Tuesday, 10 January 2012

Book Review: Uncontrolled Risk by Mark T. Williams

"Occupy" protesters would benefit from reading this book. Instead of the mindless directionless opposition to everything capitalistic they would know a lot better who and what to blame for the narrowly averted collapse of the world's financial system in 2008. Better, they would know the kinds of reforms and controls that need to be implemented to make the system operate with more stability to avoid a future recurrence.

In fact, every shareholder and voter needs to know this stuff too. After all, when things go wrong with the financial system, we all get a rather severe smack as a result. The scary fact of the matter is that the conditions that allowed the crisis to build up, the way the system works, have not substantially changed.

Williams informs us by telling the story of the rise and fall of investment banker Lehman Brothers. The story method is very effective in showing how the situation built up over decades as the people, the company, the industry, the regulatory bodies, the political scene all evolved to the 2008 climax of Lehman's collapse and the ensuing beginnings of financial Armageddon. Along the way the author introduces and explains in terms the layman can understand what might be called the technical stuff, the financial products and structures like CDO, MBS, CDS that ended up being the bombs that blew things apart.

We learn that it wasn't just the "greedy bankers" at fault. Things are not that simple in the real world. Williams takes a whole 25 page chapter to list the bad guys and institutions and summarize to what degree they did wrong, everyone from Dick Fuld, Lehman CEO and other key Lehman players, Boards of Directors, the US Congress and several Committees, the Federal Reserve, the SEC, the media, academics, accounting firms, credit rating agencies, lobbyists, the FASB, US Treasury Secretary and former Goldman Sachs CEO Hank Paulson and last but not least consumers who binged on debt and housing.

Apparently, the bankers (and others) weren't simply greedy, they were also stupid and did not truly understand the risks being taken. Prior incidents that should have been learning and warning signs, like survival and recovery from the 1998 LTCM fiasco, instead made people over-confident. Risk models used by industry that work well most of the time failed utterly in times of extreme stress when they would be most useful.

Williams sticks to the facts in the book but it would have been fascinating to get more into the psychology of the players to see what was the mix of flaws and vices. The 2008 crisis could provide valuable insight into how the thinking of institutions and societies go wrong.

The last chapter contains Williams' ten point plan for changes to reduce chances of a new financial systemic risk event. Some can easily form the basis of policy lobbying and legislation - things like mandating higher capital levels, imposing leverage constraints, creating a systemic risk regulator. Others can lie with investors - things like requiring greater executive accountability, improving Board oversight, creating smarter compensation schemes. (In the case of this latter set of changes, I am left wondering how this jives with passive index investing where investors are distant, ignorant and often uninterested in the individual companies like Lehman where dominant managers held sway and escaped control with destructive results. It's another reason I like the idea of pension savings being managed by a body like CPPIB with the motivation, resources and power to kick butt in corporate governance.)

The book and its story unfortunately contents itself, except very peripherally, with happenings in the United States. The reader therefore does not get to see how the worldwide systemic contagion occurred, or how events and conditions elsewhere exacerbated the problem.

Favorite Quotes and Notes:
  • "... the U.S. government has failed to find the perfect balance between excessive regulation - viewed as stifling to bank profitability and economic growth - and lax regulation and oversight - viewed as a recipe for financial and economic instability" - which I find to be a far more balanced and rational worldview than the strident "capitalist system is rotten" view of some people
  • "Companies that take no risk go out of business just as easily as those that take too much risk."
  • in 2006, Lehman's Chief Risk Officer Madelyn Antoncic received an industry award for best risk manager of the the year; a year later Fuld/Lehman removed her from the job and demoted her; i.e. the elaborate risk management structure at Lehman was just a facade to fool credit rating agencies into giving Lehman a lower cost of borrowing/capital to increase profits.
  • Value at Risk (VaR) the commonly used industry measure of risk is described by a Lehman shortseller in a quotation as "an airbag that works all the time, except when you have a car accident"
  • the boyhood home of Fed Reserve chairman Ben Bernanke, since then sold on to several others, was subject to a sub-prime mortgage loan foreclosure - how symbolic!
  • "Post-credit crisis, executives from TARP-taking banks continue to express public support for re-regulation of the financial markets while their paid lobbyists attempt to defeat or weaken any new regulations."
  • Canada is cited by Williams as a model to emulate, praising the consistently strict oversight and regulation here
For the individual investor, the important lesson is first, that the financial system and consequently investment markets, are still very exposed and subject to severe shocks and second, that risk assessment and management are essential never-ending tasks.We need to be ever aware and wary of what is going on. Since some risks are not controllable or often not knowable by the individual, the idea of diversification, spreading investments, gains reinforcement.

A quick 220-page read, it is well foot-noted and indexed. The writing flows smoothly too. Don't be surprised if you come out of reading it a bit angry and less confident in the capabilities of business and political leaders.

My rating: Though missing the greed vs stupidity assessment and the international linkages, it is excellent on what it does present - 4 out of 5 stars. Definitely worth reading.

Thanks to publisher McGraw-Hill for providing a review copy. The book comes in Adobe's eBook format (see McGraw-Hill site)as well as paper.


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Anonymous said...

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