How Good are RiskMetrics' Tools?

Sep.25.08 | About: RiskMetrics (RMG)

Since I wrote about Glass-Steagall, CDSs [Credit Default Swaps], Blythe Masters and the Gramm-Leach-Bliley act in an older article, I had to reply to several private e-mails on how stupid the pricing of CDSs were. Now, most CDSs are priced and transacted in an unregulated environment. In fact, most of the larger investment banks used RiskMetrics' (RMG) tools.

Most educated investors know about the details of the Paramax/UBS lawsuit - where UBS (NYSE:UBS) “insured” $1.3 billion in sub-prime loans for a premium of 0.155% per year. That is a premium of $1.55 million a year for a notional value of $1.3 billion. In fact, the numbers are in-line with actuarial numbers for insuring a house against the possibility of destruction from earthquake - but that has a 15% deductible. In the world of CDS’s, there are no deductibles. The insurer pays for all losses - including those from “markdowns”.

What bothers me here is whether Paramax used RMG’s software to figure out the premium associated with this CDS. If they did - how good is/are RiskMetrics’ tool[s]?  What if we regulated CDSs as insurance products [I am sure that the insurance commissioners will be clueless - compared to the Blythe Masters' of the world]?

Let’s play the devil’s advocate here.  Assuming that RMG’s models [till now] were excellent:

  1. CDS pricing would have been perfect.  All of the “insurers” would have collected in premium - the present value of all possible payoffs multiplied by the probability of default at each time-point in the future.
  2. If the above statement was true, then, all CDS insurers using RMG’s models would have collected “proper premiums” - that would have reflected the correct amount of risk taken on by the insurer.

Obviously, this wasn’t true in round #1. JPMorgan (NYSE:JPM)| used RMG’s tools, and they sure did lose a lot of money [though they did not lose as much as Bear (NYSE:BSC) or Lehman (LEH)]. RMG sure isn’t claiming that their software is adaptive [read - with the ability to guess correctly after the fact]. From the outside - looking in,

  1. RMG’s software to predict CDS premiums wasn’t good the first time around.
  2. RMG is not the only game in town as most companies have internal software pricing tools that are similar to RMG’s.  But I am confident that Goldman Sachs’ tools were better than the others’.
  3. RMG is a new issue [less than a year listed]. While they do not have a track record of earnings, they sure do have excellent revenue growth and gross margins for what I could read filed at the SEC.

Bottom-line:  This is an issue that is worth keeping on one’s watch list.  With all the bad press regarding CDSs, I’m sure that RMG does not have an easy road ahead, but they are backed by some of the biggest names in the derivatives business, and they are relatively unknown [till now].

Disclosures: No positions in RMG or any banks for that matter.