Wall Street’s Lesson For DoD On The True Meaning Of Accepting Risk

Former senator, governor, chairman of Goldman Sachs and self-proclaimed smartest man in the room, John Corzine, appeared today before a Congressional panel to answer questions about the events surrounding the bankruptcy of his brokerage firm, MF Global. To use a colloquial expression, the company “lost its shirt” by pursuing Corzine’s strategy of investing heavily in Euro bonds. In particular, the House Agriculture Committee wants to quiz the company’s former chief executive on what happened to some $1.2 billion of clients’ funds that disappeared.

But there is a much larger and more important story involving the collapse of MF Global. It has come to light that Corzine and the MF Global board were warned repeatedly by that company’s own senior staff that they were engaged in extremely risky trades. Corzine is reported to have caused the demotion of the vice president responsible for risk management, eventually engineering his exit and replacement by someone thought to be more pliant who, eventually, also became so alarmed that he went to the board to warn of the excessive risks of the same trades. When challenged about his risky investments, Corzine apparently declared his instincts to be better than the risk managers’ analysis. The results, however, suggest otherwise.

The MF Global story is a repetition, albeit in miniature, of the behavior by Wall Street that resulted in 2007-2008 in the collapse of the mortgage market, the bankruptcy of Lehman Brothers, the lockup of the global credit markets and the recession that continues to plague the United States. For more than a decade preceding the onset of the financial crisis, banks, brokerage houses, mortgage lenders, ratings agencies, hedge funds and government agencies downplayed and even ignored outright the obvious and recognized risks involved in many of their financial products and investments. Indeed, the excellent work of a number of business writers over the past several years has documented how a number of these firms deliberately undermined their own risk analysis operations, punishing those who sought to warn their bosses about such problems, pressured ratings agencies to declare risky investments as safe or when warned just went ahead anyway, accepting the risk but never hedging against it.

The experience of Wall Street over the past five years when it comes to ignoring risk may portend what will happen to the Department of Defense (DoD) in the years to come. Defense budgets are declining over the next decade, possibly by 20 percent or more. Such a contraction of resources will result in a small and older military with fewer modernization programs, less training and a shrinking defense industrial base. At the same time, there is no sign that this administration has any intention of significantly changing its national security strategy or defense policy. This means that a smaller and increasingly less capable military will have to stretch itself further and further to meet not just constant but actually growing demands. The challenge, to use a phrase coined by the then-Undersecretary of Defense for AT&L (now DoD’s number two official), Ashton Carter, is “to do more without more.”

But that is not what will happen. What our political leadership will do is rewrite the rules. The Pentagon will declare that it is accepting increased risk in those theaters or mission areas where it has chosen to reduce spending. Cancel the Joint Strike Fighter, for example, and accept the additional risk that the military will be unable to achieve air superiority or penetrate increasingly capable air defenses. Halt development and deployment of the phased adaptive architecture for missile defense and accept the additional risk that Iran will develop a nuclear weapon and be able to hold Europe hostage. There are no real threats, there is just increased risk. Political leaders can rationalize accepting risk by arguing that the chance of war appears low at the moment. Pentagon officials can salve their consciences by claiming that they warned us.

Like Wall Street, Pentagon officials will have to bet that there will not be a day of reckoning and that they can take greater risks because no adversary will call in their loan. What is the chance of that happening in a world where Iran is pursuing a nuclear weapons program, North Korea is building mobile long-range ballistic missiles, China is investing in an array of advanced military technologies, Hezbollah has a stockpile of 10,000 rockets and missiles, Russia is acting increasingly like the old Soviet Union and Al Qaeda shifts the loci of its operations and experiments with new ways of attacking the U.S.? The notion that this country can accept additional risk must also presume that a shrinking U.S. military will not prompt a potential adversary to change its risk calculus in a way precisely 180 degrees opposite our own; what is greater risk for the U.S. is less risk for them.

Of course there is one small difference between Wall Street and the Pentagon when it comes to accepting risk. When Wall Street loses this bet, it only costs money. When it happens to DoD, people lose their lives and some even their liberty. Have we not already paid enough in treasure and damaged lives and livelihoods to have learned the consequences of treating risk lightly? The risk the next time, to use Secretary of Defense Leon Panetta’s word, could be “catastrophic.”