November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Turbulent

Violently agitated or disturbed; tumultuous: turbulent rapids.

Having a chaotic or restless character or tendency: a turbulent period in history. Causing unrest or disturbance; unruly: turbulent, revolutionary undercurrents.

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Signs of Turbulence

Bear Stearns, Lehman Brothers, Merrill Lynch, Wachovia, Washington Mutual, National City, Goldman Sachs, AIG, Morgan Stanley, Bank of Iceland, Fifth Third, Comerica, GMAC, Barclays, Northern Rock, Fannie Mae, Freddie Mac, Constellation Energy, Citigroup, Credit Agricole, Societe Generale, Nataxis, UBS, Credit Suisse, IndyMac Bank, National Bank of Greece, Sachsen, Countrywide, GM, Viacom, Chrysler LLC, General Electric, Ford Motor, KeyCorp, Regions

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Signs of Turbulence

• MSCI World Index: (24) %• S&P 500: (19)• Russell 2000: (10)• International Stocks: (29)• Emerging Market Stocks: (36)

Virtually every stock market in the world is down double digits in 2008.

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Signs of Turbulence

• Hedge Fund Aggregate Index: (9.90) %• Global Macro Index (2.10)• Long – Short Index (13.3)• Event Driven Index (9.30)• Managed Futures Index 6.70

Most ‘safe’ hedge fund strategies lost value in 2008

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Signs of Turbulence

• TED Spread• Negative Treasury Yields• Negative TIP Yields• Muni v. Taxable Yields• ‘Breaking the Buck’

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Signs of Turbulence

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Signs of Turbulence

• TARP• Temporary Guarantee Program for Money Market • Term Securities Lending Facility• FDIC Coverage Expansion• Commercial Paper Funding Facility

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

‘Investing In Turbulent Times’

• The Perfect Storm• Risk Management Fundamentals• Going Forward

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

‘Investing In Turbulent Times’

• The Perfect Storm• Risk Management Fundamentals• Going Forward

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

The Perfect Storm

• Irrational Optimism• Uneven Regulatory System• Emergence of Complex Securities• Absolute Low Level of Interest Rates

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Complacency and Optimism

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The VIX – The Fear Gauge

“No Fear”

“Panic”

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Uneven Regulatory System

Unregulated Institutions• Hedge Funds / Private Equity• SWF

Regulated Institutions• Banks• Insurance Companies• Thrifts

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Variety of Regulatory Agencies

Treasury Department• OCC

Independent Agencies• FDIC• Federal Reserve• SEC• CFTC• FASB / GASB• PCAOB• FINRA

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

How Much Complexity?

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

“Behind AIG’s Fall, Risk Models

Failed to Pass Real-World Test”

Headline in WSJ – 11/3/08

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Absolute Low Level of Interest Rates

0.0%

1.0%

2.0%

3.0%

4.0%

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6.0%

Aug-01 Feb-02 Aug-02 Feb-03 Aug-03 Feb-04 Aug-04 Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08

One Month Bills

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Pension Plan Returns (Assumed!)

GE 8.50%

DOW CHEMICAL 8.30%

EXXONMOBIL 9.00%

KELLOGG 8.90%

WHIRLPOOL 8.50%

BOEING 8.25%

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

‘Investing In Turbulent Times’

• The Perfect Storm• Risk Management Fundamentals• Going Forward

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

What Is Risk?

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Risk:

exposure to the chance of injury or loss; a hazard or dangerous chance: It's not worth the risk

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

What Is Risk?

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

“To me, risk management is not about measurement at all. It is how we make decisions. What matters in thinking about risk is the quality of the decisions we make in the face of uncertainty.”

‘Risk: The Hottest Four-Letter Word in Financial Markets’

-Peter L. Bernstein 2006

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

A Return To Risk Management Principles

• Management• Measurement• Oversight

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Management of Risk

• Fiduciary Responsibility• Approved Policies• Independent Oversight• Defined Structure• Consistency

• Education and Resources• Understand Key Risks• Setting Risk Limits• Routine and Exception

Reporting

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Risk Management Cycle

Frequent• Cashflow • Positions

Annually• Assess Environment

– State Fiscal Situation

– Enrollment

– Fund Balance

• Review Policies

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Measurement of Risk

• Valuation Procedures• Measurement and

Attribution• Risk Adjusted Returns

• Stress Testing• Back Testing• Assess Model Risk

“Not Measured, Not Managed”

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Oversight of Risk

• Due Diligence• Independent Review• Review Processes

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Ten Commandments of Risk Management

1. Training

2. Self-Assessment

3. Written Policies

4. Independent Oversight

5. Simulation

6. Mark to Market

7. Establish Reserves

8. Establish Limits

9. Define Roles and Responsibilities

10.DEW

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

‘Investing In Turbulent Times’

• The Perfect Storm• Risk Management Fundamentals• Going Forward

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Going Forward

Inflation Fiscal Policy ?? Monetary Policy

Recession/Deflation De-Leveraging Plunge in Commodity Prices Asset Write-offs Re-Regulation Constrained Credit TIP Spreads

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Forward Curve Data

Current FWCV ChangeOne Year 1.24% 1.49% 0.25%

Two Year 1.37% 1.72% 0.35%

Three Year 1.56% 1.93% 0.37%

Four Year 1.75% 2.81% 1.06%

Five Year 2.48% 3.24% 0.76%

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Accomodative Monetary Policy

Fed Funds Target: 1.50%

Inflation (PCE) -2.40%

Real Fed Funds Rate -0.90%

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Portfolio Construction

• Return on Capital v. Return of Capital• Watch Key Risks:

– Market Risk– Credit Risk– Headline Risk

• Diversification

November 6, 2008 ‘Investing In Turbulent Times’ MCCBOA

Bibliography

• In An Uncertain World, Robert E. Rubin• The Black Swan, Nassim N. Taleb• The (Mis)Behavior of Markets, Benoit Mandelbrot