Losses, Leverage, and Liquidity

The Road Ahead for Risk Management

Carl TannenbaumVice President, Risk Specialist

DivisionFederal Reserve Bank of Chicago

Risk Conference, April 2009 Page 2

Presentation Outline

•Risk and Reinforcement: When Moods Add to Models

Risk Conference, April 2009 Page 3

Key Risk Metrics

Mean Blood Pressure Consumption Indicators

Caffeine Alcohol

Years Until Affordable Retirement

0

20

40

60

80

100

120

Mar J un Sep Dec Mar

What Word Best Describes Your Emotions?

Anger

Depression

Acceptance

Panic

Risk Conference, April 2009 Page 4

Spiraling Upward

Gains

Capital

ConfidenceAggression

Absence ofCaution

Risk Conference, April 2009 Page 5

Spiraling Downward

Losses

Capital

ConfidenceApprehension

Abundance ofCaution

Risk Conference, April 2009 Page 6

Models: Natural Accelerants

•Roll rates•VaR•Economic CapitalOnce bad things start to

happen, models close down fastL

osses

Risk Conference, April 2009 Page 7

Lessons Learned: 1

• Past is not always prologue; models should not assume that it is

• Life events are not normally distributed; why do models assume that they are?

• How do we avoid extreme overreactions?

Follow-up: models and their applications need to be recalibrated

Risk Conference, April 2009 Page 8

Source: Bloomberg, ICI Statistics & Research

Still in the MattressVolumes in Money Market Funds

Risk Conference, April 2009 Page 9

Assets of Commercial Banks

Ratio of Loans & Leases to Total Assets(All Commercial Banks, SA)

Ratio of Cash to Total Assets(All Commercial Banks, SA)

Week of Feb. 25

Week of Feb. 25

9

Risk Conference, April 2009 Page 10

Source: Federal Reserve

Still in the VaultExcess Reserves Held by Commercial Banks

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Risk Conference, April 2009 Page 12

A Thought:

We’ve gone from disintermediation right

past re-intermediation to non-intermediation

Risk Conference, April 2009 Page 13

Presentation Outline

•Risk and Reinforcement: When Moods Add to Models

•Learnings Gained the Hard Way

Risk Conference, April 2009 Page 14

Spiraling Downward

Losses

Downgrades

Collateral CallsReducedLiquidity

DistressedAsset Sales

Risk Conference, April 2009 Page 15

Liquidity Issues to Think About• Mismatches matter

– Think about liquidity transfer pricing

• Look beyond the boundaries of the balance sheet– Commitments, SPVs, sponsored funds

• Value collateral conservatively– Don’t assume availability, even with FHLB– Know when you might be asked for more

• When will investors return to buy assets in the seconday market?– Structures go back to basics

Risk Conference, April 2009 Page 16

Loss Estimates Escalate

370

945

1405

2200

Sep '07 Apr '08 Oct '08 J an '09 • Contagion increases losses

• Initial capital raising proves inadequate

• Investors become hesitant to absorb new issues

Source: IMF

Projected Credit Losses, $$ Billions

Risk Conference, April 2009 Page 17

Lessons Learned: 2

• Declines in asset prices can be a cross product of loss and liquidity– Note: A pool with a 50% PD and 50% LGD still

has an intrinsic value of 75 cents on the dollar

• Credit and liquidity risk are closely related, for both markets and institutions

• Know where you stand in the capital hierarchy

Follow-up: linking events in stress testing for liquidity and market risk

Risk Conference, April 2009 Page 18

Presentation Outline

•Risk and Reinforcement: When Moods Add to Models

•Learnings Gained the Hard Way

•Where We Stand in the Journey Back to Normalcy

Risk Conference, April 2009 Page 19

Rebuilding the Base

•Public capital predominates

•More losses ahead

•Concerns over the “quality of capital”

•How to make capital levels countercyclical?

Risk Conference, April 2009 Page 20

Where We Stand:Credit Risk

Loss

Reco

gn

itio

nLo

ss R

eco

gn

itio

n

Risk RecognitionRisk Recognition

Residential RE

Commercial RE

Consumer Credit

C&I Lending

Issues•Recession Scenario•Guarantors•Models: High-end, low-end•Inexperience

Ag Lending

Risk Conference, April 2009 Page 21

Foreclosure Filings

2008 Foreclosure Rate United States: 1.8%

1.Nevada: 7.3%

2.Florida: 4.5%

3.Arizona: 4.5%

4.California: 4.0%

5.Colorado: 2.4%

6.Michigan: 2.4%

7.Ohio: 2.3%

8.Georgia: 2.2%

9.Illinois 1.9%

10.New Jersey: 1.8%

Risk Conference, April 2009 Page 22

Credit Spreads: Still Wide

Risk Conference, April 2009 Page 23

Policy Steps

•$800 billion in fiscal stimulus•TALF, PPIFF for banks•Foreclosure mitigation•Bigger line for the FDIC•Review of Mark to Market Accounting

•Regulatory Restructuring

Risk Conference, April 2009 Page 25

Conclusions

• The American financial landscape has changed historically in just the past six months; maybe more ahead?

• The Treasury and the Fed have been exceptionally active

• We’ll be learning from and debating recent events for years to come

Losses, Leverage, and Liquidity

The Road Ahead for Risk Management

Carl TannenbaumVice President, Risk Specialist

DivisionFederal Reserve Bank of Chicago