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AIG, The Space Shuttle, and Creeping Risk

Listening to all the fully justified outrage about bonuses getting paid to the employees of AIG that took all the risky bets reminds me of the recriminations and second-guessing after the two Space Shuttle disasters.

No doubt if Edward Tufte put his mind to it he could come up with a fascinating graphic about the data leading up to the collapse of AIG, as he did with the launch decision for the ill-fated Space Shuttle Challenger. But in the meantime here are some thoughts based on the extremely thorough book, The Challenger Launch Decision, which I read years ago (a very interesting book, but very long — 566 pages).

Normalization of deviance leading to incrementally increased comfort with greater and greater risk. The Shuttle organization became more comfortable with doing things that lay outside the limits of specifications, or at least edged closer to the limits of specs. Each time this would reset their tolerance for deviation from normal. Ultimately this led to decisions that pushed risk over the edge. Like AIG (and much of the decision-making that led up to the economic collapse), in hindsight these decisions seem outrageous, but within the bubble they seem reasonable and with precedent. Which is not to excuse them by any means, just to note that we need to be especially on-guard, and reward those who are the lone voices questioning the decisions when the stakes are so high.

Assumption that others know the parameters and risks: In the case of the Shuttle, NASA engineers believed that engineers at Thiokol, the maker of the external rockets, knew the limits, when in fact there was a disconnect between the specifications that NASA used for launch decisions, and the specifications the rockets were designed to. Obviously plenty of people at AIG, and the banks who did much of the investing with them, were quite familiar with the risks, but many others were not. Thanks to how the credit rating agencies evaluated Credit Default Swaps, risks seemed lower than they were, hiding the true extreme risks from those less familiar with the ins-and-outs of CDS’s.

A realization that decisions are heavily influenced by emotions. Managers are not “amoral calculators” to use Vaughn’s phrase. Too much in the world of economics also assumes that people act rationally — consumers, bankers, investors alike. (This despite the daily evidence to the contrary, namely the emotion-driven swings of the stock market.) People will do things that are most definitely not in their self-interest (or in the interests of others they are supposedly responsible for) if they get caught up in the emotion enough.

Why Aren't Insurers More Active on Global Warming?

A report out today from Munich Re Group (an insurer of insurance companies) says that 2008 is the third highest on record in terms of financial losses caused by natural disasters (not to mention 220,000 human lives), and puts much of the blame on global warming.

Bloomberg reports (emphases mine):

Worldwide insured losses related to natural catastrophes increased about 50 percent to an estimated $45 billion last year compared with 2007, the world’s biggest reinsurer said in an e- mailed statement today. Overall losses more than doubled to about $200 billion, the Munich-based company said.

Natural disasters cost more than 220,000 lives even as the total number of such events declined 22 percent to 750, the report showed. China’s earthquake in Sichuan province in May claimed about 70,000 lives and cost $85 billion in overall losses, while Tropical Cyclone Nargis killed about 84,500 in Myanmar. September’s Hurricane Ike in the U.S. was the most expensive natural disaster for insurers, costing $15 billion.

“Climate change has already started and is very probably contributing to increasingly frequent weather extremes and ensuing natural catastrophes,” management board member Torsten Jeworrek said. “2008 has again shown how important it is for us to analyze risks like climate change in all their facets and to manage the business accordingly.”

Munich Re has been quite vocal in arguing that global warming and climate volatility are leading the insurance industry toward a financial cataclysm. According to this article, Munich Re has taken a longer view of future climate scenarios and their financial impacts, which is only prudent. While US insurers were more active on this a couple of years ago, they seem to have fallen off in their efforts, despite a more open attitude from consumers to look at green alternatives and incentives.

As one commentator put it,

“European insurers, and particularly Munich Re and Swiss Re, have always thought longer term,” said Christopher Treanor, chief executive of insurance broker Mercator Risk Services. “The U.S. as a business culture takes a shorter view.”

Where have we heard this before? This short-term thinking is getting to be a fucking epidemic, and look where it’s got us. It has to stop or we’re just going to hell in a handbasket.

Allstate, State Farm, Firemans, Progressive, Hartford - I’m calling you out. Get off your butts and start doing something about this. Why aren’t I seeing commercials from you extolling the virtues of gas-saving cars and taking public transit? Why aren’t you making it very expensive to air-freight products from China? Why don’t you give me a big break if I do a great job insulating my house?

Heck even the health insurers could get in on the act. If I eat more vegetables and less meat, and eat locally grown seasonal produce, I’m doing the earth a favor as well as my body. Reward me for it and help head off financial ruin at the same time.

And yes I realize this means you competitors have to do this collectively, or individually you’ll shoot yourselves in the foot with higher rates. But divided you will fall, and united you might just squeak by. If the current global economic meltdown has shown us anything, we’re all in this together. Acting selfishly gets us nowhere.

Global Recession, Here We Come

Remember that scene in Titanic where the ship splits in two, the back end rises up vertically, and then plunges into the freezing ocean? That’s what the world economy is about to do. And just like the passengers on the Titanic, we can see it coming and feel the gradually building momentum, but are powerless to stop it.

The New York Times is now bluntly talking about a global recession (with a similarly apt oceanic metaphor): 

When the White House brought out its $700 billion rescue plan two weeks ago, its sheer size was meant to soothe the global financial system, restoring trust and confidence. Three days after the plan was approved, it looks like a pebble tossed into a churning sea.

The crisis that began as a made-in-America subprime lending problem and radiated across the world is now circling back home, where it pummeled stock and credit markets on Monday….

The vertiginous drop in stock markets on both sides of the Atlantic on Monday reflected not only those fears, experts said, but also a growing belief that the crisis could tip the world into a global recession.

The article notes that the usual organizations that help stabilize recessions — the IMF and the Group of 7 — are either too weak today, or lack the true global influence, the latter because China and India are not part of the club. There has been very little global coordination to stem the tide, and even within Europe itself there is an every-country-for-themselves. Heck, Iceland almost went bankrupt today!

Get a tight grip on the handrail, this is going to be a bumpy ride down, followed by a long freeze.

NY Times Article