Chapter 1 The Nature of Risk: Losses and Opportunities

In his novel A Tale of Two Cities, set during the French Revolution of the late eighteenth century, Charles Dickens wrote, “It was the best of times; it was the worst of times.” Dickens may have been premature, since the same might well be said now, at the beginning of the twenty-first century.

When we think of large risks, we often think in terms of natural hazards such as hurricanes, earthquakes, or tornados. Perhaps man-made disasters come to mind—such as the terrorist attacks that occurred in the United States on September 11, 2001. We typically have overlooked financial crises, such as the credit crisis of 2008. However, these types of man-made disasters have the potential to devastate the global marketplace. Losses in multiple trillions of dollars and in much human suffering and insecurity are already being totaled as the U.S. Congress fights over a $700 billion bailout. The financial markets are collapsing as never before seen.

Many observers consider this credit crunch, brought on by subprime mortgage lending and deregulation of the credit industry, to be the worst global financial calamity ever. Its unprecedented worldwide consequences have hit country after country—in many cases even harder than they hit the United States.David J. Lynch, “Global Financial Crisis May Hit Hardest Outside U.S.,” USA Today, October 30, 2008. The initial thought that the trouble was more a U.S. isolated trouble “laid low by a Wall Street culture of heedless risk-taking” and the thinking was that “the U.S. will lose its status as the superpower of the global financial system…. Now everyone realizes they are in this global mess together. Reflecting that shared fate, Asian and European leaders gathered Saturday in Beijing to brainstorm ahead of a Nov. 15 international financial summit in Washington, D.C.” The world is now a global village; we’re so fundamentally connected that past regional disasters can no longer be contained locally.

We can attribute the 2008 collapse to financially risky behavior of a magnitude never before experienced. Its implications dwarf any other disastrous events. The 2008 U.S. credit markets were a financial house of cards with a faulty foundation built by unethical behavior in the financial markets:

1. Lenders gave home mortgages without prudent risk management to underqualified home buyers, starting the so-called subprime mortgage crisis.
2. Many mortgages, including subprime mortgages, were bundled into new instruments called mortgage-backed securities, which were guaranteed by U.S. government agencies such as Fannie Mae and Freddie Mac.
3. These new bundled instruments were sold to financial institutions around the world. Bundling the investments gave these institutions the impression that the diversification effect would in some way protect them from risk.
4. Guarantees that were supposed to safeguard these instruments, called credit default swaps, were designed to take care of an assumed few defaults on loans, but they needed to safeguard against a systemic failure of many loans.
5. Home prices started to decline simultaneously as many of the unqualified subprime mortgage holders had to begin paying larger monthly payments. They could not refinance at lower interest rates as rates rose after the 9/11 attacks.
6. These subprime mortgage holders started to default on their loans. This dramatically increased the number of foreclosures, causing nonperformance on some mortgage-backed securities.
7. Financial institutions guaranteeing the mortgage loans did not have the appropriate backing to sustain the large number of defaults. These firms thus lost ground, including one of the largest global insurers, AIG (American International Group).
8. Many large global financial institutions became insolvent, bringing the whole financial world to the brink of collapse and halting the credit markets.
9. Individuals and institutions such as banks lost confidence in the ability of other parties to repay loans, causing credit to freeze up.
10. Governments had to get into the action and bail many of these institutions out as a last resort. This unfroze the credit mechanism that propels economic activity by enabling lenders to lend again.

As we can see, a basic lack of risk management (and regulators’ inattention or inability to control these overt failures) lay at the heart of the global credit crisis. This crisis started with a lack of improperly underwritten mortgages and excessive debt. Companies depend on loans and lines of credit to conduct their routine business. If such credit lines dry up, production slows down and brings the global economy to the brink of deep recession—or even depression. The snowballing effect of this failure to manage the risk associated with providing mortgage loans to unqualified home buyers has been profound, indeed. The world is in a global crisis due to the prevailing (in)action by companies and regulators who ignored and thereby increased some of the major risks associated with mortgage defaults. When the stock markets were going up and homeowners were paying their mortgages, everything looked fine and profit opportunities abounded. But what goes up must come down, as Flannery O’Conner once wrote. When interest rates rose and home prices declined, mortgage defaults became more common. This caused the expected bundled mortgage-backed securities to fail. When the mortgages failed because of greater risk taking on Wall Street, the entire house of cards collapsed.

Additional financial instruments (called credit derivatives)In essence, a credit derivative is a financial instrument issued by one firm, which guarantees payment for contracts of another party. The guarantees are provided under a second contract. Should the issuer of the second contract not perform—for example, by defaulting or going bankrupt—the second contract goes into effect. When the mortgages defaulted, the supposed guarantor did not have enough money to pay their contract obligations. This caused others (who were counting on the payment) to default as well on other obligations. This snowball effect then caused others to default, and so forth. It became a chain reaction that generated a global financial market collapse. gave the illusion of insuring the financial risk of the bundled collateralized mortgages without actually having a true foundation—claims, that underlie all of risk management.This lack of risk management cannot be blamed on lack of warning of the risk alone. Regulators and firms were warned to adhere to risk management procedures. However, these warnings were ignored in pursuit of profit and “free markets.” See “The Crash: Risk and Regulation, What Went Wrong” by Anthony Faiola, Ellen Nakashima, and Jill Drew, Washington Post, October 15, 2008, A01. Lehman Brothers represented the largest bankruptcy in history, which meant that the U.S. government (in essence) nationalized banks and insurance giant AIG. This, in turn, killed Wall Street as we previously knew it and brought about the restructuring of government’s role in society. We can lay all of this at the feet of the investment banking industry and their inadequate risk recognition and management. Probably no other risk-related event has had, and will continue to have, as profound an impact worldwide as this risk management failure (and this includes the terrorist attacks of 9/11). Ramifications of this risk management failure will echo for decades. It will affect all voters and taxpayers throughout the world and potentially change the very structure of American government.

How was risk in this situation so badly managed? What could firms and individuals have done to protect themselves? How can government measure such risks (beforehand) to regulate and control them? These and other questions come immediately to mind when we contemplate the fateful consequences of this risk management fiasco.

With his widely acclaimed book Against the Gods: The Remarkable Story of Risk (New York City: John Wiley & Sons, 1996), Peter L. Bernstein teaches us how human beings have progressed so magnificently with their mathematics and statistics to overcome the unknown and the uncertainty associated with risk. However, no one fully practiced his plans of how to utilize the insights gained from this remarkable intellectual progression. The terrorist events of September 11, 2001; Hurricanes Katrina, Wilma, and Rita in 2005 and Hurricane Ike in 2008; and the financial meltdown of September 2008 have shown that knowledge of risk management has never, in our long history, been more important. Standard risk management practice would have identified subprime mortgages and their bundling into mortgage-backed securities as high risk. As such, people would have avoided these investments or wouldn’t have put enough money into reserve to be able to withstand defaults. This did not happen. Accordingly, this book may represent one of the most critical topics of study that the student of the twenty-first century could ever undertake.

Risk management will be a major focal point of business and societal decision making in the twenty-first century. A separate focused field of study, it draws on core knowledge bases from law, engineering, finance, economics, medicine, psychology, accounting, mathematics, statistics, and other fields to create a holistic decision-making framework that is sustainable and value-enhancing. This is the subject of this book.

In this chapter we discuss the following:

1. Links
2. The notion and definition of risks
3. Attitudes toward risks
4. Types of risk exposures
5. Perils and hazards