davenerven

Comparing This Past Week to the '87 Crash

So hedge funds had to cough up $400+ billion to pay for their Lehman's CDS positions. The market was very very nervous of more defaults before the settlement last Friday, but it looks like it's all been settled in a fairly orderly manner. Now one side is down $400+ billion and the other side is long $400+ billion. My guess is that the side that's now long $400+ billion is going to use their new cash to squeeze the heck out of the market shorts and make more money. What can be a better time to do this than now? So, perhaps, just perhaps, we can expect the rally of a lifetime soon as the shorts run for cover from a tsunami of buying. But, I might be completely wrong. Still, it is a scenario that makes sense. The world governments have done more than enough to unlock credit but I think credit was tight because of concerns over the Lehman CDS settlements. Now that is out of the way, anything can happen, which means that everything will probably happen all at once.

Counterparty Risk Management: How Could So Many Be So Wrong for So Long?

The nature of risk management has been simplified over the years as more and more people and consultancies flood into this field and attempt to create methods which dumb down this important area. Basically, for most "risk managers", risk is segregated into credit risk, where ratings are all important, and market risk, which measures the sensitivities of a trade or portfolio. Since many of the MBS are new products in 2005-2007, they relied simply on historical default rates for pricing (and introduced a high incidence of error as historical data would have been scarce). They then used ratings insurance to qualify these products as AAA. Banks then bought paper based on these AAA ratings without questioning their underlying viability to pay back principal or even interest. This is odd as normally a structured swap would be investigated carefully before issuance but for whatever reason, for MBS, people are happy to buy other issuers' paper based purely on nothing more than the rating, a free lunch and a pat on the back.

I have always taken a holistic view on risk, and for my bank, I have always advised against taking on these products, as the SUM of the risks (if calculated correctly) causes risk profile to rise exponentially to a point where the paper becomes too expensive to buy. Eg. mortgage default risk, issuer risk, guarantor risk, interest rate risk, economic risk, trend risk. People forgot about all that and just bought AAA paper because they did not do (or want to do) their homework. Or maybe their risk management team did not consider all the factors that go into a proper Monte-Carlo simulation for such products. Why was this not done? That will always puzzle me.

In short, despite what many people think, risk is not a business area that can be easily standardised, and in my experience, there are far too many "risk" people around who do not understand how to apply the basic management rules for risk, especially for new structured products.