The unequal struggle: Part 2, unlimited downside and limited upside
[Continued from yesterday’s Part 1.]
“A short option position with unlimited downside and limited upside”
– Anonymous risk manager, describing the career implications of rejecting a deal
Yesterday’s post featured the anonymous confessions, published in The Economist, of a risk manager giving a fear’s-eye view of recent turmoil in the capital markets. They’d had a nasty scare in 2005, when low-rated securities rose in price as high-rated ones fell, but “we had failed to draw the correct conclusions.”
If only investments came with signs
As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold.
A ’structured tranche’ is a horizontal slice (like the B piece illustrated above) of many different similar financial objects. Being structured, it’s not a direct claim on the underlying assets themselves (the vertical bars), rather it’s a claim against certain cash flows in the ‘cash flow waterfall – so you’re relying on the waterfall working, rather than on your ability to take control of the assets, and fix them.
With the GM pools, the seemingly impossible had happened – as if economic gravity had reversed itself temporarily.
No rules, just right?
As any risk manager will tell you, the only way to hedge a completely heterogeneous portfolio is to mirror the market (that’s the theory behind index funds, and indeed behind indices themselves). The risk managers could have insisted that every time a C was sold, a corresponding amount of A be sold:
But we did not believe that prices on AAA assets could fall by more than about 1% in price. A 20% drop on assets with virtually no default risk seemed inconceivable—though this did eventually occur. Liquidity risk was in effect not priced well enough; the market always allowed for it, but at only very small margins prior to the credit crisis.
Liquidity risk is the concern that, however good an investment may be, people simply run out of cash. Back in the summer of 2007, that seemed impossible. It seems all too possible today.
Money just flies away
So how did we get ourselves into a situation where we built up such large trading positions? [Positions held by the bank rather than by its investors – Ed.]
There were a number of factors. As is often the case, it happened so gradually that it was barely perceptible.
Fighting the last war
The focus of our risk management was on the loan portfolio and classic market risk. Loans were illiquid and accounted for on an accrual basis in the “banking book” rather than on a mark-to-market basis in the “trading book”. Rigorous credit analysis to ensure minimum loan-loss provisions was important. Loan risks and classic market risks were generally well understood and regularly reviewed. Equities, government bonds and foreign exchange, and their derivatives, were well managed in the trading book and monitored on a daily basis.
The gap in our risk management only opened up gradually over the years with the growth of traded credit products such as CDO tranches and other asset-backed securities. These sat uncomfortably between market and credit risk.
“Credit risk” is the danger that I the borrower will stop paying.
“Market risk” is the problem that even if I’m paying, my instrument might go down in value because high-yielding investment alternatives appear.
The market-risk department never really took ownership of them, believing them to be primarily credit-risk instruments, and the credit-risk department thought of them as market risk as they sat in the trading book.
Who’s got it? You got it?
“Took ownership” means that a department feels itself accountable for the issue. Because these instruments looked like a little of both, they slid through a gap between the two departments – nobody was scrutinizing them enough.
The explosive growth and profitability of the structured-credit market made this an ever greater problem. Our risk-management response was half-hearted. We set portfolio limits on each rating category but otherwise left the trading desks to their own devices.
Among my principles of life: Unwatched assets always start misbehaving.
See what happens when you don’t pay attention?
We made two assumptions which would cost us dearly.
[1] We thought that all mark-to-market positions in the trading book would receive immediate attention when losses occurred, because their profits and losses were published daily.
Logically they should have, but FAS 157 being new, people treated it as SEC reporting more than a management tool.
[2] We assumed that, if the market ran into difficulties, we could easily adjust and liquidate our positions, especially on securities rated AAA and AA.
A banker can safely own many different kinds of objects that he understands only a little if he is disciplined about selling anything whose price falls. That works only so long as there is plenty of liquidity for everything.
Our focus was always on the non-investment-grade part of the portfolio, especially the emerging-markets paper. The previous crises in
Securitization – buying slices of mystery meat – works only if the parts are accurately labeled, and as I’ve posted extensively before, a lot of people were entranced with the rating agencies:
We also trusted the rating agencies. It is hard to imagine now but the reputation of outside bond ratings was so high that if the risk department had ever assigned a lower rating, our judgment would have been immediately questioned. It was assumed that the rating agencies simply knew best.
Daddy’s off to the rating agency, children
An expert, as I know from first-hand experience, is anyone from out of town, preferably with an exotic accent. It would be all too easy, in the investment-banking culture, to belittle internal evaluations (”those guys never like anything!“) and trump them with a gilt-edged ‘independent’ rating. (I’ve previously posted how the rating agencies grew fat on ratings fees.)
We were thus comfortable with investment-grade assets and were struggling with the huge volume of business. We were too slow to sell these better-rated assets. We needed little capital to support them; there was no liquidity charge, very little default risk and a small positive margin, or “carry”, between holding the assets and their financing in the liquid interbank and repo markets. Gradually the structures became more complicated. Since they were held in the trading book, many avoided the rigorous credit process applied to the banking-book assets which might have identified some of the weaknesses.
The boys on the lower floors know what’s going on … don’t they?
Transaction velocity usually leads to underwriting obscurity – and asset-management opacity.
Spoilsports
The pressure on the risk department to keep up and approve transactions was immense. Psychology played a big part. The risk department had a separate reporting line to the board to preserve its independence. This had been reinforced by the regulators who believed it was essential for objective risk analysis and assessment. However, this separation hurt our relationship with the bankers and traders we were supposed to monitor.
We’ve all experienced flame war by email. Dismissing someone is ever so easy if you are talking only to the passive white monitor. Eyeball to eyeball is the way to confront disagreements, and to discover unexpected intelligence, capability, and goodwill in your co-workers.
In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this.
There’s an understatement.
They did not take kindly to us
Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.
I’m mostly a deal doctor. I started my career in asset management and workouts (battlefield surgery), and with the exception of a few multi-year stints in origination, I mainly work on existing properties and existing investments. That grounding in reality makes me both knowledgeable and skeptical – some would say periodically cynical – which are the qualities you want in a risk manager. They’re not the qualities that win you friends in banking.
We bankers see things differently
In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument.
When you play solitaire with yourself, you tend to win.
The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.
Originators also generally get paid more than risk managers, and wallet translates to ego and to institutional clout.
Collective common sense suffered as a result. Often in meetings, our gut reactions as risk managers were negative.
We didn’t like it
But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started. In the end, with pressure for earnings and a calm market environment, we reluctantly agreed to marginal transactions.
That rings true with my experience. If you sit on an investment committee (say), there are some things you can prove and some things you simply believe. Opposite you is an originator hungry to get this deal done, his or her adrenaline up past the point of reason and into friend-or-foe emotional engagement. You don’t want to say flat-out No – that’s rejection of the person, not just the deal – so you propose conditions or remedies. This isn’t bad – if we’re partners, I should be helping you solve your problem, not just smugly pointing it out – but unless you and I have a healthy respect for one another, I’m always at risk of becoming your lapdog.
Of course I treat my lapdog as my equal
What have we, both as risk managers and as an industry, to learn from this crisis?
Another lesson is to account properly for liquidity risk in two ways.
[1] Increase internal and external capital charges for trading-book positions. These are too low relative to banking-book positions and need to be recalibrated.
I have first-hand knowledge that banks are doing this up and down Wall Street. You’re seeing it in higher loan spreads.
[2] Bring back liquidity reserves. This has received little attention in the industry so far. Over time fair-value accounting practices have disallowed liquidity reserves, as they were deemed to allow for smoothing of earnings. However, in an environment in which an ever-increasing part of the balance-sheet is taken up by trading assets, it would be more sensible to allow liquidity reserves whose size is set in scale to the complexity of the underlying asset. That would be better than questioning the whole principle of mark-to-market accounting, as some banks are doing.
Makes sense: if you’re traveling over bumpy terrain, get bigger and tougher shock absorbers.
[3] Change the perception and standing of risk departments by giving them more prominence. The best way would be to encourage more traders to become risk managers. Unfortunately the trend has been in reverse; good risk managers end up in the front-line and good traders and bankers, once in the front-line, very rarely go the other way.
Traders are paid more than risk managers. This is unfixable.
Risk managers need to be perceived like good goalkeepers: always in the game and occasionally absolutely at the heart of it, like in a penalty shoot-out.
We’re only valuable if we say No
This is hard to achieve because the job we do has the risk profile of a short option position with unlimited downside and limited upside.
Translated into common English:
Short option position. You can be fired at any time.
Limited upside. Reject a risky, profitable deal and get a pat on the back.
Unlimited downside. Reject a risky, profitable deal that works out and get fired.
Your apprenticeship is over
This is the one position that every good risk manager knows he must avoid at all costs.
Which is why so many shrugged and said yes to questionable deals.
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