Re:Balance -- Jim Peterson

The Airbus A380 as a Risk Assessment Case: Cracked Ribs Do Not Signal Good Health

Cause for concern are reports that European air safety officials have ordered inspections of cracks in the mounting brackets that attach the wings of the Airbus A380 – already a plane with a long history of delays, design issues and cost over-runs.

And if the bland assurances being spun by the manufacturer’s publicists – that “the cracking problem … is not a safety risk in the short- to medium-term” – reflect the company’s risk assessment attitude, then a suppressed but potential catastrophe is a matter of time – a mid-air disintegration with massive casualties and the subsequent grounding of an entire discredited fleet.

I am just winding up a month-long Risk Management teaching engagement, migrating an MBA-level curriculum to a class of undergraduates.[1]

Some recalibration has been involved. At the graduate level of business and law students, our focus is on the broken models and ineffective risk processes that have characterized the worlds of finance and banking, insurance, accountancy and professional services, over the years of the credit crisis. These run through the period -- from the collapse of Bear Stearns to that of MF Global; from rogue trader Jérôme Kerviel at Société Générale to his UBS counterpart, Kweku Adoboli; from the corruption of the American subprime mortgage market to that of Japanese corporate governance at Olympus.

Younger students stay with the basics – the human behaviors by which incentives are skewed, failures are rationalized away, and incipient disasters are hidden under the mistaken illogic that safety and soundness can be inferred, only because a breakdown “hasn’t happened yet.”

The discovery of cracks in the “rib feet” of the A380s presents a long-familiar challenge: what response is proper to the emergent symptoms of a potentially devastating event?

It is all too natural to put up an optimistic face – to admire success and to wish away the language of bad news. But the consequences can be dire:

• The late Steve Jobs may well have paid with his life for his denial-based postponement in treating his pancreatic cancer.

• The Italian liner Costa Concordia would most likely be cruising in comfort, rather than lying as a hulking wreck, had the supervisors tracking its earlier near-shore wanderings acted on the ready GPS data revealing the captain’s record of reckless behavior.

• And the signs of corruption in Bernie Madoff’s Ponzi operation were well within view, both to the SEC and to his investors, had they not chosen to turn blind eyes to the readily apparent.

Historical memory is hard to hold, especially where corporate budgets and profits and bonus payments depend on the wishful avoidance of delays, repairs and caution-based slow-downs.

But for learning directly applicable to the A380 and its cracks, my students have just scrutinized the 1986 case of the space shuttle Challenger – launched to its fatal explosion, before they were born, over the engineers’ objections that cold weather would threaten the flexibility of the eroded O-ring seals on its rocket booster.

The logical flaw in the shuttle case extends: The fact that prior launches had succeeded, despite O-ring erosion, did not provide comfort for future launches under other conditions. No more, that the A380s may have flown so far without incident despite wing bracket cracks – when such potential stresses as severe weather, hard landings or simple future wear-and-tear fatigue would change the failure calculations and render invalid the assumptions underlying margins of safety. 

In other words, paraphrasing with emphasis physicist Richard Feynman on the shuttle, “the A380 rib feet were not designed to crack. Cracking was a clue that something was wrong. Cracking was not something from which safety can be inferred.”  

In the Challenger case, seven astronauts and a space vehicle were lost to the deficiencies in NASA’s risk management. As for the A380, has any learning occurred?

As soon as my final grading is done, I will be uplifting for Paris and a spring-semester teaching gig with law students there.

But not on an A380. In its wounded state, I will be happy to book on the robust aircraft of an American airline.

 

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[1] My thanks and gratitude to the congenial community of Carthage College – faculty, administration, support and especially the students in my seminar – for a welcome and an experience as warm as this unseasonable winter in Kenosha, Wisconsin.

 

The Next Home for International Financial Scandal? If You Can Find It -- It's Malta

I recently made my first visit to the tiny island nation of Malta – once the Mediterranean crossroads of crusaders, smugglers, pirates and profiteers, now better known as a way-stop on the marine route of refugees fleeing coastal North Africa for near-by Sicily and mainland Italy.

My impressions -- of a country and people with much to be modest about -- leave me uneasy, with Malta now touted as headquarters to a rapidly-expanding roster of European-based hedge funds – e.g., here and here.

This is not good news. Because if true, the fuse is lit and sparking on the next explosive weapons of financial destruction.

For all its storied history, today’s Malta is a backwater. The country’s low-wage economy survives on limited tourism for history buffs, and second-language schools serving a heavy demand for English because the native tongue with its Arabic origin and Latin orthography is unlearnably complex, marginalized, and disappearing.

In by far the smallest country in the Euro zone, with a population of 400,000 mainly unprepossessing Catholics, the focus of governance is limited to the legality of divorce. While, as I was told by the under-employed college graduate who drove our taxi from the airport, ”You’ll probably never see a policeman during your visit. There’s so little crime, they go into the parks and sleep in their cars behind the trees.”

Transport on Malta until last summer’s upgrading was dominated by fleets of clapped-out orange and yellow buses, of a vintage more worthy of pre-Castro Cuba than a full-fledged member of the European Union.

The inevitable question asked by a tourist looking over the pervasively sand-colored Italianate architecture is, “Doesn’t a country with aspirations to be taken seriously care enough to wash its cars and clean the dirt off its windows?” To which the prompt and unashamedly self-deprecating answer, “who cares?” is that the prevailing winds off the African desert make a daily layer of dust as inevitable as the sunrise itself.

After centuries of outside dominance, latterly in the form of British colonial oppression until independence in 1964 and eventual troop withdrawal in 1979, a legacy of brain drain and talent flight assures a vacuum of local vision and mediocrity of leadership.

“Maltese” evokes several things – post-Crusade centuries of knightly influence, toy-sized white dogs in the laps of ladies who lunch, and the elusive avian statue that so bedeviled Humphrey Bogart’s Sam Spade in the eponymous 1941 re-make of Dashiell Hammett’s noir novel. 

What it does not call up is a legitimate industry of well-regulated financial institutions.

So what is nascent, with the explosive growth of a Maltese hedge fund sector, is dangerous regulatory arbitrage – the potential for a rush to the bottom not seen since “regulatory capture” in Antigua and Barbuda laid the foundations for Allen Stanford’s Ponzi scheming, through his purchase of a tin-plated knighthood along with the compliant gate-keepers’ keys to that country’s thatched-cottage banking industry.

The cases are legion that even big-country regulators have been asleep on the watch – from the SEC’s failure to finger Bernie Madoff, to OFHEO’s late-arriving blinking at the sub-prime mortgage trainwrecks of Fannie Mae and Freddie Mac, to the PCAOB’s belated discovery of something rotten in reverse-merger Chinese public companies coming to America to list on its exchanges.

So the chances that the Maltese have the competence to escape a worse fate, in response to the invading hordes of hedgies in their private jets and sharply tailored suits, are precisely nil.

I have been bold in this space to make an occasional prediction about the expected times and places for outbreaks of unpleasantness – in Islamic finance, a Madoff-related suicide, or the rates of white-collar recidivism exemplified by Barry Minkow’s return to prison – with a record that is almost distressingly robust. 

Readers prepared to files these views on the likelihood of serious mischief erupting on Malta into a time capsule with a three-to-five year seal are invited to check back with me then.

In the meantime, pending the passage of time sufficient to prove me right, prudence suggests that investors seek a home for their hot and mobile Euros other than Malta.   

 

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Review -- Book of the Year: Daniel Kahneman, "Thinking, Fast and Slow"

One of my students in Risk Management at the University of Chicago beat me to a reading of Daniel Kahneman’s recently-released “Thinking, Fast and Slow” (Farrar, Straus and Giroux, 2011, 418 pp.). 

A young man of few words but crystalline insights, he brought to class this terse review of Kahneman’s reprise of four decades of ground-breaking research into the flaws and fallacies embedded in judgments and choice-making:

“Too long” – he was typically pithy. “But brilliant.”

Right, on both counts. Start with the second: 

Modern English literature would have been impossible without the works of Shakespeare, if few others. The same, going back to the 1970’s: Kahneman and his late collaborator, Amos Tversky, opened whole new fields of inquiry and perception into human behavior.

Thanks to their pioneering work, we have the means to be both entertained and informed by the lessons in “Moneyball” (both the movie and Michael Lewis’s book), such as the stubborn clinging to soon-to-obsolesce folk verities by the talent scouts gathered in Billy Beane’s baseball clubhouse in Oakland.

And we can appreciate being rightly agog at the singular slogan of the credit crisis, the feckless pronouncement of Citigroup’s Chuck Prince in the summer of 2007, that “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”   

More broadly, Kahneman and Tversky gave us the means to identify – and desirably to comprehend, although that is subject to much doubting skepticism – whole categories of sub-optimal decision-making. Consider such influences as:

• Herd behavior – and the entire population of mutual fund advisors, unable to distinguish the dubious quantity of talent in their performance from the simple effects of random luck.

• The compulsion to construct compelling if entirely unreliable stories based on tiny bodies of data – and the daily flood of the commentators’ vacuous “explanations” for insignificant price moves in the securities markets. 

• The whole industry of prediction models that are blind to their in-built exposures to rare but catastrophically destructive events – thinking, with sorrow and anger, of the graveyard population of financial structures, from Bear Stearns and Lehman Brothers to the Icelandic banks and the Irish real estate market, right on down to the “repo-to-disaster” at MF Global.

As for my student’s first words – Kahneman’s editor falls into the genre’s too-familiar pattern of over-stuffing between the covers. To be sure, the book is worth its price for its two appendices alone – Kahneman and Tversky’s landmark papers on the irresistible reliance on heuristics and biases, and the assessments of risk appetite and aversion in decision-making under conditions of uncertainty.

But it fails to distill and sharpen, for just one example, the unappreciated significance of regression to the mean in cases where hindsight attribution of causation is a cause of systemically erroneous decision analysis. 

That’s by way of quibble, for Kahneman has brought about a worthwhile trade-off: in exchange for any loss of readers deterred by an over-weight hundred pages, he has gained the achievement of a career-spanning reference work, to become dog-eared on the desks of those of us who will hope in small ways to pass his genius on to the next generation of the students of risk.  

  

This will be by way of valedictory to a difficult and challenging year -- to wish all readers a healthy and peaceful 2012 – even if the new year bids fair to be no less volatile and unpredictable than the old.

January marks this blog’s fourth birthday – celebrated in anticipation that inevitable new eruptions of corporate malfeasance, the capacities of regulators for continued mischief-making, and their continuing and frustratingly ineffective inter-actions with issuers and auditors, will all continue to provide material worth addressing. 

   

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