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— Judgment Call —
If the Hippocratic Oath equivalent of asset-liability management (ALM) is first to do no harm, why is it that so many financial organizations misunderstood elementary financial risk management principles that are at the heart of our current credit crisis? ALM is the practice of managing a business or portfolio so that the policies and actions with respect to financial assets and liabilities are coordinated. It is an essential ingredient in the governance of any financial organization. A key ALM principle is to continually assess the interplay of risk that naturally occurs between the value and maturities of assets and liabilities. In our opinion, the epicenter of today's problems in organizations with significant portfolio losses were caused by six interrelated ALM issues:
(1) inappropriately high leverage, including programs such as no- or low-money-down mortgages, enabling the mortgagee to have de minimus economic risk (i.e., "no skin in the game") or the owner of the securities to borrow heavily (i.e., collateralize) against the value of the mortgage-backed securities portfolio; (2) excessive continued exposure to the United States mortgage market; (3) imprudent financing of long-term assets via the use of short-term liabilities; (4) disproportionate counterparty exposure; (5) misunderstanding the difference between risk and uncertainty; and, (6) separation of the economic risk arising from owning the instruments versus the financial benefits accruing to the original issuers, packagers and promoters. In the early 1920s, Professor Frank H. Knight made famous the distinction between "risk" (statistical randomness with knowable probabilities) and "uncertainty" (statistical randomness with unknowable probabilities). What was viewed as risk (i.e., including default rates, correlation of values and interest rate spreads) turned out to be uncertainty, as the historical data relied upon was insufficient for assessing the integrity of mortgage-backed securities. Furthermore, the explosion of this asset class did not enable a sufficient vetting of the macroeconomic dynamics of the inter-connected counterparty relationships that resulted from the creation of structured securities and credit default swaps. Common to all financial institutions are the management of the type and level of risk that is appropriate for them to assume. A decision to take risk requires an effective policy to manage risk. The acceptance of risk by a financial institution requires policies to eliminate, transfer, reduce and retain financial risks. Yet in the context of our current credit crisis, the rise of financial risk management as a formal discipline appears to work better in theory than in practice. The failure of effective risk management policies in Long Term Capital Management, Orange County, Enron, Lehman Brothers Inc., Bear Stearns, American International Group Inc., Fannie Mae and Freddie Mac is well documented. The objective of asset-liability management is not to eliminate risk. Rather, its objective is to manage risks within a framework that appropriately matches the risks of the assets to the risks of the liabilities. ALM processes vary between entities due to the idiosyncratic nature of each organization's assets, liabilities and assessments of risk. However, all ALM policies require the creation of self-imposed risk limits. The "Big Three" risks evaluated by all ALM committees are market risk, credit risk and liquidity risk. First, market risks evaluate the impact on value from changes in equity, real estate and other asset and credit markets, interest rates (including variations in market credit spreads), foreign exchange rates and commodity prices. Second, credit risks include concentration within a portfolio of a certain type of exposure, the risk that any one investment will decline in value or default and counterparty exposure. Third, liquidity risks account for the risk of not being able to refinance debt as it matures, satisfy requests for cash or margin and collateral requirements by counterparties or investors, or execute a transaction due to a lack of demand by other market participants. It is crucial that ALM policies evaluate a portfolio from this "global" perspective. As we are observing in the current credit crisis, liquidity risk is compounding market and credit risk. Regardless of whether it was intentional or not to own an asset that is or became illiquid, illiquidity is limiting a financial institution's ability to exit that position quickly and at the current market value. As an illustration of the credit markets' symbiotic relationships, if a credit event occurs (i.e., a counterparty default) or upon a precipitous decline in value in the mortgage-backed securities market, financial institutions find themselves in a position of having to liquidate other assets to maintain liquidity. As we are observing, this spiral is a difficult one to stop. Today's credit crisis that has so severely impacted what once was a "Blue Chip" roster of financial intermediaries can be traced back to just a handful of ALM errors in risk management judgment. A long exposure to the U.S. mortgage market is a profitable investment strategy as long as the underlying real estate market remains strong. However, as the real estate market declined, the failure of the mortgagees to have enough equity in the underlying asset, and the investor owning a long term asset (i.e., a mortgage or a portfolio of mortgages) while financing it with a shorter term liability coupled with the fact that the market value of the mortgage does not move in correlation with the value of the liability creates "toxicity" for any organization exposed to this relationship. Aggravating this problem is that the organizations that are at the heart of today's credit crisis were so highly leveraged. Consequently, as the market value of the real estate assets declined, mismatches between the asset and liability values and duration magnified by leverage caused the value of the assets to decline at a far greater rate than the value of the liabilities used to finance the purchase of the mortgage-backed securities assets. An effective ALM policy that recognized a portfolio had significant exposure to U.S. mortgages, high leverage, a mismatch between the value, duration and amounts of assets and liabilities and liquidity risks should have recognized that hedging had the potential to be an effective strategy to mitigate (but not eliminate) such risks. The objective of a macro-hedge (i.e., hedging a portfolio of assets and liabilities) is to reduce the market risk, credit risk and liquidity risk based on a complete analysis of the balance sheet and off-balance sheet items. Additionally, the objective of a micro-hedge is to reduce or eliminate the risk of a specific balance sheet or off-balance sheet item. The combination of both types of hedging strategies would have facilitated a financial organization's ability to minimize differences regarding the value, amounts, maturities and correlations between their assets and liabilities. Engaging in an active mortgage-backed hedging strategy had the potential to be an effective mechanism to reduce the risks and uncertainties associated with mortgage-backed securities. This same logic is equally applicable to credit default swap portfolios. As regulators, investors and other stakeholders investigate methods
for reducing financial systemic risks, implementing minimum
requirements for effective ALM polices and procedures will be at the
center of the analysis. Larry Levine is director of corporate finance and business valuation services and Helmut Mlakar is director of financial services at middle-market business consulting firm RSM McGladrey Inc. |
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