The Frog On The Stove: Risk Creep And Financial Crises

| About: AQR Managed (AQMNX)

Summary

The parable of the frog staying in a pot of gradually heated water until he boils is a myth, but it may serve as a metaphor for some disasters.

The Challenger and Deepwater Horizon explosions are examples of the "normalization of deviance," in which smart people slide into danger without realizing it; the financial system also faces this threat.

The combined losses at Deutsche Bank (DB) and the Italian banks could very well be higher than either the regulators or the markets are discounting; if so, watch out below.

The big unknowns include huge derivatives books that, in crisis, would blow up the system, and other assets of unknown value that could default due to low liquidity.

Exposure seems small for the US until we consider the leverage and derivatives books in Europe; thus one should be defensive with TLT, BIV, TOTL, OTCRX, QLENX, AQMNX, and BXMX.

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The parable of the frog staying in a pot of gradually heated water until he boils is a common metaphor. Unfortunately, it is scientifically invalid and a myth (cf. James Fallows, 2006). Indeed, any animal that is uninjured will move away from even gradually rising heat almost immediately. However, many people like this story and believe in it; it was based on 19th century research that was once popularized, but has since been disputed by modern biologists. In spite of its inaccuracy, perhaps it can serve as a metaphor anyway. The point in question is whether we are actually able to react to the gradual but increasingly dangerous increase of risk in the banking sector that has been occurring. Or, like the frog in the myth, are we gradually becoming acclimatized to the danger, and therefore, likely to be caught by surprise? I am afraid that it is the latter case, but let us examine the evidence in detail that is currently available. But first, let's discuss the phenomenon in human behavior that actually fits the "frog on the stove" metaphor.

We can take as our two examples of such behavior the tragedy of the space shuttle Challenger explosion in 1986 and the tragedy of the Deepwater Horizon explosion in 2010. These two disasters have recently been discussed by James B. Meigs of Slate.com (republished by the Business Insider blog). Both disasters involved risk creep, or the gradual increase of lethal risk, caused by systematic self-delusion on the part of those experts tasked with risk control. Sociologist Diane Vaughan studied the Challenger disaster (cf. The Challenger Launch Decision: Risky Technology, Culture, and Deviance at NASA, 1996; The University of Chicago Press, Chicago, 575p) and has concluded somewhat counter-intuitively that organizations staffed by smart and moral people can nevertheless slide gradually into dangerous and unethical behavior.

In the case of the Challenger explosion, the top brass at NASA actually followed the safety rules rigorously, but were tragically completely wrong in their decision to launch under cold weather conditions; these particular conditions jeopardized the functioning of the rubber seals in the rocket booster fuel tanks, which failed catastrophically just after liftoff. Less senior engineers objected to the launch based on their knowledge about the effects of the cold on the seals. However, the more senior engineers that made the call at NASA went ahead because their safety protocols had been gradually degraded via a process Vaughan calls the "normalization of deviance." Essentially, evidence that failure of the seals might occur was never matched by actual catastrophic failure (until Challenger). The ongoing studies of seal failure over the years established that some leaks were quite manageable, so the threshold for stopping a launch was moved up, making even somewhat damaged seals an "acceptable" risk. Imperceptibly to the leadership, the standard of acceptable damage to the seals was gradually moved up over a period of years until failure actually did occur. No one in the hierarchy perceived that they had compromised safety, but they had in fact completely misjudged the risk.

Space Shuttle Challenger Explosion, January 28, 1986

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In the case of the Deepwater Horizon explosion, a whole series of engineering errors occurred that seem inexplicable to me. I've been around a lot of oil rigs and I've never seen mistakes made on standard procedures like the crew of the Deepwater Horizon made. The reason is that generally you die if you make these mistakes, and everybody knows it. I gave a talk on why this disaster happened a few years ago, and I recall that there were actually eight major engineering errors that were made, with three of them reliably fatal. So it is difficult to reconcile an award-winning expert crew doing this, but they actually did. The recent movie claims that cutting corners was involved in causing the tragedy, since the rig was massively behind schedule and was experiencing huge cost over-runs. I find this idea easy to accept, given the obvious safety violations that actually occurred in contravention of all normal practice. Senior members of the crew knew these procedures inside out, so they must have known they were pushing it. But here again, a case may be made that "normalization of deviance" played a major role. People would not knowingly risk immolation in a rig explosion, but if everything they proposed was approved by Federal regulators (because they actually had a stellar safety record on the rig), then perhaps an illusion of safety permitted the gradual loosening of standards, and this was perceived psychologically as an acceptable risk. Risk creep guaranteed that eventually a catastrophe would occur when enough standards were violated to cause one.

Drilling Rig Deepwater Horizon Explosion, April 20, 2010

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Gillian Tett of the Financial Times wrote recently (9/02/2016) that the central banks are ignoring numerous warning signs of elevated risk that may echo 2008. She notes that NIRP is causing huge stress in the banking and insurance sectors, but the central bankers have completely ignored the implications of this risk. As recently as the Fed's Jackson Hole conference, the subject wasn't even on the agenda. Only the Bank for International Settlements (BIS) seems really concerned. It does seem important, however, that in Denmark mortgages now carry negative interest rates, and that in Japan, the BOJ owns 15% of the free float of many major companies. It may also be important that valuations are stretched for most asset classes in major markets, and price discovery is pretty much a thing of the past, with the risk-free rate relegated to the dust-bin of history (Chart 1), as I've discussed previously.

Chart 1: Capital Market Line and Risk Free Rate ("RFR")

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Now if we turn to the latest version of the banking crisis in Europe, we can see some warning signs that the now-familiar tendency towards "normalization of deviance" may be occurring in the banking sectors in Germany and Italy, and probably elsewhere. If so, this "frog on the stove" is going to have an unhappy ending, because the risks appear to be significantly higher than either the authorities or the markets are discounting. Not only is NIRP making these banks weaker, but the Italian banking system has an NPL rate of about 17% (Chart 2), far above that seen in the 2008 crisis in the US, according to George Friedman of Geopolitical Futures (cf. http://www.mauldineconomics.com). Meanwhile, Deutsche Bank (NYSE:DB) is in huge trouble as well (Chart 3), with a pending fine of perhaps $5 billion or more about to be announced by the US government, even though DB only has a market cap of about $15 billion. More disturbingly, because its main line of business is investments, DB has a derivative book with a nominal value of about $57.7 trillion on an asset base of $2.0 trillion; net exposure is reportedly only $21 billion, assuming we can quantify this accurately, which, of course, we cannot. Indeed, others say the net exposure is $45 billion.

Chart 2: NPLs and Interest Rates in Italy

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Chart 3: Deutsche Bank Price Collapse

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Friedman has conducted a study of the interconnectedness of the system and the likely systemic response to a European banking crisis. He concludes that the direct risk to American banks is nominal, but the risk to the German and French financial systems from an Italian crisis is about $93 billion and $280 billion, respectively. Deutsche Bank's net exposure to Italy is about $13.3 billion, or in fact, most of its equity. The US has little exposure to Italy (a total of $47 billion), but about $326 billion in combined exposure to Germany and France. However, if we look at the derivatives books of US banks, we see an additional exposure of $106 billion to Italy. So although standard bank measures suggest US risk is nominal and German and French risk is survivable, this ignores the additional risk from derivatives books, and it ignores the fact that these are poorly known risks. Not only that, but as Michael Lewitt noted in a recent Barron's article (10/03/2016), in a financial crisis we now know that counterparties may not meet their obligations, and thus a derivatives book may not be netted out, leaving the bank to founder under the onslaught of unmatched trades.

Deutsche Bank is highly leveraged, with more than double the leverage of US banks, and with about $32 billion of its assets in the so-called "Level 3" category, meaning they are valued on models rather than the market, according to Laura Noonan of the Financial Times (10/01/2016). There is much talk of DB being "too-big-to-fail" ("TBTF"), but Angela Merkel's government would probably fall if they were to bail out a major bank right now. So the interactions between Italian, French and German banks are potentially on course for another major crisis. Larry Summers and Natasha Sarin of Harvard University (cf. http://fortune.com/2016/09/15/larry-summers-wall-street-too-big-to-fail/) have written that they now believe that the "TBTF" banks are no less risky than they were in 2008. They blame this on higher capital requirements and lower interest rates, factors that central bankers clearly do not perceive as risky. All in all, it appears that the banking systems in Europe and America are at risk as a result of the troubles in Italy and Germany, and that the authorities are assuming low risk when in fact risk is elevated. This is the same formula that delivered the Great Recession, and is potentially a mistake of the same nature (i.e., due to the "normalization of deviance") as those in the Challenger and Deepwater Horizon disasters.

It may make sense to be a little defensive here, perhaps holding some intermediate to long Treasuries: the I-Shares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), the Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV), and the DoubleLine SPDR Total Return Tactical Bond Fund (NYSEARCA:TOTL); also some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), the AQR Managed Futures Fund (MUTF:AQMNX), and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Fund (NYSE:BXMX).

Disclosure: I am/we are long TLT, TOTL, OTCRX, QLENX, AQMNX, BXMX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.