Risk Management and Diagnosis

CMRA is widely recognized for its expertise in all areas of risk management. We believe in a very broad and holistic approach to risk management (see our Galaxy of Risks). We also recognize that only about 1/3rd of the components of a robust risk management (see risk puzzle) program are quantitative and work with our clients on both quantitative and qualitative components of risk management.

We provide services in all areas of risk (market, credit, counterparty, operational, legal and reputational) as well as in enterprise risk management. Our experience with clients on both the buy side and the sell side provide us with a unique perspective which we harness is approaching risk. Our leadership role is establishing "best practice" allows us to provide expert advice to a wide range of clients.

For further information on related services: Valuation, Risk Governance, Structured Finance/ABS/MBS and Best Practice.

Selected Risk Management Assignments

• Performed comprehensive risk assessment and reviewed risk management policies and practices for a variety of pension funds, endowments and foundations
• Performed due diligence reviews and "risk diagnosis" on hedge funds, fund of funds and traditional asset managers on behalf of institutional investors
• Created a charter and organizational blueprint for the risk oversight function of a large commercial bank
• Reviewed and benchmarked the risk management practices of funds of funds, hedge funds and mutual funds
• Analyzed CDO's of a large investment manager and recommended structuring and risk management enhancements
• Reviewed the CLO valuation and risk management approach of a major broker/dealer
• Evaluated the VAR implementation and risk management framework of one of the largest non-US plan sponsors and reported funding to the Board of Directors
• Evaluated market, credit, operational and liquidity risk management policies, practices and approach for several banks including an emerging market bank
• Evaluated risk measurement, limits, policies and procedures and reporting processes or several large banks
• Engaged by a Japanese think tank to provide in depth research on risk management practices of major banks and investment banks
• Evaluated risk management practices of sizeable Korean broker/dealer
• Advised a major asset manager in the selection of MBS/CMO pricing and risk management systems
• Assisted the Board of a major international bank in formulating and establishing a formal "Risk Appetite Statement"
• Assisted large money manager in selecting a risk system
• Designed and helped implement a VAR process for a leading hedge fund

Selected CMRA in the Press re: Risk Management

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)

The Blow-Up
This summer, as a meltdown in the subprime credit market spilled over into other markets, all eyes were on the mathematically trained financial engineers known as "quants." Who are these guys?
By Bryant Urstadt

On Wednesday, August 8, not long after the markets closed, 200 of the smartest people on Wall Street gathered in a conference room at Four World Financial Center, the 34-story headquarters of Merrill Lynch. They were "quants", and they had a lot to talk about, for their work was at the heart of one of the most worrisome summer markets in decades.

The conference sponsored by the International Association of Financial Engineers (IAFE), and its title asked, "is Subprime the Canary in the Mine? "Subprime" borrowers are home buyers whose poor credit history means they don't qualify for market interest rates.

The panel was moderated by Leslie Rahl an MIT graduate and the founder of Capital Market Risk Advisors. Her job is to advise companies on risk and help them understand the products quants invent. But understanding was in short supply in August. Some of the quants' financial products had collapsed in price, with unexpected consequences in another financial sector: the trading of equities.

And was subprime the canary in the mine? Leslie Rahl, for instance, cautiously told me in a follow-up e-mail that it is "looking more and more like the answer is yes." Many signs have suggested so, from job losses to a continuing credit drought to a weakening dollar, but that history has not yet been written.

As a prelude to the panel discussion, Rahl, asked the audience to predict whether credit spreads would shrink or widen in the coming months. She was talking about the difference between the price of a treasury bond and the price of a riskier corporate bond, a standard Wall Street gauge for the health of the economy. A widening credit spread is generally seen as a sign of uncertainty, and a narrow spread as a sign of optimism.

"How many think spreads will widen?" she asked. The hands of about half of the smartest people on Wall Street shot up. "And how many think they'll narrow?" The other half—equally smart—raised their hands. "Well," she said. "That's what makes a market." If they didn't know, nobody could.
(November/December 2007)

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)

Market volatility puts risk at forefront
By Jay Cooper

"In general, liquidity doesn't enter into the metrics used by pension funds," said Leslie Rahl, president of Capital Market Risk Advisors, a New York-based financial advisory firm specializing in risk management.

"In times like these, non-quantitative measures need to supplement normal risk reporting. The best defense is asset allocation, manager selection and effective risk due diligence," she added.

As part of their due diligence process, pension fund officials should also be asking managers how they value instruments like CDOs that do not trade on a liquid market, Ms. Rahl said. She said pension executives should be wary of managers who allow the trader to value those securities themselves.
(August 20, 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)

Levered Bear Funds: A Peek into the Black Box
By Chidem Kurdas

"People forget that even when there's careful mark-to-market pricing, portfolio valuation does not necessarily reflect the actual price you'll get at execution," said Leslie Rahl, president of Capital Market Risk Advisors in New York. "There can be a huge difference between honest mark-to-market price and execution price."
(June 26, 2007)

Corporate Governance
The Great American Corporate Director Hunt
By Susanne McGee

It's never been more vital - or harder - to attract qualified independent directors. Who needs the hassle? Yet good corporate governance depends on how companies cope with today's director shortage.

For more than two decades, Leslie Rahl had made her living analyzing risks, but she never come across one quite like this: In December 2003, Fannie Mae approached her about taking a seat on its board of directors

Rahl was honored, and in many ways she was the perfect candidate for the now-troubled mortgage lender. A star options trader for Citibank in the 1980s, she had opened her own consulting shop, Capital Market Risk Advisors, in 1994 and was soon counseling Orange County, California, on how to handle $2 billion in derivative market player, needed a financial expert on the board to replace former Goldman, Sachs & Co. chairman Stephen Friedman, who was leaving to join George W. Bush's administration as director of the National Economic Council.

But Rahl was also a little worried. She had never been a public-company director before, and the previous few years of corporate scandals and strict new regulations had refined then nature of board service, turning what had often been a cushy networking opportunity into a high-risk endeavor. Congress's quick response to frauds at companies like Enron Corp. and WorldCom – the Sarbanes-Oxley Act of 2002 – had heaped unprecedented legal and financial responsibilities on board members. Regulators, activist shareholders and trial lawyers increasingly were targeting directors for failing to question or prevent corporate misdeeds. Complicating things further for Rahl, federal regulations had just announced and examination of Fannie Mae's accounting practices following the company's disclosure of a $1.1 billion error in its third-quarter earnings statement.

So rather than accept the position right way, the risk expert embarked on several weeks of painstaking due diligence. She spoke with other Fannie Mae directors, scrutinized the company's financial statements going back several years and even asked her husband, a bankruptcy lawyer, to vet the offer from a professional perspective. After two months of checking out the company, she agreed to join its board. (Since then the accounting probe had prompted a huge earnings restatement and the resignations of Fannie's CEO and CFO.)
(April 2005)

Risk Management Surveys

• Hedge Fund Risk Transparency Survey (06/02)
• AIMA/CMRA Hedge Fund Risk Management Survey (04/02)
• Risk Management Practices & Needs of CBO and CLO Investors (04/00)
• Russian/LTCM Crisis Survey - One Year Later (10/99)
• Risk Management During Market Turmoil (9/98)

Recent and Upcoming Speeches re: Risk Management

June 2008

Selected Articles re: Risk Management

• The biggest "CIO" (Complex, Illiquid, Opaque) Risk: "Alpha" Risk Management AIMA Journal, January 2008
• Risk Management An Evolution Forum "Gut to Quant to Wisdom" - AIMA Journal-Sept. 2005
• A New Approach to Risk-Adjusted Asset Allocation for Hedge Fund Investing - AIMA Journal-Sept. 2003
• Managing the Risks of Alternative Investment Strategies Chapter 8 - Due Diligence - Euromoney Books-Fall 2003
• Hedge Funds: A Definitive Overview of Strategies and Techniques Chapter 9 - Risk Management - John Wiley & Sons-Aug. 2003
• Hedge Fund Transparency-Unravelling the Complex and Controversial Debate - Risk Books-March 2003
• Risk Management for Hedge Funds and Fund of Funds – ICMA-Jan. 2003
• Hedge Fund Risk Transparency - AIMA Newsletter-Feb. 2002
• Performance Measurement & Attribution - Investment/Financial Services Review-Feb. 2002
• Chapter 17 - Risk Management: Where are we heading? Where have we been? - Kluwer Academic Publishers, Eds Stephen Figlewski & Richard M. Levich-2002
• Survival After The Blaze - AIMA Newsletter-April 2001
• What is Risk?
• How to Select a Buy-Side Risk Management System
• Ten Commandments of Risk Management
• Measuring Financial Risk in the 21st Century