Archive for October 2009

Whose Loss is it?

October 21, 2009

As we look at the financial system and contemplate what makes sense going forward, it should be important to think through what we plan to do with losses going forward.

losses

There are at least seven possibilities.  As a matter of public policy, we should be discussing where the attachment should be for each layer of losses.  Basel 2 tries to set the attachment for the fourth layer from the bottom, without directly addressing the three layers below.

So for major loss scenarios, we should have a broad idea of how we expect the losses to be distributed.  Recent practices have focused on just a few of these layers, especially the counterparty layer.  The “skin in the game” idea suggests that the counterparties, when they are intermediaries, should have some portion of the losses. Other counterparties are the folks who are taking the risks via securitizations and hedging transactions.

However, we do not seem to be discussing a public policy about the degree to which the first layer, the borrowers, needs to absorb some of the losses.  In all cases, absorbing some of the losses means that that layer really needs to have the capacity to absorb those losses.  Assigning losses to a layer with no resources is not an useful game.  Having resources means having valuable collateral or dependable income that can be used to absorb the loss.  It could also mean having access to credit to pay the loss, though hopefully we have learned that access to credit today is not the same as access to credit when the loss comes due.

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This picture might be a useful one for risk managers to use as well to clarify things about how losses will be borne that are being taken on by their firm.  The bottom layer does not have to be a borrower, it can also be an insured.

This might be a good way to talk about losses with a board.  Let them know for different frequency/severity pairs who pays what.  This discussion could be a good part of a discussion on Risk Appetite and Risk Limits as well as a discussion of the significance of each different layer to the risk management program of the firm.

The “skin in the game” applies at the corporate level as well.  If you are the reinsurer or another counterparty, you might want to look at this diagram for each of your customers to make sure that they each have enough “skin” where it counts.

The Glass Box Risk Model

October 19, 2009

I learned a new term today “The Glass Box Risk Model” from a post by Donald R. van Deventer,

Glass Boxes, Black Boxes, CDOs and Grocery Lists

You can read what he has to say about it.  I just wanted to pass along the term “Glass Box.”

A Glass Box Risk Model is one that is exactly the opposit of a Black Box.  With a Black Box Model, you have no idea what is going on inside.  WIth a Glass Box, you can see everything inside.

Something is needed, however, in addition to transparency, and that is clarity.  To use the physical metaphor further, the glass box could easily be crammed with so, so much complicated stuff that it is only transparent in name.  The complexity acts as a shroud that keeps real transparency from happening.

I would suggest that argues for separability of parts of the risk model.  The more different things that one tries to cram into a single model, the less likely that it is separable or truely transparent.

That probably argues against any of the elegance that modelers sometimes prize.  More code is probably preferable to less if that makes things easier to understand.

For example, I give away my age, but I stopped being a programmer about the time when actuaries took up APL.  But I heard from everyone who ever tried to assign maintenance of an APL program to someone other than the developer, that APL was a totally elegant but totally opaque programming language.

But I would suggest that the Glass Box should be the ideal for which we strive with our models.

Toward a New Theory of the Cost of Equity Capital

October 18, 2009

From David Merkel, Aleph Blog

I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

  • Beta is not a stable parameter; also, it does not measure risk well.
  • Company-specific risk is significant, and varies a great deal.  The effects on a company with a large amount of debt financing is significant.

What did they do in the old days?  They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks.  If less scientific, it was probably more accurate than MPT.  Science is often ill-applied to what may be an art.  Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

I’ve also never been a fan of the Modigliani-Miller irrelevance theorems.  They are true in fair weather, but not in foul weather.  The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency.  The cost of financing assets goes up dramatically when a company needs financing in bad times.

But the fair weather use of the M-M theorems is still useful, in my opinion.  The cost of the combination of debt, equity and other instruments used to finance depends on the assets involved, and not the composition of the financing.  If one finances with equity only, the equityholders will demand less of a return, because the stock is less risky.  If there is a significant, but not prohibitively large slug of debt, the equity will be more risky, and will sell at a higher prospective return, or, a lower P/E or P/Free Cash Flow.

Securitization is another example of this.  I will use a securitization of commercial mortgages [CMBS], to serve as my example here.  There are often tranches rated AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, and junk-rated tranches, before ending with the residual tranche, which has the equity interest.

That is what the equity interest is – the party that gets the leftovers after all of the more senior capital interests get paid.  In many securitizations, that equity tranche is small, because the underlying assets are high quality.  The smaller the equity tranche, the greater percentage reward for success, and the greater possibility of a total wipeout if things go wrong.  That is the same calculus that lies behind highly levered corporations, and private equity.

All of this follows the contingent claims model that Merton posited regarding how debt should be priced, since the equityholders have the put option of giving the debtholders the firm if things go bad, but the equityholders have all of the upside if things go well.

So, using the M-M model, Merton’s model, and securitization, which are really all the same model, I can potentially develop estimates for where equities and debts should trade.  But for average investors, what does that mean?  How does that instruct us in how to value stock and bonds of the same company against each other?

There is a hierarchy of yields across the instruments that finance a corporation.  The driving rule should be that riskier instruments deserve higher yields.  Senior bonds trade with low yields, junior bonds at higher yields, and preferred stock at higher yields yet.  As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.

Thus, and application of contingent claims theory to the firm, much as Merton did it, should serve as a replacement for MPT in order to estimate the cost of capital for a firm, and for the equity itself.  Now, there are quantitative debt raters like Egan-Jones and the quantitative side of Moody’s – the part that bought KMV).  If they are not doing this already, this is another use for the model, to be able to consult with corporations over the cost of capital for a firm, and for the equity itself.  This can replace the use of beta in calculations of the cost of equity, and lead to a more sane measure of the weighted average cost of capital.

Values could then be used by private equity for a more accurate measurement of the cost of capital, and estimates of where a portfolio company could do and IPO.  The answer varies with the assets financed, and the degree of leverage already employed.  Beyond that, CFOs could use the data to see whether Wall Street was giving them fair financing options, and take advantage of finance when it is favorable.

Black Swan Free World (7)

October 17, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

Hyman Minsky’s Financial Instability Hypothesis talks about the financial markets working in three regimes, Hedge, Speculative and Ponzi.   Under Hedge financing, investments generally have sufficient cashflow to pay both principle and interest.  Under Speculative financing, investments generally have cashflows sufficient to pay interest, but depend upon rolling over financing to continue.  Ponzi financing does not have sufficient cashflows to pay either interest or principle.  Ponzi financing requires that values will increase enough to pay both principle and interest to repay financing.

Speculative financing requires a belief that the value of the collateral will be stable to justify future refinancing or rolling over of the financing.  That belief could be called confidence.

Ponzi financing requires a belief that the value of collateral will grow faster than the interest rate charged.  That belief requires a significantly higher amount of confidence.

There are several other levels that a financial business could operate.  For example, the value of the collateral could be viewed in terms, not of its current value, but of its value in an adverse scenario.  A very conservative lender could then make sure that each investment used that adverse value as the actual amount of collateral granted.  In that situation, the investor does not want to rely upon the belief that the asset value will be stable.  A significantly more aggressive investor will want to make sure that their portfolio in total adjusts the value of collateral for the possible loss in an adverse situation, allowing for the effects of diversification in the portfolio.

Credit practices in the US have drifted against the path of having the borrower put up cash for that difference between adverse value and current value.  Instead, practice has changed so that the lender will hold capital against that adverse scenario and charge the borrowed the cost of holding that capital.

What has changed with that drift, is who will bare the losses in the adverse scenario.  That has shifted from the borrower to the lender.  So the loan transaction has changed from a simple credit transaction to a combined credit and asset value insurance transaction.  (Which makes me wonder if the geniuses who thought of this thought to charge appropriately for the insurance or if they just believed that if the market bought it when they securitized it, then the price must be right.)

This will look different from the former loan business where the borrowed bore the asset value risk because the lender will have fluctuations in their balance sheet when the adverse scenarios hit and the collateral value falls below the loan value.  And that is exactly what we are seeing right now.

In addition, as we are seeing now, when there is a extremely severe drop in the value of collateral, having the banks hold the risk of the decline in collateral value, then a drop in the collateral will have a significant impact on bank capital.  The impact on bank capital may have a major impact on the bank’s ability to lend which will impact on all of the rest of the economy that had no connection to the impaired asset class.

So to Taleb’s point about confidence,  it seems that he is stating that lending practices should revert to their prior level where collateral was valued under an adverse scenario.  Then there will be little if any confidence involved in the lending business.  And less chance that a steep drop in any one asset class will spill over to the rest of the economy.

So the dividing line would be that the financial firms that could be subject to future government bailouts would need to value collateral pessimistically and to avoid loans that are not fully collateralized.

Sounds SAFE.

But here is the problem with that proposal…

If any other firms, outside of that restriction are permitted to lend in the same markets, business will ultimately shift to those institutions.  They will be able to offer better loan terms and larger loans for the same collateral AND in most years, they will show much higher profits.

Bad risk management will drive out good.  The institutions that take the most optimistic view of risk, those who have the most confidence, will drive the firms with the more pessimistic view (whether that is their own view or the view imposed by the regulators) out of the market.

And then when the next crisis hits, regulators will find that the business has shifted to the non-regulated firms and they they will instead need to bail them out, unless they make it illegal for non-regulated firms to do any of the kinds of finance that is related to a government’s need to bailout.

Then the bank would almost always have real collateral and any drop in confidence could be resolved by assigning that collateral over to someone with cash and settling any needs for cash that the lack of confidence creates.

Taleb is not clear however whether he is referring to banks or the financial system in general or to the government with his statement.  The discussion above is about banks.

Trying to think about this idea in the context of the entire financial system, I wonder if he was suggesting a return to the gold standard.  When there was a gold standard, there was no need for confidence in the currency.  If you stay with the current currency regime, then the confidence idea, I suppose, relates to the question of inflating the currency.  If the government does seem to consistently hold the money supply at a reasonable level in proportion to the economy, then there will not be a problem.  However, I cannot think of any way of looking at the floating currency system that does not REQUIRE confidence that the government will hold inflation in check.

Applying the idea to the government, I would also say that confidence is required there as well.  A government that could be counted on to fund fully for spending programs would instill confidence, but there could be no surity, especially under the US system where the next congress could immediately trample on the good record of a all preceding governments.

Black Swan Free World (10)

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Gresham’s Law of Risk Management

October 16, 2009

Those who do not see a risk will drive those who see the risk out of the market.

Gresham’s law is of course “bad money will drive out good.” Its application to risk can be stated as the above and is well known to many market participants even though they might not have named it. Many business managers will blame their lack of success in a market to fools who are inappropriately undercutting their price and losing money doing so. For the most part, in most markets, participants are price takers, not price makers.
If someone comes into a market and wants to take a risk at half the going rate, then there is a new going rate. Market participants who do see the risk can take the new going price or withdraw.

From this you can infer that there is no benefit to better modeling of risk if it results in a significantly higher value for the risk.  Simple techniques should be used to broadly size a risk to see if your view of the risk puts you near the market or not.  Then if you are near to the market, you can spend the time and money to more carefully evaluate the risk.

It makes no sense to spend lots of time an money carefully evaluating a risk that you will not be seeing because someone who is more optimistic, or someone who does not see that risk at all will be writing all of that business.

Optimizing ERM & Economic Capital

October 15, 2009

The above was the title of a conference in London that I attended this week.  Here are some random take-aways:

    • Sometimes it makes sense to think of risk indicators instead of risk limits.

    • Should MVM reflect diversification?  But who’s diversification?

    • Using a Risk and Control Self Assessment as the central pillar to an Operational Risk program

    • Types of Operational Losses:  Financial, Reputation, Opportunity, Inefficiency

    • Setting low thresholods for risk indicators/KRIs provides an early warning of the development of possible problems

    • Is your risk profile stable?  Important question to consider.

    • Number of employees correlates to size of operational risk losses.  May be a simple way to start thinking about how to assign different operational risk capital to different operations.  Next variable might be experience level of employees – might be total experience or task specific experience.  If a company goes into a completely new business, there are likely to be operational issues if they do not hire folks with experience from other firms.

    • Instead of three color indicators, use four – Red, Orange(Amber), Yellow, Green.  Allows for elevating situations out of green without raising alarm.

    • Should look at CP33

    • Controls can encourage more risk taking.  (See John Adams work on seatbelts)

    • Disclosures of safety margin in capital held might create market expectations that would make it impossible to actually use those margins as a buffer without market repercussions.

    • Serious discussions about a number of ways that firms want to deviate from using pure market values.  Quite a shift from the discussions I heard 2 -3 years ago when strict adherence to market values was a cornerstone of good financial and risk management.  As Solvency 2 is getting closer to reality, firms are discovering some ways that the MTM regime would fundamentally change the insurance business.  People are starting to wonder how important it is to adhere to MTM for situations where liquidity needs are very low, for example.

      All in all a very good conference.

      Emerging Risk Scenario (1)

      October 14, 2009

      The British dominance of the world scene was largely seen to have ended with WWI.  However, that decline was not really an absolute decline in wealth, it was really mostly just a relative decline.  Other countries, especially the US rose in wealth faster than the UK.

      That story begins to hint at the ELEPHANT in the room.  That elephant is the relative per capita wealth of the people in China, India, and the other emerging economies.

      We have entered a period of equalization of personal wealth between the have-nots and the haves.  That will be a very disruptive process in the Have countries.  It may go gradually with small slow changes or it may go rapidly through a series of big jumps.

      But what we will see will be a series of shocks like the dot com bubble and the current financial crisis.  At the end of each shock, the PPP per capita wealth of the rising economies will be the same as at the start or more likely higher and the PPP per capital wealth of the Have economies will be lower.

      This will happen largely via shocks because there is extreme amounts of resistance to the process on the part of the Have economies.  This resistance took the form of excessive leverage in recent times.  People were unwilling to accept the fact that their PPP income was dropping, so that they borrowed to keep their lifestyle at the level that they felt that they are entitled to.

      So discussions about deficits are really about how the US will handle the coming change in distribution of the wealth of the world.  If we simply choose to resist the change and try to bring things back to “normal” by government or personal deficit spending, then eventually we will have to pay through devaluation of our currency and if we persist, those funding our debt will cut us off.

      It is hard to imagine our political process coming to the conclusion that we need to rethink our financial strategies in the light of the changing world financial order. That thinking has to come from outside the political process and eventually find its way in.

      So the Emerging Risks scenario is for the long term decline of the income of the Have economies accomplished through a long series of financial system shocks accompanies by growing government deficits and declining credit quality for the government debt of the developed nations.  At the same time, the successful “emerging market” economies become the dominant economic players and their people gradually risk in PPP income to match up with the PPP income of the “developed” nations for people who still do the same or comparable work.  That income equalization will include some significant increase in overall wealth, but not enough to maintain the incomes of the developed countries during this process.

      So if this is the emerging risk scenario. the questions are:

      1.  How would your firm fare in this scenario if no specific advance planning or anticipation is done?

      2.  Are there any things that your firm might do differently if you thought that this scenario was somewhat likely?

      3.  Assuming that this scenario occurs, what is the cost benefit of those actions?  i.e. do they make sense in that scenario?

      4.  Are there any ways to track secondary signs that this scenario might be coming to be?

      From time to time, different Emerging Risk scenarios will be posted here and in the INARM LinkedIn Emerging Risks group for discussion.

      Readers can post scenarios also – directly on LinkedIn or as a comment here (that I will “promote” to a posting.)


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