Measuring and Managing Risk in Innovative Financial Products – A CommentDavid 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 InstrumentsStatistical Entropy
Innovation, Complexity and Dark Risk
Self-Referential Feedback Compounds Dark Risk
Alternate Means of Valuation
1. Statistical EntropyLike water, information cannot rise higher than its source.
InformaitonInformationData1. Statistical Entropy
Mortgage Default ExperienceSOURCE: Mortgage Bankers Association - National Delinquency Survey
Hypothetical Detachment PointLog-Normal Distribution: Mean = 5.97; StDev = 2.16
Hypothetical Detachment Point.01% = AAA
Hypothetical Detachment Point.01% = AAALargest Sample Observation = 9.6%Behavior in the Tail is Based on What Distribution is Assumed
The Basis for DiversificationThrough mid-2006What unobserved contingency could upset this pattern?Idiosyncratic Causes for Default
Threats to DiversificationOne candidate was fairly obvious.Falling housing prices would hurt ALL borrowers
Defaults would no longer be statistically independent$$$$
Threats to Diversification12-month % change10 City Composite U.S. Home Price Index12-month % changeS&P/Case-Shiller Home Price IndicesStrongly Positive: 1995-2006Jan-95
Threats to Diversification10 City Composite U.S. Home Price Index12-month % changeS&P/Case-Shiller Home Price Indices12-month % changeNegative for 3-1/2 years in early 1990s
Threats to Diversification10 City Composite U.S. Home Price Index12-month % change
Monthly % Change (annual rate)Month-to-Month % ChangePeaked in September 2005 : Turned Negative in mid-2006S&P/Case-Shiller Home Price Indices
2. Structural ImaginationThe Lesson
1) Look for significant unrepresented variables.
2) Track these variables carefully as early warning indicators of emerging problems.
5. Alternate Means of ValuationOld Credit Risk Mantra
What is the second means of repayment?
Proposed Capital Markets Mantra
What is the second means of valuation?
4. Alternate Means of ValuationEase of Current ValuationLevel 1Observable prices in active markets Observable prices in inactive markets or observable inputs to accepted pricing modelsFew or no observable market prices and models requiring significant unobservable inputsLevel 2Level 3
4. Alternate Means of ValuationLevel 1Level 2Level 3Ease of Current ValuationIRSCDS (2006)Corporate CDOs (2006)Subprime CDOs (2006)Corporate CDOs (2008)Subprime CDOs (2008)CDS (2008)
A QuestionWas this crisis a Black Swan??
Elements of the Risk Puzzle (Original: May 2006)
Elements of the Risk Puzzle (Rev: October 2008)Commodity PricesEffective Portfolio Mgt.