The unequal struggle: Part 1, risk and reward
– Anonymous risk manager, describing the career implications of rejecting a deal
A few weeks back, The Economist published a truly remarkable confession by a (prudently) anonymous risk manager from a major financial institution, explaining in candid detail precisely how and why the risk-management function is structurally neutered within many institutions:
Bless me, father, for I have underpriced risk
Why did banks become so overexposed in the run-up to the credit crunch? A risk manager at a large global bank—someone whose job it was to make sure that the firm did not take unnecessary risks—explains in his own words.
Because human beings have fallible memories, we forget that every stability bears the seeds of its own instability. Today, with the credit markets in disarray (even as the global economy keeps running, or at least it will until it needs expansion capital), we forget that a year ago, the sky was cloudless:
Risks? What risks?
IN JANUARY 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from.
Oh, cheer up
Risk management departments are paid to be pessimists. This is hard to do – the act of living assumes a certain optimism.
Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.
What if the liquidity disappears?
The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market—not going out of it.
“Liquidity coming into the market” is investment-banker-speak for “cash that wants to be invested.” As others have pointed out, the world was starving for yield.
Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets. This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private-equity financings were increasing.
Money is a commodity, and investment yields can be commoditized. In the money store known as the capital markets, those with capital to invest find those with deals needing capital.
When there’s more money chasing fewer deals, the capital has to go ever lower on the money store’s floors. Everywhere the risk managers looked, more people were entering the store with cash to spend than with goods to sell.
“Where is the liquidity crisis supposed to come from?” somebody asked in the meeting. No one could give a good answer.
Looking back on it now we should of course have paid more attention to the first signs of trouble. No crisis comes completely out of the blue; there are always clues and advance warnings if you can only interpret them correctly. It was the hiccup in the structured-credit market in May 2005 which gave the strongest indication of what was to come. In that month bonds of General Motors were marked down by the rating agencies from investment grade to non-investment grade, or “junk”. Because the American carmaker’s bonds were widely held in structured-credit portfolios, the downgrades caused a big dislocation in the market.
Most portfolio managers have an asset-allocation and risk-management strategy. When a big position (like GM) is reclassified from safe to risky, the portfolio manager has to “rebalance the portfolio” by selling some risky stuff and buying some safer stuff. Investments can be made safer or riskier via securitization (as I posted well before the credit crunch hit); a bank can turn a blended B into an A and a C by slicing the securities into tranches.
Typically, it’s the investment banking firm that holds the junior (B or C) pieces:
Holding B’s and C’s is risky, though:
Like most banks we owned a portfolio of different tranches of collateralised-debt obligations (CDOs), which are packages of asset-backed securities. Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs; and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero.
We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.
Go back to the previous chart. Whoever holds the C is exposed to every dollar of fluctuation, so you can expect that C will act if things get dicey. Meanwhile, B will be watching C, because if C throws in the towel, B will then be exposed.
What every A holder wants from his B holders
A, the senior position, ought to be completely safe. That’s what the risk managers thought. That’s what I would have thought.
In May 2005 we held AAA tranches, expecting them to rise in value, and sold non-investment-grade tranches, expecting them to go down. From a risk-management point of view, this was perfect: have a long position in the low-risk asset, and a short one in the higher-risk one.
A long position means you intend to hold the asset for years. A short position means you plan to exit quickly.
But the reverse happened of what we had expected: AAA tranches went down in price and non-investment-grade tranches went up, resulting in losses as we marked the positions to market.
I’ve previously posted at length about the consequences of ‘marking to market’ securities positions, the need to bank on value, and how after the regulatory reform everyone is now in a Bank of Glass.
Aux tranches, citoyens! Changez les reglements!
As I wrote last March:
Enabling the revolution: FAS 157 and mark down, not up
Once upon a time, assets went on the balance sheet at cost, got depreciated, and lay inert until sold, whereupon the company got a book gain or loss. Overvalued assets were left undisturbed because selling them would mean writedowns, leading (among other slow tragedies) to the 1990s’ Japanese deflation, where banks would not touch their loans lest the balance-sheet bubbles pop. Undervalued assets slumbered happily at depreciated book values well below market.
Who cares what our liquidation value is, we’re happy
Either way, CFO’s needing a late-in-the-quarter kick up or down on earnings could conjure them via financial transactions on previously dormant assets.
Over the first years of this decade, the FASB and regulatory bodies pressured public entities to report changes in asset values – particularly down – when they occurred, rather than when they were ‘recognized,’ via a series of rules requiring writedowns if assets were permanently impaired. Later that was extended in an issuance, Financial Accounting Statement 157, requiring all assets to be ‘marked to market,’ with risk Levels 1 (best) to 3 (worst) based on the defensibility of their valuation method. FAS 157 sounded abstract, and until August everyone thought it would remain so; its market consequences were anything but.
The capital markets have an intrinsic information asymmetry – private companies (not listed on stock exchanges) need not report their earnings, whereas public companies (whose shares trade on exchanges) are required to fess up quarterly. This mattered less when the public companies were dominant, but private equity grew into giga-funds by exploiting the public markets’ unforgiving punishment of underperforming publics. When spreads exploded last August, the trading values of complex assets plummeted, and just as the bankers returning from vacation were coming to grips with this, FAS 157 took effect in October.
Many markets for highly complex positions either froze or were overwhelmed by sellers swamping buyers, leading to cliff-like drops in price (even if not in ‘intrinsic value’).
You thought you had security, didn’t you?
The risk managers had discovered that prices of financial assets move not just with credit quality, but also with supply and demand for similar products.
[These losses were] entirely counter-intuitive. Explanations of why this had happened were confusing and focused on complicated cross-correlations between tranches. In essence it turned out that there had been a short squeeze in non-investment-grade tranches, driving their prices up, and a general selling of all more senior structured tranches, even the very best AAA ones.
That’s all right if you’re a privately held institution with no plans to sell the assets, but in a transparent public company reporting quarterly earnings, the earnings vibration was disturbing.
That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions.
I don’t like the conclusions you’re drawing
[Continued tomorrow in Part 2.]
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