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									Counterparty Risk Management
During the Credit Crisis - An
Asset Manager's Perspective
Richard A. Libby, Ph.D.
Chief Credit Officer
Global Credit Group
Barclays Global Investors
28 April 2009

     The Financial Crisis of 2007-2009 is a “fifty year” economic dislocation event
      originating in over-extension in structured credit product innovations arising over
      the past thirty years, now transformed into a classic credit-driven bust

     The crisis in structured credit fell over into the general economy, creating
      downward momentum of demand, the “classical” part of the current crisis

     While recent innovations in risk management are characterized by standardization
      of analytical tools within the framework of international efforts such as Basel II,
      adequate restraints were not applied sufficiently early to reduce the scope of losses
      and write downs now estimated in the $2 to $3 trillion range. The key technical
      failure was the lack of development of sound liquidity risk management and
      macroeconomic forecasting tools

     Going forward, financial institutions and regulators need to rethink the nature of
      Risk Management process in specific areas such as liquidity risk, and need to
      reconsider the corporate governance role of Risk Management in general

2   BARCLAYS GLOBAL INVESTORS                                                    Global Credit Group
                                            2                                           CONFIDENTIAL
    The Credit Crisis Begins – an Outside View
    events before September 2007

     The origin of the Credit Crisis began in
      US housing as a rise in the number of
      foreclosures on subprime mortgage debt,
      a trend that became observable in mid
     The contributors to the Crisis next
      manifested themselves in a number of
      high-profile failures of subprime
      mortgage originators in late 2006 and
      early 2007
     Pre-Crisis events came to the attention
      of markets in general, such as the
      failures of high profile hedge funds
      managed by UBS and Bear Stearns in the
      period from March to July 2007.
      Ironically markets entered a false
      recovery in May 2007 with US 10-year
      treasuries reaching a yield of 5.25%

3   BARCLAYS GLOBAL INVESTORS                    Global Credit Group
                                          3             CONFIDENTIAL
    The Credit Crisis Begins – an Outside View
    events before September 2007

     Financial institutions began assessing the liquidity risks of their mortgage securities
      in June 2007 with the collapse of two Bear Stearns hedge funds, following on a
      threat by Merrill Lynch to seize and liquidate collateral

     The spreading concern for the liquidity of structured mortgage securities reached
      a crisis point in early August 2007 as UK financial institutions stopped funding each
      other’s short term paper, forcing the Bank of England to provide funding, later
      copied by other central banks. This point is now considered the beginning of the
      actual Credit Crisis

     The first stage of the Credit Crisis can be said to have ended with the UK bailout of
      Northern Rock. Markets calmed after that point and major equity indices hit a
      peak in October 2007. Liquidity of ABCP, which dried up in August, did not return
      to pre-crisis levels, however

4   BARCLAYS GLOBAL INVESTORS                                                      Global Credit Group
                                             4                                            CONFIDENTIAL
      The Credit Crisis Begins – an Outside View
      events before September 2007

    Before the liquidity crunch
    of August 2007, many
    analysts assumed the
    “correction” in US housing
    prices would be something
    of a soft landing. The
    liquidity crunch was instead
    the artifact of the intrinsic
    complexity and wide margin
    of error of pricing models for
    structured securities

5     BARCLAYS GLOBAL INVESTORS                    Global Credit Group
                                        5                 CONFIDENTIAL
       The Credit Crisis Begins – an Inside View
       events before September 2007

     The rise in the number of foreclosures on subprime mortgage debt was seen and
      discussed by credit analysts in many firms. In particular, stress tests of subprime
      mortgage default rates gave clear signals as to how to manage against deteriorating
      credit in an orderly fashion. The ultimate weakness of the analysis was the
      underestimating of the extent to which many investors did not do fundamental
      analyses of structured mortgage securities

     With the failures of highly leveraged hedge funds, the analyst community concluded
      that good, but not perfect, models had been abused through the overuse of
      leverage, a text book lesson that some but not all risk managers understood

     The collapse of liquidity in short term asset backed commercial paper took the
      entire industry by surprise. The failure of financial institutions to properly gauge
      the global reach and interconnectedness of mortgage securities holdings exposures
      prevented them from understanding their individual and collective overextension in
      this product. This lesson is also a text book case, but as the text itself is in
      macroeconomics, most risk managers missed it

6      BARCLAYS GLOBAL INVESTORS                                                   Global Credit Group
                                               6                                          CONFIDENTIAL
       The Credit Crisis Widens – an Outside View
       October 2007 to August 2008

     The Credit Crisis returned in late October with the first round of significant write downs by
      major financial institutions (Lehman, Merrill, Morgan Stanley), the closing of “enhanced” cash
      vehicles (Schwab, Bank of America) and the widening conclusion that the Structured Investment
      Vehicles (SIVs) would no longer be a viable product in the marketplace (Citigroup)
     As of November 2007, a number of financial news sources began quoting an estimated total
      write down figure in the range of $200 to $400 billion, now seen as a significant underestimate.
      Morgan Stanley’s $3.7 billion loss in November 2007 from failed hedges to its bet on the fall of
      subprime debt keenly focused the market on the potential size of the subprime crisis, putting
      additional liquidity pressure on all investment banks and short term credit markets
     Credit markets experienced a wave of panic in November 2007 as year end financing became
      the topic of fresh speculation
     The auction rate note market used by many US municipalities dried up in February 2008, leaving
      many issuers and investors without recourse to funds, when the major market makers (chiefly
      Citigroup, UBS, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort.
      Citigroup has since agreed to repurchase $7.3 billion of these securities; Merrill Lynch has
      agreed to repurchase securities it had sold. US regulators are engaged in preliminary
      settlements with several other broker-dealers

7      BARCLAYS GLOBAL INVESTORS                                                             Global Credit Group
                                                    7                                               CONFIDENTIAL
    The Credit Crisis Widens – an Inside View
    October 2007 to August 2008

     The initial analyses of the Credit Crisis focused on subprime mortgages and liquidity
      risk; parallels to the demise of Long-Term Capital Management in 1998 were drawn,
      particularly around the time of the Northern Rock bailout. Initial assessments of asset
      fundamentals showed upper tranches of ABS CDOs and other structured credit as being
      sound, showing that liquidity risk continued to be an underappreciated exposure class.
      Morgan Stanley’s $3.7 billion loss due to failed hedge performance in November changed
      the market’s appreciation of the depth of the Crisis
     Conservative credit managers in general saw the brief bull equity market of October
      2007 as a false signal, given the exposure of major counterparties to mortgage
      securities, and waited for Q3 2007 financials, avoiding the relaxing of credit lines into a
      deepening crisis, particularly as year end approached
     With deepening write-downs extending forecasts of the breadth and duration of the
      crisis, markets began questioning the liquidity of investment banks, most notably
      Lehman Brothers and Bear Stearns. Owning to a business model that relied heavily on
      Prime Brokerage for its liquidity needs, Bear Stearns failed the examination in mid
      March 2008 when a large number of hedge fund clients moved elsewhere
     After Bear’s acquisition by JPMorgan Chase, markets entered a short-lived period of
      calm before turning its attention to the next domino to fall: Lehman Brothers

8   BARCLAYS GLOBAL INVESTORS                                                               Global Credit Group
                                                  8                                                CONFIDENTIAL
       The Credit Crisis Widens – an Inside View
       October 2007 to August 2008

    CDS as a risk management tool                                                            5-year CDS spreads: Major US Broker-Dealers
     CDS spreads saw a significant                                     BSC

      run-up before the Bear Stearns    700                             GS

      near-collapse in mid March        600
      2008                                                              MS
     At time of Bear’s mid March
      collapse, speculation swirled     400

      around Lehman as the next         300
      weakest broker
     After markets calmed down
      once the Bear Stearns             100

      acquisition by JPMorgan Chase      0
      was seen as completed, CDS


      spreads began widening again
      as sentiment turned against the
      long term viability of major

9      BARCLAYS GLOBAL INVESTORS                                                                                                                                                                     Global Credit Group
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     The Credit Crisis Widens – an Asset Manager’s View
     October 2007 to August 2008

 Broker Dealer and Bank 5-year CDS, May to August 2008:
 As spreads widened, risk management actively revived and updated their contingency
 plans around major counterparty default

10   BARCLAYS GLOBAL INVESTORS                                              Global Credit Group
                                         10                                        CONFIDENTIAL
     The Credit Crisis becomes the Financial Crisis – an Outside View
     September 2008 to December 2008

  Although the Crisis started in subprime mortgages, it led to liquidity shocks in other
   credit markets. The crisis began to impact Alt-A and prime mortgages, leading to
   market speculation in August that the two GSEs, Fannie Mae and Freddie Mac, would
   require a bailout by the Federal Government

  Meanwhile, investment banks saw their ability to fund themselves declining across the
   board. Lehman reshuffled its management after failing to calm markets after its Q2
   2008 earnings announcement, further damaging market confidence

  With the takeover of Fannie Mae and Freddie Mac in early September, AIG was
   nationalized and the four remaining investment banks ceased to exist in quick
      — Lehman bankrupt
      — Merrill Lynch sold
      — Goldman Sachs and Morgan Stanley reborn as commercial banks

  Credit froze world wide following the Lehman collapse, requiring months of careful and
   extensive management by central banks globally

11   BARCLAYS GLOBAL INVESTORS                                                   Global Credit Group
                                               11                                       CONFIDENTIAL
     The “Great Recession” – an Inside View
     2009 First Half

      The various rescue packages for financial
       institutions are returning stability to markets,
       albeit slowly. True recovery cannot begin until
       markets are at least stabilized

      Structured credit has not revived from its mini
       “dark age” as the fundamental assumptions
       regarding credit quality and diversification that
       persisted prior to 2007 have been universally
       abandoned without new assumptions replacing

      Market disruptions have spread out from their
       source in US housing to the entire global market,
       affecting diverse asset classes from commodities
       to foreign exchange

12   BARCLAYS GLOBAL INVESTORS                             Global Credit Group
                                             12                   CONFIDENTIAL
     The “Great Recession” – an Inside View
     2009 First Half

      Concerns regarding sovereign credit risk have
       grown following the collapse of Icelandic banks
       in Q4 2008 and the size of US, UK, Irish and Swiss
       central bank support relative to GDP

      With rising joblessness and tightening credit,
       consumer spending in most markets is down,
       frustrating efforts to implement stimulus

      US housing likely has further correction to go as
       renting remains more economical than owning,
       with some evidence rents are falling in many US
       markets. As a result the housing component of
       Fed “stress tests” of banks may not be stressful

13   BARCLAYS GLOBAL INVESTORS                              Global Credit Group
                                             13                    CONFIDENTIAL
     The “Great Recession” – an Asset Manager’s View
     2007 to 2009

      Lessons learned from within a major asset management shop include:
        • Even when your own analysts have correctly assessed asset fundamentals, never
          overlook the potential for liquidity shocks caused by other investors not doing their
          homework (Cash Management)
        • Never underestimate the ability of illiquid markets to amplify the margin of error
          embedded in market signals used for investment strategies (Fixed Income)
        • Never overestimate the credit quality of your major counterparties or rely too heavily
          on credit ratings alone (Credit and Middle Office)
        • Risk Management staff must be as well versed in market incentive based behaviors as
          are your Trading and Portfolio Management staff (Risk Management; Senior
        • “De-silo” Risk Management to ensure business expertise is brought to bear on risk
          management issues and actions. Risk Management is too important to be left to “Risk
          Management” alone

14   BARCLAYS GLOBAL INVESTORS                                                              Global Credit Group
                                                  14                                               CONFIDENTIAL
     The “Great Recession” – an Asset Manager’s View
     2009 First Half

      Overall, Asset Management gets a “B” rating.
        • Certain products like money market funds acted like synthetic Savings & Loan
          Associations by providing liquidity and funding into a structure that had overextended
        • Other products like index funds saw no material challenge to their model
        • Active quantitative funds saw large swings in valuation early in the crisis due to
          deleveraging within an increasingly crowded field. Asset managers need to understand
          the degree to which overcrowding in a given management style will impact performance
        • The notion that the primary risks of Asset Management are operational and reputational
          goes unchallenged. Nonetheless the industry needs to ramp up its market, credit and
          liquidity management expertise in similar ways to the sell side
        • The industry needs to consider whether Risk Management makes for good risk
          management: does the Risk Management model suffer from Principal Agency Risk in that
          the function does not own the risks it covers? The governance model that places Risk
          Management within the overall organization does not necessary guarantee effectiveness,
          nor does it demonstrate an historically effective hedge against the “long call option”
          held by risk takers in the organization

15   BARCLAYS GLOBAL INVESTORS                                                            Global Credit Group
                                                 15                                              CONFIDENTIAL

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