Risk management (or the lack of)

For anyone who is involved in investments, it is only natural to conduct some kind of research to get a full understanding of what the money is spent on. Think about buying a new cell phone or a new MP3 player or a game console or a new car. You would spend good amount of time going through user reviews on both print and internet media and ask your friends or user forums questions regarding the product. I would hope that you won’t base your purchasing decision based on a single source without verifying this recommendation through further inquiries. I would imagine that you’d base your purchase on your diligent research, personal needs and perceived value. If the item is cheap enough, you’d probably do less research or even buy on impulse. However, if the investment is significant, you won’t part with your money without going through all the steps to satisfy yourself you’ve made the right choice.

Now, let’s apply that approach to financial investments. Lots of people invest their money in shares and some people are pretty good at it. Without fail, all the good investors do their ‘homework’. They know what they’re buying and they know what those companies are about. Not everyone who invests can or wants to do all the research necessary to achieve strong positive performance. So these folks ‘hire’ someone to do their investments for them. That’s why there’re all these private banks, investment advisors, mutual fund managers, investment consultants, brokers, etc. To a varying degree, their job is to provide the investors sound investment advice. The word ‘sound’, in this case, means advice that suits the investors’ objectives and risk appetites. Let’s not pretend otherwise, investments are full of risks. If you can buy the latest, the most hyped piece of kit and it turns out to be a dud, I can assure you that you can invest in a stock that seems to have good value and good growth potential but is actually a pig. That’s life. And that is the very reason why you pay a fee to hire one of these advisors to give you advice or invest on your behalf. You, from your personal perspective, are here to make money.

It is the fiduciary obligation and regulatory requirement for anyone who provides investment advice or invests on behalf of clients to conduct their risk management. Likewise, the directors of companies are obliged to act on the best interests of its shareholders. After all, directors are hired to run the businesses that the investors don’t necessarily have the expertise or the time to the same. What prevents those who have delegated investment responsibilities from losing the investors’ and shareholders’ money? Risk management.

Risk management is not a new thing. It has been around since the infancy of banking, but it wasn’t called ‘risk management’ and it wasn’t always a specialist area. It finally became a specialist area when people started applying mathematics, particularly statistics, to finance. Unlike some physical properties, you can, if you believe what they tell you, make financial risk disappear (in contrast with, say, energy or momentum). People have applied theories and principles that are used in risk management to optimize their investments (portfolio theory). It is a broad subject with many different characteristics. In the financial world, there are two types of risks that bankers are most concerned: market risk and credit risk.

Market risk is purely a price risk. In gross terms, it is the probability of loss due to changes in market prices. It is all about volatilities and sensitivities. Market risk professionals ask themselves questions like: how much would the valuation of our portfolio change if the general market moves x%; or what is the sensitivity of this trade or this portfolio of trades. The techniques employed in market risk measurements are perfect for markets that have high volume and strong liquidity, for these give rise to a good data set for statistical analysis, the very foundation for market risk calculation. However, current market risk theories do not take into account of liquidity and are notoriously imprecise in measuring risks arisen from low frequency events, e.g. market turmoils or dislocations. Even market risk professionals acknowledge this fact. Hence they try to adjust their results by introducing concepts like ‘fat tails’ and ‘black swans’. Being a heavily mathematical, quantitative-driven discipline, market risk practitioners are trying to put numbers on unquantifiable events. Unfortunately, that is the best the market can come up with.

Credit risk is a mixture of different components. In the most basic form, when we are looking at purely from a lending perspective, credit risk is risk of default (ie. the borrower not servicing or repaying the loan) and the resultant loss (the amount lent less the recovery value). However, if we are dealing with trading counterparties, the credit risk will have a strong market risk component built-in because our exposure to the trading partner will be heavily influenced by the movements in the market. If we are a bond investor (or indeed buy or sell credit protection via CDS), we are exposed to the price movements of the bonds, which are driven by the underlying credit of the bond issuers, as well as the risk of default by the issuer. If a borrower defaults, but due to poor documentation, you’re unable to recover the full amount owed to you, it’s actually a legal risk element wrapped around the credit risk exposure. So credit risk exposures can be multi-façade, depending on from what perspective the risk is being addressed.

What has this got to do with US sub-prime RMBS, or other ‘toxic debts’? A lot!

First of all, let’s start with the securitization process. Just prior to launching a securitization, the assets are passed to a special purpose vehicle to be held there until the notes are issued. This is called ‘warehousing’. In order to maintain the integrity of the pool of assets and to achieve the desired ratings from the rating agencies, the assets must pass certain quality tests. Once the pool has been securitized, the investors must have an adequate understanding of the nature of the asset pool so to be aware of any potential risks facing the pool and hence the level of risk associated with the seniority of the debt. If substitutions are allowed, all the hurdles have to be observed by the collateral manager. You would think that at every stage, the parties involved would have a good understanding of the risks. The truth is, they didn’t and they didn’t care.

In a typical warehousing agreement, the terms will include provisions for the warehouse provider to kick out certain assets that do not pass the quality tests. The three main tests are: price of the asset should not drop below a certain price (say 95); rating of a piece of assets falls below a rating (say AA); and the occurrence of an event of default. Short of a default actually occurring, which is normally know as a ‘credit event’, the two other measures are entirely without any credit due diligence on the parts of the sponsor, the structure, the bookrunner, the administrator. Prices are often driven by ratings (and the cash flow performance” of the collateral pool. However, the job of actually carrying out credit due diligence has been delegated to the rating agencies.

How about on the investment side? A lot of hedge fund strategies (e.g. market value, absolute return and relative value) make investment essentially based on price. Some other drivers are considered, but they are not, strictly speaking, credit analysis. There are insufficient details to allow the claim that such analysis has taken place. If there has been analysis, it has been based on very high level data rather than loan-by-loan analysis. The problem was structured credit hedge funds were some of the biggest investors in the market and these folks bought based on ratings.

Ordinary investors have played a part too. Lots fund managers offer ‘money market funds’ where the investors can withdraw their funds without delay. They invest in these funds because they provide superior interest rates to typical savings accounts. How come these funds managed to provide superior return yet allowed daily liquidity? Highly rated structured credit investments. These AAA-rated structured credit debt, although being collateralized, pay a higher coupon than other AAA-rated debts, e.g. German government Bunds or US Treasuries. Why? That’s due to the concept of risk and return: higher risk, higher return. In another word, not all AAA are created equal. So, while the AAA-rated ABS papers have the top rating, the market demands a higher coupon because the ABS papers have a higher risk. If you’re the fund manager and you need to provide superior return for your investors and these assets are rated AAA yet providing relatively high coupons, would you care the fact that the market is pricing them as if they have a higher risk? No. If you have a couple of hundred of these assets in your fund, would you spare the time to conduct detailed credit analysis on these AAA bonds? No. The ratings were good enough for them.

With all the sensitivity triggers and volatility limits imposed on the funds, it would appear that the market risk side of things has been taken care of. However, they have completely neglected the underlying credit risk. They bought on ratings and delegated their credit risk management to third parties, the credit rating agencies.

That was all well and good when the market was ‘functioning’. However, when people first started having doubts about the US sub-prime RMBS market, many bonds that previously were freely traded became illiquid as no one knew the true valuations of these securities and the whole market seized up.

That’s what happened during 2007. First there were indications on the range of defaults in the US sub-prime mortgage market and valuations of US sub-prime RMBS began to suffer. This led to the closure of two hedge funds ran by Bear Sterns which ultimately led to the acquisition of the firm by JPMorgan Chase in March 2008. Later in the second quarter, the market generally lost confidence in the whole sub-prime RMBS market and many securities ceased to be traded. The problem then extended to the broader ABS market during the third quarter and their entire sector stopped functioning and precipitated the structured investment vehicle crisis (they had problems funding their mega portfolios of ABS assets).

As a result of all this, many banks and credit institutions were forced to write down their holdings of ABS. For those banks that concentrated in mortgage lending, particularly in the sub-prime space, people lost confidence in these institutions and inter-bank lending stopped, resulting in a liquidity crisis. All these were eventually off loaded to bigger competitors or were forced to be rescued by the taxpayers.

Coming into 2008, the banking world was a very uncertain place, with many banks making record losses after collectively written off billions and billions dollars of losses. The problem was that other sub-prime mortgages, all kinds of other securities created on the back of these mortgages (RMBS) were also failing. The situation got worse as CDOs of ABS were so complex that it was nearly impossible to monitor their performance. As the world was crumbling around those who held securitized assets, these very people had very little idea of what their true risk exposures were. The traders didn’t know what the true worth was as pricing by model was no longer a viable method of pricing as no-one trusted the models any more. The risk managers didn’t know the true risk as they have been relying on rating agencies to do their work. The management didn’t know the true size of the problem as all the numbers were at best ‘educated guesses’.

Without frequent accurate, reliable asset pricing, it is impossible to consider provisioning, or to account for profits or loss. Yet, firm after firm was lining up to announce losses but at the same time claiming that these losses accounted all the expected losses on their portfolios. What was previously considered as a problem restricted to a particular asset class (sub-prime RMBS), has migrated and grown to a problem for the whole balance sheet. As doubts about the quality of all securitized assets, there were fears on the institutions themselves. The equity capital of financial firms was calculated based on calculated levels of risk on assets. The risk levels assumed certain known facts, amongst them credit ratings and liquidity. Given that there was no liquidity in the market for securitized assets and there was little or no confidence on the current credit ratings, the calculations of regulatory and economic capital requirements could not be carried out with any degree of confidence. At the same time, much of the loss provisioning was carried on based on economics (optimistic) assumptions, so the true profit or loss would not be accurately determined. As a result, share prices of the whole sector suffered.

Once share prices were depressed, it became increasing difficult for firms to raise new equity capital or sought new investors in favorable terms. There comes a point in time that the market simply lost confidence in certain firms and the whole show came crashing down form some, all because they didn’t know what kind of risk was sitting on their balance sheets.

While we are on the subject of risk management, there is another crucial point to be made. In many institutions, risk managers were seen as an inconvenience. They were never given the same level of power as those from the business. It has been revealed that many a time, managers on the business side have ignored warnings and recommendations from the risk managers when embarking on a new business. Risk management practices were ignored as something that was irrelevant. More importantly, when executives were faced with competing arguments between business and risk management, the risk folks lost out. The short sightedness of those executives and organizations ultimately cost their shareholders billions of Dollars/Euros/Pounds of shareholder value and in some cases billions more in government rescue, liquidity arrangements and guarantees.