Financial Market Opportunities and Threats

1. Financial Market Opportunities and Threats • Alton Cogert • CFA, CPA, CAIA, CGMA • President and CEO • March 29, 2012

2. Threats • Financial Repression • “Fat Tail” Events and Multiple Equilibria • Regulators and Rating Agencies • Corporate Governance

3. Opportunities • Risk Appetite • Tactical v Strategic Allocation • Different Asset Classes

4. Financial Repression PIMCO-CEO-Mohamed-El-Erian-Bloomberg-TV (YouTube video) PIMCO-CEO-Mohamed-El-Erian-Bloomberg-TV (mov file (212mb)

5. Financial Repression • Explicit/implicit control/cap of interest rates • ZIRP through 2014 • Operation Twist • Creation/maintenance of domestic market for govt debt • QE1, QE2, QE3 on the way?

6. Financial Repression • Creation/maintenance of domestic market for govt debt • Fed effectively reports to TBTF banks, who are primary dealers • Fed buys US debt - without limit? • Restrictions on transfer of assets abroad through capital controls • Ultimately, a dose of inflation • Expectations game

7. First Order Effects • Low, low rates - negative real rates • Reduced expectations for long term equity returns • Increased, but forced, risk appetite • Unstated “Beggar thy neighbor” bias • Triparty relationship: USD/EUR/RMB • Cover for QE

8. “Fat Tail” Events Word of the Day Fat-Tail (YouTube video) Word of the Day Fat-Tail .mov file (56mb)

9. “Fat Tail” Events

10. Multiple Equilibria • Two or more scenarios, each with its own distribution of outcomes, market functioning and returns. • Assess relative likelihood of scenarios • Tipping point - when relative weight given to non-status quo scenario starts to rise for a subset of investors.

11. Multiple Equilibria • Boldly betting on one of the scenarios requires a very high level of conviction in an inherently “unusually uncertain” context. • Or, positioning for the average means being in the muddled middle - pays off only if the unsustainable (middle) is sustained

12. Multiple Equilibria • Better: Early detection of structural biases for multiple equilibria with low cost tail-risk hedges. • If not: Increasing cash (another form of tail-risk hedge) until bimodal features are resolved.

13. “Fat Tail” Events • Currency crisis => Rate crisis => Fiscal crisis • Euro sovereign => Euro bank • CDS/Derivative crunch • USA Bank write downs (2nd Mortgages?) • Geopolitical (China unrest, Middle East issues, Developed social unrest) (multiple equilibria) • Inflation v Deflation (multiple equilibria)

14. Inflation Adjusted S&P 500

15. Regulators and Rating Agencies • Revising Capital Requirements • ORSA (Own Risk and Solvency Assessment) • Rating Agency Changes? • Systemically Important Financial Institutions • ERM - The Next Generation

16. ORSA in 3 Steps • Description of Risk Management Policy • Quantitative Measurement of Risk Exposure (Normal and Stressed Environments) • Prospective Solvency Assessment • 3 - 5 year time horizon

17. Corporate Governance • How active is the Board in Strategic... • Planning and alignment • Decision making • Scorecards • Risk Management • To what extent is there a Risk Culture?

18. Opportunities • Risk Appetite • Tactical v Strategic Allocation • Different Asset Classes

19. Risk Appetite • Define Reward - Yld, Ret, ROA, ROE, PVDE? • Define Risk • Develop Analytics for your Definitions • Quantify Risk Appetite Among Board and Senior Management

20. What Is Asset Allocation? Introduction to Asset Allocation - Part 1 What is Asset Allocation (YouTube video) Introduction to Asset Allocation - Part 1 What is Asset Allocation mov file (14mb)

21. Tactical v StrategicAsset Allocation • Would we make this decision if we were not facing lower portfolio book yields? • NO - Tactical • YES - Strategic

22. Tactical v StrategicAsset Allocation • Implementation - Strategic • Passive v Active Management • After tax/fee performance comparisons • Manager service levels • Other

23. Tactical v StrategicAsset Allocation • Implementation - Tactical • Strategic Issues Plus • When to reverse/change? How much? • Who makes the decision to reverse/change? • How will tactical performance be judged?

24. Tactical v StrategicAsset Allocation • Tactical • Next decision: Tactical or Strategic • Strategic • Next decision: Usually Strategic

25. Different Asset Classes • Four possible (reasonable) responses to Financial Repression: • Change Risk Profile of CFI Portfolio • Use Non-CFI as source of added income • Decrease Risk - Wait for better yields • Cash = Optionality • Do Nothing substantially different

26. Different Asset Classes • Change Risk Profile of CFI Portfolio • Review Liability Duration • Review Liquidity Requirements • Private Placements • Review True Portfolio Credit Risk

27. Different Asset Classes • Non-Core Fixed Income with Yield a significant portion of expected total return • Commercial Mortgages (BB/BBB quality) • High Yield Bonds (Broad credit range) • Emerging Market Debt (Usually Sovereign) • Bank Loans • Non-Agency RMBS

28. Different Asset Classes • Non-Core Fixed Income with Yield a significant portion of expected total return • High Yielding Dividend Equities • MLP’s, REIT’s, etc. • Other

29. Financial Market Opportunities and Threats • Largest Threats: Financial Repression, “Fat Tail” Events • Largest Opportunities: • Take a Closer Look at • Risk Appetite • Different Asset Classes • Why?

30. Financial Market Opportunities and Threats • Thank You, and a special thank you to: • Bloomberg • MyFinanceTutor.com • Russian TV

31. Financial Market Opportunities and Threats • Q & A