Bryan Burrough, William D. Cohan and Bethany McLean have a piece in this month’s Vanity Fair on Jon Corzine, the man behind the spectacular crash of MF Global. It doesn’t provide much insight into what happened at MF Global or where the missing money went. But is does paint an interesting picture of the captain of the ship.

Unlike a nautical captain who drowns when his ship sinks, Corzine may escape. According the article, he had only a small percentage of his wealth in the firm. His wealth did not vaporize. The lawyers and class action suits against Corzine will likely take a big chunk of his remaining wealth. His career as a trader and money manager are likely over.

In piecing together earlier episodes in his career, one stuck out at me from a compliance and risk perspective. While a young trader at Goldman Sachs, Corzine was involved in a screwed up trade that was mishandled and exceeded the firm’s risk limits. In the end, the trade ended up making money, but that won no accolades. The trade violated compliance and risk policies and was non grata. We generally only hear about rogue traders when they lose money. At the time, at least according to the article, Goldman took a dim view on rogue traders who made money.

The other item that emerged is the Corzine was self-made. He is certainly part of the 1% now, but didn’t start out that way. One thing that has bothered me about the Occupy Wall Street movement is a somewhat misguided rage against the 1%. When looking at the income discrepancies over the last twenty years, I think people miss the fact that the people in the 1% are not all the same people that were int he 1% twenty years ago.

Unlike aristocracy, you do not need to be born into the 1% to become part of the 1%. (Sure, it usually helps to start off well-to-do.) It seems to me that combining lots of hard work, lots of education, and little bit of good luck can get you an entrance ticket to the 1%.

Sources:

• Jon Corzine’s Riskiest Business by Bryan Burrough, William D. Cohan and Bethany McLean in Vanity Fair
  The full text of the article is not currently on-line.

The most dangerous parts of managing risk are the risks you don’t expect. Looking back at my old four-box analysis, there are really two types of unexpected risks, the risk that you know that you don’t know and the risk that you don’t know that you don’t know. In the first case you know there is an unexpected risk. In the second, you missed that there was an even a risk.

The second case has been labeled the Black Swan. Those type of risks are well written about by Taleb.

While staying up late and watching some Monty Python, I came to the conclusion that the first case is the “Spanish Inquisition.” You know the Spanish Inquisition is out there roaming the countryside. You just don’t now when or where they will appear.

You also don’t know the danger. Their two weapons are fear and surprise…and ruthless efficiency.

I’ve talked in the past about the Black Swan by Taleb and at other times about Free by Chris Anderson. I think I missed a connection between the two.

Taleb points out that the Black Swan event is only a surprise to one side. The turkey thinks life is great living on the farm. Until Thanksgiving comes around. Thanksgiving may be a surprise to the turkey, but it’s not a surprise to the farmer.

In looking at the Free model, is there a Black Swan connection? I think this cartoon puts it nicely.

The “Free” Model from Geek and Poke

• Free and Law Firms – prior post on Compliance Building
• Book Review: The Black Swan – prior post on Compliance Building

RMS Titanic

The hard work has begun as federal regulators are trying to implement the provisions of Dodd-Frank. The law pushed lots of the detail out to the agencies so there are lots of unanswered questions.

One of the hot button issues was what to do with financial institutions that were too big to fail.  Dodd-Frank came up with the concept of “systemically important.” They created a new entity, the Financial Stability Oversight Council to come up with a definition, figure who should get that designation and design safeguards for those designees.

Private equity lost the battle to get an exemption from registration under the Investment Advisers Act. It may have to fight another battle to avoid the “systemically important” label.

The Independent Community Bankers of America, a major trade group for community banks, said General Electric Co.’s GE Capital and private-equity firms Carlyle Group, KKR & Co.’s Kohlberg Kravis Roberts & Co. and Blackstone Group LP should be tagged as systemically important.

Private equity doesn’t belong in that group, shot back Blackstone spokesman Peter Rose. “We do not trade, we have no leverage at the parent-company level, our investments are clearly disclosed and transparent, our investors are with us for the long term,” he said. “Therefore there is no possibility of a, quote, ‘run on the bank.’ ”

What does this all mean?

According to section 113 of Dodd-Frank Wall Street Reform and Consumer Protection Act, the Financial Stability Oversight Council

may determine that a U.S. nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards, in accordance with this title, if the Council determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.

The term “U.S. nonbank financial company” means

a company (other than a bank holding company, a Farm Credit System institution chartered and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), or a national securities exchange (or parent thereof), clearing agency (or parent thereof, unless the parent is a bank holding company), security-based swap execution facility, or security-based swap data repository registered with the Commission, or a board of trade designated as a contract market (or parent thereof), or a derivatives clearing organization (or parent thereof, unless the parent is a bank holding company), swap execution facility or a swap data depository registered with the Commodity Futures Trading Commission), that is–
(i) incorporated or organized under the laws of the United States or any State; and
(ii) predominantly engaged in financial activities, as defined in paragraph (6).
[102(a)[4)]

A company is “predominantly engaged in financial activities” if–

(A) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, from the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated annual gross revenues of the company; or
(B) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, related to the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated assets of the company.
[102(a)[6)]

Those are some very wide open definitions for who could be considered “systemically important.”

Then the Financial Stability Oversight Council has to make a determination using these considerations:

(A) The extent of the leverage of the company;
(B) The extent and nature of the off-balance-sheet exposures of the company;
(C) The extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) The importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
(E) The importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) The extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H)The degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
(I) The amount and nature of the financial assets of the company;
(J) The amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
(K)Any other risk-related factors that the Council deems appropriate.
[113(a)(2)]

Hearing

Then it takes 2/3 of the voting members of the Council, including the Chairperson, to make the designation [113(a)(1)]. Then the financial company designated as systemically important has 30 days to request a hearing and another 30 days to submit material. [113(e)(2)] The Council has 60 days to make a final determination.

Too Big to Fail

This provision of Dodd-Frank is the Anti-AIG and to some extent the Anti-Lehman Brothers portion of the law.It is one of the many ways the law tries to address Too Big to Fail.

Capital has many forms and is made available in many ways. The U.S. government thought AIG was too big to fail because of its size and interconnectedness. They didn’t think Lehman Brothers was too big to fail, but I think they were wrong about that.

Back to the Finger Pointing

Now that the Financial Stability Oversight Council is trying to define Too Big to Fail as systemically important, the finger pointing has begun. Industries and companies are saying “not me” and saying that others should be included.

The problem is that once you are designated “systemically important” it’s not clear what additional burdens will be placed on you and whether there will be any benefit to the designation. It seems the Council has the flexibility to craft different requirements for different companies and different industries.

It may boost your ego to be considered “systemically important” but it will also lead to a regulatory headache. Private investment firms are not exempt from the designation and could be tagged.

Sources:

• Which Firms Need Tougher Oversight? Don’t Look at Me by Victoria McGrane in the Wall Street Journal
• Independent Community Bankers of America November 5 comment letter to the Financial Stability Oversight Council
• Advance Notice of Proposed Rulemaking Regarding Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies by Financial Stability Oversight Council

Image of the RMS Titanic is from Wikimedia.

With the winter Olympics going full swing in Canada, I thought I would look to how that country is dealing with securities class actions. NERA Economic Consulting just released their 2009 Update on Trends in Canadian Securities Class Actions.

Some tidbits:

• Eight securities class actions were filed in 2009, compared with the 10 filings in 2008.
• There are now more than $14.7 billion in outstanding plaintiffs’ claims in Canadian securities class actions.
• In 2009, six cases settled for total payments of approximately $51 million

These are not big numbers compared to the securities class action activity in the United States. (Which is a good thing from the corporate perspective.) But this is still a new area for Canadian law.

Sources:

• Trends in Canadian Securities Class Actions: 2009 Update
• NERA Releases 2009 Canadian Securities Class Action Trends Study by Adam Savett for RiskMetrics Group Insight

This week’s The Economist has an excellent special report: The Gods Strike Back.

The title comes from Peter Bernstein’s Against the Gods:

“The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.”

The report contains these stories:

• Taming financial risk
• Number-crunchers crunched
• Cinderella’s Moment: The role of the risk manager
• Banks and risk management
• When the River Runs Dry: Evaporating liquidity
• Fingers in the Dike: The future of financial regulation
• Blocking out the Sirens’ Song: Risk after the crisis

For me, when looking for blame, I tend to focus on the rating agencies. As the report points out, the raters were paid by the the issuers not the purchasers of the securities. That results in a misalignment of interests. Of course, they may have just gotten wrong.

Looking at the chart below you have to be impressed by how spectacularly wrong they were:

Hopefully, we will learn some lessons from the financial crisis. We should have learned by now that the next crisis will be caused by something different so we need to be able to recognize and deal with the unexpected.

The “drunkard’s walk” refers to the Brownian motion, the seemingly random movement of particles suspended in a fluid. The original thought was that you might be able to calculate the movement by measuring and calculating the interaction. It proved impossible. There are too many factors and too many interactions.

Small changes in a system can dramatically affect the outcome. This is the butterfly effect. The origin cam from a meteorologist who was using a computer model to rerun a weather prediction and one of the numbers he used was shortened from six decimal points to three decimal points. The result was a completely different weather scenario. It’s not that a butterfly can cause the problem. It’s that a seemingly inconsequential random event can lead to a big change in an outcome.

Leonard Mlodinow addressed this topic in The Drunkard’s Walk: How Randomness Rules Our Lives. (I mentioned the book previously in Criticism and Praise.) There is much more randomness in our lives than we give credit.

We poorly understand the effect of randomness.

He explores his concepts using the backdrop of Pearl Harbor. In hindsight there were many signs pointing to the eventual attack. “In any complex string of events in which each event unfolds with some element of uncertainty, there is a fundamental asymmetry between past and future.” It’s nearly impossible to predict before the fact, but relatively easy to understand afterward. We have seen the same 20/20 hindsight with the 9/11 attacks.

That’s why it is easy to explain why the weather happened three days ago, but have trouble getting the weather forecast right three days into the future.

Mlodinow never mentions it, but for me the next step is the theory of the Black Swan. How do you end up with high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations?

Combining the Black Swan with the Drunkard’s Walk and the Butterfly Effect, you see that a combination of small events can lead to an over-sized outcome. We get used to being able to calculate and measure so many things. There will always be factors that we miss, or overweight or underweight.

Not to be depressing. The Drunkard’s Walk leaves you feeling in less control than when you started. But there is a factor you can control: the number of chances that you take. “Even a coin weighted toward failure will sometimes land on success.” Keep flipping the coin.

The Drunkard’s Walk is worth reading if you deal with risk.

Nassim N. Taleb, Daniel G. Goldstein, and Mark W. Spitznagel discuss risk management and short comings in approaches in the October 2009 issue of the Harvard Business Review (subscription required).

They offer up six mistakes in the way we think about risk:

1.  We think we can manage risk by predicting extreme events.
2.  We are convinced that studying the past will help us manage risk.
3.  We don’t listen to advice about what we shouldn’t do.
4.  We assume that risk can be measured by standard deviation.
5.  We don’t appreciate that what’s mathematically equivalent isn’t psychologically so.
6.  We are taught that efficiency and maximizing shareholder value don’t tolerate redundancy.

Black Swan events – low-probability, high-impact events that are almost impossible to forecast— are increasingly dominating the economic environment. The world is a complex system, made up of a tangled web of relationships and other interdependent factors.  Complexity makes forecasting even ordinary events impossible. So, complexity increases the incidence of Black Swan events as we have a harder time seeing the relationship and connection. All we can predict is that Black Swan events will occur and we won’t expect them.

The authors propose a different approach to risk management:

“Instead of trying to anticipate low-probability, high-impact events, we should reduce our vulnerability to them. Risk management, we believe, should be about lessening the impact of what we don’t understand—not a futile attempt to develop sophisticated techniques and stories that perpetuate our illusions of being able to understand and predict the social and economic environment.”

The authors end up equating risk to ancient mythology:

“Remember that the biggest risk lies within us: We overestimate our abilities and underestimate what can go wrong. The ancients considered hubris the greatest defect, and the gods punished it mercilessly. Look at the number of heroes who faced fatal retribution for their hubris: Achilles and Agamemnon died as a price of their arrogance; Xerxes failed because of his conceit when he attacked Greece; and many generals throughout history have died for not recognizing their limits. Any corporation that doesn’t recognize its Achilles’ heel is fated to die because of it.”

That is a bit lofty for my tastes. After all, the danger of the black swan is that you don’t know that you don’t know about that risk. If you know about a risk, you can deal with it. If you know that you don’t know about risk, you can manage that also. It’s hard to be a victim of hubris when you don’t know the danger for your downfall even exists.

Nassim N. Taleb is the Distinguished Professor of Risk Engineering at New York University’s Polytechnic Institute and a principal of Universa Investments, a firm in Santa Monica, California. He is the author of several books, including The Black Swan: The Impact of the Highly Improbable. Daniel G. Goldstein is an assistant professor of marketing at London Business School and a principal research scientist at Yahoo. Mark W. Spitznagel is a principal of Universa Investments.

When thinking about risk, I break things into four quadrants. There are things we know and there are things we don’t know as individuals. I then slice slice that further again with the things we know and the things we don’t know as part of the larger organization or conscious state.

Our sweet spot is the the things we know that we know. (The green area on my chart.) Those are our operations. Those are the things we have in the realm of compliance. We may not be fully compliant and dealing with the risk. But it is known.

At the opposite corner are the things that we don’t know that we don’t know. This is the black swan territory. This is an area of danger for an organization. This is a knowledge void and a compliance void. These are risks that we don’t know about. We don’t know the magnitude of the risk and we don’t know it even exists. Our models miss this factor. Our organizations are not paying attention to these risks.

The other two areas are also interesting.

The things we know that we don’t know is an area that we know we can improve. (The orange quadrant on my chart) This is the area of known ignorance or accepted unknowns. You can manage these risks, because we know them. They have been identified, although not quantified. They may be on the list of things to address. Or we may just be willing to run naked in this area and are not worried about the risk.

The last area of the things that we don’t know we know is an area of opportunity. (The purple quadrant on my chart) This is risk that they are managing, even if they don’t know that risk exists. Often this will be a risk associated with another risk, either through causation or correlation. If an organization realizes they have this knowledge, they maybe able to create a new opportunity for themselves by discovering it. You do need realize that the causation or correlation may sever at some point, pushing this risk down into the territory of the black swan.

There is also an element of danger in the opportunity area when it comes to records management. These may be the pieces of information getting unearthed during litigation that gets an organization in trouble.

It’s important to realize and accept that there are things we don’t know. The key to bettering the organization is to continually try to reduce the amount of stuff that we don’t know.

I want to credit Liam Fahey, a professor at Babson College and co founder of the Leadership Forum, for the origins of this matrix. He gave a presentation using this analysis to a group of law firm knowledge management leaders in October of 2008.

On Sept. 16, 2009, Compliance Week and Navigant Consulting presented an exclusive editorial roundtable about compliance practices at financial services firms at The Mandarin Oriental Hotel in Boston.

(Apparently not so exclusive, considering I was able to get in. I even made it into one of the article’s pictures. – That’s me eating my fingers in the background.)

Compliance Week Editor-in-Chief Matt Kelly moderated the session, which featured Daniel Bender and John Schneider of Navigant Consulting. The full roster of participants is in the article’s sidebar.

You can read more about what we discussed during the roundtable in an article in Compliance Week: Managing Risk in the Financial Sector. (Subscription Required)

A few of my favorite quotes from the article:

Lou Iglesias, chief compliance officer of PanAgora Asset Management: Part of the role of a compliance and risk officer is “being a student of history” and learning from past industry mistakes. “And you don’t have to look back too far to find them.”

James Bone, founder of GlobalComplianceAdvisors LLC: Because there is no school for compliance, continually developing new staff to keep up with regulations is also a challenge. Even if you have an unlimited budget to hire talent, “finding people who have the right skill-set to do the things that you need to get done” isn’t always easy.