Risk Manager-In-Chief

One way to view the current economic crisis is as a pervasive failure to manage risk. In fact, bad risk management actually explains a lot of what's gone wrong in recent years. And that realization is one we'd be well advised to bring with us into the voting booth in a few weeks.

One of the main reasons the financial system is seizing up is that too many institutions borrowed beyond their capacity and used the money to make risky bets. Some of those bets took the form of subprime mortgages--loans to people who were credit risks, but would be able to service the debt as long as their new home continued to appreciate at double digit rates. Other bets were in the form of derivatives--many of which also ultimately depended on home prices endlessly defying gravity.

The bubble burst, home prices began to slide, mortgage defaults accelerated, and the extent of overleveraging--borrowing beyond your means--in the financial sector was exposed. The Treasury and the Fed are throwing everything they've got, including a bunch of stuff no one ever knew they had, at the problem, but little is really sticking yet.

What does any of this have to do with risk management? A lot.

When lenders make a loan, they face a risk of not getting paid back. If that risk is kind of high, they're likely to insist on a hefty down payment and set the interest rate on the loan higher than they would otherwise. Remember, that rate is the cost to the borrower of the loan, and if the market is working right, risky borrowers should face higher rates, both to discourage them from getting in over their heads, and to pay the lender a risk premium--a little protection money--for taking a chance.

If the risk is really high, a reasonably savvy lender won't make the loan at all.

But what if both lender and borrower fail to recognize the risks they're taking on? What if the banks think a debt, whether it's a mortgage or a complex derivative, is perfectly likely to be repaid with interest, right on time, when the reality is that it probably won't be. What if borrowers believe they'll be able to finance a loan when in reality, they won't even come close?

And what if a president and defense secretary think they'll be greeted as liberators in a country they've decided to occupy?

The failure to accurately assess risk has been truly epidemic in this country, and the costs have ranged from expensive (and I'm talking trillions here) to fatal.

The key questions are why did these failures occur and which presidential ticket would be best chosen in that regard (okay, question two is a terribly transparent set up, but please read on anyway).

The failure to assess risk in financial markets stems less from greed--that's always been there--than from a combination of "innovative" transactions and lax oversight. The Greenspan Fed not only watched the real estate bubble inflate, they blew into the balloon, touting the wonders of adjustable rate mortgages. Though the Fed is supposed to monitor the subprime market, they ignored internal warnings that large imbalances were forming. As Peter Goodman points out in this must-read article, Greenspan and other top officials blocked initiatives to regulate derivatives, despite the fact that the growing magnitude and interconnectedness of this market meant that their failure threatened the system.

Economists and bankers failed to manage the credit risk that occurs when cheap money and large external (i.e., from other countries) flows of capital finance a spending spree that's not supported by real income growth. In fact, the ability to package and sell that NINJA (no income, no job, no assets) loan you just made to some other dealer, meant that loan originators didn't need to worry about those pesky, old-school underwriting standards.

How did it come to this? The answer has a lot to do with economic ideology. Mainstream economists convinced policy makers that markets were self-disciplining. Oversight, borrowing constraints, the enforcement of lending standards...these would only cuff the invisible hand. Instead, the market would punish those who underpriced risk. Even when key markets were showing clear signs of flying off the hinges, the nation's top economists were reassuring us that these "temporary disequilibriums" were of little concern.

You see how well that has worked out. We very desperately need a new economics that sees market failures--and accurately prices risk--much sooner than the current brand.

But while bad risk management in financial markets is capturing our attention right now, the problem goes much deeper. Faulty intelligence overestimated the risk from WMD's in Iraq, and underestimated the challenges our military would face from the insurgents. In fact, when it comes to risk assessment, economic or otherwise, it is now quite impossible to trust the judgments of our leaders.

Which brings us to leadership. As noted, the economic failures to manage risk were caused by ideological blinders. The foreign policy failures were caused by the inability of our imperiousness leaders to entertain evidence that didn't fit their views. You can't assess risk if your mind is closed. Ideologues, who are by definition impervious to evidence, need not apply.

Now how does this all map onto Obama/Biden versus McCain/Palin?

Obama will be good at this. He has a balanced, evidenced-based approach to risk assessment. To the consternation of many in the base, he is not particularly ideological. He's also naturally cautious, deliberative, if not plodding. In fact, these very qualities were often (rightly) criticized during the campaign, as he failed to catch fire and communicate a simple, compelling narrative.

But at this point, many voters are looking for precisely the kind of leadership I believe he offers in this regard. It's not indecisive. It's gather the evidence, assess the risk factors, and make the call with the greatest objective, not subjective, chance of achieving the goal. It doesn't mean you check your gut at the door. It just means you let your brain into the room too.

With McCain, I fear that when it comes to making the big decisions, we'd get the subjective, shoot from the hip we've seen far too much of in recent weeks. That's certainly the message from the erratic turn the campaign has taken, as they lurch from one surprise to another. The old McCain was not particularly ideological, an advantage in judging risk; the new one is worse than Bush on this score.

McCain's economic policy is a good example. At this point, it's simply impossible to objectively look at the Bush economic record, and conclude it worked, yet McCain doubles down on it. He's also moved to right of Bush on the war, opposing timetables that Bush and even the Iraqi's themselves are brigning to the table.

But the worst sign regarding McCain as risk manager was the choice of Palin for his VP. That move, made for purely short-term political gain, with no regard for the risks it posed to the country, has turned even a number of staunch Republicans off their ticket. It's not just that she's inexperienced. It's that she doesn't seem to know what she doesn't know, and it's easy to imagine her, if she got the chance, making choices from inside the same sort of insulated Bush/Cheney bubbles that got us where we are today.

Finally, and I recognize I wade into choppy waters here, there's a relationship between a candidate's religious views and his or her ability to effectively assess risk. Of course, presidents have and will always be profoundly informed by the ethical tenets of their religion, and I see nothing wrong, and much right, with that (though how Bush's condoning of torture fits in here, I'm not sure).

But then there's these types of comments from Palin, who called the Iraqi war "a task from God," asserting that "there is a plan and that plan is God's plan" (sorry, but I think God's plan would have been infinitely better than the one in play). She made a similar point re God's will in getting their gas pipeline built up there.

With respect, that's mixing religion and policy analysis in a way that I fear leads to inadequate risk assessment. Bush never made such revealing statements, but it may be the case that evangelicals don't always make the best risk assessors.

I suggest we tout this role of risk manager-in-chief over the next few weeks. Given the challenges facing our country, it's a critically important distinction between the two tickets. And given the direction in which the polls are finally trending, it would appear that the majority of voters are ready to place a reality-based risk assessor in the oval office. To not do so would just be too...what's the word? Risky.

Comments

[ricitizen]

Krugman Wins Nobel Prize for Economics!

http://www.nytimes.com/2008/10/14/business/14nobel.html?hp

[WritusMaximus]

Obama is all about judgment, right? Then Paulson needs to be replaced. He is a member of the Bush team. He shared Bush's economic philosophy and just like Bush, Paulson is now forced to deal with the mess once the manure hit the fan. Obama should also be doing some pruning/weeding out of his economic adviser team after the election, to give those advisers with self-imposed blindness to "graciously" exit.

[sposton]

The problem is mainly related to the dominant philosophy. American have delegated to corporate interest the power to define public policy. We have forgotten the simple fact that we "license" corporations to exist primarily for public good. They may have their internal "for profit" logic but they must still deliver a positive value to the common-wealth. Once they cease to deliver value their right to exist ceases as well. Now, can you think how many large corporations deliver a positive value to us? Over the years corporate interests have inverted this logic and now we "The People" exist for for them and not the other way around. Unless we change this fundamental equation very little will change.

[WritusMaximus]

Paulson has warned folks not to embrace "protectionism" and to welcome "free trade" as a solution. Didn't we just have 8 years of the ever-free, ever-correcting "free market", where wages in general have remained stagnant/actually declined? Wages and location of jobs are now being influenced by economic factors outside our borders, such as labor in China and other countries. Heck, some nations subsidize and thereby protect sectors of their economy, but we here in the US must be pure/virgins when it comes to "free trade".

Paulson has fired a shot across the USS Obama. Will Obama lower his sails and salute the Paulson flag? Will Obama curtail/abandon his agenda to satisfy Paulson's agenda?

[sposton]

Obama will do what is in the best long term interest of Wall Street. We must realign our economy towards creating wealth the old fashioned way, by producing stuff, and away from "creating" wealth through financial manipulations. Even if we wanted, we cannot return our jobs overnight but we can discard the "free trade" false philosophy that has brought us to this disaster. We must concentrate on creating jobs here which are less likely to be offshored.

[leahi1656]

Thank you, Jared, for such a perceptive article.

Senator McCain suggests he is the better candidate because of his experience, but experience written in stone leaves no room for flexibility. And for the life of me I cannot see how experience as a POW has anything to do with being able to make the informed decisions a Commander in Chief is called upon to make.

His betrayal of country and his personal integrity by his choice of Sarah Palin borders on the downright criminal. His desperate and surly smears against Obama do nothing to enhance him in the eyes of any but the most rabid and myopic of true-believers, who are themselves locked into a world view which current events have rendered obsolete and unworkable.

McCain would sell us a Model T. Wonderful car for its times, but its time has passed. Senator McCain's time has passed as well. He clings to an obsolete ideology which is utterly unable to assess risk, and has no clear-cut vision for the future.

How very sad to witness the self-immolation of a once respected man.

[WritusMaximus]

We must also remember that Bush, just like Palin, had executive experience. Bush sure did a number on the American people these past 8 years, didn't he? Scary to think what Palin has in mind should she somehow come into power. Palin is the new kindler, gentler, compassionate face of the Neocon movement. Hillary, you have a challenger!

[archimede]

you nailed it Jared. McCain has been erratic and Palin amateurish at best.....they are definitely the riskier choice....we need true steady hands at the tiller....i mean That One :)

Lets just paint it blue my friends :P,

Undecided no more

[nellie]

IMHO, the worst risk management failure occurred when George W. Bush failed to respond to the August 6th memo stating that BinLaden was "determined to strike within the United States." Maybe if he had devoted a little time and resources to managing that risk, the world would be a very different place right now.

[The5thW]

So much commentary is still in this pre-collpse vein. Mostt thoughtful people moved on years ago, but even those starting weeks ago should be now onto questions like: do nation states and global finance further the public good or are they a cancer, and , how do we move toward local autonomy free of dependency on global capital? I suggest that the first step is to discount anyone who is a stakeholder in this current order, and find those visionaries who predicted this 40 years ago and have been working on alternatives ever since. If that is too complicated, here is a simple version: Warren Buffet is not the answer.

[margardner]

No room for complacency. Let's work hard for the Obama family these next 3 weeks and help them over the finish line. We've done this for the last 18 months we can surely push for 3 more weeks. Doesn't it seem forever now? So, everybody take a deep breath and let's chugga-chu­gga-choo-c­hoo on the "O" train to victory! Thanks sooooo much for everyone's enthusiasm and personal efforts :)

[GinnyinCO]

Great column. I especially like ThinkAgain­MyFriend's nutshell version.

"Did I get this right? It's too risky not to change! More of the Same is far more of a risk than Change!"

Yup, you got it right TAMF :)

[Yermammy]

"Faulty intelligence overestimated the risk from WMD's in Iraq"....see anything at all wrong with that statement?
It's really hard to accept anything one says, when they don't even know the facts. Now, if you don't know that Cheney was wanting to invade Iraq for years before they had a possible excuse (9/11), and then told the intelligence and military to cook the books to make it "appear" that Saddam Hussein had WMD's...how am I supposed to believe a word that you say?
Lying or just ignorant of that very pertinent fact, is not helping your argument.

Barack/Joe (for a future, not much, but better than nothing)

[mjt218]

As much as many of us would like to believe that what you're saying about Cheney is 100% true, there is not enough factual evidence available to the public to prove it. I don't Jared is trying to be subversive in that statement in any way. He's stating facts as we know them.

[Yermammy]

There are 35 articles for impeachment (not counting throwing this economy into turmoil, which hasnt' been proved- yet). I suggest you read a book (or five) that are out right now. If you expect corporate media (or the war machine corporations that sponsor them) or Nancy Pelosi (who was privy to the torture memos and illegal wiretapping as a member of the "Gang of Eight"), to tell you the truth, you are only fooling yourself. Vincent Bugliosi (amongst others) has written a book "The Prosecution of George W. Bush for First Degree Murder) which plainly and in great detail unfolds the truth about the illegal and outrageous war in Iraq. So when you SAY you'd "like to believe", all you are REALLY saying is you'd rather put your head in the sand- like an ostrich. With or without you, I'm going to see this through. Any help is badly needed though. AfterDowningStreet is a good place to start.

[dadw5boys]

LIES TO GET A REACTION !!!!!!!!

THEN MORE LIES TO LEAD YOU DOWN THE ROAD !!!!!!

THE USA WILL MOVE TOWARDS A MILITARY DICTATORSHIP SOME BELEIVE.

THE INTEREST RATE ON THE NATIONAL DEBT WILL SOON TKE 1/2 OF THE U.S. ECONOMY.

THE PYMRIAD SCHEME OF THE FEDERAL RESERVE IS ABOUT TO FAIL .

[rustyaustin]

For the love of pete, why does no one seem to know the difference between "double down" and "double or nothing." You double down from a position of strength, when you have 11 and the dealer shows 3 or 4 or 5 or 6. The risk of doubling your bet in that situation is mitigated since you know one of the dealer's cards. What McCain and Bush are continually doing is "double or nothing" which you do from a position of weakness. The problem with "double or nothing," as we have seen with Bush time and time again, is when you get back to nothing that's exactly what you have, nothing, and so you have to continue to gamble or walk away with nothing. Also, when you double your bet on a double or nothing proposition, you have not seen the dealer's card, so the risk is far greater.

[GiannaX]

OUTSTANDING post!

[Salz08]

Excellent! This breaks it all down very concisely and is just what needs to stated in these final weeks. We must have people in the media breaking this down in ways that people can understand.

While the writings of many economists are quite accurate and some seemed nearly prescient, they are full of jargon that many do not understand. One's eyes begin to glaze over as they try and winnow out the pertinent facts.

We should all be passing this along to anyone we know that is undecided.

[Liberoservative]

Awesome article...

As someone who works in healthcare and in risk managment, your analysis is spot on.....

Maybe some Republican will read this and realize that McCain is the riskiest candidate out there.... Using a business case analysis view, we would never have gone into Iraq and we will never put our nation at risk with the election of McPalin.....

Thanks for your perspective!

[kapo]

Jared, I think your argument carries more weight than you realise and the same logic that applied to the financial markets also applied in the military assessments. I dont think the intelligence was faulty but rather was massaged, just as the economic problems were covered up. It was fairly simple for anyone to go online and determine that at least some of the accusations against Iraq were false, and it was pretty obvious that Iraq was a paper tiger that had been weakened by sanctions. You can go online and get assessments of combat capabilities of every army in the world and Iraq never rated highly. The intelligence was falsified to justify the war and people went along with it because it was convenient to do so and they though America would win. If you did a bit of research however you would realise that while it was easy for a modern army to defeat Iraq, the last thing you would want to do is to occupy it. The tragedy is not that people did not know the truth, but that those who did were silenced.