Foreclosures

I have been more curious about the current situation with the mortgage crisis and foreclosures. On the news the financial situation of the Octomom has been discussed. She had sextuplets first and just recently had octuplets. She has no job, lives with her parents, and received insemination from her insurance company and there is even speculation of her receiving plastic surgery. Where does she get the money to pay for these large expenses? It was recently discovered that their house is being foreclosed on. She has been going on the web requesting money and a bailout. This situation can relate to my discussion on the frivolous use of government aid. Our taxes are going to go to pay for this woman’s home, when she could probably pay for it herself if she wasn’t so careless. She should not have had 14 kids knowing she could not afford them. Also, no one should have given her the insemination knowing she could not afford it or the cost of the children once born. She also had plastic surgery and gets periodic manicures with money she doesn’t have. I think these situations are the ones that frustrate taxpayers the most. Our money goes to pay for people who are not planning financially. This website gives information on the Octomom foreclosure.


http://www.tmz.com/2009/02/18/octomom-nadya-suleman-foreclosure/

I think more people should be educated on the proper way to handle finances. People need to learn to save. This is one reason Social Security is having trouble being eliminated. People do not know how to save on their own. More classes on financial planning should be required, and they should be required in schools before the legal drop out age of 16. Here is a link to Morningstar.com where you can learn about stocks, bonds, and investments.

http://www.morningstar.com/Cover/classroom.html

My grandmother and I had a discussion about the massive amount of foreclosures and how taxpayer’s money would be going to assist people with their mortgages. After hearing this story, the plan of assistance makes me angry. However, from another point of view, the banks holding the houses and the houses depreciating rapidly in value as they are not being cared for does not help the system either. Helping people get financially stable should be priority but you can’t just give needy people stuff for free when there is a lesson to be learned. People will think that when times get tough, someone will just bail them out. Financial education is necessary for the economy to improve. People keep blaming risk management strategies, but what about individuals who don’t exactly hire a risk manager? As individuals, we still have to manage our risk, and financial knowledge is a start.

Diversification

Diversification is a risk management strategy to hedge against risk. To protect from risky investments, investors diversify their portfolios. Not everyone has well diversified portfolios. Professor Grace mentioned in class that the state of Georgia does not allow itself to be sued because it is well and perfectly diversified. This statement was made in a sarcastic tone I might add. The majority of people do not have well diversified portfolios, which refutes one of the assumptions of the Capital Asset Pricing Model. Most people have all their money invested in one large asset, such as their home. However, some businesses and some rare people with sound financial and RMI knowledge can have well diversified portfolios. We watched a video from the Morningstar website about proper diversification. The advice was to invest in about 15 securities. You invest in some risky and some stable to neutralize your risk and maximize your returns.

Some people also diversify more with an active management strategy. They are constantly trading securities when risks increase and decrease. However, I have learned that a passive strategy is more efficient. You would think, why would you sit aside and do nothing to encourage your investments? I have learned that an active strategy is difficult and more expensive. I do not have the time to sit around and actively watch my stock and trade it at anytime. Also, it has been found that passive gain is no less than the average active gain once you account for the large number of transaction costs with each extra trade. The passive managers can get a free ride on the active managers. Diversification and managing your securities is beneficial to your investments. If you feel you do not know enough information about investing or your finances, Morningstar is a helpful website with videos about tips and the current financial crisis.

http://www.morningstar.com/Cover/Tools.html

Homework Exercise

Q: Suppose a firm's new expected revenue is 106. The cost of capital is 0.05. And we want to use the 99% confidence level for CaR (use Zc=2.326). Assume everything else the same, should the pharmaceutical company invest in the new drug?

A: The cash flow at risk for this new drug is calculated as follows at the 99% confidence level (1%):
2.326*20=46.52 for new
2.326*25=58.15 for current
2.326*35=81.41 for combined (calculated by finding the variance of the cash flows,
taking the square root, and then multiplying by Zc=2.326)

Then the present value of cash flows:
New drug=106/(1+.05)-100=0.9524

We also need to account for the fact that the new drug increases firm risk as well. We must adjust our calculation to account for this increase:
106/(1.05)-100-0.11*(change in CaR from new to old)
=106/(1.05)-100-0.11*(81.41-58.15)
= -1.6062

When using the calculation of NPV without adjusting for firm risk, the new drug's present value of future cash flows was barely positive. When choosing new projects or investments, any project with positive cash flows, NPV, should be chosen. So using this calculation, even though the firm would only earn a little extra cash, the new drug would become a new investment. However, when adjusting for firm risk, the NPV of the new drug became negative. Therefore, the new drug should not be invested in because the net present value of future cash flows is negative, which would increase risk to the firm.

Errors in the Crisis

I have discussed in previous blogs the problems and causes of the financial crisis. I keep finding more to learn about. The article below talks about errors with the crisis:

http://www.nytimes.com/2009/01/25/business/economy/25view.html?ref=business

People are wondering how the crisis happened and why we didn't learn from mistakes in the past. Risk management is supposed to prevent past problems from occurring again. I think as I stated before, however, that people don't think bad things will happen to them. We think of the Great Depression as a mistake of the past that could not possibly happen again. Risk management needs to investigate the causes of the crisis to implement preventative measures.

One of the problems mentioned involves mortgages and foreclosures. The government has not helped prevent foreclosures. More money keeps being lost, jobs have been lost, and people cannot pay for their homes. As discussed in class, most people have all their value and investments in their home. This was a point brought up to refute the CAPM assumption that people have well diversified portfolios. Most people's most expensive asset is their home. But what people don't realize is that when they keep taking out mortgage loans on their house, the house is decreasing in value. Then they are increasing their risk of loss. This article below shares personal experiences of many people who are losing their homes. I don't understand how having a lot of empty houses that just sit there unkempt and rotting helps the financial situation. Kicking people out of their homes and having nothing better to do with the houses does not help. At least when the people live in the houses the house receives some upkeep and the bank receives some money.

http://www.nytimes.com/2007/09/02/business/yourmoney/02village.html?scp=3&sq=mortgage%20crisis&st=Search

Another problem talks about governmental aid, which I think was used improperly and perhaps carelessly and thoughtlessly. The former treasurer used the money to bail out companies who asked not having an agenda to help the companies that could help the overall economy by improving themselves. For instance, the porn industry asked for money from the TARP. What good would helping the porn industry do for the overall economy? Do people really need porn? I don't think helping them would encourage enough commerce to improve purchasing and buying powers. The money was spent so quickly that now with the new Obama administration not much money is left to be spent to help. Here is an article about the Troubled Asset Relief Program so we know how the money has been spent:

http://topics.nytimes.com/topics/reference/timestopics/subjects/c/credit_crisis/bailout_plan/index.html

Money Problems

All the talk about money loss is hard to comprehend. Where does all the money go? This article discusses money loss and creation in beginner's terms:

http://baselinescenario.com/financial-crisis-for-beginners/

What I don't understand is if people are losing money, the money has to be going somewhere, but everyone seems to be in a tough financial situation. Someone or some company has to be receiving money from the losses, but who? Is the money just disappearing? I think the problem can be explained using the mortgage crisis. People have houses that are supposed to have a certain value. The value however, has been falling but the payments are still the same and may even be charging more expensive rates because of default. The default is a result of the losses people have incurred and have caused them not to have money to pay. Prices have increased on gas, groceries, etc., and people have been getting laid off. There is no money for people to pay with. The value is taken out of the home and the money built into the mortgage value disappears. What creates value is the ability and willingness of someone to buy something. When the ability as in this financial crisis is gone, the value does not exist. This article discusses the mortgage crisis causes and also touches on my last point of too much government intervention in monetary assistance:

http://www.americanthinker.com/2008/10/what_really_happened_in_the_mo.html

I also do not understand where the money is coming from to bailout companies or money for welfare type programs is coming from. The government keeps signing bills to help companies with more and more money being spent. On CNN the other day, it was talking about the actual magnitude of one trillion dollars. People used to not have a concept of a trillion. Now the deficit keeps getting larger and larger. The government is creating millions and billions of dollars out of nowhere to help these companies and making the deficit, or overall economy worse. The article below gives insight on the concept of a trillion dollars:

http://www.museumofhoaxes.com/hoax/forums/viewthread/8765/

Financial Crisis Shock

In reading articles about the current financial crisis, I have simply been focusing on the causes and not what is actually happening to people and businesses. I think from a risk management standpoint it is good to study the causes to implement preventative measures for the future. However, the effects the crisis has had on people struck me this weekend. I found out one of my friends father was laid off. One of my other friends lost his job. Another of my friend's grandmother lost her job. I had a conversation with a person about his father losing his job as well. You think bad things won't happen to you, but they can. This same concept is why companies do not implement proper risk management policies. They may implement the bare minimum because they think bankruptcy could never happen to them. This article is about things that have changed or will change with the crisis:

http://www.culture11.com/node/32274?from=feature

Prices have increased to ridiculous costs for people, and in the mean time, they are losing their jobs, which does not help the situation.

This video explains how grave the situation we are currently in is, and is the trailer for a Frontline episode which goes into more detail about the crisis, or as they call it, the Second Great Depression.

http://www.pbs.org/wgbh/pages/frontline/meltdown/

VaR for Beginners

One of my last entries discussed the VaR principle. In class, we have been discussing Value at Risk in more detail. We have used the normal distribution to calculate estimates of Value at Risk. I was exploring the financial crisis links on the class website and decided to learn more about VaR. The discussion I found is VaR for beginners:

http://baselinescenario.com/2009/01/04/risk-management-var/

Another article that discusses VaR in the New York times is much more dense. The beginners article helps clarify the NY Times:

http://www.nytimes.com/2009/01/04/magazine/04risk-t.html

Value at risk uses a normal distribution to predict the confidence level for a company. This confidence level reveals how much money the company needs to keep on hand to cover their losses. At the 99% confidence level, VaR tells the company the maximum amount they will lose 99% of the time. VaR calculated using a normal distribution ignores fat tails that could arise in a distribution. These fat tails are high risks that may occur seldomly, but still could cause huge losses to the company. In my previous blog, I discussed that this was the problem with using only one risk calculation to determine the risk of an investment. The beginner article discusses other problem found with VaR. Using the normal calculation just to make prediction easier causes mathematical error. Not all events occur in patterns like a distribution either. The world changes. Just like how we showed the CAPM assumptions are unrealistic, it is unrealistic to assume this perfect world normal distribution. Just as the CAPM assumptions cause error, the VaR normal distribution assumption also causes error.

Risk Mismanagement

In risk evaluation you can use numbers to measure risk such as beta and Value at risk, but you can also use patterns from past events. Trends in markets occur, and sometimes trends in disasters occur. You can use the trends from the past to predict future crisis. Value at risk is a common measurement of risk that puts a dollar amount on the level of risk, how much capital a company should keep on hand to cover their risks. These tools and measurements are not as accurate when used alone, as my previous blogs have mentioned. The value at risk calculation can be combined with analyzing past trends to predict risk more accurately. The crisis caused confusion about risk management and whether it is useful or wrong. Risk management worked in the case of Goldman Sachs, so what is the problem then with risk management? It is in the uses of risk management and not being aware of the holes. If you are not looking for risks or disasters you won't see them when they are coming, and therefore, will not be prepared. As in my previous blogs, the value at risk calculation assumes a normal distribution. People take the calculation as is and ignore possible fat tails and outliers far away from the mean that cause higher risks. People use only the value at risk number, but do not realize it is short term and could change easily every day. Value at risk also does not take into account put options that could put a company at large risk if prices fall below the agreed price.

This reason is why people need to understand that problems can happen and you should be prepared. Crisis make people aware that bad things can happen. Using past events make people realize it could happen. Models are not the only tools that should be used to calculate risk because some risk cannot be hedged. There are diversifiable risks and non-diversifiable risks that can happen outside of a normal distribution. Risk management and VaR calculations help the firm be prepared. There is margin for error, but at least the firm has their eyes open. The VaR calculations 2 years ago stated things were getting bad, but no one used the warnings to prepare for the current crisis.

http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?_r=2&emc=eta1&pagewanted

RIP: Modern Theory of finance

This article also discusses the current financial crisis and whether risk management is to blame. The article is a defense for risk management but criticizes the modern theory of finance. The article describes certain risk management strategies, identifying risk and calculation the risk with financial models. Beta is used as the most valid calculation of risk. However, our lessons in class will tell you that there are many calculations of risk and using them together gives you the best analysis of risk. On a sample exam question Value at risk and Beta were both used to compare the risk of two companies. One company had a Beta of 1, while the other had a Beta of 2. The one with Beta=2 had VaR= $2 million and the other had VaR= $2 billion. The Betas are fairly close, and when using only Beta comparisons, the company with a beta of 2 looks more risky. However, when taking the VaR into account, you would see that the VaR of $2 billion is way more to risk than $2 million. Therefore, the company with the more stable Beta turns out to be the riskier company.

These models and their interpretations are the problems causing the crisis. The problem stated once again as we discussed in class is that not all risks follow a normal distribution. The assumption for financial theory in the ideal world models such as CAPM and Modigliani and Miller is that risks follow a normal distribution. But, analysts ignore the fail tails of the distribution. Riskier investments have fatter tails. These fat tails are times when the market is a boom or a bust, which can happen unpredictably. The main cause of the crisis is taking these models as truth and using no other analysis.

http://www.thehindubusinessline.com/manager/2009/02/02/stories/2009020250321000.htm

Constellation Energy compared to American Barrick

Constellation Energy Group. Inc. just sold its natural gas trading company to the North American branch of Australia's Macquarie Group. Constellation was one of the largest gas trading businesses and specialized in moving about 10 billion cubic feet of natural gas per day. This company was similar to the specialization of American Barrick in mining gold. One of our questions for the case study on American Barrick was whether the company should switch from a mining company to a trading company. I was reminded of this because Constellation was going to have to increase the amount of capital to stay in the trading business. Instead of changing their business or increasing their capital, Constellation sold the business.

For companies thinking to switch their business strategies, such as Delta, the oil company in our exam, and American Barrick, they must analyze and weigh the costs. For American Barrick we decided that they were very good at hedging their risk in mining and extraction. Maybe switching over to a trading company would hurt their business even though it would eliminate extraction costs. For Delta, the past essay question discussed eliminating their oil price risk. This would force Delta to be better managers. The oil company in our exam was the same as Delta. They could eliminate the oil extraction costs as well and simply sell it. Constellation could not or did not want to switch their business strategy like the possibility with American Barrick. So they sold their company.

http://www.247wallst.com/2009/02/constellation-e.html

Did Risk Management Cause the Crisis?

I would like to comment on the article posted on the class website: Did Risk Management Cause the Crisis? Yes and no. Improper risk management (accounting controls) does not take the place of enterprise risk management.

The failure was due to a failure in maintaining and enacting appropriate risk management behaviors. Risk Management did not fail and did not cause the crisis. The lack of RM was the cause. Therefore, the RM strategies and ideas do not need to be destroyed and started over from scratch because they work for companies that implement them properly. Risk Management is not a guarantee that bad things won't happen, but firms must experience some risk to create value.

The failure also came from blind reliance on models. In class we discussed that a company's risk does not always follow a normal distribution. This is how the economy is: disasters can occur and surprises can occur. The organizations that fail do not pay enough attention to the tails in the distributions just as we discussed. Tails can be fatter than expected or predicted, which means that points are farther from the mean. These investments are more risky.

I found this article very interesting. It helped me distinguish between enterprise risk management, risk management, and financial risk management. The article defines Enterprise RM as risk management that can identify situations in which risk may be a competitive advantage instead of only a threat. "ERM encompasses all aspects of an organization in managing risks and seizing opportunities related to the achievement of the organization’s objectives… not only for protection against losses, but for reducing uncertainties, thus enabling better performance against the organization’s objectives." Our RMI 4350 class is titled Enterprise Risk Management, and we have been discussing this process exactly: identify risks and then form a plan to minimize the costs of risk to maximize the firm's value.

http://community.rims.org/RIMS/Upload/f26b1c64-8123-4c96-9c59-83fc43bc99cb.pdf