CMRA in the Press 2009

Opalesque Exclusive: Chief risk officers-the newest new hedge fund thing
Kristin M. Fox

The autumn of 2008 well may go down as The Great Fall of the financial system, as the broadmarket indexes and three storied U.S. financial institutions collapsed and the masterminds of previously unfathomable Ponzi schemes, Bernard Madoff and Alan Stanford, were exposed for lining their own pockets with billions of dollars of other people's money.

"The role of the Chief Risk Officer varies from fund to fund," says Leslie Rahl, founder and managing partner at Capital Markets Risk Advisors, a New York-based risk advisory and consultant. "At its best, a CRO wears both strategic and control hats, but in some funds it is primarily a 'cop' role, while at others it is a marketing role. It is impossible to make money without taking risk and risk is not a four-letter word. Only unintended risk-risk that is not understood and undertaken without a reasonable chance of reward-is a problem. The most effective CROs think strategically about how to allocate the firm's scare risk appetite, as well as ensure that risk is diversified within limits and well understood. A CRO also worries about what could go wrong and the least likely events and whether the fund could withstand them, leaving the portfolio manager to focus on the more likely outcomes. You need both perspectives," says Ms. Rahl.

November 2009

Beyond Box Ticking: A New Era for Risk Governance

Board-level executives' responsibility for risk does not stop at the creation of policy.

Senior managers should convey a clear message that risk should be seen as part of every employee's job, not just something that is taken care of by a small cadre of risk professionals. "Risk is not the responsibility of somebody in isolation," says Barbara Lucas, a partner at Capital Market Risk Advisors. "It is everybody's responsibility."

Even once a CRO is in place, there is no guarantee that he or she will play a role in key strategic initiatives. Among respondents to our survey, less than half say that their CRO or equivalent is involved in mergers and acquisitions, financial strategy, product development or forecasting.

This perplexes many risk professionals, who believe that the recession has reinforced the value of carrying out a secure evaluation of the risk/reward equation before making any major decisions. The CRO should, they argue, play a role in hel.ping to determine the future of their organizations. "The whole purpose of risk management is to find the optimal balance between risk and reward consistent with whatever your objectives are," says Ms. Lucas. "That is a strategic function."

September 2009

Hedge Fund Keeps Reins on Risk
By Joseph Checkler

Almost a year since the worst market crisis in generations, some investors are embracing risk again like the crash didn't happen. But for many hedge funds, the lessons learned from the crisis are causing them to keep a tight rein on their risk management, and their traders.

Like many hedge-fund managers, Mr. Tropin, 55 years old, attributes risk management to his firm's ability to survive a tough year. Mr. Tropin calls it an "aggressive daily review of global risk"—a process that can be so rigid that it promotes frustration among his fund managers.

The firm's risk manager Bill Pertusi leads a meeting at 9:30 a.m. each day in a large room in Graham's 93-year-old Irish Tudor mansion. There, a group of seven or so people—always including Messrs. Tropin and Pertusi—discusses all aspects of risk: market risks, risks in individual traders' portfolios and how they have changed since the day before, risks to the way the firm is investing its cash, counterparty risk—or risk that the firm on another side of a trade will fail, even evaluations of whether traders' are in positions that are "crowded" with other hedge funds.

"I'm not aware of anyone who has a daily meeting just to talk about risk in the absence of talking about opportunity," according to Leslie Rahl, managing partner of risk-management firm Capital Market Risk Advisors.

August 2009

Bright Ideas: How to Execute Strategic Change
By Scott Johnson

Strengthening Risk Management in the Boardroom

A new survey of large asset managers reveals several missed opportunities for strengthening risk management from the top down. Managers may be able to mine the survey for some relatively inexpensive fixes.

At nearly half of large asset managers surveyed, the chief risk officer has never had an executive session with the firm's board of directors, according to the survey, which Capital Market Risk Advisors co-sponsored with the Professional Risk Managers' International Association. "To me, that's an easy thing to do, and it really adds value," says Leslie Rahl, Founder and Managing Partner of CMRA.

Maintaining communications between the CRO and the board creates an "open, unfettered dialogue," she says, and in the event of a crisis, it can prevent the board from overreacting.

Just 7% of large managers currently have a risk appetite statement, which is another way to empower the CRO and keep risk under control. Risk appetite statements are typically documents that offer asset management professionals guidelines for dealing with risk. Still, about 29% of large managers are considering drafting such statements, a figure Rahl finds encouraging.

Finally, while many firms have a CRO, roughly half empower that individual with both a consultative, strategic role as well as the traditional "control role," in which the individual polices risk and maintains compliance. More should do so, Rahl suggests. "It is the next level of making the CRO an integral part of a well-run organization, to give them a real seat at the table as opposed to just the ability to say no," she says.

August 2009

Risk Governance Survey Shows Troubling Lack of Board-CRO Communication
By Julie Goodman

A new risk governance survey polling asset managers and banks indicates that 28% of chief risk officers never have executive sessions with their boards and that only 60% of boards approve risk policies.

The survey, conducted by Capital Market Risk Advisors (CMRA) and Professional Risk Managers' International Association (PRMIA), looked at the risk governance practices of banks, insurance companies, asset managers, hedge funds and institutional investors from 26 countries.

It was conducted over a two-week period in July, with input from 121 financial institutions. Of the respondents, 25% are asset managers, most of whom have mutual funds.

A number of fund boards have focused lately on strengthening risk management and opening communication channels between risk staff members and boards, and in some cases, they have appointed chief risk officers (CROs).

But while the survey suggests promising trends according to risk management advocates, it reveals some areas of deficiencies for corporate and fund boards.

It found that 85% of financial institutions have a chief risk officer, but 25% of those individuals are limited to a control role, as opposed to a more strategic one.

The survey says the CRO's "regular and unfettered access" to boards is still evolving, with 44% of respondents with a board and a CRO holding executive sessions at most meetings. It also says 11% have executive sessions only once a year, while 28% never hold such sessions.

"I think that risk is a little scary still to a lot of boards, and therefore the comfort level of dealing directly with a risk officer might not be there," says Leslie Rahl, founder and managing partner of CMRA.

The analysis corporate and fund boards receive also was covered by the survey. The results show that only 48% of boards receive trend analysis, and only 42% receive exception reports.

Rahl, a member of a bank board, says those trend and exception reports are extremely valuable for boards.

"It's very, very difficult when you pop in a month or six weeks after the last meeting and someone gives you a snapshot," she says. "I always advise my clients to put their risk reports into a context and provide a trend analysis."

August 2009

Potential der Risikomanager Wird Unterschätzt

Obwohl rund 85% aller Finanzinstitute einen Risikomanager beschäftigen, haben 25% dessen Aufgabenfeld auf passive Kontrollfunktion beschränkt. Zu diesem Ergebnis kommt eine amerikanische Risk Governance Studie, die in dieser Woche in New York von Capital Market Risk Advisors (CMRA) und der Professional Risk Managers International Organisation (PRMIA) veröffentlicht wurde.

Hauptsorge der Risikomanager in den USA sind aktuell gesetzliche Veränderungen der Anforderungen. Erst auf Platz 2 und 3 folgen Inflationsrisiken und Kreditverluste. Preisschwankungen, die im vergangenen Halbjahr hinter Kreditverlustrisiken noch auf Platz 2 rangierten, spielten in der aktuellen Umfrage kaum noch eine Rolle.

Ein interessantes Ergebnis der Studie war auch, dass sich bisher nur wenige Aufsichtsratsgremien das spezielle Wissen ihrer Risikomanager zunutze machen. Zwar entscheiden in 60% der befragten Unternehmen die Aufsichtsratsgremien über die Risikopolitik, aber nur 16% der Risikomanager haben eine Berichtspflicht gegenüber dem Aufsichtsrat. 20% der Risikomanager gaben sogar an, nie an Aufsichtsratssitzungen teilzunehmen. Hier besteht noch erhebliches Entwicklungspotential. Die Studie sieht hier jedoch bereits eine eindeutige Tendenz zu einer stärkeren Einbeziehung der Risikomanager.

July 2009

Hedge Funds Review

Concern Over Regulation is One of the Top Risks for 2009

The top three concerns of chief risk officers for the second half of 2009 are credit losses, volatility and the possibility of governments changing the rules. In the US the main concerns centre on the introduction of followed by inflation and credit.

These were some of the findings contained in a risk governance survey benchmarking risk governance practices of banks, insurance companies, asset managers, hedge funds and institutional investors. The survey was carried out by the Professional Risk Managers' International Association (PRMIA) and Capital Market Risk Advisors (CMRA).

The survey found that hedge fund boards are less likely than the boards of other types of financial institutions to have executive sessions with the chief risk officer (CRO). Under a fifth (14%) of hedge funds and funds of hedge funds (FoHFs) respondents only have an executive session once a year while 29% said they never have one.

Only 43% of hedge funds report on credit risk to their boards noted the survey. However, although only a small number (14%) of institutional investors currently have a board risk committee while 21% plan to create one. Almost half of institutional investors responding to the survey (47%) said they have a CRO.

Over a quarter (27%) of institutional investors currently have a risk appetite statement and an additional 13% plan to create one. Only 27% of institutional investor boards receive trend analysis and a fifth receive exception reports.

The survey was based on results from 121 participants from 26 countries.

Across all respondent types, there was wide agreement on the need for a CRO but influence on strategy compared with control varies. Almost a quarter (70%) of respondents have a CRO, and 15% have someone with a different title but an equivalent function. A quarter said their CROs have a control role only.

The importance of the CRO having regular and unfettered access to the board is still evolving.

CMRA is a financial advisory firm providing risk management advisory and litigation support services to institutional investors, hedge funds, funds of funds, mutual funds, investment and commercial banks, insurance companies and other market participants.

July 2009

47% of Funds Have Chief Risk Officer, Survey Says
By Barry B. Burr

Only 47% of pension funds, endowments, foundations and sovereign wealth funds have a chief risk officer, according to a survey of risk governance practices at financial institutions worldwide.

Also, 27% of these four fund sponsor types have a "risk-appetite statement," defining the variability of results they want to take, while 13% plan to create one, according to the survey by Professional Risk Managers' International Association and Capital Market Risk Advisors.

Among the fund sponsors, 14% have a risk committee of their board, while 21% plan to create one.

The survey of 121 financial institutions also included traditional investment managers, hedge funds, investment banks and insurance companies.

When all responding financial institutions were included, 85% have a chief risk officer or a similar position.

The survey, the first of its kind by the two organizations, looks at risk from the financial institutions' governance or board point of view, said Leslie Rahl, CMRA founder and managing partner.

"Formal risk appetite statements haven't fully caught on with institutional investors," Ms. Rahl said, calling the documents "a valuable tool for the board to communicated risk appetite with management."

July 2009

National Mortgage News Online

Pension Funds Have Drawn Back from Mortgages
By Bonnie Sinnock

Individual pension funds have a complex and varied range of involvement in the mortgage space, but under today's market conditions generally they are likely to maintain only a moderate stake in the agency-dominated securitized residential market in the short term, while their participation in the largely distressed nonagency residential and commercial markets is more questionable.

Given the Federal Reserve's mortgage-backed securities purchases and their effect on the market, "this is probably not the time to expand allocations aggressively into agency MBS," Peter Niculescu, partner and Head of Fixed Income Advisory at Capital Markets Risk Advisors, New York, told NMN. When the Fed's involvement ends, pension fund involvement could change.

He said pension funds might be market weighted or underweighted going forward, although they would be unlikely to be underweighted to a great degree. The asset class suits pension funds' needs given the duration of their liabilities, and at times pension funds have been significant agency MBS investors. However, due to current market conditions they are in about the middle of the pack when it comes to market share and influence today.

As for nonagency residential and commercial MBS, the degree of pension fund investment going forward is questionable and likely to be varied because the asset class is considered largely distressed and "the dispersion in prices between recognized pricing services is larger than in a more stable environment and more emphasis is being placed on independent valuation," Leslie Rahl, Founder and Managing Partner of CMRA, told NMN. In addition, there continues to be relatively little agreement on price and on risk factors.

Pension funds will probably make their decisions on these assets on a case-by-case basis depending on which is stronger, the appeal of their low prices or concerns about their distressed nature, Mr. Niculescu said.

There also is so-called headline or reputational risk to consider, something that may be magnified when it comes to public retirement funds. The extent to which pension funds took mortgage-related losses during the recent downturn has varied tremendously with some players heavily exposed and others less exposed, Ms. Rahl said.

July 2009

Credit Losses Biggest Risk Concern For Rest of Year
By Carol E. Curtis

Financial services firms rank credit losses as their number one concern of risk management heading into the second half of the year. Market volatility and government inconsistency follow close behind, says a new risk governance survey from the Professional Risk Managers' International Assn. (PRMIA) and Capital Market Risk Advisors (CMRA).

The survey of more than 140 banks, investment banks, asset managers and insurance companies asked about the primary concerns of risk professionals for the second half of 2009.

Risk professionals were asked to rank a number of concerns from1 (highest) to 3 (lowest). Preliminary findings, released June 20, ranked top concerns as credit losses (1.54), volatility (1.70), government changing the rules (1.80), counterparty risk (2.19), accountants changing the rules (2.49), and inflation (2.67), PRMIA said in a release.

Banks ranked volatility as much less of a concern than did asset managers and insurance companies, giving it a 2.63 ranking behind credit losses (1.26), government changing the rules (1.69), counterparty risk (2.25), and accountants changing the rules (2.58).

"The survey confirms our anecdotal findings that the government's inconsistency remains a major concern," said Peter N. Niculescu, a partner at CMRA.

July 2009

Opalesque Exclusive: Hedge Fund Managers Concerns are Focused on Real and Familiar Pain of Counterparty and Volatility Risk, not Regulation
By Kirsten Bischoff

As it turns out, regulation is not the biggest fear for hedge fund managers. Volatility and counterparty risk are the biggest concerns according to the preliminary results of the Risk Governance Survey performed by PRIMA and Capital Market Risk Advisors.

The survey, which included 140 participants from 27 countries (the majority of which were US-based) focused on what managers biggest concerns were for the back half of 2009. The survey showed that across the financial industry, regulatory risk is very much a major concern. However, a smaller focus on hedge fund and fund of funds respondents shows that the greater concern lies with the all too real and familiar pains of 2008, which were counterparty risk and volatility.

Prior to 2008, counterparty risk was not very high on the list of concerns for hedge fund managers. Survey's such as Global Custodian Magazine's Prime Brokerage Rankings did not even include counterparty risk as a measured category in 2008. However, the fallout from Bear Stearns and Lehman Brothers has remained a focus for many hedge funds. Nine months later, there are still funds that were counterparties to Lehman Brothers that have yet to recover monies the firm was in possession of upon bankruptcy. Opalesque has even spoken to firms that, as of two months ago were holding in special accounts monies still needing to be returned to Lehman Brothers.

Banks surveyed reported credit risk as their greatest concern, perhaps serving to bolster hedge funds' fears on counterparty risk, as reports of large investment firms returning to "pre-Lehman" risk has been reported.

While hedge funds are certainly not discounting the possibility of harsh restrictions imposed through increased regulation, perhaps it sees the benefit some of the reporting requirements will bring to the industry as a whole. Counterparty risk reporting and other reporting (such as volatility risk) will be part of the requirements of hedge fund with excess of $30m in assets, under the most recent regulation aimed at the hedge fund industry.

July 2009

U.S. Clearing Banks Submit Repo Reform Proposals to Fed
By Elinor Comlay and Kristina Cooke

The two U.S. clearing banks for tri-party repurchase agreements, Bank of New York Mellon Corp and JPMorgan Chase & Co, have submitted proposals to the Federal Reserve on how to make the market more resilient.

The banks told Reuters that the proposals for fortifying the more than $2 trillion market include establishing an emergency entity to support dealers in crisis and expanding financing through existing central counterparties.

The bank has also suggested setting up a cross-industry working group to look, in particular, at systemic risk and perhaps come up with some form of 'best practices' framework for the market.

One other possibility, analysts said, would be adding other banks to the two existing custodian banks.

"If I were sitting where the Fed is sitting, I think I would probably want to think about whether we need more than two clearing banks, because that's a tremendous amount of risk in a limited number of institutions," said Barbara Lucas, a partner at Capital Market Risk Advisors in New York.

July 2009

Ex-Worker Said to Steal Goldman Code
By Graham Bowley

He is no John Dillinger, no public enemy No. 1. But Sergey Aleynikov nonetheless masterminded a dazzling bank theft, the authorities say, and he did it without brandishing a gun or cracking a vault.

Peter Niculescu, a partner at Capital Market Risk Advisors, an advisory firm specializing in risk management and capital markets, said computerized trading had become increasingly important drivers of revenue growth within banks over the last 10 years.

But he said stealing a bank's trading code did not necessarily guarantee riches, because running it somewhere else was not easy without, for example, a bank's databases or links to customers.

"If you have the code, but not the database then it is of limited value," he said. "It is not easy to transfer the code and run it somewhere else."

July 2009

Capital Market Risk Advisors and Risk Fundamentals launch joint venture

Capital Market Risk Advisors and Risk Fundamentals launch joint venture to provide institutional investors, hedge funds and funds of funds to address quantitative and qualitative risk

Capital Market Risk Advisors (CMRA) and Risk Fundamentals has announced a joint venture combining CMRA's pre-eminent risk management and risk governance consulting services with Risk Fundamentals' state of the art risk transparency software. The joint initiative will provide institutional investors, hedge funds and funds of funds with holistic services to address both quantitative and qualitative risks.

"I'm delighted to be able to announce this new partnership," said Leslie Rahl, founder and Managing Partner of CMRA." CMRA has long been a leader in risk management, risk governance, and development of best practices. By joining forces with Risk Fundamentals, we will be able to augment our customized consulting services with more standardized services directed at midsize funds and plans."

"Risk Fundamentals is a state of the art risk management and transparency solution for hedge funds, funds of funds and institutional investors," added Richard Horwitz, President. "By offering industry standard risk information across managers and asset classes in conjunction with CMRA's consulting services, we hope to provide market participants with a new and effective way to understand and manage risk."

June 2009

FundFire's Tuesday People Roundup: Peter Niculescu
By Tom Stabile

Capital Market Risk Advisors

The risk management and litigation support consultant announced that Peter Niculescu has joined as partner and head of the firm's fixed income consulting practice. The firm provides advisory and support services to a range of financial services firms and organizations, such as institutional plan sponsors, foundations, endowments, asset managers, hedge funds and banks.

Niculescu had joined a few months ago but he says the firm made the announcement formal last week. He came from a post as Executive VP and Head of Capital Markets for Fannie Mae, and previously was managing director for mortgage and fixed income research at Goldman Sachs.

While Capital Market Risk Advisors (CMRA) has offered fixed income-oriented consulting in the past, Niculescu is the first partner dedicated to this area. "This is an expansion of CMRA's activities," he adds. "I would not be surprised to see fairly significant demand for these services right now."

Niculescu says that among the principal risk management tasks the firm handles for clients are studying the true risks in an investment portfolio, defining the risk appetite of an organization, and analyzing valuation issues related to risk assessment.

"Most risk analysis through 2007 was based on some sort of some historical comparison and stress testing," he says. "But as we have gone through 2008 and 2009, the circumstances we've seen have transcended most of the patterns from financial history. This has transformed risk analysis from modeling on historically based scenarios to constructing an enhanced analysis based on plausible scenarios."

The litigation support practice includes providing expert opinion and analysis about the markets from either the plaintiff or defendant perspective for clients.

June 2009

Obama treads lightly on Wall Street
By Matthew Goldstein

President Obama, in a speech on the financial crisis at Georgetown University in April, spoke eloquently about the need to move away from a Wall Street-fueled "bubble and bust economy." But Obama's proposal for overhauling the financial regulatory system falls well short of his stated goal of making "sure such a crisis never happens again."

"You have 88 pages of big picture stuff but few details," says Barbara Lucas, a long-time banking lawyer and principal with Capital Market Risk Advisors. "The thing that troubles me is the vast grant of undefined power to the Fed and Treasury."

June 2009

Out of the comfort zone
By Mark Pengelly

US banking supervisors will complete stress tests early this month to determine if the country's largest banks need to hold more capital to withstand a worsening in economic conditions. But industry practitioners raise concerns about the effectiveness of stress tests based on macroeconomic conditions, and question whether the results are comparable. Mark Pengelly investigates

Stress testing is considered by many risk managers to be a useful supplement to other, more quantitative risk measures, such as value-at-risk. By taking a variety of core scenarios, such as the 1987 stock market crash and the Russian debt default of 1998, banks have been able to determine how their own portfolios and hedges would be affected by similar shifts in market variables.

Given the nature of the recent systemic rout, in which losses spread quickly from US subprime mortgage portfolios to other asset classes, industry observers are surprised at the apparent lack of detail provided by the stress tests on correlation and other more complicated variables. "In our experience, it is the subtle variables, such as correlations, basis risk and assumptions on recoveries that are really critical in stress testing. It is not clear to me how prescriptive regulators have been in those areas, and whether each firm will be consistent with those or address them in a different way," says Leslie Rahl, president of Capital Market Risk Advisors, a New York-based risk management consultancy.

These variables include correlations between asset classes and markets - for instance, between debt and equity or Libor and the US prime rate. In the context of an entire firm, they could also encompass the relationship between different business lines, says Rahl. "What would be the impact if, at the same time as these things happened to the economy, you had to double your haircut to hedge fund clients because you were concerned about them as a credit entity?"

May 2009

How Boards Are Turning Risk Into Opportunity
By Tony Chapelle

Good risk management can help managers turn up hidden opportunities for profit in the economic downturn, besides helping protect companies from risks.

Indeed, Leslie Rahl finds more companies employing risk management not only as a "cop" function but also for strategic opportunity. Rahl, who is the president of Capital Market Risk Advisors, points to the trend of boards' developing risk appetites based upon "risk budgets" or balancing risks versus reward.

May 2009

Treasury's OTC plan is broadly welcomed
By Aline van Duyn, Henny Sender and Francesco Guerrera

The proposed regulatory overhaul of the multi-trillion dollar derivatives industry is expected to vastly increase the amount of information available to regulators around the world and could increase the cost of trading and taking on positions.

"As long as dealers are still allowed to do customised derivatives with clients, they can still make money," says Leslie Rahl, president of Capital Markets Risk Advisors.

May 2009

No sense rushing products to market
By Julie Goodman

US fund firms and financial institutions have been groping for survival tactics since the market turmoil began. While the industry has retooled its risk assessment programmes, it continues to grapple with a central question: how can firms execute thorough risk analysis with all the requisite controls without stifling innovation?

Product development could increase revenue. And healthy risk management could impact performance by reducing the potential for "surprises," says Barbara Lucas, a partner with Capital Market Risk Advisors who has worked extensively on risk governance.

"While new products can potentially offer important new sources of revenues, it is important to think through and have an appropriate structure in place to handle whatever risks products present in advance of rushing to market," she says.

April 2009

Survey: Few measure counterparty risk Leverage, liquidity measurements also seen as lacking

Most pension funds do not measure counterparty risk, six months after the collapse of Lehman Brothers Holdings Inc., a survey by Pensions & Investments and Capital Market Risk Advisors shows.

The P&I/CMRA survey found that pension funds appear to be lacking in two other crucial risk areas: measurement of liquidity and leverage. About half of respondents said they do not measure leverage or liquidity in funds in which they invest. Given the collapse of the global financial system and the steep decline of capital markets over the past nearly 19 months, however, this lack of oversight and monitoring is going to change. The problem is, it's not like flipping a switch: Pension executives are going to have to either open up their wallets or simplify their asset allocations and eliminate exotic investments.

The survey was split into two parts: one for pension executives and one for plan board members or trustees. Roughly 40 people responded to each question on the survey.

The survey of pension executives and trustees found that 70% of respondents do not gauge counterparty risk for the overall pension fund. Counterparty risk, also known as default risk, is the possibility that one party to a trade will fail to meet its contractual obligations.

The results were "startling but not surprising," said Leslie Rahl, president of New York-based Capital Market Risk Advisors. "It's a rather important finding when you consider that managing and measuring counterparty risk began to be raised in 1999" after the 1998 failure of Long Term Capital Management.

In addition, the disintegration last September of Lehman Brothers left money managers, pension funds, custodians and banks holding the proverbial bag, with hundreds if not thousands of trades unsettled. That should have pushed the issue of counterparty risk squarely to the top of investment committee agendas.

Ms. Rahl said even though more pension funds measure liquidity risk than counterparty risk, "that's something that should be moved up the priority scale" as well.

Overall, too few pension fund executives and trustees are fully plugged into their plan's risk management process and simply receive risk reports mostly on a quarterly basis, according to the survey.

"The main conclusion that I drew is that pension funds want and need more," she said. "There seems to be a general understanding that what they're getting is not sufficient."

In fact, while the majority of pension board respondents (58%) receive quarterly risk reports, 39% plan to increase the frequency of risk reporting.

"Clearly at the board level, they're crying out for information on a more frequent basis," Ms. Rahl said. She added that the results largely confirm what pension fund executives have told her.

The P&I/CMRA survey, however, found that on average, respondents spent just $150,000 on risk management in 2008, with the maximum of $500,000. They planned to increase that amount by an average of 20% in 2009.

In a related finding, respondents on average had 1.4 people assigned to risk management, with a maximum of 12. Only 10% of respondents said they planned to add more risk management staff."If you can't either outsource some of it or invest in doing some of it yourself, simplify your life and simplify your portfolio,"

Ms. Rahl said, suggesting that simplifying a portfolio meant taking a close look at asset allocation and possibly eliminating esoteric investments. "I believe very strongly that if you don't understand it, don't buy it."

Separately, some pension funds are planning to implement risk budgeting, according to the P&I/CMRA survey. Currently, just 24% of respondents use risk budgeting, but another 12% said they planned to do so.

"That 50% increase caught my eye," Ms. Rahl said. "There's generally a fairly high correlation" between planning something and doing it. "If someone says they plan to, that generally means it's on the agenda."

With most pension funds still weak on risk management, the big unanswered question is: Will the credit crisis and ensuing drop in capital markets and global recession finally kick pension boards and executives into action?

"This is the event," Ms Rahl said. "My phone's been ringing off the hook."

April 2009

Viewpoint: Lesson Learned in '30s: End Marking to Market
By Peter Niculescu

A lot of attention has been paid to mark-to-market accounting of late, with recent congressional hearings and proposals by the Financial Accounting Standards Board to modify impairment accounting and valuations.

But few know that there is even an argument that the decision to end this method of accounting for capital helped end the Great Depression. Disclosure of market marks, by contrast, is not a problem and, in fact, should be extended and enhanced. Using mark-to-market accounting in profit and capital calculations is the culprit: It contributes to a vicious spiral.

In 1938 the Office of the Comptroller of the Currency ended mark-to-market securities evaluations in banking, saying, "Bank investments should be considered in the light of inherent soundness rather than on a basis of day-to-day market fluctuations" (Federal Reserve Bulletin, July 1938). The remaining years of the 20th century did not suffer this contribution to exacerbating banking crises. Even the deep recession of 1981 and the subsequent savings and loan and banking failures were less disastrous because capital was not marked to market. Gradually over the last decade, the mark-to-market approach has come back into accounting theory and capital calculations — and with it extreme financial instability.

Going back further, financial history shows an irregular pattern of financial meltdowns every few decades throughout the 19th and early 20th centuries. The marked-to-market balance sheet was then thought of as a natural means to assess bank and trust company capital. But when markets become distressed, marking to market causes cascading financial failures. Every depositor tries to flee a bank that cannot sell its illiquid assets, and the institution fails.

This problem was recognized in 1931, and the regulators tried to mitigate the effect by reducing the impact of marking to market. It did not help until, in 1938, they repealed it.

Marking to market works like this: Securities have to be marked down through profits and capital at current market prices if there is a reasonable chance of a loss of any principal, even if these are fire-sale prices. The banks that invest in securities risk being rapidly made undercapitalized. They have to sell securities to reduce their capital needs and capital exposure. As distressed investors sell, security prices drop, prompting more distressed selling and risking more undercapitalization. The vicious spiral kicks in.

The phenomenon was well known in the Great Depression. Friedman and Schwartz, who wrote the definitive monetary history of the United States, put it this way: "Banks had to dump their assets on the market, which inevitably forced a decline in the market value of those assets and hence of the remaining assets they held. The impairment in the market value of assets held by banks, particularly in their bond portfolios, was the most important source of impairment of capital leading to bank suspensions, rather than the default of specific loans or of specific bond issues."

A contemporary observer, R.W. Goldschmidt, made the same point in the 1930s: "The depression of bond values, which started as far back as 1929 in the field of urban real estate bonds and reached foreign bonds and land bank bonds in the course of 1931, began to endanger the whole banking structure and notably the large city banks the moment first-grade bonds were affected in a most dramatic way."

Distressed prices are generally far below the expected payments (the "inherent soundness") that the investor will get over time. Risky, distressed securities must surrender a large risk premium.

But what of true marking to market? The complete marking to market (not just of financial assets) of all financial institutions' balance sheets should be reported quarterly (not just annually). It is not required or disclosed today for most banks or insurance companies. If it were disclosed, it might show that most major financial institutions in the country have negative marks. But what does that mean? Only that if everybody tries to sell at the same time, it can't be done.

It emphatically does not mean the institutions should be shut down. If they are generating positive cash flow, then they can borrow and lend and will probably generate good returns in the long term. The regulator can decide to shut them or not, making an assessment of long-term viability. But do not look at distressed asset prices as the only indicator.

Capital based on the mark-to-market approach is only an accounting theory, not a fact. Capital is widely misunderstood as being cash on hand, a stock of gold coins in some deposit box. Nothing could be further from the truth. Capital is an accounting concept that mixes accrual accounting for loans and liabilities with accounting for securities that is sometimes accrual but becomes mark-to-market when securities become distressed. So we get stability until markets melt down, then dynamic instability when the vicious spiral gets going.

Mark-to-market accounting is required to affect only securities assets, not loans and not liabilities. Half of financial intermediation happened through the securities markets until the meltdown began. Marking to market now stops securitization. Nobody can afford to invest in securities if they risk a mark-to-market hit to their capital.

Intermediation can only happen through loans or securities that have no realistic risk from marking to market (such as the mortgage-backed securities of government-sponsored enterprises). Bringing back securitization requires the end of capital marking to market, and rapid economic recovery needs a revival of the securities markets as well as expanded lending by banks.

The OCC said it well in 1938: "By severing appraisal of bank investments from current market quotations, it is believed that the banks will be encouraged to purchase securities of sound business and industrial concerns, whether large or small, for their true worth and not for speculative gains." And "as the banks avail themselves of the opportunity, the necessity will be diminished for the creation of government agencies to furnish credit facilities which the banks should provide."

March 2009

Downpayment Insurance
By Peter Niculescu and Beth A. Wilkinson

Much of the government's housing policy to date has focused on helping struggling homeowners stay in their homes and resolving the problems caused by declining asset values. Both are important. But unless policies encourage people to buy houses and work off the current inventory backlog, house prices will continue to tumble.

One step toward this goal is to stabilize housing prices by reducing the risk of buying a home with little or no cost to the taxpayer. One solution is a government-sponsored downpayment insurance program for new home buyers. This could bring responsible home buyers back into the market and create a floor for home prices.

Here's how the program would work. Home buyers could purchase insurance for their downpayments: To qualify, they would have to keep the home for at least five years. The insurance policy would be written on an assessment of average home values in the neighborhood. If a homeowner can maintain or improve the home and sell it for more than his neighbor's, he gets any profit above the original purchase price. If home prices are lower when he sells, the homeowner gets to keep the downpayment.

To mitigate the risk to the taxpayer, the policy should be capped at 25% of the home value. Larger downpayments would not be fully insured, nor would larger declines in home prices. The program we're outlining is meant to temporarily stabilize home prices. Thus it should have a relatively short life, perhaps two years.

How much will it cost taxpayers? Maybe nothing. Housing is going through a powerful correction but will revive over time, and the economy will too. If, as is most likely, the insurance helps to arrest the drop in home prices before five years are up, taxpayers will pay no claims but keep the premiums.

Even if prices do keep dropping, the cost will likely be less than most of the other stimulus measures being proposed. To incur a monetary cost to the taxpayer, the person who bought a home over the next two years would have to sell it, and average prices in his neighborhood beyond five years would have to fall. Most homeowners at that point would choose to stay in their homes, knowing their downpayment is still safe. For those who are at risk of default and have to sell, the taxpayer will make payments straight into their pockets, reducing the chance of foreclosure.

At that point, downpayment insurance becomes an automatic stimulus package that only kicks in when it is really needed.

Since virtually all conforming mortgages are now being underwritten by an arm of the government (the Federal Housing Administration, Fannie Mae or Freddie Mac) the taxpayer is already exposed to the risk of default. For the Federal Housing Administration programs in particular, the government is bearing the full risk of further home price declines on home purchases with loan-to-value ratios frequently above 90% or 95%. This program merely extends the taxpayers' exposure by a fraction: the downpayment on home purchases going forward.

March 2009

Déjà Vu All Over Again
by Paul D. Kaplan

"We seem to have a once-in-a-lifetime crisis every three or four years."

–Leslie Rahl, founder of Capital Market Risk Advisors

The dramatic events on Wall Street and in financial centers around the world that started on "Black Sunday," Sept. 14, have upset many common assumptions about the global financial system. What started as a mortgage crisis spread to nearly every corner of the financial system when Lehman Brothers collapsed, Merrill Lynch sold itself to Bank of America, and AIG became strapped for cash--all in a single weekend. These and the events that followed have shaken investor confidence to the core. As of Dec. 31, the Dow Jones Industrial Average was down 22.4% since Black Sunday. The yield spread on junk bonds over LIBOR reached an unprecedented 16%. The markets for many assets have become illiquid, and credit is dried up for nearly anyone who needs it. The U.S. Federal Reserve, the U.S. Treasury, and their counterparts around the world have taken dramatic steps to restore liquidity to asset markets, stimulate lenders to make loans again, shore up investor confidence in equity markets, and avoid a deep global recession.

February 2009

When Proof Meets Pudding How have crisis-proofing strategies fared during the recent turmoil?
By Christopher Wright

In the July/August issue of CFA Magazine, the Portfolio Performance section looked at four basic approaches to crisis-proofing a portfolio: hedging, shorting, diversification, and "waiting it out." How do the four approaches look in light of the subsequent market crash?

Hedging doesn't always work perfectly in a crisis, as Leslie Rahl, president of Capital Market Risk Advisors in New York City, points out. Rolling hedges can go wrong—for example, rolling repos (repurchase agreements) in the current crisis and rolling futures in the 1993 Metalgesellschaft debacle. Managers should not count on being able to rebalance continually in a crisis.

Risk management cannot guarantee unqualified success in all market conditions, Rahl says, but those who work to reduce factor concentrations stand to do considerably better than those who do not.

The importance of measuring and managing counterparty risk also became evident in the recent crisis. Counterparties under stress from large losses attributable to inadequate capitalization, imprudent leverage exposures, or substantial share-price declines expose their trading partners to settlement delays, margin call increases, and risk of total loss. These hazards are not confined to over-the-counter (OTC) derivatives and are present, for example, in the choice of custodian or prime broker and in securities short-sale lending agreements.

Early Warning Signs

The 2008 financial crisis, in general terms, was preceded by easy money (accommodative monetary policy), loose lending standards (no-doc loans), speculative excesses (the housing bubble), massive leveraging by significant players (a U.S. rule change in 2004 resulting in investment banks bulking up), and wild growth in systemically important but opaque financial instruments (mortgage-backed securities, credit default swaps). All these factors had figured in previous crises, but the 2008 catastrophe was not exactly like any previous event—nor will future crises fit the same mold. So, what can asset managers learn from the debacle? Are there any indicators they can watch that will reliably signal future trouble?

Credit default swap prices on certain industries and specific names would have been predictive of the 2008 crisis, according to Rahl. But in her view, simply watching the same indicators every time is like gearing up to fight the last war.

February 2009

Cover story: How Caisse's Bet on Quants Went Wrong
By Konrad Yakabuski

The entire global financial industry has been transformed in recent years by the intricate models that originated in the 1990s with a group of computer scientists and mathematicians at U.S. investment bank JPMorgan Chase & Co. The models, which fall under a broad category known as Value-at-Risk (VaR), use historical price movements and dozens of other variables to predict the extent and likelihood of potential losses on an investment.

If a typical poll claims accuracy 19 times out of 20, VaR could promise to be right 99 times out of 100. But it was useless in predicting what would happen when that one-in-100 moment arrived, much less a one-in-a-million meltdown.

Most institutions came to employ some form of VaR, but some placed more faith in it than others.

Those who did bank on it may, like the Caisse, be suffering the consequences now. Some experts believe that VaR has caused bigger losses at many financial institutions because it has a built-in bias in favour of highly leveraged investments. And since it assigns such low probabilities to nightmare scenarios, most institutions that relied on it never paused long enough to consider what would happen if the unthinkable arose.

"The failing is not in VaR but in the fact that many people stopped there," says Leslie Rahl, president of New York-based Capital Market Risk Advisors. "The quantitative approach is about one-third of the puzzle. You would also have to take into account a vast number of qualitative factors."

Ms. Rahl, a derivatives expert who has advised the Caisse on risk in the past, recommends that institutions regularly conduct a series of "stress tests" to determine how prepared they would be to deal with sudden strains on liquidity.

"One of the stress tests they should do is [to see] what would happen if margin requirements are increased. I don't know if the Caisse was doing that. Clearly, a lot of people were not," says Ms. Rahl, who joined the board of Canadian Imperial Bank of Commerce in 2007 when the institution, hit hard by the subprime mortgage meltdown, moved to better manage its risk.

January 2009

Last Summer's Missed Opportunity
By Matthew Goldstein

With the Obama administration busy working on a new plan for bailing out the nation's crumbling banking system, one can only wonder whether government policy makers missed an opportunity nearly a year ago to nip the financial crisis in the bud.

Flash back to a year ago February, before Bear Stearns collapsed into the waiting arms of JPMorgan Chase, when there was a lot of talk about bailing out the bond insurers—also known on Wall Street as the monolines. Former New York State Governor Eliot Spitzer was in the news almost every day it seemed, warning that the weakened state of bond insurers like MBIA and Ambac posed a big threat to the financial system. Then Spitzer shot himself in the foot by getting caught-up in a dalliance with a high-priced call girl and disappeared from the scene.

Almost as quickly, the problems facing the bond insurers receded as a pressing issue. There was a lot less urgent talk about the bond insurers and their need to raise fresh capital in order to avoid painful ratings downgrades. In fact, in the weeks immediately following the collapse of Bear, there was a false sense of security that the worst of the financial crisis was over. Of course, Lehman Brothers bankruptcy filing on Sept. 15 and the subsequent budget-busting government bailouts of AIG, Citigroup and Bank of America have rendered that little bit of optimism a distant memory.

Even today, some think the government still might be better off bolstering the bond insurers rather than doling out tens of billions of dollars in a bank by bank rescue plan. Risk management consultant Leslie Rahl, president of consulting firm Capital Market Risk Advisors, says if the government recapitalized the bond insurers and allowed them to regain their Triple A credit ratings, it might provide the biggest bang for the buck. That's because it would enable a slew of banks that had purchased CDS, or bond insurance, to avoid taking future write-downs on the deterioration in the underlying insured assets. "On a pure dollar for dollar basis you may get more bang by propping up the monolines because you get a multiplier effect," says Rahl.

January 2009

The Federal Bailout Hasn't Fixed Bank of America
Bank of America’s Hasty Merrill Takeover Has Put its Future-and the Federal Bailout Program-in Question
By David Henry, Matthew Goldstein and Roben Farzad

Bank of America's (BAC) spectacular fall from grace has driven home two key points. First, even lenders that seem relatively safe from the credit storm can find ways to steer right into it, resulting in multibillion-dollar losses and brutal share sell-offs. Second, Washington's $138 billion rescue package of the Charlotte lender, cobbled together on the fly, is failing.

As the Obama Administration moves to change strategy to stabilize the banks, it will have to think bigger. The bailout, as it's currently structured, has amounted to little more than a temporary tonic to help BofA digest its controversial acquisition of brokerage giant Merrill Lynch. "It's a Band-Aid," Leslie Rahl, president of consulting firm Capital Market Risk Advisors, says of the government's remedy for ailing banks. "It's a camouflage, as opposed to a real solution."

January 2009

Risk Management Factors into Pricing, Long-Term Strategies
By Michael Murray

Life insurance companies in the United States will face significant challenges this year with increasing emphasis on risk management across their industry.

"Risk management has become a top priority for all financial firms in the wake of the meltdown experienced in 2008," said Leslie Rahl, president of Capital Market Risk Advisors, New York. "Declining asset values, increased volatility and decreased or non-existent liquidity have adversely affected insurance companies, pension plans, endowments and foundations, as well as banks, investment banks and hedge funds."

January 2009