The Essence of Risk Management – Lessons from Greensill
Greensill. History does not repeat, but sometimes it rhymes. And then sometimes it does actually repeat.
Long story short, magician financier reinvents a neglected area of finance, adds some secret sauce and hey presto, turns BBB or worse assets into AAA assets that yield AA returns. The secret sauce is always fiendishly complicated, but just in case there are curmudgeonly folk who do not completely trust / understand / care about special sauce 1, there is the added draw of special sauce 2, which is an insurance contract that will ensure that that any residual risk, if that were possible, also disappears. It always helps if you are in a yield hungry environment, negative short term interest rates just being an added bonus. Then sell as much as you can and watch the fees roll in. What could possibly go wrong?
The best analogy is that this is like a poker game. Turning base metals into gold is a fool’s errand, so as in a poker game the main issue of the participants is to determine the fool. In this poker game, the participants are:
1. Those borrowing the money
2. Those structuring the loans into notes
3. Those insuring the notes
4. Those selling the notes
5. Those buying the notes
Whilst I claim no insight into the participants, actions speak louder than words, and in this game of poker, foolish is taking risks that are not being compensated by the potential reward. Going all in with a pair of twos in seven card stud implies a great deal of skill and knowledge of the current game or a great deal of risk.
Looking at the participants, those borrowing the money have skin in the game only to the extent that they cannot borrow elsewhere. And if they cannot borrow elsewhere but still manage to raise finance in this fashion, it tends to imply that they are the opposite of foolish. Those structuring the notes have little skin in the game, apart from the present value of all those fees that they hope to collect in the future. This may be a large number, but being paid to turn base metal into gold for a fee still appears to be rational so long as you can sell the gold. The insurers are being paid to provide a guarantee. They are taking real risk and are being paid a fee to so do. So long as the fee compensates them for the risk, they are acting rationally, and so long as they continue to act rationally, cannot be described as foolish. Those selling the notes should believe that base metal plus special sauce 1 and 2 does turn it into gold, and then added to the reputation of their institution for probity, allows them to sell to clients, for which they receive fees. Those buying the notes should believe all of the above, especially institutional buyers, but most likely are heavily relying on the aforementioned probity of the institution doing the selling, and they receive the return, good or bad, on the notes.
Looking at the above, there are three potential fools in the game, 3, 4 and 5. In the event, participant 3, Tokio Marine, determined that the risk was not worth the fee and pulled the plug. Clearly not fools. That left two fools standing. Or rather chopped off at the knees with multi-billion dollar losses.
The worst aspect of this game of poker from a risk management perspective is that it was a straight rerun of the monoline disaster of the last credit crisis. Neglected area of finance, home loans, check. Secret sauce 1, multi-variate credit models (remember copulas?), check. Secret sauce 2, protection from loses, provided by the monolines, check. And then bad things happened. The best news, if one were a shareholder of Tokio Marine, is that they clearly learned the lesson required from that disaster, and manged to get clear of Dodge, in a timely fashion. The unfortunate ones who did not learn the lesson stayed in the game and paid the price.
From a risk management perspective, this was a three legged stool, and quoting from the Bene Gesserit (with thanks to Frank Herbert), that is the most unstable of platforms. It relied on, leg 1, the supply of loans with special sauce 1, leg 2, the existence of insurance, special sauce 2, and leg 3, the willingness of investors to buy the loans. Any one if the three leave the game, the stool falls. Those left, pick up the pieces, which they are doing, most likely to their regret.
The essence of risk management, be it in finance or any other business, is to understand, as much as it is possible, the risks that your institution is taking, and then to understand, as much as it is possible, the impact on those risks turning into reality, either singly or in combination, on the performance of the business. Experience and bravery is required. Experience is necessary, as unlike in this case, events do normally rhyme and not repeat. Bravery, because unlike the Fed governor who said his job was “to take away the punch bowl just as the party got going”, the risk managers bosses are probably at the party and enjoying the ride. Takes nerve.

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