Monday, October 25, 2010
Today's guest blogger is James R. Hackney, Jr., Professor of Law and Faculty Director of Research at Northeastern University School of Law.
Risk Management, Torts and Corporate Finance
My guess it that I am one of the few American law professors who teach both torts and corporate finance. This coincidence has as much to say about my educational and professional background as it does the about the curriculum needs of my institution. At first blush, one might assume that the two fields could not be further apart. However, there is one very important unifying characteristic—both are concerned with risk management. Of course, torts scholarship and doctrine focus on how we should distribute the economic consequences of accident risks, and by extension what constitutes an ideal level of risk (and accidents). In corporate finance, risk is a central concept in theories dealing with diversification, asset valuation, the efficiency of markets, and the valuation of derivatives (options). The other commonality between corporate finance and torts is that they both rely on science (or the practical application of scientific techniques) in the effort to manage risk. Two recent events, the Gulf oil spill and the financial crisis, illustrate the conjunction between risk management and science in both the tort and corporate finance arenas. They also illustrate the dangers in placing too much belief in the science or methods of risk management.
The Gulf oil crisis was an environmental catastrophe of monumental proportions. One of the interesting features of the crisis is that it illustrated the failure of a major institution, British Petroleum (“BP”), to adequately account for the risks of its activities. It also highlighted that government regulators had obviously failed at the risk calculus as well. The science of cost/benefit analysis (Learned Hand) is appropriately called into question. Of course, this is a reoccurring theme—the actual catastrophic event causes us to either second guess our risk calculus or want to do away with risk calculus all together. Guido Calabresi aptly described this phenomenon in Tragic Choices.
Similar to our belief that cost/benefit analysis will adequately manage risks in the torts arena, there was a belief that the science of corporate finance could manage risks in the financial arena. The financial sector was allowed to produce a plethora of exotic financial products over the last few decades that were designed to manage or minimize risk. Collateralized debt obligations are bundles of risky assets (most notably, in relationship to the most recent crisis, real estate mortgages). The science of diversification, as articulated by the Nobel Prize winning economist Harry Markowitz, would suggest that holding this diverse bundle of assets would minimize the risk. (Of course, the science of diversification also includes the caveat that systematic risk, such as the wholesale collapse of the real estate market, cannot be diversified away.) In addition, players in the market, such as Goldman Sachs, further hedged their bets (or simply just bet) regarding real estate through the purchase of credit default swaps (CDSs). The CDS phenomenon is a perfect example of the strategy of hedging (via derivatives) in action. Just as the science of cost/benefit analysis failed us in avoiding the Gulf disaster, theories of diversification and hedging deployed in the praxis of finance failed us in the lead up to the financial crisis. This is nothing new. Asset bubbles have been a consistent phenomenon in recent decades, and indeed throughout human history.
A big part of the cultural malaise that we associate both with the Gulf disaster and the financial crisis (apart from the natural and economic consequences) is that once the events occurred and there was an obvious need to clean up the mess, the science and technologies that BP, Wall Street, and the government chose to deploy again seemed woefully inept. The repeated attempts by our most brilliant scientists and engineers to “cap” the spill to no avail seemed to deflate the nation. Our continued inability to stem the tide of foreclosures and unemployment continue to frustrate the body politic. The science of macroeconomic policy, even in the hands of an expert on the Great Depression, Federal Reserve Chairman Benjamin Bernanke, is obviously coming up short or not working quickly enough to satisfy our quick thirst for results. (Of course, in both the BP and economic crisis contexts any critique of the expertise deployed must be limited to those actually relied upon to render advice. As in most situations, there were those within the scientific community whose voices may not have been heeded.) It is difficult to measure the long-term effects the Gulf and financial crises will have on our society. My hunch is that it will make us a bit more skeptical regarding our capacity to manage risks and rely on private actors (as well as the government) to do so. It may also make us less sanguine with regard to the scope and application of science.
- James R. Hackney, Jr.
Professor of Law
Northeastern University School of Law