– Thoughts on Strategy and Management

Energy can not be created

When you start reading current newspapers it is very likely that you will find several articles and columns concerning the sub prime crisis. Now it seems that each and every editor, journalist, writer in every newspaper or magazine does understand risk management business, rating issues and can explain what happens and which management failures had been made in the past.
But: Where have all the comments and analysis been in the last 12 months?

Life moves in mysterious ways. A couple of day ago I organized my old magazines; most of them focus on financial management or strategic management. Two times a year I do this review in order to identify those issues that had an impact on management and those that had not. This time I faced several very interesting headlines and articles, most of them similar like this: “MBS and ABS business and their success in 2006” or “Splitting and reducing credit default risks through syndication”; “100 % (and above) house financing – the new business segment”. And on 4th of October 2007: “The gambling bank”. This is funny, isn’t it?

So what happened? Rating agencies used estimated figures to run calculation models? Yes, that’s true, but actually not the core of the issues. Just three notes to describe the core (more data can be found in this post):  

  • In the EUR-Zone banks have increased their lending to the private sector at 6.200 billion EUR since 1997. In the same period of time the nominal GDP increased only at 3.400 billion EUR.
  • In the USA debts of private households and enterprises increased 7.400 billion EUR more than the GDP. In 1997 the debts of private households had a ratio of 120 % of GDP; 10 years later the ratio was around 160 % of GDP.
  • The segments of loan portfolios with high PD ratios has increased dramatically in the last couple of years. (This is the result of some calculations and quality tests that banks have been made in the last months to estimate their expected loss.)

More loan business can be equally to more credit default risks. Of course it is possible that a single player increases its loan business activities in total and reduces its credit default risk at the same time. But this is not possible for an entire market (someone has to have the bad loans).

This remembers me to education in physics. Our teacher told us, that energy can not be created; energy can just be transformed to other forms of energy. The same law can be applied to credit default risks: It is possible to transfer them: to someone else or to another type of risk. But at the end of the day the risk still exists… in the best case not in your books. In particular the transformation to someone else is a little bit of the German saying “Sankt Florians Principle” ==> “Please spare my house, burn other houses”….

So what lessons can be learned?

  1. Despite all financial innovations, the old fashioned triangle is still valid: A financial product has three attributes: Risk, return and liquidity. More returns will cause more risks. Or to describe it very simple: There is no free lunch (in global financial markets, too!).
  2. Employment of scoring models to estimate the probability of default requires that those objects (e.g. customers, cash flows) have been observed in the past yet. Entering a new business segment (e.g. very low income), which have not been observed in the past, is equal to have less hard data.
  3. If you share your risks and transfer them to the market (and everyone does the same), the market becomes risky and will reflect these (concentrated) risks to the players.
  4. Last but not least a hint for practice: Mark all data in calculation models which are founded more on assumptions and use of estimates (in order to get the calculation running) to distinguish them from hard proofed data (my staff members do so). Do not only present the calculation results, sometime it is more important to present and to discuss the calculation parameters and assumptions.

One Comment

  1. hi it,s really a good thing.