American International Group Inc. named Peter Hancock, described by former employer JPMorgan as an “architect” of the derivatives business, to oversee finance and risk, including the insurer’s money-losing credit-default swap unit on Monday, February 11th 2010. Mr. Hancock spent 20 years at one of the predecessor banks that now make up JPMorgan Chase & Co and eventually rose to be CFO and head of risk management before stepping down in 2000.

The Stamford, Connecticut chapter of the Professional Risk Managers' International Association ("PRMIA") held a very informative meeting on Wednesday, November 7th 2007 entitled "The Emperors' New Clothes?: After the Credit Crunch, What's the Future of Structured Credit, Financial Guarantors and Rating Agencies". Toomre Capital Markets LLC ("TCM") thought this was one of the most informative industry events yet and strongly recommends that the reader pay close attention to the incestuous circle of structured credit, financial guarantors and rating agencies. The speakers were:

• James Chanos – Managing Partner, Kynikos Assocaiates
• William Ackman – Managing Member, Pershing Sqaure Capital
• Edward Grebeck – CEO, Tempus Advisors

Some readers no doubt will recognize James Chanos and his fund Kynikos Associates as one of the most prominent short-seller hedge funds. Bill Ackman and his hedge fund Pershing Square Capital are primarily focused on the long side, but does have substantial short interest in the financial institution, rating agency and financial guarantor sectors. Bill is perhaps most well known for his excellent (and very negative) research report on MBIA from several years ago. The FORTUNE magazine article from May 16, 2005 entitled The Mystery of The $890 Billion Insurer has more information.

During the trading hours of November 7th, equities in the financial sector were under considerable pressure. This pressure is primarily tied to the great uncertainty about just what are Collateralized Debt Obligations worth, where the resulting large losses are buried and what are the secondary repercussions of the sub-prime meltdown, such as SIVs, option ARMs, and commercial mortgage credit-worthiness. After the close, American International Group ("AIG") reported 3rd quarter results that fell short of expectations primarily due to their losses from the mortgage markets. Then, Morgan Stanley ("MS") pre-announced that it be taking a $3.7 billion in losses in its proprietary trading businesses tied to principal investments in CDOs and other sub-prime mortgage-backed securities. (This amount may change over the balance of November until the end of Morgan Stanley's year end.)

Against this backdrop, James Chanos and William Ackman suggested that the markets are still in the early innings of this mortgage credit crunch process. Whereas some analysts have been suggesting as many as 1.5 to 2.0 million families may lose their residencies due to foreclosure in this mortgage credit cycle, their collective view is that the base level of foreclosures will be much worse, perhaps approaching 3.5 million or even 4.0 million incidents. They suggested that the collective market does not yet appreciate that things could get that bad nor have financial professionals begun to fully appreciate some of the national political repercussions of so many people losing their homes.

Reuters is reporting the obvious on Monday, November 5th, 2007: Cantor CEO says big CDO market has shut down. Apparently Cantor Fitzgerald LP Chairman and Chief Executive Howard Lutnick publicly has stated what Toomre Capital Markets LLC ("TCM") and many others have been saying for several weeks now: There are effectively no buyers and what people and organizations own on their books in CDO format, sub-prime mortgage format or just as general collateral has one place to go: DOWN.

The complete CDO market seizure means that there still are tremendous losses to come for those financial intermediaries that retained CDO bond classes, those investment portfolios that invested in them and, perhaps most importantly, all of those organizations that put on CDO "arbitrage" strategies. Perhaps people have not fully appreciated the full impact of this credit crisis? Maybe $25 Billion of the originally estimated $100 Billion dollars in losses have been reported by investment banks and global banking institutions. Where is that $75 Billion in other losses lurking? And assumes that the original $100 Billion number was even conservative enough… Some are already speculating that the total losses from CDO investments may total more than $250 Billion.

"The big CDO market is gone," Lutnick told the Reuters Finance Summit. "You'll see all the banks step out of it because they just can't do (the deals anymore) because they won't be able to churn them out to the buyers because the buyers are gone." Lutnick, whose firm controls one of the world's largest bond brokerages, said the easy buyers of CDOs have left the market. That leaves what he described as sophisticated buyers, who are willing to do their own math and find their own value for distressed CDOs. That will spawn a market for packaging the securities in a way that appeals to those investors, Lutnick said.

"The (CDO) repackaging business will be there, and it will grow enormously," Lutnick said. "No one is going to believe anybody anymore (about CDOs)," Lutnick said. "It's not just about the rating. You have to run your own math and come to your own view."

Toomre Capital Markets LLC ("TCM") would like to highlight a couple of items from UBS's 3rd quarter 2007 earnings report that was released on Tuesday, October 30th, 2007. Buried in the earnings report (a copy of the pdf file is attached to the bottom of this posting) is a discussion about the investment bank's market risk. The report states that "Investment Bank Value at Risk ["VaR"] (VaR-10-day, 99% confidence based on 5 years of historical data) ended the quarter at CHF 676 million, up from CHF 454 million at the end of the prior period end." Apparently the approximately 49% increase in VaR during the 3rd quarter was driven primarily by increased market volatility. As the report states, "The largest contributor to Investment Bank VaR at quarter end was credit spread on mortgage-related positions."

The earnings report continues with "'Backtesting' compares 1-day VaR calculated on positions at the close of each business day with the revenues arising from those positions on the following business day (excluding intraday trading revenues, fees and commissions)… When backtesting revenues are negative and greater than the previous day's VaR, a 'backtesting exception' occurs." The report then makes the rather startling admission: "In the third quarter [of 2007] we suffered our first backtesting exceptions in total – 16 in total – since 1988."

That is right folks! UBS's investment banking unit had losses on 16 days [Yes that is right sixteen days!!!] of the third quarter that it exceeded the Value-at-Risk calculated by its own risk management function. As an M.I.T.-trained engineer and the son of a mathematics professor no less, Lars Toomre is a little fuzzy with statistics and math. However, 16 out of 63 third-quarter 2007 trading days does make it seem like the losses at UBS exceeded it supposed daily VaR 25.3968% of the time!!!

Under a normal Gaussian distribution (bell-shaped statistical curve fitting that many are familiar with), a 99th percentile event is some 2.58 standard deviation units from the mean measurement and is meant to represent extremely unlikely events. In insurance terms, the 99th confidence interval is often used to represent that realized losses from all events but that single extremely unusual one in a hundred year event will be less than the stated amount. UBS' VaR modeling did not even capture greater than one standard deviation events (i.e. less than 84.13% of the time).

Clearly, UBS' realized experience during the 3rd quarter of 2007 greatly exceeded the losses that they estimated would occur only 1% of the time. Some of this variation no doubt can be attributed to the sharp pick up in volatility, and particularly in the seemingly one-way movement of sub-prime mortgage and other structured finance securities. And yes, some market sectors did have an almost step like decline in valuations. However, Toomre Capital Markets would suggest that the volatility in structured finance prices already was increasing in both the first and second quarters. Did not the UBS security prices reflect the sharp declines in the various ABX indices that started in the fourth quarter of 2006? Why were there no backtesting exceptions during earlier accounting periods?

So while several of the 'backtesting exception' days can be excused, an outside observer might be very accurate in observing that either the risk management process itself and/or the data feeding it was flawed, or more likely, UBS had extremely concentrated positions that declined in value relative to the historical volatility of their prices.

Toomre Capital Markets LLC ("TCM") provides advisory services to firms either engaged in or providing technology to the financial services industry. Our specialties include applying emerging technology and innovative ideas to the broad field of Enterprise Risk Management ("ERM"). We assist these clients with implementing and marketing innovative solutions to the problems and opportunities that today's financial services firms and their customers confront.

As part of our services, TCM consults closely with Advanced Micro Devices, providing subject matter expertise on the capital markets, structured finance and risk management. Another example of our work is a newly released white paper entitled "Operational Risk" that TCM wrote on behalf of AMD. We encourage the reader to review this white paper and to contact AMD or TCM to discuss thoughts and possible applications or consulting engagements.

Since the note White Paper: "Market Risk and Algorithmic Trading" was posted, there has been considerable web traffic looking for further information on either algorithmic trading or the topic of enterprise risk management ("ERM") in general. Partly as a result, TCM has been asked to create a posting with links to each of the white papers TCM has written on behalf of this technology client. These white papers include:

• The Future of Real-Time Enterprise Risk Management ("ERM")
• Driving Value in Credit Products
• Adopting a New Standard for ERM in the Energy Sector
• Market Risk and Algorithmic Trading
• And coming shortly… Operational Risk Management

According to the October 16th 2006 Bloomberg article Credit Suisse Lost $120 Million in Korean Derivatives Gone Awry, "Credit Suisse Group, Switzerland's second-biggest bank, lost about $120 million on South Korean derivatives in the third quarter, an undisclosed stumble by equity traders struggling to catch the leaders in the securities industry. The debacle, which wasn't reported to shareholders, resulted from the Zurich-based bank's failure to protect itself against swings in the value of Korean stock options, said two people with knowledge of the matter. The loss equals about 13 percent of Credit Suisse's second-quarter revenue from equities trading." This October 27th 2006 DealBreaker.com posting details how various Credit Suisse staff members in the New York office are now worried about the possible impact on their 2006 bonuses (especially as rumors circulate that the losses may exceed the reported $120 million).

Wall Street & Technology has published an article written by Paul Allen entitled Banks Take Their Places on the Grid. The article focuses on how grid computing is helping to alleviate Wall Street’s ever-increasing demand for more and more computational power as both portfolio and risk managers strive to get an accurate view of each fund’s value and associated risk with the increasing use of credit derivatives and other exotic investments. The article goes on to quote Chad Hersh, a senior analyst from Celent, who wrote in a recent report entitled ‘Grid Computing: A Guide For Financial Services Firms’ that “Grid computing is going to be a major investment for virtually every large company, financial services or otherwise.”

As the WS&T article explains, “In essence, a grid leverages all the different pieces of a firm's hardware -- which can include anything from a laptop to a mainframe -- to form a huge pool of computing power. When a task or calculation is submitted for processing, the grid software divides it up and farms those pieces out to wherever it has identified available computing capacity; once completed, the parts then are reaggregated. And because the grid can make use of idle desktops and inexpensive servers, for example, it provides firms with the ability to scale up their computing resources faster and more cheaply than previously possible.” The article notes that grids have proven to be particularly adept at processing computationally intensive tasks that traditionally take considerable time to complete and often are run in batch-type cycles, such as derivative pricing analytics, Monte Carlo simulations, portfolio performance analytics and calculating the value and incremental risk profile of portfolios as the result of trading activity.

Recently, I’ve been thinking a lot about the Bird Flu. The six most recent posts on Lars Toomre’s blog have been about the bird flu.

With this in the back of my mind, I went to a house party for the Humane Society of the United States. One of their fact sheets mentioned that poultry now makes up more 95% of the animals killed for food in the United States, with over 9 billion birds killed each year.

Everyone is talking about concerns about bird flu crossing species boundaries and today’s news reports of a cat that has died from the bird flu. They suspect the cat contracted the bird flu by eating an infected bird.

In a press release on Monday, January 23, 2006 entitled Swiss Re Capital Management and Advisory Names Key Executive to Environment & Commodity Markets Team, Swiss Re announced that a former colleague of TCM, Brian O’Hearne, has been named to lead Swiss Re’s North American activities in the Environment and Commodity Markets. Brian will be focusing on weather and commodity trading, business and product development and risk management. In his new role, Mr. O'Hearne will report to Juerg Trueb, Swiss Re Global Head of Environmental & Commodity Markets, and Dan Ozizmir, CMA Group Head of Asset-Backed Securities/Insurance Linked Securities and Environmental and Commodity Markets. The news release continues:

Streambase Systems and Advanced Micro Devices are both clients of Toomre Capital Markets’ risk technology services. Earlier this week, both companies jointly announced that Streambase’s flagship Stream Processing Engine is now capable of running in 64-bit mode, fully taking advantage of advanced 64-bit high performance computer chips like the AMD Opteron™ processor. As noted in this previous TCM post, systems based upon AMD Opteron processors enjoy a highly scalable architecture that delivers next-generation performance with twice the power efficiency of Intel chips (according to Sun Microsystems’ Andy Bechtolsheim in eWeek). With this Streambase software release, enterprises can effectively eliminate latency in processing real-time data streams while penetrating the physical barrier that limits applications to 4 gigabytes (GB) when using 32-bit systems. As the press release StreamBase Extends Enterprise Adoption with Accelerated Real-Time, 64-Bit Performance Gains states, “enterprises using StreamBase can react to real-time data faster and execute right-time business decisions that capitalize on opportunities and reduce risks.”

Streambase and AMD make a great combination in solving real-time Enterprise Risk Management issues and improving Economic Value Added (“EVA”). Toomre Capital Markets LLC assists enterprises to customize these tools to measure, monitor and manage each individual organization’s specific risk portfolio. Please contact Lars Toomre at TCM, Bill Hobbib at Streambase Systems or Dio Dipasupil at AMD for further information on how your organization can move to world-class, real-time Enterprise Risk Management.

Professor Perry Mehrling has written an excellent book entitled “Fisher Black and The Revolutionary Idea of Finance” (ISBN 0471457329). Lars Toomre had the pleasure of receiving a copy of this book for Christmas and heartily recommends it to anyone interested in the field of options, derivatives, portfolio insurance and/or global asset allocation models. As the book jacket states Fisher Black was “the high priest of modern finance, who saw the big picture that linked up all the smaller developments, both theoretical and practical. The big picture was all about risk and about a sea change in our understanding of the place of risk in modern society. Fisher Black learned the Capital Asset Pricing Model (“CAPM”) that teaches a scientific approach to risk, telling when and how to avoid it, but also when and how to embrace it. Fisher Black lived his life the dictates of that model, treating risk as nothing more than the price of reward.” This is an excellent story about the birth of quantitative finance and financial engineering, and a highly recommended addition to the TCM reading list.

Recently Toomre Capital Markets LLC was challenged to suggest what software should be used to implement a “Transaction Cost Analysis” application in a cost effective manner. The original description of the desired application seemed simple enough: provide an analytic tool to allow any investment professional across the organization to easily assess in real-time the effectiveness of a realized trade execution vis-à-vis a theoretical ideal. However, what this “simple” inquiry evolved into was a detailed discussion of what would be required to move from their current technology environment to one that allowed for real-time analytics, reporting and compliance monitoring – in short, real-time analysis and enterprise risk management across their several trading areas.

The inquirer elaborated that their current technology environment utilized data feeds from Reuters and Comstock for equities, GovPX for Treasuries, another from an unnamed prime brokerage and yet one more from an Order Management System (“OMS”) vendor. Bloomberg terminals provided additional information, but were not electronically linked to their internal systems. Primary investment decisions were focused around trader/portfolio manager Excel worksheets which also passed trade and position information back and forth with their “back office” system. Their analytics group uses their own unique applications that utilize both historical price information and the current market data feeds. Their middle office (e.g. “risk management”) utilizes market and transaction data from all sources to assess risk and control limits. Senior management receives summaries from all functional areas on a periodic basis.

The above description is similar to many investment firms formed in the last decade. This inquirer approached Toomre Capital Markets as a result of a recently commissioned mongraph entitled “The Future of Real-Time Enterprise Risk Management” which focuses on moving from periodic reporting to a real-time environment. TCM welcomes the opportunity to discuss these subjects of “Real-Time Enterprise Risk Management” and “Transaction Cost Analysis” with other interested investment professionals. Please feel free to contact us directly or to leave a comment here.

The article “Swiss Re Steps up Risk Shift” by Charles Fleming in the December 8, 2005 edition of The Wall Street Journal offers a short summary of the continuing convergence of the fortuitous loss (insurance/reinsurance) markets and the capital markets. While this convergence has been a process that has been on-going for several years in fits and starts, the recent increase in retrocessional pricing (i.e. reinsurance for reinsurers) due to the massive 2005 storm losses has finally brought the traditional reinsurance market to a level close to an Insurance-Linked Securities (“ILS”) execution. As a result, the negative arbitrage from an ILS issuance has narrowed and the market is likely to see more issuance in this securitization sector. These ILS securitizations and insurance-linked swaps are alternative forms of capital raising for replenishing the 2005 storm losses (in addition to the capital raised by existing and new reinsurers in Bermuda and the Cayman Islands).

As outlined in the Bloomberg news story entitled Mizuho Error Sparks $3.5 Bln of Share Transactions,” Mizuho Financial Group Inc., Japan's second-largest bank, said its brokerage unit was responsible for an erroneous sell order that sparked $3.5 billion of share transactions in a company valued at $93 million. ``We deeply regret having caused such a big problem,'' Mizuho Securities Co., a brokerage unit of the bank, said in a statement to the Tokyo Stock Exchange.

More than 700,000 shares in J-Com Co. changed hands in its stock market debut today, making the stock the most active by value on the exchange. The Osaka-based telecommunications company sold 2,800 shares in its initial public offering earlier this month, representing a fifth of the outstanding stock. ``The Tokyo market's reputation is tarnished and it has lost the trust of investors because it hasn't learned from previous errors,'' said Hisakazu Amano, who helps oversee about $630 million at T&D Asset Management in Tokyo.

Mizuho's error echoes a similar mistake on Nov. 30, 2001, when UBS AG sold 610,000 shares in Dentsu Inc. for 16 yen apiece on the company's debut. UBS had helped sell the shares at 420,000 yen in the IPO. Last month, the Tokyo Stock Exchange was unable to begin equity trading for the first time in its history after its computer system failed.

It appears in this case is that the number 600,000 was entered in both the number of shares and price fields (stated in Yen) of some order submitted by Mizuho Securities Co. resulting in such a large (and unreasonable) order being submitted to the exchange for a recent IPO. The interesting questions to be answered by the on-going investigations is how much of this order was processed electronically and why there were no checks on either the amount of the order or the number of shares. A key part of modern pre-trade compliance systems is to check whether each order is within reasonable bounds both for the customer executing the trade and the security for which the proposed transaction is to occur. That this trade was executed as part of an IPO process does not excuse this failure in pre-trade compliance. Sadly, with the likely increase in algorithmic trading systems across many asset classes, this will not be the last story of this type.