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The Gray Rhino
How to Recognize and Act on the Obvious Dangers We Ignore
By Michele Wucker St. Martin's Press
Copyright © 2016 Michele Wucker
All rights reserved.
ISBN: 978-1-4668-8700-8
CHAPTER 1
MEET THE GRAY RHINO
In the autumn of 2001, Glenn Labhart was chief risk officer at Dynegy. The energy company was considering buying an energy trading company whose stock had fallen by 80 percent in recent weeks, sending shock waves through the energy markets. Dynegy's chairman and CEO, Charles Watson, knew the company well — or thought he did — and had a plan to buy its energy marketing capabilities for a song, stabilize the energy markets, combine the two companies' trading capabilities, and protect itself from the exposure it already had in case the company failed. It was a chance to be a white knight, and to make some money in the process.
Labhart, a plainspoken, no-nonsense Texan, was a seventeen-year veteran oil-and-gas trader and a former risk consultant who now had a $42 billion portfolio of trading, power generation, and energy assets, along with the associated insurance and credit risk, under his oversight. He already had helped steer Dynegy through the recent California energy crisis and the aftermath of the 9/11 terrorist attacks. He had developed a dynamic tool to provide real-time risk-management information. Now he was tasked with assessing the risks associated with the $25 billion deal and advising the board.
He did a value-at-risk analysis of the company to generate a set of metrics not unlike the dashboard of a car, with its speedometer and gas gauge. It had already become obvious that Dynegy would have to put more capital into the company it was considering buying and assume a significant amount of its debt. The more Labhart looked at the company's financials, though, the more concerned he became. "I extrapolated out to one year for risk-adjusted return on capital, and the results were sobering," he told me in a conversation over coffee. He just couldn't figure out how the company had calculated the profitability and cash flow of its trading operations. When he tried to envision standing in front of a ratings agency and justifying the deal, he simply couldn't picture it.
Nearly fifteen years later, Labhart vividly recalled a 7:30 AM due diligence meeting, at the venerable Houston law firm Baker Botts, with Dynegy executives and their lawyers about their risk assessment. He told them bluntly, "If we're going to do this kind of deal, we need to ask them how they value risk on non-liquid assets." He presented his report to the board, warning members that the numbers didn't seem to add up and that they needed to do more due diligence or hold off on the deal. "The report said we didn't need to do this," Labhart recalled. "I said we needed to ask more questions, but the train had left the station. I wish I'd had more lead time."
The company to be acquired was, of course, Enron, the corporation that went down in the annals of business history as an example of the colossal failure of auditors, analysts, and investors to recognize that a firm valued at $90 billion was merely a house of cards. It has become a classic example of greed and willful ignorance of warning signals.
Recounting the story, Labhart quickly sketched a daunting organizational chart, outlining the short-term and long-term assets and liabilities and flows within the company. He drew an arrow and a circle around the thing that had set off alarm bells for him: the way the company marked its assets to market — an accounting practice commonly used for securities trading but which this company used to value its turbines. "How do you mark-to-market a turbine?" he asked. Unlike frequently traded stocks and bonds, turbines are large, unwieldy machines that simply don't lend themselves to easy exchange — and for which, therefore, prices are hard to determine.
While Labhart wished his report had gotten the board's attention soon enough to prevent the deal earlier, his warning wasn't completely in vain. The report did convince board members to be sure to include protections in the deal, just in case he turned out to be right. "When you're chief risk officer, you're being second-guessed a lot because you're taking a negative look," Labhart said in hindsight. But even when you're second-guessed there may still be room to make a difference.
As the date of the proposed merger neared, Labhart worked with management on a contingency clause that would reduce Dynegy's credit risk by giving it ownership of the Northern Natural Gas Company, the only pipeline Enron owned and its most profitable physical asset. Enron put the 16,500-mile pipeline up as collateral.
On November 19, 2001, Enron filed with the SEC notifying it of $690 million in new debts, leaving Dynegy in a very difficult position. It had already channeled $1.5 billion in financing to Enron and assumed responsibility for nearly another billion dollars of debt. Rating agencies downgraded Enron's debt to junk status. On November 28, as Enron's stock price approached zero, Dynegy withdrew its offer. Early the next year, as its own stock price wobbled because of the debacle, it took possession of the pipeline, which, at least temporarily, stabilized Dynegy. The following year, the Global Association of Risk Professionals named Labhart Financial Risk Manager of the Year.
Dynegy's experience and Enron's collapse may be a particularly dramatic case, but the episode has much in common with events that unfold every single day for people faced with evidence of danger: we simply don't want to see it. We avoid asking the questions for which we don't want to know the answers, because we don't want to deal with the consequences of knowing, especially when inconvenient truths get in the way of the stories we tell ourselves about how wonderful things will be if they go the way we've told ourselves they would. We view risks through rose-colored glasses, downplaying the possibility that our bets may go wrong — even as we overreact to less likely yet more emotionally resonant threats.
Even when we do recognize the existence of a clear and present danger, perverse incentives embedded in our political and financial systems — a heavy emphasis on short-term thinking, poorly allocated resources, and mispriced risks — are often arrayed against doing the right thing to get out of the way. As a result, we can't count on the best designed warning systems in the world to sound the alarm loud enough to persuade our leaders to do what they need to do. Even when we acknowledge evidence of danger, all too often we don't act until the threat is fully upon us — and, sometimes, when it's too late.
But the consequences of the grim unfolding of human nature and perverse incentives — the Enrons, WorldComs, Long-Term Capitals, collapsed buildings and bridges, and disasters of all kind that litter our history, from the geopolitical to the humanitarian and the personal — are not inevitable.
In recent years, behavioral economists have identified many of the cognitive biases that keep us from acting in our best interests, and helped draw much needed attention to the ways in which warped perceptions and emotional and irrational motivations shape the decisions we make. In Chapters 2 and 3, we'll explore some of these biases, along with strategies for countering them. An equally difficult challenge, to be addressed in Chapter 4, is the set of perverse incentives, structural obstacles, and crass calculations of self-interest — the tragedy of the commons — that prevent individuals, businesses, and governments from acting in time even when we recognize the many problems in front of us.
There are examples among the wreckage of people who see the danger, are willing to say something, and sometimes can prevent at least part of the worst-case scenario from unfolding. Their success is a combination of leadership and character, awareness of the ways in which we humans trip ourselves up and how we can avoid those mistakes, and sometimes sheer luck in having the right set of circumstances — for example, sufficient resources and a critical mass of others who recognize a challenge and are motivated to respond.
Breaking the Rules
Imagine that you're on safari in Africa, where you've traveled far for a chance to see a rhinoceros alive before it's too late. The Western black rhino was declared extinct in 2011, after five years without a sighting, and the number of all remaining black rhinos is in the low thousands. You know time is running out. You've seen the grisly photos of dead rhinos, with their horns brutally hacked off of their faces by poachers to be traded in Asia at a dearer price than that for cocaine or heroin.
It's been three days, and you and your two best friends are anxious to see what you came for, to shoot a prize trophy not with a gun but with your top-of-the-line camera. The sun is so fierce that you can see the heat shimmering in the air. But you and your friends are determined, so focused on your mission that you ignore your guide's instructions and drift away while he's not looking.
You're nearly ready to give up and return to the group. But, suddenly, there they are: a rhino cow and her calf. The massive mother flicks away flies with her tail and her long ears. You realize that you've forgotten to breathe: the very definition of a breathtaking sight.
The calf is several yards away from the mother, who is looking in the other direction. You creep closer, trying to get just the right angle. Getting a picture with your telephoto lens is one thing, but a close-up would be worth the risk. You forget everything the guide has told you about avoiding startling the rhinos by keeping out of their immediate territory, staying downwind, and being quiet. They're more afraid of you than you are of them, he'd said.
Your friends are also too excited to remember the admonition to be quiet. "Try to get him to look at you so we can get a picture of his face," one whispers. Without thinking about the consequences, the other friend whistles. The calf looks your way, but, unfortunately, so does the mother. That's when you realize your mistake. You've disturbed a rhino cow. Worse yet, you've managed to get closer to her calf than she is. The baby rhino quickly scampers back to her side, but she's still angry. She shifts her weight from one side to the other as she decides what to do.
That's the least of your problems, though, because a bull rhino has appeared nearby, and he has noticed you, too. He's easily half again as big as the cow. He lowers his head and paws the ground with his left hoof, preparing to charge. The tip of his horn is pointed right at you as he gathers all two tons of his weight and prepares to launch himself in your direction.
You've already ignored the advice the guide gave you — that the best way to avoid being charged by a rhino is not to provoke the animal in the first place. Once the rhino charges, it's nearly impossible to stop him. But it's too late now. The rhino has taken his first steps, and starts accelerating to his top speed of close to forty miles an hour.
As he bears down on you, you freeze. What to do? You could climb a tree, but there is none high or strong enough. Throw something in his path? Can you make enough noise to scare him? You could run in a zigzag pattern or in the opposite direction, but the heat has sapped your energy. If you were close enough to the safari vehicle, you could get the driver to put the pedal to the metal, but you've wandered too far from the group for that. You look at your friends for ideas, but they're paralyzed, too. Your final option is to wait for the rhino to get close and then jump out of the way, counting on his inability to turn quickly to save you from being trampled. If there is one thing you must remember about what to do when a rhino charges, your guide has told you, it is this: Do not stand still. Freezing is not an option. But, so far, by (seemingly) making no choice that's what you've chosen to do.
Problematic Pachyderms
Thinking about what to do when facing a rhino's charge is very much the way many leaders approach an impending threat, whether it's a tectonic geopolitical shift with implications for the future of the world as we know it; a market disruption or a management challenge that affects the future of a company, organization, country, or region; or a personal decision with consequences for us or our families. When crisis looms, leaders need to make decisions quickly. Each choice depends on what happened beforehand; every error compounds the stakes. Good decisions ahead of time — like staying away from potentially angry rhinos — make all the difference. Once mistakes have been made, the stakes rise and the options narrow to the point where the choices are not between good and bad but among bad, worse, and almost unthinkable.
A Gray Rhino is a highly probable, high-impact threat: something we ought to see coming, like a two-ton rhinoceros aiming its horn in our direction and preparing to charge. Like its cousin, the Elephant in the Room, a Gray Rhino is something we ought to be able to see clearly by virtue of its size. You would think that something so enormous would get the attention it deserves. To the contrary, the very obviousness of these problematic pachyderms is part of what makes us so bad at responding to them. We consistently fail to recognize the obvious, and so prevent highly probable, high-impact crises: the ones that we have the power to do something about. Heads of state, CEOs of businesses and organizations, like all of us, are often worse at handling Gray Rhinos than they are at acting swiftly when an unexpected crisis arises seemingly out of the blue. This has huge and dangerous implications for leaders, who are particularly vulnerable to threats they ought to see coming but nevertheless fail to recognize and react to in time.
When facing a rhinoceros that's about to charge, doing nothing is seldom the best option. Yet all too often that's exactly what happens. Danger rarely comes as a complete surprise; instead, it follows many missed opportunities for taking precautions, reading and responding to warning signals. The impulse to freeze is hard to overcome. Sometimes the grip of denial is so strong that we do nothing at all; or, even worse, as in many market booms leading to bust, we do more of what was dangerous in the first place. Think of the family who wouldn't evacuate ahead of a hurricane. The smoker who just wouldn't quit. The president who wouldn't give up his cheeseburgers until he had a heart attack. The gambler who kept digging himself deeper into a hole in the false hope of climbing out.
Perverse incentives and calculated self-interest can turbocharge our natural impulse for denial. Think of the bankers who were warned of the dangers of subprime loans but wouldn't get out of these risky investments, and the policy-makers who wouldn't step in. ("This time" is rarely, if ever, different.) The officials who knew how badly bridges had deteriorated but kept putting off needed repairs. The foremen of a factory building with cracks in the walls who insisted on business as usual until the whole thing collapsed. The supervisors and executives, warned of suspicious accounting, who refused to listen to the whistle-blowers. The engineers who knew how dangerous a flawed fifty-seven- cent ignition switch could be but did nothing to change it. The CEO of a market-leading company that failed to respond to the disruptive new technologies that took away its head start seemingly overnight and left it struggling to stay alive. The aging patriarch who knows the clock is ticking and it's time to let the new generation take over but prefers to drive his company or country into the ground rather than relinquish control.
Many of the biggest problems the world faces are Gray Rhinos. Look at climate change, for which scientists have presented a clear case that more than 350 parts per million (ppm) of carbon dioxide is dangerous for the planet. Yet we are at 400 ppm and rising, as efforts taken so far seem to make only a dent. Rising sea levels are causing one catastrophic weather event after another: in New York City, hundred-year storms Irene and Sandy two years in a row; in the Philippines, Typhoon Haiyan, the most powerful storm ever measured. In 2013, forty-one weather-related disasters each left more than $1 billion in damages, a record.
Unsustainable national debt levels, anemic economic growth, and profound changes in labor-market dynamics have left many countries vulnerable to a new round of financial crises. Widening income disparities will intensify social unrest and political turmoil, sparking riots, toppling governments, and destroying economies. Water shortages around the world are already threatening populations, stability, and supply chains, and will only get worse: by 2030, the United Nations predicts, half of the world will face water shortages as demand outpaces supply by 40 percent. This will dry up crops and cause people to go hungry, force tens of millions of people to move from their homes, and could even spark wars over water sources that cross national boundaries.
(Continues...)
Excerpted from The Gray Rhino by Michele Wucker. Copyright © 2016 Michele Wucker. Excerpted by permission of St. Martin's Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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