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Analytics Magazine

Forum: Economic Crisis – After the Meltdown

Spring 2009

Don N. KleinmuntzBy Don Kleinmuntz

Over the past year, we have seen extraordinary economic turmoil — the most dramatic such events in many decades. An apparent correction in an over-inflated U.S. housing market combined with the collapse of a small corner of the mortgage market — subprime loans — led to a cascading chain of events, culminating in a world-wide crisis of confidence among lenders, who withdrew their funds at an unprecedented pace. Disruption in global credit markets led to financial distress and failure of major banks and financial service firms, sudden shortages of cash for businesses of all types and major declines in world stock markets. By the end of the year, it was clear that these events were triggering economic downturns in the United States and around the world. And, as we look at our year-end investment statements and listen to news reports of tight budgets, job cutbacks and disappointing corporate earnings, we might be justified in giving more than a little bit of thought to our personal financial security.

Explanations of how and why the financial collapse and economic meltdown occurred are going to be many-faceted. There is one common pattern, however: Critical failures of risk management happened at every stage of the meltdown. Examples include:
(1) Homebuyers failed to appreciate the risks as well as the benefits of home ownership and received either little information or misleading information about the risks associated with variable rate subprime mortgage loans;
(2) Subprime mortgage lenders failed to appreciate that their business model was unsustainable and would ultimately implode as borrowers defaulted in massive numbers;
(3) Banks, hedge funds and other sophisticated investment enterprises both issued and invested in bonds and collateralized debt obligations backed by subprime mortgage loans without accurately assessing all the relevant risks;
(4) Credit rating agencies and insurance companies provided assurances of safety but failed to appreciate the questionable assumptions and limited data being used to value debt-backed securities;
(5) Businesses in many industries failed to anticipate the fragile and interconnected nature of world credit markets; and
(6) Government regulators failed to provide oversight or take corrective action for any of the above.

So are these pervasive and systematic failures of risk management something new or unusual? No. An Internet search of “risk management” plus “failure” produced 12 million hits on Yahoo! and 4 million hits on Google. Not surprisingly, recent references are to names like Bear Stearns, Lehman Brothers, IndyMac, AIG, Fannie Mae and so on. But the search also uncovers old, familiar names like Enron, Arthur Andersen, Long Term Capital Management and Barings Bank. Not all references are in the private sector, either — they include the 9-11 Commission Report, NASA reports on both Columbia and Challenger disasters, the Food and Drug Administration, the Department of Defense, and various reports on bridge and other infrastructure failures, including the flooding of New Orleans caused by Hurricane Katrina.

Current discussions of the economic meltdown are understandably focused on government bailouts, economic stimulus packages and other measures intended to mitigate the severity of downturn and to hasten the recovery. Sooner or later, everyone’s thoughts will turn to trying to understand why the meltdown happened and how to prevent similar events in the future. Members of the operations research/ management science community and other analysts need to be ready to step forward and participate in the discussion. Did risk management methods and processes fail, and how should they be improved? If they were poorly implemented, what were the barriers to implementation? Are we prepared to engage in this discussion and put our ideas into practice?

Many of us have expertise in risk management theory and methods, as well as practical experience in applying risk management to significant problems. Financial engineers are critical to understanding recent events, since they were the ones who designed many of the sophisticated financial derivatives that were at the core of the credit market collapse, and who will work to improve on what they have already accomplished. But the risk management problem was magnified by the new and unfamiliar nature of the risks and by the highly complex and interconnected nature of our financial and economic system. These challenges are familiar to risk managers in supply chains, infrastructure protection and related areas. However, each area has evolved distinct methods and models for analyzing and understanding risk, and there appears to be insufficient communication and collaboration across areas. This is just one example, albeit a timely one, where a unified view of risk management may be useful.

Don N. Kleinmuntz (dnk@strata-decision.com) is a co-founder of Strata Decision Technology, a company that develops software for financial planning and resource allocation. He also has a part-time research appointment at the University of Southern California and is the president of the Institute for Operations Research and the Management Sciences (www.informs.com).

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