Why Wall Street Ignores Real Risk And Why History Will Repeat Itself

Econophile's picture

This article was originally published on The Daily Capitalist.

This week I attended and reported from the Milken Institute Global Conference in Beverly Hills. It was an excellent event with top panelists from the financial world.

My last session, and one of the more interesting ones at the conference, was, "New Risk Management Strategies."

The session was described as follows:

The market volatility of the past few years has given the financial services community an urgent new focus on risk management. From the home office to the end product, risk management is having a profound influence on the industry's structure as well as the solutions provided to clients. The institutionalization of risk management is resulting in the application of strategy mitigation tactics across the financial services spectrum. Major firms now look beyond diversification in favor of alternative investments and customized and structured solutions as the preferred tools for managing risk. In this panel, we will discuss how the major providers of wealth advice are not only implementing structural risk management practices at the firm level but also in their clients' portfolios.

The panelists were:

Jim Lenz, Chief Credit and Risk Officer, Wells Fargo Advisors

Jim Lenz is chief credit and risk officer at Wells Fargo Advisors and a member of its Executive Committee. He has held a number of positions in more than 25 years in the banking and capital markets industry.

John Moninger, Executive Vice President, Advisory and Brokerage Consulting Services, LPL Financial

John Moninger is executive vice president of advisory and brokerage consulting services for LPL Financial. He also leads the firm's wealth management services, providing advice and solutions to high-net-worth and ultra-high-net-worth clients.

David Morton, Chief Research Officer and Co-Chief Investment Officer, Foxhall Capital Management

David Morton is chief research officer and co-chief investment officer of Foxhall Capital Management, a global manager that uses exchange-traded funds to create separately managed accounts, mutual funds and variable insurance portfolios. He leads the research team.

Colbert Narcisse, Chief Operating Officer, Global Investment Strategies and Solutions Group, Morgan Stanley Smith Barney

Colbert Narcisse is a managing director and the chief operating officer of the Global Investment Strategy & Client Solutions Division at Morgan Stanley Smith Barney. Narcisse is responsible for asset manager relationships, business risk, marketing and strategic planning and analysis.

Moderator: Jon Najarian, Co-Founder, optionMonster.com (brother and partner of Pete Najarian, star of "Fast Money.")

I found the panel's approach to the subject to be disappointing; I was thinking I had walked into the wrong panel.In a post-2008 Black Swan world they, in my opinion, have done nothing to deal with investment risk, especially the kind of systemic investment risk that characterized the current bust. What they have done is to better protect themselves from risk (lawsuits).

I do not mean to characterize these impressive men as dullards. Far from it. As you can see they have all had illustrious careers in the financial world. That they have survived to 2011 is evidence of their ability. But they are risk experts and have responsibility for risk management in their firms. Other than Mr. Morton, none of them are analysts. None of them are economists. That is, they are oriented toward operations and sales. Many of them are multi-taskers and risk management is one of their functions. Most of their discussion related to the retail level of the investment business.

If I can summarize their improved risk management strategy, it would be as follows:

They employ investment strategies that are more tailored to specific client needs. They are more "anticipatory" of clients goals. Beyond diversification, they offer a broader range of investments including alternative investments, such as commodities and emerging markets. There is more focus on macro and world events in making investment decisions. This allows clients to have exposure to a broader range of markets and products. They are much more careful with the selection and due diligence investigation of products. Compensation of salespeople is less short-term based, focusing on a longer term relationship with the clients. They do a lot more training of their salespeople for products they sell.

That's about it. To be fair, I am probably oversimplifying things. If you wish to see the entire program, go here.

I didn't hear the word "Black Swan," but I did hear "Category (Sigma) 7" from one panelist which tells me he was still involved in pre-BLack Swan "Oldthink." I also didn't hear about challenging the analytical models still used despite their repeated failure (Efficient Market Theory, Cap M, Modern Portfolio Theory, Gaussian models, etc.).

At the end they opened it up to questions from the smallish audience and I was able to ask a question.

My question was, "I wish to play the Devil's Advocate and ask you a rather pointed question. [Some joking back and forth here.] If you had employed these new risk strategies before 2008, how do you think you would have come out?"

Two panelists took a crack at it. Here is their answer. This video was taken by me with my little hand-held Flipcam, so please bear with me. The first speaker is John Moninger of LPL. The second speaker is Colbert Narcisse of Morgan Stanley. It's bumpy at first but gets better. Play it at 720 and turn up the volume a bit. If you wish to see their video, see the above link and go to minute 66.

"We now know what to do." "Risk [management] in wealth management has always been very rigorous. If you look at litigation expense that number has gone down significantly between 2000 and 2008."

What they are saying is that they are doing a better job of limiting their risk/cost from customer claims, but they are doing little about systemic risk to protect their clients. I was under the impression that they were going to talk about the risk/exposure to their clients' wealth. These fellows are looking at it from the other side of the mirror: how can we effect strategies that limit our risk exposure to customers' claims. Now you would think that the best way to manage risk would be to do a better job of managing their customers' wealth. While they all say they do that, they aren't doing things much differently than pre-2008.

I am not sure litigation costs are a good measure of risk. A better measure would be how many customers bailed out of the stock market and didn't come back. It is no secret that the stock market customer base shrank substantially after the Crash. One panelist noted with some distaste that customers act on fear "regardless of the facts." Very true. But the fearful man might be acting quite rationally from his perspective. Bad outcomes tend to make investors gun shy.

One may ask why they aren't doing more to deal with systemic investment risk and the truth is that they don't know how to do that and therefore they focus on selling a broad range of products because ... that is how they make money. So let's put things in perspective. The retail guys are in the business of selling products. If they don't do that, they don't eat (I sold stock for two years). The salespeople's job is to sell what the company tells them to sell. I talked to a few of these guys at the conference and they can quite easily tell you the reasons why the market will do this or that, based on their firm's talking points. They were wrong about most things. But they meant well.

It means that for the wire houses, they are back to work as usual, selling product. They have tightened up their respective ships somewhat, but they are all looking at the world from inside the same box. But, it's still sell or die. It should be perform or die. Well, actually, the market does that for them doesn't it.

The more things change, the more they remain the same. And that means they will do the same things all over again.

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The Alarmist's picture

Risk management is the lie they tell the unwitting to think they have given some thought on how to protect the unwitting from the inevitable meltdown that must come from a system that is based on laying off risk on other parties and then "re-setting" the system so they can set it up for another round.

As I said above, Wall Street is a wholesaler of risk, so it is hardly in their interest to actually minimise it ... risk management means that they have given some thought on how to shunt it off on others, much like those giant culverts you see in the Alps or other mountain ranges to shunt avalanches off on the next poor schmuck below.


falak pema's picture

risk management in financial wealth management is very rigorous...Its true if you're an Oligarch. "If you own 100 Million...it's inevitable to go to 101 Million..." Now that is risk management mantra down to a button. Inevitable is key word...But if you want to go from zero to 1 million...it's inevitable that you'll lose...so that the guy with a 100 can go to 101..You lose from zero to -100 as you are owned for life! Wow, its so simple really risk management when the table is not level; when the roulette wheel doesn't pay you for zero number...it's inevitable you lose more the longer you stay at it!

Math is the only language that the Gods and the Oligarchs speak well!

twotraps's picture

Alarmist, well said.  I would add that a really sinister layer of complication comes from the fact that none if it is illegal per se.....due the extraordinary, heavy, complicated and constant lobbying pressure in Washington.  Look at the many players involved in the housing debacle, a bankers dream, no risk and not illegal, no one is held accountable for anything.  Perfect.  THAT is the ultimate example of spreading risk around for the extreme benefit of the few.   Not the change the subject, but what can we do about it?  What happens if the stock mkt 're-prices' like crude over the next month? 

chinaboy's picture

Not just risk managers. The market itself does not act on investment needs. Everything is a trade. Risk on you make money, risk off someone else makes money. In many cases, money is made within micro-second.

At this point, we ridicule risk management. In history, generations will ridicule us for the the crazy market we are trading up.

No one doubt it will happen again. The only thing is no one knows when.



The Alarmist's picture

The premise is totally bass-ackwards.  Wall Street does not ignore risk, Wall Street is a wholesaler of risk for parties who wittingly sell it to parties who wittingly or, more often than not, unwittingly buy it.  The beast cannot get enough risk to spread around to feed its enormous appetite, and so the blow-ups have been getting bigger and bigger in order to keep the beast fed. 

I would go so far as to say that Wall Street is no less than Shiva the Destroyer, except that (1)  no true karma Yogi would take credit for his acts, and (2) the destruction of Shiva ultimately makes way for some future good through recreation.


jm's picture

Bad risk management isn't exclusive to  finance.  I remember a month ago all kinds of nuclear engineers (they could be sanitation engineers for all we know) got on here spewing crap about how Fukushima was nothing.  Move along, let the experts handle it.  These "experts" are just as pathetic as financial "experts". Maybe more if Godzilla shows up and eats Tokyo, or some people over there get massive radiation problems.  

Finance is not all bad.  People can get returns.  Finance is about innovation, and it does this.  More people than ever before are able to get exposure to fixed income and commodities via ETFs.  Innovation isn't the problem. 

The problems are corruption and lack of enforcement.  Another deeper problem is that people and institutions at all levels are accustomed to blaming others and getting bailed out.  Responsibility is fading off into the sunset.   

I think this good article adequately captured the weird sociology that goes on in wealth management.  You shock and awe people by hiring very smart people to work on insoluble problems.  You wrap everything in a cloak of complicated jargon to impress.  You say everything is now under control.  If you believe this, you are a fool. 

Luck and bad luck dominate control.  Nobody has it all figured out.  Even when you figure something out, everything blows up in your face.  We'll never figure it all out.

Nobody can predict the future, and we don't have good enough imaginations to see every contingency.  Our Maker made us such that we don't handle non-linearity well at all.

As to risk management.  The intractible problem is liquidity.  Compensate its lack of solution with rules of thumb.  Buy cheap; cut your losses; diversify with a mix of fixed and floating cashflows; stay within your system.  Think of things that can go worng and use that to supplement historical.

Everything humans touch, make, and do is imperfect. 


Coldfire's picture


Risk [management] in wealth management [is] very rigorous.

That is simply, fucking absurd.

destiny's picture

This is why history repeats itself......



its actually quite long but those who have done their homwork will find here a clear and precise, nicely ordered synthesis to what is known to many.

Love and money's picture

Great reporting from sunny California.

Great comments.

Great link to House of Representatives true colors, as if we didn't already know....

Thank you, all.

Kickaha's picture

While people like to speak the phrase "systemic risk", I find it odd that nobody seems to expound on it.

Perhaps in doing so, you cannot avoid excoriating the system from which all milk and honey flows to the uberrich.

Investing requires a lot of hard work, part of which is a long-term commitment to personally managing the risks inherent in your investment.  With stock, after you invest in it, you have to participate in corporate governance to try as best you can to insure that your investment does not go awry.

A securities trader goes a different route.  He pretty much has to, since profits hinge not upon any particular knowledge of the underlying investment, but in acting immediately and just before everybody else when his TA pinpoints a bottom or a top.  The strategy to prevent risk is to buy a derivative as a hedge

There is always somebody willing to sell a derivative.  It's like printing money, and the income statement for the current quarter looks great, especially if the accounting model is one which doesn't require the creation of a loss reserve just in case the insurer has to pay out on that policy at some point in the future.

Buying a derivative to hedge a risk does not cancel the risk.  It is, instead a transfer of the  risk.  The trader feels comfortable leverage himself to the hilt and trading continuously, since his risks are limited due to hedging.  But the system takes on increasing amounts of risk via that hedging.  Totalling up the value of outstanding derivatives is a good measure of the systemic risk.  What is that number these days?  I think I read it is something higher than some multiple of world GDP?

You cannot address "systemic risk" without attacking the entire trading structure and the selling of derivatives. 

That is why nobody addresses it.  The sellers of the derivatives want no regulation, no transparancy, because they understand perfectly their role in pocketing instant present day profits by creating and selling insurance policies which give the illusion of limiting the personal risk of the trader/buyers.  It is an illusion, because the insurance sellers are frauds having no loss reserves created to cover possible losses. 

I imagine that supporters of the system readily rationalize that "hedges offset each other" and the risks are really statistically insignificant even if the amounts insured are bigger than the entire financial universe.

But to expect anybody in finance to seriously address "systemic risk" would require them to rethink the entire present day trading culture on Wall St.  Or come up with a political solution such as treating the US Treasury and the Fed as their pool of loss reserves.

Certainly, it can happen again, as long as traders are allowed to hedge their risks via derivatives in a financial world where undercapitalized players can sell insurance without adequate loss reserves.


Urban Redneck's picture

I think some of the problem with institutions' risk management structures is that they are solely concerned with financial risk and they always take a quantitative approach to addressing the risk, which leads to either ignorance of systemic risk or really ugly math equations.  That they would recommend  emerging markets as a risk mitigation strategy is strange and makes me question their actual risk mitigation skills, since one of the primary risk management concerns in undeveloped and emerging markets is managing non-financial risks (such as expropriation, civil unrest, natural disaster, unreliable public services, et al.)   

williambanzai7's picture

Thanks for this. I have thought about this on many occasions. But bringing it up at the Milken event is a nice touch indeed.

It is all about contingent liability tefloning.

I am a Man I am Forty's picture

financial institutions make a living screwing over their customers so their biggest concern is how to avoid losing lawsuits when they get sued

boiltherich's picture

Why Wall Street Ignores Real Risk And Why History Will Repeat Itself

As long as there is a federal reserve and politicians for hire there will be no risk.  REAL RISK?  Risk is risk, there is no such thing as real risk.  There will always be two sets of FASB accounting rules, there will always be too big to fail and those like me will always have a lower standard of living than last month or year.  There will always be preferential tax laws and enforcement for those with something to tax, there will always be two definitions of fraud, there will always be a class war. 

One day soon those of us not in the investor class will give a very VERY nasty shock to those with positive net worth, both of you, so do enjoy your toys and puff up your pretty little egos now, you will not have them much longer.

InfiniteHedge's picture

Systemic risk?

Gold. Cash. Land. Lead. Prayer.

Hmmm. No commissions.

AccreditedEYE's picture

Alternative Investments & Emerging Markets? That's sooo post financial crisis version I. Capital is moving away from massive, collective institutional control. The Squid fears this...

sangell's picture

Interesting post and good question. I came across a Saturday Evening Post from 1912. Old magazines are very interesting for a lot of reasons, not least because they are time capsules. The ads in particular. One I recall was from the American Gas Association or something like that. Gas lighting was under tremendous pressure at the time from the 'high tech' industry of the day, electricity. The gas guys were selling yesterday, a stable Victorian world that was about to be vaporized by technology and WW1. They sensed it and to use a more recent cliche they sought to minimize 'cognitive dissonance' as other ads in that ancient magazine were extolling new fangled gadgets like El Toasto, electric lamps and vacuum cleaners and other expensive electric appliances. That toaster and lamp were, as I recall about $12 bucks. A lot of money back then but... if you still had one today, it would probably still work.

BTW the I found the magazines in the attic of the house I was living in and it still retained the old gas lighting fixtures on the walls though some had been converted to electric screw in bulb fixtures.

We are in a similiar, transitional era. Your panelists were guys stuck in 1912. It is the world they know and are comfortable with. It pays them well. That it may be as obsolete as gas lighting is something they would refuse to see even if they saw it.

DarthVaderMentor's picture

Well said Sangell. A con man will keep running the same con they know and love until either they run out of sheep to fleece or they go to jail.

Rainman's picture

It is true of all Ponzis.....keep selling or die.

tom a taxpayer's picture

"We don't need no stinkin' risk management. We have Brother Ben, Cousin Timmy, Uncle Sap, Godfather Hank Paulson, and millions of taxpayers to pay us win or lose."

Manthong's picture

Yes, but do not forget the spiritual enlightenment of Maharishi Madoff.

Thorny Xi's picture

The Michael Milken Institute ... how appropriate. 

But hey, at least he did some time playing golf at Eglin's minimum security "prison" after he robbed his clients.

SloSquez's picture

Uh, excuse you.  Michael Milken was a "financial innovator" of the highest order.  Shame on you for pointing out there is no difference.

victor82's picture

And, I should add, he had a wonderfully shaped piece of furniture in his main trading office back in his Salad days.

There really was an "X-Desk".

Peons! How dare you bring into question the tastes of your Bankster Masters!

tony bonn's picture

"in my opinion, have done nothing to deal with investment risk"

of course not.....they were bailed out and enriched from the economic implosion....nothing has changed except that the hubris and arrogance is only larger.....but we know exactly what follows such arrogance...

JW n FL's picture

Leverage? 0.04% skin in the game you say? v. 0.4% which still sucks you say?

how dare you cut into the bonus pool of monies, they are not making loans.. they have to show income some way! why not leverage the shit out of the cash already on hand! YAY!


****** "Who has an incentive to increase debt relative to equity in really big ways? Again, it’s the largest banks. The executives in these companies are paid based on their return on equity -- and the easiest way to increase that is to add leverage. Of course, this increases returns only when times are good. It also increases the potential losses when markets tumble. In other words, greater leverage increases risk." ******




Investment Bankers’ Culture of Ownership?

Sanjai Bhagat
University of Colorado at Boulder - Department of Finance

Brian J. Bolton
University of New Hampshire

August 24, 2010

We study the executive compensation structure in the largest 14 U.S. financial institutions during 2000-2008. Our results are mostly consistent with and supportive of the findings of Bebchuk, Cohen and Spamann (2010), that is, managerial incentives matter - incentives generated by executive compensation programs led to excessive risk-taking by banks leading to the current financial crisis. Also, our results are generally not supportive of the conclusions of Fahlenbrach and Stulz (2009) that the poor performance of banks during the crisis was the result of unforeseen risk.



But hey! why not RISK! MORE!!

****** "Dimon also wants JPMorgan to become more global, especially by expanding more into emerging markets. U.S. Treasury Secretary Timothy Geithner endorsed this approach in an interview he gave to the New Republic, effectively arguing that we should want big, highly leveraged U.S. banks to make large bets on highly volatile emerging markets." ******




RockyRacoon's picture

No risk unless the person whose money you are playing with demands normal fiduciary behaviour and honest dealing -- and wants the money back.

tawdzilla's picture

Risk management???  They have no risk!  What is there to manage??

SloSquez's picture

Exactly, there is no risk for these types. 

JW n FL's picture
Republican-controlled committee voted for a 18-month delay of regulations intended to reduce risk in OTC derivatives.
rocker's picture

They are still blowing on the bubble.  Robo is sucking it in. LOL    Way too frothy now.