New World of Financial Risk.

¶ … New World of Financial Risk. A synopsis of the content is given followed by a specification of the thesis's main point. Three supporting opinions/reasons for this thesis are outlined, as well as three opposing opinions/reasons. Finally, a summary and opinion of the thesis is presented.

The New World of Financial Risk

The following paper reviews the article The New World of Financial Risk (Johnson & Kwak, 2009). A synopsis of the content is given followed by a specification of the thesis's main point. Three supporting opinions/reasons for this thesis are outlined, as well as three opposing opinions/reasons. Finally, a summary and opinion of the thesis is presented.

Johnson and Kwak (2009) note that when it comes to human endeavor and financial and business activities, risk is ever-present. For this reason, managing risk has been a concern for millennia. Today, the risk diversification and management are critical components of modern investment and finance. Yet, with risk comes opportunities for rewards. It is not risk itself that is bad, but instead mismanagement or underestimating risk that can be detrimental. One such area of troublesome risk is over leveraging.

Using Lehman Brothers Holdings, Inc.'s collapse as an example, Johnson and Kwak (2009) state that they had a leverage ratio above 30. Although high leverage is not necessarily a death knell, it's what is done with the funds that are borrowed. The catalyst for Lehman's ultimate failure was liquidity risk, which snowballed into the Federal Reserve freezing money markets and financial institutions reconsidering counterparty risk, which eventually led to the AIG bailout.

The last two decades has seen a market where participants have systematically underestimated risk. Part of this is due to the psychological effect concerning the fact that the longer one goes without a crisis the more convinced one becomes that crisis can be averted. In addition, investors relied on bond rating agencies who "made dubious calls in the past several years" (Johnson & Kwak, 2009). Faulty value-at-risk models, unanticipated housing price declines, securitization creating even more risky securities, and new ways to hedge fixed-income securities all contributed to the financial problems. In response, new tools were developed.

According to Johnson and Kwak (2009) new liquidity measures, guarantees for a variety of assets, and bank recapitalization was developed to deal with the new world of risk. However, there are still no guarantees that these will work. Sub-prime mortgages, prime mortgages, commercial mortgages, auto loans, credit cards, corporate debt, and mortgage-backed securities are all possible areas where banks are expected to take writedowns. Non-financial firms too are experiencing economic troubles, with the worst recession in decades. In the short-term, the authors surmise, businesses will just have to adapt to doing business with less credit. Long-term, Johnson and Kwak look to new regulations and more conservative financial institution behavior, to create a healthier and more transparent financial system. Of course, the downside is this will lead to increased costs of doing business.

Three Supporting Opinions/Reasons:

The first supporting opinion Johnson and Kwak (2009) use to promote a positive image of the overcoming of the economic turmoil recently experienced in America is the nationalization of institutions like Fannie Mae and Freddie Mac. With this response, the American government has taken on the risk, "transferring their assets to the government balance sheet." These instances of nationalization, as well as bailouts and guarantees of new debt issued by banks, by the FDIC, are based on the premise that the American government has an unmatched ability to raise money and thus can absorb the risk.

Second and third supporting opinions center on the improvement of the financial system. The current Administration will be able to develop better systems to manage risk across the financial system. In this will be the development of better ways to identify risk. This will lead to a more robust and more transparent system, when it all comes together (Johnson & Kwak, 2009). A complementary component of the healthier system is increased disclosure.

Johnson and Kwak (2009) use this anticipated increased disclosure as their third supporting opinion. They theorize that increased disclosure requirements will be developed for off-balance sheet exposures, including items like structured investment vehicles. Hedge funds will require some measure of disclosure as well. Each of these should help revitalize the financial system and prevent similar problems from occurring in the future.

Three Opposing Opinions/Reasons:

The three opposing opinions to Johnson and Kwak's (2009) theory that the United States will be able to overcome the new financial risks begin with examples of the struggles in implementing similar programs, specifically nationalization, in other countries as well as a note that sovereign debt may be exceeding expectations. "CDS spreads on U.S. sovereign (U.S. Treasury) debt had climbed from 6 basis points at the end of April to almost 40 basis points in November." Other countries have had it worse though, including the financial collapse of Iceland, and troubles in countries like Greece and Ireland. Although not the economic size of the U.S., these countries could demonstrate the potential hazards of America nationalizing beyond its true means.

Johnson and Kwak (2009) also note that a resurgence of political risk is a possibility, as a second opposing factor. Unpleasant political consequences can be triggered by financial crises and recessions. As the authors call it, 'old-fashioned protectionism' could come into play. In this instance, the U.S. could favor Americans over foreign creditors. This could wreak further havoc in an increasingly globalized economy.

Lastly, as a third opposing factor, the house of cards that was lending may not be finished falling, according to Johnson and Kwak (2009). As noted earlier, sub-prime mortgages are continuing to fall in value. Auto loans, credit cards, prime mortgages, commercial mortgages, mortgage-backed securities, and corporate debt are all areas where banks are expected to take writedowns. Recapitalization, in the first round, is likely not to be enough to sustain them. Banks like Citigroup already are in need of fresh bailout funds.