Ring around the Rosie December 18, 2008
Posted by wonderingin in Accounting, Banking, Corporate Finance.add a comment
Modern financial reporting contains elements similar to the observer effect in physics where the act of observing the behavior of sub-atomic particles actually changes their behavior.
Investment banking and financial services have focused much of their energy on creating innovative (black box) financial instruments (e.g. derivatives, mortgage-backed securities, structured financial products) which generated wealth (for their creators) while often skirting existing capital, regulatory, or accounting requirements. SIVs (off balance sheet special purpose investment vehicles) were also involved in many instances.
Financial gurus create products designed to get around particular accounting or regulatory constraints for which their clients gladly pay. Something blows up, regulators clamp down and demand that the accountants write new (often heavy-handed) rules to limit or eliminate the offending practices or products and then the game starts all over again.
Chuck Prince of Citigroup said it best, “As long as the music is playing, you’ve got to get up and dance.” This time around, however, when the music stopped, all of the chairs were knocked over, some broken beyond recognition. It reminds me of the nursery rhyme Ring around the Rosie.
Let’s hope the credit crisis is not a financial version of the bubonic plague.
Prudence pays – most of the time December 13, 2008
Posted by wonderingin in Corporate Finance, Personal Finance.add a comment
A recent article in the Wall Street Journal (Americanus Prudens: In Search of an Endangered Species) lauded the return of thriftiness and prudence as virtues in America. Prudence requires patience and discipline – two more scarce virtues in our culture.
Prudence has not always been rewarded. Profligate borrowers benefited from cheap financing and rising asset values while savers received little return on their savings amid a growing risk of inflation. Shareholders and executives of highly leveraged businesses enjoyed phenomenal financial rewards – until the music stopped. And now, it is the prudent who will shoulder much of the cleanup burden.
At the same time, risk-taking is at the heart of the free enterprise system. Anyone should be free to take whatever business and financial risks they feel appropriate as long as they are risking solely their own money. When other people’s money is involved (owners, shareholders, lenders), the standard must be prudent risk taking.
What is prudent risk taking?
Prudent risk taking involves taking an action or actions which involve significant risks only after fully understanding those risks and clearly assessing the probability and cost of each signifcant risk, as well as what actions can be taken to mitigate those risks.
In the runup to the current credit and financial crisis, borrowers, lenders, investment banks, and investors all made the same mistakes:
- They assumed that markets and asset values would continue to rise (it’s different this time).
- They trusted without verification (ninja loans, credit ratings, investment bankers)
- They implicitly assumed modest downside cases based on recent economic history (how bad can it get?) while we now face a financial crisis and recession more severe than anything experienced by most people living today.
- Finally, in each case, the actors took great risks with other people’s money.
There are some very hard lessons here:
- We each need to learn to assess our own risks and make our own decisions.
- We should not trust the advice of others without independent verification.
- We will all sleep better if we are a bit less greedy – after all, you can’t take any of it with you when you leave!
