A Billion Here, A Billion There...
Though there is a question about whether former Illinois Senator Everett Dirksen ever said "A billion here, a billion there, and pretty soon you're talking real money," the statement is apt.
A quick read of the headlines suggests things are going to get ugly fast, and with little chance of a let-up anytime soon. Federal Reserve Chairman Ben S. Bernanke, in his October 15, 2007 address to members of the Economic Club of New York was no less sanguine. He offered that "Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time, and we may well see some setbacks." Click here to read the full text of his speech.
Billions of dollars in losses, due to sub-prime problems and related woes, pummeled recent earnings for more than a few organizations, sending the equity markets into a tailspin on October 19, 2007. Pundits report that the Dow had its worst day since early August, with worries about a looming recession being only one of several fears. Twenty years after Black Monday (October 19, 1987), the term "deja vu" comes to mind. At that time, this blog's author worked on a futures and options trading desk and well remembers the frenzy that ensued. Names then considered "too big to fail," no longer exist. Sobering lessons learned?
Hopefully.
At a time of unprecedented technological advances in terms of analytical capabilities and information flow, why is it that risk management is still anathema to some? Arguably there will be times when "tail" events occur, despite the best intentions to create, implement and periodically review back-office, middle-office and trading desk activities. One possible silver lining is that organizations (for which this applies) go back to the drawing board to design a more effective set of checks and balances. Improved risk architecture could include any number of things, including the following:
- Frequent and thorough testing of valuation models by independent third parties
- Regular and more granular correlation analysis that (a) takes into consideration the reality that market convergence does sometime occur and (b) then tries to identify when it is most likely to present itself accordingly
- Assessment of hedge effectiveness, and by extension, (a) what factors create "hedge leakage" and (b) thereby leave an organization exposed to adverse market conditions
- Identification of risk drivers, along with both a quantitative and common sense ("smell test") assessment of their likely behavior and probability of occurrence
- Identification as to how to improve collateral management
- Better training for everyone involved in trading activity and oversight
- Improved (or creation) risk budget that explicitly lays out how money is to be allocated on a risk capital basis.
Some will win as markets tremble but what about the losers? After today, equity-laden retirement portfolios won't look so good. Entire employee teams are shutting down as the credit crisis takes hold. Depressed times will certainly force plan sponsors to rethink their investment decisions.
How much money has to disappear before billions mean something other than zeros on a piece of paper?
