Roubini concludes: Risky assets likely to fall in the short-term: Equities Credit spreads Housing. Commodities Emerging market assets US dollar

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1 Nouriel Roubini, chairman at RGE Monitor and professor at Stern School of Business, New York University, spoke to CFA UK members asking Where Are We Now in the Crisis and How Far Will It Go? Roubini concludes: The US is experiencing a severe recession lasting four to six quarters from Q1 of It will be deeper and more protracted than the mild recessions of and Expect negative growth starting in Q1 of 2008 The credit crunch will spread into consumer credit in the US, including student loans, credit cards and car loans US consumer spending, which makes up 71% of GDP, will fall sharply due to a falls in house prices - households not being able to use their homes as an ATM and tighter credit controls The rest of the world will not decouple; it will rather recouple with the US hard landing leading to a global economic slowdown Inflation will cease to be a problem as demand in the US, and subsequently the rest of the world, subsides Roubini believe this recession will last much longer than the previous two recessions, each lasting eight months, because of four deteriorating conditions. 1) The housing recession is the worst since the great depression. Roubini predicts that by the end of this year, given the dynamics of supply and demand and the excess inventory, home prices will fall by at least 20%. 2) Due to US mortgages being non-recourse loans, homeowners who find themselves in negative equity can walk away from their debts. If 50% of homeowners in default walk away from their mortgages, this will result in losses of more than $1 trillion for the financial system. 3) Falling house prices will leave a loss of wealth effect. Further to this, the credit crunch will spread to consumer credit, making it hard for consumers to secure loans. These effects will decrease consumption which makes up 71% of GDP. 70% of demand is in trouble states Roubini. 4) Although Roubini admits that as long as there is job generation and as long as there is income generation the US consumer is going to keep on consuming, he points out that for six months in a row private employment has been falling and for five months in a row, total employment has also been falling. Risky assets likely to fall in the short-term: Equities Credit spreads Housing Commodities Emerging market assets US dollar According to Roubini, Cash is king in 2008.

2 Roger Urwin, global head investment consulting at Watson Wyatt, addressed: Risk: Lessons from the credit crunch. We should rethink how we look at risk, moving from simple to more sophisticated models. The credit crunch is a huge opportunity to get minds to think about risk in a sensible way Models reflect core investment believes and these should be reviewed Many in the profession think there are incredibly smart people in unbelievably simple situations. Urwin thinks believably simple people in incredibly complex situations is more realistic Current fund governance focuses on doing things right. This doesn t address the value creating goals of funds doing the right things A CIO is crucial for good governance. This role can be internal or outsourced Good governance has following characteristics: o Strong beliefs o Risk budget framework o Investment executive ( CIO ) o Real-time decision making Pension funds are moving from relative return mandates to absolute return mandates, though it takes a long time for thinking to become institutionalised Urwin s explanations for the credit crunch are 1) Over competition for 10% plus returns. Narrow risk premiums are only good for lower level returns. As a result, leverage became the master, not the slave. 2) Over complexity in the supply chain. Securitisation and opaque derivatives hindered transparency. 3) Over compensation. A number of people were being paid excessively for the job which they were doing.

3 Lindsay Tomlinson, FSIP, vice chairman at Barclays Global Investors Europe, addressed: Incorporating Risk into the Investment Process. The economic system cannot eliminate systemic risk There is a risk paradox: The political and societal view is that taking risk is a good thing, but realised risk or losing money is not allowed Recent events are a classic market bubble: an idea takes hold, followed by mania, a realisation people can t pay then panic and a crash. This happens every three or four years somewhere in financial markets Risk can be categorised into investment risk and non-investment risk Non investment risk includes legislation and operational risk Strategies should form three tiers: Liabilities at the foundation Liability hedges are at the next level Alpha generation through diversification should form the top level UK pension schemes have too much exposure to equities: [Equity] returns are difficult to predict, risk is also difficult to predict and correlations seem to come together in a down markets. Common ways that managers lose money include: Mishandling client orders and breaking guidelines Trading errors Duration mismatches Counterparty risk Other operating risks such as those arising from new investment types and inappropriate behaviour Ways of alleviating these loses include standardisation of trades, elimination of paper and catching errors quickly Models are of value: We re confronted with massive complexity in the real world using models is codifying ideas and putting them into practice Investment professionals should refine models and think when investing Investment is a game you win by not losing

4 Riccado Rebonato, head of group market risk for the Royal Bank of Scotland, addressed: Risk Aversion for Structured Products - the Interplay of Realised and Implied Volatilities. Two factors that contributed to the current situation 1) Retail investors do not make the distinction between real yields and nominal yields As such, a lot of products, especially in SE Asia, have been driven by retail investors, via financial intermediaries, to pick up nominal yields 2) Demand for savings outstrips supply in the global economy as a whole Large demand for savings from China and India have resulted in investments in US dollar and the Euro These investments have depressed yields for US and European assets This has lead investors to look for higher returns elsewhere, such as in structured products This search for yield has increased further due to pension deficits and the need to meet pension commitments The role of implied volatility Implied volatility is compensation per unit of volatility risk Banks receive volatility/optionality from investors in various forms, for example, if an investor is buying an emerging market bond, he is selling optionality As banks inventories have become bloated, so they have offered less and less in return for volatility, so if investors want the same return, they must take more risk Maturities for structured products have increased as investors have had to give up some optionality in return for higher yields. This same process has led to greater leverage and complexity of structured products Although implied volatility has increased in the past few months, it is still low historically as the compensation for taking risk has fallen in the past ten years The causal link between implied and realised volatility Gamma traders stabilised the market: buying low and selling high when the price vibrated around a certain level Because traders were so long volatility and gamma, they had to engage in enormous amounts of trading that, in normal market conditions, pinned down the market as a whole, muting market movements As a result, the causal link between implied and realised volatility has been inverted However, big sudden movements kill the position of a long gamma trader

5 This affects market liquidity: Effects on liquidity The bid/offer spread is compensation for a market maker for his inventory risk In low fluctuating markets he wants a big inventory. During large fluctuations he wants a small inventory and will ask for large compensations through large bid/offer spreads, thus decreasing the number of traders in the market Such conditions make it extremely difficult to manage risk Risk tolerance has not decreased Although the CDO/ABS markets have had their day, the dynamics that created the instability we have witnessed are still with us: The need for yield enhancement means that what is fixed is not your risk tolerance, but what you have to get out of your investment So there will be a similar situation in a different asset class

6 Felix Goltz, of EDHEC Business School, presented results from his Survey of Asset Management Practitioners in Europe. The survey assesses Industry Practices vs. Academic State of the Art. Goltz concludes: Practical solutions for portfolio optimisation are not widely used Value at Risk (VaR) is calculated assuming a normal (or close to normal) distribution. This is despite the fact that a normal distribution assumption renders VaR computation pointless Over 67% of respondents do not measure their funds against benchmarks, despite a perception that investment professionals pay too much attention to benchmarks Almost 80% of respondents used the Sharpe ratio to measure absolute performance Goltz states: it s not surprising people use the Sharpe ratio, but what is surprising is that people don t use risk adjustments Information ratios are not adapted for extreme risk Out performance of indices measures do not make proper adjustments for risk Peer group analysis doesn t take into account the risk exposure peers are taking

7 Todd Groome, monetary and capital markets advisor for the International Monetary Fund (IMF), addressed: Regulating Financial Risk Management. No two crisis are the same, so regulation is always looking back Direct regulation of risk management practices is undesirable and impractical Regulation is an economic tax, so needs to be carefully designed and applied Market discipline is still the first and best line of defense. This should be supported by appropriate transparency The IMF analysis of the winners and losers in the crisis found that the losers were the ones who didn t act on the information they were given from their risk managers The problems weren t the risk models, but the users of the models and as such this isn t a risk model failure, it s a governance failure You can only influence risk management practices not regulate them Regulation should not replace the judgement of risk managers, that has been tried in the US and it resulted in a lack of development in risk management practises Instead, regulators should ask good questions: When a regulatory supervisor comes in and asks good questions, you will change your practices The best way to influence risk management practices is through: o capital regulation o accounting and financial reporting standards o data availability o and, most importantly, supervisory dialogue However, supervisors need more resources and skills to bridge the gap between their knowledge and the way financial institutions actually operate

8 Danny Truell, chief investment officer of the Wellcome Trust, addressed: Taking Risk in Perpetuity: Culture, Governance and Inconsistency. Three main areas where the Wellcome Trust has gained unconventional success : o Culture o Governance o Inconsistency Culture Assets and people make you rich, not asset classes No one ever got rich from a correlation matrix Commitment to real assets Tolerance of high levels of short-term volatility Align oneself with the strongest partners Look at the long-term investment horizon Focus on farming assets, and not hunting Market timing is as a key ingredient of success Governance An investment committee should have the power to say no but not be asked to say yes Real time governance is of great importance: there are times when one has to make decisions and make decisions fast Empower the CIO Inconsistency Warren Buffet states that Berkshire Hathaway s advantage is that there s no strategic plan Innovation is a strength and consistency a weakness Have no innate geographical bias and diversify into a global multi-asset financial portfolio Exploit the longer-term leverage cycle.