The "cockroach theory" comes from the idea that a single problem in a company is often a sign of deeper, systemic risk management failures. In 2023, a Bloomberg columnist asked whether Credit Suisse needed a “cockroach exterminator” after the collapse of Archegos and Greensill. More recently, JPMorgan Chase & Co.’s Jamie Dimon said to analysts, “I probably shouldn’t say this, but when you see one cockroach, there are probably more.”
CEO Dimon’s comment related to the bankrupt auto supply company First Brands, with approximately $800 million in unsecured supply-chain financing liabilities, close on the heels of subprime auto lender Tricolor, where JPMorgan disclosed a $170 million loss. Many public and private organizations have been caught up in the fraud, but other financial institutions avoided it.
The drivers of a bank’s profitability and long-term growth do not stop with the credit (loan) portfolios. Potential losses and reputational damage lurk in every nook and cranny, hidden from all the risk reports. Cockroaches are lurking across the enterprise, aligned with the idiosyncratic risk being taken to earn returns. There are market and liquidity risks in trading books, cybersecurity risks in IT, operational risks in all the internal business processes and external infrastructure required to connect with suppliers, customers, and bank utility services, including exchanges, DTCC, SWIFT, and ACH.
Complex Credit Exposures
First Brands managed to borrow over $10 billion, and how much of this was collateralized will be the subject of bankruptcy proceedings. But with presumably high levels of collateral, what went wrong? Even the oldest form of finance, factoring receivables, is vulnerable. When invoices are fabricated or reused, the loan loses its value.
Brenda Boultwood
Corporate financing strategies are far more complex than in the Enron days when concerns centered on on- and off-balance sheet exposures and disclosures. In a post-global financial crisis world, private firms such as First Brands rely on a web of non-traditional lenders including private credit providers, business-development companies, hedge funds and trade-finance lenders. The debt is often packaged as structured finance including collaterized loan obligations (CLOs).
The high level of debt, the opaque nature of the collateral, and the diverse set of lenders create vulnerabilities for some – but not all.
Asking the Right Questions
Before we go down the rabbit hole of which firms were surprised by the First Brands cockroaches, it’s instructive to understand which ones were not. After Apollo Global Management took a significant credit loss at Vari-Form in 2019, it evaluated corporate histories and lawsuits, and shorted firms associated with the principal, Patrick James, also the founder and former CEO of First Brands.
The family office of George Soros refused to lend to First Brands based on this track record. In fact, Asset Based Lending Consultants conducted due diligence on First Brands and would not endorse their activities. Some banks cut First Brands off after standard collateral reviews, others questioned the dependence on second-tier ratings agencies. This is ex ante risk management, happening before the deal is done.
It’s not just the credit risk that has become more complex. A broad set of idiosyncratic enterprise risks sit in a firm’s roach motel. Business processes have been digitized and optimized onshore, offshore, and some hybrid. Have the market, liquidity, cyber, operational, and business risks been identified, acknowledged? And have we made deliberate decisions about the risks to retain, to mitigate, and to avoid?
Do the risks support the strategy? Can the risks be justified by the returns?
When Does It Matter Most?
When risk-taking is deliberate, the idea that exterminators are required for the roach motels of firms deliberately managing risks has never been appropriate. Firms must grow and hit earnings targets.
That said, the market relies on guardrails. These include credible internal risk management, oversight, disclosures, and incentives that reward outcomes that benefit shareholders/investors, lenders, and employees.
To state the obvious, experienced risk management personnel and due-diligence processes are expensive. Cost-cutting can eliminate institutional knowledge. A new generation of talent will lack the scars and intuition. But this is part of the tradeoff banks make as they manage corporate and talent performance.
Parting Thoughts
The next firm taken down by its risk management choices is a question of when, not if.
Financing and management systems will only become more complex. The next risk event will happen. The solution is never about rolling back the clock, but rather about mandating ex ante risk transparency before the deal is done. CEOs must weigh the tradeoff between pre-deal risk awareness and profitability. Unintentional “cockroaches” are a result of faulty risk identification or inexperienced management.
Correlated idiosyncratic risks converge to create a systemic shock. Add bad policy and weak oversight, and investors panic. That’s when the music stops.
Brenda Boultwood is the Distinguished Visiting Professor, Admiral Crowe Chair, in the Economics Department at the United States Naval Academy. The views expressed in this article are her own and should not be attributed to the United States Naval Academy, the U.S. Navy or the U.S. Department of Defense.
She is the former Director of the Office of Risk Management at the International Monetary Fund. She has previously served as a board member at both the Committee of Chief Risk Officers (CCRO) and GARP, and is also the former senior vice president and chief risk officer at Constellation Energy. She held a variety of business, risk management, and compliance roles at JPMorgan Chase and Bank One.