Providing Integrity for Satellite Navigation: Lessons Learned (Thus Far) from the Financial Collapse of 2008 - 2009

This paper examines the failures in risk assessment and risk management that contributed directly to the worldwide financial crisis of 2008 2009 and identifies lessons that are applicable to risk management in general and to satellite navigation integrity verification in particular. The market-distorting events leading up to the financial crisis are reviewed, and the role of flawed riskmanagement concepts is revealed. In particular, overexploitation of the erroneous Efficient Market Hypothesis (EMH) and the unquestioned assumption of Gaussian market state transition probabilities led to the formulation of risk-quantification models upon which the debt market that collapsed in 2008 were based. This paper derives several lessons from the failures that led to the financial collapse, including the preference for probabilistic models in risk assessment and the need to highlight the assumptions behind deterministic models when they are used instead, particularly when one deterministic model is derived from another. These lessons serve as reminders that, despite the high level of conservatism applied to satellite navigation risk modeling; faulty assumptions can create serious problems if careful vigilance regarding the ongoing applicability of these models is not vigorously and continuously maintained. 1.0 INTRODUCTION The causes of the financial crisis that has led to a severe global economic downturn since mid-2008 are many and complex. Beyond the combination of natural forces and human errors that led to the devastation of Hurricane Katrina in 2005 (see [1]), the less-desirable attributes of human nature – avarice, selfishness, narcissism – played a direct role in setting the stage for the financial crisis. However, the building blocks of the financial market structures that collapsed at the onset of the crisis were originally developed by academic economists and researchers who were not primarily motivated by personal greed. The framework of financial market modeling and risk management that economists developed over decades became nearly universally accepted by the 1980’s, even though many of its flaws were readily apparent. As the decades progressed, quantitative models built atop this framework diverged further and further from reality. They provided the mathematical underpinnings to the complex securitized-debt investments that were extremely profitable for their originators in the investment-banking community but which collapsed into junk as their fundamental assumptions were shown to be invalid. This paper examines the contribution of faulty risk assessment and risk management to the recent financial crisis. As with the paper on Hurricane Katrina from ION GNSS 2008 [1], the goal is to learn lessons from this experience that can improve the way that risk is assessed and managed in engineering projects, particularly those related to satellite navigation. These lessons are mostly indirect, as the context of risk management for safetycritical applications of satellite navigation is far more responsible and conservative than the approach taken by the financial community. Despite this, several connections can be drawn that relate to the details of how risk calculations are performed and the degree to which deterministic models of risk are dependent on underlying assumptions that cannot be proven. This paper is organized into the following sections. Section 2.0 describes briefly explains the origins of the Figure 1: 10-Year Treasury Bond Yields, 1964-2009 financial crisis in terms of the development and sudden collapse of debt-based securities. Section 3.0 gives an overview of financial risk modeling and highlights specific theories that led to the construction of these securities. Section 4.0 summarizes the general lessons that can be learned from this disaster and which are relevant to engineering risk management as a whole. Section 5.0 examines two specific aspects of integrity risk modeling for satellite navigation that are linked to these lessons. Section 6.0 summarizes the paper and restates the lessons to be learned. 2.0 AN OVERVIEW OF THE FINANCIAL CRISIS The financial crisis that began in late 2007 and gathered strength leading up to the collapse of Lehman Brothers in September 2008 was mostly a collapse of the market for debt (bonds) as opposed to equities (stocks). The debt market had changed dramatically in the decade or so leading up to the crisis. Several reasons have been cited for this change, but a primary motivation is shown in Figure 1, which plots the percentage yield on 10-year U.S. treasury bonds over the last 45 years [2]. The 10-year treasury bond is a benchmark in the debt markets because it is fully backed by the U.S. Government and is thus seen by most as “zero risk” or, at the very least, the least-risky form of debt. To obtain a higher yield in the debt markets implies taking on more risk of default – risk of not being paid back. As shown in Figure 1, the yield on “risk-free” treasury bonds had dropped to historically low levels by the late 1990’s and dropped further after the 2000-2001 stockmarket decline as the Federal Reserve kept interest rates low to limit the damage to the broader economy. The maintenance of low interest rates during this decade fed the explosion of “easy money” that made it easy for consumers to borrow and spend past their means. The securitized-debt market that arose from this situation in the first half of this decade provided the mechanism and motivation for “easy money” to spread so easily throughout the broader economy. Faced with the low yields on “safe” treasury bonds, and having a limited number of options to invest at higher yields with more risk, significant demand arose for debt investment vehicles that could do three things (see [4]): Year Yield (% ) Low Treasury yields created demand for higher-yielding investments. Yield (% ) 1) Provide higher yields with only slightly higher risk than treasury bonds; 2) Provide multiple options tailored for different riskversus-reward objectives; 3) Provide healthy profits (“fees”) to loan originators and sellers (retail and investment banks). The market in Collateralized Debt Obligations (CDOs) based on residential home mortgages grew so quickly because of its success in meeting these objectives. A simplified “wine glass pyramid” picture of how these securities were structured is shown in Figure 2 ([3], also see [4]). On the left-hand-side of the figure, collections of thousands of individual home mortgages are shown, and these combined mortgages pay principal and interest when the individual homeowners included in the collection pay their mortgages every month. The resulting outflow of money (shown at the top, flowing from the bottle exit) is sufficient to fill all of the glasses and trays shown below if all of these homeowners pay their mortgages in full. However, the CDO is structured with the knowledge that a few homeowners may stop paying and/or eventually default on their loans. Therefore, the first glass to be filled, at the top of the pyramid, is the least risky. Once it is filled, the “overflow” fills the next row of glasses, and so on until all rows are full or until the money runs out and the bottom row or rows go unfilled. Because the risk of mortgage non-payment and default was thought to be well-understood, this structure allowed packages of mortgages to be “securitized” and sold to external investors in pieces known as “tranches”. Investors aiming for a level of risk only slightly higher than treasury bonds but with significantly higher yields would purchase the “1 tranche”, which was designed such that the agencies who rate debt instruments (Moody’s, Standard & Poor’s, etc.) would assign it the highest rating (i.e., lowest risk) of “AAA” or equivalent. Other investors with different risk vs. return preferences, such as mutual funds and hedge funds, purchased the lower tranches, taking on more risk but receiving a higher yield when their tranches filled up. The investors’ risk could be lowered further by purchasing “credit default swaps” (CDSs), which were essentially insurance against default of the underlying tranche of the CDO. Because the 1 tranche, in particular, was rated “AAA”, it was seen as having a very low default risk; thus a CDS against it could be bought relatively cheaply, even though a default would be enormously expensive to the firm selling the CDS. mortgage payments overflows