Counterparty Risk Management During the Credit Crisis - An Asset Manager's Perspective

1. Counterparty Risk Management During the Credit Crisis - An Asset Manager's Perspective Richard A. Libby, Ph.D. Chief Credit Officer Global Credit Group Barclays Global Investors 28 April 2009

2. Overview • The Financial Crisis of 2007-2009 is a “fifty year” economic dislocation event originating in over-extension in structured credit product innovations arising over the past thirty years, now transformed into a classic credit-driven bust • The crisis in structured credit fell over into the general economy, creating downward momentum of demand, the “classical” part of the current crisis • While recent innovations in risk management are characterized by standardization of analytical tools within the framework of international efforts such as Basel II, adequate restraints were not applied sufficiently early to reduce the scope of losses and write downs now estimated in the $2 to $3 trillion range. The key technical failure was the lack of development of sound liquidity risk management and macroeconomic forecasting tools • Going forward, financial institutions and regulators need to rethink the nature of Risk Management process in specific areas such as liquidity risk, and need to reconsider the corporate governance role of Risk Management in general

3. The Credit Crisis Begins – an Outside Viewevents before September 2007 • The origin of the Credit Crisis began in US housing as a rise in the number of foreclosures on subprime mortgage debt, a trend that became observable in mid 2006 • The contributors to the Crisis next manifested themselves in a number of high-profile failures of subprime mortgage originators in late 2006 and early 2007 • Pre-Crisis events came to the attention of markets in general, such as the failures of high profile hedge funds managed by UBS and Bear Stearns in the period from March to July 2007. Ironically markets entered a false recovery in May 2007 with US 10-year treasuries reaching a yield of 5.25%

4. The Credit Crisis Begins – an Outside Viewevents before September 2007 • Financial institutions began assessing the liquidity risks of their mortgage securities in June 2007 with the collapse of two Bear Stearns hedge funds, following on a threat by Merrill Lynch to seize and liquidate collateral • The spreading concern for the liquidity of structured mortgage securities reached a crisis point in early August 2007 as UK financial institutions stopped funding each other’s short term paper, forcing the Bank of England to provide funding, later copied by other central banks. This point is now considered the beginning of the actual Credit Crisis • The first stage of the Credit Crisis can be said to have ended with the UK bailout of Northern Rock. Markets calmed after that point and major equity indices hit a peak in October 2007. Liquidity of ABCP, which dried up in August, did not return to pre-crisis levels, however

5. The Credit Crisis Begins – an Outside Viewevents before September 2007 Before the liquidity crunch of August 2007, many analysts assumed the “correction” in US housing prices would be something of a soft landing. The liquidity crunch was instead the artifact of the intrinsic complexity and wide margin of error of pricing models for structured securities

6. The Credit Crisis Begins – an Inside Viewevents before September 2007 • The rise in the number of foreclosures on subprime mortgage debt was seen and discussed by credit analysts in many firms. In particular, stress tests of subprime mortgage default rates gave clear signals as to how to manage against deteriorating credit in an orderly fashion. The ultimate weakness of the analysis was the underestimating of the extent to which many investors did not do fundamental analyses of structured mortgage securities • With the failures of highly leveraged hedge funds, the analyst community concluded that good, but not perfect, models had been abused through the overuse of leverage, a text book lesson that some but not all risk managers understood • The collapse of liquidity in short term asset backed commercial paper took the entire industry by surprise. The failure of financial institutions to properly gauge the global reach and interconnectedness of mortgage securities holdings exposures prevented them from understanding their individual and collective overextension in this product. This lesson is also a text book case, but as the text itself is in macroeconomics, most risk managers missed it

7. The Credit Crisis Widens – an Outside ViewOctober 2007 to August 2008 • The Credit Crisis returned in late October with the first round of significant write downs by major financial institutions (Lehman, Merrill, Morgan Stanley), the closing of “enhanced” cash vehicles (Schwab, Bank of America) and the widening conclusion that the Structured Investment Vehicles (SIVs) would no longer be a viable product in the marketplace (Citigroup) • As of November 2007, a number of financial news sources began quoting an estimated total write down figure in the range of $200 to $400 billion, now seen as a significant underestimate. Morgan Stanley’s $3.7 billion loss in November 2007 from failed hedges to its bet on the fall of subprime debt keenly focused the market on the potential size of the subprime crisis, putting additional liquidity pressure on all investment banks and short term credit markets • Credit markets experienced a wave of panic in November 2007 as year end financing became the topic of fresh speculation • The auction rate note market used by many US municipalities dried up in February 2008, leaving many issuers and investors without recourse to funds, when the major market makers (chiefly Citigroup, UBS, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort. Citigroup has since agreed to repurchase $7.3 billion of these securities; Merrill Lynch has agreed to repurchase securities it had sold. US regulators are engaged in preliminary settlements with several other broker-dealers

8. The Credit Crisis Widens – an Inside ViewOctober 2007 to August 2008 • The initial analyses of the Credit Crisis focused on subprime mortgages and liquidity risk; parallels to the demise of Long-Term Capital Management in 1998 were drawn, particularly around the time of the Northern Rock bailout. Initial assessments of asset fundamentals showed upper tranches of ABS CDOs and other structured credit as being sound, showing that liquidity risk continued to be an underappreciated exposure class. Morgan Stanley’s $3.7 billion loss due to failed hedge performance in November changed the market’s appreciation of the depth of the Crisis • Conservative credit managers in general saw the brief bull equity market of October 2007 as a false signal, given the exposure of major counterparties to mortgage securities, and waited for Q3 2007 financials, avoiding the relaxing of credit lines into a deepening crisis, particularly as year end approached • With deepening write-downs extending forecasts of the breadth and duration of the crisis, markets began questioning the liquidity of investment banks, most notably Lehman Brothers and Bear Stearns. Owning to a business model that relied heavily on Prime Brokerage for its liquidity needs, Bear Stearns failed the examination in mid March 2008 when a large number of hedge fund clients moved elsewhere • After Bear’s acquisition by JPMorgan Chase, markets entered a short-lived period of calm before turning its attention to the next domino to fall: Lehman Brothers

9. The Credit Crisis Widens – an Inside ViewOctober 2007 to August 2008 CDS as a risk management tool • CDS spreads saw a significant run-up before the Bear Stearns near-collapse in mid March 2008 • At time of Bear’s mid March collapse, speculation swirled around Lehman as the next weakest broker • After markets calmed down once the Bear Stearns acquisition by JPMorgan Chase was seen as completed, CDS spreads began widening again as sentiment turned against the long term viability of major institutions

10. The Credit Crisis Widens – an Asset Manager’s ViewOctober 2007 to August 2008 Broker Dealer and Bank 5-year CDS, May to August 2008: As spreads widened, risk management actively revived and updated their contingency plans around major counterparty default

11. The Credit Crisis becomes the Financial Crisis – an Outside ViewSeptember 2008 to December 2008 • Although the Crisis started in subprime mortgages, it led to liquidity shocks in other credit markets. The crisis began to impact Alt-A and prime mortgages, leading to market speculation in August that the two GSEs, Fannie Mae and Freddie Mac, would require a bailout by the Federal Government • Meanwhile, investment banks saw their ability to fund themselves declining across the board. Lehman reshuffled its management after failing to calm markets after its Q2 2008 earnings announcement, further damaging market confidence • With the takeover of Fannie Mae and Freddie Mac in early September, AIG was nationalized and the four remaining investment banks ceased to exist in quick succession: • Lehman bankrupt • Merrill Lynch sold • Goldman Sachs and Morgan Stanley reborn as commercial banks • Credit froze world wide following the Lehman collapse, requiring months of careful and extensive management by central banks globally

12. The “Great Recession” – an Inside View2009 First Half • The various rescue packages for financial institutions are returning stability to markets, albeit slowly. True recovery cannot begin until markets are at least stabilized • Structured credit has not revived from its mini “dark age” as the fundamental assumptions regarding credit quality and diversification that persisted prior to 2007 have been universally abandoned without new assumptions replacing them • Market disruptions have spread out from their source in US housing to the entire global market, affecting diverse asset classes from commodities to foreign exchange

13. The “Great Recession” – an Inside View2009 First Half • Concerns regarding sovereign credit risk have grown following the collapse of Icelandic banks in Q4 2008 and the size of US, UK, Irish and Swiss central bank support relative to GDP • With rising joblessness and tightening credit, consumer spending in most markets is down, frustrating efforts to implement stimulus measures • US housing likely has further correction to go as renting remains more economical than owning, with some evidence rents are falling in many US markets. As a result the housing component of Fed “stress tests” of banks may not be stressful enough

14. The “Great Recession” – an Asset Manager’s View2007 to 2009 • Lessons learned from within a major asset management shop include: • Even when your own analysts have correctly assessed asset fundamentals, never overlook the potential for liquidity shocks caused by other investors not doing their homework (Cash Management) • Never underestimate the ability of illiquid markets to amplify the margin of error embedded in market signals used for investment strategies (Fixed Income) • Never overestimate the credit quality of your major counterparties or rely too heavily on credit ratings alone (Credit and Middle Office) • Risk Management staff must be as well versed in market incentive based behaviors as are your Trading and Portfolio Management staff (Risk Management; Senior Management) • “De-silo” Risk Management to ensure business expertise is brought to bear on risk management issues and actions. Risk Management is too important to be left to “Risk Management” alone

15. The “Great Recession” – an Asset Manager’s View2009 First Half • Overall, Asset Management gets a “B” rating. • Certain products like money market funds acted like synthetic Savings & Loan Associations by providing liquidity and funding into a structure that had overextended itself • Other products like index funds saw no material challenge to their model • Active quantitative funds saw large swings in valuation early in the crisis due to deleveraging within an increasingly crowded field. Asset managers need to understand the degree to which overcrowding in a given management style will impact performance • The notion that the primary risks of Asset Management are operational and reputational goes unchallenged. Nonetheless the industry needs to ramp up its market, credit and liquidity management expertise in similar ways to the sell side • The industry needs to consider whether Risk Management makes for good risk management: does the Risk Management model suffer from Principal Agency Risk in that the function does not own the risks it covers? The governance model that places Risk Management within the overall organization does not necessary guarantee effectiveness, nor does it demonstrate an historically effective hedge against the “long call option” held by risk takers in the organization