Homeland Security Watch

News and analysis of critical issues in homeland security

October 29, 2008

Chertoff Addresses the Beta

Filed under: Risk Assessment — by Jonah Czerwinski on October 29, 2008

When businesses consider investments in projects or acquisitions, they’ll often times use something called the capital asset pricing model, or CAPM. In that equation we quantify some ordinarily unquantifiable things. For example, risk. In the CAPM and other applications, risk is referred to as beta. This month, Secretary Chertoff delivered an address at the Wharton School of Business to explain his views on how the nation should deal with risk management and how his Department has tried to value the beta in our nation’s homeland security mission.

Chertoff explains his rule of thumb as follows: “I look at the issue of, you know, probability and consequence, I put a lot of weight on the consequence end of the equation.” In a nutshell: weight the consequences more than the likelihood of something bad happening.

This is an interesting choice, and a tough one for the head of DHS. The mindset Chertoff offered to the audience of business students and faculty was not the sort we are taught in M&A class or the kind you’ll find on Wall Street. If it was, firms that consider investing in a company would not value the assets, liabilities, and synergies; they’d first consider what the consequences would be if, say, the entire leadership of that target company turns out to be a bunch of frauds on the verge of indictment and what could limit the impact of such an outcome or limit the likelihood of it at all. It isn’t a smart on Wall Street and it could represent an imbalance when it comes to the homeland in general.

The Secretary explains that “managing risk is fundamentally looking ahead to the possibility of a disaster that is yet to happen and then to make cost-benefit driven plans to prevent disaster or to reduce our vulnerability to the disaster or mitigate the effects of the disaster that occurs.” Hard to argue with that. However, Don, a Wharton student in the audience asked the Secretary to clarify “how it’s possible to [defend the homeland] when the costs of remedying a risk are too great or the probability itself are too small and it’s necessary just to let it go.”

Secretary Chertoff offered “the one general principle” that he applies when considering risk management. “I put a lot of weight on consequences. [If the] consequence is catastrophic, even if it’s the low probability, is to me something that warrants a lot of effort to prevent and to prepare for. [If the consequence] is bad but not out of the ordinary is one where I might be more willing to be a little bit more modest in terms of preventive measures that I take…. So my big rule of thumb is when I look at the issue of, you know, probability and consequence, I put a lot of weight on the consequence end of the equation.”

Of course, this may not really be what happens in practice: In FY09 DHS received about $500 million to combat smuggled nuclear weapons (low likelihood/devastating consequence) and $1.3 billion to combat improvised explosive devices (high likelihood/less deadly consequence). So it appears that despite an advertised focus on consequences over likelihood, DHS continues to invest in combating those threats that are more likely over those that are more devastating.

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5 Comments »

Comment by Arnold

October 29, 2008 @ 4:45 pm

But how does the equation change when you take into account that investing in detection has a much lower “rate of return” in preventing nuclear terrorism that investing in locking down nuclear weapons and weapons-usable material at the source?

Of course, the total investment in preventing nuclear terrorism is still far below that of a missile defense system designed against threats that do not yet exist (i.e. North Korean and Iranian missiles that can hit the U.S.).

Comment by Jonah Czerwinski

October 29, 2008 @ 5:08 pm

Arnold — Good question. My guess is that Chteroff could duck that one since MPC&A (securing the source activities) is not part of his budget. That’s for DoE, State, and DoD. I know that DHS does consider these efforts as part of their calculus for, say, designing the global nuc detection architecture. Its just that Chertoff doesn’t have to face a trade-off since these are two different budgets.

The problem with this overall view of risk, however, is that there’s no end in sight for spending. All you need to do is imagine a scenario that is so devastating and would cost $100 billion to design/develop/deploy a defense against and — whether or not is very likely — you have some justification for going forward.

Comment by Arnold

October 29, 2008 @ 5:32 pm

To be honest, I knew it was somewhat of an unfair question in that Chertoff does not have much say in nuclear matters beyond detection and preparedness/response. I just wanted to put in a plug for security at the source.

I see the problem you raise, but I guess the answer is not that unlimited amounts are spent on all imagined threats with catastrophic consequences, but that those with a low, but real, possibility are dealt with in some manner. So nuclear terrorism, some forms of bio, pan flu, etc. But this requires a framework for deciding what low probability/high consequence threats are worth spending money on.

As much as I would argue that nuclear terrorism requires urgent attention, I would also argue that the “EMP” threat is overblown. But I’ve done my own analysis of this issue and have came to this conclusion. DHS, and the wider national security enterprise, must come up with their versions of such an analytic exercise and make choices.

Another problem then becomes when the choice is made and people disagree with it. See the EMP threat or the trouble Chertoff landed himself in with his remarks concerning airline vs. train security.

Comment by William R. Cumming

October 30, 2008 @ 10:48 am

A somwhat facetious comment from me. Now that we know that Chertoff does finally recognize Mother Nature as a potential terrorist and his risk management analysis says let’s deal with the asteroid and meteorite danger (hight consequences) I guess we should ask how does he measure consequences? What are his measurement techniques? Just finished reading about the threat of global cooling from volcanoes in science magazine. Interesting threat. Because Carter’s REorg project creating FEMA in 1977-1978 supported strongly by OMB did not want far out risk management they restricted FEMA from planning for extreme catastrophe. Of course, at that time, pre-Nuclear Winter, execution of the SIOP was not considered an extreme event.
But let’s look at DHS management. How much has really been done to prioritize its programs, functions, and activities and in doing so looked at first principles. I argue Risk Management and the tradeoffs between probability and consequences is always tough and in particular when Congress does not risk manage except for potential election defeat. So where does that leave us? Interesting that NO Chief Economist positon in DHS examing benefits and cost. After all this post did start with a Wharton presentation!

Comment by Arnold

October 30, 2008 @ 11:33 am

Funny that you mention the danger from asteroids. In case you missed it, a recent article from the Atlantic describing that danger and calling for urgent action:

http://www.theatlantic.com/doc/200806/asteroids

And even better, the article is called “The Sky is Falling.”

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