Idiosyncratic vs. Systemic Risk. What’s the Difference and Why Does It Matter?


In the investing world, idiosyncratic versus systemic risk refers to risk related to a specific security. In theory, idiosyncratic risk can be diversified away while systemic risk cannot. So, idiosyncratic risk affects only one security; systemic risk affects all (or at least many) securities.

For example, when Theranos had its spectacular flameout admitting to “fake” blood tests on “fake” machines, only its debt and equity securities were directly impacted. That is an idiosyncratic risk. The US economy was picking up at the time and US stocks were up 13% for the year and that is a systematic risk or rather, reward.

Systemic risk need not be global, it can be industry-specific. For example, today with Amazon plowing ahead and consumer shopping patterns changing rapidly, all brick and mortar retailer’s securities are affected. That is a systemic risk.

This distinction is important in general business as well, since the best way to solve problems usually differs, depending on whether the problem is idiosyncratic or systemic.

Take retail as an example. Ten years ago, when a brick and mortar retailer failed, it was because they alone missed trends or otherwise executed poorly. So, there were lots of bidders for the assets. The store’s problems were unique. Today, however, because the entire industry is in trouble, the assets and merchandise sell at low prices. With systemic risk, selling assets to counter problems won’t be nearly as successful as when faced with risk that is idiosyncratic.

A few pointers about how idiosyncratic and systemic problems differ.

When it is an idiosyncratic problem…

  • It is easier to raise debt or equity. All else considered, investors aren’t down on or suspicious of your industry. If you are experiencing liquidity problems, creditors, particularly trade creditors, won’t have you flagged as a risk because of your industry. That doesn’t mean you won’t have to pay more or that the terms won’t be severe, but they’re likely will be money available.
  • Customer problems are isolated. If you have a problem with a customer, it is only one customer, not all of them or an entire segment.
  • Liquidating assets to raise funds will likely yield more. For example, when I shepherded a scrap metal company through bankruptcy, scrap metal prices were very high and the global economy was booming. We were able to sell the business for a price far in excess of what was warranted by cash flow if well run.

The buyer was a steel mill that shut down most of the operation to lower scrap prices and thereby lower its cost of raw materials. Scrap metal prices were so high that it made economic sense to dig up three feet of the ground under the scrap and run it through a process used to salvage auto fluff (the mostly plastics with some small metals that come from the innards of crushed cars) to retrieve the costly metals.

Six months later, global metal markets crashed and it was time to sell the company’s crushed car shredder, the largest in the world. The poor lender that financed that equipment was screwed. No buyers (except the low ball bid from the steel mill that bought the company) made an acceptable offer. Systemic risk trumped.

As far as the source of the idiosyncratic risk, well, if you repeatedly shoot yourself in the head, you will eventually die, metaphorically speaking at least.

  • Fingers may point inward. When the problem is idiosyncratic, important people (e.g., directors, customers, creditors) may think you are the source of the problem – it is just happening at your company, after all. These are common situations in which people like me are brought in to run the company from the outside. When the whole industry is in the toilet, on the other hand (systemic risk), a common refrain from lenders is, “Good company, bad market. Let’s just sit and wait for better times.”

When it is a systemic problem…

  • Customers and creditors expect you to have a problem. There will be less concern about the capability of management. That said, everyone will be looking for your problem, so you have less time to recover. But creditors, customers, and even lenders will have less faith in your recovery plan. Not because they don’t think you can execute the plan, but because that plan may matter little in the face of industry or larger market problems.
  • Lenders tighten up and, in aggregate, may opt to reduce exposure to your industry. Unfortunately, this comes at precisely the time when you need to borrow more and with a higher risk profile.

In late 2008, just days before the crash, an equity investor in a factor (a business that buys accounts receivables from cash-strapped companies) with a mediocre record at best, cashed out his equity with junior lien debt held by (surprise) a now-defunct high yield fund. The factor’s senior secured lender, like many in the industry, was CIT.

For those who forgot or never cared about the details of the great crash, CIT imploded in 2009. They could not fund all of their customers. They picked mine not to fund, because, well, my customer’s portfolio of credits had lots of problems and other clients were more profitable and promising. Worse, CIT’s main competitor as a lender to factors was Wells Fargo which decided to raise the minimum size loan they would make to squeeze out the smaller factors since most of their portfolio was at the larger end. So, in the end, my client was forced to sell the performing part of its portfolio at unfavorable terms to another factor. Those terms were so unfavorable, my client got little in the way of recovery from the “good” assets.

  • It is harder to unload assets to raise cash – and doing so brings less cash. In truly dire situations, this can be good. Underwater secured creditors may opt to wait things out until better times bring better collateral recoveries.

A few more pointers

  • Even if your problem is at heart an idiosyncratic one (your company didn’t execute well, for example), if you are experiencing systemic risk, that should govern how you respond.
  • Idiosyncratic vs systemic matters for opportunities as well as problems. But that is for another newsletter.

In short, the response to your problem should be dictated as much by the typeof problem as by the details of the specific situation at hand. Applying a systemic strategy to an idiosyncratic problem – or vice versa – can lead to much wasted time, effort and money, with little results to show for it.

When faced with a problem, first sit back and assess whether the problem is idiosyncratic or systemic. Then, shape your action plans accordingly.

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