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Losses, Leverage, and Liquidity

This presentation discusses the challenges faced by risk management in the face of losses, leverage, and liquidity issues. It highlights key risk metrics, lessons learned, and strategies for managing risk in a volatile market.

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Losses, Leverage, and Liquidity

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  1. Losses, Leverage, and Liquidity The Road Ahead for Risk Management Carl Tannenbaum Vice President, Risk Specialist Division Federal Reserve Bank of Chicago

  2. Presentation Outline • Risk and Reinforcement: When Moods Add to Models

  3. Key Risk Metrics

  4. Spiraling Upward Gains Absence of Caution Capital Aggression Confidence

  5. Spiraling Downward Losses Abundance of Caution Capital Apprehension Confidence

  6. Models: Natural Accelerants • Roll rates • VaR • Economic Capital • Once bad things start to happen, models close down fast Losses

  7. Lessons Learned: 1 • Past is not always prologue; models should not assume that it is • Life events are not normally distributed; why do models assume that they are? • How do we avoid extreme overreactions? • Follow-up: models and their applications need to be recalibrated

  8. Still in the MattressVolumes in Money Market Funds Source: Bloomberg, ICI Statistics & Research

  9. Assets of Commercial Banks Ratio of Cash to Total Assets(All Commercial Banks, SA) Ratio of Loans & Leases to Total Assets(All Commercial Banks, SA) Week of Feb. 25 Week of Feb. 25 9

  10. Still in the VaultExcess Reserves Held by Commercial Banks Source: Federal Reserve

  11. A Thought: We’ve gone from disintermediation right past re-intermediation to non-intermediation

  12. Presentation Outline • Risk and Reinforcement: When Moods Add to Models • Learnings Gained the Hard Way

  13. Spiraling Downward Losses Distressed Asset Sales Downgrades Reduced Liquidity Collateral Calls

  14. Liquidity Issues to Think About • Mismatches matter • Think about liquidity transfer pricing • Look beyond the boundaries of the balance sheet • Commitments, SPVs, sponsored funds • Value collateral conservatively • Don’t assume availability, even with FHLB • Know when you might be asked for more • When will investors return to buy assets in the seconday market? • Structures go back to basics

  15. Loss Estimates Escalate Projected Credit Losses, $$ Billions • Contagion increases losses • Initial capital raising proves inadequate • Investors become hesitant to absorb new issues Source: IMF

  16. Lessons Learned: 2 • Declines in asset prices can be a cross product of loss and liquidity • Note: A pool with a 50% PD and 50% LGD still has an intrinsic value of 75 cents on the dollar • Credit and liquidity risk are closely related, for both markets and institutions • Know where you stand in the capital hierarchy • Follow-up: linking events in stress testing for liquidity and market risk

  17. Presentation Outline • Risk and Reinforcement: When Moods Add to Models • Learnings Gained the Hard Way • Where We Stand in the Journey Back to Normalcy

  18. Rebuilding the Base • Public capital predominates • More losses ahead • Concerns over the “quality of capital” • How to make capital levels countercyclical?

  19. Where We Stand:Credit Risk • Issues • Recession Scenario • Guarantors • Models: High-end, low-end • Inexperience Residential RE Commercial RE Loss Recognition Consumer Credit Ag Lending C&I Lending Risk Recognition

  20. Foreclosure Filings 2008 Foreclosure Rate United States: 1.8% Nevada: 7.3% Florida: 4.5% Arizona: 4.5% California: 4.0% Colorado: 2.4% Michigan: 2.4% Ohio: 2.3% Georgia: 2.2% Illinois 1.9% New Jersey: 1.8%

  21. Credit Spreads: Still Wide

  22. Policy Steps • $800 billion in fiscal stimulus • TALF, PPIFF for banks • Foreclosure mitigation • Bigger line for the FDIC • Review of Mark to Market Accounting • Regulatory Restructuring

  23. Conclusions • The American financial landscape has changed historically in just the past six months; maybe more ahead? • The Treasury and the Fed have been exceptionally active • We’ll be learning from and debating recent events for years to come

  24. Losses, Leverage, and Liquidity The Road Ahead for Risk Management Carl Tannenbaum Vice President, Risk Specialist Division Federal Reserve Bank of Chicago

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