On Complacency | Why Risk Management Always Matters

September 14, 2017  | by Dana Moreau, Brian Rondeau

Governance and Policy | Industry Knowledge | Investment Strategy | Risk Management

Like nearly everything in the financial markets, risk is cyclical.  History repeats itself.  The echoes of past crises are always heard in present ones, yet new crises are rarely predicted and not always properly planned for.  We are in the midst of one of the longest economic expansions in US history, 98 months and counting, trailing only the 120 month and 106 month expansions of the 1990s and 1960s, respectively.  There have been bumps along the way, but this has been an extended benign period for risk in the capital markets.

 

A few early indicators are starting to point to some weakness ahead.  The corporate debt to GDP ratio has returned to pre-crisis levels as corporations have taken advantage of historically low yields to deploy financial leverage and goose returns to equity holders.  The last four recessions in the US have all been preceded by excessive loan growth.  This cycle has been no exception with the Federal Reserve reporting bank loan growth in excess of 10% for 2015 and 2016.  Historically, this translates into softer underwriting standards (as we are seeing in auto finance where 90 day delinquencies have just hit a post-crisis high) and bank asset quality trouble, with potential bank failures appearing within the following 3-5 years.

The point here is not to try and predict the next economic downturn or the end of the current credit cycle.  More important is getting your risk management ducks in a row before the downturn happens and the turmoil eventually returns.  The further we get from the last financial crisis, the more market participants lose sight of the hard-earned lessons received during that time.  This is seen in market participants’ expectations of a stock market increase and the implied volatility of the S&P 500.

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A counterparty risk analyst that started their career in 2010 now has 7 years of experience and hasn’t been through a major counterparty default.  As the events of 2008 unfolded, there were few responses in real time that had a meaningful impact on risk outcomes.  The actions that truly helped protect an investor during the crisis all took place well before banks started failing.

Documentation, collateralization, and exposure management are the three pillars on which proper counterparty risk defenses are built.  Investors need to ensure proper negotiation of trading documents to put their firm in the best position possible with respect to key trading terms.  They also need to make sure they have tight controls around collateral posting and monitoring to limit unnecessary risk.  And finally, the only way the proper emergency steps can be taken when the ice starts to crack is to fully understand what exposure exists with what counterparty.  All three of these steps can seem tedious, and tight controls around them may appear like overkill, during a benign credit environment.  Don’t fall into the complacency trap.

. . . complacency in risk management is itself a cyclical risk.

Shortly after Lehman Brothers had filed for bankruptcy and many investors had (temporarily) lost their shirts, one investment manager was still reporting incredible returns. Bernard L. Madoff Investment Securities.  Because of this firm’s great success, its investors tapped it as a source of liquidity when their other investments had all taken a nosedive.  By early December 2008, Bernie Madoff was facing $7 billion in client withdrawal requests and the jig was up.

Even if you were early in that line of client redemptions you lost almost everything.  Reaction time didn’t matter.  The only thing that could have saved you was effective and complete due diligence at the time of your initial investment, allowing you to see enough red flags to avoid the Ponzi scheme altogether.  Yet this was a time of strong market returns and greed had likely taken its cyclical place ahead of fear.  Today, and each day for the past eight years, was the day for proper risk management.

Another area where an investor must avoid complacent risk management is with the structuring of investment portfolios.  In a low yielding environment like this one, there are only a few places investors can turn in pursuit of excess return.  Three of asset management’s favorite tools are leverage, illiquidity and credit risk.  Each of these tools has their place in a carefully risk-managed portfolio, but each can be dangerous when portfolio managers are lulled into a false sense of security.  Careful independent monitoring of liquidity metrics, multiple measures of portfolio leverage, and exposure to changes in credit spreads are especially important in stable periods.  Rigorous stress testing and scenario analyses can indicate where portfolios are over-exposed.  These practices are important because once market volatility spikes many of the possible remedies to problematic positioning become closed to investors.

Don’t let widening spreads, struggling banks or investment manager fraud be your impetus for thinking about risk.  Risk is cyclical.  Ironically, complacency in risk management is itself a cyclical risk.  The longer that a benign period persists, the greater and nearer the risk of taking your eye off the ball becomes.  To make matters worse, the further we get from the last crisis, the greater the potential magnitude and likelihood of the next crisis grows.  Take the necessary steps and precautions now to limit the damage in the future.

Authors

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Dana Moreau has firm-wide oversight and responsibility for risk management. Prior to overseeing risk management, Dana was with Commonfund’s Hedge Fund Strategies Group sharing responsibility for portfolio analysis, manager identification, due diligence, and investment monitoring.  His primary focus during this time was on portfolio construction, risk management and the operational oversight of the funds. As a member of the Hedge Fund Strategies Group he led the effort to implement a research management system and oversaw the onboarding of an external risk engine, each of which are now utilized firm-wide. Prior to joining Commonfund, Dana worked at State Street Bank & Trust where his primary responsibilities were portfolio accounting and administration for the bank’s hedge fund clients. He has a B.A. in Economics from Assumption College and an M.B.A. from Columbia University.
Dana J. Moreau
Chief Risk Officer
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Brian Rondeau is a member of the Risk Management team and is responsible for the due diligence process of external managers and counterparty credit risk. Prior to joining Commonfund, he was Vice President – Risk at Harvard Management Company where he led a team responsible for counterparty credit risk as well as investment risk on Harvard’s illiquid asset class portfolios. In addition, Brian was involved in liquidity risk management, managing HMC’s banking relationships and analysis related to sustainable investing at Harvard. Prior to Harvard, he spent four years with RBS Greenwich Capital in risk roles analyzing financial institutions and the asset-backed finance business. Brian is a Chartered Financial Analyst and member of the Boston Security Analysts Society. He earned a B.A. from Columbia University.
Brian Rondeau
Director, CFA
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Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.