The New York Chapter explores credit risk management and behaving wisely

The historical sense involves a perception, not only of the pastness of the past, but of its presence.

--T.S. Eliot, "Tradition and the Individual Talent," The Sacred Wood, 1920

The January meeting of RMA's New York Chapter featured its Annual Chief Credit Officers Panel in a discussion that began with lessons learned--or should have been learned--after the most recent credit cycle. The panel then discussed the roles of fundamental credit analysis and advanced portfolio management techniques and concluded with what they believe may lie ahead. Patrick Reidy, senior vice president at The Bank of Tokyo-Mitsubishi and chapter president, introduced the panel and posed the questions. One word may have been heard more than any other: liquidity.

Lessons Learned

Patrick Ryan, CCO, Citigroup's Global Corporate and Investment Bank, reviewed lessons learned during the last cycle, including the impact of industry deregulation, country risk events, sponsor behavior, and structured finance:

* "Deregulated industries--especially power and telecom--proved to be the bane of our existence in 2002 and 2003," he said. "Some businesses were organized with management teams, capital structures, and risk management practices that were not robust enough when industry structures changed radically.

* Country risk can be significant for Citigroup, which operates in 100 countries and plans to have very large franchises in 10 to 15 of them. "A country crisis brings about a convergence of risk elements--market, credit, and operational," said Ryan.

* Sponsor behavior. If an investment decision counts on some form of support from a corporate or project parent, it may not be there because of the company's fiduciary responsibilities to its shareholders. In the last cycle, "risk versus return became entirely asymmetric," he said. The relationship returns built up over many years, he explained, were asymmetric to the amount of risk taken in financing should support no longer be available.

* Structured finance has been receiving considerable attention in the media and in the regulatory community, a trend that will continue. Lessons learned involve the type of client the bank is dealing with and the complexity of its corporate structure, its balance-sheet and off-balance-sheet activities, and its investments and other uses of cash.

Ryan noted common themes among these lessons:

* Structure, terms, and conditions matter. "Among other things, they determine whether you can get a seat at the table when things don't go as planned and what your rights and remedies are," he said. In the current environment, terms and conditions are weakening dramatically.

* Economics and the fundamentals of supply and demand do matter.

* Credit fundamentals do matter, and there is no substitute for understanding a customer's management and a fundamental analysis of cash flow and liquidity. "High leverage can hurt, but a lack of liquidity can kill," he said.

* Bankers also must consider valuation and how the enterprise value of the company fits within the loan-to-value spectrum.

The Role of Fundamental Financial Analysis

Patrick Reidy, Bank of Tokyo-Mitsubishi, acknowledged that there are investors for whom fundamental analysis is not as important as changes in market value and the ability to move quickly in and out of investments. He questioned whether large, unexpected losses can be detected at all through fundamental analysis. Stephen Holcomb. CCO, Morgan Stanley, maintains that fundamental financial analysis "is the central part of the process we go through in making our decisions. Analysis is key to understanding the customer and its management and decision-making structure."

Bharat Masrani, CRO, TD Bank Financial Group, said, "Not only is fundamental financial analysis important--it's critical. While trading businesses allow you to move in and out of credits on a regular basis, dealing with clients on a longer-term basis means you must understand what's going on. You can't just rely on the view of the markets, because markets are not always reflective of inherent risks."

Holcomb said he couldn't imagine regulators being satisfied that banks can hedge every risk that exists. "There's a time when there won't be liquidity, and we'll quickly learn that not everything is salable," he said. "So the regulators will want to be assured there's solid financial analysis behind an institution's decision making."

Morgan Stanley relies on strong in-house training to give new hires what they need to perform good financial analysis, and Holcomb said lenders go through the same training as the firm's investment bankers.

Remarking that different skills sets are being hired in--some quantitative, some the more traditional fundamental analysis--Reidy asked whether there's cross-training for employees to gain both fundamental analysis and portfolio management skills. Masrani said that TD Bank recognizes the value of having both skills sets, there are obstacles arising from compensation systems. The bank looks for diverse skills sets in its new hires, noting "availability of quality resources is an issue that's as cyclical as the credit cycle." TD Bank is able to enhance its training through programs offered by RMA and others, but acknowledged that all banks have problems with training, as it's often the first area to be cut in a budget crisis.

Advanced Portfolio Management Techniques

Benefits. Having had experience in both the buy-and-hold and mark-to-market worlds at Morgan Stanley, Holcomb feels one great benefit of advanced portfolio management techniques is greater liquidity from broadening the base of those participating. "The CDS [credit default swap] market was nonexistent five years ago and until recently was dominated by a handful of institutions," he said. "Now there are hedge funds and bank loan funds that raise their own interesting risk questions about what could happen in the next crunch. The big issue is whether that liquidity remains when we get to the next down-cycle."

Referring to the problems of the last cycle, Masrani said that not only had the market misunderstood what was happening, but lenders had missed them as well. "So one of the big benefits of advanced portfolio management is to have more data points coming into your shop and therefore be able to react in more of a real-time basis," he said.

Challenges. Ryan believes that the most important challenge in portfolio management techniques is accurately aggregating all risks taken in a very active portfolio management construct. "You may find yourself creating a structured vehicle that mitigates some risk but not all of it. You may have indexed products somewhere in the institution that have tranches of some of the very risk you got rid of in the first place. The more you do, the more you have to be careful."

Noting that, under the original Basel Accord, banks began managing underlying assets by using cash syndicated markets, Reidy said the trend now is toward a full market where people are distributing assets on both a cash and a synthetic basis. Masrani said that accounting standards are not keeping up with some of the techniques now available to financial institutions. "You mark-to-market your hedging book, whereas your loans are on an accrual basis, which can potentially create confusion in your financial statements," he said.

Masrani questioned whether buyers of risk understand what they're taking on. "Often these institutions are not as well regulated," he said. "We have had very good liquidity, partly due to the introduction of leverage by large trading banks and hedge funds. We may face illiquidity when we all seek to sell. It will be interesting to see if the same players will be there in a downturn." As for apparent and hidden leverage at every level and, in some cases, of a mismatch between how investors are funding themselves and the liquidity in their investments, Holcomb acknowledged that the issue is very worrisome. "Given what we know about the behavior of hedge funds when they feel they need liquidity, they, too, have investors that will be looking for the door. We must stay on top of this."

Another challenge in instituting advanced portfolio management is overcoming cultural biases. "All of us knew this was the way to go, even before the last cycle hit," said Masrani. "But banks naturally like to think of themselves as superior pickers--hence, they are slow to adopt portfolio management theory."

Final Thoughts

Asked about an overarching point of focus for credit professionals, Ryan answered "cash flow." Holcomb added that this is the point in the cycle to be shedding risk. "If we haven't already crossed the top of the bubble (and there now are signs that there's too much money chasing too few deals, interest rates are on the rise, ratings agencies are beginning to forecast higher default rates, and loan structures are deteriorating), we're at the cusp, and we should be taking steps to make sure the walls of the fort are up," he said. "We've seen credit standards erode and a greater degree of problems with structures and covenants. Also, look at sectors with a lot of leverage, like hedge funds, which are doing deals with leverage rates at seven times--any kind of shock will tip the scales."

"Have we really learned any lessons at all?" asked Masrani. "Every cycle we have the same problem: We think we've found the magic bullet, and we haven't. The last downturn turned around quickly because of liquidity; but now we're seeing the reverse of liquidity. While we all know the next down cycle is inevitable, we don't know which event will trigger it. Large single-name exposures seem to be a problem in every cycle--we think we transfer risk out, but we make exceptions, and when markets turn, banks always seem to be holding the credit. Lessons are forgotten quickly."

Holcomb agreed, saying that the economy is at a fragile point. "We must be prepared for an exogenous event. It wasn't the destruction of the World Trade Center that hurt financial institutions, per se; rather, it was the effect the event had on the consumer, who drives the economy. So any single exogenous event can have a monumental effect on the economy, but so could a panic, such as investors suddenly beginning to sell and then everyone else trying to get to the door first."

An audience member asked the panel members how their organizations hold staff accountable for the decisions they make. Ryan said that Citigroup uses a risk/reward return on capital benchmark that is consistent among the institution's origination forces. Citi also allocates portfolio results back out to users of capital--in good times as well as bad. Masrani said the last cycle taught TD Bank to clarify at the outset who owns the risk--in this case, it's the business. "Risk management gives risk oversight but does not own the risk," he said. "Interests must be aligned organizationally. We've also been working toward more market-based transfer pricing. Lending generally is a loss leader--if you're going to use it, you're going to pay for it."

Another audience member asked what causes panelists to have sleepless nights. "No one can predict what will cause the train to derail," answered Masrani. "Look at the effect of the deficit on exchange rates. It boils down to liquidity. One of these events will have a reverse effect, and credit markets will be stressed." Masrani also mentioned reputation risk and the expectation to "be our brother's keeper. We banks may have expertise in certain risks, but managing reputation risk is more difficult," he said. For Ryan, it's the issue of systems, controls, and pricing mechanisms in financial institutions, especially during times of stress in the markets; the proliferation of new, hard-to-value products; the need for systems to be able to talk to each other; and dealing with a liquidity crunch. Holcomb allowed that, while institutions can quantify their risks to a particular industry or country, "when the crunch comes, what is the risk position we haven't identified--the class of products that goes completely out of whack with what the models predicted? There is a lot of structured product being done but the unknown is what always gets you up at night." Picking up on Masrani's comment about reputation risk, Holcomb pointed to regulatory risk, saying, "Regulators are changing the location of the goal posts on us and, as Bharat said, expecting us to become our brothers' keepers. We now must know if what we're doing with a client runs counter to the client's own regulations."

"History teaches us that men and nations behave wisely once they have exhausted all other alternatives," Abba Eban once said. The role of risk management today is to have many Risk management alternatives at our disposal--all of them wise--and to use them to help keep past mistakes in the past. As the panel at the New York Chapter meeting agreed, advanced techniques, strong fundamental credit analysis, and good judgment are all necessary risk management tools for 2005.

Contact Beverly Foster by e-mail at [email protected].

Beverly Foster is editor of The RMA Journal.

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