Leslie Rahl

Leslie Rahl is the Founder and Managing Partner of Capital Market Risk Advisors (CMRA), the preeminent risk management firm providing consulting and litigation support services to major U.S. and international financial services companies and institutional investors. Ms. Rahl spent 19 years at Citibank, including nine years as co-head of Citibank's Derivatives Group in North America. She launched its caps and collars business in 1983 as an extension of the proprietary options arbitrage portfolio she ran and was a pioneer in the development of the swaps and derivatives business.

As a pioneer in the derivatives and structured finance businesses and a long-time adviser to all types of financial services companies, Ms. Rahl has a unique cross-industry perspective. Mrs. Rahl is the author of Hedge Fund Transparency: Unraveling the Complex and Controversial Debate published in March 2003 by Risk Books and the editor of Risk Budgeting a New Approach to Investing published in November 2000 by Risk Books. Her articles have appeared in a wide range of publications. A frequent speaker at conferences and symposia, and frequently quoted in the press, she is the author of two books and many articles involving her areas of expertise.

Ms. Rahl was named one of the Top 50 Women in Finance by Euro money in 1997 and was profiled in both the fifth and tenth anniversary issues of Risk Magazine. She was listed in "Who's Who in Derivatives" by Risk Magazine and was profiled in Fortune Magazine's "On the Rise" and Institutional Investor's "The Next Generation of Financial Leaders."

Ms. Rahl is on the Board of Directors of the Canadian Imperial Bank of Commerce (CIBC), and the International Association of Financial Engineers (IAFE). She is a member of the hedge fund committee of the Alternative Investment Management Association (AIMA). She was a Director of the International Swaps Dealers Association (ISDA) for five years, chaired the IAFE's Investor Risk Committee (IRC), and is a former Director of Fannie Mae the MIT Investment Management Company and the New York State Common Retirement Board.

Ms. Rahl is a co-founder of the High Water Women Foundation and has recently retired from its Board. She was on the Board of 100 Women in Hedge Funds for its formative first three years and chaired the Philanthropy Committee.

Ms. Rahl is the author of Hedge Fund Transparency: Unraveling the Complex and Controversial Debate published in March 2003 by Risk Books and the editor of Risk Budgeting a New Approach to Investing published in November 2000 by Risk Books. Her articles have appeared in a wide range of publications.

SM (MBA) Sloan School - MIT	1972
SB in Computer Science - MIT	1971

 

Ms. Rahl is an expert in a wide array of subjects. Areas in which she is regarded as an expert include but are not limited to:

Derivatives including CDS

Structured Finance/ABS/MBS/CDOS/CLOS

Risk Management

Valuations

Best Practices

Capital Market Strategy

Risk Governance

Leslie Rahl in the Press

Cascades, Contagions, and Death Spirals
The next "Big One" is coming! So plan, now. But for what exactly? And how?
By Christopher Wright

We interrupt this market to bring you the latest crisis.

Regarding the slump in asset prices, "this was the first global bubble ever, in that it all spread across all asset classes and all countries with very few exceptions," says perma-bear Jeremy Grantham, chairman of Grantham, Mayo Van Otterloo & Company (GMO).

It is often said that in a crisis, the markets move in sync. (correlations go to 1.) Asset classes can also move in opposite directions. "Some correlations go to -1," says Leslie Rahl, president of Capital Market Risk Advisors in New York City. For example, consider the rise of REITs when the NASDAQ was collapsing in 2001.

Leslie Rahl says "People put too much emphasis on asset diversification and not enough on diversifying the more subtle risk factors such sensitivities to volatility, to flights to quality, to credit, etc."

Managers can profit from analyzing their holdings for the correlative effects of such common factors as instrument opacity, complexity, illiquidity, and leverage. The key is understanding a portfolio's risk-factor concentrations.

"For instance", says Rahl, "maybe you want a limit in your portfolio on hard-to-value investments that is independent of asset class."

An overlooked common factor in the current credit crisis is vintage. MBS holders and credit rating agencies may have thought the assets behind these instruments were diversified by geography, but they didn't consider that different credit standards, some looser that others, in different years. "Most of these securities," noted Rahl, "were built with a high concentration of a single vintage.
(July/August 2008)

Opinions Diverge on Who Calls Valuation Shots When Liquidity is Scarce
Martin de Sa'Pinto, Senior Financial Correspondent

MONTE CARLO, Monaco - The liquidity crunch brought home to many investors, portfolio managers, service providers and prime brokers how sharply valuations can diverge when a portfolio becomes unexpectedly illiquid. This was particularly true for highly leveraged portfolios that, as the result of not-always-sharp fluctuations in the prices of securities, found themselves facing margin calls and forced to unwind positions rapidly.

The complexity of the security in question is clearly an issue, and when there is a lack of consensus on valuation methods, different constituencies will often make a strong case for completely distinct methods that can produce widely diverging valuations.

This was the basis for a panel discussion at the Global Alternative Investment Management conference in Monaco on June 19 was moderated by Henny Sender, international financial correspondent at the Financial Times.

"Valuation and transparency are among the hottest topics facing hedge funds and investors today," said Ms. Sender in her introduction. "How quickly can valuations change? If you don't have a good sense of valuation you cannot manage the risk of your positions."

In such circumstances, "I was a diehard advocate for mark-to-market, and I still believe it's the lesser of evils, but there are times when model-based pricing might make sense," said Ms. Rahl. This would of course imply that the model-based methodology was favored over mark-to-market because either market prices were stale or unavailable, or the relationship between the underlying and the proxy was weak. "The option of using such a valuation methodology would require strict checks and balances within a fund," she said.

"Marks on the collateral don't necessarily represent the price at which a trade can be unwound," said Ms. Rahl. "In some situations we have seen the exact same trades with two different counterparties being unwound at vastly different prices."

Ms. Rahl said relevant documentation, including research reports, broker quotes and screen shots, should be printed out and kept on file so that it is at least available in the case of a dispute.
(July 2008)

VaR Enough?
Market turbulence tests the limits of Value at Risk
By Irwin Speizer

When an investment bank that is supposed to know better loses billions of dollars betting on subprime mortgages, you have to wonder what happened to the concept of risk management. "You can't rely on VaR as your only metric," says Leslie Rahl, president and founder of New York–based Capital Market Risk Advisors. "We recommend people use three to five different metrics. It's like a doctor ordering an X ray, an MRI and a CAT scan — they all tell you slightly different things."

A veteran of 35 years in the financial industry and a financial engineering pioneer, Rahl ran the derivatives business at Citibank in the 1980s before establishing her consulting firm in 1991. She preaches the importance of rigorous risk analysis and testing to cope with the impact of the types of investments she peddled in her earlier role.

Rahl recommends applying stress tests to see how a portfolio would react to sharp drops, market shifts, unusual situations or changes in underlying assumptions. Stress-testing models, which are included in risk systems, can reveal weaknesses that a simple VaR test misses. But Rahl says too many financial firms continue to rely mostly on VaR. Back in April 2000, Rahl's firm conducted a survey of risk practices and found that 45 percent of financial firms, including hedge funds, were not using stress tests at all. Although she hasn't updated the survey, she says she has noticed only a slight improvement since then.

"In risk management only about a third is quantitative," Rahl says. "A third is still a big part of the puzzle, so it is quite valuable." The remaining two thirds of the puzzle is where good risk managers earn their money. Ultimately, an accurate forecast depends on knowledge, experience and chutzpah.

"It has nothing to do with the computer," Rahl says. "It has to do with wisdom and experience."

And perhaps a bit of luck.
(June 2008)

 
Debtwire
Citibank responds, sues for breach of contract in credit default swap case
By Danielle Reed, New York

Citibank filed a response 23 April and countersued for breach of contract in its ongoing court battle with a hedge fund over a credit default swap.

Whatever the outcome of this particular case, the mere fact that such issues are being litigated highlights a source of concern to longtime derivatives market participants: Namely, the growing participation of hedge funds in the CDS market. "One of the things that has been of great concern to me for a long time is [the] many new entrants to the credit default swap market, especially hedge funds who have not cut their teeth on less complex over-the-counter derivatives...before taking on large sized positions in CDS," said Leslie Rahl, founder and president of Capital Market Risk Advisors. A pioneer in the derivatives market, Rahl said she is "pro-derivatives" but fears that "some of the newer players don't fully understand the differences between a liquid, transparent securities market and the world of over-the-counter derivatives."
(April 28, 2008)

Don't Trust the Wall St rally
By Bethany McLean, Editor at Large

Up till now, all eyes have been on the losses that are hitting the financial sector from the acronym soup of new instruments such as CDOs and SIVs. Everyone is scared, and rightly so of the MUB (Monster Under the Bed) that might be lurking in supposedly safe havens.

The last decade saw the explosion of securitization – the carving up and redistributing of risk-the boom in hedge funds, and the private equity mania.

In a paper published in the fall of 2005, risk management gurus Leslie Rahl and Barbara Lucas of Capital Market Risk Advisors, noted that in the past decade, a lot of things have happened that aren't supposed to happen, from the interest rate hikes of 1994 to the 1998 collapse of LTCM to the 2001 terrorist attacks. Or as the authors put it, "once-in-a-lifetime events seem to occur every few years."
(March 23, 2008)

Risk Management Decoded
By Liz Peek

"Risk management" has a nice ring to it. Not only does it suggest that a hedge fund team, for instance, has pretty much thought of all the things that could go wrong — it has also, bless its heart, managed those nasty surprises.

Leslie Rahl, founder and president of Capital Market Risk Advisors and a board member of Fannie Mae, has an excellent perch from which to view the unfolding of this latest debacle. According to her Web site, her company is "the preeminent financial advisory firm specializing in risk management, hedge funds, financial forensics, and risk governance."

Ms. Rahl graduated both from the Massachusetts Institute of Technology and its Sloan School of Management and was formerly head of Citibank's derivatives group. She actually understands all those complex formulas that are supposed to identify risk. Numbers are to Ms. Rahl as Cheerios are to the rest of us: uncomplicated and easily consumed.

Her take? "Risk management is all about thinking about two or three standard deviations from the mean. No one ever expects events to fall beyond that. Once in a lifetime events that fall outside that parameter have exponential, not arithmetic, consequences. Risk management is built around models, and models are built around assumptions. The models will work if things behave the way you model them to — but they never actually do. These events are somewhat expected, but we keep forgetting. You can't expect a computer model to anticipate changes. This is the big flaw — I keep reminding clients of this — that their assumptions are not the worst case."

"By definition, most risk people are young quants," Ms. Rahl said. Most, she said, do not carry their modeling back far enough to include similar events, such as the 1994 bankruptcy of Orange County, which she views as somewhat analogous to today's situation. "In 1994, the money funds broke the buck," Ms. Rahl said, referring to the unthinkable: a money market fund that experiences such credit issues with its portfolio that it no longer trades at a dollar. A similar deterioration in shortterm instruments occurred over the past two months, as a few money market funds got into trouble. The credit problems in the early 1990s stemmed from holdings of "inverse floaters" and the "kitchen sinks" — the names given to the leftovers of collateralized mortgage obligations after they had been sliced and diced and the higher-grade parts of the securities had been bought by savvier investors.

At the end of the day, we are reminded of the peril of investing in instruments so complicated that few could really understand them. "Even for me, who loves complex things, it's very complicated," Ms. Rahl said. That's all we had to know.
(September 13, 2007)

Amassing your governance capital
By Alice Korngold

On a nonprofit board, you will work with others to develop the organization's greater vision, revenue model, and case for support. Leslie Rahl, president of Capital Market Risk Advisors, points out that "you deal with matters of ethics that transcend what you learned in business school. You learn the dynamics of being part of a team of peers, of knowing when to defer to others, especially in situations where you are also ultimately responsible and accountable."

Rahl was asked to join the board of Fannie Mae in 2004. Her firm specializes in risk management, hedge funds, financial forensics, and derivatives, and she has authored books on hedge funds. She has an undergraduate degree from MIT and an M.B.A. from MIT's Sloan School.

Clearly, her business expertise qualified her to serve on the Fannie Mae board, but it was her nonprofit board experience that distinguished and elevated her as a candidate. "When they were interviewing me for the position," she explains, "the Fannie Mae board members spent a great deal of time asking me about my work on the board of 100 Women in Hedge Funds and my experience in chairing its philanthropy committee in particular." She adds, "Once I was identified for the Fannie Mae board, and my business qualifications were dear, my having served on a nonprofit board was definitely considered a plus."

Business background may open the door, but leadership experience gets you into the boardroom. Rahl was recently elected to the board of CIBC, a leading North American financial institution Hedge funds vary widely in the quality of their internal controls and disclosures, said Barbara Lucas, a partner at Capital Market Risk Advisors, a financial advisory firm. When it comes to the quality of hedge fund operations, "we see the good, the bad, the ugly and the indifferent," said Lucas, a longtime securities attorney. "It's really all over the place."
(Third Quarter 2007)

The Pain Moves Beyond Subprime
By Matthew Goldstein and David Henry

The ultimate worry is that the trouble in the junk-debt markets will spread to the traditional corporate bond market and create a full-fledged credit crunch that would threaten the economy. That scenario may be unfolding. Issuance of investment-grade corporate bonds fell 72% in July from June's level and 34% from July, 2006, according to Dealogic. And some say the subprime-mortgage and leveraged-loan markets are harbingers of wider credit troubles. …Adds Leslie Rahl, president of Capital Market Risk Advisors in New York and former co-head of Citibank's derivatives group: "Nothing stays rosy forever. We've been in a rosy world, with credit spreads at historically tight levels for some time now. But we seem to be leaving it."
(August 2, 2007)

The calm after the storm - or the eye of the hurricane?
By Suzanne McGee

Late February's stock market rout sent the Dow Jones Industrial Average to its largest one-day loss in more than four years, and sent prices on the riskiest kinds of debt into a nosedive.

Then something odd happened: The sky didn't fall.

But an important four-letter word - risk - has crept quietly back into the marketplace once more. Risk-aversion may not be dominating headlines today the same way it did three or four weeks ago, but it is lurking in the background, waiting for another opportunity to surface.

"We can't rewind the clock and go back to the environment where people felt as carefree as they seemed to in the first month or two of 2007," says Leslie Rahl, a founder of Capital Market Risk Advisors, a firm that has advised financial institutions on managing all kinds of risks since the mid-1990s, when the first derivative debacles roiled financial markets.

Rahl isn't fielding calls from clients desperate to extricate themselves from the fallout of a risk misjudgment. Still, she sees the turmoil of late February and early March as the first stage in a global repricing of risk that is long overdue, and she is urging those clients to "stress test" their portfolios in anticipation of more upheaval.

"While I don't sense that the market believes today that this is imminent, there is general agreement that it has to happen; in some markets, risk premia are as tight as they have ever been," Rahl says. "I think the future is more fragile than the market is pricing it today, and the biggest lesson of the subprime market's implosion so far is how quickly risk can be repriced."
(April 9, 2007)

Wall Street women: dress code of silence
By Christina Binkley

On Wall Street, it's still baby steps, as women like Leslie Rahl can attest. Rahl, president of Capital Market Risk Advisors in New York, ran the derivatives business for Citibank for 10 years in the 1980s; it was she and her colleagues who called in the SEC when Orange County, Calif., was going under. And she recalls the old standard, mannish suit-with-a-bow. "Many of my colleagues wore those stupid little women's ties," says Rahl, who says she never owned one.

Today, she says, she has carved out a look that is careful and correct, yet still feminine. "It's very important for women to be women and not little men," she says. But she doesn't trust the vagaries of designer labels. She relies on the advice of her favorite Upper East Side boutique, Miriam Rigler, which provides her staple of pant suits for board meetings, sweaters and jackets for hedge-fund clients.
(March 29, 2007)

The Synthetic CDO Shell Game Could the hottest market in all of fixed income be a disaster in the making?
By Bill Shepherd

"One of the questions people have to ask themselves is, how will these synthetic instruments behave in times of stress?" says Leslie Rahl, a former Citibank risk expert who now runs Capital Market Risk Advisors, a risk consultancy in New York. Normal risk modeling only approximates normal markets-the real test comes in extreme markets. And as Rahl likes to say, "We have a once-in-a-lifetime crisis every three or four years."

"If you want to get out early, it costs you," says CMRA's Rahl. "People don't fully understand the degree to which, if over-the-counter markets freeze up, there could be substantial differences between what a theoretical model tells you something is worth and where a buyer and a seller are willing to transact."

Even the skimpy historical record may be distorted by the ways that new entrants change market behavior. "There have been significant changes in how the credit markets work," notes Rahl. For instance, "the role of banks in working out bad credits has changed dramatically. Bondholders now play a much more significant role. So looking at data from the 1980s, probably there's little resemblance to the workout patterns and partners of today."
(May 16, 2005)

Wall St. takes stock five years after LTCM crisis
By Eric Burroughs

"LTCM increased the amount of transparency from hedge funds, but it's not very well defined," said Leslie Rahl, a partner at Capital Market Risk Advisors, a New York-based risk management advisory firm.

"The whole issue of valuation is a big one," she said, particularly for instruments ranging from mortgage-backed securities to many derivatives for which trading is not always active and price quotes can vary greatly.
(September 26, 2003)

Derivatives pioneers

Lisa Polsky and Leslie Rahl, pioneers of the over-the-counter derivative markets, started their careers in the 1970s. Wall Street was then largely a man's world but was about to change dramatically. "Derivatives markets began to develop when women began coming out of universities with the appropriate credentials," remembers Rahl, principal of Capital Market Risk Advisors in New York. "We were becoming mathematicians and MBAs. In my class at the Massachusetts Institute of Technology (MIT), for example, there were 50 women and 950 men. That was the largest class of women that MIT had ever had up until that time."

After a spell as Citibank's traders, both women's careers at the bank continued on an upward path - and eventually coincided when they became joint heads of the risk management products group in the 1980s.

Rahl joined the bank in 1972 with a BS in computer science and an MBA from MIT. After managing the bank's growing back-office operation for 10 years, she began to trade a proprietary option portfolio in 1982 and went on to oversee the bank's push into interest rate options. Keen to trade, her entry into derivatives at Citibank was no fluke. in the early 1980s, she agreed to set up a team for the head of Citibank's investment bank in return for such an opportunity. It was around this time that the Chicago Board of Trade had started to trade interest rate options on futures. A door opened, and Rahl never let it shut. "My boss said: 'Well, you don't really know much about trading, but you went to MIT, so you can probably trade these options as well as anyone else'. It was really a situation of being in the right place at the right time," says Rahl. Through the 1980s, she oversaw the bank's interest rate risk management department.

...After the two women worked together in the risk management group, their career paths diverged. Rahl took maternity leave in 1990, and decided to raise her child without the pressures of the dealing room in the background. Her new life included running a part-time risk consultancy at home, Leslie Rahl Associates. Since then, Capital Market Risk Advisors, formed in July 1994, has become one of Wall Street's largest independent risk consultancies, with 25 professional staff. About half the firm's clients are commercial and investment banks, while the remainder are pension funds, mutual funds and corporates.

...Both women remember the first trades that launched their careers and the long list of Citibank alumni who made major contributions to the development of derivative markets, including Yves de Balmann, now vice chairman at Bankers Trust, David Pritchard, now with the UK's Securities and Investments Board, and Lee Wakeman, currently consulting for CIBC Wood Gundy, who is often credited with bringing a new level of sophistication to the study of term structure.

What made Citibank such a fertile environment for talent? Simple, says Rahl: the bank was a triple-A credit at the time, had a strong balance sheet, and a global client base that rivaled that of any bank in the world. "Citibank attracted a lot of smart people just for that reason," she explains. "Of course, circumstances changed with time and the bank ran into problems with loans later on. But, if you look at the alumni it spawned, it was a real powerhouse."

Rahl believes it was a dead heat between Citibank and Salomon Brothers as to who sold the first interest rate cap. But when it comes to interest rate collars, she is confident that Citibank edged out the competition with a blockbuster transaction in 1983. This inaugural trade, a 10-year, $100 million deal for a real estate concern, was prompted by business conversation at a cocktail reception.

"It was a sizable and long-term deal even by today's standards," notes Rahl. "Caps had been around for a couple of months. But the concept of the collar, or a "floor/ceiling" as it was called at the time, evolved when we learned that some clients didn't want to pay premiums. The collar was a way to eliminate the premium fee or at least to reduce significantly the upfront cash that needed to change hands. The client said, 'I love the idea of buying a cap, but I don't want to write a cheque. Is there something you can do?'."

Rahl's suggested solution was not zero-cost, but involved significantly reduced upfront fees. When asked to explain how the deal was priced, she laughs. Fortunately, she recalls, the spreads that could be charged on such a transaction were so large that pricing and hedging precision were not the critical factors they have come to be some 14 years later.

"The futures markets were clearly an invaluable tool for us," Rahl says. But the futures strip didn't go out that far back then, maybe two years. So you had to stack futures, which had its own series of inherent risks. Most banks used a blend of stacked futures and intermediate US Treasury instruments. If you just stacked futures, you had this huge curve bet. And if you hedged everything in Treasuries, you'd have a huge basis risk. So generally what was done was to use a combination to get some yield-curve protection and Treasury-Eurodollar (Ted) spread protection."

And what about a pricing model? "We priced options by drawing a forward yield curve, drawing the cap line, and saying: `If it never pierces the cap, it has zero value. If it pierces the cap, it has a value equal to a swap.' That was one of the methods we bandied about in those early days. In addition to using the Black-Scholes model, which we thought was pretty sophisticated, we had two normalized style yield curves. On any given day, we would pick either yield curve A or B, high or low, as our term structure of volatility. That's the way we priced and hedged.

"Thank goodness interest rates kept coming down and it didn't really matter," she chuckles. "These were the go-go years for caps and collars. It was a great period for option sellers because interest rates and market volatilities just kept coming down after the big interest rate spike in the early 1980s. Everything was working in the seller's favour, except the relatively primitive nature of option price modeling. But it was not as hard to make money in those early days."

Documentation was a thorny issue at the time. Rahl recalls that caps were sometimes categorized as swaps in which one counterparty never pays anything and the other counterparty pays out "if Libor is greater than X. "It took a few years for the industry to reach a common ground on documentation," she admits. "The market was fortunate not to run into problems before that. Improved documentation made a enormous difference in the ability of the market to grow and prosper thereafter. It was 1989, I believe, when ISDA came up with the cap and collar addendum to the standard master agreement."

...Meanwhile, on Rahl's desk, interest rate options-caps, collars, floors and swaptions were becoming significant, providing alternative risk management products for floating-rate or fixed-rate borrowers. Interest rate caps and collars provided interest rate protection without fixing rates, allowing many borrowers to fund at the short end of the yield curve with limited risk as rates fell. Citibank was soon taking a 10-25% market share in each product. Then it began warehousing option positions - and interest rate and currency swaps - to accommodate its customer base and to manage the enormous derivatives book it was building up.

By 1985, caps and collars were "established business", says Rahl. Interest rate swaptions followed in late 1987 and early 1988. These allowed for the monetisation of embedded options in callable bonds and gave Citibank a hedge. Soon the bank controlled as much as 50% of the market in swaptions, which brought risk management to the top of the agenda.

"Our risk in the cap and collar deals was structural," says Rahl. "Basically, clients wanted to buy caps so everything was one way. Dealers would sell, clients would buy, so dealers tend to have a short position on volatility. After the 1987 crash, interest rates plummeted. Although most made quite a bit of money by benefiting from the fall in rates rather than the increase in volatility, the Street decided it wasn't such a nifty position to be in. Not that there weren't times that you wanted to be short volatility, but you didn't want a business where you always had a structural position. So there was a lot of research and financial engineering effort put into figuring out option products where the Street could be a buyer."

To solve this problem, Citibank and others looked to the covered call writers in the institutional investment community. Their options tended to be short term and so did not cover the kind of longer-dated risk dealers were assuming in their cap and collar books. The only place where long-dated options were in great supply was the callable bond market, as longer-dated options were embedded in the bonds. Citibank soon switched on to the idea of using the swaption concept as a natural hedge. Rahl says that Chip Carver, now with Goldman Sachs, played a key role in the development of the swaption market. "There was a very large supply of those embedded options and it gave dealers a natural hedge," she says.

In early 1989, ISDA estimated the size of the cap/collar/swaption market at $325 billion. It wasn't long before Citibank broadened the concept to include non-dollar interest rates, equities, precious metals, energy and emerging markets, says Polsky. "You had a cap, you had a collar, you had a floor, you had a swap and swaption," adds Rahl. "Whatever a client who needed hedge protection wanted, you had the tools to meet his needs. This helped take away some of the clients' excuses for not hedging."

But it wasn't all plain sailing. Rahl recalls that in the mid-to-late 1980s, the success of the derivatives markets was creating competitive tension within the bank over who deserved credit for deals - the relationship managers responsible for traditional corporate lending or the "upstart" derivatives marketers.

There were also some painful lessons from the market. "The [1987] stock market crash had some indirect effects on the swap market that people hadn't really thought about, and that made them very nervous about dealer credit," she recalls. "It became very hard to repo your securities, and you had all these short positions because you had all these clients that wanted to pay you a fixed rate, but you couldn't repo them very effectively. Spreads really widened out in the swap market because of what was going on in the repo market. That was really a wake-up call about the interdependence of some of these markets. Clearly when you have that kind of turmoil, you worry about credit risk, because you don't know who's going to be burned."

"Lisa and I often laugh about what's happened to us," says Rahl. "We believe it's largely because many bankers in charge never thought derivatives were going to be all that big and important, so it seemed safe to give them up."
(December 1997)

Grant's Interest Rate Observer
Making a model

"What Red Adair is to oil and gas exploration, CMRA is to financial engineering
(August 12, 1994)

Five years of risk

Most derivative houses now provision for credit risk. But very few do so for liquidity. LESLIE RAHL thinks he liquidity of underlying markets, or the lack of it, will be of increasing concern, forcing houses to provision accordingly. "In the same way people set aside reserves depending on the credit of the counterparty, I think you're going to have people set aside for liquidity. The reserve you'd set aside for a three-year US dollar interest rate swap would be quite different from CTE [Ecu Italian government bond] swaption."

But how do you measure liquidity? Volume is one measure. "You know that volumes are greater in swaps than in caps. You can also use industry statistics. For example, for swaps you could use International Swap Dealers Association volume figures for different maturity swaps." The point is that houses should make a distinction between where they mark to market (which is normally mid-market) and here they are actually able to transact. "You might do a few [hypothetical] transactions to see where it is possible to transact and then construct a simple matrix based on product and maturity," Rahl explains. Maturity is important because, for example, 10-year swaps are a lot less liquid than three-year.

Liquidity is one of the broad areas that regulators must examine to get an idea of the risks a firm is taking. "Although risk management techniques differ from firm to firm, there are some basic questions you could ask about risk management, such as whether a firm measures return on risk, the credit quality of counterparties, and whether it deals mostly in liquid or illiquid parts of the market."

Rahl feels increased disclosure, rather in more regulation, would be enough to soothe the regulators' fears. Everyone, but particularly regulators, needs more information, she says, and information presented an understandable form. The trouble is, regulators still don't know what information to ask for.

But won't derivative houses play the "It's proprietary" card to avoid disclosing anything sensitive? "A lot of information is not as proprietary as people would like to make it," she says. The type of business done by houses is important but, she feels, not necessarily proprietary. For example, whether derivative business is customer-driven or primarily for the firm's own book, or whether the business is mainly in vanilla or exotic products. "There's a big difference between a firm that does mostly short-dated swaps against Libor, and one which does a lot of exotic long-dated transactions," says Rahl.

Given how the derivative industry has grown, Rahl is surprised regulators have taken so long to bring their guns to bear. "It's natural that regulators should want to take a closer look at something as big and important as the industry's become. It's not just that it's grown, but that derivatives are used by so many different types of company and are so integral to the capital markets."

And regulation is inevitable. "Once you bite that bullet, the more the industry educates the regulators, the more likely we are to be happy with the results."

The trouble is that regulators tend to be fazed by derivatives' complexities: "I'm not sure the people charged with regulation understand the business sufficiently to create intelligent regulation. It's easy for an expert to talk fast and use a lot of buzz words, but that means it's impossible for non-experts to figure out what they're talking about, making proper regulatory control very difficult. "

But further growth in the derivative market could be curtailed by a lack of good-quality counterparties. "There are practical limits. How much credit can you take, even triple-A credit?" asks Rahl. Although the market still makes some distinction between genuine and synthetic triple-A institutions, those vehicles provide one alternative.

But the real question is what happens to the rest of the market when such vehicles are commonplace. "When the triple-A club was very small, not being a member wasn't necessarily devastating. But if there were two or three dozen triple-A entities, would you be able to operate with a single-A rating?"

A clearing house for OTC products could be one alternative: "I could easily envisage a clearing house in which, once a deal is done, a central margining credit-enhancement vehicle takes over."

Rahl thinks derivative firms may therefore suffer the twin pressures of being forced to buy credit enhancement while building up capital as a result of regulators' concerns. Those pressures could lead to an exodus of houses whose profitability was poor to start with.

"A lot of institutions entered the business without any real competitive advantage in terms of clientele or trading expertise," Rahl says. "Their margins may not be able to withstand those pressures."

Leslie Rahl set up Leslie Rahl Associates in 1991, specializing in risk management and trading strategies. She was previously at Citibank, which she joined in 1972, and set up its caps business and ran the derivatives unit during the 1980s.
(December 1992)