Do you think the Euro will still be around in 5 years?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Perhaps “in its current form” should be added to that.  For any corporate treasurer, this is an important question and should encourage them to re-examine their currency exposures and hedging practices.  (Exposures may include hidden exposures like imported components in goods bought from domestic suppliers for example.)  The effects of a Euro break up, or of a change in its form may well be felt much more and further afield than most people might realize.  An independent analysis and view might be appropriate for many businesses.  Whatever your view, this should be on the radar as high risk.

 

Too little too late has characterized all or most actions during the current crisis.  Denial, prevarication and changing positions have also been in plentiful evidence.  Of course, it is politicians of various different stripes and different nationalities and cultures that are trying to find a common solution to the problem.  Not necessarily the recipe for a timely, practical and effective solution.  The main player, Angela Merkel, has been trying to keep domestic political balls in the air during all this and that appears to have precluded swift and decisive action. 

 

Of course it could be argued that without going to the brink, countries like Italy will not institute any truly effective reforms.  On the other hand, the longer it takes to come to a satisfactory solution, the higher the cost is likely to be and the higher the risk that the house of cards will come crashing down.

 

There seems to be an intent to maintain the Eurozone in its current form.  However, when going close to the brink, events can get out of control and unintended consequences come about.  (Look back in history to how the First World War started.)

 

 

Next: Do I think the Euro will still be around in 5 years?

Confronting and Managing Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The recent confrontation between Greece and EU officials provide a good lesson for risk managers.  EU officials continue to minimize potential risks, fail to take realize their magnitude and communicate the problems, and take the necessary steps to remedy the situation.  These are all symptoms of a failure of risk management.  

 

Greek Prime Minister Papandreou made a stand, against the proposed Greek debt restructuring, and even though he was forced to backpedal, Wyplosz argues that he did the Eurozone a favor by providing it an opportunity to change course.  The Greek government has largely been following the dictates of EU officials to not restructure their debt, but this might have been the least costly remedy if done in a timely manner.  

 

The Greek revolt, even if short lived, is good news on the European crisis front – it might provoke the long-awaited policy turnaround that is necessary to end the Eurozone crisis.  It may finally awaken Eurozone leaders to the futility of the path they’ve chosen.  One way or another, a disorderly Greek default is in the cards with its attendant contagion for all of the rest of the PIIGS (Portugal, Ireland, Italy, and Spain) and maybe even France.  The cost of a default could be much larger than delaying the inevitable Greek restructuring.

 

Dazed and Confused?  Eurozone officials took the wrong path in early 2010, because they did not fundamentally understand the nature and depth of the problem.  Perhaps, they did not want to deal with it and brazenly assumed things would revert back to normal.  However, the seriousness of the surging debt and slow growth revealed all the flaws hidden in the euro’s first ten years.  There is a cost for their negligence. 

 

At that point a real solution is inevitable – one that requires Eurozone leaders and the ECB to play on the same side with credible rules for all.  An ECB backstop for Eurozone bonds will be required, but this does not mean underwriting banks and sovereigns. The ECB guarantee should be set to protect the ECB and to force a debt restructuring for countries that face unbearably high interest rates. 

 

Banks will have to be bailed out, possibly with EFSF resources, but in a way that minimizes moral hazard and maximizes taxpayer protection.  That means wiping out shareholders and, if need be, unsecured bondholders.  The cost of the bailout could reach into the hundreds of billions and does not include recapitalizing financial institutions.  A long-term cost is the sustained period of sub-trend growth resulting from the overhang.

 

Can we learn anything for risk management?

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/7222

Eurozone Risk Identification & Mitigation

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Eurozone policymakers and politicians continue to ignore the growing risks to the euro and the failure to take appropriate action to address these risks.  They continue to view recent developments as a temporary liquidity crisis instead of a solvency issue.  They commit all the classic failures of risk management outlined by Rene Stulz in a recent article in the Journal of Corporate Finance (2008).  A proposed outline on VOXEU identifies some of the methods how the Euro crisis can be addressed. 

The Eurozone crisis has taken a turn for the worst.  A group of German economists from the “German Council of Economic Experts” have proposed a temporary program to stabilize financial markets by creating two temporary entities: the European Redemption Pact and the European Redemption Fund. 

This involves the creation of a joint debt vehicle with a finite maturity date.  The objective is to ease temporary market dislocations and mandate the implementation of credible fiscal reforms for all Eurozone members.  This program would combine two elements: accounting and solidarity.  Accounting requires member countries to consolidate public debt and eventually reduce debt levels toward more sustainable levels.  Solidarity requires assistance from stronger members to weaker partners, but encourages fiscal discipline. 

The European Redemption Pact is based on a revised Growth & Stability Pact that combines joint and several liabilities and a strong commitment to push countries toward a 60% debt-to-GDP ratio.  The point is to separate the accumulated debt of member countries into a part that is compatible with a 60% debt threshold and a part that exceeds this limit.     Participants can refinance themselves through a joint European Redemption Fund (ERF) until the debt refinanced reaches the 60% debt threshold.  Participants in the program would be jointly liable, but each country is required to service its own debt financed through the ERF. 

The advantage of the program is its limited duration and the strong strings attached for participation (tax provisions, collateral & redemption guidance).  Another advantage of the program is a market rate for weaker members and for stronger member’s avoidance of a potential messy default.

The classic failures of risk management include using the appropriate metrics, measuring known risks, accounting for all risks, failure to communicate and failure to monitor and manage.  Can we learn something from events in Europe?

For more on the article A European Redemption Pact, please follow the link: http://www.voxeu.org/index.php?q=node/7253

Who is Risk’s Steve Jobs

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

We all already miss Steve Jobs.  In fact it may be argued we miss him too much as media articles are asking if we are making him a saint.  That is another issue for another time as far as I am concerned.

 

My question is “Who is Risk’s Steve Jobs?”  Who is the individual who has had the force of character to change the risk industry?  Who has created a paradigm shift in risk products and services?  Most interestingly, what risk manager has been a massive failure and let go rather unceremoniously from their own company, to only come back and have an even greater triumph?

Risk Sim

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Everyone who has been to business school is familiar with business simulations.  These computer models simulate economic conditions and the competitive environment of one industry or another.  You spend the weekend, or time during an offsite competing against either the computer, or your peers to see who can run the most successful company according to the simulation.

 

Business simulations are fun, and students and training participants enjoy them up to a point.  Simulations attempt to get participants to learn how to juggle the multitude of factors that affect the outcomes of business decisions. 

 

Business simulations function by taking a set of rules, and correlations between rules and create outcomes based on the participant’s decisions. They are based on a set of assumed cause and effect relationships. If a simulation is played for too long of a period of time (or too many rounds), then it has been my experience that participants start to focus on reverse engineering the simulation, rather than thinking about making good decisions.

 

This raises an interesting question; “Can we create a risk management simulation?”  In other words, can we create a realistic simulation that allows a risk manager to develop their skill at making risk based decisions?  Are there a set of well known rules and correlations – cause and effect mechanisms, that will allow the construction of such a simulation?

Italy – Credibility or Fundamentals

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Credit default swaps for Italy have surged over the last few weeks as the Italian government of Silvio Berlusconi seems to be occupied elsewhere.

In the Voxeu article Credibility is not everything, Paolo Manasse notes that many analysts have argued that the Eurozone emergency meetings could restore creditability if they came out with an all encompassing program.  However, this may not work in Italy where the problem is not credibility, but continued deterioration of the fundamentals.

For Italy, self-fulfilling prophecies may generate opposite and unpredictable outcomes for the same level of fundamentals.  This can result multiple equilibria such as a favorable debt/GDP and primary balance depending on market expectations which may suggest solvency or insolvency depending on prevailing market view. 

The favorable prospects of Italy joining the euro and reducing currency risk allowed the average cost of debt to drop from 10% to 4% in 1996 and the interest bill declined from 12% to 4% of GDP.  This allowed for a significant improvement of the budget and a strong reduction of the debt ratio.  However, this progress was squandered due to a deterioration of fundamentals since 2004.  The debt to GDP level is now back to 1996 levels and the primary balance is near negative territory.  It is only a matter of time before market rates move higher on worsening fundamentals.

The market gave too little consideration to fundamentals such as the debt/GDP ratio and primary surplus, assuming that Italy’s default and possible exit from the euro was inconceivable.  If you look at history, bond yields could return to levels last seen in 1996.  The prospect of Mr. Berlusconi resignation is necessary at this point, however, it is hardly a substitute for taking decisive action for fiscal adjustment.

Italy provides a good lesson for risk management.  Risks can return when we least expect them and the risk manager cannot get distracted from their primary job –managing risk. 

For more on this story follow the link:  http://www.voxeu.org/index.php?q=node/7187

1952

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

 

One of my guilty pleasures is going through old magazines – particularly old business magazines from the 50’s and 60’s.  It is a very useful exercise in that you frequently observe that the factors and practices that made companies successful 50 and 60 years ago are the same factors or practices that make them successful today.  In essence there are a set of best business practices that are timeless.

 

This raises an interesting, and perhaps troubling point.  What risk practices are timeless?  What risk practices that we currently utilize would have also been considered to be best risk practice in the 1950’s?  What risk practices from the 1950’s are still considered to be best risk practices?  What risk practices from today will be considered best risk practice in 2060?