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Tools for Measuring Risk Evolve in Volatile Times
Asset Securitization Report--SourceMedia (June 16, 2008)
It has been a tumultuous year in the credit markets, especially for portfolio managers who have been charged with the task of coming up with successful investment strategies, despite the industry's volatile state.
At the heart of the credit management industry is the International Association of Credit Portfolio Managers (IACPM). The association aims to help its members achieve a balance between mitigating risk and maintaining profits.
Allan Yarish, a managing director and head of global credit portfolio management for Societe Generale Corporate and Investment Banking, as well as the chairperson of the IACPM, spoke with Asset Securitization Report to discuss the current state of the credit markets and how the role of the credit portfolio manager has evolved.
Yarish began his career at SocGen in 2002 at the bank's New York offices, moving to Paris in 2003 where he currently resides.
Before he worked in his current position, he was with Royal Bank of Canada (RBC) for 18 years based in Toronto and Montreal. At RBC, he worked in economics, credit analysis, relationship management and, for the last five years of his stint at the bank, in credit portfolio management. Gabrielle Stein conducted the interview.
ASR: Why did you get involved with the IACPM and what are your primary responsibilities as chairperson of the organization?
Yarish: I got involved in the IACPM before it existed formally as an organization. It was originally an informal discussion amongst banks including Bank of Montreal, Royal Bank of Canada, CIBC World Markets, JPMorgan, Citigroup, Chase Bank, Bank One Corp. , National Bank of Detroit, Bank of America, Barclays Capital and Deutsche Bank, starting in the late 90s. These banks were among the early adopters of credit portfolio management. We met informally, 20 people at a time, to discuss ideas and problems that we were facing related to large corporate loan books. As these discussions progressed, we noticed that more people wanted to get involved and other banks started expressing an interest.
In November 2001, we decided to turn these discussions into a formal organization and it has just grown from there. We wanted to provide an industry voice to regulators, accounting agencies, and so forth.
ASR: How has the role of credit portfolio managers at financial institutions grown or changed as a result of the current economic slowdown and the relative dry-up in liquidity over the past year?
Yarish: The absence of liquidity in the last several months has meant that there is a lot more focus on organic versions of portfolio management. You can't rely on credit markets to take your position down. You have to do much more in terms of the original lending decisions. You have to be more disciplined in the size of the exposures that you take on.
ASR: In risk analysis, which are the primary institutions that you think should be helping portfolio managers in analyzing the risk that they are taking on?
Yarish: Portfolio managers should be primarily relying on their own analytical capabilities.
There are lots of different analytical tools that range from the rating agencies to various Merton model-type (asset-value model) of calculations to, more simply, news services. I don't think any of them are magic bullets, but you can't afford to ignore them.
Personally, there are several news analysis services that I find useful because they distill the day's news into a credit view. That doesn't mean that the banks shouldn't do their own credit analysis, but these services give you headlines and you can decide from that where you need to focus your activity. There are also some quantitative techniques that give you disciplined ways of addressing the questions. However, analysis is something you want the portfolio manager to do for themselves.
ASR: How should the role of the rating agencies be taken into account when evaluating risk?
Yarish: The rating agencies provide a good external benchmark, and anybody involved in managing credit portfolios needs to look at the rating agency ratings and take them into account. But the clear lesson of the current crisis is that you cannot manage solely by using rating agencies. You need to measure and manage credit on your own.
ASR: How has your perception of credit risk changed as a result of the events of the past nine months? How did people take on so much risk without realizing it?
Yarish: In the credit risk space, we often make the distinction between systemic risk and idiosyncratic risk. The standard view of credit, especially high-grade credit, is that real losses on high-grade credit are extremely idiosyncratic. What has changed is that this is true in a buy-and-hold accrual accounting world. In a mark-to-market accounting world, systemic risk dominates idiosyncratic risk when it comes to high-grade credit because in high-grade credit, defaults are extremely rare but credit spreads move in a highly correlated manner. As a consequence, this generates large mark-to-market gains or losses on a very correlated basis.
As long as investment-grade obligors are healthy and are a long way away from default, the main risk for a mark-to-market lender is the P&L impact of market spread movements. This really is systemic risk. When it comes to real defaults though, risk among investment-grade borrowers tends to be very idiosyncratic.
I think that balance between the two is changing and that is why people took on so much risk. They thought the classic way of managing a risk portfolio was based on idiosyncratic risk, and it is, generally, highly uncorrelated. But across a large portfolio, and especially when these portfolios have been leveraged and amplified through tranching and so on, it has really turned it into a pure systemic risk exposure and it became highly correlated across a variety of different forms of credit.
ASR: Are there evolving measures of risk, for instance specific tools, that would help address the current market volatility, or even to anticipate risk?
Yarish: I am not so certain it is a question of tools, but every crisis teaches us something. People need to think about what happens when the market turns against them and they need to think about the reaction of others in the market, especially if they are holding mark-to-market positions. Market prices will be influenced by fundamentals but they will also be influenced by views of others.
One thing that is desperately needed in credit markets, but is nonexistent, is the equivalent to an open interest number that will let you know how much credit protection has been bought or sold in various forms and some sort of clearinghouse that could make that information available. This would provide a good systemwide measure of potential volatility.
ASR: What gives you a good night's sleep knowing that all is accounted for in terms of evaluating risk?
Yarish: Risk, by definition, is about taking an exposure to something that is uncertain and partly unpredictable. All you can do as a portfolio manager is ensure that you have taken risks in sizes that you are able to withstand if things go awry, and you can hope you understand what the downsides are and the magnitude of those downsides.
I think what is interesting, from a portfolio manager standpoint, is that the risk to date has not been in conventional bank corporate loans. Risk has clearly affected mortgages, but conventional loans of any description, even high quality mortgages, have generally not had a crisis.
However, in earlier cycles, the risk was concentrated in much more conventional products, and I think we learned how to manage those products reasonably well. New growth came in areas that organizationally were somewhat different than where the old types of risk were held, and we need to learn how to apply the discipline of our older approach to the new areas.
ASR: Do you view the idea of contagion risk or the possibility of unforeseen events any differently than nine months ago?
Yarish: The credit crisis has provoked a repricing in all sectors of credit, even though the actual loss on lending has essentially been limited to subprime and those sectors related to it - for instance, U.S. home builders. It is clear that stresses in one area of the credit market clearly have an impact in other areas even when there is no tangible evidence of fundamental credit quality deterioration in the other areas.
Credit market stress is clearly provoking some tension in other asset classes - non-investment-grade corporate, for example. The open question is whether fundamental credit deterioration will spread more broadly and more rapidly. I think it is reasonable to expect that there will be an increase in defaults across a variety of credit assets, but it is unreasonable to expect that they will be at crisis levels the way they have been with subprime mortgages.
ASR: How is the IACPM treating the issue of transparency in the market? Have you made any steps toward implementing additional transparency in portfolio management practices?
Yarish: The industry in general is going through a very significant regulatory change right now, although it is a little delayed for U.S. financial institutions. The implementation of Basel II requires us to rethink all of our disclosure practices, and this is something that the IACPM is eager to try to promote as an industry standard. But even for the early adopters, we are still in the first year of Basel II and probably the best thing is to allow for some experimentation amongst different institutions and to try to coalesce after we have had some experimentation with it.
ASR: What makes a good portfolio manager? Are portfolio managers wired in a certain way? Are there certain personality traits that thread through the industry?
Yarish: You have to distinguish between the two types of credit portfolio managers. Those managing funds where they are relatively unconstrained in terms of asset selection are one category of portfolio managers. Typically, the IACPM's members are people who work for large financial institutions that generate an inflow of credit assets. The portfolio managers don't necessarily select all of the assets that come into the portfolio. You have to be a hybrid between being a credit trader, a credit originator and a credit quant. And it is finding the appropriate balance between these skills that becomes important for bank portfolio managers. The bank is using credit as a way to maximize the value it can get out of its client relationships and the portfolio manager is trying to maximize the value of credit as an investment to the institution.
ASR: Do risk portfolio managers have time for hobbies? When you are not at the IACPM or SocGen, what do you like to do in your spare time?
Yarish: We have had a lot less spare time in the last year. But for portfolio managers, like everyone else, there is no one hobby that fits them all.
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