Ralph Oppenheimer on risk and derivatives

Evan Davis
All right, so Ralph, I mean let’s just talk about the financial risks of a company like yours.  You’ve got stakes in things, you’ve got counterparties to whom you’ve sold things that haven’t yet paid you but you might have paid for the steel, talk us through the financial risks of a company like yours.

Ralph Oppenheimer, Stemcor Holdings
We are a finance institution, a secondary bank.  We give credit to our customers; they may not pay us.  We prepay our suppliers; they may not deliver the goods we have prepaid for.  We also often are in a position that we own goods or have contracted to purchase them on a forward basis, which we haven’t yet sold, and with volatility those prices can suddenly collapse and we can lose a lot of money because we’re sitting on stocks which have depreciated in value.  So we have a tremendous amount of risk in our business, and controlling that risk and minimising that risk is central to our daily work.

Evan Davis
Now, like a bank, you say you're a secondary bank of a form, banks have to maintain a certain amount of capital so that there’s a buffer: if things turn against them, they don’t go bust at the first gust of wind.  On your website you mention that you like to maintain capital relative to value at risk and probable loss given default.  Now just talk us through what we’re talking about.

Ralph Oppenheimer
We have a value at risk model, and we do this largely to show how clever and scientific we are and to please our banks.  I personally don’t pay much attention to it.  I think it’s typical of some of the jargon and paraphernalia that surrounds different professions.  It doesn’t stop people going bankrupt; it didn’t stop Long-Term Capital, who had the best mathematical brains in the world, from being an absolute disaster.

Evan Davis
The hedge fund back in New York in the ’90s, yeah.

Ralph Oppenheimer
That’s right, yes.  So we do our value at risk.  We sort of regularly advise our banks where we stand on our value at risk model.  They think everything is hunky dory and are very sort of pleased and satisfied, but that’s not what manages to control the risk in our business; it’s going into the detail.  Knowing that so and so customer is not going to perform, that we've prepaid that supplier more than we should have done, we've really got to go down into the detail, drill down, and not look at these aggregate numbers, which like most averages don’t mean so much.

Evan Davis
And so you think people perhaps sometimes use the rather technical financial models, well, as a sort of security blanket, it’s a phoney?

Ralph Oppenheimer
It’s a cover.  In my view it can be very phoney.  Yes, it’s a disguise over what you're really doing. 

Evan Davis
And the complexity of it is seductive, because you think it looks very complicated, it must be very clever and somehow it’s…

Ralph Oppenheimer
Absolutely

Evan Davis
But there’s no substitute for just knowing the clients and knowing the business.

Ralph Oppenheimer
Knowing the clients, knowing what they're doing, knowing what their real risks are, yes.

Evan Davis
What is the value at risk though, I mean presumably the whole value of the company’s almost at risk at some point, I mean value at risk measures the…?

Ralph Oppenheimer
Well the value at risk is a way of saying if a customer owes you £100, what is the probability of him not paying?  That might be 10%.  So perhaps the value at risk in that case is only 10.

Evan Davis
Right, and of course that means if he doesn’t pay you, it can still be £100, which is more than the value at risk.

Ralph Oppenheimer
Which is why the model is rather phoney and it doesn’t really tell you what the risks are.

Evan Davis
Okay, the next one is derivatives.  We know that companies making steel, selling steel use derivatives to hedge their exposure to the market, but what do you guys do in terms of derivatives to manage risk?

Ralph Oppenheimer
Well our business has been a physical business where we've actually physically bought, taken possession, shipped, and we haven’t historically used derivatives in the way that the non-ferrous industries, aluminium, copper and so forth, in those industries derivative trading is often 30 times the physical trading.  Now in the last two years new derivatives have been developed in the steel industry and in the iron ore industry, and they're gradually increasing in utilisation, and in many ways this is a good idea because it does allow you to, for example, offer a fixed price to a customer over one year.  And you're not going to be able to buy from your suppliers at a fixed price during that year, but you can hedge the risk that the price might go up and you end up by losing lots of money by some sort of derivative.

So there is a role for derivatives, but the problem with derivatives is that they become a play thing of hedge funds, of gamblers, of speculators, and Warren Buffett, who is my great hero in business, Warren Buffett said that derivatives are, I think he said mass weapons of destruction and they can bring down a whole company, a whole industry.  It is the speculation by hedge funds and private equity people who say well, you know, copper is a good thing, let’s go and buy copper forwards, six months or twelve months, with no intention of actually ever buying any physical copper, with no real underlying trade, purely as a speculation.  It is the fact that there is more and more of that and some people say this is good, it brings liquidity to the market, it’s what the professional bankers and so forth will always tell you, but it is the flipside, the dangerous side of derivatives which needs regulation, which needs very careful control.

Evan Davis
You think it’s destabilising rather than stabilising?  Because in principle, if you have a thicker market with more people trading, the prices should be more stable at any one point in time, and the price should reflect the world view of the risk and…

Ralph Oppenheimer
I think it can be destabilising, because if you have an upturn people jump onto a bandwagon, so you get far more purchasing than is warranted, and when there’s a downturn, vice versa, the same again, so no, I think it is probably destabilising.

Evan Davis
Ralph Oppenheimer, thank you very much.

(6’54”)