Moody's issued a special comment paper focusing on Basel II amendments already introduced, as well as statements from the Basel Committee on Banking Supervision (Risk.net). The paper highlights enhancements relating to a bank's trading book, securitization, and counterparty credit risk. In particular, the recommendations involve strengthening Tier I capital, introducing tougher liquidity standards, including counter-cyclical provisioning, discussing systemic risk provisions (which is becoming popular in the United States), and including leverage ratios as a supplementary measure. Moody's also believes that proposed Capital Requirement Directive changes to the quality of capital and securitization were also a positive step. In addition, the paper mentions that “One important amendment calls for stricter operational requirements for credit analysis for banks holding securitisation exposures. We believe that the increased requirement for credit analysis for banks holding securitised exposures is going to be an important element of improved risk management, and should ensure that only banks with the necessary information and analytical tools hold securitised products.” Of course, it could also mean that less securitization takes place. While this may be the intended result, the unintended consequence of reducing the efficient flow of capital, or not allowing those who want to off-load or bear risk access to the vehicles they need, will also need to be considered further - either now or later.

Meredith Whitney was recently on CNBC (the video is provided below) discussing the banks and financials. Some observations from the interview include:

• This will be a tactical quarter for the banks.
• She has a bullish call on Goldman Sachs, but a bearish call on financial stocks in general.
• A huge refinance wave will create the "Mother-of-all" mortgage quarters, boosting earnings for the quarter for many banks, even though business in general is not getting better.
• Core earnings numbers may not be very good, but below the line numbers will be good due to all the mortgage activity. This will result in huge moves in tangible book value for the banks, even with unimpressive earnings numbers. These stocks trade on multiples of tangible book.
• A move from $18 billion in incentives to $75 billion in incentives to modify mortgages, with less modification liability, could cause some banks move 15% short-term.
• Mortgage modification numbers will increase logarithmically, causing past dues to become current, and allowing the banks to receive fees for the modifications.
• As a result of the fees and less litigation due to the current legislation, banks may even seek to modify mortgages which have not yet defaulted, or are not yet past due.
• Bank of America (BAC) is the cheapest of the banks, based on tangible book value (excluding Citi).
• Bank solvency has been off the table for a few quarters now, but main street has not been helped by the financial bailouts as much. A lot of refinancing is occurring, but not a lot of new lending. The new legislation and increased risk aversion is actually providing less access to credit.
• The next couple of years will be debt market-focused due to the tsunami of debt issuance needed to pay-off current spending.
• She also mentioned in the discussion (not included in the CNBC online video) that unemployment could reach toward 13%.
  
  
  Source: CNBC Video
  

In an interview with the WSJ, Gary Gensler, Chairman of the Commodity Futures Trading Commission, said he believes the most critical change needed in the oversight of derivatives is the regulation of dealers involved in derivatives (see article). He goes on to say that "only through the dealer can we get the whole panoply" of information regarding derivative contracts. Such a move would require customized contracts traded over-the-counter (OTC) to go through a central repository, similar to an exchange clearing house.

Gensler believes that "central clearing will further lower risk," but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily. One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem. In the mean time, I guess at least the exchanges (NYX, NDAQ, CME) will be happy as the potential for increased order flow continues to rise.

Now that the Obama Administration has released its proposed Financial Regulatory Reform: A New Foundation for updating the regulatory structure of the financial system (pdf file of reform, WSJ article), the public debate will begin in earnest regarding the details and proposals in the document. Ironically, while the public seems open to new financial regulation, the release of the document is coming at a time when some citizens are starting to worry about growing deficits and government intervention (see WSJ/NBC poll article), with almost seven in 10 people surveyed saying that they had concerns about federal interventions into the economy. Nonetheless, finding ways to limit risk and prevent another credit crisis through added regulation of banks and hedge funds still rings a populist tone, and is likely to continue to receive support.

Like many others, I feel that there are aspects of the new regulations that seem appropriate and make sense, with others that seem counterproductive. As for those that concern me, I agree with some who point out that it seems odd that the Fed is going to be given greater power (and responsibility) to fix some of the very problems it may have caused or contributed to (see Larry Kudlow article). I also worry that the new proposed Consumer Financial Protection Agency could end up just adding new and potentially unnecessary regulations and red-tape paperwork, along with producing counterproductive limits on rates and fees that will do less to protect individual consumers and more to reduce the availability of needed products that are offered to such individuals. Such restrictions, if not properly crafted, are likely to reduce the earnings of financial services companies, and even worse, limit their ability to effectively manage risk (through fee and rate changes).

The idea of requiring companies to retain 5% of all structured product offerings also has me concerned, even though this specific proposal seems to be generating some of the most support, at least initially. Recently I wrote that I have worries about forcing companies to retain a stake in each securitized product they develop since I believe it could actually make companies more risky (since they cannot off-load and manage all their risk, see previous post). Furthermore, while I agree that forcing companies to have some "skin-in-the-game" would make it less likely that they would offer risky products, it also makes it more likely, in my opinion, that they would offer less structured products. While this may be a desired outcome for some, the impact of this would be less liquidity and available credit at a time when the country can least afford it.

Another area that is generating support involves the idea of controlling systemic risk. I too believe that this is a good idea in theory, but am unclear exactly how this would be measured and acted upon. As recently reported in the WSJ (see article), one potential area to start with is leverage. As the chart below illustrates, financial sector borrowing increased steadily between 2004-2007, before dropping in 2008 as companies began unwinding leveraged positions. It is now well known that banks, hedge funds, and average citizens were carrying too much debt, thereby helping to increase systemic risk, and trigger the credit crunch.

Source: WSJ, Fed data
Yale economist John Geanakoplos, who has studied leverage in the economy, believes that regulators need to gather daily data from all market participants and then publish aggregate data. The feeling is that if market participants knew that leverage values were getting to extreme levels, they would be more likely to begin backing-off their own debt and leverage levels in anticipation of eventual market corrections, or restrictions imposed by regulators. Focusing at least in part on debt and leverage seems to make sense.

Unfortunately, measuring system-wide daily leverage changes at banks and hedge funds may be difficult at best, and suspect at worst. Yet, maybe the focus does not need to be on the three person hedge funds that are investing $10-50 million in capital. Getting comprehensive data which includes smaller players may not be necessary. Risk manager Richard Bookstaber - whose book "A Demon of Our Own Design" is recommended reading - believes that focusing on just the largest financial firms and hedge funds would cover roughly 80% of the risk, allowing you to see systemic trends.

At this point it is unclear if such trending information on leverage levels would be enough. Other related areas that could also cause potential cascading effects, such as specific derivative use (i.e., CDS) and counter-party risk, should also be examine - although regulating that which has not yet been developed is obviously difficult. Nonetheless, looking for new ways to measure leverage might be a good place to start for spotting worrisome trends. Such a signal could allow investors, funds, and the Fed (or other regulator) to take action. Of course, what action they take is another area of debate, and potential new area of concern.

A number of firms are beginning to become more active in using clawback provisions (see WSJ article). The clawback rules are being put in place to allow firms to take back money paid to traders and others whose trading positions blow-up at a later time. Such provisions are believe to help keep employees from entering into positions or strategies that may be too risky, but which may provide a large initial return and subsequent nice bonus. The worry of course is that such rules may cause some traders to become too careful, essentially shying away from necessary and manageable risk. There is also a worry that good traders may move on to other firms with less restrictive provisions.

What is probably most unnerving about such provisions is that it implies that the companies utilizing such a provision really have no idea what their risk levels are, or how to go about managing such risk. With risk management policies in place, especially those that elevate risk management functions within a firm and properly reward both traders and risk managers that at least attempt to manage and price such risk, a company should be able to better understand the risk they are taking and prevent traders from entering positions with excessive risk. If a properly analyzed trade later blows-up because of unforeseen events, then it could be argued that it is just the cost of doing business. Sure, if traders circumvent risk management procedures put in place at the firms, or are negligent in obtaining the necessary data or developing the best possible model, then by all means penalize them, regardless of whether the trade worked out or not. But as long as the traders and risk analysts accessed the risk based on the available data and models, and have their work approved by the risk managers, then it seems counterproductive to penalize traders for events outside their control. Sure, you will recover some bonuses, but you will lose much more in terms of talent, reputation, and lost capital. Recovering a rogue traders bonus may be too little too late and of little value, other than helping to pay the bankruptcy lawyers.

A recent New York Times article follows up on a previous discussion (see blog post) regarding modeling and risk management. While financial engineering and quants will continue to receive some criticism for the recent problems in the markets, along with development of generally inadequate risk management models, the NY Times article further explores whether it was the models or human failure that are to blame for the current financial situation. There is no doubt that some models, especially black box models, have created some of the problems, but we cannot really fix the problem until we know the root causes. Is it simply a matter of not having sophisticated enough modeling techniques, or are poor assumptions, inadequate data, and lack of oversight also to blame?

Research at the IMF found that quantitative methods underestimated defaults for subprime borrowers, at times often relying on computerized credit-scoring models instead of human judgment (then again, I am not sure Moody's or S&P were much better or more timely, but I digress). On the other hand, economists at the Fed concluded that risk models had correctly predicted that a drop in real estate prices of 10-20 percent would be bad for subprime mortgage-backed securities (not a surprise), but that analysts themselves assigned a very low probability of this happening. In fact, the Fed study might be at the heart of the problem - human behavior.

As mentioned in the article, asset prices depend on not only our belief, but the belief of others. In an "efficient" market the participants expect that the true (or near true) price is reflected, even if the belief of one person is far from the efficient value. Of course, it is hard to model the beliefs of the market, so often the beliefs, hopes, or profit motives of one person may come into play, with at times disastrous results. The problem is compounded when risk management models are assumed to follow some natural law, when in fact both the theory that defines the model, and the inputs provided to the models, are more stochastic in nature.

As I have argued before, we need risk models, even those based on imperfect mathematics and assumptions, but we must always take into consideration what could happen if we are wrong. If our assumptions are too optimistic or too pessimistic, what is the fallout? We should be asking ourselves how confident we are in mathematics used AND the assumptions made. Are there assumption scenarios that could bring a company to its knees? What models are best to help understand all the possible outcomes that we should be worried about? These are the questions risk managers need to continue to ask. Yet in many instances blind black box models with fixed assumptions were trusted. Unfortunately, I suspect that even with the recent problems and consequences hanging over our heads, asking which models and assumptions point to the highest profits or lowest levels of regulatory capital will once again start to be considered. After all, its just human nature. Of course, avoiding pain is also a natural human instinct. Maybe there is a lesson to be learn there as well when the next bailout is voted on.

An recent article in the WSJ discusses the AIG risk models developed by Gary Gordton (note, Gorton, not Gordon as originally posted), a professor at the Yale School of Management. The headline of the article boldly states "Behind AIG's Fall, Risk Models Failed to Pass Real-World Test." Yet, did the models really fail? Gordton's models were developed to gauge the risk of AIG's credit default swaps, but according to the article, "... AIG didn't anticipate how market forces and contract terms not weighted by the models would turn the swaps, over the short term, into huge financial liabilities." The quote is interesting in that it highlights what may be at the heart of AIG's problems. As a result of its ignorance on whether the short-term collateral risk needed to be considered, or its belief that such risk was not something to be worried about, AIG made a decision to not have Gordton assess these threats - even stating later that it knew his models did not consider such risk. So this begs the question once again. Did the models really fail (as approached by Gordton and approved by AIG), or was it more of a lack of understanding of the very products they were modeling? I know some will ask what's the difference - in the end the models were incomplete - but the distinction is significant.

In hindsight, it is easy to point fingers and wonder exactly what risk AIG was even trying to manage. But the real problem here seems to be less about one particular modeler getting it wrong, or developing incomplete models, and more about management ignoring to consider some risk while putting faith in the very same models that were not designed to give the level of confidence or enterprise-wide coverage that is being used to engender confidence. Even the WSJ article (in the body of the story) mentions how "Mr. Gordton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances." Of course, this did not keep AIG from trading as though it did, and therein lies the problem. The failure here is less about modeling, or even risk management, and more about corporate management and decision making. Yet, the perception that the problem is with modeling is widespread. Even Warren Buffett is quoted as saying "All I can say is, beware of geeks .... bearing formulas." But what is the alternative? Shall we abandon all risk modeling and simply use our gut instincts? Should we just take risk off the table completely? I don't believe so. While better risk management models should continue to be developed, maybe a little humility is a good place to start. Understanding a company's limitations is key to uncovering its strengths and protecting against its weaknesses.

There is an interesting article over at the All About Alpha site regarding the impact of the short selling bans on 130/30 funds. While the article discusses the obvious challenge of maintaining a 30 percent short position when many stocks cannot be shorted, it brings up an interesting point about data and quantitative modeling. As quants go forward with model development, they will need to be careful when back testing their models given the periods of time in the market when short selling was either restricted or tightened for various equities. As one expert was quoted as saying:

"Managers with quant models for generating trades will probably have their heads in their hands. Not only will the quant models have to be redeveloped, but the managers will lose months if not years worth of model evolution, back-testing and intellectual investment. I can predict a few horror scenarios where code and expertise in these models may have been lost.”

There is no doubt that many non-quants or retail investors will say "big deal, isn't it just a bunch of traders taking the hit? Why should I care?" Yet, they should. Besides attempting to make a profit and generate abnormal return, quant funds, like many other strategy based funds, seek to profit from inefficiencies in the market, which ironically helps to keep the market more efficient. When this ability is hampered, as it is when short sale rules are not only changed, but selectively changed, you just add more inefficiency and market volatility (have you seen the VIX lately?).

Sure, naked short selling is wrong, and bans need to be enforced, but interfering with the normal market checks and balances could take months to sort out, even after short selling rules are returned to normal (or at least consistent for more than two weeks at a time). Until then, risk management, arbitrage, and finding someone to take the other side of the trade will be more difficult. All the while, day traders will continue to enjoy the volatility, while retail investors will continue to get nauseous, wondering if things will ever calm down.

The drumbeat continues for adopting some type of central clearing house for the complex derivative products that are current causing issues in the marketplace (see Financial Times article). Such a move has been discussed for some time now (see posts here and here), but recent failures are certainly expected to cause the interest in creating such a clearing house to increase. Unfortunately, such an implementation, which I would support, would not be perfect, nor would it cover every existing type of over-the-counter product. Not everything can be perfectly standardized to allow for an efficient clearing. OTC trading will still be necessary for those specialized products that are offered to not only create investment banking fees, but also hedge a specific risk that a company is worried about. The ability to create these products is necessary to encourage both financial innovation, and reasonable risk taking.

So how would you guard against unreasonable risk taking? The same way as before: regulatory capital. The difference this time is that I suspect that the amount of risk capital that companies will be asked to set aside will have as much to do with both the complexity and liquidity levels as it does with the expected default rates and levels of exposure. Products that cannot be traded on exchanges or through a special clearing house will no doubt be too complex and/or too illiquid to make a market. As such, to better insure that these hard to sell and hard to understand assets are properly covered for counterparty risk, required regulatory capital will increase. If excessively complex, the level of regulatory capital may become so extreme that such "self insurance" could prevent such products from even being developed. Hopefully this will not be the case, or the intent. Responsible financial engineers (I know, that sounds like an oxymoron anymore) need to be able to continue to structure products that will allow for the off-loading of risk on both sides of the transaction. Otherwise, financial innovation and reasonable risk taking will slow down, along with the returns the markets desire. Hopefully regulators will find a "reasonable" balance that will still allow for innovation and risk management. While a flat and less volatile market sounds pretty good right now, eventually risk-taking and an expectation of return will come back to the market. Hopefully future regulation and intervention will allow it.

There is an interesting article by Felix Salmon over at the Market Movers blog on how risk aversion is changing among retail investors. It used to be that when someone was risk adverse, they wanted to make sure that their principal was protected, even if that meant giving up return. Now risk adverse investors are more worried about losing everything. Even if a nice product is offered that protects principal, it could be viewed as risky if the bank or institution offering it has the chance of going bankrupt. Riskier products, such as various types of index funds, might now be preferred. Even though they to can go down in value, and have been, the chances of them going to zero is smaller, so investors feel safer. I guess this is comparable to the current demand for gold coins. Even if gold goes down in value, investors still have something in their hand beyond just a worthless stock certificate or bank statement.

We have heard the old computer adage "garbage in - garbage out" to highlight how even a sophisticated computer program will produce nonsensical output if provided nonsensical input. The world of risk management is no different. The quants on Wall Street that are hard at work developing the next best trading and risk management systems are not perfect, but their job and measured performance becomes even more difficult when they are given bad information (see NY Times blog article).

On the surface, the goal of the risk management quants seem simply - tell me how much of the portfolio is at risk, and then tell me how much I need to sell, or how much capital I need to set aside so that I can sleep at night. In a sense, prepare me for the 100 year flood. Yet the 100 year floods seem to be occurring more often. Why is this? One possible reason is the "garbage in - garbage out" phenomenon, the problem of which is exacerbated as the markets continue to become more complex. Recent case in point, Lehman Brothers. As talk continued about a potential failure with Lehman, it became almost impossible to tell what their exposure was. Who are the counterparties? What are the default rates? What are the recovery rates? And most frightening of all, was does this new product even do? If companies cannot even understand the products they are selling, how can one expect to develop an adequate risk management system to help protect against the 100 year flood when it is not clear that water damage is even the problem, or that the strength of the levees is even important?

There is no doubt that some systems on Wall Street were provided optimistic data and assumptions, or had smoothed-out historical data in order to reduce the number of times the warning bells sounded, ultimately keeping companies from scaling back positions or redeploying capital to less profitable areas. But I suspect that there was an equal number of firms that diligently tried to provide the best information possible, but were simply in the dark. Why is this the case? There are no doubt a number of reasons, many of which are financial, but the separation between those that develop such risk management systems from those that develop products that need to be managed is not helping the situation. The information gap most likely goes both ways as the financial engineers are unaware of the workings of the risk management systems, while the risk managers are blind to the real exposures of the complex structured products that are being purchased and sold.

As more retail investors enter the markets, institutional trading continues to rise, and the securitization and engineering of products increases, both volatility and the values at risk will continue to affect markets. As new products are offered to the markets, it is essential that those who develop such products are on the same team as those who manage the risk. Risk management truly needs to be an enterprise-wide proposition, with incentives in place to reward those who properly managing risk, just as they are in place for those who engineer and sell the latest structured product. Performance on Wall Street is measured in money. If risk managers start to become rewarded in a similar manner, or if the risk management of new products begins to influence how new products are rewarded, we may then begin to find that the garbage provided to risk managers will begin to smell a little better.

Yet another article about how poorly hedge funds are doing this year, with the average fund losing more than 4 percent to date (see NY Times article). Compared to the general markets, not terrible, but certainly not what many investors in hedge funds are looking for when making such investments. The term 'hedge fund' has come to mean a number of things over the years. It will be interesting to see if the recent market troubles will cause some to go back to the basics of hedging and protecting assets. Protecting capital, in addition to generating alpha, may come back in vogue again, offering even more opportunities for those with both investment and risk management expertise.

Update: Of course, this is not as easy as it seems. As also reported recently in a New York Post article, funds with a "simple and traditional" long-short strategy are also down 3.2 percent, with some down over 20 percent. Good managers are still in short supply, and even the good ones get it wrong every now and then.

Commodity index investors (ie, speculators) sold $39 billion worth of crude oil futures between the July market peaks and September 2nd, a time that saw a rapid sell-off in crude oil prices (see Independend.ie article). The analysis was once again done my Michael Masters, president of Masters Capital Management, who recently blamed speculators for driving up prices. The drop also comes at time when the IEA is forecasting lower demand, and pension and hedge funds are unwinding commodity positions, each of which have put pressure on prices. In the end, such debate may be academic as to whether we call those selling speculators (be it hedge funds, pension funds, index funds, or individual traders). Given the exposure we all have to pensions and index funds (even us retail money mortals), we all might be classified as speculators, notwithstanding the evil mustache-twisting monopoly banker image. Of course, all this talk says nothing as for whether speculators are even inherently bad for the markets in whole (see US News & World Report blog). After all, who is going to take the other side of the position when a company is looking to hedge its risk? If the market is rising or falling, will there always be the perfect number of textbook farmers and bakers on the other side of the wheat contract? Probably not. How many companies will show higher profits, or at least less loss, due to placing proper hedges? Raising margins to decrease leverage and unhealthy exposure is one thing, but making it more difficult for the market to even function is another. If we eliminate all trades and traders that don't actually plan to buy or sell the commodity, liquidity will decrease. If this does happen, individuals may find themselves living in a much riskier world, even if the price of crude seems a little less volatile day-to-day.

As reported at the Financial Times, US banks are being asked by the Federal Reserve to run a comprehensive series of stress tests to ensure they have enough liquidity to withstand various types of financial shock. The Fed regulators are asking for scenario analysis and testing to get an idea of how the banks would perform if there was a sudden and sharp downturn in the markets, or if an individual bank had to endure a major liquidity shortage, such as the one that brought down Bear Stearns. The tests are simulating mild to catastrophic disruptions, and appear to be focusing on the balances held for the various prime brokerage businesses that lend money to hedge funds. A few hedge funds have blown-up as a result of the recent credit meltdown. It is unclear if these failures were simply a warning sign of something bigger that is worrying the Fed, or just one of many areas in need of scrutiny.

While it is unknown if and how the Fed will use the specific data, the results could provide the information they need to implement new regulatory requirements if as proposed by policymakers they eventually take over some of the responsibility currently given to the SEC and other regulators. New requirements for regulatory capital are always met with mixed emotions. On the one hand, diligent and conservative risk management can provide confidence to both the markets and investors that a company can remain solvent, even in tough times. On the other hand, stricter regulation is usually followed by higher levels of regulatory capital that must be set aside, thereby reducing the banks ability to deploy its capital in the most profitable manner. The Fed and SEC recently identified the monitoring of liquidity as something they want to cooperate on with the investment banks. This current move appears to be one of the initial steps.

The WSJ has a nice article summarizing the auction-rate security mess, along with a short primer on what auction rate securities are, as well as how they are bought and sold through auction. Definitely worth the read for those interested in what has recently become a larger Wall Street focus. Auction-rate securities are essentially a form of debt issued by municipalities, student-loan organizations, and others interested in borrowing for the long-term, but doing so at short-term interest rates. How is this achieved? By auction, of course. Every 7, 28, or 35 days, depending on the product, banks will hold auctions in what amounts to a resetting of the interest rates as the securities are passed on to the new security holders (or reset for existing holders that want to stay long).

As reported, UBS, Merrill Lynch, and Citigroup alone have committed to buying back more than $36 billion of the securities. The problem that each of these companies find themselves in, among others, is that at times the auction-rate securities may have been promoted as being similar to short-term CDs, but with higher returns. Unfortunately, as credit problems increased, the auction-rate security market also began to freeze up, making it difficult for these securities to be re-priced. Many investors were left with bank statements that simply listed a "null" placeholder where their security prices were once quoted, implying that liquidity was poor enough that a reliable price could not be provided. To complicate matters, apparently the liquidity issue has persisted for a while, even as more securities were being marketed and sold, causing many banks to prop-up the market by issuing their own bids. The WSJ reports that UBS alone may have submitted bids in just under 70% of its auctions between January 2006 to February 2008. Allegations against Merrill Lynch imply that they gave the false impression that demand was high, driven in part by dark pools of liquidity in the auction market (see previous posts here, here, here, and here on dark pools of liquidity).

As recourse, and a way for UBS to hopefully reduced the intensity of this recent black eye (how many eyes does UBS even have?), the company has agreed to buy back from investors nearly $19 billion of auction-rate securities, starting with individuals and charities this October, all the way to institutional clients in mid-2010. It is worth noting that while UBS plans to start buying back securities in October, the actual purchase could take longer. As reported in a Barron's article back in May, and discussed in a previous post, how much money investors get back from auction-rate securities depends on who originally issued the securities. The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will probably have to wait a little longer. If you or one of you investment funds purchased auction-rate securities sold by a CDO or student-loan trust, well, you may be waiting a while to get your money back, possibly many years.

The auction-rate security issues once again highlight the need for better due diligence and a better understanding of risk. As we often forget, higher reward is almost always accompanied by higher risk - I dare say 100% of the time, but someone will always find exceptions in an inefficient market. If you look for more return, you need to understand the risk. Auction-rate securities based on CDOs should have raised red flags for some. Deception is one thing, but offering a blind-eye is another. Furthermore, the way we talk about risk also probably needs to change. For instance, have you ever noticed that we seem to be having "100 year floods" every other year, or how the metaphorical "perfect storm", whether in finance, insurance, or other fields seems to occur with more regularity? Anecdotal? Sure. But eventually simply stating that the recent event was the prefect storm or a once-in-a-lifetime event will not cut it. There are only so many times that you can cry wolf before no one cares about the real danger lurking in the woods. Maybe auction-rate securities and their current issues provide another one of those warning calls we need to listen to, regardless of its eventual magnitude and implications in the current market.

The New York Times has an article today about how the CEO at Freddie Mac ignored the warnings signs of potential problems, in particular its financing of questionable loans that threatened its financial health. Not necessarily news, and you can decide who you want to believe, but it once again stresses the need for not only implementing a risk management system within companies, but actually listening to the recommendations offered by the chief risk officer. Insiders at Freddie Mac say that the CEO of Freddie Mac, Richard Syron, made things worse by repeatedly ignoring recommendations from the chief risk officer at Freddie, David Andrukonis, regarding poor underwriting standards that were becoming too weak and too risky.

Andrukonis is quoted as saying:

“The thinking was that if something really bad happened to the housing market, then the government would need Freddie and Fannie more than ever, and would have to rescue them. Everybody understood that at some level the company was putting taxpayers at risk.”

Moral hazard at is best, or ugliest. Of course, this comment is not quite as telling as the one made by CEO Syron, who contends:

“If I had better foresight, maybe I could have improved things a little bit. But frankly, if I had perfect foresight, I would never have taken this job in the first place.”

While none of us has 20-20 business vision, the need for better insight is exactly why companies need to utilize some type of risk management. Although not a perfect science (far from it), risk management can at least provide managers some of that needed foresight. While the future cannot be forecast at a level that makes it easier to sleep at night, risk management can at least provide scenario analysis supported with statistics and various risk measures, among other techniques, that will give managers some idea of where potential problems lie so that safeguards can be taken (such as increasing capital or laying off risk) and corrective action can be planned and anticipated.

It appears that Wall Street and Corporate America are getting the message as companies struggle to educate themselves on enterprise risk management, implement risk management systems, and hire employees with the proper risk management skills. Understanding credit risk, market risk, operational risk, Value-at-Risk, Basel II, RAROC, and GARCH volatility modeling are causing businesses to seek out universities and consultants as they rush to receive the needed education and training. Of course, like TQM in the 1980s and 1990s, it is up to businesses to actually practice what they preach, or at least practice what they put in place. Fortunately, for those interested in risk management, challenges and job security will be available as innovation and capital growth offer new problems for businesses. Hopefully, it will not take another Bear Stearns, Freddie, or Fannie in a few years to once again drive the point home.

The airlines, some of which have been hedging, some of which have not, are finding themselves in a difficult position - do they hedge the cost of their fuel with crude oil around $120 a barrel, and jet fuel near $3.50 a gallon? These companies must decide whether it is time to lock into prices, or whether they should simply be at the mercy of the future spot price, hoping that when they need fuel 3 to 6 months out, the market will be a little more "rational".

With high prices for fuel, it helps to drive home the point that hedging is not always the most profitable, or short-term earnings friendly move, but may be a smart long-term play. When prices are rising, then yes, you get the benefit of buying fuel on the cheap, and possibly the added benefit of raising product prices along with your competitors to compensate for the higher overall fuel cost (which may not impact you as much since you were hedged). But the story is different on the down side. As spot prices fall, you are locked into higher priced futures contracts for your raw material and energy needs, while your "risky" competitors who decided not to hedge, or simply could not hedge since they were not credit worthy and did not have the proper margin, are taking advantage of lower spot prices. To add insult to injury, you no longer have pricing power, and may even see price cuts as your competitors put the squeeze on you. If options are employed instead of futures, such that you have the right but not the obligation to pay the higher strike prices as spot prices drop (compared to how you would be obligated with a futures contract), you still do not get away unscathed. The options you buy will not come cheap, and are likely to be quite expensive during times when prices are volatile - just when you are probably most interested in hedging.

Of course, is this really what hedging is about - trying to time the market? Ideally, no. Let us look at the airlines again. In an attempt to have some forward looking predictability, they book revenue by selling tickets 3-6 months out. Shouldn't they be hedging their fuel costs now, for payment 3-6 months forward, to insure that given the prices they are currently selling tickets that they can make a profit in 3-6 months based on revenues (ticket sales) and cost (fuel) they will realize at that time? I would think so. Why do many fail to do exactly this? Well, there are probably a number of reasons, but a short-term perspective which is more interested in making earnings next quarter is probably one of the biggest culprits, not to mention those pesky credit issues. It is the classic problem for risk managers. They love you when the hedge "works", but hate you when it does "not work". If done properly, the hedge works in both situations - high and low costs - but this is not what the CFO and investors see. They only see how the company is paying $3.50 a gallon for fuel when the spot price is $3.00 a gallon. Reminding them that the company only paid $3.50 a gallon when prices were $4.00 a gallon a month ago doesn't compute, nor does the fact that you are able to help the company price its tickets properly in order to generate stable returns, since you know in advance what your cost of fuel is going to be. Ah, don't bother me with those details. Again they ask: "Why is our cost of fuel $3.50 now when spot prices are $3.00." Sigh....

Yet all of this discussion may miss the bigger issue. Anytime a company, or industry for that matter, can only show profits when it gets the hedge "right", or in other words, was fortunate or lucky enough this quarter and showed a profit since their hedge allowed them to cut costs or undercut their competitors, then it might be time to look for other sectors to invest in. Next quarter they may not be as fortunate. Companies that have the same problems with $10 per barrel oil, as with $100 per barrel oil, are simply at the mercy of the markets. These companies may make for an interesting trade at times, but in the end, you might as well take your money to the casino and bet on red or black. At least then you could save transaction costs and the bid-ask spread (well, sort of), while at the same time not worrying about strikes, delays, or passengers stranded on the tarmac.