wisdom of crowds

In times of financial stress, politicized debate, and geopolitical conflict, it’s reassuring to know that there’s a body of wisdom most every informed person accepts. Of course, our benighted forebears got so many things wrong – imagine believing that the earth was flat or trusting in the healing power of leeches! But since the conventional wisdom of today stems from public awareness campaigns following rigorous peer-reviewed scientific research, it obviously won’t need future revision.

For instance, we know that cell phone talking and texting is the deadliest distraction in a moving vehicle. We’ve learned that austerity kills – when unemployment rises during recessions, bringing along with it the twin perils of excessive drinking and suicide, the mortality rate climbs. We know who principally lost during the housing crisis – it was those unfortunate buyers who entered the market at the bubble’s zenith and overextended their finances by putting down too little money and gambling on price appreciation. And we all cringe at how effusively Americans share the gory details of their personal lives online, longing for the greater discretion of other cultures.

Fatality-producing accidents involving a distracted driver stem, in 62% of cases, from daydreaming or being lost in thought, according to Erie Insurance’s analysis of national crash data. By contrast, mobile-phone use caused these accidents 12% of the time, followed by the relative laggards of rubbernecking, eating and drinking, or moving a pet or insect. In other words, given a fatal accident, a daydream believer is five times more likely to be involved than a fast-texting teenager.

Economic recoveries bring a higher death rate, and recessions a lower death rate, according to University of Chicago professor Casey Mulligan’s excellent synopsis of research (which includes the Great Depression but not the Great Recession). Although the phrase “austerity kills” is a popular one, increases in death by suicide are overwhelmed by recession-accompanying mortality-rate declines in most other categories. For instance, economic contraction brings fewer hours worked in high-hazard industries like construction, and hence fewer accidents. Additionally, traffic accidents fall as fewer vehicles travel the roadways during recession. UVA Professor Christopher Ruhm shows that eight of ten key sources of fatality demonstrate procyclical behavior, as does the total mortality rate. Perhaps the phrase should be modified to read “prosperity kills.”

Of defaulting homeowners in Los Angeles County studied by Fed economist Steven Laufer, 40% had purchased their homes before 2004 – given the meteoric ascent of home prices in California up to 2007, more than 90% of them would have had positive equity against their original mortgages. For these buyers, the culprit was cash-out refinancing, which left a quarter of them with LTVs of 140% and one-tenth of them with LTVs of 170%. In sum, aggressive equity extraction by homebuyers who purchased homes before 2004, rather than unfortunate timing, led to 30% of all defaults from 2006 to 2009.

Only 15% of Americans share ‘everything’ or ‘most things’ online, well below the worldwide average of 24% surveyed by Ipsos OTX in twenty-four different nations. By contrast, 60% of Saudis, 50% of Indonesians, and 30% of Poles share the full gamut of their emotional highs and lows via online status updates. So next time you bemoan a Facebook post that divulges too much personal information, just imagine how your feed would look if you lived in Riyadh!

Unfortunately, “conventional wisdom” can be equally misleading in risk management topics. Here are a few examples:

“I can rely on economic forecasts to make sure I hedge my interest rate exposure on time.” Forecasts generally lack predictive power. For instance, as we’ve demonstrated in the pages of this newsletter, unemployment rate forecasts for next month are only accurate when they predict little or no change from the current month. With positive or negative spikes (i.e. more than 0.2%), we found only one correct call out of three hundred and eighteen attempts! Successful forecasting is directly tied to the rate’s not moving from one month to the next. This is like a weatherman who forever predicts that tomorrow’s weather will mirror today’s; he always gets it right, except on days when a new front blows in and changes atmospheric conditions. This is precisely when you want a weatherman to warn you about changing weather. Those who rely on economic forecasts can never be sure that they will have time to take risk off the table.

“I’ve hedged my top foreign currency exposures by notional, so I have definitively reduced my risk.” Consider a Euro functional company with significant manufacturing operations in China, Malaysia, Brazil, Poland, and Romania. Putting on forward contracts to sell Euros and buy each of those currencies can increase hedging costs unnecessarily. Since the EUR’s movements against CNY are strongly correlated to MYR, weakly correlated to BRL, weakly inversely correlated to RON, and strongly inversely correlated to PLN, hedging each of these currencies in entirety negates the significant natural offsets that may exist. If cross-correlation is not taken into account, the company’s hedges may reflect far higher notional amounts than actually required to produce a given risk reduction. And if any exposures suddenly go away, the hedge unwind costs will be larger than they needed to be, magnifying currency risk.

“Hedge accounting criteria constrain me from hedging my full consolidated currency exposures.” It is certainly true that hedge accounting rules impose certain constraints: the specific entity with the currency exposure is usually required to be party to the hedging instrument, and the hedged transaction must be denominated in a different currency from the hedging unit’s functional currency. While this caps the notional amount of currency exposure that can be directly designated, firms can also benefit from indirect designation (level two) or split designation (level three) to increase their hedge accounting capacity. While higher-level hedge designation does require additional setup and analysis to implement correctly, firms that do so can achieve their risk reduction objectives more comprehensively.

In risk management, as in many other areas of life, the conventional wisdom often isn’t really wisdom. If you have questions about how to separate myth from reality regarding market timing, hedge structuring, or accounting for derivatives, please don’t hesitate to give us a call. And stay cool out there, but don’t go swimming until at least one hour after eating a meal – at least, according to conventional wisdom!