Observationsonthe FinancialCrisis: ImplicationsforAssetManagement Management,Risk Management,andRegulatoryReform

RobertC.Merton HarvardBusinessSchool InstitutionalMoneyCongress2009 Frankfurt February26,2009

MyRemarksareDividedinto3Parts
Structural elements of a financial crisis: How does risk propagate so rapidly across the system? Is there a structural relation between financial innovation and th risk the i k of f crisis? i i ? Wh What t are the th implications i li ti of f the th inevitable i it bl incompleteness i l t of f proprietary risk, accounting, and regulatory models? The Trend in institutional asset management has been toward decomposing and outsourcing the investment process between alpha generation and efficient beta exposures. Will this continue post-crisis? What are the challenges to proper management of this process? Hedge funds and proprietary trading desks have been significantly dislocated by the financial crisis. Will they continue to perform their financial functions or will new institutional forms replace them? Substantial regulatory changes will be a consequence of the financial crisis. i i Although Alth h th there are still till many i important t t unresolved l d questions ti about b t the th causes of the breakdown of the global financial system, there are some recommendations which are likely to be robust with respect to risk measurement, risk management, and government macro financial and bailout policies. policies
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Copyright 2009 by Robert C. Merton

FunctionalDescriptionofBeingaLenderWhenThereis RiskofDefaultandofWritingaGuaranteeofDebt
RISKYDEBT+GUARANTEEOFDEBT=RISKFREEDEBT RISKYDEBT=RISKFREEDEBTGUARANTEEOFDEBT

Corporation Operating p gAssets, ,A Debt( (facevalueB), ),D CommonStock,E

A=D+E
INDEFAULT,THEHOLDEROFTHEGUARANTEERECEIVESPROMISEDVALUEOF THEDEBTMINUS VALUEOFASSETSRECOVEREDFROMDEFAULTINGENTITY= MAX[0,BA] VALUEOFGUARANTEE=PUTOPTIONONTHEASSETSOFBORROWER CREDITDEFAULTSWAPSAREGUARANTEESOFDEBTANDTHEREFOREAREPUT OPTIONSONTHEASSETSOFTHEBORROWER
Copyright 2009 by Robert C. Merton

NonlinearMacroRiskBuildup
Firm/Mortgage g g Debt

C Corporate/Household t /H h ld S Sector t Liability

DC DC

D 'C
Corporate/Housing Co po e/ ous g Assets, sse s, A C Firm/Mortgage Debt G Guarantee

Banking System Li bilit Liability

A 'C

AC
Bank Deposit Guarantee

Government Liability

GC
G 'C

GB

G 'B
GB

GC

A 'C
Copyright 2009 by Robert C. Merton

AC

Corporate /Housing Assets, AC

A 'B

AB

Bank Assets, AB 4

HigherCreditPutPricewhenAsset VolatilityIncreasesandAssetsDecline
Illustrative Sovereign Spreads for High and Illustrative CreditSpreads for High and Low Sovereign Volatility LowAssetAsset Volatility
5000 Sprea ads (basis poin nts over bench hmark) 4500 4000 3500 3000 2500 2000 1500 1000 500 0 50 70 90 110 130 150 Sovereign Asset ($ billions) Asset ($billions) ) Spread - High Volatility S Spread d-L Low Volatility

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Copyright 2009 by Robert C. Merton

EffectofNonlinearRiskandVolatilityShift
5-Year Loan with $100 Principal
Asset Valu e Asset Vola tility Put Price B-S Delta Actual Delta $200 0.50 $14 -.08 -.10 $160 0.50 $18 -.11 -.14 $120 0.50 $24 -.17 NA
% Change -40% 0% +71%

W ith Increasing Volatility

Asset Valu e Asset Vola tility Put Price B-S Delta Actual Delta
Copyright 2009 by Robert C. Merton

$200 0.50 $14 -.08 -.51

$160 0.75 $35 -.10 -.44

$120 1.00 $53 -.14 NA

-40% +100% +279%

InnovationandCrisis:Behavioral:FamiliarRisk versusNew N Ri Risk k

Corporate Pension Plan: Immunized match-funded: No risk to Corporation N fi Nonfinancial i l Corporation C ti Operating Assets Pension Assets [100 long-maturity fixed-rate b d] bonds] Senior Debt Pension Liabilities [100 long-maturity fixed payments] t] Common Stock

Corporate Pension Plan: Mismatch Funded: Risky to Corporation Nonfinancial Corporation Operating Assets Pension Assets [75 Common Stock; 25 bonds] Senior Debt Pension Liabilities [100 long-maturity fixed payments] Common Stock
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Copyright 2009 by Robert C. Merton

RiskComparison: E iti in Equities i Pension P i Fund F dVS. VS Swap S

Incremental Pension risk is: receive: the total return on stocks on 75 Give up: the total return on bonds on 75 Derivative: Total-Return Equity Swap for Total-Return on Bonds on 75 notational amount Incremental Swap risk is: Receive the total return on stocks on 75 Pay the total return on bonds on 75

Risk and Return on Equities in the pension fund is identical to Swap

Copyright 2009 by Robert C. Merton

OnMathematicalModelsinFinancePractice
Any virtue can become a vice if taken to extreme, and just so with the application of mathematical models in finance practice. I therefore close with an added word of caution about their use. At times the mathematics of the models become too interesting and we lose sight of the models ultimate purpose. The h mathematics h i of f the h models d l are precise, i but b the h models d l are not, being only approximations to the complex, real world. Their accuracy as a useful approximation to that world varies considerably across time and place The practitioner should therefore apply the models only tentatively, place. tentatively assessing their limitations carefully in each application. R.C. R C M Merton, I Influence fl of f Mathematical M h i l Models M d l in i Finance Fi on Practice, P i Phil. Trans. Royal Society of London, 1994.

ModelsareAlwaysAbstractionsfromComplexReality: I li ti f Implications forR Ratings ti A Agencies i and dR Regulators l t

Credit Evaluation: 1) Probability of Default 2) Expected Recovery Rate in Default 3) Degree of Procyclicality in Default Ratings Agencies (S&P and Fitch) 1) Ratings based on Probability of Default only Incomplete model for ratings induces bias in assets selected for structures Behavior: Maximize value, subject to meeting ratings constraint Minimi e cost, Minimize cost s subject bject to meeting ratings constraint Prediction of bias in asset choices
Copyright 2009 by Robert C. Merton

Low Expected Recovery Rate in Default High Procyclicality (Beta) in Default

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Domain of Investment Management: Stages of Production Process for Given Objective Function
Passive Well-Diversified Efficient Portfolio Efficient Exposures

Active Asset-Class Allocation Macro Sector Market Timing

Super Efficient P tf li of Portfolio f Risky Assets (Optimal Combination of Risky Assets) Optimal Portfolio of Assets Alter Shape of Returns on Underlying Optimal Portfolio Structured Efficient Form of Returns to Government

Superior Performing Micro Aggregate Excess-Return Portfolio Alpha Alpha Engines Engines

Riskless Asset Portfolio

(Derivative Securities with Non-Linear Payoffs) y ff )

Components of Best Performing Risky Assets Only Portfolio: Diversification Risk Modulation

Risk Modulation through Hedging or Leveraging Constrained Asset Holdings Market Timing Active Management

Risk Modulation through Insurance or non-linear leverage g Pre-programmed dynamic trading Building Block State-Contingent Securities to create specialized i i payout patterns

Expropriation efficient Regulatory efficient Liquidity tradeoff Transaction cost efficient

Copyright 2009 by Robert C. Merton

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GeneratingSuperiorInvestmentPerformance:Traditional AlphaSeekingversusFinancialServicesAlpha
Traditional Alpha-Seeking

Depends on being faster, smarter, better models or better information-inputs Is it sustainable? Is it scalable? The Cost of Active Investing
Kenneth French Dartmouth College g - Tuck School of Business; ; National Bureau of Economic Research (NBER) ( ) April 9, 2008 Abstract: I compare the fees, expenses, and trading costs society pays to invest in the U.S. stock market with an estimate of what would be paid if everyone invested passively. Averaging over 1980 to 2006, I find investors spend 0.67% of the aggregate value of the market each year searching for superior returns. t Society's S i t ' capitalized it li d cost t of f price i discovery di is i at t least l t 10% of f the th current t market k t cap. Under U d reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 1980 to 2006 period if he switched to a passive market portfolio.

Non-economic costs and benefits Depends on being lightly regulated, strong credit-standing, long-horizon, flexible liquidity needs, large pool of assets, reputational capital and sponsorship p p value Is it sustainable? Is it scalable? Is it a comparative advantage?

Financial Services Alpha Financial-Services

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Copyright 2009 by Robert C. Merton

DestructiveFeedbackLoops:Guarantors writing i i G Guaranteesof ftheir h i O OwnG Guarantors

Guarantor writes a g guarantee in which its assets will not be adequate to meet its obligations precisely in those states of the world in which it will be called on to pay. Less-than-AAA L th AAA government td debt bt h held ld by b a bank b k whose h deposits are guaranteed by that government. A co corporation po at o writing w t g a CDS C S contract co t act on o its ts own ow debt Funding a corporate pension fund with the plan sponsors own stock. The Pension Benefit Guarantee Corp investing in the equities of the companies whose pensions it guarantees. A company writing put options on its own stock. stock
Copyright 2009 by Robert C. Merton

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Recommendations:RiskMeasurement
Financial institutions p provide p prescribed risk data to central processing authority on confidential or coded basis. Aggregate risk parameters to regulators and public. Fair-value F i l accounting ti always l required i d and d considered id d by b regulator, whether or not capital-adequacy ratios and other specific regulatory rules are based on it. Encourage development and implementation of riskaccounting reporting measures for non-financial firms. Creation C i of f national i l Capital C i l Market M k Safety S f Board B d (A. (A Lo). L ) International coordination is critical but single global body unrealistic.
Copyright 2009 by Robert C. Merton

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Recommendations:RiskManagement
OTC derivative contract p positions between financial institutions and above a threshold size must have two-way mark-to-market collateral at least equal to the contract liability value independent of credit rating. value, rating Central clearing for OTC contracts (above threshold volume). a c a product p oduct can ca be offered o e ed with w t either e t e a fixed ed No financial redemption price/NAV or a fixed rate of return without an explicit guarantor. E.g., money-market fund; stable-value fund. Require R i financial fi i l engineering i i expertise i among senior i management, board members, and regulators of financial g central banks, BIS, and IMF. institutions, including
Copyright 2009 by Robert C. Merton

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Recommendations:GovernmentRegulation and dMacroeconomic M i Policy P li

Establish U.S. Sovereign wealth fund to hold and manage assets acquired. Separate from Reserve/Monetary Policy (Fed) and debt Management (UST) Government risk balance sheet with market-based estimates of the liability value and risk-exposures from guarantees. Functional perspective on regulation to be more dynamic and take into account non-linear risk exposures, exposures connectedness / network coupling and mismatch of innovations and infrastructures to support them. Do not use legislation to perform business management and governance functions. f ti Integrated macrofinance framework for macroeconomic and monetary model analysis and incorporation into policy setting.

Copyright 2009 by Robert C. Merton

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