From the Financial Times
Published: August 15 2008 19:31 Last updated: August 15 2008 19:31
Trouble has been in prospect ever since the credit squeeze began last summer, but this was the week when both shoes dropped at once, everywhere from the UK to Japan and most points between. For decades, a concerted world slowdown would have only one cause: a US recession. That is no longer entirely true. To paraphrase Tolstoy, each unhappy economy is unhappy in its own way.
Japan has begun to contract, and plummeting exports are not the sole culprit: domestic demand is weak and consumer confidence has never been lower.
Spain’s economic woes have persuaded the prime minister, José Luis RodrÃguez Zapatero, to interrupt his summer holiday; the key problem there was a housing boom, an unsustainable overhang of new property, and the subsequent collapse of a construction sector that provided every eighth job. The UK’s housing boom has ended for a different reason: the banks no longer care to play the game.
Meanwhile, Germany’s resurgent export sector seems to have been smothered by a strong euro, and perhaps the hangover from an unexpectedly good first three months: the economy shrank by 0.5 per cent in the second quarter.
Yet in spite of this wide range of predicaments there is a common thread: the soaring price of commodities, coupled with the return of inflation, is hurting consumers and tying the hands of central bankers.
That suggests that there may be some sunshine behind the storm clouds. Commodity prices are falling, although they are hardly a bargain. That is a consequence of weakening demand, of course, but it is also an antidote. Yet it is too early to write off the slowdown as an oil-induced blip. Oil prices may yet rise from here, and would have to fall much further before they reached the levels to which the world has become accustomed.
Meanwhile, global imbalances have not gone away, and the absence of co-ordinated economic and exchange-rate policy is bringing real costs. The current mantra among central bankers is that each of them is struggling to deal with imported inflation; it may look that way, but the world as a whole cannot import inflation. Globally, monetary policy has proved too loose to keep prices in check.
An obvious culprit has been the combination of low US interest rates and several developing countries – especially China – pegging their currencies to the dollar.
Since China is not about to subject itself to the shock of a sudden switch to a floating exchange rate, the world’s finance ministers need to discuss – seriously, this time – how else to unwind the current global imbalances. The recent appreciation of the dollar, and thus the renminbi, gives the Chinese a chance to lock in some of the appreciation against the euro and the pound. They should take it.
Saturday, August 16, 2008
Confessions of a Risk Manager - The Economist
Aug 7th 2008From The Economist print edition
Why did banks become so overexposed in the run-up to the credit crunch? A risk manager at a large global bank—someone whose job it was to make sure that the firm did not take unnecessary risks—explains in his own words
Gary Neil
IN JANUARY 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.
As risk managers we were responsible for approving credit requests and transactions submitted to us by the bankers and traders in the front-line. We also monitored and reported the level of risk across the bank’s portfolio and set limits for overall credit and market-risk positions.
The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market—not going out of it. Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets. This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private-equity financings were increasing. “Where is the liquidity crisis supposed to come from?” somebody asked in the meeting. No one could give a good answer.
Looking back on it now we should of course have paid more attention to the first signs of trouble. No crisis comes completely out of the blue; there are always clues and advance warnings if you can only interpret them correctly. It was the hiccup in the structured-credit market in May 2005 which gave the strongest indication of what was to come. In that month bonds of General Motors were marked down by the rating agencies from investment grade to non-investment grade, or “junk”. Because the American carmaker’s bonds were widely held in structured-credit portfolios, the downgrades caused a big dislocation in the market.
Like most banks we owned a portfolio of different tranches of collateralised-debt obligations (CDOs), which are packages of asset-backed securities. Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs; and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero. We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.
In May 2005 we held AAA tranches, expecting them to rise in value, and sold non-investment-grade tranches, expecting them to go down. From a risk-management point of view, this was perfect: have a long position in the low-risk asset, and a short one in the higher-risk one. But the reverse happened of what we had expected: AAA tranches went down in price and non-investment-grade tranches went up, resulting in losses as we marked the positions to market.
This was entirely counter-intuitive. Explanations of why this had happened were confusing and focused on complicated cross-correlations between tranches. In essence it turned out that there had been a short squeeze in non-investment-grade tranches, driving their prices up, and a general selling of all more senior structured tranches, even the very best AAA ones.
That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions. As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold. But we did not believe that prices on AAA assets could fall by more than about 1% in price. A 20% drop on assets with virtually no default risk seemed inconceivable—though this did eventually occur. Liquidity risk was in effect not priced well enough; the market always allowed for it, but at only very small margins prior to the credit crisis.
So how did we get ourselves into a situation where we built up such large trading positions? There were a number of factors. As is often the case, it happened so gradually that it was barely perceptible.
Fighting the last war
The focus of our risk management was on the loan portfolio and classic market risk. Loans were illiquid and accounted for on an accrual basis in the “banking book” rather than on a mark-to-market basis in the “trading book”. Rigorous credit analysis to ensure minimum loan-loss provisions was important. Loan risks and classic market risks were generally well understood and regularly reviewed. Equities, government bonds and foreign exchange, and their derivatives, were well managed in the trading book and monitored on a daily basis.
The gap in our risk management only opened up gradually over the years with the growth of traded credit products such as CDO tranches and other asset-backed securities. These sat uncomfortably between market and credit risk. The market-risk department never really took ownership of them, believing them to be primarily credit-risk instruments, and the credit-risk department thought of them as market risk as they sat in the trading book.
The explosive growth and profitability of the structured-credit market made this an ever greater problem. Our risk-management response was half-hearted. We set portfolio limits on each rating category but otherwise left the trading desks to their own devices. We made two assumptions which would cost us dearly. First, we thought that all mark-to-market positions in the trading book would receive immediate attention when losses occurred, because their profits and losses were published daily. Second, we assumed that, if the market ran into difficulties, we could easily adjust and liquidate our positions, especially on securities rated AAA and AA. Our focus was always on the non-investment-grade part of the portfolio, especially the emerging-markets paper. The previous crises in Russia and Latin America had left a deeply ingrained fear of sudden liquidity shocks and widening credit spreads. Ironically, of course, in the credit crunch the emerging-market bonds have outperformed the Western credit assets.
We also trusted the rating agencies. It is hard to imagine now but the reputation of outside bond ratings was so high that if the risk department had ever assigned a lower rating, our judgment would have been immediately questioned. It was assumed that the rating agencies simply knew best.
We were thus comfortable with investment-grade assets and were struggling with the huge volume of business. We were too slow to sell these better-rated assets. We needed little capital to support them; there was no liquidity charge, very little default risk and a small positive margin, or “carry”, between holding the assets and their financing in the liquid interbank and repo markets. Gradually the structures became more complicated. Since they were held in the trading book, many avoided the rigorous credit process applied to the banking-book assets which might have identified some of the weaknesses.
The pressure on the risk department to keep up and approve transactions was immense. Psychology played a big part. The risk department had a separate reporting line to the board to preserve its independence. This had been reinforced by the regulators who believed it was essential for objective risk analysis and assessment. However, this separation hurt our relationship with the bankers and traders we were supposed to monitor.
Spoilsports
In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough.
We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.
At the root of it all, however, was—and still is—a deeply ingrained flaw in the decision-making process. In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument. The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.
Collective common sense suffered as a result. Often in meetings, our gut reactions as risk managers were negative. But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started. In the end, with pressure for earnings and a calm market environment, we reluctantly agreed to marginal transactions.
Over time we accumulated a balance-sheet of traded assets which allowed for very little margin of error. We owned a large portfolio of “very low-risk” assets which turned out to be high-risk. A small price movement on billions of dollars’ worth of securities would translate into large mark-to-market losses. We thought that we had focused correctly on the non-investment-grade paper, of which we held little. We had not paid enough attention to the ever-growing mountain of highly rated but potentially illiquid assets. We had not fully appreciated that 20% of a very large number can inflict far greater losses than 80% of a small number.
Goals and goalkeepers
What have we, both as risk managers and as an industry, to learn from this crisis? A number of thoughts come to mind.
One lesson is to go back to basics, to analyse your balance-sheet positions by type, size and complexity both before and after you have hedged them. Do not assume that ratings are always correct and if they are, remember that they can change quickly.
Another lesson is to account properly for liquidity risk in two ways. One is to increase internal and external capital charges for trading-book positions. These are too low relative to banking-book positions and need to be recalibrated. The other is to bring back liquidity reserves. This has received little attention in the industry so far. Over time fair-value accounting practices have disallowed liquidity reserves, as they were deemed to allow for smoothing of earnings. However, in an environment in which an ever-increasing part of the balance-sheet is taken up by trading assets, it would be more sensible to allow liquidity reserves whose size is set in scale to the complexity of the underlying asset. That would be better than questioning the whole principle of mark-to-market accounting, as some banks are doing.
Last but not least, change the perception and standing of risk departments by giving them more prominence. The best way would be to encourage more traders to become risk managers. Unfortunately the trend has been in reverse; good risk managers end up in the front-line and good traders and bankers, once in the front-line, very rarely go the other way. Risk managers need to be perceived like good goalkeepers: always in the game and occasionally absolutely at the heart of it, like in a penalty shoot-out.
This is hard to achieve because the job we do has the risk profile of a short option position with unlimited downside and limited upside. This is the one position that every good risk manager knows he must avoid at all costs. A wise firm will need to bear this in mind when it tries to persuade its best staff to take on such a crucial task.
Why did banks become so overexposed in the run-up to the credit crunch? A risk manager at a large global bank—someone whose job it was to make sure that the firm did not take unnecessary risks—explains in his own words
Gary Neil
IN JANUARY 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.
As risk managers we were responsible for approving credit requests and transactions submitted to us by the bankers and traders in the front-line. We also monitored and reported the level of risk across the bank’s portfolio and set limits for overall credit and market-risk positions.
The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market—not going out of it. Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets. This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private-equity financings were increasing. “Where is the liquidity crisis supposed to come from?” somebody asked in the meeting. No one could give a good answer.
Looking back on it now we should of course have paid more attention to the first signs of trouble. No crisis comes completely out of the blue; there are always clues and advance warnings if you can only interpret them correctly. It was the hiccup in the structured-credit market in May 2005 which gave the strongest indication of what was to come. In that month bonds of General Motors were marked down by the rating agencies from investment grade to non-investment grade, or “junk”. Because the American carmaker’s bonds were widely held in structured-credit portfolios, the downgrades caused a big dislocation in the market.
Like most banks we owned a portfolio of different tranches of collateralised-debt obligations (CDOs), which are packages of asset-backed securities. Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs; and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero. We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.
In May 2005 we held AAA tranches, expecting them to rise in value, and sold non-investment-grade tranches, expecting them to go down. From a risk-management point of view, this was perfect: have a long position in the low-risk asset, and a short one in the higher-risk one. But the reverse happened of what we had expected: AAA tranches went down in price and non-investment-grade tranches went up, resulting in losses as we marked the positions to market.
This was entirely counter-intuitive. Explanations of why this had happened were confusing and focused on complicated cross-correlations between tranches. In essence it turned out that there had been a short squeeze in non-investment-grade tranches, driving their prices up, and a general selling of all more senior structured tranches, even the very best AAA ones.
That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions. As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold. But we did not believe that prices on AAA assets could fall by more than about 1% in price. A 20% drop on assets with virtually no default risk seemed inconceivable—though this did eventually occur. Liquidity risk was in effect not priced well enough; the market always allowed for it, but at only very small margins prior to the credit crisis.
So how did we get ourselves into a situation where we built up such large trading positions? There were a number of factors. As is often the case, it happened so gradually that it was barely perceptible.
Fighting the last war
The focus of our risk management was on the loan portfolio and classic market risk. Loans were illiquid and accounted for on an accrual basis in the “banking book” rather than on a mark-to-market basis in the “trading book”. Rigorous credit analysis to ensure minimum loan-loss provisions was important. Loan risks and classic market risks were generally well understood and regularly reviewed. Equities, government bonds and foreign exchange, and their derivatives, were well managed in the trading book and monitored on a daily basis.
The gap in our risk management only opened up gradually over the years with the growth of traded credit products such as CDO tranches and other asset-backed securities. These sat uncomfortably between market and credit risk. The market-risk department never really took ownership of them, believing them to be primarily credit-risk instruments, and the credit-risk department thought of them as market risk as they sat in the trading book.
The explosive growth and profitability of the structured-credit market made this an ever greater problem. Our risk-management response was half-hearted. We set portfolio limits on each rating category but otherwise left the trading desks to their own devices. We made two assumptions which would cost us dearly. First, we thought that all mark-to-market positions in the trading book would receive immediate attention when losses occurred, because their profits and losses were published daily. Second, we assumed that, if the market ran into difficulties, we could easily adjust and liquidate our positions, especially on securities rated AAA and AA. Our focus was always on the non-investment-grade part of the portfolio, especially the emerging-markets paper. The previous crises in Russia and Latin America had left a deeply ingrained fear of sudden liquidity shocks and widening credit spreads. Ironically, of course, in the credit crunch the emerging-market bonds have outperformed the Western credit assets.
We also trusted the rating agencies. It is hard to imagine now but the reputation of outside bond ratings was so high that if the risk department had ever assigned a lower rating, our judgment would have been immediately questioned. It was assumed that the rating agencies simply knew best.
We were thus comfortable with investment-grade assets and were struggling with the huge volume of business. We were too slow to sell these better-rated assets. We needed little capital to support them; there was no liquidity charge, very little default risk and a small positive margin, or “carry”, between holding the assets and their financing in the liquid interbank and repo markets. Gradually the structures became more complicated. Since they were held in the trading book, many avoided the rigorous credit process applied to the banking-book assets which might have identified some of the weaknesses.
The pressure on the risk department to keep up and approve transactions was immense. Psychology played a big part. The risk department had a separate reporting line to the board to preserve its independence. This had been reinforced by the regulators who believed it was essential for objective risk analysis and assessment. However, this separation hurt our relationship with the bankers and traders we were supposed to monitor.
Spoilsports
In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough.
We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.
At the root of it all, however, was—and still is—a deeply ingrained flaw in the decision-making process. In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument. The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.
Collective common sense suffered as a result. Often in meetings, our gut reactions as risk managers were negative. But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started. In the end, with pressure for earnings and a calm market environment, we reluctantly agreed to marginal transactions.
Over time we accumulated a balance-sheet of traded assets which allowed for very little margin of error. We owned a large portfolio of “very low-risk” assets which turned out to be high-risk. A small price movement on billions of dollars’ worth of securities would translate into large mark-to-market losses. We thought that we had focused correctly on the non-investment-grade paper, of which we held little. We had not paid enough attention to the ever-growing mountain of highly rated but potentially illiquid assets. We had not fully appreciated that 20% of a very large number can inflict far greater losses than 80% of a small number.
Goals and goalkeepers
What have we, both as risk managers and as an industry, to learn from this crisis? A number of thoughts come to mind.
One lesson is to go back to basics, to analyse your balance-sheet positions by type, size and complexity both before and after you have hedged them. Do not assume that ratings are always correct and if they are, remember that they can change quickly.
Another lesson is to account properly for liquidity risk in two ways. One is to increase internal and external capital charges for trading-book positions. These are too low relative to banking-book positions and need to be recalibrated. The other is to bring back liquidity reserves. This has received little attention in the industry so far. Over time fair-value accounting practices have disallowed liquidity reserves, as they were deemed to allow for smoothing of earnings. However, in an environment in which an ever-increasing part of the balance-sheet is taken up by trading assets, it would be more sensible to allow liquidity reserves whose size is set in scale to the complexity of the underlying asset. That would be better than questioning the whole principle of mark-to-market accounting, as some banks are doing.
Last but not least, change the perception and standing of risk departments by giving them more prominence. The best way would be to encourage more traders to become risk managers. Unfortunately the trend has been in reverse; good risk managers end up in the front-line and good traders and bankers, once in the front-line, very rarely go the other way. Risk managers need to be perceived like good goalkeepers: always in the game and occasionally absolutely at the heart of it, like in a penalty shoot-out.
This is hard to achieve because the job we do has the risk profile of a short option position with unlimited downside and limited upside. This is the one position that every good risk manager knows he must avoid at all costs. A wise firm will need to bear this in mind when it tries to persuade its best staff to take on such a crucial task.
Belated Withdrawal From Risk
From the New York Times
Saturday August 16, 2008
FLOYD NORRIS
Published: August 14, 2008
Sometimes what appears to be best for every individual is bad for the group. Now is such a time in the banking business.
Banks that took foolish risks in the mortgage business now want to take no risks at all. A similar risk aversion is growing at Fannie Mae and Freddie Mac, the two government-sponsored enterprises — perhaps government-guaranteed enterprises would now be a more accurate description — that dominate the mortgage market.
JPMorgan Chase started the latest downdraft in bank share prices this week when it said in a filing with the Securities and Exchange Commission that it expected a lot more losses before the mortgage situation stabilized.
And what will it do about that? “In response to continued weakness in housing markets,” it told the S.E.C., “loan underwriting and account management criteria have been tightened, with a particular focus on M.S.A.’s with the most significant housing price declines.”
M.S.A.’s, for those of you not up on the jargon, are “metropolitan statistical areas,” which means areas like Los Angeles and Las Vegas. JPMorgan said it would clamp down on auto loans and credit cards, as well as mortgages, in areas where home prices are falling.
That vow not to lend where the money is needed the most came a few days after Fannie Mae announced a strategy of selling foreclosed properties as rapidly as possible, and of trying to force banks to share some of its losses.
Daniel H. Mudd, Fannie’s chief executive, told investors that Fannie was “using a lot of innovative ways to get the property out the door.” This is not, he said, a good time to be holding on to foreclosed properties “and hoping for a better day.”
I’m not sure what those “innovative ways” were, but I suspect they involved price cutting. RadarLogic, a firm that monitors home sales, tries to separate out what it calls “motivated sales,” chiefly by looking at whether a bank or foreclosure service firm is the seller. It says that in hard-hit markets like Miami and Las Vegas, the motivated sale prices are about 25 percent lower than other sale prices.
Fannie and Freddie are trying to earn their way out of this mess by jacking up the fees they charge to banks for buying or guaranteeing loans. Their expected profit margin on new business is at the highest level in years, and borrowers who can get loans are paying higher rates as a result.
Fannie also vows to force banks to buy back defaulted loans if there is evidence of fraud or violations of procedures. Mr. Mudd said such recoveries were up fivefold, and he expected them to keep rising. Fannie also will stop buying so-called Alt-A loans, which are credit-score driven. Freddie says its portfolio of loans will not grow this year.
It is easy to understand why this is happening. A year ago, when Mr. Mudd had a similar conference call with investors, the mortgage crisis was just starting to mushroom, and he conceded Fannie would be hurt.
But he had no idea how much hurt there would be. “We fundamentally held our standards,” he said. Fannie lost market share in the wild days, but the loans it did make “remained Fannie Mae quality loans. So we feel pretty good about that.”
Those good feelings are gone. Fannie measures its credit losses in basis points — hundredths of a percentage point — of outstanding mortgages. A year ago, Mr. Mudd forecast an annual loss rate of 4 to 6 basis points, and scoffed when one questioner suggested the rate might rise to twice that level.
Fannie’s latest forecast for 2008, raised last week, is 23 to 26 basis points.
Foreclosures are soaring. In 2006, Fannie and Freddie between them acquired 52,967 properties, a figure that leaped 36 percent, to 71,961, in 2007. During the first half of this year, there were 66,420 foreclosures by Fannie and Freddie.
Not only are there more foreclosures, the losses are much larger. In 2005, Fannie lost an average of 7 percent of the unpaid principal when it sold a foreclosed property. So far this year, the figure is 26 percent, and in California it is up to 40 percent. In all of 2006, Fannie foreclosed on 93 California homes. The current rate is almost 1,000 a month.
In the year since Mr. Mudd claimed Fannie had held its standards high, both Fannie and Freddie shares have lost nearly 90 percent of their value. Freddie says it plans to raise $5.5 billion in new capital. With a current market capitalization of under $4 billion, that may not be easy.
Each bank is acting rationally. Financial institutions need to conserve capital, so they raise prices, tighten standards and sell foreclosed properties quickly. But when all do those reasonable things — which should have been done years ago — they deepen the crisis for homeowners, and for themselves.
Saturday August 16, 2008
FLOYD NORRIS
Published: August 14, 2008
Sometimes what appears to be best for every individual is bad for the group. Now is such a time in the banking business.
Banks that took foolish risks in the mortgage business now want to take no risks at all. A similar risk aversion is growing at Fannie Mae and Freddie Mac, the two government-sponsored enterprises — perhaps government-guaranteed enterprises would now be a more accurate description — that dominate the mortgage market.
JPMorgan Chase started the latest downdraft in bank share prices this week when it said in a filing with the Securities and Exchange Commission that it expected a lot more losses before the mortgage situation stabilized.
And what will it do about that? “In response to continued weakness in housing markets,” it told the S.E.C., “loan underwriting and account management criteria have been tightened, with a particular focus on M.S.A.’s with the most significant housing price declines.”
M.S.A.’s, for those of you not up on the jargon, are “metropolitan statistical areas,” which means areas like Los Angeles and Las Vegas. JPMorgan said it would clamp down on auto loans and credit cards, as well as mortgages, in areas where home prices are falling.
That vow not to lend where the money is needed the most came a few days after Fannie Mae announced a strategy of selling foreclosed properties as rapidly as possible, and of trying to force banks to share some of its losses.
Daniel H. Mudd, Fannie’s chief executive, told investors that Fannie was “using a lot of innovative ways to get the property out the door.” This is not, he said, a good time to be holding on to foreclosed properties “and hoping for a better day.”
I’m not sure what those “innovative ways” were, but I suspect they involved price cutting. RadarLogic, a firm that monitors home sales, tries to separate out what it calls “motivated sales,” chiefly by looking at whether a bank or foreclosure service firm is the seller. It says that in hard-hit markets like Miami and Las Vegas, the motivated sale prices are about 25 percent lower than other sale prices.
Fannie and Freddie are trying to earn their way out of this mess by jacking up the fees they charge to banks for buying or guaranteeing loans. Their expected profit margin on new business is at the highest level in years, and borrowers who can get loans are paying higher rates as a result.
Fannie also vows to force banks to buy back defaulted loans if there is evidence of fraud or violations of procedures. Mr. Mudd said such recoveries were up fivefold, and he expected them to keep rising. Fannie also will stop buying so-called Alt-A loans, which are credit-score driven. Freddie says its portfolio of loans will not grow this year.
It is easy to understand why this is happening. A year ago, when Mr. Mudd had a similar conference call with investors, the mortgage crisis was just starting to mushroom, and he conceded Fannie would be hurt.
But he had no idea how much hurt there would be. “We fundamentally held our standards,” he said. Fannie lost market share in the wild days, but the loans it did make “remained Fannie Mae quality loans. So we feel pretty good about that.”
Those good feelings are gone. Fannie measures its credit losses in basis points — hundredths of a percentage point — of outstanding mortgages. A year ago, Mr. Mudd forecast an annual loss rate of 4 to 6 basis points, and scoffed when one questioner suggested the rate might rise to twice that level.
Fannie’s latest forecast for 2008, raised last week, is 23 to 26 basis points.
Foreclosures are soaring. In 2006, Fannie and Freddie between them acquired 52,967 properties, a figure that leaped 36 percent, to 71,961, in 2007. During the first half of this year, there were 66,420 foreclosures by Fannie and Freddie.
Not only are there more foreclosures, the losses are much larger. In 2005, Fannie lost an average of 7 percent of the unpaid principal when it sold a foreclosed property. So far this year, the figure is 26 percent, and in California it is up to 40 percent. In all of 2006, Fannie foreclosed on 93 California homes. The current rate is almost 1,000 a month.
In the year since Mr. Mudd claimed Fannie had held its standards high, both Fannie and Freddie shares have lost nearly 90 percent of their value. Freddie says it plans to raise $5.5 billion in new capital. With a current market capitalization of under $4 billion, that may not be easy.
Each bank is acting rationally. Financial institutions need to conserve capital, so they raise prices, tighten standards and sell foreclosed properties quickly. But when all do those reasonable things — which should have been done years ago — they deepen the crisis for homeowners, and for themselves.
Liquidity Forecasting is the Next Challenge
From the Financial Times
By Christopher Finger
Published: August 3 2008 10:51 Last updated: August 3 2008 10:51
As chief executive of JPMorgan in the late 1980s and early 1990s, Dennis Weatherstone, who died recently, insisted on a daily report of the entire bank’s risk-taking activities.
In the light of recent events, it is tempting to cast Sir Dennis and his report as creatures of the past century, no longer appropriate for today’s complex markets.
Statistical risk models are designed to forecast how much a portfolio’s value may fluctuate over some trading horizon. To be useful, the forecast should apply to the time over which trading decisions are made; it should be the forecasts on today’s positions that are relevant, not those on hypothetical future trades. For actively managed portfolios, the risk horizon is typically one day or one week.
Importantly, financial crises do not transpire over these horizons. The models do not pretend to predict crises, then, but rather to indicate the potential for large short-term market moves. And forecasts over these short horizons can be validated: we can objectively differentiate a good from a bad model.
So do the models succeed at their goal? Recent anecdotes suggest not.
Large banks disclose both their risk forecasts and their real profit and loss. The risk forecasts typically take the form of value-at-risk, or VaR – that is, the worst-case loss that is expected, for example, with 99 per cent confidence. About one day in 100, subject to statistical fluctuations, the bank should experience a VaR excession – a day where the loss is greater than the VaR forecast.
The third quarter of 2007 (62 trading days) was ripe with disclosures of embarrassingly many excessions: as many as 16 for some banks. For good reason, there has been plenty of criticism of Sir Dennis’s reports.
But a keen observer of VaR disclosures would have questioned the models well before the current crisis. It was not unusual for banks to disclose years with zero excessions (on average we would expect two or three) and one bank went nine years without one. While the flurry of excessions in 2007 raised plenty of doubts, the lack of excessions in previous years did not, even though under a good model, nine years without an excession is 100 times less likely than a fiscal quarter with nine or more. Statistical evidence to challenge the forecasts existed but, in rising markets, it was easy to mumble about conservatism and accept demonstrably bad forecasts as good risk disclosure.
So the supposed beneficiaries of risk disclosure have been guilty of apathy, but how could the banks themselves produce such poor forecasts? One explanation is that some favoured simplicity and stability over performance. Twenty-five years of financial research have established two facts: first, risk changes, with market volatility greater in some periods than others; and second, these changes can be forecast. Methods that ignore these facts produce inferior forecasts.
Models that recognise that risk changes – even those applied generically to all asset classes – continue to produce useful forecasts. For the ABX contracts (the actively traded indices based on subprime mortgage-backed securities), forecast volatility picked up in the early spring of 2007, dropped as the crisis appeared to have slowed and then rose in the late summer. VaR forecasts showed an appropriate level of excessions over 2007 and 2008.
It is, however, simplistic to say some banks ignored better modelling choices. The real trouble was not how they modelled based on historical data, but how they modelled when there were no data at all.
At the heart of the subprime crisis were complex securities with poor data on their underlying collateral. Not surprisingly, few of these traded actively. Unfortunately, one approach was to pretend there is no risk in securities that are difficult to model, do not trade and yet appear safe enough.
There are no perfect answers, but using the few mortgage-backed products that do trade to proxy risk is at least better than the alternative.
Enhancements to today’s risk-forecasting models must address these securities with little pricing information.
Certainly, a flight to simplicity – investors demanding products they can better analyse and value – will lessen the burden. But that still leaves the vagaries of market liquidity. It is here that we must focus our efforts in the future.
Christopher Finger is head of global risk research at RiskMetrics Group
By Christopher Finger
Published: August 3 2008 10:51 Last updated: August 3 2008 10:51
As chief executive of JPMorgan in the late 1980s and early 1990s, Dennis Weatherstone, who died recently, insisted on a daily report of the entire bank’s risk-taking activities.
In the light of recent events, it is tempting to cast Sir Dennis and his report as creatures of the past century, no longer appropriate for today’s complex markets.
Statistical risk models are designed to forecast how much a portfolio’s value may fluctuate over some trading horizon. To be useful, the forecast should apply to the time over which trading decisions are made; it should be the forecasts on today’s positions that are relevant, not those on hypothetical future trades. For actively managed portfolios, the risk horizon is typically one day or one week.
Importantly, financial crises do not transpire over these horizons. The models do not pretend to predict crises, then, but rather to indicate the potential for large short-term market moves. And forecasts over these short horizons can be validated: we can objectively differentiate a good from a bad model.
So do the models succeed at their goal? Recent anecdotes suggest not.
Large banks disclose both their risk forecasts and their real profit and loss. The risk forecasts typically take the form of value-at-risk, or VaR – that is, the worst-case loss that is expected, for example, with 99 per cent confidence. About one day in 100, subject to statistical fluctuations, the bank should experience a VaR excession – a day where the loss is greater than the VaR forecast.
The third quarter of 2007 (62 trading days) was ripe with disclosures of embarrassingly many excessions: as many as 16 for some banks. For good reason, there has been plenty of criticism of Sir Dennis’s reports.
But a keen observer of VaR disclosures would have questioned the models well before the current crisis. It was not unusual for banks to disclose years with zero excessions (on average we would expect two or three) and one bank went nine years without one. While the flurry of excessions in 2007 raised plenty of doubts, the lack of excessions in previous years did not, even though under a good model, nine years without an excession is 100 times less likely than a fiscal quarter with nine or more. Statistical evidence to challenge the forecasts existed but, in rising markets, it was easy to mumble about conservatism and accept demonstrably bad forecasts as good risk disclosure.
So the supposed beneficiaries of risk disclosure have been guilty of apathy, but how could the banks themselves produce such poor forecasts? One explanation is that some favoured simplicity and stability over performance. Twenty-five years of financial research have established two facts: first, risk changes, with market volatility greater in some periods than others; and second, these changes can be forecast. Methods that ignore these facts produce inferior forecasts.
Models that recognise that risk changes – even those applied generically to all asset classes – continue to produce useful forecasts. For the ABX contracts (the actively traded indices based on subprime mortgage-backed securities), forecast volatility picked up in the early spring of 2007, dropped as the crisis appeared to have slowed and then rose in the late summer. VaR forecasts showed an appropriate level of excessions over 2007 and 2008.
It is, however, simplistic to say some banks ignored better modelling choices. The real trouble was not how they modelled based on historical data, but how they modelled when there were no data at all.
At the heart of the subprime crisis were complex securities with poor data on their underlying collateral. Not surprisingly, few of these traded actively. Unfortunately, one approach was to pretend there is no risk in securities that are difficult to model, do not trade and yet appear safe enough.
There are no perfect answers, but using the few mortgage-backed products that do trade to proxy risk is at least better than the alternative.
Enhancements to today’s risk-forecasting models must address these securities with little pricing information.
Certainly, a flight to simplicity – investors demanding products they can better analyse and value – will lessen the burden. But that still leaves the vagaries of market liquidity. It is here that we must focus our efforts in the future.
Christopher Finger is head of global risk research at RiskMetrics Group
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