Perfect Storms


We reduce the likelihood of a financial meltdown by borrowing insights from the field of engineering.


Our task is to reduce damage from perfect storms. These storms are perfectly unpredictable, a confluence of many failures that individually should never happen. There are no sure-fire preventative measures. If we can’t predict the storm, then what can we do to reduce the damage from the storm?

At one end of the Cub Run commercial cave tour in Kentucky there is a 65 foot high spiral staircase leading from the main level of the cave up to the surface. Examine the supports attaching this staircase to the surrounding walls and you’ll notice they are pointed in very unusual angles. The engineer was a retired automotive expert from GM Experimental and the staircase supports were modeled after those found in the crumple-zones of most late model cars. "I built the staircase to support triple the weight we should see on any typical cave tour, but in case it collapses it will simply tilt over to one side."

What’s our crumple zone for systemic (financial) risks? How do we fail softly? First we must admit there is no perfect solution, or it would be prohibitively expensive. We need to accept the fact that major losses sometimes occur and look for ways to minimize those losses. Perfect storms come up suddenly, and overwhelm (or take advantage of weaknesses in) safeguards or even safeguards of safeguards. We first define what constitutes a collapse.

In the case of the funding agency+, collapse comes in the form of capital flight. Investors race to the exit due to a collapse of confidence in fund management. Our task is to take this collapse in confidence and tilt it over to one side. We can’t let the weight of the structure contribute to its complete destruction. So we put in place our angle bars:

  • Investors only buy and sell during open season+, and only to and from the funding agency
  • We maintain a hefty reserve fund and will automatically dip into this fund at the first hint of a reputational collapse
  • We build tall firewalls between individual funds, so collapse in confidence in one fund does not spread to the next
  • We have many investors who are committed for the duration and cannot race to the exit (e.g., agency managers, management of Investible Units+, and to a limited extent retail investors)

A crisis in confidence can come from mismanagement, fraud, misrepresentation, negligence or breach of fiduciary duties. We put in place triple safeguards to avoid these outcomes. Luck happens to the prepared, bad luck happens to the unprepared. But when our safeguards fail we willingly take a personal financial bath to restore confidence. Trust is all we have and the first rule of rebuilding trust is quick admission of wrong and promptness in restitution.

Expect the Unexpected+

There is a consistency in our response to ‘the unexpected’. Our funding agency and our investees live for the unexpected. It’s our core competency. This is true for both fortuitous accidents as well as damaging ones. Success in unpredictable R&D+, by definition, will be ‘unexpected’. Failure in our funding agency, especially in the area of Systemic Risks, will be ‘unexpected’. Our team, investees, agency management+, third party partners and committed investors, all constantly strive to both reduce the scope of the unexpected, and to be much better at detecting and reacting to the unexpected when it finally happens.

We have a framework, but we need more. We mentally step forward into the future and look back. What if that safety valve fails? What’s coming up in the new business year and how does it affect established safety protocols? What’s the real story behind that failure of our competitor? What was that noise? In the end, though, there is no crystal ball.

Expect the unexpected is a more expansive view of contingency planning. We put in place reasonable protections against improbable wrongs, perhaps an early warning system. But protections are only as good as their weakest link, which in our case is found in voter apathy or complacency+. We need our citizen – investors to pay attention. The more eyeballs we can put on an issue the better our chances of detecting and forestalling catastrophic results, or in the case of a fortuitous accident, the better our chance of catching the opportunity when it surfaces.

We put in place protections. We are better at anticipating risks. We have better detection systems. We better react to accidents when they occur. These are the cornerstones of a robust risk protection system.

By definition we can’t anticipate or protect against perfect storms. Instead we look to minimize the damage from these storms when they eventually happen. Financial firewalls are our best tool for this purpose. We compartmentalize work so damages remain localized. For example, we use different creditors for different perpetual funds, and make sure these creditors are not in turn using the same reinsurance agency, as was the case with creditors and AIG during the 2008 financial crisis. Redundancy and backup become the cornerstones of this approach.

Having a single large fund may be more economical, but at a higher risk. We focus on effectiveness and not cost savings. And one measure of effectiveness is being able to weather inevitable financial storms. If you’re not protecting the future then you’re not being effective. Fortunately our mission is to launch multiple blockbuster+ products. Outrageous success drowns out calls for greater efficiencies; calls to mortgage the future+ for the sake of a few more percentage points profit. Outrageous success means we have the funds needed for redundancy and backup and we are not pressured to cut costs for the sake of today’s investors.

Editor's Picks for September, 2011

Further Reading
Reba Tull
Joined: 03/30/2011
Analogy doesn't work

Cute engineering analogy, but I don’t see its application. A crumple-zone is hardly a good analogy for a protection of our funding agency+ reputation. The car is destroyed but the occupants (agency management+) walk away.