Credit Crisis and Risk Management Dominate Forum Discussion
By Mimi Lord
Interestingly, last year’s EMF speakers had forewarned that over-leveraging and other financial excesses during the 2003–06 housing boom were bound to lead to financial instability. Dan Fuss, of Loomis, Sayles & Company LLP, had cautioned that if a liquidity shock occurred when assets were highly leveraged, redemptions might not be manageable and investors could “fall through the ice.”
As 2007 unfolded, the waters did, in fact, become increasingly icy, with the housing boom turning into a bust and the vast universe of securities backed by subprime debt becoming suspect. Massive write-offs at financial institutions—some quite prestigious—mounted; access to capital dried up; and the Federal Reserve felt compelled to make aggressive rate cuts to avert or at least lessen the effects of a looming recession.
Uncertain financial markets show little signs of normalizing, as 2008 progresses. Consequently, reactions, advice, and strategies for working within such a volatile environment formed the centerpiece of this year’s EMF content.
The “Anatomy of a Credit Crisis” was an apt title for one of the opening sessions and could have served well as the overall conference theme. Alan Schwartz, CEO of Bear Stearns, recapped the buildup of credit risk that stemmed from easy lending practices based on expectations of ever-rising home prices. He explained that, unlike previous housing booms, many lenders in the recent cycle no longer held onto loans but sold them to investment firms that repackaged them into mortgage-backed securities. These asset pools consisted of various tranches of loans based on credit quality. When housing prices began to soften, mortgage delinquencies and defaults started rising and cash flows into the investment pools diminished. This caused prices of the poorest-quality securities to plummet and investors to realize that the value of various structured investments could drop a lot more.
Among the plethora of newer financial instruments came the now-infamous collateralized debt obligation, a narrower packaging of securities consisting largely of subprime debt. Schwartz described the irony of the AAA rating given to these CDOs, based on rating agencies’ thesis that the diversification of securities made them worthy of the top credit rating. However, in the summer of 2007, “people realized that there was no diversification within the AAA CDOs—they were all made up of BBB-mortgage-backed securities—and they were all bad,” said Schwartz. The creation of CDOs essentially ceased. In addition, the leveraged loan market screeched to a halt as demand dried up for the huge backlog of high-yield debt that had been committed to leveraged buyouts.
As the credit markets started unraveling, Schwartz noted, problems ballooned. Housing prices continued to weaken, more delinquencies turned into foreclosures, and additional tranches of mortgage-backed securities became worthless. Fears began to mount that corporate default rates also could rise. Meanwhile, said Schwartz, initial rate cuts by the Federal Reserve failed to restore confidence in the credit markets, and the Fed had to resort to loan auctions and more drastic rate cuts.
Some Bet on Growing Defaults
With Schwartz’s historical review in mind, it’s easy to see why many investors suffered losses on mortgage-backed securities. Others, however, foresaw the collapse of subprime debt and were able to reap huge profits. Among those was Paulson & Co. Inc. hedge-fund managers, who identified the problem early and shorted a tranche of securities, which they considered very vulnerable, via credit default swaps—instruments that are similar to put options on bonds. In his remarks at the EMF, Paulson’s James Wong described how the firm viewed the opportunity in 2005: “BBB residential mortgage-backed securities bonds were trading close to par, so premiums were only 1 percent. We thought there was a very good chance the bonds could go to zero—in other words, we could risk 1 percent to make 100 percent.” Since the firm believed other sectors would suffer as well, Paulson also shorted debt and equity of homebuilders, mortgage originators, and monoline insurance companies.
Although Paulson has since monetized most of its short positions, Wong said the firm continues to believe there is “more pain to come.” Housing prices may continue falling until they reach a level that is 20–25 percent below their early 2006 peak levels. In Wong’s view, the extent of defaults will not be discernible until some of the poorest- quality loans reset over the next several months. Highly leveraged financial institutions with deteriorating asset quality remain vulnerable, both in U.S. and international markets. Wong referred back to the financial problems in the late 1990s, when excessive leverage led to the collapse of Long-Term Capital Management. “Including derivative exposure,” Wong explained, “we now have the equivalent of several Long-Term Capitals out there that are effectively levered up to 100 to 1. Who’s going to bail them out? This is an unprecedented problem in an unprecedented time.”
Lessons From 2007
Howard Marks, of Oaktree Capital Management, reminded EMF attendees that the lessons from the recent credit debacle are the same as those of prior financial crises. He listed a dozen such lessons.
- Too much capital availability makes money flow to the wrong places.
- When capital goes where it shouldn’t, bad things happen.
- When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.
- Widespread disregard for risk creates great risk.
- Inadequate due diligence leads to investment losses.
- In heady times, capital is devoted to innovative investments, many of which fail the test of time.
- Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.
- Psychological and technical factors can swamp fundamentals.
- Markets change, invalidating models.
- Leverage magnifies outcomes but doesn’t add value.
- Excesses eventually correct themselves.
- Investment survival has to be achieved in the short run, not on average over the long run.
Expanding on the last point, Marks noted: “Ensuring the ability to weather the bad times is incompatible with maximizing returns in good times.”
Proceed With Caution
The magnitude of the unfolding credit crisis colored nearly all sessions of this year’s endowment forum, topics of which ranged from governance issues to hedge fund investing to global growth. Professional money managers were generally reserved regarding market upsides in the current environment, although several speakers indicated that big opportunities still exist in certain segments of emerging and frontier markets. Other presenters, such as Marilyn Fedak, of AllianceBernstein, indicated that the financial sector is providing some positive situations related to the subprime crisis. Speaking at a preconference seminar hosted by Vanguard, Fedak cautioned that investors need to test worst-case scenarios before taking action.
For the most part, endowment officers and money managers agreed that the fallout from the housing bubble and subsequent subprime crisis will continue for some time. When preconference panelists were asked about their greatest concerns, Gus Sauter, Vanguard’s chief investment officer, cited the potential for a protracted credit crunch, stemming from banks’ unwillingness to lend because of inadequate reserves.
Certain Hedge Funds Shine in Poor Markets
Another EMF panel, “Hedge Funds That Truly Hedge,” extolled the overall portfolio benefits of a hedge fund component consisting of multiple, diversified hedge funds that (a) do not seek to augment systematic returns of the market through leverage, but (b) provide absolute returns that have low correlations with market returns of traditional asset classes.
Jay Compson, of Absolute Investment Advisers, noted that in the past certain asset classes, such as real estate investment trusts and international developed-markets equity, provided diversification from S&P 500 market behavior. However, in recent years, publicly traded equity asset classes in general have become increasingly sensitive to market risk and thus provide fewer diversification benefits. A portfolio of diversified hedge funds, in contrast, can reduce sensitivity to market factors and thus provide a buffer in market downturns without requiring leverage.
Connie Teska, of Pluscios Management, compared the risk-reward attributes of hedge funds and traditional asset classes over the past decade, as shown in Figure 1.
Figure 1—Risk-Reward Attributes
As indicated in the figure, the HFRI Index of hedge funds over the past 10 years provided higher returns with considerably less volatility than either the S&P 500 Index of U.S. equities or the MSCI World Index of global equities. The hedge fund index’s Sharpe Ratio, which measures return per unit of risk, was significantly higher than that of the other three asset classes. Teska also pointed out that hedge funds can help to smooth an earnings stream in an overall portfolio because of the concentration of monthly returns around the mean. Perhaps most importantly, she said, hedge funds can preserve capital in declining equity markets. According to Teska, the HFRI Fund of Funds Composite Index declined in only 26 months over the past 10 years, compared to 47 months for the S&P 500. And in nearly all of the months where both indices declined, the hedge fund index was down significantly less than the S&P 500.
Both Compson and Teska stressed the importance of diversifying hedge fund styles and managers, as well as examining potential managers’ returns over the course of an entire market cycle. They advised: Beware of newer managers without sufficient history to indicate performance during market downturns and dislocations. Compson also cautioned attendees about “long-long-long-short” managers who may only outperform in bull markets.
Governance Gets Another Look
Jonathan Hirtle, of Hirtle, Callaghan & Co., led off the sessions on governance, noting that endowment governance has become more challenging because of rapid changes in investment vehicles and market conditions. “We have arrived at a tipping point,” he said, “where our old, culturally biased decision processes can no longer manage market complexities,” he said. “Consequently, investment committee governance must rely on a predetermined, logic-based, well-articulated decision framework.”
Hirtle referred to a governance structure provided in Keith Ambachtsheer’s and Don Ezra’s Pension Fund Excellence (John Wiley and Sons, 1998), which clearly delineates the appropriate roles for governing fiduciaries, managing fiduciaries, and operating fiduciaries, as shown in Figure 2.
Figure 2—Governing Structure and Related Roles
Courtesy of Jonathan Hirtle
Hirtle noted that some endowments do not have an investment office and thus need to rely on consultants for many investment-related decisions. This can result, he noted, in a lack of day-to-day focus and accountability. Hirtle advised considering an experienced investment department—either inside or outside the organization—as an additional alpha source (where excess returns are generated by skill) in such areas as asset allocation and investment strategy.
In another session on governance, Jay Yoder, investment committee chair, Albright College, Reading, Pennsylvania, echoed Hirtle’s emphasis on the need for experienced investment staff. In Yoder’s opinion, the most important role of the investment committee chair is to ensure that a highly competent chief investment officer is in place. He advised that the CIO be compensated appropriately and be given considerable rein to carry out his or her strategies.
Robert Hering, investment committee chair at Rutgers University, Newark, New Jersey, referred to the difficulties that public universities are experiencing because of smaller state allocations to higher education. In such an environment, it can be challenging to build a case for an in-house investment office.
Nicola Kerslake, of SEI, kicked off discussions on international investing, acknowledging the significant improvements in emerging markets over the past decade. She specifically noted liberalization of capital markets, reduction in external debt balances, and strengthening of legal infrastructure. Not only have emerging markets increased their economic integration with other countries and regions, but they have also benefited from the growth of domestic consumer classes. As examples, Kerslake referred to the expansion of the educated middle class in India and the urbanization of China. China’s industrial efficiencies and enormous economic growth in recent years are allowing the country to boost health-care and education spending.
Kerslake also referred to the dramatic increases in wealth in the Middle East and Russia because of oil and gas profits. Wealthy countries are investing such sovereign funds in significant infrastructure projects within their own nations and in financial opportunities around the globe.
In terms of investing opportunities in emerging markets, Kerslake said SEI is finding attractive situations in private equity and mezzanine financing. In addition, certain real assets—such as land, natural resources, and alternative energy—continue to show long-term positive prospects.
An Inside Look at an Endowment
In the final session, Scott Malpass, CIO of the University of Notre Dame’s $7 billion endowment, provided an overview of the institution’s investment philosophy and management approach. The approach includes: (a) an emphasis on global investing; (b) a commitment to equities and a long-term horizon; (c) the exploitation of market inefficiencies; (d) partnering with world-class managers; (e) a culture of risk management; and (f) high standards of ethics and fiduciary responsibility.
During his lengthy tenure, Malpass has cultivated a dedicated investment team and partnerships with money managers around the world. Currently, he works with 162 different managers, about 60 percent of whom deal with the more complex areas of private equity and hedge funds. Six accountants in the endowment’s operations area are devoted to analyzing hedge funds’ management and risk procedures. Spending from the endowment has grown to provide 20 percent of the university’s overall budget. Figure 3 shows the approximate strategic asset allocation of the endowment.
|Asset Allocation of Notre Dame Endowment|
|40%||public equities, including domestic, international, and long/short|
|15%||marketable alternatives (event-driven, opportunistic, distressed)|
|Total: 100 %|
As did other speakers, Malpass expressed continuing concerns about the credit markets and increasing defaults. As for opportunities, he said that the faster economic growth of emerging and frontier markets will continue for many years. He particularly noted China, where huge potential exists for private equity because of very fragmented industries; and Africa, with its enormous land mass and relatively young population.
Other EMF sessions focused on effective strategies for growing endowments, evaluating investment advisers, and approaching consultant services. Go to www.nacubo.org for complete audio archives of EMF conference sessions.
MIMI LORD is chief investment officer of Spero-Smith Investment Advisers Inc., Cleveland, Ohio. She was the 2007 recipient of NACUBO’s Rodney H. Adams Award for contributions to the field of endowment management.
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