Executive Director, Strategy
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With Lehman Brothers having followed the ill-trodden footsteps of Bear Stearns, many have questioned the risk management capabilities, techniques and desire of Wall Street. We know that greed and hubris played a role in the failure of these firms, but were risk management techniques absent, or were the results simply swept under the carpet in light of the earnings that the risk was generating for the firm? I’d argue that in many cases it was the latter.
A decent proxy for the risk that a firm is taking is tracked in its average daily trading value-at-risk (VaR), which measures the amount of money that the firm could lose on a bad day, typically to a 95% degree of confidence. As of the end of 2007, the average among U.S.-listed global securities firms was a VaR of 0.17% of the firms’ net assets. The firms that had the highest VaR as a percentage of their net assets were the independent broker/dealers: Lehman Brothers., Goldman Sachs, Bear Stearns, Morgan Stanley and Merrill Lynch, in that order. The firms at the bottom of this list with the lowest trading risk were the banks: Bank of America, JP Morgan and Citigroup. On average, the broker/dealers’ VaR was over twice that of the diversified banks’. Clearly the regulatory oversight of the commercial banks plays into the risk appetite of these firms, but the extent to which this difference between the business models risk appetite would impact the firms’ future, could not have been imagined.
Leverage, another key contributor to a firms' overall risk, also has played a critical role in this crisis. Looking at the gross leverage ratio (the firms' total assets divided by its total shareholders equity) again reveals some stark differences between the two business models. The average sell-side firm has a gross-leverage ratio of 18.8; that’s 18.8 times leverage. As of the end of 2007, once again the independent broker/dealers are at the top of the list: Morgan Stanley, Merrill, Lehman, Bear Stearns and Goldman, in that order. At the bottom of the list are Bank of America, JP Morgan and Citigroup. The brokers on average were leveraged 30 times, and the banks 14 times.
So then it should come as no surprise that two of the banks, JP Morgan and Bank of America, have emerged as the “winners” of this crisis so far. These firms have minimized losses and write-downs and have acquired the assets at fire-sale prices. They maintained a relatively low trading VaR and were far less leveraged than their competitors.
Has Wall Street learned from their mistakes and righted their ships in a more risk-averse direction? Maybe… although Merrill has decreased it’s VaR through Q2 2008, both Goldman and Morgan Stanley increased theirs. However, all three firms have decreased their gross leverage ratios; only slightly in the case of Merrill, but significantly for both Goldman and Morgan Stanley.
A question that I've been asked by some colleagues is why hasn't the buy-side been affected by the subprime crisis? In truth it has; overall asset values are down along with the markets, investor flows into funds, particularly higher margin actively managed funds, have slowed and they've also lost value in assets related to financial institutions, both equity and debt. Also, many hedge funds have taken a sound beating this year because of their higher appetite for risk.
However, the buy-side impact has paled in comparison to the sell-side for a few reasons. One, the traditional buy-side (excluding hedge funds) is much more risk averse than the sell-side. In some countries, regulation restricts investment funds from owning too much risk (for example, the '40 Act in the U.S. and UCITS in Europe stipulate what investment funds can and can't invest in). Second, the sell-side in an act of sheer greed, held on to much of the riskiest, and therefore potentially highest returning, credit products. As a result, they suffered the worst when the markets for these securities dried up and the prices plummeted. Third, the buy-side is far less leveraged. Using a group of U.S.-listed investment managers as a proxy shows the [traditional] buy-side maintains a gross leverage ratio of around 1.5 times.
Clearly there's a place for risk in an investment portfolio. Risk does equal return as the saying goes. But greed and hubris, at the cost of shareholders, have upended global financial markets and cost governments and taxpayers billions of Dollars, Euros and Pounds. There’s a fine line to walk between using risk properly to generate profits and letting it get completely out of hand. The firms that use it properly, are very likely aware of their risk on a daily, if not minute-to-minute basis, have a set of tools and technologies to measure and control risk and hedge it appropriately. The firms that get out of hand are likely unaware of the depth of their situation, don't measure, control and hedge risk as well and likely struggled to understand their full exposure across securities and entities.
When the dust settles from this crisis and markets begin to stabilize, there’s no doubt that regulators will hand down new edicts on the securities industry mandating increased control, oversight and transparency. Smart firms will, in addition to reactive regulatory compliance actions, look at their internal operations for additional opportunities to mitigate risk. Whether it’s outdated risk models or systems, poor valuation techniques or manual post-trade processes, no stone should be unturned. Our industry has clearly learned that failure to fully grasp and control risk will lead to the downfall of the firm. It’s not just idle speculation anymore, we’ve seen the downfall of top tier firms with our own eyes and we know that it could happen again. Securities firms need to start planning now, otherwise it won’t be a question of “if” history repeats itself, but “when.”