Alright folks,
Just paste or give the link of the article you found interesting today. Don't give more than one link, as it can be overwhelming. I think this will add a flavor to the frequent junks that we see in the threads. To start with, I have one article from The Economist. Thanks.
Confessions of a risk manager
Aug 7th 2008
From The Economist print edition
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
Gary Neil
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. 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.
As risk managers we were responsible for approving credit requests
and transactions submitted to us by the bankers and traders in the
front-line. We also monitored and reported the level of risk across the
bank’s portfolio and set limits for overall credit and market-risk
positions.
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. 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. “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
“junkâ€. Because the American carmaker’s bonds were widely held in
structured-credit portfolios, the downgrades caused a big dislocation
in the market.
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.
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. 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.
This was 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 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.
As risk managers we should have insisted that all structured tranches,
not just the non-investment-grade ones, 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.
So how did we get ourselves into a situation where we built up such
large trading positions? 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 bookâ€. 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. 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.
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. We made two
assumptions which would cost us dearly. First, 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. Second, we assumed that, if the market ran into
difficulties, we could easily adjust and liquidate our positions,
especially on securities rated AAA and AA. Our focus was always on the
non-investment-grade part of the portfolio, especially the
emerging-markets paper. The previous crises in Russia and Latin America
had left a deeply ingrained fear of sudden liquidity shocks and
widening credit spreads. Ironically, of course, in the credit crunch
the emerging-market bonds have outperformed the Western credit assets.
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.
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 “carryâ€, 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 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.
Spoilsports
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. 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-commercialâ€,
“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.
At the root of it all, however, was—and still is—a deeply ingrained
flaw in the decision-making process. 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. 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 “mitigatedâ€. 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.
Gary Neil
Collective common sense suffered as a result. Often in meetings, our
gut reactions as risk managers were negative. 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.
Over time we accumulated a balance-sheet of traded assets which
allowed for very little margin of error. We owned a large portfolio of
“very low-risk†assets which turned out to be high-risk. A small price
movement on billions of dollars’ worth of securities would translate
into large mark-to-market losses. We thought that we had focused
correctly on the non-investment-grade paper, of which we held little.
We had not paid enough attention to the ever-growing mountain of highly
rated but potentially illiquid assets. We had not fully appreciated
that 20% of a very large number can inflict far greater losses than 80%
of a small number.
Goals and goalkeepers
What have we, both as risk managers and as an industry, to learn
from this crisis? A number of thoughts come to mind. One lesson is to
go back to basics, to analyse your balance-sheet positions by type,
size and complexity both before and after you have hedged them. Do not
assume that ratings are always correct and if they are, remember that
they can change quickly.
Another lesson is to account properly for liquidity risk in two
ways. One is to increase internal and external capital charges for
trading-book positions. These are too low relative to banking-book
positions and need to be recalibrated. The other is to 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.
Last but not least, 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. 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.
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.
This is the one position that every good risk manager knows he must
avoid at all costs. A wise firm will need to bear this in mind when it
tries to persuade its best staff to take on such a crucial task.
Source: http://www.economist.com/finance/displaystory.cfm?source=most_recommended&story_id=11897037