The crisis: What have we learned about risk and return?

René M. Stulz

Inquire Meeting, Luxembourg, October 3, 2011

Roadmap

• How much did we learn from the previous crisis?

• A crisis is a situation where diversification does not work, but why?

• Implications of liquidity shocks• Illiquidity, liquidity risk, and asset returns• Tail risk and asset returns• Practical implications

“The worst financial crisis in the last fifty years”

“There was virtually nobody who saw that low- probability event as a possibility.”

Robert Rubin

But

• We had 1987• We had 1997-1998• We had 2000-2001• So, what’s left to learn from 2007-…?

This time is different• One of the most famous economics

books of the last few years!• The point is that people always think

that this time it will work out well.• With Rüdiger Fahlenbrach and Robert

Prilmeier, I have a paper titled: This time is the same: Using bank performance in 1998 to explain bank performance during the recent financial crisis

Table 2 – Buy-and-hold returns during the financial crisis and returns during the crisis of 1998

(1) (4) (5)Crisis return 1998 0.6550***

(4.73)0.4895***

(3.11)0.4409***

(2.59)Rebound return 1998 0.0535

(0.66)-0.0122(-0.11)

Return in 2006 -0.2591**(-2.55)

-0.2023*(-1.77)

Book-to-market -0.1847(-1.54)

-0.3627***(-3.25)

Log (market value) -0.0488***(-4.11)

-0.0194(-1.44)

Beta 0.1195***(3.10)

0.0887**(2.16)

Leverage -0.0206***(-3.28)

Tier 1 capital ratio 0.0192***(2.81)

Number of observations 347 345 318R-squared 0.06 0.16 0.13

Economic magnitude:One std decrease in 1998 returns (0.125) -> 610 basis points lower annualized returns during 2007/2008

One std increase in 2006 leverage -> 700 basis points lower annualized returns during 2007/2008

After 1998

• Heavy criticism of VaR because of fat tails; focus on stress tests.

• Extreme Value Theory is hot.• Liquidity-adjusted risk measures and asset

pricing models are hot. • Yet, financial institutions that did poorly in 1998

did poorly during the recent crisis.• More generally, we went back to doing after

1998 what we did before.

What happened?

• Did we fail to learn?• Was it not worth it to change?– The state motto of Luxembourg is “We want to

remain what we are”• We forgot? • Some of all three.• Economics, politics, and psychology all play a

role.

What would you rather focus on?

Google searches for Financial Crisis

Crises can only occur if they have an extremely low ex ante probability

• Asset markets may not be perfectly efficient, but they are efficient enough that if suddenly investors expect a price to fall in a year, it will fall today!

• So, crises are tail events by definition.• But why are crisis outcomes so bad? Why do

they appear to come from a different distribution?

What makes a crisis? Diversification failure

“ Granted, we had a huge balance sheet with lots of positions, but we didn't think we had that much risk. We were looking at day-to-day and month-to-month swings that were very small. I know it seems incredible. Maybe we got lulled in after four years."

Source: JP Morgan

# of hedge fund styles experiencing worst returns (10)

Non-parametric dependence for hedge fund styles

Why do correlations get so high?

• Suppose market model holds, but market volatility increases.

• Realized correlations will be high, so high volatility of common factor is an explanation.

• Another implication of high volatility is that tail outcomes will look abnormal if evaluated using average volatility.

What is missing?

• This explanation does not tell us why volatility of common factor is high.

• With it, a systemic crisis is just an episode with higher volatility.

• This explanation has a hard time accommodating LTCM-like outcomes were uncorrelated positions become highly correlated. It does not explain the hedge fund evidence.

Key feature of 1998 and 2008

• In both crises, liquidity disappeared. Why?• Investors run from risky assets to safe assets.• Part of the story is that they don’t believe that

they were right in assessing the risk of assets.• Assets that appeared to be riskless are

suddenly risky.

Credit crisis

• Before the crisis, AAA structured finance securities were viewed as riskless.

• When it became clear they were not, liquidity disappeared.

• What makes an asset liquid? The fact that no information is required to trade it.

Reassessing risk during crisis

• Information asymmetries become important, which kills liquidity (Gorton and Holmstrom)

• Investors discover neglected risks (Shleifer and Vishny)

• Investors don’t know how to measure risk anymore; it is all uncertainty (Caballero and Krishnamurthy)

• So, investors perceived higher risk, which increases risk premia in addition to reducing liquidity

Asset liquidity versus funding liquidity(Brunnermeier and Pedersen)

• Asset liquidity is the ability to sell without price pressure.

• Funding liquidity is the ability to raise funds to finance positions.

• With less liquidity, margins increase.• This forces deleveraging.• Which leads to losses, which leads to more

deleveraging.

Which banks did better?

• Paper with Andrea Beltratti, forthcoming in Journal of Financial Economics

• Those with less fragile funding.• Those with more equity.• But not those with better governance.

Liquidity disappears

• Diversification disappears• Fire sales show up• Markets stop working• Hedge fund evidence: Unrelated hedge fund

strategies are more likely to have extreme down returns when asset liquidity and funding liquidity have experienced adverse shocks.

Mitchell and Pulvino, Arbitrage crashes and the speed of capital

Hedge fund evidence

• Boyson, Stahel, Stulz, JF (2010), JOIM (2012)• Clustering of hedge fund style performance

(seen in earlier slides)• Clustering is much more likely during and

following liquidity shows• We use liquidity shock index based on bid-ask

spreads, growth of repo market, prime broker stocks, credit spreads

Should illiquidity and exposure to liquidity risk be compensated?

• One has to distinguish between illiquidity and liquidity risk. An illiquid asset is one that one cannot trade without making price concessions.

• Acharya and Pedersen, CAPM holds net of liquidity effects• Illiquidity should be compensated – otherwise, why would

you hold the asset? • There is now ample evidence that there is a liquidity risk

factor and that one earns compensation being exposed to that factor.

• An important question to always ask: Is my positive alpha just compensation for illiquidity or for bearing liquidity risk?

Papers at this conference

• Franzoni/Nowak/Phalippou: Find that private equity has an alpha of 0 when taking into account liquidity risk

• Dong/Feng/Sadka: Mutual funds loading on liquidity risk perform better, but the better performance is only partly explained by liquidity risk premium

• Bongaerts/De Jong/Driessen: Illiquidity is priced in bonds, but liquidity risk is not.

What about crash exposures?

• After the 1987 crash, investors were willing to pay more for crash insurance in the options markets.

• So, we should expect that assets more exposed to crashes should earn a premium.

• Historically, it might have been small because the probability of crashes was small. Is it still small?

How to measure crash exposure?

• Two papers in the conference attempt to do that.

• Both approaches inspired from EVT.• One paper looks at the tail of the cross-section

of returns.• Another paper looks at tail-dependence in

returns between individual stocks and the market.

What do the papers really measure?

• Both papers identify a premium for exposure to their measure of tail risk.

• What is that premium for? – Is the cross-sectional measure a proxy for volatility? – Why does not beta capture the tail dependence? Is

there a non-linearity? • Do these papers capture exposure to systemic

risk? Tail returns in a typical year have little to do with systemic risk.

Practical implications?

• No, this time is not different. Run liquidity dry-up scenarios. Measure your exposure to tail risk.

• Should you take tail risk or not? – Hurricane risk or tsunami risk?

• If it is tsunami risk, do you have time to get out of the way? Depends on liquidity.

• Should you take liquidity risk? – It pays, but only if you don’t have to trade when things

go bad, but you don’t have to pay 2-20 for taking it.