Model Risk and upfront greed

The recent discussions around black swans and hand-wringing around Type 3 risks seems to misplace the observation that models on their own do not lose money, only people's application manage to do that. The classic example is losses deriving from synthetic tranches referencing sub-prime credits where people were booking deals using models that were a shoe-in from the corporate Gaussian model - or in many cases booked as single name CDS - losses attributed in this activity can hardly be blamed on the model only that the traders used and their support staff allowed an inappropriate use.

Models are by definition a simplification of the real world, the choice of model is a trade-off between sophistication and computational speed. Its key role is to value something that is bespoke based on what is available in the open traded market - so that the bespoke premium can be extracted and the risk can be hedged using the same tradeable instruments.

All well and good. The key trick is actually in the risk aggregation process. For example we hedge a variance contract on the SP500 using a portfolio of traded options across many maturities and strikes. The residual risk should therefore be low and hence so should the daily PL volatility so long as the forward variance of the contract is derived from the volatility surface backed out from the listed options. In this example it is standard practice to aggregate the vega exposure of both the contract and the options and declare that for changes in implied volatility the resulting portfolio has low exposure. Since volatility is an input to VaR calculations, the resulting capital charge is also small. The question for a risk manager is whether they can allow the trader to continue building up a variance-option basis - how much vega basis is simply too much and why and should other measures such as stress testing be changed to capture the split between the options and the variance during market disruptions. The difficulty for a risk manager is that they need to be in the detail to spot the behaviour pattern and raise the issue.

Coming back to model risk - both the variance contract and options are based on Black-Scholes where the distribution of market moves has been modified via the spot and forward volatility curves. The inadequacies of the model - in particular to undervalue extreme market events is well understood by the trading community and their behaviour at a micro level adjusts accordingly.

The problem for banks is when as in the structured credit world, the trading community do not fully understand the model issues and have yet to alter their behaviour. This is the result of rapid expansion where all the trading desks are grappling with are trade capture and operational integrity rather than risk management. The movements in credit and their traded tranches should now force them to reasses their risk.

The problem therefore is how the bank allows large build up of basis risk between one strategy that clients are fond of (IR turbos, long equity correlation, long mezz credit, short variance) and the available hedges. Aggregation on which limits are set allows perfect netting that in some circumstances is optimistic at best. It is always important to question excessive margins on transactions and get the finance people to hold some of the money back as adjustments.

At the end of the day, models never capture the greed to book all margins upfront.

Wrong Financial Incentives

The recent market turbulence is not unlike the bursting of the dotcom bubble a few years back in the way that a collection of people (brokers, bankers, marketers, structurers, traders, asset manager) are given pressure to perform based on wrong financial incentives. For example a real estate broker is paid by volume of new deals he brings, not by the quality of the credit. A marketer also gets paid upfront in terms of fee income for a structured product whose risk remains on the trading books for many years.

A trader in a hedge fund can be paid based on excess returns on average volatility is pushed to sell deep OTM options (tinny puts) that provide some income most of the time and blow up once in a while. Even private equity groups can be paid based on their income on realised sells and not on a MTM-based return. Even prime brokerage houses with their crude haircutting are pushed to maximise fee income by maximising balance sheet. Some people knowingly enter risky transactions for free merely to create bragging rights in the plethora of league tables - how nuts is that!

All of these incentives force a group of individually smart people to go down a path or make collective decisions that is catastrophic for the shareholders in the company. The problem with the sub-prime disaster is that wrong financial incentives, loosely based on fees now and no questions asked about the collateral, is in place at each step of the origination and securitisation stage. The resulting collective behaviour is that nobody was paid to check the credit quality of the lender or the quality of the collateral - which looks like bank lending 101. In fact I would hazard a guess that if anyone did, they would be branded as someone who "just didn't get it".

The problem with financial incentives is that they are self-serving, if everyone is doing so well then why rock the boat? The reaction to radical changes in incentive schemes when things are going well is usually brutal with threats to take their business and clients elsewhere. So the only time you can effect change is at the beginning and after the proverbial has hit the fan, which then is of course too late!

Lending to external trading vehicles leaves you short liquidity

Lending to vehicles such as Hedge Funds, Special Purpose Vehicles is the same as renting your balance sheet for a fee, whilst retaining downside exposure when things go wrong. This sort of lending can be done in a number of ways - prime brokerage, repo agreements, backstop facilities. The difficulty with these type of relationships is that they do not price in the fact that when things go wrong, it is the lender that has to take whatever assets that have been bought and try to sell them in the open market. This is after the vehicle has lost all of its money and is effectively bankrupt.

The exposure therefore looks much more like having a long exposure to a super-senior piece of a CDO, where the vehicle takes the equity. In this arrangement, the hedger would look at the tranche delta and put on some hedges in the honest opinion that once the equity has been gobbled up, the exposure is all his.

In prime brokerage, the underlying assumption is that they will be able to get out of any risk before the equity is wiped out, thus allowing an orderly retreat. In other words the prime brokerage guy would never spend some of that fee income on a hedging strategy and therefore go through a surprise realisation that the assets are theirs during a period of market meltdown.

Both approaches - the CDO super-senior risk and the prime brokerage haircutting absolutely do not price in the risk of liquidity. At inception most people look at historical graphs and announce that the size of whatever trade can be supported during a timely retreat. This observation misses a couple of important points. 1) hedge funds are related since there are a small number of trades they can execute 2) historical analysis usually reflects the good times as everyone gets in on the trade (crowded) and thus has suppressed volatility 3) the point at which you have to force a liquidation in particular when it is deemed highly unlikely (AAA ABS assets as an example) then things are likely to be very bad for everyone.

The key exception is Amaranth that betted against the market. Unfortunately until 2007 this was the only large hedge fund collapse. Oh happy days.

So my conclusion is that when you lend to a trading operation, you are buying protection on the first loss piece of the assets in question. And that's it - no point in pretending these vehicles are anything other than two ex-traders and a bloomberg which no assets other than their upfront collateral.

Risk Pearls of Wisdom - Introduction

The purpose of this blog is to discuss big picture issues that surround issues that face senior managers and their risk departments within the financial industry. The goal is not to name and shame those houses that have done a poor job of risk managing i.e. have blown a whole in their capital base, rather to concentrate on whether there are lessons to be learnt.

Risk management of financial entities can involve high degree of derivative knowledge and detailed understanding of their models. I will try to steer away from that type of discussion, rather focus on the dynamics associated between those that are given free reign to take risk and their relationship with those that sponsor them - either directly through management or indirectly through access to liquidity or balance sheet.

The tone of the blog is always going to be slightly on the dark side, given we are focusing on post mortems of recent disasters , but will try to keep things upbeat. I will make sure the blog does not descend into an expose of financial excess, I will leave it to the Spectator to do that!

I look forward to anyone providing insights or experiences, I hope you keep to the spirit in which this blog is intended. I cannot accept any entry that names any financial institute that remains a going concern.