Cyclicality: Between Risk Amnesia and Risk Obsession

1. Cyclicality: Between Risk Amnesia and Risk Obsession J.V. Rizzi, CapGen Capital, LLC European Credit Risk 2008 Paris, February 2008 (The views expressed are those of the presenter and do not represent those of CapGen Capital, LLC

2. 1 Introduction

3. 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 Introduction. In financial markets, progress is cyclical, not cumulative (James Grant) (The most expensive words in finance: this time is different)

4. (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 Bubble Meter (or what I am telling you?)

5. Strategy: Peso Strategy-Pays well in all but the worst states where it crashes (picking up nickels…) • Competition: margins squeezed in traditional asset creation and distribution • Mispricing: risk mispriced given excess liquidity chasing limited • Strategic Shift: from intermediary to principal • appropriateness • timing sensitive • problematic value • requirements • Strong Balance Sheet • Pricing and Trading Discipline • Risk Premium • 5L Portfolio: asset heavy • long • low • large • leveraged • (i)liquid (…in front of a steamroller)

6. (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 The Perfect Storm? Summer of 2007 (…in a storm we all get wet)

7. 2 The problem

8. The Problem (It is difficult to price rationally when risk seems remote and hard to measure…) Risk Dimensions: • Frequency: exposure vs experience • Impact severity • (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. HPLIE Frequency A C B D HILPE Impact (…and conditions seem favourable. T. Geither, NY Fed)

9. The Problem (Continued) (HILPE are likely to occur…) 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 (…because there are so many HILPE that can occur)

10. Reinforcement (Pressure to play can distort risk decisions) 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 (You only find out how dirty the laundry was during the rinse cycle)

11. Reinforcement (continued) (Once in a lifetime events happen…) 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 (… every three or four years)

12. (no sense marking to market…) Framework UncertaintyAsymmetrical InformationBehavioral Bias State dependent events Adverse selection over optimism events beyond the data moral hazard disaster myopia Decisions at Risk (DAR) 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)

13. Risk Appetite: Pro cyclical (A) Virtuous Circle Begins (B) Contrarian Paradise (C) Bubble Trouble (D) Vicious Circle Begins Low High Time since last correction Good A C Market State B D Weak Risk Asset Prices ­ Collateral Value Investor Demand ­ ­ ­ Bank Risk Appetite and the Credit Cycle (Do you want to eat well…) Risk Appetite Credit Cycle • Virtuous Circle • Vicious Circle Asset Prices ­ Collateral Value Investor Demand ­ ­ ­ Bank • Tipping Point • switch from momentum to fundamentals • prisoner’s dilemma problem (…or sleep well?)

14. (not all risk is the same) Value Implications of Risk Appetite Changes 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)

15. 3 RISK Management Framework

16. 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

17. Governance Risk 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

18. 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 / Loss Distribution • 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)

19. Market State Bull Bear Revenue 5(L) 5(S) Risk Application (Be fearful when others are greedy…) • 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. (…and greedy when others are fearful)

20. 4 Conclusion

21. Conclusion (There are no winners in markets…) • 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 (…just losers and those who get out in time)