Kamakura's Andrew Cowton, based in Melbourne, passed on a question from a reader who asks, "Is cash flow at risk a concept that successfully avoids the problems outlined in the Kamakura blog post from April 6, 2009 "Is your Value at Risk from Value-at-Risk? Beware..."? The answer is "yes," if one does it right, but many, many people do it wrong. We invoke a key slogan from Bill Clinton's successful challenge of President George H.W. Bush to show what it takes to get it right in this post.
James Carville, key strategist for Bill Clinton's challenge to incumbent President George H. W. Bush in 1992 coined a simple phrase to remind both Clinton's campaign workers and the nation's voters what was at stake in that year's election. The phrase "It's the Economy, Stupid" was blunt but effective. Cutting through the haze of the political campaign, this phrase grabbed voters by the throat and shook them to focus on what was wrong that Bill Clinton claimed he could fix.
Andrew's friend, who we call MJ after Lance Armstrong's bike shop in Austin Texas, sent along an intricate article talking about how to simulate cash flow at risk in a very complex way, complete with probability distributions of cash in and cash out on a forward looking basis. This is good as far as it goes, because it at least focuses on an issue that was a problem even for President Barack Obama's key economic adviser Larry Summers, when he was president of Harvard University. Summers, anticipating a rate rise (according to Forbes magazine) that would increase the cost of financing the multi-billion expansion of the Harvard campus, put in place billions of interest rate swaps. Unfortunately for both Harvard and Summers this was a naked open position, not a hedge, interest rates moved against Harvard, and the university was facing a cash margin call of $542 million. No problem one would think, given Harvard's then $32 billion endowment, but alas--the endowment was in illiquid assets and had other assets subject to usage restrictions. The university was forced to issue bonds to meet the margin call-a classic "cash flow at risk" mistake.
So forecasting cash flow at risk, liquidity risk, and the probability that one can't meet one's cash needs is a critical element of total risk management. In fact, the Australia Prudential Regulatory Authority issued liquidity risk analytical guidelines nearly a decade ago to get Australian banks to focus on this issue. The problem, as the article that MJ provided illustrates, is that most people get it wrong. The simulations in that article were intricate, complex and completely worthless because it was a simulation that allowed for no possibility that the bank would get in trouble. The analysis was based on historical volatility of cash flows during a period when the bank was not in trouble, and therefore they would produce no forecast that would even crudely approximate cash needs in a truly distressed environment. This is the cash flow equivalent of the huge mistake outlined in our April 6 post--the assumption that equity returns are normally distributed at their historical monthly mean and standard deviation implied a probability of a -100% return in a month of 0.000000 for Bear Stearns, which did in fact collapse. We have to be very careful not to bury ourself in similar analysis, complex but inaccurate, with respect to cash flow at risk.
In the brochure "Kamakura Risk Manager, In Depth" on www.kamakuraco.com we take the reader through case studies of Countrywide Financial Corporation and Northern Rock plc, both of which collapsed in the current crisis. Countrywide lost 100% of its commercial paper supply in six months, and lost 94% of its commercial paper in only 3 months, as its credit risk as an organization turned off liability suppliers. Northern Rock lost 63% of its "customer accounts" in only six months, despite never having reported a loss during that interval. How could this happen? "It's the Economy, Stupid" comes to the rescue.
As we discuss throughout this blog, macro economic factors move, they cause substantial damage to asset values, and when this happens, the investors (both retail and institutional) do a "credit risk cat scan" that sees the risk even before the risk is passed through financial statements. Even in the face of deposit insurance, liability suppliers run away. Cash Flow at Risk MUST include this transmission mechanism to be of any practical use. This is one of the primary uses of Kamakura Risk Manager by sophisticated users. It's the only way to show how cash flow at risk and liquidity risk lead to bankruptcy or rescue as asset values are impaired.
MJ, many thanks for the comments. When it comes to liquidity risk and cash flow at risk, James Carville got it right for the Clinton campaign and risk managers as well. It's the economy!
Donald R. van Deventer
April 23, 2009