November 17, 2009Scott Lane

A Risk Management Paradigm

Risk Management Paradigm

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My Background

• Graduated from UWEC with Accounting major, 1995

• Public accounting after graduation, mostly with KPMG

CPA (currently inactive)

Two years consulting Credit Suisse on US GAAP in Zurich, Switzerland

• GMAC-RFC, subprime mortgage banking & securitization

Corporate Accounting Director, then VP Risk Management

Implemented Sarbanes-Oxley 404 in 2004, reinvented the wheel

MBA from Duke University while at GMAC

• TPG Credit, hedge fund manager in Minneapolis

Controller there since early 2006, built people, processes, systems, from ground up

Endured 2008 financial melt down

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Agenda

I. Overview of Risk Management Paradigm

II. Financial Crisis:

− What Happened?

− Risk Managers Contribution to the Problem?

− What can be done?

III. Careers in Risk Management

IV. Further Reading

V. Summary and Recap

VI. Questions

Focus is on Financial Service Organizations (i.e., banks, hedge funds)

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I. Overview

Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events. 1

Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary..

1 Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It" pg. 46, John Wiley & Sons, 2009

General Definition

What is Risk Management?

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I. Overview

What is Risk Management?

Risk management is the identification of events that could result in unwanted negative consequences or economic losses and then taking steps to mitigate or manage those events.

Ultimately risk management is planning for the unlikely event that could cause harm.

My Definition

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I. Overview (continued)

Risk of loss from the value change of an

asset or liability

Risk Management for Financial Services

Market Risk

Risk of loss from a borrower or counter-

party not meeting obligations

Credit Risk

Risk of loss from a failure of people,

processes, or systems /

infrastructure

Operations Risk

What is Risk Management?

Often measured via Monte Carlo

simulations (Value at Risk) using historical

data

Involves forecasting defaults and severities

using historical data

Primarily qualitative at this point, use tools such as “heat maps”

etc.

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I. Overview (continued)

Flood Example:Flood Example:

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I. Overview (continued)

Bank Loss Reserve Example (same concept as the flood):Bank Loss Reserve Example (same concept as the flood):Known as a Known as a ““tail tail eventevent”” or or ““black black

swanswan””

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I. Overview (continued)

More Examples:More Examples:• GPA Risk Management

− When you take a couple difficult classes in a semester, do you look for some easier classes to offset?

− If so then you are actively managing your GPA risk

− You might be able to manage all hard classes but why take that risk?

• Career Risk Management

− Did you join SAS just to make or friends or were you looking to build your resume and network with employers?

• Event Risk Management

− If you needed to be in Minneapolis tomorrow at 10 AM for an important interview, what time would you leave?

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II. Financial CrisisUS Housing Prices on the Eve of the Financial Crisis, Everyone US Housing Prices on the Eve of the Financial Crisis, Everyone

Assumed Values Would Always RiseAssumed Values Would Always Rise

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II. Financial Crisis (continued)

• After September 11, 2001 and during the subsequent recession the US adopted a loose monetary policy (keep America rolling, go out and shop)

Credit became cheap, underwriting standards were loosened, consumers treated their houses as ATM’s and borrowed against the increase values, thus increasing consumer spending

Consumer spending is roughly 70% of US GDP

• Complex investments / products were developed and sold to investors that were based on housing and consumer credit

Securitization led to wide dispersion of credit risk, the use of credit default swaps and derivatives exploded, adding further dispersion of risk

These products were highly complex

The Credit Crisis: What Happened?The Credit Crisis: What Happened?

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II. Financial Crisis (continued)

• Memories were short: things were too good for too long

• Ultimately there was too much leverage in the financial system / economy as credit risk was drastically undervalued

The Credit Crisis: What Happened?The Credit Crisis: What Happened?

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II. Financial Crisis (continued)

• Risk Managers Relied too Heavily on Historical Data

US housing prices never decreased in the past, therefore it was assumed they would not in the future, this was a critical assumption that did not come true

• Hubris: Risk Managers Relied too Heavily on Quantitative Models

• Risk Managers Assumed Individual Risks were not Correlated

Correlation goes to 1 in a crisis

The Credit Crisis: How Did Risk The Credit Crisis: How Did Risk Managers Contribute to the Problem?Managers Contribute to the Problem?

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II. Financial Crisis (continued)

• Models Became Too Complex

Advancements in computing power resulted in incredibly complex models, too complex for most people to fully understand

• In short: What Was Deemed Statistically Remote Actually Happened and Nobody was Prepared for it

The Credit Crisis: How Did Risk The Credit Crisis: How Did Risk Managers Contribute to the Problem?Managers Contribute to the Problem?

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II. Financial Crisis (continued)

Bad Model Assumption: Housing Prices Did Actually Fall, by a lotBad Model Assumption: Housing Prices Did Actually Fall, by a lot!!

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II. Financial Crisis (continued)

• The good news: we now have a large tail event to include in our models (the current crisis)

• Ensure proper rewards and punishments, not just rewards – current bonus structure shares only upside

• Counter balance complexity with simplicity

“Derivatives are financial weapons of mass destruction” Warren Buffet

• Consider model assumptions and output in the context of what makes sense, including qualitative considerations

• Push for counter-cyclical loss reserving

The Credit Crisis: What Can Risk The Credit Crisis: What Can Risk Managers do Now?Managers do Now?

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Underwriting / Investing

Risk ManagementTreasury

Auditing / Internal or

Public

III. Careers

Corporate Functions / Roles“Everyone is a risk manager”

Controller / Accounting

Operations Risk Market & Credit Risk

Undergraduate Course Work: Statistics, Economics, Finance,

Accounting Degree a Good Start

Graduate School, MBA, Statistics, etc.

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IV. Further Reading

When Genius Failed: The Rise and Fall of Long-Term Capital Management, Roger Lowenstein

The Black Swan, Nicholas Taleb

House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, William Cohan

The Economist, best weekly or daily periodical available

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V. Summary and Recap

• Risk management is about preparing for unlikely events

• Reliance on historical data and quantitative models, coupled with hubris and bad assumptions, greatly contributed to the current financial crisis

• Common sense and qualitative considerations should always be layered on top of any model

• Overly complex models can make the situation worse

• Everyone is a risk manager at some level

• There is plenty of good reading out there on risk management, both case studies and technical analysis and theories

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VI. Questions