FROM THE OFFICE OF PUBLIC AFFAIRS

As the nature of financial risks evolve, so must risk management.  Today I want to suggest two changes that risk managers should make to keep up with a new macroeconomic era.

 For the past five years, the source of the greatest variance between investment objectives and outcomes has been credit risk, not market risk.  The art and science of risk management grew up focused on market risk, but now needs to get back to the basics of credit risk.  Keeping a closer eye on credit risk demands a crisp understanding of firms’ creditworthiness.   But a risk manager who seeks the critical firm-level details of cash flow and real economic leverage in today’s capital markets will find they are too often absent.  As long as investors are in the dark about companies’ real, economic leverage, risk management threatens to remain less a science, less even an art, than a crap shoot.

The field of risk management bears the marks of coming into maturity during the past twenty-five or so years.  Its tools are attuned to the sharp swings in output and inflation expectations from the 1970s to the early 1990s.  The trick to making money in the debt markets was to anticipate corresponding changes in real and nominal interest rates: catching the turns from the negative real U.S. interest rates in the late 1970s, to the highly-volatile nominal and real rates of the 1980s, and to the low nominal rates of the early 1990s.   Risk managers for their part concentrated on stress-testing portfolios against outsized moves in interest and exchange rates.  It was good enough for your model, or your credit officer, to rely upon rules of thumb for credit spreads, for both corporate and sovereign debt, as long as you could hang on for the macroeconomic ride.

In a period of more stable output and prices, it becomes by definition less important to anticipate changes in macroeconomic conditions and more important to assess the credit standing of individual borrowers.  In this environment we have learned that investment risk is a little less about macroeconomics and a little more about microeconomics.

To take a micro example, we know that the real value of a firm is the present value of future unencumbered cash flow.  If the discount rate is volatile, differences in expected cash flows between two firms are almost background noise.  But if the discount rate is stable, differences in expected cash flow demand center stage – not just for equity investors, but for debt investors too.  Just investing in the energy sector is no longer good enough.  It actually matters whether the company you are investing in is Enron or Chevron.

In a world where credit matters, risk managers cannot be content with stress-testing portfolios against macroeconomic variables.  The transition to a world where credit matters has been an expensive education for some.  The strategies of the 1980s and early 1990s – of tracking indexes and trading off rule-of-thumb spread relationships – have been hard to shed.  We have grown accustomed to outsourcing vital judgments about credit quality to the rating agencies and, less obviously, to the indexes.  Reliance on indexing in particular has led us to a “herd mentality” of investing in which is better to fail together than make critical risk-and-reward judgments as individuals.  

We need to watch the risks specific to the companies in our portfolios.  Careful study of historical market prices will not provide us with a better understanding of credit quality.  We need to focus on basic elements of credit: leverage and cash flow. 

For a long time we have assumed that leverage was visible to anyone willing to dissect an annual report.  We now know better.  Going forward, users of financial information – yourselves included – are on notice to demand full disclosure of firms’ real economic leverage.

We need to explode the idea that the balance sheet remains a useful concept for measuring a firm’s true assets and liabilities.  We need to move beyond the false dichotomy between the balance sheet and the off-balance sheet.  You all know this with respect to your own firm.  Why do we continue, collectively, to pretend that we can make reasoned investment decisions about other firms without knowledge of their real, economic leverage?

As I look back over the last decade, I see a series of events all about inadequate disclosure and elevated leverage. 

In 1994, in the wake of the bond market sell off and Orange County, the hue and cry was about derivatives; keener-eyed critics knew it had more to do with inadequate disclosure and off-balance sheet leverage.
 In Asian crisis of 1997, whole countries were criticized for the purported failure of their economic model; some of us saw inadequate disclosure and off-balance sheet leverage run amok.  In 1998, anxieties focused on hedge funds; but the real issue was inadequate disclosure and excessive off-balance sheet leverage.  In my judgment, Enron also was more a story of inadequate disclosure of the real economic leverage via off-balance sheet devices.  Each of these was a credit event: a failure of other market participants to understand the amount of leverage employed – a confusion between leverage and real cash flow.

 Our capital markets need a measure of all the contractually-obligated liabilities, whether contingent or fixed, future or current.  We need a parallel measure of all the firm’s contractually obligated revenues.  Tying them together will give the firm’s contractually-obligated net present value – a true indicator of the firm’s leverage.  This is not an untested or novel idea.  The concept of NPV appears everywhere in modern finance except in financial reporting. 

Contractually-obligated NPV will in most cases be negative.  That’s the little secret of capitalism: it involves risk.  Disclosing the true leverage will focus investors’ attention on how companies plan to close the gap – how they plan to generate the cash flow needed to exceed net obligations.  I hope this attention will encourage firms to bring to life their Management Discussion and Analysis passages by providing the key indicators of business performance that management itself uses to judge expected cash flow. 

Why don’t more firms disclose this information?  Habit.  People are reluctant to change their ways.  Habit is the most underestimated variable in human behavior and, therefore, in finance and economics.  Firms claim that that they don’t want to aid competitors.  I don't buy it, at least not for most of their business indicators and nearly all financial measures.  Moreover, this claim simply reflects a value judgment that keeping secrets from competitors is more important than informing the owners – that investors are better off if they remain ignorant of what’s going on inside the companies that they own. 

Our publicly-traded capital markets cannot function on so faulty a foundation.  In the division of labor in our financial markets, too many have complacently accepted the status quo of corporate disclosure.  Too few have seen it as their responsibility to work systematically to improve the quality of information that investors receive.

I suggest that you as risk managers should not tolerate these practices.  You should demand that companies disclose this information in periodic disclosures.  In its absence, how can you rationally manage investment decisions, other than on the lottery-ticket theory of investing?