Nordic Capital Markets Forum - 26 February 2008 A Risk Managers View on the Credit Crisis

1. Nordic Capital Markets Forum - 26 February 2008A Risk Managers View on the Credit Crisis Morten Weis, Nordea Bank AB. Group Market Risk Management

2. Disclaimer & acknowledgements: • The material and statements presented here are the personal views of the speaker and does not necessarily represent the views of Nordea Bank AB. • The material and statements here are based open information from the media, and my own reflections on these through numerous discussions with my colleagues. Any errors are to blame on me personally.

3. Topics • The overall aim of this presentation is to share with the audience my perception of some of the mechanisms that leads to large sophisticated banks having to restate income just weeks after publishing their financial results. • I will first talk about accounting rules and then turn to reflections about how banks perform valuation of complex instruments, in very general terms, and use the credit market as an example to illustrate some of my statements.

4. Accounting rules are important • International accounting rules (IFRS, GAAP) instruct banks to report earnings and balance sheets based on fair value. • Fair value is the value that a willing and knowledgeable counterpart is ready to pay/receive in an arms-length transactions. • Fair value is per definition not the value you would get in a distressed sale. But - per definition should fair value incorporate all relevant risks (and always credit risk). • In Europe and in USA, actively quoted prices should always be used represent fair value - when they exist. • If active markets does not exist for a given instrument - a valuation technique must be used.

5. Accounting • A valuation technique could be referring the value of another instrument, that is traded actively, to the instrument in focus. • A valuation technique can also be a sophisticated mathematical model with many complex assumptions and input parameters, that not even be objectively observable. • In Europe - you are not allowed to recognise an up-front gain from a transaction, if you estimate fair value by a valuation technique that is based on unobservable input parameters. [This is changing in US after the introduction of FAS 157].

6. Valuation is not an exact science • In modern finance, the reported fair value of a given transaction will be a subjective statement if no active market exist. • Two banks enters a financial contract: • e.g. Bank A sell protection against default risk on portfolio X to Bank B. • Bank A receives a premium from Bank B, that should be the fair price of the liability Bank A now have. • For both banks the value of the transactions should be close to zero on day 1. • But - there is a very real possibility for both Bank A and Bank B to view the transaction as having a positive value on day 1, due to differences in the valuation techniques they apply. The more complex the instrument is - the larger the probability will be. • In addition - the counterparts might work under different accounting rules.

7. External stakeholders influence on valuations • We have seen several incidents where external stakeholders have forces institutions to alter valuations. • On of the opening acts of the crisis was the failure of two Bear Sterns hedge funds that collapsed after their leverage providers dramatically changed their view on the value of the assets posted as collateral. • Bear Stern did not agree, seized the assets in the funds and left investors with tremendous losses. • Later we have seen AIG restating valuations dramatically, pushed by their external auditors that points to other institutions having made drastic write-downs for similar assets.

8. Is lack of liquidity the same as distressed sale? • If you read the accounting guidelines - NO. • You should report the value as what would be the “exit price” if you sold the item today. • You are not allowed to disregard observable prices in an active market even if it is less liquid than normal or because there is an imbalance between supply and demand. • If no active market exist - any relevant observable price information for similar instruments must be incorporated in the entity’s valuation technique. • The ABX credit derivative index for sub-prime mortgage bonds is often mentioned in this context because it is observable.

10. Common assumptions behind valuation models • Most modern financial valuation techniques are based on so-called risk-neutral models. Models that are based on the assumption that arbitrage is not possible and that markets are effective. Almost all models are based on two components: • A determination of the probability distribution for the underlying asset based on prices of traded instruments (options) related to the underlying asset. • Constrained on the probability distribution of today - mathematical assumptions on the dynamics of the underlying describes how the probability distribution for the underlying will evolve in the future. • Note: for the most common CDO model - the assumption is actually that there is no dynamics from today until maturity.

11. Common features of valuation models • Per construction - the common models will return you the prices that you see in the market. But - only on the “standard instruments” that have an active market. • Bank use the models to value complex instruments that are not traded in an active markets and where there is little, if any, direct price transparency. • In addition, banks may need to “extrapolate” the observable input data or estimate unobservable parameters needed by the model. • Tomorrow - the banks will recalibrate their model to the new prices in the market for “standard instruments” - I.e. they will say there is a new probability distribution for the underlying asset and they will state a new value for the complex instrument. In some sense you can say that banks only trust their models for one day at the time.

12. How to see if the value is correct? • The models estimate of the value of a complex derivative should represents the theoretical hedge cost of the instrument until maturity of the contract. • I guess that few banks are able to verify if that holds. • The model might be changed many times before maturity of the transaction (it is not uncommon to trade 10 - 30 years contracts in markets that have existed in much less time). • You can only test if the value is correct, if you trade the instrument. • There is increasingly focus on consensus pricing services, but there are mixed signals from the accountants if these in general serve as representing “tradable prices”.

13. What can happen if the model is wrong? • When an extreme event happens that is not predicted by the model - one should not expect any from your model. • Risk figures based on the model will not predict what happens. • The “rules” in the market place can change dramatically after an extreme event. It don’t need to be a temporary change. • If it is a collective model error across the industry some products might disappear from the scene. • An entity can face lack of capital because the estimated demand for capital was based on figures from a model that did not predict a repricing of risk.

14. Why banks choose the valuation they do • Consensus often arise because the people that build models talk together - they typically think the same way (they are all physicist) - and the model users have similar business and incentives. • Management want models that enables them to offer new products (i.e. products that have higher margins). Competition is harsh. • Dealers shares this incentive and of course they also want models that quantifies the risks in the product on a day-to-day basis, such that they can manage their positions. • Risk managers want models that can explain day-to-day price moves - and models that seems “reasonable”. • Regulators want banks to apply “best practice” models.

15. Credit derivatives - models • All models price derivatives by modelling the underlying process - here the probability of default of one or several issuers. • But - the market is not in balance! • The credit derivative market is approx. 20 times larger than the underlying corporate bond market. • My claim: The derivative market “controls” the underlying market - not the opposite. • “Current” Itraxx IG 5Y spread level corresponds to 7% loss in 5 years among the 125 most liquid investment grade firms in Europe. • Liquidity, supply and demand, and many other “real world” factors are not modelled!

16. Itraxx investment grade S8 5Y, 12%-22%

17. Is fair value the correct value? • If the whole market is wrong - then it is right… • If it is common to ignore certain risk elements in the valuation of a product - then it will be fair value, because it is the value that other market participants are willing to trade at. • Valuation adjustments serves to correct the outputs of models that are to simple, in a quest to obtain fair value levels. • When the market’s view on risk changes rapidly - you don’t get new valuation models overnight - and you need to try keeping track of the valuation uncertainty through valuation adjustments. • The design of valuation adjustments is an important risk management task.

18. The fair value philosophy • You start seeing people questioning the idea of demanding “fair value” reporting for items that is not traded. • The thinking in the US seems to be that increased disclosure about exposures and valuations should create a market discipline between banks, if valuations are based on unobservable input. • The creation of liquid indices was a step from leading banks to create a reference frame for valuation of bespoke transactions to reduce the uncertainty in valuations and to create coherent pricing of risk. • Now - some banks will probably question if the liquid indices are a blessing or a curse.

19. Accountant vs. regulators • It is interesting to note that the regulators have a slightly different approach to valuations than the accountants. • Basel II requires institutions to consider valuation adjustments that to me seems to be in conflict with IFRS. • E.g. institutions must consider valuation adjustments that reflect how long time it will take to unwind a position, which is not accepted by IAS39, where you must use the bid/ask on the screen no matter the size of your position. • The Basel II thinking seems more biased towards a risk-based thinking than towards “objectivity”. • From a risk management perspective it is relevant for a stress tests to reflect distressed sale - fair value is not supposed to reflect that.

20. What can you do as a risk manager? • Use common sense. E.g. CPDO’s seemed for many in the risk management community as a “contradiction” - AAA paying 200 bps - before the crisis! • In the current environment, if you own house is not at fire, then try to do the best in understanding the scenario unfolding as we speak - and then communicate to senior management what they need to understand. • Focus on your model assumptions. • As the Australian FSA stated after the large fx-option scandal in National Australian Bank - “there should be a culture where the risk manager is always right - even when he is wrong”. • The crisis show that industry have some way to go before that is a common perception….. And I guess Risk Managers in general should become better in raising their voices.