A sting in the tail

After recent financial turmoil, market participants are thinking much more rigorously about ways to protect themselves against the possibility of rare but extreme events. However, effectively hedging tail risk is not straightforward. By Mark Pengelly


When asked what posed the greatest challenge for a statesman, former UK prime minister Harold Macmillan is reported to have responded: “Events, my dear boy, events.” The same could be said for risk managers, especially when extreme events prove so tough to accurately forecast.

Truly disastrous market shocks have been in rather short supply, making it exceptionally difficult to estimate the probability of future extreme events with any degree of precision. Recent periods of marked turbulence include the US savings and loan crisis in the late 1980s, the Asian financial crisis of 1997/98 and the bursting of the dotcom bubble in 2000. Yet nothing has come close to the scale of the recent market meltdown, and many market participants were ill-prepared for such a massive tail event.

“To a greater or lesser extent, tail risk has been pretty much ignored prior to the past two or three years. Some people were aware they were taking tail risks, but risk policies ignored them and how they should be hedged,” says Carlos Blanco, managing director at Berkeley, California-based consultancy Black Swan Risk Advisors (BSRA). Since the outbreak of the US subprime mortgage crisis in 2007, and the subsequent bankruptcy of Lehman Brothers in September 2008, market participants have begun to take it much more seriously.

The failure of Lehman provides a particularly important lesson to risk managers. Not only did the bankruptcy drum home the importance of systemic risk, but evidence on the circumstances of the firm’s collapse shows how Lehman itself struggled with tail risk.

According to a report by bankruptcy examiner Anton Valukas filed on March 11, Lehman had employed stress testing since 2005 to capture the risk of tail events. The stress tests were based on 13 or 14 market shocks, including some that aped historical events such as the October 1987 stock market crash and the Russian debt crisis of 1998.

However, untraded assets such as commercial real estate and private equity investments were excluded from the tests. At first, this was because Lehman did not have significant investments in these areas, but they were not included even as these positions became an increasingly important part of Lehman’s risk profile in 2006 and 2007. This meant Lehman did not have a regular and systematic means of analysing the “catastrophic loss the firm could suffer from these increasingly large and illiquid investments”, the report says.

Experimental stress tests conducted in 2008 showed a large proportion of Lehman’s tail risk lay with the businesses that had been excluded from the regular exercises. One test showed the excluded positions could produce $10.9 billion of losses, although the results were never shared with senior management, according to the Valukas report.

“Lehman was portraying itself as a great risk manager to the market and the rating agencies, but the truth is its risk management process sucked,” says Blanco at BSRA. At the very least, one lesson that could be drawn from the episode is that the risk department must be given explicit responsibility for dealing with tail risk, he adds: “Somebody should be accountable for dealing with tail risk and it should be a part of the risk function.”

Common risk measures also stand accused of failing to properly consider tail risk. Both value-at-risk and the Gaussian copula have come under fire in recent years for failing to capture the risk of rare but extreme events. “If you’re going to rely on quantitative measures, they have to be the right ones. They don’t have to be foolproof, but at least they should be technically correct,” says Blanco.

Encouraged by regulators, market participants have relied too much on the use of VAR in recent years, he suggests. Instead, more attention should be paid to measures such as expected tail loss or conditional VAR, which captures expected losses when they exceed a specific quantile. Another useful measure is probable maximum loss, says Blanco.

Meanwhile, risk managers highlight stress tests as a major tool in dealing with tail risk. Reverse stress tests, or the process of seeking out scenarios that could seriously threaten an institution or a portfolio, are also growing in popularity. “Market participants need to identify the kind of tail events to which their own portfolios or business revenues are exposed. Once they’ve done that, they need to have some idea of a cash value that is at risk in a scenario they’ve identified,” says Joe Holderness, London-based head of JP Morgan’s credit portfolio group.

But coming up with plausible tail risk scenarios is not easy and requires imagination. “Many problems in the crisis were caused and compounded by a failure of the imagination. Market participants considered the improbable impossible and only stress-tested the probable. Now, people have some experience in seeing unlikely things happen,” says Holderness. In going through possible tail risk scenarios, it is useful to have a team of people with diverse skills. “You want a multiplicity of views,” he adds.

David Rowe, executive vice-president for risk management at systems vendor SunGard in London, agrees. Asking basic questions about market trends and structure could have helped market participants prepare for the subprime mortgage crisis, he believes: “If we’ve not had a decline in housing prices across the country since the Great Depression, I’m not going to say we must exit the subprime mortgage market tomorrow. But we should give serious attention to the hypothetical and ask ‘what if prices did fall?’.”

This exercise might have set alarm bells ringing about the scale of the impact that would have been felt if house prices dropped, he thinks. It might have also raised issues such as the number of homeowners with mortgages on teaser rates, many of whom had relied on rising property prices when taking out the loans. The difficulties faced by these borrowers as teaser rates reset at higher levels added to the downward pressure on real estate. Rather than thinking of a house price crash or other tail event as an isolated scenario, this process should help risk managers think about how events play out, he says.

“Too often we think of stress tests as comparative statistics – we shock exchange rates or interest rates and see what happens. In fact, crises don’t unfold that way. Crises unfold in a cascade of loosely connected events,” says Rowe.

Working out how these events will unfurl is never easy, Rowe admits. Nonetheless, there’s no doubt walking through these possibilities would have helped. While accuracy may be hard to come by when predicting tail events, market participants suggest it is more important to identify potential risks in the first place.

For instance, in the run-up to the financial crisis, it was tricky to model the exact impact a housing shock might have on subprime mortgage-backed securities (MBSs) – but that should not have stopped risk managers realising MBSs would be hit if house prices dropped. “The state of modelling MBSs wasn’t very advanced, but you could have become totally lost in the trees and forgotten the thing to do was to shock housing,” says Vineer Bhansali, who oversees analytics and quantitative investment portfolios at Newport Beach, California-based bond manager Pimco. Having found that many subprime mortgages would become highly impaired during this kind of scenario, the firm responded by putting on hedges and making its portfolios more resilient, he says.

Instead of getting carried away thinking about the probability of extreme events, Bhansali thinks risk managers should concentrate on their potential impact: “Most people fixate too much on the probability and getting the distribution right. That’s less relevant because the probability of a tail event is so hard to forecast anyway. What’s more relevant is the intensity of what happens to your portfolio during that severe event.” If these events are found to threaten portfolios in a big way, market participants should consider hedging, whatever the cost, he asserts.

However, the inherently uncertain nature of tail events means it is difficult to find effective hedges for tail risk. “In the centre of the distribution, you may be relatively confident you’re going to do a good job. With the tail, it is always a much more complex exercise and you need to approach it with much more caution,” says Blanco at BSRA.

There are certain factors that are common to all instances of tail risk. “When there’s a systemic event, certain things always happen: volatility rises, correlations rise and everybody tries to sell securities at the same time. That also leads to liquidity gaps,” says Bhansali.

These kinds of characteristics make finding and implementing hedges for tail risk events even more difficult. With valuation and trading likely to prove more troublesome in illiquid markets, risk managers say it is better to stick to simple, vanilla products as opposed to more exotic hedges. Another benefit of using vanilla hedges is the opportunity to hedge in large sizes, says Bhansali.

When implementing hedges against tail risk, one problem could be timing. “If the tail event happens, it’s quite common to want to take the hedge gains, but these are not easy decisions to make. Timing is always a difficult thing to get right,” says JP Morgan’s Holderness. For instance, a bank could have made huge gains on a convex options strategy referencing the S&P 500 index during the financial crisis, but would have had great difficulty closing out its position at exactly the right time. Consequently, market participants should not expect to realise the full gains from hedges designed to mitigate tail risk.

One particular feature of tail events that has been underlined by the recent crisis is the significance of counterparty and wrong-way risk. “The counterparty and wrong-way aspect of tail risk hedges can be very important,” notes Chris Finger, Geneva-based head of research at risk management and analytics firm RiskMetrics. Wrong-way risk could involve buying a put option on gold from a gold mining company, for example – a trade that would increase in value as the creditworthiness of the counterparty is likely to deteriorate.

In the context of the financial crisis, similar wrong-way risk materialised after banks hedged bumper volumes of super-senior collateralised debt obligations of asset-backed securities with players such as monolines. “Those who thought it was a good idea to buy super-senior protection from people whose only business was writing super-senior protection in many different formats were completely misguided. That was a very foolish thing to do,” remarks one risk manager.

While avoiding wrong-way risk, market participants say a diverse group of trading counterparties is also preferable for tail risk hedges. For hedge funds, the failure of Lehman provided a compelling case for trading with multiple dealers or prime brokers. For banks, the poor performance of trades conducted with hedge funds, designed to offset exposures, demonstrated the need to lay off tail risks across a broader range of clients. Meanwhile, with markets in flux, risk managers say it is crucial to be aware that correlations between assets can change rapidly during a tail event. Emphasising this point, they cite the failed hedging strategy of some market players during the financial crisis, which involved going short mezzanine structured credit, yet funding this position by going long super-senior risk. As the entire capital structure sank, such hedges swiftly proved ineffective.

Although there’s no one-size-fits-all strategy, being cognisant of these possibilities and developing strategies to deal with tail events is critical, say market participants. This means seeking tail risk hedges even when the risk of a tail event appears remote. “People just forget about tail risk when markets aren’t that volatile,” says Sanjay Sharma, chief risk officer for global arbitrage and trading at Royal Bank of Canada Capital Markets in New York. “Right now, if you want to protect against a market decline of the S&P 500 index and you buy protection with volatility futures, it is so cheap people will say I do not need to hedge tail risk.”

But like other market participants, Sharma says tail risk hedging is best viewed as insurance. While it may be tempting for firms to forget about the possibility of tail events during periods of high economic growth and double-digit returns, they need to take the opposite view. “You have to take a contrarian approach. The potential for surprise is greatest when hedges are cheap rather than when they are expensive. When they are expensive, the surprise has already happened,” he says.

Like any contrarian bet, this move could prove costly over the short term. At Pimco, Bhansali says the firm recommends giving up 5–10% of the expected returns of a portfolio in order to hedge tail risk. “If your portfolio returns around 10% a year, you should be willing to spend about 1% of that a year on buying hedges that are around 10% out-of-the-money,” he suggests.

But if tail risk strategies work out, firms should feel the benefit over the long term – a point underlined by SunGard’s Rowe: “These things make sense, but they’re not free. It takes courage to accept the fact that your performance will lag that of your competitors in good times, when euphoric markets fail to recognise the value of the protection you have put in place.”

While forgoing some returns in order to hedge tail risks, market participants also advocate placing a general cap on the amount of tail risk an institution is willing to undertake. This means rather than being an afterthought, tail risk should help inform management decisions about which businesses to cultivate and which ones to exit, says Blanco at BSRA.
Before mid-2007, some firms were discriminated against for not participating in subprime mortgages or trading with monolines, market participants observe. The short-term costs of this approach do not seem as heavy now.

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