Bettinger, Lori H.

Danis, Michelle A.

Giles, James

Hsu, Michael J.

Silva, Kevin D.

Spurry, Steven M.

Venkatesh, P.C.

Wong, Heather

Yale University

Yale University EliScholar – A Digital Platform for Scholarly Publishing at Yale YPFS Documents Browse by Media Type 4-26-2007 SEC Memo Re Risk Management Reviews of Consolidated Supervised Entities Lori H. Bettinger Michelle A. Danis James Giles Michael J. Hsu Kevin D. Silva See next page for additional authors Follow this and additional works at: https://elischolar.library.yale.edu/ypfs-documents Recommended Citation Bettinger, Lori H.; Danis, Michelle A.; Giles, James; Hsu, Michael J.; Silva, Kevin D.; Spurry, Steven M.; Venkatesh, P.C.; and Wong, Heather, "SEC Memo Re Risk Management Reviews of Consolidated Supervised Entities" (2007). YPFS Documents. 5739. https://elischolar.library.yale.edu/ypfs-documents/5739 This Document is brought to you for free and open access by the Browse by Media Type at EliScholar – A Digital Platform for Scholarly Publishing at Yale. It has been accepted for inclusion in YPFS Documents by an authorized administrator of EliScholar – A Digital Platform for Scholarly Publishing at Yale. For more information, please contact elischolar@yale.edu. Author/Creator Lori H. Bettinger, Michelle A. Danis, James Giles, Michael J. Hsu, Kevin D. Silva, Steven M. Spurry, P.C. Venkatesh, and Heather Wong This document is available at EliScholar – A Digital Platform for Scholarly Publishing at Yale: https://elischolar.library.yale.edu/ypfs-documents/5739 SEC_TM_FCIC_1053601MEMORANDUMApril 26, 2007TO:THROUGH:FROM:RE:Erik R. Sirri, DirectorRobert L. D. Colby, Deputy DirectorHerbert F. Brooks, Chief of OperationsMichael A. Macchiaroli, Associate DirectorThomas K. McGowan, Assistant DirectorDivision of Market RegulationMatthew J. Eichner, Assistant DirectorLori H. Bettinger, Financial EconomistMichelle A. Danis, Financial EconomistJames T. Giles, AccountantMichael J. Hsu, Financial EconomistKevin D. Silva, Financial Risk AnalystSteven M. Spurry, Financial EconomistP.C. Venkatesh, Financial EconomistHeather Wong, AccountantRisk Management Reviews of Consolidated Supervised EntitiesOffice of Prudential Supervision and Risk Analysis ("OPSRA") staff met over the past four weekswith senior risk managers at the CSEs to review March market and credit risk packages.There were several common themes in discussions with firms:• Event-driven lending portfolios at most CSE firms increased during the month. Theseincreases were the results of increased leveraged buy-out activity, measured both by thevolume and size of deals, as well as some significant corporate acquisitions not arranged byfinancial sponsors. The portfolio increases were also fueled by a decline in the velocity ofcommitments moving through the pipeline as more deals are requiring lengthy regulatoryapprovals. These developments have led at least one CSE firm to increase substantially thesystematic hedging of its portfolio. Regardless of the amount of hedging activity, whichgenerally provides protection only against a systematic widening of credit spreads, the firmsstill rely primarily on their underwriting and committee approval processes to limit theidiosyncratic risk of their largest positions.• The underlying risk characteristics of the leveraged loans in the pipeline areincreasingly distinct from traditional bank loans. Risk managers at several firms notedthat the percentage of-commitments with covenant-lite features has increased dramaticallduring e uarter 7 and that the ability to get "covenant-flex" (Le. the a I I 0 putcovenants into the credit agreement if the deal isn't able to be syndicated effectively withoutthe covenants) has decreased. In addition, firms have noted the continued increase in theuse of PIK (payment-in-kind) loan features in commitments. Interest payments to investorsaccrue during the life of the PIK loan, and are only paid when the debt is redeemed. Whilethese features may provide borrowers with significant flexibility to deal with broad economicdownturns or firm specific issues, the resulting postponement of covenant breachessubstantially reduces the ability of creditors to take action on a deteriorating credit. As aresult risk managers have expressed concern that the recovery rates associated with theseloans may be far lower than typically seen in the bank loan market when defaults occur.SEC_TM_FCIC_1053602., .. ~April 26, 2007Page 2• In the leveraged lending business, the ability to distribute risk relies heavily on thestructured bid. Increasingly, the leveraged loan market is heavily dependent on theCollateralized Loan Obligation (UCLO") bid as these structured vehicles purchase the majorityof originated loans sold to the institutional market. As one risk manager highlighted thismonth, the ability of CLO deals to get done relies abili to sell the e ui tranche,typically e rlS les - % 0 e deal. These equity tranches are sold to a variety ofinvestors, including dedicated COO/CLO equity hedge funds, insurance companies, andbanks, as well as the CLO asset managers themselves. In some cases, CSE firms mayfinance the purchase of these CLO equity tranches, albeit on a collateralized basIs wltn~anthaIrcuts (e.g. 50%). While the market for this equity as well as the rest of the CLOtranches currently appears robust, given the recent problems experienced in other structuredmarkets (e.g. ABS COOs with subprime collateral as discussed below), this is a risk thatshould garner special attention.• Subprime MBS deals continue to get done. In spite of recent problems faced by subprimeoriginators and the deterioration in the performance of subprime collateral backing previousdeals, securitizations of subprime whole loans by the CSE firms are continuing, albeit atlower prices and a slower pace. Most firms noted that the securitization profit (Le."securitization arb") has eroded significantly or become negative in some cases. While firmshave generally been able to print new deals, including collateral originated by very troubled ornow bankrupt originators (e.g., New Century), they have in some cases retained more of thelower rated tranches than they have in the recent past.• Quarterly net profits in the subprime mortgage businesses are the result of largergains offsetting smaller losses. Most CSE firms had modest to large profits in theirmortgage businesses, including the subprime sector, dl.iiing the first quarter. However,underlying these nel profits are substantially larger gross profits and losses. Most CSE firmswere, and still are, long the ABX asset-based index through selling protection to clientsincluding hedge funds. They have bought offsetting protection through other derivativeinstruments including substantial amounts of single name default swaps (single name COSon ABS), largely from COOs. The positions, notably single name CDS on ABS, that drove thelarge profits for many of the CSE firms are challenging from a price verification standpoint. Inmany cases, the size of these positions remains largely unchanged from the end of Februaryso the gains are unrealized. Given the substantial unrealized gains on these products andthe limited price transparency in this area, risk managers and financial controllers are veryfocused on the marking process.• COO warehouses of subprime ABS collateral have generated losses. One ripple effectof the subprime shakeout has been in the.Q.QQ space, where some CSEs are involved infinancing the accumulation of subprime collateral to be securitized into COOs. Several firmshighlighted losses some si nificant, from the tivities. Typically, the firm will purchaseasse s or an asset manager's and immediately sell those assets forward to the COO,creating the economics of secured lending, often without recourse to the asset manager.Under normal market conditions, the forward price more than covers hedging costs during thewarehouse period. However, in a distressed market, these COO deals may not be completedat a profit. In these cases, the type of risk-sharing agreement the financing bank has with theCOO asset manager becomes important. In some cases where CSE firms lost money on the"ramping up" of subprime collateral for ABS COO deals, the asset manager did- not have toput up any equity, which is equivalent to financing the positions without haircuts. In othercases, the asset manager's sharing of risk was capped. As risk managers at one firmexplained, a lesson learned from this experience is that their asset manager partners need tohave "more skin in the game".In addition, CSE firms noted that the market for super senior tranches of ABS COOscontaining subprime exposure remains weak. As a result, some CSE firms still hold aContains Confidential Business Information - For SEC Use OnlySEC_TM_FCIC_1053603April 26, 2007Page 3significant amount of this exposure. These AAA rated tranches are of significant size (e.g.$500 million and above) and, as a result, relatively few investors are in a position to purchasemeaningful amounts of these instruments. Monoline insurance companies have dominatedthis market. Several CSEs noted that the monolines have recently backed away from themezzanine super senior market (Le. those tranches containing mostly BBB and BBB-tranches of sub-prime residential mortgage backed securities in both cash and.CDS form)and are currently "sitting on the sidelines". Risk managers hypothesize that this recent lackof appetite is due both to record high issuance of these tranches. in the first quarter and thecontinued negative subprime news.We also expect to discuss the following firm-specific issues during the next round of meetings:Bear Stearns• Following a loss of $135 million in February, Bear's Adjustable Rate Mortgages (ARMs) andNon-Agency CMO desks, which are the most significant to its overall Mortgage business froma risk and P/L perspective, had a combined profit of only $3 million in March. However, thedesks were able to securitize and sell over $10 billion in collateral throughout the month in anattempt to keep things moving through the pipeline and create some momentum in themarket. We will continue to discuss in detail the success of the mortgage desks in turningover assets, as well as the work done by risk managers in price verifying existing inventory.• As discussed last month, Bear's Independent Model Validation Group (within the RiskManagement Department) is currently operating with insufficient staff. As a result, the ModelReview Committee did not conduct its most recently scheduled quarterly meeting. The chairof the Committee (who is the also the Chief Risk Officer for Asia and Europe) is currentlyfocused on hiring a new manager for the group. As an interim measure, he is having themore technical product line risk mangers perform the most pressing model control work. Wewill discuss the status of the model validation function and its staffing again next month.Goldman Sachs• While Goldman's mortgage business as a whole has earned a positive profit year-to-date,individual desks have exhibited significant P/L volatility. The ASS COO desk, whichaccumulates RMBS and existing ASS COO tranches for re-securitization (and retains certaintranches resulting from those deals), has lost approximately $320 million year-to-date. Theselosses are larger than the potential impact anticipated by market risk management's "Fall of1998" Stress Test, the primary risk measurement tool used for managing this activity. As thisbusiness has significant exposure to the US subprime mortgage sector, risk managers andcontrollers have explained that, for this particular product space, the "Spring of 2007" hasactually been worse than the "Fall of 1998". Since the market turmoil began, the desk hasceased accumulating collateral for new deals and been proactively exiting its current risk,selling or securitizing product at a loss. As this wind-down continues throughout next month.we will follow-up regarding the remaining positions and any additional losses.• We discussed again with the market risk m<:lnager the challenges associated with using theSovereign Stress Test for controlling the firm's sovereign risk, and with allocating limitsacross businesses. As there has been a proliferation in the types of instruments andstrategies desks can trade, more granular and sophisticated tools are required. For instance,recently the Bank Loan Origination business purchased short-dated CDS protection onRussia (the sovereign) in order to hedge a loan to a Russian corporation - a strategy viewedby risk management as sub-optimal. One tool that market risk management is developing tobetter capture such basis risks is a VaR by country. We will continue to discuss suchenhancements, as well as any changes to the sovereign risk limits structure.Contains Confidential Business Information - For SEC Use OnlySEC_TM_FCIC_1053604April 26,2007Page 4Lehman Brothers• Lehman's firmwide VaR hit an intra-month high of $82 million, just below their limit of $85million, before ending the month down at $65 million. Even as VaR has risen over the pastfew months, the firm has remained well under its risk appetite limit, which represents theaggregate amount of market, event, and counterparty credit risk that Lehman is willing totake. The head of market risk noted that while the VaR limit effectively constrains thebusiness' ability to take risks in liquid products, traders who still wish to increase their risk-taking activities could do this through more illiquid products, which are captured through theevent risk calculation rather than through VaR. By moving into more illiquid areas, a tradercould take more risk while remaining within their VaR and risk appetite limits. Market riskmanagement understands that the potential for creating perverse risk-taking incentive exists,and will continue to monitor VaR usage closely.• Lehman's pipeline of commitments continues to grow and credit risk managers do notanticipate a slowdown in the near future. The size of potential commitments also continuesto grow, with Lehman-backed sponsors bidding unsuccessfully for the $24 billion Sallie Maedeal. Activity in commercial real estate remains robust, especially in Europe where Lehmanis providing $2.8 billion in financing, including $400 million in bridge equity, for a singlebuilding in France.Merrill Lynch• Merrill's exposure to credit spreads has significantly declined from the high levels seen lastyear as the result of a management decision to reduce exposure in this space. The declinehas been accomplished through a reduction in directional long positions, increased hedging,and increases in short proprietary positions. However, Merrill's overall VaR remains high,reflecting increases in equity and interest rate exposure.• The commodities business continues to expand the scope of its activities beyond power andgas. Merrill recently participated in a large aluminum trade to hedge production related to anM&A transaction. They were also recently granted a license to trade physical power inJapan. Future growth areas include options on oil, agricultural products, coal, and ethanol.There are no New Product Reviews pending for the commodities business, but we willcontinue to monitor activity closely in this space. We are scheduled to meet with the newglobal head of Commodities Risk Management next month.• Merrill recently issued its first securitization consisting of only First Franklin originatedmortgages since its acquisition of First Franklin. The deal was well received in the marketas the majority of the $2.2 billion deal was sold. Unlike previous deals, Merrill did notincorporate language guaranteeing the repurchase of any loans that incur early paymentdefaults (UEPD"). They have stated instead that they will repurchase EPD loans on a case bycase basis. We will continue to monitor the progression of this and future deals for anyadverse reaction by the market because of these changes in practice.Morgan Stanley• As highlighted in last month's memo, the firm terminated its subprime mortgag-e warehouseline to New Century and foreclosed on the collateral. During the past month, the firm has helda closed auction process in an attempt to liquidate this collateral. As of the date of ourmeeting on April 12th , dealers invited to this auction had submitted preliminary bids and werein the process of performing due diligence on the collateral. The firm indicated that thepreliminary bids had come in above Morgan's marks on the collateral. However, during ourmeeting, the Chief Credit Officer stated that New Century and its advisor had approachedContains Confidential Business Information - For SEC Use OnlySEC_TM_FCIC_1053605April 26, 2007Page 5Morgan Stanley about re-opening the auction to a wider audience with New Centuryproviding support to the bidders in their due diligence efforts. While a decision had not yetbeen made regarding whether the finn will re-open the auction process, they are currentlydiscussing the idea. This decision to potentially re-open the auction to a wider set of biddersand under a more transparent process (Le. open outcry) is at least partially motivated bylitigation concems. The finn appears to be willing to take more time in liquidating thiscollateral in exchange for greater insulation from legal claims. We will continue to monitordevelopments in this area.• As discussed previously, the Credit Department at Morgan Stanley had provided us withshort-term tactical and long-term strategic plans for enhancing the overall effectiveness of itscredit systems, particularly around data quality and flexibility. We continue to discuss thedepartment's remediation plans in this area during our monthly risk meetings. While we haveseen substantial progress made on many short-tenn objectives regarding improving dataquality, a major system release, ICE 2.0, was repeatedly delayed and little progress wasevident in the firm's fonnulation of its long-term strategic plans to re-engineer the creditsystems. As a result, during this past month, the finn replaced the IT manager in charge ofsupporting the credit systems infrastructure and made the long awaited conceptual change ofmigrating the ownership of the underlying data to the businesses. We met with the senior ITmanagers now responsible for the credit systems. During this meeting they articulated thefinn's strategic plans for re-engineering the credit systems as well as the change in reportinglines. While this endeavor may take a few years to complete, we have asked to be updatedas key milestones are reached.Contains Confidential Business Information - For SEC Use Only

SEC Memo Re Risk Management Reviews of Consolidated Supervised Entities

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SEC Memo Re Risk Management Reviews of Consolidated Supervised Entities

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