CapGen Capital, LLC © copyright 2008 European Credit Risk 2008 Paris, February 2008 ( The views...

CapGen Capital, LLC © copyright 2008

European Credit Risk 2008

Paris, February 2008

(The views expressed are those of the presenter and do not represent those of CapGen Capital, LLC

Cyclicality: Between Risk Amnesia and Risk Obsession

J.V. Rizzi, CapGen Capital, LLC


1 Introduction

3CapGen Capital, LLC © copyright 2008

Introduction.

Golden Age of Credit (2003-1H07)

Low Rates

Tight Spreads

High Liquidity

Declining Defaults

Competition to employ liquidity increased -- especially

Alternative assets

Proprietary trading

Principal Financing

Underwriting exposure

In financial markets, progress is cyclical, not cumulative (James Grant)

(The most expensive words in finance: this time is different)


Bubble Meter

(Do you want to believe what you see,…)

Price Appreciation: asset class price price appreciation greater than 20%

Weak Regulation: unregulated shadow banking system

Opaque Markets: illiquid OTC products

Collateral Lending Basis: bet on continued price appreciation

Low Interest Rates: Reach for yield

(or what I am telling you?)


Competition: margins squeezed in traditional asset creation and distribution

Mispricing: risk mispriced given excess liquidity chasing limited

Strategic Shift: from intermediary to principal

(…in front of a steamroller)

Strategy: Peso Strategy-Pays well in all but the worst states where it crashes

appropriateness

timing sensitive

problematic value

requirements

– Strong Balance Sheet

– Pricing and Trading Discipline

– Risk Premium

(picking up nickels…)

5L Portfolio: asset heavy

long

low

large

leveraged

(i)liquid


The Perfect Storm? Summer of 2007

(There is no Perfect Storm…)

Risk Returns:

Credit Default Swaps

VIX

Ted spread

Losses--Hall of Shame

Citi 3.3 + 8

UBS 3.4 + 10

B of A 4

Deutsche 3.1

JPMC 2.1

Goldman 1.5

Lehman 0.7

Credit Suisse 1.7

Bear Stearns 0.7

Merrill 7.9

(…in a storm we all get wet)


2 The problem


The Problem

Risk Dimensions:

Frequency: exposure vs experience

Impact severity

A C

B DFre

qu

enc

y

Impact

HPLIE

HILPE

• (A) High Probability Low Impact Events:Manage through risk mitigation

• (B) Low Probability Low Impact Events: retained as a cost of business

• (C) High Probability High Impact Events: avoid

• (D) High Impact Low Probability Events: frequently ignored. Best handled by risk transfer.

(…and conditions seem favourable. T. Geither, NY Fed)

(It is difficult to price rationally when risk seems remote and hard to measure…)


The Problem (Continued)

Understanding (HILPE difficult to understand)

Statistical: insufficient data to determine probability distribution

Behavioural: data infrequency clouds hazard perception. Risk perception is based on recent events. Consequently, we ignore low frequency remote events. Thus, vigilance declines by the square of the time since last problem

(HILPE are likely to occur…)

(…because there are so many HILPE that can occur)


Reinforcement

Rational Bubble: You know it cannot last, but you follow the crowd Hope: belief you can get out in time Reputation: peer comparisons and best practices increase the cost of not

following the crowd

Killer “Bs” : Budgets and Bonuses Problem: accounting and compensation systems have difficulty with HILPE Latency Period: if the impact horizon exceed the accounting period, then it pays to

assume HILPE risk– Punished for not putting “profit” over safety – Escape punishment for not putting safety first

– Cycle changes less frequent– Risk to anyone manager is small although the organizational impact may be large

Mismatch: Stock option compensation programs increase managerial risk appetite for HILPE

(Pressure to play can distort risk decisions)

(You only find out how dirty the laundry was during the rinse cycle)


Reinforcement (continued)

Models: Confusing history with science- Model risk increases as data frequency decreases

Inadequately reflect cyclical effect on and correlation among probability of default (PD), loss given default (LGD) and exposure at default (EAD)

Liquidity risk neglected

Interaction between market and credit risk poorly understood

Result: underestimate HILPE

Underlying risk builds during the expansion as apparent risk declines

Losses materialize in the contraction

(Once in a lifetime events happen…)

(… every three or four years)


Decisions at Risk (DAR)

•(no sense marking to market…)

•Framework

Uncertainty Asymmetrical Information Behavioral Bias

State dependent events Adverse selection over optimism

events beyond the data moral hazard disaster myopia

Control

Mechanisms

Board

monitoring

Incentives

termination

Regulators

Rating Agencies

Shareholders• DAR Risk level: especially high for option like nature of structured products. CDO investors synthetically selling insurance on the real estate market.

-- more sensitive to down markets - put option

-- accounting

-- opaque

(…if there is no market)


Risk Appetite: Pro cyclical

Virtuous Circle

Tipping Point- switch from momentum to fundamentals

- prisoner’s dilemma problem

(…or sleep well?)

Risk Appetite and the Credit Cycle

(A) Virtuous Circle Begins

(B) Contrarian Paradise

(C) Bubble Trouble

(D) Vicious Circle Begins

Vicious Circle

High

A C

B D

Good

Low

Weak

Market State

Risk

Tim

e since last correction

Asset Prices

Investor Demand

Collateral Value

Bank

Asset Prices

Investor Demand

Collateral Value

Bank

Credit Cycle

(Do you want to eat well…)

Risk Appetite


Value Implications of Risk Appetite Changes

(not all risk is the same)

Evaluate Performance - paying alpha business for beta returns. Reflected I declining P/E ratios. Merrill

shifted the risk profile to increase nominal income, but destroyed value.

(Risk is the price you never thought you would pay)

Alpha

optimal portfolio efficient frontierfor business portfolio

C Beta

ReturnA = Actual

A B = AlternativeB C = Target

Zeta

Changes

X

Risk


3 RISK Management Framework


Framework

Focus: Strategic not transactional

Value Proposition: Reduce financial distress by maintaining capital market access under all conditions to ensure funding of strategic plan

Factors: profit volatility, investment opportunities, capital market conditions

Emphasis: value creation not risk reduction

Tools: Risk management is not free

Pre-loss funding

Underwriting

Mitigation

Transfer

Post loss funding

capital structure

risk capacity

Risk Management Strategy: implied by business strategy. Input not consequence of business strategy

level of risk retained relative to capital

types of risk retained


GovernanceRisk Management is board level responsibility

understand principle risks

establish Risk Profile

Alignment of interest interests

Firm with shareholders

managers with firm

Mechanisms

incentives

link risk and compensation committees

Monitoring

interim

external

Focus

Business model and profile changes

Compensation arrangements

Performance -- beware the 5L

Skill

Risk

Luck

Market timing and trend chasing

Single scenario strategies

Consequences not probabilities


Managing the Bubble Bath(In a storm…)

Avoid the bubble: difficult

Ride the wave: Keep seatbelts buckled

understand and manage the risk through the cycle

clearly defined risk appetite and exposure management

- concentrate on consequences not probabilities

profit warning

divident and rating at risk

management replaced

raise capital

regulators enter

- run multiple scenarios: single scenario strategy, the current scenario only, are dangerous deadends.

Bankroll management: hold enough capital to stay in the game because short term variance can wipe you out

Compensation system adjustments

short term results largely based on noise and luck

long term results determined by skill

(…we all get wet)

Profit / Loss Distribution


Portfolio Policy: counter vs pro-cyclical

Choices: shift based on market state and risk appetite– 5 (L): Long, Low, Large, Leveraged and (i) Liquid– 5 (S): Short, Small, Safe, Sane and Sellable

Trend Chasing: portfolio decisions based on past returns.

Market StateBull Bear

Revenue

Risk

5(S)

5(L)

Application

(Be fearful when others are greedy…)

(…and greedy when others are fearful)


4 Conclusion


Conclusion

The deeper we are into illiquid products and structures, the more difficult it is to manage

Identify adverse scenarios, stress to determine consequences, compare to risk appetite, and take appropriate portfolio decisions

Requirements

– Risk management -- strategic vs. transactional

– Aligned compensation

– Strong governance and Board involvement

– Supportive ownership structure

(There are no winners in markets…)

(…just losers and those who get out in time)

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