Firms Devastated in the Downturn had More Risk Managers Than Ever Before
It is ironic that in the last decade more attention has been placed upon risk management than ever before. Every failed bank in this cycle manned a risk department with a veritable army of experts, but like the Romans feeling secure that Hannibal would never cross the Alps with elephants to attack them, the unexpected did happen.
The primary reason why there is stress in the financial system today is real estate. Its value appreciated quickly, and at that point loans were taken out against its value. Yet it was perceived to be a low-risk asset until just before the crisis hit.
In 2004 Franklin Raines, CEO of Fannie Mae, was asked in a House committee meeting why his company’s equity was 3 percent of assets, whereas when a bank’s equity ratio dips below 4 percent it is deemed to be in deep trouble. Raines replies, “There aren’t any banks that only have multifamily and single-family loans. Those assets are so riskless that their capital for holding them should be under 2 percent.”
To understand what ails the capital markets, one must appreciate the progression of thought that accrued over the three decades prior to the panic of 2008.
The 1970s began with PE multiples on stocks withering from over 50x during the “nifty fifty” phenomenon (pay any price for “greatness” — think Xerox, IBM, Polaroid, Avon) to the mid-single digits by 1973-74.
Valuation remained depressed, and short-term yields topped 20 percent before that decade was over. The investment management industry saw its talent migrate elsewhere; jobs were scarce, and those few available in the industry were paid a pittance, especially when compared to investment banking.
The superstars of that era were attracted to value, or they succeeded by heavily weighting the energy and capital goods sectors almost to the exclusion of all else. Investment management was a financial backwater, undesired by MBAs from Harvard, Stanford, or Tuck. Although the culture of each firm was unique, generally managers were left alone and permitted to concentrate sectoral bets. They did not engage in complex hedges to ameliorate risk.
Although theoretically known, alpha (outperformance of an index used to benchmark) and beta (returns achieved solely through being invested in the stock market in general) were inseparable, and the principal tactic to deal with risk was to know when to move away from the crowd.
Because commissions were $1 per share, 100-page long reports from boutique firms such as Donaldson Lufkin, Jenrette were easily paid for with client funds to guide decision making, and trading was extremely infrequent. Portfolio managers knew what they owned intimately and made strategic investments to last over time.
Today, thanks to “dark pools” and ECNs (electronic communication networks), institutional stock commissions are zero or near zero. The emphasis is on getting in and out, hedging, pursuing an activist agenda against management for a quick buck, deftly reacting to news, getting a jump on proximal indicators of next quarter’s sales and earnings — almost anything but avoiding risk by exercising sound judgment and simply buying a good company at a reasonable price and holding it.
The 1980s ushered in portfolio insurance, which parlayed an academic breakthrough that rapid, mechanistically enforced selling at a key inflection point of momentum would theoretically save holders of stocks from a bear market. This it failed to do, instead being a key accelerant to the collapse of equities in October 1987.
By the millennium, risk management came into its own, employing vast ranks and seemingly effectively dampening poor performance. With everyone employing it, we were like the children of Lake Wobegone, who are all above average. But in its essential form, its primary message was to force portfolio managers not to manage as they learned in the 1970s, that is exploiting and then avoiding movements from one investment concept to another, but instead to spread out their bets by minimizing something known as value-at-risk (the sum of the variance inherent in all positions in one’s portfolio).
In plain English, this meant that having many small positions would reduce variation, but if a manager possessed true stock picking skill, his methodology applied consistently across hundreds or even thousands of choices would maximize alpha. His beta could then be laid off in the burgeoning markets for derivatives: futures and options.
Counterintuitively, demand for beta increased, for the academic community recognized that in an efficient market, it was senseless to do anything other than hold an index of stocks. A sort of truce in the institutional marketplace developed, with one faction mining alpha with increasingly sophisticated strategies (which required massive leverage to work, since excess returns were arbitraged to skinny possibilities) and another accommodating that group by dutifully accepting its offloaded beta.
With the sharp downturn following the Internet boom, demand for hedged, active return strategies skyrocketed. Although most hedge funds would provide transparency to their investors, many would instead choose to keep information about their portfolio holdings close to the vest.
Promising a serving of cake and being able to eat it, too, they would assure potential and actual partners that their desire for risk aversion and high return on investment was being met. They would grind out monthly returns that were very good but almost never great or poor, suggesting all systems were working like a well-oiled machine.
They would walk them through dazzling software-based control mechanisms designed to constantly react to sophisticated statistical measurements not only of the old standby, value-at-risk, but also geeky quantitative output such as gamma, rho, or delta. Returns were sliced and diced by ratios such as Sortino, Sharpe, information, tracking error, or downside deviation.
Meanwhile, by not really offering a look under the hood and instead just passing out copies of the owner’s manual, the deck was cleared for delivering precisely what the client was asking for — the impossibility of high, risk – reduced returns.
[Editor’s note: This passage is reprinted from William W. Baker’s book, Endless Money: The Moral Hazards of Socialism, with the permission of John Wiley & Sons, Inc (©2010). You can get your own copy here.]