My Testimony to the Senate Banking Committee

On June 19 I testified before the Senate Banking Committee, at a hearing of the Subcommittee on Securities, Insurance and Investment. You can read my prepared testimony here.

I am Signing Off

Going forward, I will not be doing new posts for this blog on a frequent basis. (You can probably see things have already been tailing off).
Here is a review of my book that I thought was particularly interesting. It is heartening to think that my book has a little bit of something for everyone.

Tom Daula on Risk Management

In light of the risk management problems that have occurred at Morgan Stanley, I thought it was interesting to run into this description of risk management at Morgan Stanley on the web. It was written by the firm's Chief Risk Officer, Tom Daula. It all sounds pretty reasonable to me. I guess I would give him an A for the planning and an F for the execution.
Given that things did not work out according to plan, it would be enlightening to know where these plans went astray.

Mark to value versus mark to liquidity during market crises

There is the song lyric “the darkest hour is just before dawn” which probably was not speaking about liquidity crises, but it could have been. I have written a lot about liquidity crises, both in past blog posts and in my book, A Demon of Our Own Design. In a nutshell, the issue with a liquidity crisis is that there is a market shock that forces investors who are highly leveraged to liquidate. Their liquidation drops prices further – remember the market already had some sort of a shock, so it doesn’t take much to move prices down more – and this causes even more forced selling. You end up with a downward spiral in prices. This is helped along because some of the people who might be natural buyers run for the sidelines. They see the market is in disarray and watch a lot of apparently smart people hanging on by their fingernails, and they don’t want to take the risk. Or they want to take the risk, but their bosses, who are further removed from the scene, will think they are imprudent gamblers if they do.

The end result of this cycle is that prices are determined by liquidity issues, not by value. The value players have by and large been scared away. Once the dust settles and the highly leveraged players are done bailing, everything moves back to normal, where “normal” means that prices are determined more by value again. Granted, on the margin liquidity will still affect the price. If there is a pension fund that has a large position to move, prices will adjust for that in order to find the other side of the market. But in most markets, that sort of thing will move prices a few percent here and there, if that much.

Things are deservedly considered to be bad right now. There are major institutions that have gotten themselves into terrible positions. This is a crisis that has a risk of having systemic repercussions both because of its depth and because of the types of markets that are involved. So my intent is not be sounding an “all clear” siren. But I wonder if some people are confusing the liquidity-driven marks with the value-based marks, and in doing so are making things look even worse than they are. This already was on my mind when I watched the level of write-downs of positions, but the most recent event that really makes this a question to pose is the sale of assets by E-Trade for pennies on the dollar. Is that really a representation of where value is? What is the implied default rate that would make that fair value?

I have seen a number of sources extrapolate the E-Trade transaction, asking what would happen if all the Level 3 positions of banks and investment banks were to be remarked based on this transaction. This seems to be a variation on the game that started a month or so ago of assessing the prospects of a bank staying in business based on the ratio of Level 3 assets to capital. I think this is an exercise that is alarmist. Level 3 positions are not all sub-prime or even all CDO. There may be Level 3 positions that are good as gold, but simply do not have comparables or models that can provide adequate marking. And it is no surprise that these institutions are highly leveraged – they typically might have a balance sheet that is twenty times their capital. So with that sort of leverage, and with the sorts of businesses they are in (remember, they tend to make markets in things that you can’t just run out and buy on an exchange), it is not surprising to me that they will have Level 3 assets that are greater than their capital. But again, “Level 3” does not mean “worthless”.

Granted if you are in a position where you may be forced to liquidate, the mark to liquidity is what you are concerned about, and for E-Trade apparently that was the case. But if you have the ability to weather the storm, what will finally matter is the mark to value.

Conversations with the Trading Desk

Most crises are crystal clear after the fact, and the subprime crisis is no different. At least as far as it has affected the various banks and investment banks, the problem is that they had too much inventory in something that was risky and illiquid. How did they end up in that situation? Is it something that they should have recognized before they were hit with multi-billion dollars write downs?

I often replay these sorts of problems in my mind. Putting myself in the situation of the risk manager at one of these firms, here is one way I could have seen things playing out over the course of meetings with the trading desks.

Session 1
Me: “Hey, guys, have you noticed that our CDO-related inventory has been growing. It wasn’t too long ago that we had just a few billion, and then it went up to $20 billion, and now nearly $40 billion. That seems worrisome to me.”

Them: “Maybe that’s because you aren’t sitting here on the desk watching these things all day long like we are. Look, you can’t make money in this business without ending up holding some inventory from time to time. At least if you can, be sure to let us know how. And in this case a lot of this inventory is rated AAA. You wouldn’t have a problem if we had a bunch of AAA corporate bonds, would you? I mean, that stuff is a better bet than our company is.”

Session 2
Me: “You know, even if this stuff is AAA and you aren’t worried about defaults, spreads are really low right now. If they go up for some reason – and even up to somewhere in the range of their historically “normal” levels – we could see a multi-billion dollar write down on this inventory.”

Them: “Oh, right. Good catch. We’ll put something in place for a hedge against credit spreads widening.”

Session 3
Me: “This stuff that you are saying is AAA. What if those ratings are off? I mean, it is not like the rating agencies have any experience with these sorts of structured products. They are basing the ratings on historical default probabilities and historical correlations. Don’t you think with all the changes we are seeing in the market – the very explosion in the issuance of CDOs, for one – that these correlations could be different than they have been in the past? And, for that matter, why should we be betting on what rating agencies have to say?”

Them: “Well, if you have a better way of assessing the risk of these things, let us know. Otherwise, do you mind if we get back to work. We’re trying to make money here.”

Session 4
Me: “I’m sorry to bother you again. But, maybe we have been focusing on the wrong thing here. The issue for us is not so much if these are really AAA or not; our concern is not just with defaults being higher than we expected. The issue is whether these could trade substantially lower for any reason. And I think I have one scenario that could lead to much lower prices: The instruments in our inventory are not very liquid. That is, after all, the reason we have ended up holding these things in our inventory rather than pushing them out to a client. So what if someone suddenly is forced to liquidate, a hedge fund, say, that gets into trouble. The price in the market could plummet. And it wouldn’t take much of a price drop to hit us hard. When you have $40 billion of this stuff, a ten percent drop will lead to a mark to market loss that will wipe out all the profits you guys have made over the last few years.”

Them: “Good to see you are cranking out the scenarios. But if we worried about every little “what if” that you can cook up, we wouldn’t be doing anything. We are risk takers. That’s how we make money. So if you want us to stop making money – or if you have a better idea on how to do it without taking risk – then let us know. Otherwise, do you mind if we get back to work here?”

The point in this set of conversations is that the risk manager is always at a disadvantage when dealing with the trading desk.

First, the traders obviously know their market better than the risk manager can ever hope to. So if a concern gets elevated to the point of an us-versus-them debate with the traders on one side and the risk manager on the other, the traders will be able to run circles around most risk managers. So a firm either has to get the traders to share the same mindset as the risk manager, or the management of the firm has to handicap the risk manager if things come to blows.

Second, for each blowup that occurs, there will be ten cases where there was a legitimate concern but nothing happened. That is, if measured based on the realized outcome, the odds are the risk manager will be wrong more often than he is right. So there is the risk of looking like the boy who cried wolf.

Another point which is not expressed in the set of conversations above is that in most large firms the risk manager makes himself too busy to really focus on risk management. If he lets himself get sucked into making the role look weighty, he will end up spending his time running an organization, worrying about having adequate face time with senior management, and elbowing his way into all the right meetings. What he should be doing instead of all that is spend time trying to think outside of the box. There are possibly hundreds -- in some cases thousands -- of people in his organization, reams of risk reports to run through and meetings all day long. The risk manager can end up looking really, really busy while not actually doing his job.

On this score, I have suggested to a number of people at Citigroup (and the same points would hold true for Morgan Stanley and probably any number of other firms) that the real risk manager should not have people management and report generation responsibilities. He should be able to have the time and space to question and think. He should be able to use all the risk data as an input and demand other types of analysis he deems necessary, but then have the time to sit back and think. In this respect, his role would not look much different than any number of very successful portfolio managers. (I treat Citigroup in a chapter of my book entitled "Colossus" as an example of an overly complex, and thus crisis-prone organization).

On the Optimality of Coarse Behavior Rules

Many people ask about the source for my cockroach analogy, which I go through on page 232ff in A Demon of Our Own Design. The source for this analogy is my paper with Joe Langsam in the Journal of Theoretical Biology. So I am linking to that paper here.

The argument in the paper is pretty readable if you read past the citations and the math, and it is relevant to how we construct financial markets and manage risk in those markets.

What if there comes a time when the Fed has to tighten?

It might seem now that it was in a different world, but it was in this one, and in fact it was in the United States. Traders watched their bank of broker screens as the 30-year Treasury dropped below 8% for the first time in their youthful memory. That was in the 1980s. I was working at Morgan Stanley at the time, and someone on the Treasury desk made a trade for his own account just so he could frame the ticket from that momentous event. Yes, interest rates can go above 8%. In fact, at the time an 8% rate seemed quite reasonable.

I mention this because over the past decade or so we have constructed a financial landscape where an 8% interest rate not only is hard for us to envision, but where it would be disastrous. The reason is the huge stock of adjustable rate mortgages. Looking at the dislocations that are coming about from the subprime problems and the related credit crunch, it is hard to fathom the effect on the housing market and the overall economy if all those remaining homeowners with various flavors of adjustable rate mortgages saw rates shoot up hundreds of basis points. I don’t know how to quantify the effect, but I would hope that there are researchers at the Fed who do. And I would bet that the implications are pretty scary. Maybe so scary that the Fed would not be able to push interest rates up very far for fear of triggering a populist revolt.

Of course, now all of the discussion is about possible Fed easing. So I am worrying about something that is not even on the radar screen. But can anyone envision a scenario where a substantial increase in interest rates would make sense from an economic standpoint, but where the Fed finds its hands tied because the costs to homeowners would be too great?

Risk Management and Shake-up Time at the Investment Banks

What a mess. With multi-billion dollar trading losses, we are starting to see heads roll. Citigroup is losing its long-time fixed income head Tom Maheras and several of his lieutenants. Merrill is continuing in its approach to managing human capital, bringing in new blood and losing experienced hands in the fixed income business. Oh, and they are putting someone into a Chief Risk Officer role. Talk about closing the barn door….

Other firms have fared very poorly but so far without executing any of the troops. Morgan Stanley layered a heart-stopping $390MM one-day loss in its prop trading desk on top of far bigger losses on leveraged loans and the like. This loss in Process Driven Trading was similar in timing to the losses at Goldman’s Global Alpha fund, AQR and other quant hedge funds. Which pretty much tells us that what this secretive group at Morgan Stanley was up to was a not-so-secretive strategy: They had a lot of capital riding on the same sort of momentum and value versus growth quant equity strategies as the rest of the gang.

What I don’t understand in all of this is that for all the mention in the press of the risk takers, there is not a single mention I have found of the people who are supposed to be overseeing the risk. If you are the Chief Risk Officer and everything blows up, don’t you bear some responsibility?

To get the idea of the CRO job, let me tell you a bit about myself. Although I am older and have a slight build, I am an Olympic athlete. My event is the shot put. I consider myself a top notch athlete in this event. I work out like the other competitors, follow a high protein diet, steer clear of performance enhancing drugs and train at the local track. The only trouble I have is when the Olympics roll around every four years, because it turns out that for an Olympic athlete, I am not very good. But then, that is only an occasional blip in my otherwise Olympic-worthy regimen.

In the CRO job 99% of the days there is nothing going wrong. The only test you get of how well you are doing – short of pouring out risk reports and looking ponderous and prudent in meetings – is what happens to the firm during times of market crisis. Every few years something calamitous happens in the market; if the firm gets blown away, that suggests you did not do a very good job.

What about the job of the risk taker? Well, a risk taker does, after all, take risk. He tries to do so intelligently, that is, he tries to put on positions that he hopes have a high return per unit of risk. But how much risk he takes and where he takes it has to be dictated by someone. You can’t just say “take risk, and good luck”.

The job of the risk manager at these firms is to convey the risk parameters to the risk takers, to define the boundaries. And that should involve more than simply running a value at risk calculation on the computer. If that is all you want, you don’t need a guy making a few million a year and employing a staff of hundreds. Before I would be so harsh on Tom Maheras and his compatriots, I would be calling to task the people who allowed that risk level to be taken in the first place.

Testimony before the House Financial Services Committee

I testified before the House Financial Services Committee on Tuesday in a hearing on "Systemic Risk: Examining Regulators Ability to Respond to Threats to the Financial System". In my written testimony I provided my views on specific questions they had posed in their invitation.

One of the points I made in my testimony was the idea of the government taking on a role as a liquidity provider of last resort. This is something I addressed in my September 10th post, "Bailouts for Profit", and it was also a central point brought up in the testimony of another member of the panel, Professor Steven Schwarcz of Duke University. I had considered this a radical idea, but it was a dominant focus from the members of the committee during the two hours of questions.