Geoff Considine

Risk Management Lessons from Bear Stearns

To Eric and User (above):

You are both correct that high volatility and higher default risk go hand in hand. This is actually a fact that makes portfolio theory look even more effective. default risk is the extreme tail risk in a fairly efficient market. These banks are high vol and therefore have higher tail risk. These are high risk / high return assets. I am working on a paper that looks at a wide range of financials and a significant fraction are very risky--but the spread is amazing. Some are reasonable and some are downright scary.

I am going to continue to study this theme and write more, so suggestions for stocks to examine are useful.

As far as 'false positives' this is always an interesting issue and it relates to QPP and Moody's KMV and CDS's. Because default and extreme distress is rare, you have limited cases to really validate against. People use case studies as I have done here--and Altman does in his work. It is often called stress testing.

Geoff

Risk Management Lessons from Bear Stearns

to comments above:

I did not profile BSC in my earlier piece because it was not something I was looking at. Many of the large financials are showing higher risk than I want. It is hard to screen the entire universe--your point is correct--but it is fairly easy to screen the companies you are considering buying or own.

A lot of my point here was the following. CDS (credit default swaps) are priced in large part by implied volatility, and QPP outlooks for volatility track implied vol quite well--hence the agreement (on average)--this is well documented in quant circles. The market data contains 'priced in' default risk--which is why CDS prices track implied vol. Many professional firms track these stats and use these models--but retail investors and wealth managers tend to be unaware of these tools / metrics / stats.

The BSC debauchle has brought this issue to the fore and it emphasizes the importance of risk management--as Enron and Worldcom did before.