Risk Management what went wrong

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Risk Management-what went wrong ?

• Oliver Jakob
• 04/17/08

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General Thoughts
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Some general thoughts

• Does Market Risk actually matter ????

Earnings per share by fiscal year for two
companies
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What is the risk appetite ?

• So hard to quantify..
• Whats the right measure capital base, market
  perception ?
• Universal banks vs. Securities firms
• Funding mix versus risk appetite

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Methodology
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VaR and Stress

• VaR is notoriously bad for regime shifts

VaR estimate for daily move, as of June 2007
approx. 1.3bps
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VaR and Stress
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VaR and Stress
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VaR and Stress

• Size of losses far exceeds disclosed VaR (even if
  adjusted for quarterly time horizon)

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VaR and Stress

• What is the right stress for Alt-A Option-ARMs ?
• In reality, stress tests largely rating based.
  AAA-rated credits widen 20bps with a WAL of
  3yrs, loss would be from 100 to 99.40 or 6mm on
  1bn Dollar position. Real losses were 100 times
  that.

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Particle Finance vs. ABS

• MBS and CDO2 are incredibly complex derivatives
  which were valued/traded risk-managed without any
  of the analytics prevalent in Derivatives
  trading.
• The bulk of the risk factors arent readily
  hedgable
• Macro hedges (short homebuilder stocks, buy
  protection FNMA, MBIA, etc) were implemented but
  without clear understanding of the relationship
  between the hedges and the mortgage inventory

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Particle Finance vs. ABS

• Contrast Synthetic CSO vs. Mortgages

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Ratings

• Ratings based on backward-looking experience
  (scenario-analysis)
• Largely based on points, not on a distribution
• Conflict of interest
• Some egregious examples between risk-neutral
  pricing and assumed real world probabilities
  (CPDOs)
• The problem with underwriting standards

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Risk Management Structure
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Organizational thoughts

• Whos the audience ?
• Management ?
• Regulators ?
• OrgChart
• Reporting to CFO ?
• Reporting to CEO ?
• Product
• Low-level monitoring / enforcement ?
• Price Verification ?
• Big picture risk strategy ?
• PL explanation ?
• Regulatory peace ?

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Organizational thoughts

• Hedging
• Concentration only
• Market bias past a certain level
• All market bias
• Trading only or Banking other revenue streams
• Regulatory interaction
• Retention
• Reward system
• The culture of revenue generation
• Attraction of the buy-side

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Conclusion
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A subjective outlook

• Re-intermediation
• More regulation
• Securitization as non-recourse, largely
  risk-free financing (risk retained by originator)
• Bond insurance returns to Public Finance
• Quo vadis, Risk Management ??????

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The way forward

• Risk needs to understand business (bottom-up
  risk management)
• Risk needs to understand risk AND reward there
  is no point focusing only on one side of the
  equation
• Risk should report to Executive level
• Evolution of regulation