Tuesday, December 23, 2008

It's Time for Risk Management

Even if you’re on the right track, you’ll get run over if you just sit there. – Will Rogers

As presented in the last post, we face an economy in which we can’t be certain that we can recognize the right track. Just sitting there is, consequently, even more risky. We are passing through a major economic storm, possibly the largest of our lives. We need to remain vigilant, aware of the risks and taking all reasonable precautions against possible disruptive events.

I often think of a home video that appeared many times immediately following the tsunami that hit the Thai coastland in December, 2004. There was one scene in which the tourist was shooting the beach as the water started receding. Several people stood on the beach, watching the water go out. Then they noticed something on the horizon, a growing wave that was approaching them. Most people started walking backwards, then turned and started running away from the rapidly approaching water. Yet there was one man who sat down on the beach and waited for the wave to crash over him – and then he was enveloped by the water.

What was going through his mind? Was he a fatalist, accepting that he should die? Was he suffering from an incurable disease, something for which he could not escape? Or was he thinking that he had seen many large waves before and this one would not be much different, simply washing by him and he would float to the top to swim away?

Many people died in the tsunami – and we should expect that many companies will die during this economic storm. We’ve already seen 23 US banks collapse this year. That’s 20 more than in 2007 and, based on history, makes it very likely we will see a larger group collapse in 2009. Just last week, S&P lowered its ratings on eleven major banks by as much as two levels, saying, “they faced more operational risk amid a worsening financial meltdown” (1). Many are the same banks that the US government recently bought into. This will result in a reduction in the amount of loans they can finance, further slowing economic growth.

Private investment firms are facing similar problems. Roughly $50B of personal, charitable and corporate wealth has reportedly gone up in smoke with the collapse of Bernard Madoff’s firm (2), wiping out charities and retirees’ life savings. Some of the victims had never even heard of Madoff; they had entrusted their savings to an investment manager who simply handed the money over to Madoff. Yesterday, we heard that Cerberus, the firm that owns Chrysler, is restricting withdrawals from its hedge funds (3).

Recognize that even though something starts slowly, if it has some characteristics that are different than what you have seen in the past (especially the recent past), there is a strong probability that something is emerging; something with which you have no experience, something that may upset all your plans. It should be a given, then, that sitting in the same place may be very dangerous.

We don’t have to look any further back than this past autumn to see an example of the consequence of being complacent. The stock market dive was one of the most severe and sudden on record. Warning signs were emerging for several years, yet even those entrusted with regulating the market and our economy chose to downplay the potential severity of what could happen. The party atmosphere continued until the first wave of financial bankruptcies broke it up.

All of us want to believe that the worst is already behind us, yet even if there aren’t any more dramatic events, such as major bank or automaker failures, smaller businesses may still feel catastrophic damages. Remember what happens with a hurricane. First, there is wind and cloudy skies, then the rain comes. Next, the winds start destroying what mankind has built. This may be the most dramatic time, but after the winds come even worse floods, the result of atmospheric low pressures and many inches of rain swelling the streams and rivers. It wasn’t the winds that so severely damaged New Orleans, it was the floods.

Even if we believe the most dramatic and disruptive events are over for the economy, we still need to protect ourselves from the rising levels of loan defaults, retail bankruptcies and customers who can’t pay.

Do you have a risk management plan in place that addresses what you will do if several of your major customers fail? Or a large number of your smaller customers fail? And what if some of your suppliers and competitors fail? The economic landscape may look radically different in 18 to 24 months. Have you rethought your vision of your business’ position and how it must be prepared to weather the storm?

Most importantly, do you execute according to that risk management plan – or do you sit there, confident you are on the right track, in danger of being run over?

  • How confident are you that you know what your investment manager has invested your money in?

  • How financially stable are your customers? Are they demanding longer payment terms and/or lower prices?

  • How financially stable are your suppliers? Are they delivering on time?

  • How secure are the loans you depend upon? Can any of them be called by your bank at any time?

  • Can your business be affected by the closing of a major employer in your community and if so, what provisions can you make for such an event?

  • Is your business affected by the level of tax revenues collected by your local government – and how can you insulate your business from the impact?

  • If you’ve invested in municipal bonds or paper, how likely to default are those entities on those contracts as their investments turn sour?

This list can go on and on. Even if you believe you are on the right track, can you afford to sit still or do you need to be pro-active in managing your risk?

************* References ***************

  1. Logutenkova, E. (2008) Goldman, UBS, Deutsche, Morgan Stanley Lowered by S&P (Update3). Bloomberg Online, Dec. 19, 2008. Retrieved on Dec. 19, 2008 at http://www.bloomberg.com/apps/news?pid=20601100&sid=a9hZzgILSsqA&refer=germany.

  2. Victims of Scandal Reflect on Shocking Turnabout. December 20, 2008. Wall Street Journal Online. Retrieved on Dec. 20, 2008 at http://online.wsj.com/article/SB122972955226822819.html.

  3. Lattman, (2008) P. Cerberus Is Blocking Withdrawals. Wall Street Journal Online. December 23, 2008. Retrieved on Dec. 23, 2008 at http://online.wsj.com/article/SB123007849628231737.html.