measuring and managing risk in innovative financial products – a comment
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Measuring and Managing Risk in Innovative Financial Products – A Comment. David M. Rowe, Ph.D. EVP for Risk Management – SunGard Federal Reserve Bank of Atlanta - Financial Markets Conference Jekyll Island, Georgia May 12, 2009. Lessons for Risk Management of Complex Financial Instruments. - PowerPoint PPT PresentationTRANSCRIPT
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Measuring and Managing Risk in Innovative Financial Products – A Comment
David M. Rowe, Ph.D.
EVP for Risk Management – SunGard
Federal Reserve Bank of Atlanta - Financial Markets Conference
Jekyll Island, Georgia
May 12, 2009
Lessons for Risk Management of Complex Financial Instruments
1. Statistical Entropy
2. Structural Imagination
3. Innovation, Complexity and Dark Risk
4. Self-Referential Feedback Compounds Dark Risk
5. Alternate Means of Valuation
1. Statistical Entropy
Like water, information cannot rise higher than its source.
Data
Information
Info
r m ai
ton
Information
Data
o Info
r m ai
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n
This is extraction of information,
NOT creation of information
1. Statistical Entropy
Mortgage Default Experience
SOURCE: Mortgage Bankers Association - National Delinquency Survey
Hypothetical Detachment Point
Hypothetical Subprime Default Probability Density
-
0.0500
0.1000
0.1500
0.2000
0.2500
0 5 10 15 20 25
Defaults (%)
Pro
bab
ilit
y D
ensi
ty
Log-Normal Distribution: Mean = 5.97; StDev = 2.16
Hypothetical Detachment Point
Hypothetical Subprime Default Probability Density
-
0.0500
0.1000
0.1500
0.2000
0.2500
0 5 10 15 20 25
Defaults (%)
Pro
bab
ilit
y D
ensi
ty
.01% = AAA
Hypothetical Detachment Point
Hypothetical Subprime Default Probability Density
-
0.0500
0.1000
0.1500
0.2000
0.2500
0 5 10 15 20 25
Defaults (%)
Pro
bab
ilit
y D
ensi
ty
.01% = AAA
Largest Sample Observation = 9.6%
Behavior in the Tail is Based on What Distribution is Assumed
The Basis for Diversification
Through mid-2006
What unobserved contingency could upset this pattern?
Idiosyncratic Causes for Default
Threats to Diversification
One candidate was fairly obvious.
Falling housing prices would hurt ALL borrowers
Defaults would no longer be statistically independent
$ $ $ $
Threats to Diversification
12-month % change
10 City Composite U.S. Home Price Index
12
-mo
nth
% c
ha
ng
e
S&P/Case-Shiller Home Price Indices
Strongly Positive: 1995-2006
Jan-
95
Threats to Diversification
10 City Composite U.S. Home Price Index
Aug 1990
Mar 1994
12
-mo
nth
% c
ha
ng
e
S&P/Case-Shiller Home Price Indices
12-month % change
Negative for 3-1/2 years in early 1990s
Threats to Diversification
10 City Composite U.S. Home Price Index
12
-mo
nth
% c
ha
ng
eM
on
thly
% C
ha
ng
e (
an
nu
al
rate
)
September 2005
Month-to-Month % ChangePeaked in September 2005 : Turned Negative in mid-2006
Aug 1990
Mar 1994
S&P/Case-Shiller Home Price Indices
2. Structural Imagination
The Lesson
1) Look for significant unrepresented variables.
2) Track these variables carefully as early warning indicators of emerging problems.
3. Innovation, Complexity and Dark Risk
+
Complexity
0
0.05
0.1
0.15
0.2
0.25
0.3
0 5 10 15
Defaults (%)
Pro
bab
ilit
y D
ensi
ty
Limited Data
Dark Risk
4. Beware Self-Referential Feedback
Achieving Greater Volume Required
Relaxing Underwriting Standards
Risk Estimates Based on
Historical Data Become
Progressively Less Reliable
Further
Innovations (e.g. Compound
Repackaging, CDO2 ) Increased
Complexity
DARKRISK
A Unique Innovation Generated Attractive
Returns
Growth in Volume
5. Alternate Means of Valuation
Old Credit Risk Mantra What is the second means of repayment?
Proposed Capital Markets MantraWhat is the second means of valuation?
4. Alternate Means of Valuation
Subprime CDOs (2006)
Corporate CDOs (2006)
CDS
IRS
Ease of Current Valuation
Level 1 Observable prices in active markets
Observable prices in inactive markets or observable inputs to accepted pricing models
Few or no observable market prices and models requiring significant unobservable inputs
Level 2
Level 3
4. Alternate Means of Valuation
Level 1
Level 2
Level 3
Ease of Current
Valuation
Effectiveness of Alternate Means of Valuation Level 2 Level 3
IRS
CDS (2006)
Corporate CDOs (2006)
Subprime CDOs (2006)
Level ?
Level ?
Corporate CDOs (2008)
Subprime CDOs (2008)
CDS (2008)
A Question
Was this crisis a Black Swan?
?
Product Complexity
Pace of Innovation
Volume GrowthCommodity
Prices
Geopolitical Risk
Information Security
Extreme Events
Model RiskLiquidity
Technological Change
Emerging Markets Operational Risk
Regulatory Uncertainty
Effective Portfolio Mgt.
External Linkages
???? Unknown Unknowns ????Miscellaneous
Elements of the Risk Puzzle (Original: May 2006)
Product Complexity
Pace of Innovation
Volume GrowthCommodity
Prices
Geopolitical Risk
Information Security
Extreme Events
Model RiskLiquidity
Technological Change
Emerging Markets Operational Risk
Regulatory Uncertainty
Effective Portfolio Mgt.
External Linkages
???? Unknown Unknowns ????Miscellaneous
Elements of the Risk Puzzle (Rev: October 2008)
Pace of Innovation
Product Complexity
Model Risk
Volume Growth
External Linkages
Liquidity
Commodity Prices
Effective Portfolio Mgt.