, calculated as 'total adjusted assets divided by Tier 1 capital', won't do. Strip the nuances, limit 'adjusting', add a surplus.
  
• Limit and make all new financial products subject to (Fed) approval
  
• Limit the proportion of participating in products that only spread risk (e.g. Citi's CLX) instead of neutralizing or matching risk
• Raise the discount rate as fast as possible,

to prevent moral hazard and economical laziness that eventually undoubtedly ends in a global economic melt down.

However, there's one small problem..... The FED has to keep the discount rate low because otherwise financial institutions that run into trouble aren't able to finance their loss in a cheap way and will activate the nuclear systemic risk bomb (chain reaction).

It seems we're totally stuck in a governmental financial policy paradox. Nevertheless the FED should act now!

Links:
- Henry Blodge Video on Modern marketing...
- 30 year treasury bonds
- Historical Federal discount rates
- Can Basel III Work?
- The Economist: Base Camp Basel (2010)
- Citi's Financial Crisis Derivatives Should Be Banished From Earth
- Capital Adequacy Ratio (CAR)
- Treasury yields

OTC Warning

In a 55 minute Pbs-video it becomes clear what kind of serious derivatives (OTC) problems we still have.

Warning!
Watching this video will dramatically change your view on risks and players in the financial system. If you want to protect yourself on the short term against the effects of what is going on in the skyscrapers of the financial markets: don't watch this video! Don't blame yourself, because it's not 'just funny' to become aware of risks you can't handle anyway....

However, if you are professionally active in investment risk or if you're a member of a (pension fund) Investment Committee, hiding is no option and this video is a good investment and a 'must see'......

The Warning

Enjoy, shiver, learn.....

If you like big numbers, please look for 15 seconds at the size of the 'Over The Counter' (OTC) Market (Q2 2009):

$604,622,000,000,000
(are you still with me?)

There's a dutch proverb that states:

a warned person counts for two.....

Links:
- OTC derivatives statistics
- Financial crisis explained

Isle of Risk

Last decades, our perceptions of Financial Risk haven been constantly changing and - for sure - they will continue to do so in the future.

In the sixties and seventies of the 20th century 'risk' was mainly plain 'technical risk'. Risk Management was mainly used to support current strategies, as a defensive instrument.

More de-Tailed studies of risk in the nineties, created new instruments and models to manage (investment) risks. This led to the understanding that it was possible to take more risk because we could understand and manage it in a better way.

Next, at the beginning of the 21th century, these new risk models were expanded and transformed from passive to active instruments. New products and markets were developed by combining, cutting and mixing traditional asset products (stock, bonds, mortgages) with derivates. And just like in chemistry, where mixing innocent individual molecules could lead to an explosive new molecule, the asset markets got flooded with toxic, unknown risk-correlated products.

For most of us it became clear that it was not the risk ingredients (bonds, stocks, derivatives, etc) themselves that caused this turmoil, but our own (irresponsible) behavior, e.g. the way we ourselves were managing the asset products and models. Behavioral Finance was born.

After we poisoned the investment market landscape in the second half of this last decade, things turned for the worse. Instead of looking what we had done, where we were on the risk map and how we could clean up this mess, we kept on building debt and - except for sub prime mortgages - refused to restructure the market 0r to restrict the use of derivatives.
No restrictions nor ethical guidelines on making money just from money (who pays for making money of money?).

Instead, with the latest development High Frequency Trading (1,000 orders per second ! ), covering about 60% of all U.S. equity trading and nearly half of U.S. futures trading, we finally lost our site on what is ethical or not.
Main question is: Who has the guts and the power to stop this development?

Anyway, it's clear that our 'behavior' and a 'map of the risk landscape' are critical in understanding where we are heading with Risk......
Let's start with behavioral finance

Behavioral Finance
One of the world’s best experts in the field of behavioral finance is James Montier.
His book Behavioural Finance is a classical must-read.

In a 2002 classic report titled 'Part Man, Part Monkey', Montier gives a number of common mental investment pitfalls. Here's a sum up of those pitfalls that might apply to actuaries just as well:

• You know less than you think you do
• Be less certain in your views, aim for timid forecasts and bold choices
• Don't get hung up on one technique, tool, approach or view - flexibility and pragmatism are the order of the day
• Listen to those who don't agree with you
• You didn't know it all along, you just think you did
• Forget relative valuation, forget market price, work out what the stock is worth (use reverse DCFs)
• Don't take information at face value, think carefully about how it was presented to you
  

Trinity of Risk
According to Montier the word 'Risk' is perhaps the most misunderstood concept in finance. In classical finance, risk is identified as the relative price volatility (beta). However that's not what risk really is about. 'Downside risk' (ie loss) is what really matters when it comes down to performance measurement. From an investment point of view, risk can be split up into three interrelated elements, the so called 'trinity of risk':

• Business Risk (risk of business going broke)
  
• Financial Risk (risk of using leverage)
  
• Valuation risk (the margin of safety)
  

Valuation risk is the most tricky type of risk, as is explained in an excellent article 'The Biggest Mistakes in Valuation...' by Donald R. van Deventer from Kamakura Corporation. Here's the wrap up of the top 7 valuation mistakes in a humorous "daily life analogy"

1. The Fake Rolex Watch Mistake
   Ask the investment bank which sold you a fake Rolex what the Watch is worth
2. The Poker Game Mistake
   Ask someone else playing in the same game how you should bet
3. The War of the Worlds Mistake
   Believe in a valuation technique Because everyone else thinks it's true
4. The Cash Card Mistake
   Tell an investment banker exactly how your firm evaluates complex securities
5. The Carton of Eggs Mistake
   Don't check to see if the eggs are broken, just look at the egg carton before buying
6. The "My Brother-In-Law Told Me It Was a Good Investment" Mistake
   Bernie Madoff and the rating agencies
7. The 2+2=5 Mistake
   Technical errors in valuation

Financial Crisis 2008-201x
Back to Montier, who's very clear about the role of Bernanke with regard to the role of the FD in the current

• Ben Bernanke, Washington Post, October 27, 2005
  “There is no housing bubble to go bust.”
• Speech Bernanke FED May 17, 2007
  “We believe the effect of the troubles in the subprime sector on the broader housing market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

Montier believes Bernanke missed the boat, had poor ideas on how to recover and on top of this, failed to learn from his mistakes. Montier guesses: There are none so blind as those who will not see!

Happy Investor
For those of you who -after all this - don't succeed in becoming a happy investor, Montier has a simple advice on improving (plain) happiness. Here's the wrap up:

• Don’t equate happiness with money.
• Exercise regularly.
• Devote time and effort to close relationships.
• Pause for reflection, meditate on the good things in life.
• Seek work that engages your skills, look to enjoy your job.
• Give your body the sleep it needs.
• Don’t pursue happiness for its own sake, enjoy the moment.
• Take control of your life, set yourself achievable goals.

Map of Risk
Risk is an interesting and never ending subject of discussion and development. Drawing a map of Risk, literally helps you to oversee the Risk battlefield. Draw your own map of risk in life to remember where you are, where you've been and where you'll be heading.....

To help you get on the way, take a look at my Isle of Risk

(click the image for a larger image)

James Montier's Links
- Google Book Behavioural investing
- Was It All Just A Bad Dream? (febr. 2010)
- The Little Book of Behavioral Investing
- Applied behavioural Finance (pdf presentation)

Other links:
- High Frequency Trading Is A Scam
- High Frequency Trading Youtube
- FT: Markets: Ghosts in the machine
- High Frequency Trading -- Results from Simulation

Powerpoint Mortality

Whether you're an actuary, accountant, consultant or salesman, when we take up a new challenging project, we're inclined to spend most of our time on data mining, modeling, reconsidering, detailing, arguing, making things perfect and finally, drawing the conclusions and writing the exhaustive proposal report....

Fortunately - in this case - your right on schedule! You've got exactly one day left before your Board presentation of the project. Still completely in a rush and overexcited about the stunning results of your successful investigation, you start up your laptop to wrap up your proposal report in a full flash Powerpoint presentation.

That night at 01.00 AM, you successfully finish your ppt presentation. Just in time! Completely satisfied about this phenomenal achievement, you e-mail the ppt to Nosica, the Board's secretary you know well. She, as well as the Board, will be impressed by your 'night shift work'. Who said that actuaries had a 9 to 5 job?

The next day, at 14.00 AM you enter the Board room, full of confidence. Your presentation is start-ready, the beamer glows, you're fully concentrated on your audience and in a 'cashing' flow....

After 20 minutes of presentation, including your ten recommended practices and some questions, you leave the 26th floor. All went well...
Time for a drink and a well earned good night sleep...

Next morning, 09.00 AM, the Board's secretary replacement calls you: Your proposal has been declined....

You're flabbergasted, how could this happen? After all this work you've been through.

What went wrong?

The answer is simple, you denied Wayne Burggraff's Law of Presentation:

It takes one hour of preparation
for each minute of presentation time

So next time, in case of a 20 minutes presentation, invest 20 hours of your time in research, development, organizing, outlining, fleshing out, and rehearsing your presentation.
In essence: if you fail to prepare well, you are well prepared to fail.

Tips.....
Here are some practical tips that might help you with your preparation:

1. Ask yourself: ''If I had only sixty seconds on the stage, what would I absolutely have to say to get my message across."
   -- Jeff Dewar --
2. The simplest way to customize is to phone members of the audience in advance and ask them what they expect from your session and why they expect it. Then use their quotes throughout your presentation."
   -- Alan Pease --
3. No one can remember more than three points.
   -- Philip Crosby --
   
   

Fear of presentation
As actuaries it's surprising to see that people are more afraid (41%) of speaking to a group than of death (19%).
Now it's clear why we search the help of Powerpoint to 'survive' on stage.

Powerpoint Mortality
We all know Powerpoint..... Powerpoint itself is not good or bad, it's the way you use it.

The mortality rate of Powerpoint is humorously demonstrated by Don McMillan:

Life after death by Powerpoint

Who Needs Powerpoint?
Last January I was heading for a presentation with the help of Powerpoint. Full house. However, on the supreme moment the local beamer gave up. I simply decided to bring my message in an interactive session with my audience, without the help of Powerpoint.

Yes, it was different, challenging and even fun! Because of my thorough preparation - I was able to concentrate on almost everyone of my audience. So...., another Maggid's tip could be:

Prepare your presentation without Powerpoint!

A presentation try out
In the mid nineties my employer's company was heading to get listed at the stock exchange. I remember I had to give a presentation before a panel of 70 international analysts, who would probably raise all kind of difficult questions. In order to prepare 'abap', I called my strategy director as well as my CFO and asked them to act as my 'try out analysts audience'.

I told my colleagues I would give the presentation three times in a row. In the first two presentations they were obliged to interrupt me as much as possible, to raise difficult or weird questions and to put me to test (keeping my humor and concentration). During the third presentation they had to act as normal audience.

To make a long story short: after three presentations, my two colleagues kept their breath in combination with a desperate look in their eyes. I told them not to worry and reassured them my presentation at the analyst session would be successful.

And so it was, as I was fully prepared on every possible question and didn't had the need to look at my ppt presentation, I could fully focus on my audience. Lesson: Make the preparation tough, you'll benefit from it in the final presentation.

The actuarial master
Yes, there are a lot of rules, regarding the use of Powerpoint.
The Golden Rule is that all PowerPoint presentation rules, principles, and guidelines are just secondary to doing what is ultimately right for your audience. Critical point is, you can only break the presentation rules if you know them .

It's just like in actuarial science, once you've become an actuary (a master) the real art of your profession is not anymore in applying equations and methods 'by the book'. Now it comes down to break the existing rules and conventions in a such a professional way, that new risk and social challenges are being (re)solved in a different way. Key point here is that not only your professional skills have to be outrageous, but your presentation skills as well. As the success of a good peace of actuarial craftsmanship, is completely dependent on the way it is presented.

Mindmapping
Let's conclude with some practical free(ware) presentation tips.
Although you're probably aware not to overuse clip art, it's good practice to set up your presentation in a consistent and well polished style.

Of course you can use expensive business packages to illustrate your presentations, but there's also an excellent freeware application called: EDraw Mindmap 4

With the help of Edraw, creating presentations and mind-mapping is a question of minutes.

Enjoy preparing and giving presentations, learn to be(come) yourself on stage and overcome any possible fear of speaking to groups......

Related links:
- EDraw Mindmap 4 (Completely freeware!)
- EDraw Mind Map 1.0
- Edraw Max (not freeware)
- Lovelycharts (free, one application; online)
- Presentation skills (youtube)
- The New Office Math (youtube;Don McMillan )
- Presentation skills (ppt)