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How Come Economists Didn’t Predict the Financial Crisis?

Why didn’t anyone see the financial crisis coming? It’s the one question that everyone has been asking for more than two years and yet no one seems to have an answer to.

If you read Michael Lewis’ book The Big Short, which you really should, the answer becomes a little clearer, and you see that some people did indeed foresee the collapse — and greatly profited off of it. But by and large, it was unpredicted so we are still asking why.

University of Chicago finance professor Raghu Rajan offers some articular, insightful thoughts on the matter regarding why economists in particular couldn’t see the financial crisis coming.

I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

Like medicine, economics has become highly compartmentalized – macroeconomists typically do not pay attention to what financial economists or real-estate economists study, and vice versa. Yet, in order to see the crisis coming, you had to know something about each of these areas, just like it takes a good general practitioner to recognize an exotic disease. Because the profession rewards only careful, well-supported, but necessarily narrow analysis, few economists try to span sub-fields.

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Even if they did, they would shy away from forecasting. The main advantage that academic economists’ have over professional forecasters may be their greater awareness of established relationships between factors. What is hardest to forecast, though, are turning points – when the old relationships break down. While there may be some factors that signal turning points – a run-up in short-term leverage and asset prices, for example, often presages a bust – they are not infallible predictors of trouble to come.

The meager professional rewards for breadth, coupled with the inaccuracy and reputational risk associated with forecasting, leads to disengagement for most academics. And it may well be that academic economists have little to say about short-term economic movements, so that forecasting, with all its errors, is best left to professional forecasters.

The danger, though, is that disengagement from short-term developments leads academic economists to ignore medium-term trends that they can address. If so, the true reason why academics missed the crisis could be far more mundane than inadequate models, ideological blindness, or corruption and thus far more worrisome; many simply were not paying attention!

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One of my favorite quotes comes from Alduous Huxley: “That men do not learn very much from the lessons of history is the most important of all the lessons of history.

So given that, my cynical mind makes it hard to believe that economists will do any better the next time. And maybe that is true. Maybe no one will learn anything from the financial collapse that spurred the biggest global economic downturn since the Great Depression.

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But you still have to at least try to learn from it.

JPMorgan Chase Reportedly Ignored Its Risk Management Department’s Warnings About Madoff

Exhibit #8,492,299 why companies should start listening to their risk managers.

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Senior executives at JPMorgan Chase expressed serious doubts about the legitimacy of Bernard L.

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Madoff’s investment business more than 18 months before his Ponzi scheme collapsed but continued to do business with him, according to internal bank documents made public in a lawsuit on Thursday.

On June 15, 2007, an evidently high-level risk management officer for Chase’s investment bank sent a lunchtime e-mail to colleagues to report that another bank executive “just told me that there is a well-known cloud over the head of Madoff and that his returns are speculated to be part of a Ponzi scheme.”

Then again, it’s not altogether surprising that a financial firm would bury its head in the sand as long as money was still coming in and the risk ultimately did not fall on its shoulders. I feel like we’ve seen that somewhere else on Wall Street in the past few years.

Despite those suspicions and many more, the bank allowed Mr. Madoff to move billions of dollars of investors’ cash in and out of his Chase bank accounts right until the day of his arrest in December 2008 — although by then, the bank had withdrawn all but $35 million of the $276 million it had invested in Madoff-linked hedge funds, according to the litigation.

The Madoff saga continues to unfold.

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Super Bowl: A Game of Risk

The most-watched sporting event of the year is upon us. This Sunday, the Packers will take on the Steelers in a battle of brawn. But such a large event undoubtedly poses serious risks to everyone in attendance, including vendors, teams and spectators. To understand how the NFL and the stadium handle such threats, I contacted Chris Rogers, director of risk control for Aon Risk Solutions’ national entertainment group with a few questions.

RM: For an event the size of the Super Bowl, there are bound to be concerns regarding the safety of fans, vendors and the facilities used. How does the NFL and Cowboys Stadium go about protecting these assets?

Chris Rogers: As with any event of this nature, the sponsors and promoters are very concerned with fan and participant safety. All responsible organizations spend a large amount of time in the planning and preparation phases necessary to put on such a grand event. Safety and security will be at the forefront of all deliberations during decision-making times. These plans and preparations will have begun virtually the same day that it was announced when and where the Super Bowl would be played and continues right up to, and during, the game itself.

Today, most of these plans will follow the basic outline of the National Incident Management System (NIMS) and their model of Incident Command Structure (ICS), which provides for a structured approach to coordinating all the various entities that will be involved. Using this system, risk and threat assessments will be completed that attempt to identify what threats may be posed and how best to eliminate or mitigate them. These plans will also incorporate the training needed by safety and security personnel working the event.

RM: Does the league or the stadium incorporate weather policies and procedures into the overall emergency planning process. If so, how?

CR: Weather is a large factor in the planning and preparation process. Using historical data and assistance from public and private weather services, various scenarios will be mapped out and preparations will be made for response personnel. These plans would include situations before the game as well as during. Plans will also be reviewed regarding “Sheltering-In-Place” procedures should that be required.

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Weather-trained experts will be on site during the game for immediate consultation and assistance.

RM: What types of events could cause a cancellation of the game? How would that be managed?

CR: The events that might be cause for an event of this nature to be canceled would include: severe weather situations (lightning, earthquake, flooding, tornadoes, etc), civil disorder, major fire, terrorist attack, structural collapse, major news events (assassination of a political figure, outbreak of war), as well as pandemic illness (SARS, flu, etc.).

Each of these situations will have to be addressed by risk and security personnel to determine how likely the event might be as well as how severe it might be. In other words, they will conduct a risk assessment for each during which they will address the likelihood of occurrence and how well prepared they are to handle such a situation as well as what the consequences might be if the event occurs. After this assessment, they will begin to decrease their vulnerability by outlining current controls and capabilities as well as a plan for reducing those vulnerabilities wherever they can. These reductions could involve the “hardening” of the venue with new barriers (additional perimeter fencing, additional security personnel, additional lighting, etc.) as well as implementing new restrictions on deliveries and access to the venue or providing additional training for staff and response personnel.

Another aspect of this will be who will be responsible for deciding when and if a cancellation is needed. This will be decided well beforehand and would include procedures for advising all participants that a cancellation is in effect. These procedures will obviously vary depending upon when the decision is made (before the event, just prior to the event or during the event) as each will have unique challenges associated with it.

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RM: How does the stadium work to prevent possible terrorist attacks. What types of security measures are taken inside and outside of the stadium?

CR: The potential for a terrorist attack is an ongoing threat that any stadium hosting an event must be prepared for. For several years now, large public assembly venues have been “hardening” themselves as a target in order to discourage an attack or at least make it as difficult as possible for someone to do harm. This hardening includes structural changes (additional barriers, increased security patrols, new access control systems, closed circuit TVs, etc.) along with procedural changes (employee and vendor background checks, training, delivery appointments, etc.).

There will also be many meetings with law enforcement agencies to review any known or suspected threats. Pictures of any known threats will be circulated and discussions held regarding possible scenarios that might be an issue. And if the event should be designated as a Special Security Event (SSE), additional military and government personnel and capabilities will be made available as well.

RM: Who do you think will win? Why?

CR: As for who will win, GO PACKERS. As for why, because they have a quarterback with a great last name (even though he spells it differently).

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D&O Liability and Climate Change

With climate change increasingly becoming a hot-button issue in courtrooms and among regulators, the risk that directors and officers may become the targets of  lawsuits based on their companies’ climate change-related disclosures is becoming more likely. In an online-exclusive article for Risk Management, attorneys William Passannante and Alex Hardiman of Anderson, Kill & Olick examine this issue and offer some insight into how companies should respond to this growing threat.

The increased regulatory activity and private litigation activity surrounding the climate change issue suggests future increased liabilities. While the treatment of liability for climate change related issues by the courts and governmental entities is in an early stage of evolution, the liability and regulatory machinery are grinding forward. Ensuring that corporate indemnities and insurance are in place to respond is an important step.

For more on this emerging risk, read the complete article, only on RMmagazine.com.