Against the Gods: The Remarkable Story of Risk (63 page)

Procter & Gamble, as described by Carol Loomis, a reporter for
Fortune magazine, was being "chewed up [during 1994] by derivatives
that incorporated astounding leverage and confounding complexity."
These derivatives also were created by Bankers Trust, whose full-page
ads in business and financial publications proclaimed, "Risk wears many
disguises. Helping you see beneath its surface is the strength of Bankers
Trust."

Procter & Gamble's management dutifully followed Gibson in acting out prospect theory. Whether Raymond Mains, the corporate treasurer, was doing a good job was not determined by the absolute level
of interest rates that the company paid to borrow money; the company
judged his performance on a what-have-you-done-for-us-lately basis.
In other words, they looked only at how much less Mains was paying
compared with what money had cost them the year before. The heat in
that oven was hot. In a sarcastic comment on the company's disaster,
Nobel Laureate Merton Miller joked, "You know Procter & Gamble?
Procter is the widow and Gamble is the orphan."

The deal that triggered all the trouble was extremely complicated in
detail-fun in the negotiating, like analyzing a case at Harvard Business
School. It was signed in the fall of 1993, following four years in which
short-term interest rates declined almost without interruption from
about 10% to less than 3%; the deal revealed P&G's belief that, after such
an extended decline, a significant increase in interest rates was so unlikely as to be impossible. Clearly, nobody in the executive offices had read Galton-regression to the mean appears to have been unknown to them.

They bet the ranch on what would have been no more than a modest saving if interest rates had remained stable or had fallen further. The deal involved a notional amount of $200 million in the form of a five-year loan from Bankers to P&G, but the maximum interest saving to the company compared with what it would have paid in a straight commercial-paper borrowing would have been $7.5 million over the life of the loan. According to the Fortune article, if things went wrong instead of right-if interest rates rose instead of continuing to fall-the exposure would put the company into the position of "covering the risks of interest rate earthquakes."

On February 4, 1994, only four months after the deal was signed, the Federal Reserve startled the markets by raising short-term interest rates. As Loomis reported, "With remarkable fury, these quakes then occurred." It is obvious that the P&G executives had never heard of Kahneman and Tversky either, for on February 14, already showing losses, the company entered into yet another contract, this one for $94 million over years, that had them betting once again that interest rates would fall.

Interest rates did not fall. The interest rate on commercial paper had climbed from 3 1/4% in February to 6 1/2% in December while the prime rate moved from 6% to 8 1/2%. It was a catastrophe for P&G. Under the initial contract, they were left with a commitment to pay Bankers Trust 14 1/2 percentage points in interest until late 1998 and, under the second contract, to pay 16.4 percentage points in interest over the same period.

Bankers Trust is being sued here, too, and has received no payments from P&G at this writing. Mr. Mains is no longer with the company.

What are we to make of all this? Are derivatives a suicidal invention of the devil or the last word in risk management?*
Bad enough that fine companies like Procter & Gamble and Gibson Greetings can get into
trouble, but is the entire financial system at risk because so many people are trying to shed risks and slough them off onto someone else?
How well can the someone else manage that responsibility? In a more
fundamental sense, as the twentieth century draws to a close, what does
the immense popularity of derivatives tell us about society's view of risk
and the uncertain future that lies ahead? I shall postpone my response
to that last question to the next, and final, chapter.

James Morgan, a columnist for the Financial Times, once remarked,
"A derivative is like a razor. You can use it to shave yourself.... Or
you can use it to commit suicide."10 Users of derivatives have that
choice. They do not have to use derivatives to commit suicide.

Precisely who persuaded whom to do what in the case of Procter
& Gamble and the other companies remains obscure, but the cause of
the disasters is clear enough: they took the risk of volatility instead of
hedging it. They made the stability of their cash flows, and thereby
the integrity of their long-term future, hostages to the accuracy of
their interest-rate forecasts. While Bankers Trust and the other dealers in derivatives were managing their books on the basis of Pascal's
Triangle, Gauss's bell curves, and Markowitz's covariances, the corporate risk-takers were relying on Keynesian degrees of belief. This
was not the place to bet the corporate ranch or to act out failures of
invariance.

Speculators who think they know what the future holds always
risk being wrong and losing out. The long history of finance is cluttered with stories of fortunes lost on big bets. No one needed derivatives in order to go broke in a hurry. No one need go broke any faster
just because derivatives have become a widely used financial instrument in our times. The instrument is the messenger; the investor is the
message.

The losses at a few corporations in 1994 made banner headlines but
posed no threat to anyone else. But suppose the errors had run in the
other direction-that is, suppose the corporation had had huge winnings instead of losses. Would the counterparties to these transactions
have been able to pay? The counterparties to most of the big tailormade derivatives contracts are major money-center banks and top-tier
investment bankers and insurance companies. The big players all made a lot less money in 1994, the year of surprises, than they had made in 1993, but none of them was at any point in trouble. Bankers Trust, for example, reported that losses "were all within our capital limits and we knew the extent of our exposures all the time.... The risk control processes worked fine."

The financial solvency of these institutions supports the financial solvency of the world economic system itself. Every single day, they are involved in millions of transactions involving trillions of dollars in a complex set of arrangements whose smooth functioning is essential. The margin for error is miniscule. Poor controls over the size and diversification of exposures are intolerable when the underlying volatility of the derivatives is so high and when so much is at stake beyond the fortunes of any single institution.

Everyone is aware of the dangers inherent in this situation, from the management of each institution on up to the governmental regulatory agencies that supervise the system. So-called "systemic risk" has become a parlor word in those circles and is the focus of attention at central banks and ministries of finance around the world. The measurement of the overall risk exposure in the system has been progressing in both comprehensiveness and sophistication.*

But there is only a fine line between guaranteeing absolute safety and stifling the development of financial innovations that, properly handled, could reduce the volatility of corporate cash flows. Corporations that shelter their cash flows from volatility can afford to take greater internal risks in the form of higher levels of investment or expenditures on research and development. Financial institutions themselves are vulnerable to volatility in interest rates and exchange rates; to the extent that they can hedge that volatility, they can extend more credit to a wider universe of deserving borrowers.

Society stands to benefit from such an environment. In November
1994, Alan Greenspan, Chairman of the Federal Reserve Board,
declared:

There are some who would argue that the role of the bank supervisor is to minimize or even eliminate bank failure; but this view is mistaken, in my judgment. The willingness to take risk is essential to the
growth of a free market economy.... [I]f all savers and their financial intermediaries invested only in risk-free assets, the potential for
business growth would never be realized."

he great statistician Maurice Kendall once wrote, "Humanity
did not take control of society out of the realm of Divine
Providence ... to put it at the mercy of the laws of chance."'
As we look ahead toward the new millennium, what are the prospects
that we can finish that job, that we can hope to bring more risks under
control and make progress at the same time?

The answer must focus on Leibniz's admonition of 1703, which is
as pertinent today as it was when he sent it off to Jacob Bernoulli:
"Nature has established patterns originating in the return of events, but
only for the most part." As I pointed out in the Introduction, that
qualification is the key to the whole story. Without it, there would be
no risk, for everything would be predictable. Without it, there would
be no change, for every event would be identical to a previous event.
Without it, life would have no mystery.

The effort to comprehend the meaning of nature's tendency to
repeat itself, but only imperfectly, is what motivated the heroes of this
book. But despite the many ingenious tools they created to attack the
puzzle, much remains unsolved. Discontinuities, irregularities, and
volatilities seem to be proliferating rather than diminishing. In the
world of finance, new instruments turn up at a bewildering pace, new
markets are growing faster than old markets, and global interdependence makes risk management increasingly complex. Economic insecurity, especially in the job market, makes daily headlines. The environment, health, personal safety, and even the planet Earth itself
appear to be under attack from enemies never before encountered.

The goal of wresting society from the mercy of the laws of chance
continues to elude us. Why?