Sunday, May 30, 2010

Risk Management and Me

David Brooks, the wonderful columnist for the NY Times, said recently that the problems with the BP oil disaster and the Wall Street financial meltdown was that they were both a product of bad risk management.

Bad risk management? What does that mean?

I think of risk management as calculating the cost of losing. Like when I was a kid: I get into a fist fight, I think, of course, I'm going to win, and cost free, so I underestimate the potential cost of getting a broken jaw and going to the hospital AND the cost of the lawsuit that follows...because I miss-managed my risk--never considering the possibility of losing--by starting the fight in the first place. But that happened when I was a kid. When I didn't know how to manage my risk of fighting a guy three years older and fifty pounds heavier. Now that I'm grown up, I may still start fights, but I have an insurance policy to cover hospital stays, and a lawyer, in case I lose.

Risk management is nothing more than the old tried and true cost benefit analysis under another name. In the cost benefit analysis formula of decision-making, one first estimates the potential revenue of an action, then subtract the estimated calculated cost (hopefully both the present and future costs--and underestimating the future cost must really include the cost of losing, of making a mistake), and it gives you the potential profit of a situation.

The problem with BP and Wall Street--AND the Iraq war and probably the Afghan war as well--is that they underestimated the risk, the potential cost, of making a mistake. They though they were to smart to lose. They had stolen fire--in this case, high technology--from the Gods: guided bombs, computers and underwater robots. Since calculating risk is calculating what am I going to have to pay--money and lives--for the cleanup of one's mistake, one's loss. And if you never consider losing, well...

But--and I think this is the important thing--bad risk management is not just a problem of BP, Wall Street and the attack on Iraq, it is at the core of the whole socio-economic disaster that is the US (and Europe) today. After all, what is a sub-prime foreclosure but bad risk management on the part of both the banks and the individuals who took out the loan...and the government who both allowed and encouraged it: where the banks thought that "bundling," buying and selling of large groupings of sub-prime loans, made them risk free--there were no potential future costs. Similarly individuals took out sub-prime loans, thinking that housing prices were going to go up forever, and they could sell or get more high paying jobs or their rich Aunt would die and leave them a bundle before interest rates on their variable mortgages would ever go up. It is a society of bad risk-managers.

Moreover, what is procuring and using an individual credit card but a study in risk management: to properly assess one's future ability to pay off a loan. If we are bad risk-managers, however, we think/estimate that the future will always be better than the present, therefore we can borrow against it endlessly...never considering the possibility that the future will be worse.

We used to call good risk management "saving for a rainy day". Well, its pouring...and America's savings rate--or non-savings rate--hovered around zero more or less for the past few years, prior to the meltdown. That's called living through a rainstorm without having a raincoat, an umbrella or even, in some cases, a roof on the house.

So why should the public be so outrage over BP's failure, or Wall Street's, or Bush's, Cheney's and Rumsfeld's decision to go into Iraq, when those decision makers came from the the same cost-underestimating culture as the public. We American are all guilty of the lousy risk management...call it foresight blindness...we never considered for a moment the true cost of failure--the time required to to have systems and money available to correct for a future mistake: a oil wellhead breaking, the sub-prime bundling being a matter of mathematical-model hubris and mistaken calculation, or that the Iraqi Sunni insurgents being so tenaciously resistant and clever (we'll see about the Taliban in Afghanistan).

Leaders come from the same culture as the followers. And in a democracy--one man, one vote, remember--everyone is to blame. If you don't like the mess the Ivy League decision makers have gotten us into, vote for somebody from State College, USA. Or maybe better somebody who never went to college, but who knows that mistakes are possible, the future is never totally benign, contingencies must be prepared for, and greed, certainty and arrogance are the most expensive mistakes a society can make.

3 Comments:

Blogger Brian Thomas Evans said...

What do we say to those people who saw the potential risks years ago, screamed fire and were ignored. In the banking world there were numerous attempts to regulate banking while the Right was de-regulating it, heck it was Senator Graham that helped bring in the Investment Banks who famously introduced the sub-prime product only to bet against it and rack in billions, yes billions. BP’s is required to install safety measures on their off shore wells everywhere else in the world but here because “we shouldn’t burden businesses, they can self regulate”. BP self regulated a costs cutting savings of $500,000 only to, as you point out, make a risk management decision that will end up costing US billions, yes billions. And Iraq…all I can say is the night…err I mean the morning…err (I’m not even sure he really won), when Bush got elected I turned over to Tia and said…”we’ll be invading Iraq next year”…I wasn’t off by much. We live in a democracy but the government is a Republic and it was designed that way so the majority couldn’t screw everything up as bad as they are…what gives? I think it’s money.

11:08 AM  
Blogger 健豪 said...

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5:18 PM  
Blogger Cliff Osmond said...

Money is just a medium of exchange. What is being exchanged? The goods and services of a greedy and corrupted society. As to your comments about a republic: yes, it was set up that way properly to protect against an electorate that (1) were unexposed to the machinations of political power and hence they needed an intemediary of statesmanlike leaders, and (2) those leaders (a) had enough money and powerthemselves that they were relatively uncorruptiable, and (b) they were the prodcut of the Age of Enlightenment, and learned at the bookshelf of the Bible, Shakespeare and the other greats, and not TV, bastardized art and an educational system that has moved too far from primary education and toward social engineering and experiment.

11:38 PM  

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