Lessons Learned: Defining New Risk Management Practices

1

Bennett W. Golub, PhDVice Chairman & Co-Head,

Global Risk & Quantitative Analysis

Lessons Learned: Defining New Risk Management Practices

AFP Corporate Risk Forum FloridaFebruary 23, 2009

2

Table of Contents

I. General and Practical Risk Management Principles

II. Genesis of the Market Crisis

III. Lessons Learned From the Crisis

Lesson 1: The Paramount Importance of Liquidity

Lesson 2: By the Time a Crisis Strikes, Its Too Late to Start Preparing for It

Lesson 3: “Certification” is Useless During Systemic Events

Lesson 4: The Importance of Counterparty Risk Management

Lesson 5: Structured Finance Vehicles Have Raised Systemic Risk

Lesson 6: Investors Need to Look Through the Data

Lesson 7: The Market’s Appetite for Risk Can Change Dramatically

Lesson 8: The Market’s Level of Risk Can Change Dramatically

Lesson 9: Don’t Let the Market Determine Your Level of Risk

Lesson 10: The Nature of Risk May Be Changing

IV. The Good, the Bad, and the Ugly About Risk Management

3

General Risk Management Principles

Know the client – it’s their money

•What level of risk does the client want?

•What limits exist on the construction of the portfolio?

Know what you own – a bottoms-up approach to risk management

•What do I actually own and what are its characteristics?

•Reverse-engineer and model each asset and liability

•Aggregate security specific exposures to measure portfolio active exposure and risk

Strive to make portfolio managers act like risk managers

•Risk Management groups must focus on increasing the effectiveness of portfolio managers

•While a Risk Manager must operate closely and collegially with portfolio managers in order to close

the investment process, he/she must be independent of the portfolio management function

Constantly changing financial markets require process-driven vigilance and skepticism

•Given their known limitations, risk models and financial analytics always need to be monitored for

effectiveness and relevance. If they stop working, is it the model or the market?

•Systems and processes must constantly be reinvented to stay current

Risk management does not mean risk avoidance

•Confidence in risk measurement allows for more decisive active portfolio positioning

4

Practical Risk Management Principles

Successful risk management requires a significant and sustained commitment of organizational resources, people and systems

•Risk cultures develop over years and decades, not during crises

•The sources and timing of market disruptions cannot easily be forecasted

Understand the sources of investment performance

•Do the portfolio managers know what they do well, and what they do poorly?

•Adjust future investment management processes accordingly

If an analysis or tool has no impact on managing portfolios, it adds no value

•Tools and ideas must make it easy to manage risk

Don’t let the perfect become the enemy of the good: manage the tradeoff between the long-term desire for robust systems vs. the need to use the best available knowledge quickly

•A two-track solution is often required

- The stakes of being wrong while infrastructure is upgraded are too high

- Constant challenge - managing between responsiveness, anarchy and bureaucracy

5

Genesis of the Market Crisis

A Long Period of Low Yields Led to Increased Issuance of Risky Debt, Setting the Stage for the Recent Crisis

Source: JMP, Barclays (LehmanLive), Moody’s|Economy.com

Mortgage and Corporate Bond Spreads

Sub-Prime and Alt-A Mortgage Originations

High Yield and Leveraged Loan (amt outstanding, US$ Bn)

Bond Issuance (amt US$ Bn)

0

100

200

300

400

500

600

700

800

2000 2001 2002 2003 2004 2005 2006 2007 2008

bp

s

AAA Corporate BBB Corporate MBS

0

0.05

0.1

0.15

0.2

0.25

2000 2001 2002 2003 2004 2005 2006 2007 2008

Sub-Prime Alt-A

0

500

1000

1500

2000

2500

3000

2000 2001 2002 2003 2004 2005 2006 2007 2008

RMBS CMBS ABS CDO HY Corp HG Corp

0

200

400

600

800

1000

1200

1400

1600

2000 2001 2002 2003 2004 2005 2006 2007 2008

High Yield Leverage Loan

6


Increased Borrowing Spreads & Collateral Haircuts Forced Rapid De-Leveraging

Product Mar-07 Feb-09

AA Corporate Bond 3 20

BB Leveraged Loan 15-20 N/A**

BB High Yield Bond 10-15 N/A**

Equities 50 50

Investment Grade

CDS/Derivatives

1 5-9***

AAA CDO of ABS 4 N/A**

AAA CLO 4 N/A**

AAA Residential MBS 2 30-40*

* May be difficult to find

** No Market

***May vary

Typical Haircut / Initial Margin Level by Asset Class(Percent, Approximate Estimates)

Funding Pressures (January 1,2007 - February 10, 2009)

0

1

2

3

4

5

6

7

Jan-07 May-07 Sep-07 Jan-08 May -08 Sep-08 Jan-09

3-Month T-Bill

30-Day Asset-Backed CP3-Month $ LIBOR

Source: Bloomberg; Citi

7

0

100

200

300

400

500

600

700

800

Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 M ay-07 Oct-07 M ar-08 Aug-08 Jan-09

AAA AA A BBB


Source: Barclays (LehmanLive)

The De-Leveraging Leads to Significant Spread Widening

MBS OAS (bps) CMBS Spread to Swap (bps)

Credit OAS by Credit Quality (bps)Spreads to Treasuries of Selected ABS Sub-sectors (bps)

(AAA-Rated)

0

50

100

150

200

Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 M ay-07 Oct-07 M ar-08 Aug-08 Jan-09

0

600

1200

1800

2400

3000

3600

4200

Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09

AAA AA A BBB

0

200

400

600

800

1000

1200

1400

Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09

3-Yr Credit Card 3-Yr Auto Loan 3-Yr Home Eq

8

Stock Price History: Financial Services1 Stock Price History: Commercial Banks1

Stock Price History: Insurance Companies1 Stock Price History: GSE & Guarantor1


Crisis touches banks, broker-dealers, insurance companies, mortgage originators, money market funds, hedge funds, and asset managers

The Financial Services Sector Was Hit Very Hard

0

50

100

150

Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09

Merrill Lynch Morgan Stanley Citigroup

UBS JP Morgan Lehman

Goldman Sachs

0

50

100

150


PNC Bank of New York Mellon

Citigroup WachoviaBank of America Wells Fargo

JP Morgan Washington Mutual

0

50

100

150


AIG Allianz Se AXA Met Life Prudential

0

50

100

150

200

250


FNM FRE AMBAC MBIA

1Data as of 10 February 2009 ; All data are normalized.Source: Bloomberg

9

Changing the Rules of the Game

The Rules are Changing Rapidly as the U.S. Government Tries to Prevent Collapse

7 FNM and FRE placed into conservatorship by Federal Housing Finance Authority and US Treasury

17 Federal Reserve takes 80% stake in AIG in return for $85bn loan

19 Treasury provides $50bn insurance program for money market funds

Fed establishes ABCP liquidity facility for money market funds

Governments worldwide announce short-selling restrictions

25 WAMU seized by FDIC; assets sold to JPMorgan for $1.9 bn

29 Citigroup purchases Wachovia with $2.16 bn FDIC guarantee; subsequent private transaction with Wells Fargo announced

3 US Congress passes Troubled Asset Relief Program (TARP) legislation authorizing Treasury to purchase up to $700 bn in assets

7 Fed announces the Commercial Paper Funding Facility to buy CP directly from eligiblecompanies (CPFF is separate from TARP)

13 US government announces equity investments aggregating $125bn in Citibank,JPMorgan, Wells Fargo, Bank of America, The Bank of New York Mellon, Goldman Sachs,Morgan Stanley, State Street, and Merrill Lynch

22 Fed announces $600 bn Money Market Investor Funding Facility (MMIFF) to buy CDs, bank notes, and commercial paper from money market funds

SEPT.

OCT.

10


NOV.

DEC.

JAN.

Timeline reflects selected events from 2008 September – 2009 January

Source: Federal Reserve Bank of St. Louis

10 Fed and Treasury announce restructuring of AIG financial support; Treasury will purchase $40bn in preferred shares under TARP and Fed’s loan to AIG will be reduced to $60bn

23 Citigroup receives $306bn US government rescue package for losses on toxic assets and $20bn cash infusion

24 Treasury extends $50bn money market insurance program until April 30, 2009

25 Fed announces $600bn purchase of FNMA/FHLMC/GNMA debt and mortgagepass-throughs

Fed creates Term Asset-Backed Securities Loan Facility (TALF) to lend $200bnto holders of high-grade securities with $20bn back-stop from the TARP

19 Treasury authorizes loans of up to $13.4bn for GM and $4bn for Chrysler fromthe TARP

29 Treasury announces equity investments of $5bn in GMAC and agrees to lend up to $1bn to GM

30 Fed announces program to buy up to $500bn of agency MBS; hires BlackRock, Goldman, PIMCO, and Wellington to implement the program

7 Federal Reserve Board announces two changes to the MMIFF that 1) expand the setof institutions eligible to participate in the MMIFF and 2) reduce the minimum yield on assets

eligible to be sold to the MMIFF

The Rules are Changing Rapidly as the U.S. Government Tries to Prevent Collapse

11


SEPT.

OCT.

18 Lloyds TSB merges with HBOS in £12.2bn deal

19 Governments worldwide announce short-selling restrictions

29 Irish and Greek governments safeguard securities of six banks and building societies

UK mortgage lender Bradford & Bingley nationalized; assets sold to Santander

German commercial property lender Hypo Real Estate receives €35bn bailout from government and

private banks

5-6 German, Austrian, Danish, and Swedish governments guarantee bank deposits

6 Germany announces €50bn plan to save Hypo Real Estate after first rescue attempt fell apart

7 UK government announces £400bn rescue package

10 UK government announces investment in HBOS, RBS, Barclays, and Lloyds TSB; actions followed by governments in US, Europe, Australia, New Zealand, and Hong Kong

16 UBS transfers US$60bn of problem assets to Swiss National Bank and sells CHF 6bn in mandatory

convertible notes to the Swiss Federation

17 Germany passes €500bn bank bailout

19 South Korea announces $130bn financial rescue package to stabilize its markets though a state

guarantee on banks’ foreign debts

19 Dutch government injects €10bn into ING

20 Sweden’s government announces bank rescue plan, with credit guarantees to banks and mortgage

lenders up to 1.5 trillion kroner ($205bn)

Timeline reflects selected events from 2008 Sept – 2009 Jan; Source: BBC News

The Rules are Changing Rapidly as Global Governments Try to Prevent Collapse

12


27 KBC Groep – Belgian government injects €3.5bn to boost solvency at the Belgian financial services insurance and banking units

28 Dutch government injects €3.0bn of non-voting shares into Aegon

6 IMF approves $16.4bn loan to Ukraine

9 China sets a two-year $586bn stimulus package

10 Carnegie, a Swedish investment bank, loses its banking license and is under supervision of the national debt office

19 IMF approves $2.1bn loan for Iceland

24 UK government announces a temporary cut in the level of VAT - to 15% from 17.5%

25 IMF approves $7.6bn loan for Pakistan to shore up the country's economy

28 Bayerische Landesbank to receive €10bn in capital from Bavaria (€7bn) and SoFFin (€3bn), and will also receive a state guarantee for future debt issuance of up to €15bn

30 HSH Nordbank receives a guarantee of up to €30bn in new debt from SoFFin (German stabilization fund)

11 French government injects €10.5bn in preference shares into its 6 largest banks (BNP Paribas, Societe Generale, Credit Agricole, Caisse d’Epargne, Banque Populaire, & Credit Mutuel)

19 Commerzbank receives €8.2bn via silent participations from SoFFin and a guarantee of new debt issuance up to €15bn

21 Irish government announces to inject €7bn into Allied Irish Banks, Bank of Ireland, and Anglo Irish Bank

8 Commerzbank receives €10bn from SoFFin in the form of silent participations (€8.2bn) and new common equity (€1.8bn)

The Rules are Changing Rapidly as Global Governments Try to Prevent Collapse

OCT.

NOV.

DEC.

JAN.

13

Lesson 1: The Paramount Importance of Liquidity

Liquidity is the life blood of commerce and the ability to meet immediate obligations is critical to financial survival. Market participants lost sight of this and suffered greatly as a result. Without necessary liquidity, nothing else matters.

There are many specific lessons associated with liquidity:

•Lesson 1a: Price ≠ Fair Value Unless Special Conditions Hold

•Lesson 1b: Cash and Cash Flow are the Only Robust Sources of Liquidity

•Lesson 1c: Complexity and Opacity Matter More Than You Think

•Lesson 1d: The Supply of and Demand for a Portfolio’s Liquidity Must be Managed

•Lesson 1e: Collateral Can be a Two-Edged Sword

•Lesson 1f: Liquidity/Illiquidity is a Common Risk Factor

14

Lesson 1a: Price ≠ Fair Value Unless Special Conditions Hold

Absent Liquidity and the Ability to Arbitrage, Prices Need Not Have Any Reliable Relationship to Fair or Intrinsic Value

In equilibrium, no-arbitrage conditions will generally lead prices to approach the market’s best assessment of fair value

• Efficient markets

• Low transactions costs

• Equal borrowing and lending costs

• Perfect information

The crisis has demonstrated that none of these conditions are generally true

The ability to discover prices for many sectors of the market has broken down

Whereas historically, the buy-side problem was devoting the time and effort required to obtain accurate pricing. More recently, good prices simply do not exist because trading activity in many bond markets has come to a standstill.

• Alternative unbiased fair valuation procedures must be developed

15

Lesson 1b: Cash and Cash Flow are the Only Robust Sources of Liquidity

The objective of maximizing wealth, assuming efficient markets exists, can address liquidity concerns as an afterthought

•Value can be extracted from portfolios through the mechanism of the market

• If Price ~=Fair Value, then there is no need to make special provisions for liquidity

In the absence of functioning markets, as has been the case in the recent crisis, cash may not necessarily be generated from wealth, or, alternatively, the cost of doing so becomes exceedingly onerous

However, if the portfolio contains cash or cash producing securities, liquidity can be extracted relatively efficiently

•Fixed income coupons and principal payments

•Cash dividends from stocks or real estate investments

•Distributions from private partnerships

For purposes of meeting liabilities, only certain cash flows can be relied upon

•Cash and high quality fixed income securities meet this need

•Secured bank lines may also permit cash to be raised by borrowing

16

Lesson 1c: Complexity and Opacity Matter More Than You Think

When market participants anticipate liquidity and prices close to intrinsic value, investors can trade products they do not fully understand because arbitrage and relative value trading will preserve the fair value of the investments

• Non-expert investors can “free ride” the experts

The more complex the product, the fewer genuinely expert investors exist

• Many structured products are so complex that only a handful of investors can value them rigorously

When there are severe credit issues in a complex and opaque product space, oftentimes, the expert investors are hit the worst since they will tend to have concentrated exposures

• In the recent crisis, these investors have either been liquidated, become liquidity impaired, or are

“full”

Non-expert investors will pass on “cheap securities” to avoid “poisoned chalices”

As a result, the only bids, if any, come from vulture investors who will pay prices that are “too cheap to be wrong”

• When specialized buyers and sellers can no longer transact, the only price is what the guy with cash

is willing to pay

• Prices fall to “stupid cheap” levels to bring in new buyers

- “Take it or leave it” becomes the clearing price!

17

Lesson 1d: The Supply of and Demand for a Portfolio’s Liquidity Must be Managed

Measuring a portfolio’s ability to supply liquidity requires decomposing it position by position, not just “averaging”

Fund/Sector

Base NAV (MM) Cash

< .2 Day

0.2-1 Days

1-3 Days

3-5 Days

5-10 Days

10-20 Days

> 20 Days

Private Plcmt

Volume NA TOTAL

Team ABC 1718 26.1 11.0 15.4 11.7 6.9 11.4 7.5 9.9 0.0 0.1 73.9Strategy 1 243 6.9 4.9 20.3 22.5 9.7 13.4 10.4 11.6 0.0 0.3 93.1

Portfolio 25 4.5 20.5 34.2 23.2 7.2 3.9 4.7 1.7 0.0 0.0 95.5Portfolio 79 6.6 5.2 25.7 20.9 10.8 10.9 8.2 11.3 0.0 0.4 93.4Portfolio 130 1.9 2.1 15.8 25.0 10.1 17.6 13.5 13.7 0.0 0.3 98.1Portfolio 9 85.4 0.0 0.0 0.0 0.8 2.8 0.0 10.9 0.0 0.1 14.6

Strategy 2 61 6.1 19.9 41.5 16.9 7.7 3.1 1.6 2.7 0.2 0.2 93.9Portfolio 37 4.7 16.8 42.5 19.8 8.9 2.9 1.2 2.8 0.4 0.1 95.3Portfolio 25 8.2 24.5 40.1 12.5 5.9 3.5 2.3 2.7 0.0 0.4 91.9

Strategy 3 158 8.5 9.3 34.4 21.0 8.6 8.5 4.2 5.4 0.1 0.1 91.5Portfolio 44 8.7 12.6 33.8 21.5 7.3 7.5 3.2 5.5 0.0 0.1 91.3Portfolio 57 8.3 8.0 34.6 20.7 9.3 8.8 4.2 6.1 0.0 0.1 91.7Portfolio 57 8.6 8.0 34.6 21.0 9.0 9.0 4.9 4.6 0.4 0.1 91.4

Strategy 4 814 2.2 18.0 15.9 11.9 8.8 17.1 10.7 15.3 0.0 0.0 97.8Portfolio 6 4.9 46.5 27.9 16.4 1.3 0.2 2.5 0.3 0.0 0.0 95.2Portfolio 11 3.6 32.6 40.6 12.5 6.5 1.3 0.6 2.4 0.0 0.0 96.4Portfolio 37 0.3 23.3 6.3 21.5 31.4 17.3 0.0 0.0 0.0 0.0 99.8Portfolio 199 1.0 0.0 3.1 23.6 17.2 15.0 16.4 23.7 0.0 0.0 99.0Portfolio 515 2.3 21.5 19.9 6.6 4.3 19.9 10.5 14.9 0.0 0.0 97.7Portfolio 50 5.2 47.2 27.2 12.1 6.5 1.9 0.0 0.0 0.0 0.0 94.8Portfolio 1 100.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0



10 to 20 > 20

Current Liquidity Data as % of NAV: Days of 3 Month Average Daily Volume Owned

Prvt PlctVolume

NAGross Exposure + Cash as % of NAV Cash < .2 .2 to 1 1 to 3 3 to 5 5 to 10

Source: BlackRock

18

Lesson 1d: The Supply of and Demand for a Portfolio’s Liquidity Must be Managed

Source: BlackRock

Businesses “demand” liquidity

-60%

-40%

-20%

0%

20%

40%

60%

Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09

Port 1 Port 2 Port 3 Port 4 Port 5 Port 6 Port 7

Portfolios “supply” liquidity

0%

25%

50%

75%

100%


Cash/FX/Other

Equity

Loan

Bond/Very Low

Bond/Low

Bond/Moderate

Bond/Liquid0%

25%

50%

75%

100%


Cash/FX/Other

Equity

Loan

Bond/Very Low

Bond/Low

Bond/Moderate

Bond/Liquid

Better Liquidity 41% 33% 32% 38% 34% 38% 44%

Worse Liquidity 59% 67% 68% 62% 66% 62% 56%

Better Liquidity 45% 39% 38% 53% 47% 38% 46%

Worse Liquidity 55% 61% 62% 47% 53% 62% 54%

19

Lesson 1e: Collateral Can Be a Two-Edged Sword

Taking collateral mitigates counterparty exposures:

•Always be on the alert for any errors due to “computer problems” or “mistakes” and other

indicators of dealer stress when collateral is due

•Aggressively manage the valuation process for collateral

- Challenge dealer when appropriate

- Push back on increasingly aggressive dealer repo desks

- The system does not protect borrowers sufficiently from forced liquidations

- Carefully scrutinize the quality of the collateral being delivered

•When borrowing, require a notice period before haircuts are changed

Collateral agreements require two-way flows depending on market movements

•Changing collateral standards mean that liquid securities or cash is often required to meet

collateral requirements on most derivatives contracts

•The inability to meet these demands for collateral can set off a rapid downward spiral in terms of

access to liquidity

While they have discretion, nervous repo lenders often have little incentive to liquidate collateral in an orderly way

•Haircuts should be required to be sized to match the likely liquidity of the collateral during a

crisis, and the disposition of seized collateral should be done under a fiduciary obligation

•Individual lenders do not have incentives to preserve the system’s stability

20

Lesson 1f: Liquidity/Illiquidity is a Common Risk Factor

The degree of liquidity of an investment can have a material impact not only on the ability to raise cash but on changes in its market value as well

There are times when the markets will value liquidity more greatly than others. When markets are functioning well, liquidity is often not valued highly, but if markets get disrupted, the value of liquidity will rise

•Academic studies confirm this observation: Stocks with high sensitivities to liquidity have returns

that are on average 7.5% higher than stocks with low liquidity sensitivities. (Pastor and Stambaugh

2003)

Perversely, when markets are extremely disrupted, liquid securities may actually be hit hardest initially because liquidity-poor investors will race to sell their most liquid positions first

•This common aspect of securities will on occasion create atypical correlations in the market where

all liquid positions get hurt together

21

Lesson 1f: Liquidity/Illiquidity is a Common Risk Factor

The adverse market impact on the more illiquid positions will propagate more slowly because the ability to measure changes in market values for these securities is more limited as the markets are less transparent

•With tight credit conditions, lenders will refuse to take illiquid securities as collateral for market

value-based loans, thereby leading to forced sales

In the later stages of a liquidity crisis, the value of illiquid securities will fall spasmodically with observed executions

•More liquid positions will then retain more value relative to the illiquid ones

In a liquidity crisis, portfolios holding a “diversified” set of illiquid assets may discover that the portfolio does not behave the way their long-term asset allocation models suggested

22

Lesson 2: By the Time a Crisis Strikes, Its Too Late to Start Preparing for It

Effective risk management requires a material and sustained commitment of resources

• A robust risk management effort is a very expensive long term investment

A team of professional risk managers with substantive subject matter expertise and strong communications skills is critical in order for risk management process to have an impact

• Risk managers need to have the skills required to garner respect from risk takers

• Organizational career paths need to provide necessary rewards to attract and retain talent

A significant investment in analytics and information management technology is required to leverage risk managers and to create a reliable “information utility” that can be relied on across an organization

• Organizations need to avoid internal “information wars” that result in the inability to make and

enforce decisions

• Accessing and using information must be fast and easy in order for it to be useful on a regular basis

Having the team and efficient information infrastructure in place will allow an organization to respond to unanticipated issues or challenges that may arise

• While it is impossible to anticipate every potential contingency, a comprehensive database of

portfolio holdings and their characteristics will facilitate a fast response in the event of a crisis

23

Lesson 3: “Certification” Is Useless During Systemic Events

•The recent crisis has revealed the fallacy of relying upon under-capitalized“certifiers” of financial products

-Bond Insurers

-Auction Managers

-GSEs

-Rating Agencies

-SIVs

•Prudent investors need to rely upon their own credit analysis and surveillance capabilities to understand the underlying credits that are ostensibly being “wrapped”

•Ironically, the situation has gotten so bad that much of the market has become totally dependent on the last line of defense – direct government guarantees and recapitalization

•What remains to be seen is the robustness of the U.S. government’s guarantees, although if that fails, it is hard to imagine that other elements of the U.S. financial system will survive, except direct holdings of precious metals

24

Lesson 4: The Importance of Counterparty Risk Management

Currently, most important trading counterparties maintain their viability only through direct government support

• This situation makes the counterparty management situation temporarily much easier

Absent government guarantees, regular surveillance of counterparties is critical

• Determine appropriate terms of trade

- Delivery versus Payment (DVP)

- Maximum exposure limits, etc.

Measure concentrations of exposure by account – clients cannot be netted against each other

• Direct Exposure

- TBA Mortgages

- Derivatives

- Trade Settlement

- Commercial Paper Holdings

- Bonds

- Prime Brokerage Cash

• Indirect Exposure

- Guarantees – now mostly worthless

- Enhancers – now mostly worthless

- Liquidity Providers

25

Lesson 5: Structured Finance Vehicles Have Raised Systemic Risk

The increasing use of structured financial vehicles has created many instances of mechanistic forced selling

•Unlike traditional lenders, these vehicles have neither the discretion nor the ability to provide for

orderly liquidation

Rating-Contingent Vehicles

•SIVs

•CDOs

•CLOs

•ISDAs

0

500

1000

1500

2000

2500

3000

3500

4000

Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09

Total US Volume of Cash

BWIC

($mil)

60

65

70

75

80

85

90

95

100

105

Avg Loan Bid Px ($)

Cash BWIC Bid Px

Market Value Contingent Vehicles

•CSOs

•CDOs

•CLOs

•Principal protected CPPI structures

Source: BlackRock

26


Investors need to be more hands-on and develop a direct connection to the underlying origination processes and the underlying borrowers, along with the collateral provided (if applicable)

The original attraction of securitization, from the perspective of investors, was to provide ways to invest in attractive new asset classes while permitting information costs to be economized

•Investment bankers assembled deals by bundling together assets and reporting the initial data on

the characteristics of the underlying assets

•Servicers provided ongoing information on the asset’s performance throughout their lives,

facilitating surveillance

•Rating agencies evaluated the initial credit risk of deals and then monitored the risk throughout the

life of the deals

•Broker/dealer trading desks made markets in the securities and provided investors with the regular

valuations they required

27


The crisis demonstrated weaknesses of this model as the quality and performance of the underlying assets were materially worse than expected

•The integrity of the actual underwriting standards and borrower behavior were much worse than

ever anticipated

•In many cases, originators created loans primarily for sale and retained little, if any, interest in

their ongoing performance

Going forward, investors will need to get more deeply involved in the information cycle

•Certainly, relying on ratings alone was a failed strategy

•In the recent crisis, previous default and delinquency data was artificially low because, for a while,

increasingly attractive lending terms masked defaults with refi’s

•Even using a more rigorous analytical approach based on taking historical performance data and

building and relying only on statistical models and stress test is insufficient

28


The Risk Appetite Index captures risk factors that are reliable measures of global risk

•Direction of movement that fits economic intuition

•Significant sensitivity to risk events

•Low correlation across factors

The risk index is constructed by taking the simple average of risk factor rankings. Rankings are relative to each risk factor’s own history.

Risk Factor DescriptionRisk

Loving

Risk

AversionInterpretation

Market Volatility

G3 Implied Vol Implied Volatility from EUR, GBP and JPY Uncertainty in the FX market

Equity Implied Vol S&P Volatility Index - VIX Uncertainty in the equity market

EM Risk

EM CDSEmerging Markets Spreads: Brazil, Russia and Turkey

5yr CDS ContractCredit risk in 'high beta' emerging markets

EM Equity to Vol RatioBrazil, Mexico, Turkey, India Stock Exchange Indices:

Index Level divided by 3m realized volatilitySovereign risk in volatile emerging markets

Market Liquidity

TED Spread 3m Libor - 3m Treasury rate Liquidity Risk

Risk Appetite Ratios

Equity Bond RatioFTSE World Index over Treasury, Bund and JGB bond

prices

Flight to quality, movement in global

equities vs. government bonds

Gold Price to Global Gold Gold Spot Price over S&P Gold IndexGold as 'safe haven' manifests when gold

equity sector does not follow Gold Spot

S&P 500 P/E S&P Adjusted Price Earning Ratio Confidence in corporate profits growth

29


The market’s appetite for risk has fluctuated wildly

Currently, risk appetite shows signs of increasing

Source: BlackRock

Index Value Z-score

Today 66% 0.62

Yesterday 84% 1.42

Last Week 68% 0.69

Average St. Dev.

53% 22%

Equally weighted index which is composed of 8 independent measures of market risk conditions. Each measure is given a percentile rank depending on its degree of risk loving or risk aversion relative to the period in analysis.

Risk & Quantitative AnalysisMarket Risk Sentiment Index - Short Term : 3m02/10/2009 16:19

Risk Appetite Index

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09

G3 Implied FX VOL

16.0

17.0

18.0

19.0

20.0

11/19 12/4 12/19 1/3 1/18 2/2

TED Spread

0

60

120

180

240

11/19 12/4 12/19 1/3 1/18 2/2

Gold Price to Global Gold

2.5

2.7

2.9

3.1

3.3

3.5

3.7

3.9

4.1

4.3

11/19 2/6

Equity Implied VOL

12172227323742475257626772778287

11/19 2/6

S&P 500 P/E

15.0

16.0

17.0

18.0

19.0

20.0

21.0

22.0

23.0

24.0

11/19 2/6

Equity Bond Ratio

120

130

140

150

160

11/19 2/6

EM Equity to Vol Ratio

200

400

600

11/19 2/6

EM CDS

110

170

230

290

350

410

470

530

590

650

710

11/19 2/6

Risk Appetite Index - Last 30 Days

0%

25%

50%

75%

100%

1/12

29%

46%

49%

53%

95%

97%

63%

-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%

Equity Bond Ratio

Equity Implied VOL

G3 Implied FX Vol

EM CDS

Gold Price to Global Gold

S&P 500 P/E

EM Equity to Vol Ratio

TED Spread

Chg 3m Chg 1m Chg 1w Today <--- Risk Aversion Risk Loving --->

30


Levels of risk in the market can vary greatly over time

The risk of a constant portfolio of identical holdings increased over 400% in just a year due to the market crisis

Source: BlackRock

0

200400

600

800

10001200

1400

Feb-04 Aug-04 Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09

USD 10 Yr (Try 10Y) USD MBS ATM USD LEHCMBSINV AAA 85P (CMBS AAA > 8.5 yr)

Time Series – VolatilitiesFeb 10, 2004 - Feb 10, 2009 (in bps)

0

100

200

300

400

500

600

Feb-04 Aug-04 Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09

Historic Portfolio Active Risk Constant Portfolio Active Risk

XXX Representative AccountHistoric Active Risk (bps)

Using Feb 10, 2009 Positions

31


The composition of risk in an identical portfolio can also change radically due to market volatility

Source: BlackRock

-50

50

150

250

350

450

550

Feb-04 Jul-04 Dec-04 May-05 Oct-05 Mar-06 Aug-06 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09

Credit Swap Rates ABS RMBS CMBS Total

Historic Risk Holding Positions Constant as of February 10, 2009

32

Lesson 9: Don’t Let the Market Determine Your Level of Risk

•Read some financial history to get a perspective on how bad things can get

—“The Market Can Stay Irrational Longer Than You Can Stay

Solvent” ― Keynes

•Rapidly changing levels of market volatility can change the level of financial risk

—If a portfolio or institution is hedged or has matched its assets and liabilities, the impact of

these changes may be attenuated

•Active decisions need to be made about how or if to respond to the changed level of risk

•Managing the level of risk may result in being a seller at precisely the “wrong”time

•But ultimately, the level of risk has to be one which fits the risk tolerance of the investor or institution

33

Lesson 10: The Nature of Market Risk May Be Changing

•As more power and control over the financial system shifts from the financial capitals to the political capitals across the globe, the drivers of market dynamics may shift away in varying degrees from both economic fundamentals or market technical conditions

•The markets of the developed world may take on more of the characteristics typically assumed with emerging markets

•The risk management teams of the future may come to rely less on economists and statisticians and more on politically-oriented analyst

—Quants may find themselves getting traded in for politicos who have a better read of which

factors are most likely to drive the political process

34

The Good, the Bad, and the Ugly About Risk Management

The Good

• Helps correct errors and misconceptions or lack of basic knowledge of risk principles that may exist in your organization

• Provides an independent view of firm and portfolio exposures

- Separates risk management & measurement from the risk takers

• Remember: if you think you know where the market is going, there is no risk!

- Identifies ways to diversify to manage volatility

• Provides a governance channel to elevate and share risk information in the organization

• Provides a partial defense against “black swan” events

- A crucial but under appreciated role of risk managers is providing the ability to

react effectively to market/portfolio problems in a timely manner to mitigate losses

- A team of smart and “plugged in” risk managers and a strong infrastructure creates

the capability to respond to those unimagined situations when they arise

35


Source: BlackRock

The Bad

•Maintaining a right-sized and equipped risk management team is very expensive

•Risk management “best practices” are limited by current knowledge and the limitations of collective experience

“Before the discovery of Australia, people in the

Old World were convinced that all swans were

white, an unassailable belief as it seemed

completely confirmed by empirical evidence. The

sighting of the first black swan … illustrates a

severe limitation to our learning from observations

or experience and the fragility of our knowledge.”

― The Black Swan by Nassim N. Taleb, p.4.

-15 -10 -5 0 5 10 150

500

1000

1500

2000

2500

Mea

n14 o

ccur

renc

es b

elow

-7.

5

11 o

ccur

renc

es a

bove

7.5

10-Year Swap Daily Spread Distribution 1988 - 2008

Note: Skewness > (<) 0 ==> right (left) skew. Kurtosis > (<) 3 ==> fat (thin) tails

—For example, US swap spread have a daily

standard deviation of 1.5bp, yet they tightened

or widened by more than 7.5 bps

(5.0 standard deviations, or 1 in 13,418 years) 25

times over the last 11 years

•Most risk models do not even do a very good job of capturing the extreme events that actually occur in the data

36


The Ugly

• Inadequate risk management can be catastrophic!

Lessons Learned: Defining New Risk Management Practices

Documents