Tuesday, June 10, 2008

How About Risk Management Without Steroids?

In recent years, risk managers have often relied on hedging as a way to mitigate risk. When a firm hedges its asset positions, it presumably can hold more assets, expanding its balance sheet and earning greater returns on its capital.

There is, however, a basic problem with this approach. A perfect hedge (i.e., one that offsets a loss on the primary asset dollar for dollar) would eliminate any potential profit on the primary asset. For example, assume a firm holds $1 billion of 30-year U.S. Treasury bonds. A perfect hedge would be a short position of $1 billion of 30-year U.S. Treasury bonds, taken at the same time that the firm buys the long position. Any such transaction would offer essentially no profit potential, since all gains on the long position would be completely offset by losses on the short position, and vice versa. No firm will bother with trades like this. An imperfect hedge is necessary to have the potential for profit.

Thus, hedged transactions in the real world will be imperfectly hedged. Finding the right hedge can become a matter of guesswork and judgment. You have to pick something that doesn't take all the pizzazz out of the trade, but saves you from the rising waters when Katrina blows in. The history of hedging is replete with spectacular failures. In the 1987 stock market crash, the portfolio insurance on which numerous institutional investors counted not only failed, but may have aggravated the market's downturn. In 1998, Long Term Capital Management's collapse was attributable in part to hedged positions moving the wrong way at the wrong time. Most recently, Lehman's $2.8 billion second quarter 2008 writedown, the first quarterly loss in its history, resulted in part from hedges doing the Funky Chicken when they were expected to do the Twist.

The fact that credit has been so inexpensive in recent years may well have encouraged the use of hedges. When a bank can borrow cheaply, its incentive to increase its balance sheet is magnified. Lower-yielding (or higher risk) assets can become attractive, and the availability of hedges helps it rationalize bulking up the balance sheet. The imperfections of the hedges may be less glaring against a backdrop of inexpensive money.

However, in the financial markets, as elsewhere, there is a season for all things. The risky side of taking risks sometimes manifests itself. Then, losses are sustained. Hedges, necessarily imperfect to begin with, may reveal unexpectedly unpleasant characteristics. The safety net breaks and write-offs follow.

Using hedges to manage risk is like taking steroids. Steroids have legitimate medicinal uses, and when used properly can help to save lives. Even then, they may have side effects. But you shouldn't use steroids to become something that you're not.

Hedges are analogous. They can play a legitimate role in trading strategies. But a firm can't use hedges to rationalize greatly increasing its asset levels without commensurately increasing its capital. You're taking naked risk when you hedge your bets. It's one thing if a run-of-the-mill hedge fund does this. However, major banks, and other financial institutions that are de jure or de facto protected by the U.S. taxpayer, shouldn't use hedges as a substitute for careful evaluation and limitation of risk. They should prudently analyze risks, including the exposure that hedges involve, and maintain an extra dollop of capital for the moment when their hedges let them down.

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