MCCBOA November 6, 2008‘Investing In Turbulent Times’ Turbulent Violently agitated or disturbed;...

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.


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


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.


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


Signs of Turbulence

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


Signs of Turbulence


Signs of Turbulence

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


‘Investing In Turbulent Times’

• The Perfect Storm• Risk Management Fundamentals• Going Forward


The Perfect Storm

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


Complacency and Optimism

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The VIX – The Fear Gauge

“No Fear”

“Panic”


Uneven Regulatory System

Unregulated Institutions• Hedge Funds / Private Equity• SWF

Regulated Institutions• Banks• Insurance Companies• Thrifts


Variety of Regulatory Agencies

Treasury Department• OCC

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


How Much Complexity?


“Behind AIG’s Fall, Risk Models

Failed to Pass Real-World Test”

Headline in WSJ – 11/3/08


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


Pension Plan Returns (Assumed!)

GE 8.50%

DOW CHEMICAL 8.30%

EXXONMOBIL 9.00%

KELLOGG 8.90%

WHIRLPOOL 8.50%

BOEING 8.25%


What Is Risk?


Risk:

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


What Is Risk?


“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


A Return To Risk Management Principles

• Management• Measurement• Oversight


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


Risk Management Cycle

Frequent• Cashflow • Positions

Annually• Assess Environment

– State Fiscal Situation

– Enrollment

– Fund Balance

• Review Policies


Measurement of Risk

• Valuation Procedures• Measurement and

Attribution• Risk Adjusted Returns

• Stress Testing• Back Testing• Assess Model Risk

“Not Measured, Not Managed”


Oversight of Risk

• Due Diligence• Independent Review• Review Processes


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


Going Forward

Inflation Fiscal Policy ?? Monetary Policy

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


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%


Accomodative Monetary Policy

Fed Funds Target: 1.50%

Inflation (PCE) -2.40%

Real Fed Funds Rate -0.90%


Portfolio Construction

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

– Market Risk– Credit Risk– Headline Risk

• Diversification


Bibliography

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

MCCBOA November 6, 2008‘Investing In Turbulent Times’ Turbulent Violently agitated or disturbed;...

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