Are Your Counterparties Putting Your Business at Risk?

Using Big Data to Forecast Counterparty Risk

by Lynn Brewer, Founder of The Integrity Institute

Risk is inherent in any business. Business models require companies to accept, manage and mitigate risk to the greatest extent possible. Our global economy has indeed proved to be an intricate web of transactions designed to mitigate or create risk, depending upon whom you ask. But what about your counterparties—those businesses which are inextricably tied directly or indirectly to your company, upon which your success or failure is dependent—what are they doing to create risk for your company? How does your company manage to survive if your largest customer or counterparty fails? Managing your own risk now depends upon managing the danger that your counterparties will falter or worse fail virtually without warning, whether as a result of their own poor management or due to circumstances beyond their control such as a global economic crises. How you manage your counterparties could likely mean the difference between success and failure.

Interestingly enough, in January 1999, the International Securities Dealers Association (ISDA) brought together a group of 12 major internationally active commercial and investment banks and announced the formation of a Counterparty Risk Management Policy Group (CRMPG). Today, most of those participant banks are gone—bankrupt, merged, acquired, or failed all together.

In 2008, the failures of long-standing companies like Bear Stearns and Lehman Brothers in the United States, as well as many others, revealed the systemic impact of corporate disasters. The conclusion must therefore be drawn that governance requires a broader focus on counterparty risks and the systemic risks associated therewith. It is no longer about whether your company is doing “the right thing” but whether your counterparties are advancing their own position at your peril. As pointed out in South Africa’s leading accounting magazine Accountancy SA, in its June 2012 issue, the article entitled ’Effective Credit Risk Management: Vital for Business Survival,’ it was noted, with the fragility of business,

. . . companies must recognise that counterparty risk can no longer be brushed over. The dramatic collapse of Lehman Brothers placed some of the world’s largest banks and insurance companies at risk. If these giant institutions could collapse, surely any business can – and if that business is connected to yours, its collapse could well lead to the downfall of your operation.

In the United States, BusinessWeek magazine’s June 2006 cover story was entitled ’Inside Wall Street’s Culture of Risk. [1]’ It was about the economic risks being taken by Wall Street banks and the foreshadow of what might happen in the event that the ’big bet’ didn’t pay off. “The world is stretching for return’” said financial historian David Grant. . . “The last time investors stretched so far, during the dot-com boom of the late ‘90s, the results were disastrous. . . . If banks succeed, they’ll rack up even bigger earnings. But if they borrow too much money for their trades or take on more risk than they can manage, the wreckage could be considerable.” This is exactly what happened and the wreckage was indeed considerable for the rest of the world.

For all the risks they’re taking on, banks insist they’re safer than ever. They’ve hired many of the greatest mathematical minds in the world to create impossibly complex risk models” to manage their risk. Following the collapse of Lehman Brothers in September 2008, Bear Stearns’ failure to manage its own risk made it necessary to sell the company to JP Morgan Chase in 2008, or else face the same fate as Lehman Brothers.

The big ’what if’ that risk managers feared in 2006 was the ’fat tail’ “The term comes from the shape of a bell curve of probabilities, in which the long, thin tails on both ends represent extremely rare outcomes. Fat tails mean catastrophes are more likely than one would guess given normal day-to-day fluctuations…. ‘The abnormal is really abnormal,’ says a risk manager who was part of the team that bailed out Long Term Capital Management whose own failure in the late 1990s nearly cost the US economy its standing in the world. Blindsided by the collapse of Bear Stearns and Lehman Brothers, it will take the global economy nearly ten years to recover.

This leads us to the question presented in the 2006 BusinessWeek article “So why, then, are banks racing ahead to build bigger, more complicated trading operations, risk huge losses and long-term damage to their credibility if things go wrong? For one, the banks think they can handle the risk. For another, their shareholders and clients are demanding it.” The article made no effort to disguise anyone’s agenda—“the rewards are justifying the risks: Big investment banks are booking record profits, and their stocks have zoomed, up 64% since 2001.” “Thinner Safety Cushions” were created as the banks were “using vast sums of borrowed money to jack up the risk even more.” Between 2001 and 2006, Goldman’s value at risk (VAR) had “jumped from $92 million, up 135% from $39 million 2001.” Despite the warning from the man who first proclaimed derivatives were “weapons of mass destruction,” Berkshire Hathaway’s CEO, Warren Buffett, rightly noted, ”A world where huge amounts of leverage have been brought into the system is a dangerous world”.

The shift in the global economy has caused a dramatic shift in the leverage reflected in the balance sheet of companies. While large companies in the United States have conserved cash to weather the storm, the big banks have achieved this with the help of the US taxpayers in the form of massive bailouts. But other countries have not been so fortunate such as Greece. In South Africa, as noted in the article, “Companies in general remain more leveraged than ever before.”

Of course, ’bad debts’ are often qualitative and the standard of ’bad debt’ varies from company to company. The key is to ensure your own business is strategically resilient no matter what happens with your counterparties, which requires advances in risk modeling. To achieve this objective of forecasting risk, it requires we analyse the same data through a fundamentally different lens to quantifiably measure the structural integrity, which provides companies with the strategic resilience to sustain market forces such as the failure of a large counterparty.

Numbers rule the world

In December 2001, the fifth largest corporation in the United States filed for bankruptcy. Its demise came virtually without warning. For those of us inside the company, there were plenty of warning signs but for Wall Street there were few. Over a ten year period, ending December 31, 2000, Enron would present investors with a total return of 1,415%. Compared to the S&P 500’s meagre 383% return, Enron was considered the darling of Wall Street. Much of Enron’s rapid growth had come as a result of its trading of derivatives with Wall Street firms such as Bear Stearns, Lehman Brothers and the Goldman Sachs Group. Despite being named the ’Most Innovative Company’ for six years in a row by Fortune Magazine, suddenly Enron imploded virtually without warning.

From 1998 to 2001, I held one of many positions inside Enron that allowed me to witness first-hand the malfeasance that brought down the company. Ultimately, I left the company to blow the whistle – first to class action lawyers in late 2000 and then to the media in early summer 2001, and ultimately to the head of the US Energy and Commerce Committee, Senator Byron Dorgan, the day after Enron filed for bankruptcy. In 2002, I wrote in Confessions of an Enron Executive, “Look to Enron to foretell the future.”

Many thought Enron was an anomaly—the ‘Black Swan’—the once in a lifetime event—created by a legal loophole that US regulators thought Sarbanes-Oxley would fix. I knew Enron was about much more—it was about incentives paid for taking excessive risk that remained unchecked by the board of directors with no concern as to whether Enron’s performance was sustainable or what the long-term consequences would be if it wasn’t. There was absolutely no consideration as to whether sustainable corporate performance was essential to our global economy. And why should we—Enron had produced staggering returns over the previous ten years—1,415% to be exact. Enron would report for year end 2000 net income of $1.3B USD / 12652191056.5 ZAR in today’s exchange.[[[PAGE]]]

In less than a decade, we would find out just how devastating such outcomes can be when we falsely believe stock price is the only thing that matters – and how quickly the stock price rises is irrelevant. Even if stock price is simply an illusion or the baseball player is pumped full of steroids, we still demand home runs. The performances of Bear Stearns, Lehman Brothers, and MF Global were also unsustainable causing each company to fail a mere seven years later after the failure of Enron and the passage of Sarbanes-Oxley.

Since leaving Enron in late 2000, I have focused on one thing—identifying the consistent pattern of behaviours that exist in companies that fail virtually without warning—the Black Swans that CNBC now reports are “a regular part of our market landscape.” [2] In the words of the great researcher Jim Collins, author of Built to Last; Good to Great; and Great by Choice, I have sought to isolate the markers of disease in organisations that can turn into cancer if left undetected. This effort has been my personal ’corporate genome’ project.

The first assumption in building a quantitative model is that all information is flawed in some manner. The second assumption is that identifying exactly where the flaws exist is not nearly as important as understanding what the likely impact will be if the information does prove to be flawed. This requires we shift our modeling towards predicting outcomes, a theory supported by Nobel laureate Joseph Stiglitz, who states “Standard models should be graded on their predictive ability—and especially their ability to predict in circumstances that matter.”

We began by advancing a form of mathematical game theory that had proved significant in its ability to predict allegations of securities fraud one or two years in advance. We wanted to provide sufficient ’runway’ for CEOs, counterparties, and investors to take corrective action or remediate problems. The data analysis we performed is the largest single study of its kind – over 833,000 financial statements filed by every publicly-traded company listed on the US stock exchanges between 1995 and 2011 – more than 33,000 companies in all. We included companies that had filed registration statements intending to go public but never actually filed an Initial Public Offering (IPO). After identifying the pattern of behaviour in companies that failed, and finding the perfect blend of variables to provide sufficient ’lift’, we translated the results into a scoring system we call The Integrity Index™ which rates or scores each financial statement on a score of 1-1000. The lower the score, the higher the risk the company is structurally unsound. The more prolonged a company’s Integrity Index score remains low, the greater the risk the company will face allegations of securities fraud or worse fail. We then ran an independent study as to the efficacy of utilising The Integrity Index Ratings as the foundation for a broad-spectrum approach to managing systemic risk utilising governance variables as one of the key components to predict corporate disasters. The initial results of the analysis show The Integrity Index ratings and underlying model correctly predicted 81.96% of allegations over the four-year period (2004-2007) with a range of 80.6%-84.7%. The results of the study indicate a gain in a company's Integrity Index rating correlates to an increase in continuous five-year survival. Thirty-three of the 38 subgroups display positive changes in Survival Rate from its previous subgroup. Survival Rate directly correlates to The Integrity Index score with an R2 value of 98.14%. This study establishes the connection between The Integrity Index score and allegations of securities fraud as well as links The Integrity Index™ score to sustainable corporate performance and strategic resilience.

To demonstrate the results of the Integrity Index for the period 2005-2010, we analysed the threshold of success based upon Integrity Index Ratings to determine whether there was a correlation and found the higher the number the greater the resiliency of the company. There is not necessarily a correlation between stock price and Integrity Index ratings. In fact, our model does not contain any stock price variable so we may find that a company with a very low score has a high stock price because its earnings are being manipulated, causing an artificially high stock price that is unsustainable. This is the critical component of counterparty risk – whether the company’s performance is sustainable – will the company be able to settle its accounts when the bill comes due? And if not, what will the cost be to your company if the company is unable to perform under the terms of the agreement?

As Figure 1 demonstrates, the survival rate of companies with sustained Integrity Index Ratings survive at a greater rate than those with a low Integrity Index Rating. We found that 100% of companies with an historical average Integrity Index score below 25 have failed. There is only one company that has scored below 50 that has survived.[[[PAGE]]]

Charting the course

Business presents challenges and overcoming those challenges requires advancing critical risk models – such as counterparty risk. The benefit today is that Big Data presents a unique opportunity to isolate critical issues before they become a problem. Making risk-based decisions requires your ability to forecast that risk. It also requires discipline to recognize when changing course is essential to a company’s survival. Models that predict risk are yet the next step in our evolution as risk managers. The key is to avoid these ’Black Swans’, which is what The Integrity Index can help to do.

In my humble opinion, counterparty risk is the greatest risk facing our global economy and while it is critical to the global economy that the United States economy remain strong, JPMorgan Chase’s ’London Whale’ demonstrates how US companies will exploit the regulatory environments in other countries to advance their earnings, potentially at great peril to their shareholders, counterparties, and as we witnessed in 2008, the global economy. The one thing our research has proven is that while our capital markets have a few ’Bernie Madoffs’, by and large most publicly-traded companies are run by well-intentioned people. There are very few CEOs who actively seek to destroy the company by committing fraud; however, without the ability to predict fraud even Jamie Dimon, CEO of JPMorgan Chase, dubbed ’The Last Man Standing’, is at risk as he admitted his ignorance over what was occurring at the trading desk in London. I know from personally meeting with Ken Lay, former CEO of Enron, just two weeks before his death, that he too felt as though he had been blindsided by the turn of events at Enron. The proclamation by both men that they didn’t know what was happening is a frightening reality – it means that what happened to them can happen to any of us.

Notes:
[1] Inside Wall Street's Culture of Risk; Business Week; June 12, 2006; Thornton, Emily; Henry, David; Carter, Adrienne
[2] Black Swans Now a Regular Part of Market Landscape; Cox, Jeff; CNBC.com; March 16, 2011