The Magic Number

 
 

The financial world will see more crisis situations in the future, not fewer. Many factors make this likely, chief among them being the increasingly interconnected nature of the business world, the development of faster and broader technology, and the growing complexity of financial arrangements.

If more crises are on the way, it is vitally important to build mechanisms that will function in crisis situations. Recent events suggest that those mechanisms are not yet in place.

The Role of Uncertainty

Analysis of financial emergencies in the last three decades shows that uncertainty can make the difference between a manageable problem and a full-blown crisis. As an example, the collapse of hedge fund Long-Term Capital Management in 1998 was controlled largely because the extent of the firm’s commitments could be sufficiently determined. In contrast, efforts to save Barings Bank in 1995 failed in part because the full ramifications of the bank’s exposure could not be established.

More recently, the sub-prime mortgage and credit default swap disaster demonstrated the role that uncertainty can play in a crisis. Standard financial metrics relying on historical data or market-based estimates proved of little value when events bucked historical trends and markets seized up. Irresponsible lending practices, deficient government oversight, unreliable ratings analysis and a host of other errors caused the mortgage default rate to skyrocket. Uncertainty regarding sub-prime mortgage bonds quickly spread to the rest of the industry, paralyzing the market just when valuation of the bonds became critical. The crisis reached such proportions that entities with little or no involvement in the mortgage business were threatened by the spread of this uncertainty.

While metrics based on historical data and market valuations are useful under normal operating conditions, they can become irrelevant in a crisis situation. What is needed instead is a reliable, hard-number maximum value that answers the question, “How bad can this get?”

Once that question is answered, the crisis can be contained and addressed. Certainty concerning the dimensions of the issue at hand can arrest liquidity-killing panic and get frozen markets moving again. Certainty can spell the difference between a disruption and a crisis.

The hard-number value I recommend is called “maximum loss value” (MLV). It contains no market-dependent or estimated components. It is calculated during normal operations, does not change during a crisis and can quantify the worst-case scenario.

The Maximum Loss Value

Just as it sounds, the maximum loss value is the total amount at risk in a financial arrangement. It represents the worst-case scenario, and therefore has a close association with traditional capping mechanisms. It does not rely on historical data or market valuation, so it will not change during a crisis. It differs greatly from most exposure calculations because it contains no “potential” or “probable” values, and it lacks those components because it is a crisis number. Its primary purpose is to function when the other numbers do not.

The concept of maximum loss value is not new. Many financial arrangements self-create this number; for example, a lender’s MLV for a fixed-rate loan is the amount (both principal and interest) still owed to the lender. Many financial agreements set upper boundaries for variables such as floating interest rates, and there are numerous products designed to limit what would otherwise be open-ended risk.

Financial arrangements with open-ended exposures will benefit significantly from the establishment of a maximum loss value. The effort to assign a MLV to every deal will identify these dangerous arrangements, and then some form of capping must be put in place before a meaningful MLV can be generated. This capping can be a mutually beneficial mechanism worked into the agreement covering the arrangement, a product purchased to set that limit, or something entirely new. This last instance will probably apply to highly complex arrangements with values that can shift radically, so capping them will require some ingenuity. Serious consideration should be given to exiting any arrangement that is so arcane that its managers insist it cannot be capped.

Remember that the purpose of the maximum loss value is to create certainty in a crisis: it must be able to answer the question, “How bad can this get?”

Maximum Loss Value Under Normal Circumstances

Although the MLV is a crisis number, it does have application when business is functioning normally. The assignment of the maximum loss value should go all the way down to transaction level, allowing for analysis in different aggregations.

Just like any other yardstick, these MLV groupings can then be analyzed for dangerous concentrations, unusual shifts and deteriorating creditworthiness. While some of these aggregations will no doubt be quite large, that should elicit even more examination-not less. After all, one of the biggest lessons from the recent meltdown is the need to scrutinize large concentrations of presumably “safe” exposure. Instead of “too big to fail,” perhaps the lesson from the 2008 crisis should be “too big to ignore.”

In addition to rigorous analysis, there are many ways to address an oversized MLV. The use of traditional capping mechanisms has already been mentioned as an important tool in this effort. Other existing techniques such as collateralization and hedging have their place in managing the MLV once it is established, but with the caveat that both collateralization and hedging can be subject to disruption in a crisis.

The true value of collateral is often learned when it is taken or liquidated — and the current glut of forfeited homes is ample proof that the estimated value of collateral can be very different from its crisis value. Likewise, many hedging devices can be affected by the disrupted markets the MLV is designed to avoid. With that said, an “adjusted” maximum loss value reflecting the effects of collateralization and hedging is acceptable as long as it does not take the place of the true MLV.

Maximum Loss Value During Crisis

While the MLV has an application under normal business conditions, its true service lies in a crisis or in the run-up to a crisis. Instability can arise anywhere, from geographic regions to individual products, and the MLV can help determine the extent of the problem. Few crises occur without the observation that “this has never happened before.” Thus, historically based calculations often prove useless. As uncertainty regarding a corporation, region or product begins to spread, liquidity flees the endangered part of the market and often takes the utility of market-based numbers with it.

Enter the maximum loss value. In a crisis, aggregating the MLV of the emerging threat will serve two purposes: It can demonstrate which entities, regions and markets are not directly threatened by the problem at hand, and it can establish the extent of the danger in those affected. The latter case might appear to be a death sentence at first, but, in fact, it is the first step in resolving the crisis. Only after the full nature of the emerging threat is understood can its resolution begin. And while that resolution is being assembled, panic can be reduced through the reliable determination of the problem’s scope and nature.

One of the biggest hurdles of the 2008 financial meltdown was the argument over the scope and nature of the problem. The measurement tools cited at that time often generated increased uncertainty — and even suspicion — as the largest entities involved in the crisis argued over the numbers. A commitment to the creation of an MLV framework should, over time, build a mutually understood mechanism for determining the extent of a crisis.

Advantages and Benefits of the Maximum Loss Value Approach

In addition to the establishment of a reliable number designed to create certainty and kill panic, the maximum loss value has other advantages and benefits. This approach leverages existing techniques and mechanisms, proposes no requirement for pooled emergency funds or increased reserves, and limits extra expenditures if the additional capping mechanisms are worked into agreements instead of purchased outright. While the MLV calculation can be applied by almost anyone to just about any financial dealing, its greatest benefit is for financial institutions and businesses that are financial institutions in everything but name.

Confidence in the world’s financial institutions has been badly shaken, so it would be encouraging to see those entities take the lead in preparing for the next crisis before it develops. An excellent starting point would be the aforementioned agreements-based cap, which would be an innovative and cost-effective means of limiting exposure. If even one financial institution took the initiative and started exploring methods for writing mutually beneficial capping mechanisms into agreements, others would soon follow suit. This would in turn contribute to the establishment of an MLV structure across the financial world, one which would function even more effectively in a crisis because it is fully understood by everyone involved.

Create Genuine Certainty

While exposure numbers based in historical data and market valuations have great utility under normal operating circumstances, a disruption can render them useless. The uncertainty that arises from the inability to answer the question, “How bad can this get?” can cause the disruption to grow toward crisis levels, as needed liquidity flees the endangered area.

Building a hard-number maximum loss value, understood across the financial world and unchanging in the face of a crisis, will help end the uncertainty and establish the extent of the problem. With the true scope of the issue identified, efforts to correct the situation can go forward while liquidity lost to uncertainty returns. These practices could eventually lead to the establishment of an MLV framework involving most of the world’s financial institutions. That framework could, in turn, help identify issues before they become serious problems and avoid a crisis before it has the chance to even get started.

 
Vincent H. O'Neil

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About the Author

Vincent H. O'Neil has been a risk manager in the public and private sectors for 30 years and now works as a risk consultant, writer and public speaker.

 
 
 

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