The CLO/CDO and derivatives market has been heating up for well over a year now, with CDO issuance alone hitting $40 billion year to date, nearly half of total volume in 2005, according to Lehman Brothers. While this is exciting news, several market sources warn that too many risk managers lack the know-how to anticipate shaky deal structures and they warn that it might take a credit meltdown to get banks to polish their risk teams.
Risk managers with years of experience in the asset securitization market are hard to come by, said market sources, so banks end up recruiting recent business school graduates, or newly minted PhDs, to assess deals and anticipate problems. Sometimes they hire professionals with years of risk management experience from other financial sectors, but with little experience in asset securitization. The trouble with this approach is that such professionals often end up relying on rote mechanical methods, rather than instinct and experience, to sniff out trouble spots in deals.
"I will not argue that an institution should ever use anything less than the best quantitative tools," said Mark Adelson, the head of structured finance research at Nomura Securities. "What I'm arguing is that by itself that is not enough."
To be sure, many risk management executives are very talented, educated and well informed, and do a good job of protecting their institutions. Risk managers, in addition to maintaining a healthy tension between their institutions' structuring and sales departments and themselves, have the challenge of dealing with deal particularities that are not always quantifiable, said Adelson.
For instance, if a risk manager wanted to assess the likelihood of defaults for 2007 deals, they might wonder which vintages to use to base their analysis. From 1996 to 1999, for instances, defaults were low, but increased in 2000 into 2002. They have fallen back again since 2002, creating a benign environment that's lulled the market into a false sense of security, said Jim Anderson, an industry consultant with more than 15 years of experience assessing mortgage-backed securitization deals.
"You have to have the background to make those kinds of assessments," said Anderson. "If you spent the last seven years of your life as a physics PhD candidate and did not read The Wall Street Journal, you might not know that history."
Some market professionals see the difficulty as a matter of an increasingly tricky structured finance market relying on old techniques to get by. Cash flow deals are structured so that they require hands-on management.
"Cash is frequently managed. Managers trade everything in and out," said Volkan Kurtas, a director at Bayerische Hypo- und Vereinsbank, who specializes in structured credit. A senior risk manager for three years in both cash and synthetics, Kurtas recalled that all of the academic models were designed to apply to synthetic deals, but not cash transactions. Frequently, risk managers on CLOs and CDOs have good models for more static synthetic deals, which require little hands-on maintenance, and rely on those standards to manage cash deals.
Recent resignations at Deutsche Bank reflect the problems in credit risk management, according to some market sources. The credit risk management group there has shed about 10 executives in the last 18 months. Although 90% of the credit risk management group's business relates to deals done in New York, the global group head is in Hong Kong, said a person familiar with the situation.
Worse, risk management executives often betray ignorance of common concepts in the ABS market. One source said he overheard one of his risk management colleagues asking a trader what ARM bonds were.
Through a company spokesperson, Deutsche Bank said: "There has been some turnover in the last 18 months, but we are now fully staffed." The bank declined further comment.
Part of the trouble could be the way banks respond to demand for a new product, say some.
"This product area has experienced explosive growth. Banks want to build departments quickly; this business in particular requires a lot of depth and breadth of experience in the capital markets," said Janet Tavakoli, president of Tavakoli Structured Finance. "The trouble is that there is a tendency to view risk management as a cost center and not a revenue generator."
At banks, the revenue generating groups wield the clout, and risk management does not fit that description, especially because their job is often to put the damper on some deals. They often end up paid less than the bankers, traders and analysts, who, as rainmakers, are near the top of the ABS world's pecking order, say industry sources.
"Risk management tends to attract people who are not alpha males and alpha females. Trading tends to attract more aggressive personalities [who] can intimidate people who are more analytically minded," said Tavakoli.
Hence, if a risk management pro tries to confront a trader about the workings of a deal, the latter hardly hesitates telling a risk manager to get outta here', then trade the deal the way he or she likes, said Anderson.
One reason banks and credit risk management groups seem to have let their guard down is that the credit markets have been relatively benign since 2002, according to Anderson. If interest rates continue increasing, that might trigger increased consumer defaults, which might eventually impact a lot of ABS deals.
"People will say why is risk management letting us down?'" he said. "At that point, there will be a push to getting people that are experts."
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