Measuring and Managing Risk in Innovative Financial Products – A Comment David M. Rowe, Ph.D. EVP for Risk Management – SunGard Federal Reserve Bank of Atlanta - Financial Markets Conference Jekyll Island, Georgia May 12, 2009

Lessons for Risk Management of Complex Financial Instruments 1.Statistical Entropy 2.Structural Imagination 3.Innovation, Complexity and Dark Risk 4.Self-Referential Feedback Compounds Dark Risk 5.Alternate Means of Valuation

1. Statistical Entropy Like water, information cannot rise higher than its source. Data Information

I n f o r m a i t o n Data o I n f o r m a i t n This is extraction of information, NOT creation of information 1. Statistical Entropy

Mortgage Default Experience SOURCE: Mortgage Bankers Association - National Delinquency Survey

Hypothetical Detachment Point Log-Normal Distribution: Mean = 5.97; StDev = 2.16

Hypothetical Detachment Point Hypothetical Subprime Default Probability Density Defaults (%) Probability Density.01% = AAA

Hypothetical Detachment Point Hypothetical Subprime Default Probability Density Defaults (%) Probability Density.01% = AAA Largest Sample Observation = 9.6% Behavior in the Tail is Based on What Distribution is Assumed

The Basis for Diversification Through mid-2006 What unobserved contingency could upset this pattern? Idiosyncratic Causes for Default

Threats to Diversification One candidate was fairly obvious. Falling housing prices would hurt ALL borrowers Defaults would no longer be statistically independent $ $$ $

Threats to Diversification 12-month % change 10 City Composite U.S. Home Price Index 12-month % change S&P/Case-Shiller Home Price Indices Strongly Positive: Jan-95

Threats to Diversification 10 City Composite U.S. Home Price Index Aug 1990 Mar month % change S&P/Case-Shiller Home Price Indices 12-month % change Negative for 3-1/2 years in early 1990s

Threats to Diversification 10 City Composite U.S. Home Price Index 12-month % change Monthly % Change (annual rate) September 2005 Month-to-Month % Change Peaked in September 2005 : Turned Negative in mid-2006 Aug 1990 Mar 1994 S&P/Case-Shiller Home Price Indices

2. Structural Imagination The Lesson 1)Look for significant unrepresented variables. 2)Track these variables carefully as early warning indicators of emerging problems.

3. Innovation, Complexity and Dark Risk + ComplexityLimited Data  Dark Risk

4. Beware Self-Referential Feedback Achieving Greater Volume Required Relaxing Underwriting Standards  Risk Estimates Based on Historical Data Become Progressively Less Reliable  Further Innovations (e.g. Compound Repackaging, CDO 2 ) Increased Complexity      DARK RISK A Unique Innovation Generated Attractive Returns Growth in Volume 

5. Alternate Means of Valuation Old Credit Risk Mantra What is the second means of repayment? Proposed Capital Markets Mantra What is the second means of valuation?

4. Alternate Means of Valuation Subprime CDOs (2006) Corporate CDOs (2006) CDS IRS Ease of Current Valuation Level 1 Observable prices in active markets Observable prices in inactive markets or observable inputs to accepted pricing models Few or no observable market prices and models requiring significant unobservable inputs Level 2 Level 3

4. Alternate Means of Valuation Level 1 Level 2 Level 3 Ease of Current Valuation Effectiveness of Alternate Means of Valuation Level 2 Level 3 IRS CDS (2006) Corporate CDOs (2006) Subprime CDOs (2006) Level ? Corporate CDOs (2008) Subprime CDOs (2008) CDS (2008)

A Question Was this crisis a Black Swan? ?

Product Complexity Pace of Innovation Volume Growth Commodity Prices Geopolitical Risk Information Security Extreme Events Model Risk Liquidity Technological Change Emerging Markets Operational Risk Regulatory Uncertainty Effective Portfolio Mgt. External Linkages ???? Unknown Unknowns ???? Miscellaneous Elements of the Risk Puzzle (Original: May 2006)

Product Complexity Pace of Innovation Volume Growth Commodity Prices Geopolitical Risk Information Security Extreme Events Model Risk Liquidity Technological Change Emerging Markets Operational Risk Regulatory Uncertainty Effective Portfolio Mgt. External Linkages ???? Unknown Unknowns ???? Miscellaneous Elements of the Risk Puzzle (Rev: October 2008) Pace of Innovation Product Complexity Model Risk Volume Growth External Linkages Liquidity Commodity Prices Effective Portfolio Mgt.