Warnings About Financial Institutions and Derivatives

Risks of Financial Institutions
The nature of a financial institution is that there are a lot of ways to go to hell in a bucket. You can push credit too far, do a dumb acquisition, leverage yourself excessively---its not just derivatives [that can bring about your downfall].

Maybe it's unique to us, but we're quite sensitive to financial risks. Financial institutions make us nervous when they're trying to do well.

We're exceptionally goosey of leveraged financial institutions. If they start talking about how good their risk management is, it makes us nervous.

We fret way earlier than other people. We've left a lot of money on the table through early fretting. It's the way we are -- you'll just have to live with it.

Derivatives
The system is almost insanely irresponsible. and what people think are fixes aren't realy fixes. It's so complicated I can't do it justice here - but you can't believe the trillions of dollars involved. You can't believe the complexity. You can't believe how difficult it is to do the accounting. You can't believe how big the incentives are to have wishful thinking about values and wishful thinking about ability to clear.

People don't think about the consequences of the consequences. People start by trying to hedge against interest rate changes, which is very difficult and complicated. Then, the hedges make the [reported profits] lumpy. So they use the new derivatives to smooth this. Well, now you've morphed into lying. This turns into a Mad Hatter's Tea Party. This happens to vast, sophisticated corporations.

Somebody has to step in and say, "We're not going to do it - it's just too hard."

I think a good litmus test of the mental and moral quality at any large institutions [with significant derivative exposure] would be to ask them, "Do you really understand your derivatives book?" Anyone who says yes is either crazy or lying.

It's easy to see [the dangers] when you talk about [what happened with] the energy derivatives - they went kerflooey. When [the companies] reached for the assets that were on their books, the money wasn't there. When it comes to financial assets, we haven't had any such denouement and the accountings hasn't changed so the denouement is ahead of us.

Derivatives are full of clauses that say if one party's credit gets downgraded then it has to put up collateral. It's like margin - you can go broke [just putting up more margin]. In an attempt to protect themselves, they've introduced instability. Nobody seems to recognize what a disaster of a system they've created. It's a demented system. 

In engineering people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon. It's aided by false accounting. I'm more pessimistic about this than Warren is.

Accounting for Derivatives
I hate with a passion GAAP [Generally Accepted Accounting Principles] as applied to derivatives and swaps. JP Morgan sold out to this type of accounting to front-end revenues. I think it's a disgrace.

It's bonkers, and the accountants sold out. Everyone caved, adopted loose [accounting] standards, and created exotic derivatives linked to theoretical models. As a result, all kinds of earnings, blessed by accountants, are not really being earned. When you reach for the money, it melts away. It was never there.

It [accounting for derivatives] is just disgusting. It is a sewer, and if I'm right, there will be hell to pay in due course. All of you will have to prepare to deal with a blowup of derivative books.

Likelihood of a Derivatives Blowup
We tried to sell Gen Re's derivatives operations and couldn't, so we started liquidating it. We had to take big markdowns. I would confidently predict that most of the derivatives books of [this country's] major banks cannot be liquidated for anything like what they're carried on the books at. When the denouement will happen and how severe it will be, I don't know. But I fear the consequences could be fearsome. I think there are major problems, worse than in the energy field, and look at the destruction there.

I'll be amazed if we don't have some kind of significant [derivatives-related] blowup in the next five to ten years.

I think we're he only big corporation in America to be running off its derivative book.

It's a crazy idea for people who are already rich -  like Berkshire - to be in this business. It's a crazy business for big banks to be in.

Yo would be disgusted if you had a fair mind and spent a month really delving into a big derivative operation. You would think it was Lewis Carroll. You would think it was the Mad Hatter's Tea Party. And the false precision of these people is just unbelievable. They make the worst economics professors look like gods. Moreover, there is depravity augmenting the folly. Read the book F.I.A.S.C.O., by law professor and former derivative trader Frank Partnoy, an insider account of the depravity of derivative trading at one of the biggest and best-regarded Wall Street firms. This book will turn your stomach.

We'll see how well it works.

I'm not a crazy environmentalist, but waste makes me cringe. I make it a habit to contact companies that mail me catalogs that I don't read, telling them to take me off of their lists. I also do little things like bring a couple of bags to the grocery store every time I go in order to avoid generating more plastic waste.

The other day, I was buying my son a sweatshirt in T.J. Maxx, and the clerk popped it into a plastic bag. I said, "Thanks, but I really don't need that bag." He promptly balled it up and threw it in the trash. It makes me sad how so many people just don't get it. If everyone would just think a little bit about this in their daily lives, I think it'd make a big difference for the world we leave to our kids and grandkids.

Crazy, Man.

Information Week’s new blog, Plug Into the Cloud, is already in the thick of the controversy on the emerging cloud computing trend. A recent post lists a bunch of highly opinionated comments on the topic by site visitors, running the gamut from “Cloud computing is kind of like the Emperor’s New Clothes” to “cloud software can actually be more expensive than the software I load onto my hard drive.”

Jeff Doyle writes an interesting post about resistance to IPv6 adoption (what, you think we forgot?). Instead of the usual focus on IPv6 as an application issue, he points out that it’s actually an infrastructure thing. Would you wait to upgrade routers, switches, software, or servers until you can find a way to make the newer systems profitable? Would you wait to increase bandwidth only after you have customers waiting to use it? If you’ve answered these questions “no”, then why are you waiting to upgrade to IPv6?

We posted about whether or not there were recession proof products in IT yesterday. Network World Management Maven Denise Dubie also writes about readers weighing in on IT and the economy – from having to do even more with less to seeing the economic downtown as an opportunity to highlight IT’s true value to the business.

And finally, on the lighter side: What would we do without crazy billionaires and their crazy purchases? According to a New York Times article, a company controlled by Google’s top execs just added a fighter jet to their roster. “Presumably no attacks on Microsoft are planned at this time.” (image from Wikipedia)

Faulk says he and others in his section of the NSA facility at Fort Gordon routinely shared salacious or tantalizing phone calls that had been intercepted, alerting office mates to certain time codes of "cuts" that were available on each operator's computer.

"Hey, check this out," Faulk says he would be told, "there's good phone sex or there's some pillow talk, pull up this call, it's really funny, go check it out. It would be some colonel making pillow talk and we would say, 'Wow, this was crazy'," Faulk told ABC News.

Warrants are a security device. They protect us against government abuse of power.

I’m assuming the author wants us to read the title as “Things to Look Out For in Performing Risk Analysis” and not “Risk Management is Folly - Stop, Stop, Stop!” The former is fine, the latter isn’t supported by the evidence presented by the subjects of the article.
The subjects of the article are a good study from Wade Baker & Co. at Verizon, and a report from RSA’s Security for Business Innovation Council. Let’s take a look at each of these and examine why what they’re saying might contribute to poor risk management, shall we?

1.)  THE VERIZON REPORT

The Verizon report is an analysis of some 530 forensic investigations their company performed.  It is well worth your time as it’s chock full of interesting information.  As it relates to the Dark Reading piece, a coarse summary would be that “likelihood” is “different” for different people and so you can’t use the same “likelihood” across different industries.

Distilled through the lens of FAIR:

“different threat communities may be applicable based on Probability of Action factors which include: Value, Level of Effort and Risk (of Getting Caught).”

Or, even further distilled and in the words of my six year old son,

“Duh-uh”.

With regards to what I assume is the purpose of the article (What Doesn’t Work in Risk Analysis) this concept  seems just to rehash the old GIGO argument regarding risk analysis.  Great.  Can’t argue with that, nor it’s corollary QIQO (quality in, quality out).

But let me ask you -  is this really a problem common in your analysis?  Did reading this article make you go “Crap, we’ve been using data normalized across multiple industries in our analysis! They’re all wrong!”  Or have you already been accounting for the unique value proposition your company has to the specific threat community you’re worried about?  See, maybe I’m just not your average analyst, but even in my NIST/OCTAVE days, this has *never* been an issue for me.

Let me be specific, this is not a problem with Verizon’s very cool report.  It’s just that I don’t see what the big deal is.  This article is starting to feel like someone is running through the motions, trying to play the ” a crazy title gets people to read a boring article” game.

Speaking of cool reports - You know what would be cool?  I think it would be interesting to see is the quality of these companies’ “risk management process” established using good criteria,  and then correlated to the frequency and magnitude of real-world losses across the aggregate sample.  In other words, can we establish evidence that strong risk management practices not just reduce “risk” but also reduce actual incidents.

2.)  THE RSA COUNCIL “EXPLORES WHY LEGACY METHODS OF EVALUATING INFORMATION SECURITY RISK DON’T WORK IN TODAY’S CONNECTED WORLD, IN WHICH ANY NEW BUSINESS INNOVATION INHERENTLY CARRIES SOME LEVEL OF RISK TO INFORMATION.”

This report from the RSA council puts forth a seemingly obvious proposition, that risk must be balanced by reward.  Why is this news?  Now as I read the article it’s not clear if:

• The RSA Council is claiming that the CISO’s office should be the ones determining reward.  Absurd.

or

• Businesses aren’t doing a good job at determining risk and reward.

Let’s go with the latter.  So I’m pretty sure (good) businesses do a good job at estimating reward.  Businesses I’ve been a part of?  We LOVE(D) estimating reward.  We don’t tend to start projects all willy-nilly. No we tend to be careful to identify the size of the market and what it will cost to address the market.  So what could the problem be that this RSA council is trying to address?  Maybe it has to do with something like the following:

Yesterday, I got a demo of an IT-GRC application that shall remain nameless.  It seemed to be very good at the “C” bits - lots of information on regulations and expectations and even what sorts of controls would answer the regulations (which is goofy, but we’ll have to talk about that later).  It also gave you the ability to build workflow quite nicely.  But it measured NOTHING.  There really was no observable “G” and “R” was really Medium X Low X Low = High sorts of stuff.  So let’s use this relatively expensive tool as evidence of what your average CISO is armed with going into a Risk/Reward sort of meeting.  I imagine a nice board room with wood-grain paneling and glass bowls filled with little chocolate covered mints designed to give everyone involved in the meeting (CEO, CFO, CIO, CSO, VP S&M, etc…) a little sugar rush when needed and fresh breath.  The conversation goes a little something like this (apologies to Rich):

Business Guy Who Wants to Make Money Because That’s What Businesses Do: Based on market studies, we believe that initial gross revenues from the new product and technology rollout will be eleventy gazillion dollars based on a 37% market penetration in Scandinavia, alone.

CSO: Well now, we have a likelihood of “High” and a “C” impact of Medium, and an “I” impact of Low, and an “A” impact of “High” and because we are a (bank/hospital/retailer/basically any business that breathes anymore) we weight “C” by a factor of 2 - we multiplied those all together and got a “High”.

So can you guys delay the product rollout by 9 months and give me a bunch more money that’s not in the budget so that I can get this thing down to a “Medium”, please?

Again, I just don’t see the problem with Information Risk Management being that our businesses have no idea what the rewards of business might be.  Now maybe we need get a seat in that boardroom just to be able to talk about our “Mediums”, sure.  And maybe we’re infantile in our ability to describe our problem space.  But I cannot fathom that “Risk Management Doesn’t Work” because businesses haven’t been considering “reward”.

WHY RISK MANAGEMENT MAY  NOT BE WORKIN’ FOR YOU

Two meta-categories of causation:

• No skills

and/or

• No resources

Any ancillary “cause” can be mapped to one of these categories.  You could have significant resources but crappy models, and have conversations like our imaginary CSO, above.  You could have really good models and people trained and motivated to use them, but scarce time & money, so no conversation happens.

Now my question for you is - which does it make sense to acquire *first* to solve the “Why Risk Management Doesn’t Work” problems, skills or resources?

Charlie Rose:  
And so when you look at where we are going, there seems to be two issues that are apparent to me at least, risk and leverage.  We just lost sight of risk and leverage of what was appropriate?

Warren Buffett:  
Yeah.  Again, because it pays off for a while.  You know, you can lose leverage, and it's the only way a smart guy can go broke.  If you owe money, you can't pay them out.  You just pay for everything, you do smart things, you eventually get very rich.  If you do smart things and use leverage and do one wrong thing along the way, it could wipe you out, because anything times zero is zero.  But it's reinforcing when the people around you are doing it successfully, you're doing it successfully, and it's a lot like Cinderella at the ball.  I mean you know at midnight everything is going to turn to pumpkins and mice; right?  But if the evening goes along, I mean, you know, the guys look better all the time, the music sounds better, it's more and more fun, you think why the hell should I leave at quarter of 12.  I'll leave at two minutes to 12.  But the trouble is, there are no clocks on the wall.  And everybody thinks they're going to leave at two minutes to 12.

Charlie Rose:  
And should wise people have known better?

Warren Buffett:  
People should always know better.

Charlie Rose:  
Yeah.

Warren Buffett:  
I mean people -- people don't get -- they don't get smarter about things that get as basic as greed and you can't stand to see your neighbor getting rich.  You know you're smarter than he is, and he's doing these things, you know, and he's getting rich, and your spouse is getting unhappy with you because you aren't doing -- pretty soon you start doing it.  And so you get what I call the natural progression, the three Is.  The innovators, the imitators, and the idiots.  And that's what happens.  Everybody just kind of goes along.  And you look kind of silly if you disagree.  I mean, you know, you could have these crazy Internet valuations in the late 1990s, but they prove themselves out in the market.  The next day they were selling for more than they were the day before, and people said, you know, you're crazy if you don't get in on this.  So it's very human.  Now, with housing it's something even more dramatic than that, because most people aspire to own their own home.  And if you really think that houses prices are going to go up next year and the year after, you feel if I don't buy it this year, I'm going to have to buy it next year.  That's not true of an Internet stock.  But it's true of a home.  And when somebody makes it very easy for you to do it by saying you don't really have to put up my money, you can lie about your income a little, or we'll give you 100 percent mortgage, you're going to do it, because everybody that's done it has been proven right.  You have what they call social tools, and, you know, you're going to feel like an idiot if you didn't do it, because the house cost more.

Warren Buffett:  
Oh, I think confidence will come back.  I will tell you this.  This country is going -- be living better ten years from now than it is now.  It will be living better in 20 years from now than ten years from now.  The ingredients that made this country, you know, the miracle of the world -- I mean we had a seven for one improvement in the average American standard of living in the 20th century.  Now, we had the great depression, we had two world wars, we had the flu epidemic.  You know, we had oil shock.  You know, we had all these terrible things happen.  But something about the American system unleashed more and of a potential to human beings over that hundred years so that we had a seven for one improvement in -- there's never been any -- I mean, you have centuries where if you've got a 1 percent improvement, then it's something.  So we've got a great system.  And we've got more productive capacity now than we ever have.  The American worker is more productive than he's ever been.  We've got more people to do it.  We've got all the ingredients for a sensational future.  It's just that right now the athlete's on the floor.  But we -- this is a super athlete.

The event runs during 14-16 October 2008. I’m delivering the same four presentations I gave at TechEd US (and have used at most other TechEds around the world, too):

• Do these ten things now or else get 0wn3d!
• Virtualization and security: what does it mean for me?
• Privacy: the why, the what, and the how
• 21st century networking: throw away your medieval gateways

That’s gonna be a crazy week, because I’ll have been in Hong Kong for TechEd there the week prior. I get home from Hong Kong on Saturday, spend the night in Seattle, then on Sunday fly down to Sao Paulo! Oh well, I still love my job :)

If you’re headed to TechEd Brazil, be sure to introduce yourself to me after one of my talks. See you soon!