Building Confidence Post-Crisis: Challenges and Solutions for Implementing a Risk Framework

Chad Burhance, Managing DirectorGlobal Risk Services

State Street Investment Analytics

September 2009

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Goals of Presentation

> Review contributing factors to recent financial crisis

> Communicate emerging view that there was insufficient risk management practices across the investment process

> Evaluate challenges that current risk management practices have in accurately detecting the many facets of risk

> Explore potential new methods and techniques to address risk management challenges

> Encourage how to better incorporate these practices into an overreaching risk management framework and culture

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Post Crisis ReviewRearview Mirror of Causes

> Some things are debatable

− No single cause led to the global financial crisis

− Issues were myriad− Overabundance of credit/leverage

− Lack of regulatory oversight

− Overreliance on financial modelsvs. common sense and due diligence

− Overaggressive appetite for risk

− Concentration risk: too many assetsin to few players

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Post Crisis ReviewRearview Mirror of Causes

> Others are not debatable

− Inadequate investment in risk management infrastructure− Need strong tools and expertise to properly analyze increasing

investment complexity

− Misalignment of risk management within the investment process− There is no return without risk

− But there is risk without return

− Not enough transparency− Into what is owned, how it is structured and its economic behavior

− Overreliance on risk and asset allocation models with flawed assumptions

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Post Crisis ReviewRearview Mirror of Causes

Why Toxic Assets Are So Hard to Clean Up

“Securitization was maddeningly complex. Mandated transparency is the only solution.”“Each time these tranches were mixed together with other tranches in a new pool, the securities became more complex. Assume a hypothetical CDO2 held 100 CLOs, each holding 250 corporate loans -- then we would need information on 25,000 underlying loans to determine the value of the security. But assume the CDO2 held 100 CDOs each holding 100 RMBS comprising a mere 2,000 mortgages -- the number now rises to 20 million!” - Wall Street Journal, 21 July 2009

Some Funds Stop Grading on Curve

“Recent history would suggest such meltdowns aren't so rare…Investors using standard asset-allocation approaches have been hammered. Last year, all their supposedly diversified investments

plummeted in unison. In short, the underlying assumptions failed.”-FiLife, a Wall Street Journal Partner, 8 September 2009

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test

“In a 2006 SEC filing, AIG said none of the swap deals now causing it pain had ever experienced high enough defaults to consider the likelihood of making a payout more than ‘remote, even in severe recessionary market scenarios’.” - Wall Street Journal, 31 October 2008

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Coming out of the CrisisBuilding Confidence: Broad Themes to Protect Portfolios

> Qualitative

− Increased transparency

− Increased due-diligence

− Risk as part of the investment process –A framework is needed to

− Mitigate risk

− Manage risk

− Make better portfolio decisions

− Solve business problems

> Quantitative

− Independent valuation

− Calculation of “risk drivers”

− Understanding of interdependencies within the portfolio

− Undiversified measures

− Correlation dependencies

− Identification of the worst cases scenarios

Fund Allocation PCTRETL100 PCTR

Standard Deviation

VaR ETL ETL100Beta To Portfolio

Incr ETLDivers Ratio

Total 100 3.77 3.40 7.47 9.20 1.00 1.23

Fund 1 35.2 26.1 22.4 3.89 3.25 5.86 0.74 (2.28)

Fund 2 12.2 2.0 2.5 1.52 0.87 1.90 0.17 (0.95)

Fund 3 26.8 24.7 34.8 4.71 5.18 11.92 0.92 0.63

Fund 4 25.7 47.2 40.3 8.01 5.26 14.38 1.83 1.37

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Building Confidence in the Investment Process

> Improving transparency across the investment spectrum

− What do we own?− What is it?

− How does it pay out?

− What is worth?− Hard to price / illiquid?

− Hard to model?

− What is its risk?− What drives its risk characteristics?

− What could hurt this position?

− Who are WE doing business with?

− Who are THEY doing business?

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Risk Information Flows

> Good decisions stand on many shoulders

Methodology Measurement Monitoring

ComputationsPricing theoryStatistics

Stress TestsExposuresVaR

ComplianceRisk LimitsPolicy

Management

AllocationRebalancingHedging

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Portfolios Are Complex and Multi-Faceted

> Risk is multi-dimensional

> There is no single risk measure

> Multiple views of risk must be understood− Market

− Interest rate

− Currency

− Counterparty

− Liquidity

− Credit

"We got blindsided by some developments that weren't accounted for by the models we were using…”

- A well know pension manager. Source: WSJ 9/10/2009

Strategy AllocationStandard Deviation

VaR ETL ETL 100

Total 100.0 3.77 3.40 7.47 9.20

Equity Hedge 35.2 3.89 3.25 5.86

Fixed Income Arb

12.2 1.52 0.87 1.90

Event Driven 26.8 4.71 5.18 11.92

Emerging Markets

25.7 8.01 5.26 14.38

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Lessons LearnedRisk Measurement Is Not Just about Value-at-Risk (VaR)

> Lessons from 2008 panic

− VaR is a tool, not a panacea− Normal vs. extreme tails — confidence intervals− Short- vs. long-term volatility

− Stress tests as valuable tool− Diversification can fail− Unlikely, but possible, scenarios should be

tested− Important to plan for recovery events in addition

to downside events

− Liability-centric measurement of risk− Balance needs to exceed hurdle rates vs. risk

in a low interest rate environment− Asset / liability matching: Surplus at risk

> Stress testing

− Event explanation?

− Risk mitigation?

− Likely vs. unlikely events?

− Market factors as well as economic factors?

− Opportunity identification?

− Single factor vs. multifactor?

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Lessons Learned from the CrisisBack Testing

> Back testing should not only be a post-crisis task

− Helps ensure risk projections and modeling are consistent with the risk experienced

− Is the test calibrated correctly?

− Are there assumptions that could improve the results and predictive capability?

− Is it being budgeted appropriately?

− If and where did it breakdown?

− Provides a self assessment

− How are we doing?

− Passing or failing grade?

Historical VaR Projection vs. Realized ReturnsSeptember 2008

VaR AverageProjection

HorizonPortfolioReturns-

Based RVaR

MSCI World RVaR

-3.25% 12 Months -5.54% -9.08%

  24 Months -4.10% -2.38%

  36 Months -3.96% -2.29%

  48 Months -3.45% -2.36%

  60 Months -2.66% -3.26%

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What is the Size of the Risk?• Price it and determine Risk

characteristics– React to changes in underlying– Sensitivity to different factors

• Does not tell me interrelationships with rest of portfolio

– StDev, TE, Delta, Stand Alone VaR

Understanding the Risk Quadrants

Where are the Risks?

> Concentrations and Exposures− What’s in my portfolio?

− What do I own in both public and private markets?

− Direct and commingled with others.

− Incomplete picture without entire portfolio.

> Does not tell me size or sensitivity.− Market Value-%, NPV

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What’s the Quality of Risk?• Upside vs. Downside

– Diversification vs. Contribution– VaR / ETL / CVaR

• Relies on correlations.• VaR, ETL, Downside TE• Does not tell me impact of

changes in correlation?

What is the Extreme Risk?• Undiversified Risk?

– What happens when correlations fail?– What is the Perfect Storm?

• Disaster scenario– Stress Tests Historical and Predictive– VaR100 / ETL 100

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Risk FrameworkImplementation Considerations

> Four basic elements− People

− Process

− Technology

− Governance

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Risk FrameworkImplementation Considerations

> Data is the primary focus: Without the accurate, reliable data, no process can be successful

TechnologySupports the Entire Process

Thank You