Credit Risk Management Tools

The recent Wall Street Journal article “Odds-On Imperfection: Monte Carlo Simulation” asserts that Monte Carlo simulation did not predict the market crash, and cites a chorus of critics calling for a fix to the technique. The article equates the technique of Monte Carlo simulation with the models that are using it – two very different things. For instance, the article states, “These models were supposed to help quantify and manage the risks of mortgage-backed securities, credit-default swaps and other complex instruments. But given the events of the past couple of years, it appears that the models often gave big institutions, as well as small investors, a false sense of security.”

This is true – the models for decision making under uncertainty gave a false sense of security. But that’s because the assumptions underlying the risk analysis models were flawed, not because the technique of Monte Carlo simulation was problematic. Monte Carlo simulation is simply a mathematical technique that recalculates many different possible scenarios – but only within boundaries set by the user.  You can’t change the underlying math behind these “what-if” calculations.

The article comes close to making this distinction in one sentence: “Critics emphasize that the problem isn't Monte Carlo itself, but the assumptions that go into it.”  It then goes on to describe efforts by firms to include “fatter tail” distributions that more accurately reflect the probability of extreme events occurring as an effort to improve Monte Carlo simulation.  Tools like @RISK (risk analysis software add-in for Microsoft Excel) allow complete control over the definition of many dozens of distribution types, enabling users to create as fat a tail as they want. While these efforts make sense, it should be made clear that these are changes to underlying model assumptions, not changes to Monte Carlo simulation itself. To equate Monte Carlo simulation as a technique with the probability distributions people decide to use is to equate a carpenter’s choice of nails with his hammer.

Finally, the article cites the need to run tens or hundreds of thousands of scenarios, instead of just 100 or 1000.  This too is user-defined, and tools like @RISK can run as many scenarios as desired.

Randy Heffernan
Vice President

In assigning blame for what they are now calling "the credit crunch," the news media have been pointing vaguely in the direction of risk assessment and the models produced by Monte Carlo simulation.  But with the exception of Joe Nocera's excellent piece focusing on value-at-risk in the New York Times, I had not seen a clear explanation of the factors feeding into the exponential decline of the credit markets until I came across a policy paper from the Association of Chartered Certified Accountants, "Climbing out of the Credit Crunch."

This paper provides an excellent, plain-English account of the interplay of the many factors that brought the current turmoil in the financial sector--a number of these factors the ACCA identifies are psychological and attitudinal.  Its discussion of risk identification and management focuses not on risk analysis models but on the underlying assumptions--a common "garbage in, garbage out" observation--and a passive, unquestioning reliance on these models.  This leads the ACCA to one of what it identifies as a major risk management failure: "a very clear disconnect between incentives to senior staff" and [highly sophisticated] risk management functions."

The point is that risk management is so crucial to financial performance that executives who keep a close, critical eye on the tools and techniques they are using to assess risk should be rewarded for that vigilance. 

As a regular visitor to Norway, it is hard not to be impressed by the wealth generation in the country. Even more impressive is the discipline of the government and population to accept that the majority of the vast oil windfall of the country should be invested for the future (in a pension fund) and not spent today (high tax rates and price levels being one testament to that).

In this blog I allow myself some raw speculation as to whether holistic risk management thinking is being adequately applied when it comes to the government’s management of the wealth generated by this windfall.

In the spring of 1997, the Ministry of Finance decided that the Government Pension Fund–Global (previously known as the Government Petroleum Fund) should invest parts of its portfolio in equities. In January 1998 the fund consisted of bond investments worth NOK 113 billion (about USD 15 billion at current exchange rates). Since then inflows of new capital into the fund (also boosted by the high oil price) have been significant; in 2007, capital inflows averaged more than USD 300 million per trading day. By January 2008 the fund was worth over NOK 2000 billion (about USD 300 billion) and it is forecast to be worth over NOK 4000 billion (about USD 600 billion) by 2015 (according to the National Budget 2009)—the ultimate in retirement planning. Over time the fund’s investment guidelines have been relaxed, with the fund currently consisting of about 50% equities and 50% bonds, including government, corporate, securitized and inflation linked bonds.

To some extent there is a natural diversification in the fund. For example, to the extent that it is believed that global equities in aggregate are negatively affected by high oil prices, then there is a natural hedge in the portfolio, as increases in the oil price will reduce the equity value but lead to increased capital inflows (although the balance of this will change as the equity portfolio becomes larger). Similarly, oil-related new inflows and the investment in inflation-linked bonds could also provide some protection against long-term inflation (arguably, equities may or may not be a good long term inflation hedge). In addition, the fund of course also uses advanced tools of portfolio management, which are surely applied with rigor. However, as we know from the credit crisis, such tools can lead one to a false sense of confidence if they miss the big picture (deckchairs on the Titanic, etc!).

In this context, I allow myself to speculate (hypothesise?!) as to whether the fund should be devoting far more significant efforts to invest in non-traditional assets. (The fund’s performance is essentially currently measured against a benchmark portfolio of bonds and equities and so such efforts or investments would be hard to justify against these objectives).

The most obvious scenario in which the fund could lose out significantly would be a shift in the world’s energy sources (over the many decades of pension obligations), which could create an environment that is simultaneously largely unfavorable for most asset classes in the fund. Conceivably the potentially massive costs associated with creating a low-carbon global economy could produce a situation that is unfavorable for most global equity investments, that could unleash inflationary forces that reduce the value of many bond investments, and potentially reduce demand for oil (and its price). Such a “nightmare” scenario for the fund does not seem beyond the realms of reality. 

The most obvious strategy to mitigate the effects of this scenario would be for the fund to proactively take very large positions in alternative energy technologies. Such positions would presumably need to be very large (and possibly require the fund to itself create and support the development of new innovative companies in this area, not just to passively invest in existing ones). The costs and risks in doing so would be large (particularly as the scenario may never materialize), but it could be a prudent one, given the already very large fund that already exists for a small population base of about 5m people. Could it be so bad if 5%-10% of that fund were invested in such technologies? (Such investments would arguably support, or at least relate to, some of the fund’s other goals—such as ethical or social investments). A risk assessment would be a good idea. Now, back to the real world!

Dr. Michael Rees
Director of Training and Consulting