Monday, December 1st, 2014
points of failure

A week ago, the lead segment on 60 Minutes highlighted the decrepit state of infrastructure in the United States.60 Minutes | The video and transcript of the piece are available here, along with extra material.  In case you thought that the collapse of the I-35W bridge in Minneapolis would have caused some action, think again.  Since that tragedy in 2007, inaction has been the order of the day.

That despite business and labor being on the same side of an issue for once — and almost everyone talking about the need to do something to address the infrastructure weaknesses before another calamity occurs.  A secondary theme of the 60 Minutes piece was the depressing effect the lack of investment is likely to have on the economy going forward.

Our elected officials seem to have a risk management philosophy that involves risks not being dealt with until the moment at which they can’t be ignored any longer.  (In that, the politicians are similar to investment managers who have an institutional imperative to stay in the relative performance game no matter the long-term risks being baked into the market cake.)

A compelling example of a lurking problem is the Portal Bridge, a “single point of failure” that is the most heavily-traveled railroad bridge in the Western Hemisphere.  It’s more than a hundred years old and its weaknesses already cause massive delays on a regular basis.New York Times | This earlier New York Times story provides more detail about the bridge.

Shifting to the investment world, one wonders whether there are single points of failure in the market infrastructure.  Is there a Portal Bridge out there that is a critical weakness in the system?  Though the pricing of “public” securities is dependent on the presumption of liquidity, I doubt that even those with the most on the line have enough understanding of the market’s workings to really answer that question.  It’s human nature to think that if it’s working now, it will continue to work.

Chances are that it will, but there are nightmare scenarios we can imagine — cyber-crime or cyber-warfare or terrorism or some “act of God” — that could shut the markets down for a time.  Or maybe there really is a single point of failure in the market plumbing that could fail on its own.

But let’s move past those thoughts of a single point of failure to the assessment of the weaknesses in a system.  That’s how organizations should be analyzed, including investment organizations, which are instead most often judged by bottom-line performance, with little effort to factor in the lurking risks.

The same goes for markets or parts of markets.  We know that the risks can get overlooked for long periods of time, especially given the institutionalized herdingthe research puzzle | It is, as I wrote earlier this year, “a business of herding.” we have built into the modern investment industry.  The financial crisis is an easy recent example, as the sell-side and buy-side chased mortgage paper until well past the time at which the underlying collateral couldn’t support the dance floor.

When the price of an asset veers dramatically away from expectations about it, the implications are hard to figure.  The markets are complex adaptive systems, after all, not statistics.the research puzzle | Despite the workings of “the risk machine.”

Consider the recent (amazing) move in oil.  As far as its effect on the stock market, for example, you could argue either side.  I’ll leave those predictions to the pundits; given the financialization of commodities over the last two decades and the integrated strategies of today, untying one knot may or may not untie others.

The first casualties are obvious — the stocks of sketchy firms that have thrived during the propagation of the U.S. oil-independence meme have gotten slammed.  Some of the master limited partnerships (MLPs), which have been an easy reach for retail investors during our reach-for-yield times, have also shown significant weakness.

Lots of eyes are on the high yield market, where spreads have been widening for months already and where energy deals have played an increasing, if not overly large, role of late.  (The gamier issues are probably in the hands of active managers rather than the big passive ETFs.)

There are also lots of private deals on the books that looked good a couple of months ago that don’t look good at all right now.  Institutional investors will have their hands full trying to figure out if the upcoming quarterly valuations of their energy exposures make any sense.  What oil price level should be used?  Where will impairments show up?

And, it’s possible that there are some financings that are hung up that could burn the facilitating intermediaries.  (When the music stops, you don’t want to be holding the paper.)  Then, of course, there are destabilizing implications for nations around the world.

Perhaps none of these worries will have spillover effects of a magnitude that matter at all — and perhaps oil prices will bounce back as quickly as they have fallen, as if it was all a mirage in the desert (or on the plains).

Price, itself, can be a point of failure.  We have trouble imagining big moves against us (although we can easily dream of big moves in our favor), and we don’t — we can’t — see the whole picture.  There are derivative instruments and structured products and margin calls and hidden exposures that come out to play when we least expect them.

After a triggering event, we are forced to react and to focus our attention on the implications and ripple effects of it.  If only we spent a bit more time thinking about points of potential failure — and trying to “value” and prepare for them — during the quiet interludes that we are given.