By James Hamilton, J.D., LL.M.
Citing the Amaranth hedge fund implosion, an SEC senior official cautioned that from a risk management perspective concentrations are clearly undesirable and should be avoided. The question is however, recently stated Director of Trading and Markets Erik Sirri, how much concentration is too much. While in retrospect it is easy to look at what happened to that hedge fund and chalk up its demise to a concentrated natural gas bet gone wrong, or attribute the distress of other hedge funds to concentrated subprime exposures, prospective identification of risky concentrations is hard because bright line tests for how much is too much are elusive.
In addition, concentration must be assessed across many different dimensions. For example, the official asks how concentrated is a portfolio of fund derivatives of $15 billion notional hedged with the underlying hedge fund shares. Diversification across specific funds can offset concentration in a particular strategy.
Another complication is the possibility of a position suddenly becoming concentrated because of the actions of other market participants. As trading comes to a halt when liquidity dries up, positions that appeared to be modest in size relative to market activity can prove virtually impossible to exit, leaving little or no ability to actively risk manage the position through hedging activities.
A separate problem arises with securitized products such as mortgage-backed securities, which rely on the diversification of an underlying pool of assets. But reliance on diversification adds a new risk factor, said the director, namely the correlation among defaults or losses on underlying collateral. This correlation exhibits a form of negative convexity that is particularly difficult to capture and manage.
Another key component of risk management for securitized products and OTC derivatives is the valuation process. While it is tempting to rely on dealer quotes for the valuation of derivatives trading in liquid over-the-counter markets, noted the official, it is also a very risky proposition since one is relying on the continued liquidity of the market for marking. Even more, he continued, relying on dealer quotes is an abdication of the basic responsibility of a trader to understand risks.
While mark-to-model has taken on an ugly connotation in recent months, noted the director, it must be remembered that the process of modeling the positions' value ensures that complex risks, such as out-of-the-money puts, are understood. Simply relying on a price from another market participant involves no such understanding of risks, he averred, and is tantamount to flying blind.
Yet another fundamental rule of risk management is that risk is fungible. A trading firm that carefully measures and limits risk of a particular type is likely to find its traders and counterparties exposing the firm to risks of a type that are not as easily identified.
For example, firms may try to limit market risk exposure by limiting the balance sheet allocated to particular traders or businesses. But, given the availability of off-balance sheet funding arrangements, noted the official, the efficacy of such governance tools is obviously quite limited. And there is also a possibility that relatively straightforward market risk will be transformed to less easily measured liquidity risk. In a similar vein, a variety of market risk exposures can be easily transformed into counterparty credit risk using over-the-counter derivatives.
In the director’s view, a particular challenge to risk management is presented by asset backed securities collateralized debt obligations, which are essentially re-securitizations of already securitized products. These instruments create tranches with differing risk-return profiles intended to appeal to different investors. The riskiest tranche bears losses first. The least risky tranches are called super seniors. Since At deal inception super seniors are all rated AAA, risk managers are lulled into complacency.
The AAA ratings in particular made market participants comfortable holding concentrations that would have been unthinkable otherwise. But, while super seniors receive principal and interest payments until the lower tranches are wiped out, observed the SEC official, from a fair value perspective the price at which the investor can sell the position will decline.
In addition, the concentrated positions in super seniors emerged as a result of specific governance policies intended to minimize other risks. For example, the riskiest tranches were priced attractively relative to expected cash flows. Since the overall cash flow from the underlying assets is invariant to the capital structure, the cost for skewing distribution toward the lower tranches was that higher tranches such as super seniors were relatively overpriced and thus more difficult to sell.
In this way, governance mechanisms intended to limit one type of risk effectively led to other risks being assumed that were more complex and difficult to analyze. In turn, a risk management problem occurred when concentrated positions in super seniors developed into a risk that suddenly became illiquid. Once markets start moving adversely and liquidity goes away, said the official, there is little left other than to hope.