Sunday, December 2, 2007

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).

13 comments:

  1. Rick,

    Do you have any comments on the validity of the E*Trade Citadel transaction as a benchmark for RMBS and CDO paper? While this was a basket of different types of paper, one can infer a rough sense of values given that prime first lien securitizations (rated AA or higher) comprised more than half the portfolio. There is a post on Calculated Risk that decribes an attempt to do this. Any comments on whether you think this trade will impact values across the street?

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  2. Did you see a 28 November article in the Washington Post by Stephen Pearlstein? You sound much like him.

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  3. Because of the inclusion of rated collateral within securitisations (primarily CDOs but also SIVs/ABS CP and monoline portfolios for that matter) most traders have an implicit objective assumption about what credit ratings mean. AAA, for example, means 1% risk of default over 10 years. The reason is that is what assumption is used within the credit tranching models used by the rating agencies. However, ratings are ALWAYS subjective relative designations. They are never objective and they do not imply a precise distribution of expected losses. If you believe otherwise, just simply ask yourself how much historical data would be required to characterise a AAA default distribution. Enough said. The problem which ratings is how they are used quantitatively - we have a simple empirical problem - we do not have sufficient data. Period. We certainly have nothing like sufficient data to characterise the loss distributions for a new debt product like subprime mortgages. They should never have been rated. They should certainly never have been the subject of double and triple levels of securitisation (CDOs, CDO squareds). Sometimes we take a reasonable looking approach and bastardise it. In this case, it is garbage in, garbage out.

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  4. Rick, you're writing is very interesting reading. Absent a correction from some major debacle - how much respect does the Risk side of the house get in Financial firms? It doesn't take much imagination to see every conversation shaping up like your example (Chicken Little vs. the Rainmakers)

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  5. I have added to this post to try to address the question asked by Tim.

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  6. More like a conversation with himself - if this is how he behaved as a risk manager without any b*lls then no wonder he fabricates theories and exploits rumors in his book. (Which is a defense of the meek risk manager -even if they review things and approve them they are unaccountable).

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  7. I have added a new post on mark to value versus mark to liquidity which answers the question posed by "B" in his comment about E-Trade.

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  8. Your comment:

    "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."

    describes more than just risk managers. It seems to me that much of corporate business consists of meetings whose primary purpose is to make people feel busy and important.

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  9. I know about 40 VP level risk manager most of them wouldnt have the brains to ask the questions you mnetion much less act on them

    Wall street with go the way of Detroit

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  10. Hey Rick,

    do you mind telling me what's the principle trading strategy made by the trading desk over here?

    Is is similar to those SIVs were doing? borrowing on the short end of the yield curve to finance the longer end (like Citron's style you mentioned in your book).

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  11. I'm a market maker for israeli OTC stocks and you are right about those guys, who trade. They're usually fresh out of college without any respect for risk. History repeats itself. I was expecting the 1987 October 19-th scenario, but Bernanke didn't let it happen. I am biased he shouldn't get into the picture and let it fall. Totally agree with Jim Rogers that Fed wasn't established to bail out the hedge funds. Let 'em crash! The ones who didn't deal with crap like subprime wouldn't even feel it while shorting the stock index futures.

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  12. In investment banks you do not get paid to save money - simple!
    Until this changes this process (boom and bust) will repeat.
    If you have a view you need to have the ability to express it to make money. Opposing views (and market bets) need to be allowed.
    The problem is: how do you structure an organisation to do this, survive and prosper? You cannot.
    You have to allow people to pay for their mistakes. Nothing changes. Get used to it.
    The financial bailouts and economic stimuli are all coming. This is the real game and not the game that you are taught.

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  13. having worked in risk control (back office - no P&L) and risk management (front office - P&L) I think this article gets to one of the major problems banks have. in order to capture flow and volume they need to be big. Being big means lots of employees and reports and numbers to churn. That means the partnership culture goes out the window and that the controller ends up weaker than the front office and at the same time always in ar** covering mode. This leads to overreliance on models and being able to prove they ran a scenario even if he/she doesn't act upon it. The internal dynamic of trader / controller is echoed in bank / regulator. A sensible discussion is not possible; traders are not held responsible for tail losses and controllers / regulators feel exposed and so react defensively.

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