RMO Q&A

Thomas Donahue, Director, Derivatives Management, MetLife

Thomas Donahue, director for derivatives management at MetLife, outlines the issues inherent in the insurance giant's pursuant of greater risk-adjusted returns.

What is the biggest trend you are seeing in risk management?

The short-term focus is on Y2K and year-end funding issues. Financial institutions are attempting to balance the risk of being too liquid, versus having a surprise need for funds. Over the last ten years or so, the turn of the year has often exhibited seasonal tendencies. The turn gets expensive during the summer, and then in mid-to-late fall, the concern eases and the turn pricing comes down. Technical factors such as whether the turn is on a weekend, such as on Friday in 1999, or if it occurs mid-week is also a factor.

Companies are also trying to smooth cash flows so that some cash flows occur in December and some in January. The idea is to prevent the cash flows from being "bunched up" at end of year. This "bunched up" phenomenon often occurs due to ease in calculating the accounting numbers. In addition, companies are considering whether to pay down Commercial Paper borrowings in order to avoid any liquidity squeezes. Since several large investment banks have a year-end for November 30th, companies may assume that dealers will be less willing to carry inventories of corporate debt. On the other hand, many believe that the Fed will ensure that the system is awash in liquidity via the Fed Funds market or Treasury open market operations. Many marker participants believed that a good deal of foreign money will come to the US for the turn, since we appear to be most Y2K compliant.

A long-term trend is the internal "turf battles" that occur as various organizations within an institution try to lay claim to operations risk responsibilities. The corporate risk committee wants it, internal audit wants it, and comptrollers department wants it. Typically, associating the responsibility with internal audit is the "kiss of death," since any information that audit receives will be used against the business line or so it is believed.

What are some of the projects that your group is working on?

A significant project that is being undertaken is a more thorough testing of our risk models and attempting to measure how well the model continues to reflect actual market prices and events. We are fine tuning our results based on continued testing.

What are the biggest challenges facing this industry? What are the solutions?

The big challenges are the changing nature of assets in which we are investing. We are now buying names with more credit risk and investing in emerging markets and high yield bank loans. This has helped us achieve greater diversification, as well as to increase our return numbers within an acceptable incremental increase in risk.

Where do you think risk management is headed in the next five years?

Risk amendment in the coming years should see a greater integration of credit and market risk, and a more sophisticated approach to what-if scenarios. Every market crisis or operational disaster pro vides greater impetus to learn how to better implement and apply risk measurement techniques. Our testing techniques will be more refined and results will occur faster. We must guard against the temptation to think that because we can quantify risks more easily, we are get ting increasingly better predictive abilities.

What are your business line managers demanding from risk technology?

Traders and risk mangers want to know how they will be judged. The traders want to maximize their income and not have a surprise capital change intra-trade and after the trade has occurred. Risk mangers want to know what risk tolerances will be allowed and how they will be judged.

Where are we now and stress testing. Giving the enormous variety of assets that we own and the specialized skills that are required to support these assets, correctly evaluating risks can be a major challenge. New markets, illiquid instruments, structural risks, special purpose vehicles, differences in accounting and tax treatment all lead to potential surprises on the financial statements. We plan to perform a thorough evaluation of the nature of some of the asset markets and look beyond the valuation of the assets and focus on who is active in these markets and what drivers are adding liquidity and what will occur in the demand/supply interaction in the market if financing, valuation, or investment authorizations of these assets were to be dramatically changed. One example is that the Federal Reserve's decision in about 1989 to change the ability of money funds to purchase A2/P2 commercial paper as a percentage of assets held. A frequent pitfall is that evaluations are done of a transaction at inception and what the results are likely to be at the end of the investment horizon. If for some reason related to accounting, tax and credit-related events, the investor wants to sell or assign his ownership during the investment periodic, the treatment of gains and losses or tax impact may be dramatically different. Stress testing often focuses exclusively on market risk and not as effectively on the accounting and tax treatment of the economic results.