Headspace

The calibre of speakers greatly surpass the earlier Op Risk Asia conference I attended in June. Almost every speaker told me something I didn't know about the Sub Prime problem in the Policy Session. Hark:

*The problem of IAS 39: on one hand, the balance sheet requires mark to market valuation for derivatives (which takes into account expected losses), on the other hand, it prohibits the accounting of provisioning of expected loss, provisioning is only allowed for incurred loss. Recall, Basel 2 requires capital allocation of risks undertaken, this means that the correct picture is only seen in the B/S and not the P/L.

*Fair Value Accounting is the best of the worst system: in an illiquid market, the FV accounting might not be effective in showing the correct valuation of assets, since assets are assumed to be liquid and can be gotten rid off in a hurry if required.

*Better disclosure but not more disclosure; heavy handed regulation may not be the way to deal with in a crisis (a la Bernanke).

*S&P should not be blamed because S&P assessed only the credit risk of a company and its cash flow not the products and cannot be relied upon without independent review

*Models should show expected exposure size but model selection might be difficult because each model has its own flaws. The key to a good estimate of exposure size could be stress testing and scenario analysis.

*Sub prime financial crisis could possibly be a problem of information asymmetry as a result of the outsourcing of risk (instead of the underwriting of risks) banks, traditionally experienced with independent assessment, is taking on risk and outsourcing the risk via CDOs and CDO^2 products. The investors purchasing these products are not well versed with the assessment, undertakes the risk without knowing what they have undertaken.

*Sovereign Wealth Funds (SWFs), due to their possible geopolitical influence, will require careful policy making to ensure that investments are made with the purpose of long term gains and with minimum intrusion in the recipient's country policies.

*SWFs should not be uber cash vehicles - reserves held should be sufficient to support 3-4 mths of imports; excess reserves should be invested. (SWFs with excess reserves are mainly from commodity producing countries.) High reserves and investments in local economy pushes up inflation and if inflation increases in the climate of low USD, it is stressful to maintain the value of their reserves, which is typically held in USD.

*Engle's address is a variation of the speech made for the FT.com video - same key themes addressed, with a reference made to Spline-Garch model as a method to assess the volatility of a country. Engle found that key macroeconomic variables (size of country, high inflation, recession, volatility of ST i/r, volatility of output growth and volatility of inflation) serve to explain the volatility experienced by the country. However, Engle noted that the volatility experienced now is not as high as 2002 and volatility can be addressed by fixing macroeconomic variables.

*Engle also talked about the sub-prime crisis and his take was not that no one understood the risk but that, there was no data - the CDO is a new product, and that the correlation of the different assets in a tranch of CDO was not understood.

*The fact on wall street is that products are not made to reduce the fiction in transaction costs and to distribute risk but to take advantage of loopholes inherent in existing regulations. Products are packaged and structured in whichever way is acceptable to clients.

*VAR is not a solution. Sometimes VAR may create illiquidity in the market especially during stressed market conditions due to a product dumping by all investors to cut losses.

*Wary eyes should be kept on option-like income where the downside exposure is enormous. A hard stand should be made on sustainable business models.

*Concentration risk: consider nominal limits instead of expected loss limits.

*It's okay to use the word 'orgy' at a presentation on sub-prime crisis.