Can You Prepare for Systemic Risk?

Jason Stipp: I am Jason Stipp for Morningstar. It's Risk Control Week on Morningstar.com, and today we are talking to you about the concept of systemic risk. This is something that's been on a lot of investors minds since the recent downturn.

And here with me to offer some insight on what systemic risk is and what it might mean for your portfolio is Morningstar markets editor, Jeremy Glaser.

Jeremy, thanks for joining me.

Jeremy Glaser: You are welcome Jason.

Stipp: This is a concept that we have been hearing a lot about, this idea of a system and a risk from the system, but I think it's kind of squishy in some people's minds. Can you give some clarity or some structure around how to think of this notion of systemic risk?

Glaser: It absolutely is a squishy concept, unlike something like volatility, which you can go out into the market and actually measure, something like systemic risk doesn't have a really good quantitative measurement. It's an idea that we have to grapple with without putting a lot of numbers around it.

And I think the best way to think about it is, instead of a risk related to an individual company failing or individual product not succeeding, it's that the entire system is going to come down. The entire system will fail. So let's say, it's a bank that's too big to fail or in some other way that there is no way that it can continue to succeed even without it.

Stipp: And I think the recent example of how that plays out, is that a lot of things will go down at the same time. So you can't really diversify away this sort of systemic risk, and that's what we start to see in the financial crisis. And I think maybe that's a good way to frame what systemic risk might be, at least, a good recent way to frame it.

Glaser: The financial crisis was a great example. If you take a look at Lehman Brothers, on its face, it doesn't seem like it would be big enough to bring the entire world financial system and the world economy for that matter to its knees, but it was. And the reason was, it was incredibly interconnected to a lot of different institutions and it challenged investor notions of what the system should look like.

The idea that you'd be able to get this overnight financing every night without worrying about it and that bankruptcies would happen in a certain controlled way, that those notions just kind of fell apart, people started to panic.

And when they started to panic you saw other organizations and other financial firms come under extreme pressures. Either get forced into suitors' arms or to really just make it by the regulators pumping a ton of liquidity into the marketplace. And there were times that it looked really scary.

And because the financial institutions are so interconnected into this so-called real economy, you end up with businesses that need financing to get inventory and to do other things just to run their business day-to-day, couldn't get that. And then it becomes difficult for that manufacturer to work out and that hits end demand, and you see this cycle. And before you know the entire economy is in a lot of trouble, because the whole system and the way that we conceived the system, kind of fell apart at the seams.

Stipp: So what we are seeing really then is not necessarily just the financial system, because it's so systemic that even the guy that makes widgets down the street can't get that short term funding to make his payroll and suddenly his business is at risk because of this systemic problem?

Glaser: Precisely.

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Stipp: So, I think that we managed through intense and very massive government intervention to step away from the financial crisis, and the abyss that we saw in 2008, but now it seems like the European crisis has come up, and it's obviously shaking the global markets, left and right, depending on what the news is. Is this another example of a systemic risk that we're facing here?

Glaser: I think it is. One of the ways that I've heard systemic risk described is that it's not so much one domino falling over and hitting all of the other dominos; it's that when that one domino falls, everybody looks at all the other dominos to figure out what's the next one to go. And Greece is a great example of this.

So, the fact that Greece itself is defaulting shouldn't be that big of a deal. Sovereign defaults are absolutely nothing new. If you look over the history of nations, they've defaulted all the time. And even in recent history, there has been a ton of defaults. Look at Argentina, they defaulted and there was not a huge impact on the entire global economy. In a lot of ways, Argentina is more important than Greece on a lot of metrics in that way.

So, you could say, well, it's part of the euro, has some extra things, but for the most part, we can handle a Greek default. It could have some impact on European banks as well. But one of the things that really concerns people is, well, what does this mean for sovereign debts and for the credit quality of countries across the entire globe?

So people start looking at Spain, and say, wow, Spain looks really bad, and so does Portugal, and maybe Italy, and then Ireland, and then the U.K. and then the United States. And you hear people kind of go through this mental exercise, where they say, if this could happen in Greece, why couldn't it happen in any of these other places, and what would the consequences of that be?

And especially in the time like this, when people are still a little bit gun-shy from the financial crisis, you'll see a lot of pressure now for governments to get their medium- and long-term fiscal picture into balance fast, instead of, people thought they'd have long time to kind of get some of these budget deficits under control after a lot of this stimulus spending. And that concerns a lot of people who expect to have stable policy.

So I think that you could have a systemic risk here. And it's not so much that Greece is so important, it's that the Greece default kind of signals that people are really worried about sovereign debt and that it's something that could trickle through everything else.

Stipp: So in a similar way, then, as you were saying the financial crisis caused us to look at how this overnight funding is working and how sustainable it is, and how sustainable the whole system had been for a while, the Greek crisis, even though in and of itself is not necessarily going to bring everything down, it's really causing us to take a step back and look at how countries are running their balance sheet.

Glaser: Absolutely.

Stipp: So given that then, I mean is there a way that we can kind of predict where this systemic risk will come from? So, we did happen to see it through Lehman and Bear Stearns, and then it suddenly became apparent, we're starting to see it through Greece. How can we begin to get a handle on what could cause the next shift in perception and suddenly realize that a bigger system is at risk?

Glaser: It's extremely hard to figure out where this is going to come from. Certainly, the financial system is a place where a lot of these systemic events come from, and that has to do with, like we were talking about earlier, just how interconnected it is with all other industries. If we stopped making bean bag chairs for a couple of weeks, or the bean bag industry fell apart, you're not going to see an enormous impact on the rest of the economy, but if banks stop lending altogether and there is no credit and no financing, in a modern economy, that's going to bring everything to halt.

So I think that's an area to keep an eye out for systemic risk, but there are also issues that no one ever considered before, that become very important. Take a look at the flash crash. There's idea that this high frequency trading was going to bring the entire stock market down, 10% in a couple hours, was something that I don't think anyone really seriously considered and now it's on the radar screen of anyone thinking about systemic risk in a serious way.

So it's really impossible to predict where it's going to come from and it could come from extremely unlikely corners.

Stipp: So I guess from a portfolio perspective, I have a little bit of an issue with that, because you're basically telling me that there might be risks that I don't even know about, that I haven't even conceived of yet, what in the world should I do, then, given the fact that I might be facing something around the corner, and I don't even know it's there.

Glaser: Again, it's another one of these challenging cases, but I think there's two big things you need to keep in mind. The first is that if you have short-term liabilities, you need to have the duration of your portfolio also be short term. So, if you're sending the kid to college next year your assets should be mostly in cash or in short-term bonds. The risky assets, which could decline the most during some sort of systemic event, you need to have more time for them to have long-term appreciation. So I think that's something to definitely keep in mind.

The second part is you need to not panic during any of these systemic events. Now, granted the flash crash was only a couple hours, but even during the financial crisis, the investors tended to overreact to a lot of these events. So the markets sold off way past for where that new equilibrium level should be, and it took a while for it to come back, but it eventually did as people saw the underlying value in a lot of these stocks and the underlying value on a lot of these risky assets.

So certainly, you can definitely almost get an opportunity from these systemic events if you're able to stomach it. If you don't think it's absolute Armageddon then chances are things are going to recover from the absolute fire-sale prices. And if it is Armageddon, you might have more important things to worry about than just your stock portfolio declining a little bit.

Stipp: Sure. I think your two points are actually very connected, because if you do have the short-term assets that you need, that are easily liquefied, and you know that you can cover your short-term liabilities you're probably much more likely to be calm during moments of market volatility knowing that you can ride them out. So thanks so much for your insights, Jeremy.

Glaser: You're very welcome Jason.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.