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13th Annual CAP Workshop Columbia University, November 3, 2006 Making Proactive Use of Risk Management an Integral Part of Strategic Decisions Bear, Stearns.

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Presentation on theme: "13th Annual CAP Workshop Columbia University, November 3, 2006 Making Proactive Use of Risk Management an Integral Part of Strategic Decisions Bear, Stearns."— Presentation transcript:

1 13th Annual CAP Workshop Columbia University, November 3, 2006 Making Proactive Use of Risk Management an Integral Part of Strategic Decisions Bear, Stearns & Co. Inc. 383 Madison Avenue New York, New York (212) Leo M. Tilman Chief Institutional Strategist Senior Managing Director

2 13th Annual CAP Workshop Columbia University, November 3, The data underlying the information contained herein has been obtained from sources that we believe are reliable, but we do not guarantee the accuracy of the underlying data or computations based thereon. The information in this report is illustrative and is not intended to predict actual results, which may differ substantially from those reflected herein. Performance analysis is based on certain assumptions with respect to significant factors that may prove not to be as assumed. You should understand the assumptions and evaluate whether they are appropriate for your purposes. Performance results are often based on mathematical models that use inputs to calculate results. As with all models, results may vary significantly depending upon the value of the inputs given. Models used in any analysis may be proprietary making the results difficult for any third party to reproduce. Contact your registered representatives for explanations of any modeling techniques and the inputs employed in this report. The securities referenced herein are more fully described in offering documents prepared by the issuers, which you are strongly urged to request and review. Bear, Stearns & Co. Inc. ("Bear Stearns") and/or its affiliates or employees may have positions, make a market or deal as principal in the securities referred to herein or related instruments, while this document is circulating. During such period, Bear Stearns may engage in transactions with, or provide or seek to provide investment banking or other services to, the issuers identified in this report. Bear Stearns may have managed or co-managed a public offering of securities within the last three years for the issuers identified in this report, including regularly acting as an underwriter for Government Sponsored Enterprise issuers. Directors, officers or employees of Bear Stearns or its affiliates may be directors of such issuers. This document is not a solicitation of any transaction in the securities referred to herein which may made only by prospectus when required by law, in which event you may obtain such prospectus from Bear Stearns. Any opinions expressed herein are subject to change without notice. We act as principal in transactions with you, and accordingly, you must determine the appropriateness for you of such transactions and address any legal, tax or accounting considerations applicable to you. Bear Stearns shall not be a fiduciary or advisor unless we have agreed in writing to receive compensation specifically to act in such capacities. If you are subject to ERISA, this report is being furnished on the condition that it will not form a primary basis for any investment decision. Unauthorized duplication, distribution or public display is strictly prohibited by federal law. Disclaimer Parts of this presentation are from the forthcoming book: Ho, Lee, Tilman, Financial Institutions (Oxford University Press, exp. 2007). Proper attribution is requested. Copyright © 2006 Ho, Lee, Tilman. All rights reserved. Important Notice

3 13th Annual CAP Workshop Columbia University, November 3, Agenda  Role of ERM in strategic investment and corporate decisions  General observations regarding the current market environment – Global macroeconomic outlook – Status quo: rates, curve, spreads, and volatilities – Secular vs. cyclical factors – Disintermediation, balance sheet arbitrage and alphas  Illustration: 2006 Scenarios and Likelihoods – Which expectations realized? What was unexpected? Lessons learned – Inferences regarding desirable risk exposures  Business models – Defining sources of earnings and alpha in terms of dimensions of risk – Implications for balance sheet management and ALM – The need for a holistic framework

4 13th Annual CAP Workshop Columbia University, November 3, 2006 Role of ERM in Strategic Investment and Corporate Decisions

5 13th Annual CAP Workshop Columbia University, November 3, Current Use of ERM in Strategic Decisions Business Objective Problem Definition Solution ERM OK? Implementation YES Current Offering Lacks Higher Risk/Margin Consumer Products Originate More Subprime Loans Improve Margins OK, but: Limit is 10% of total assets; each $1mm+ loan is subject to committee review Dispatch the sales force NO

6 13th Annual CAP Workshop Columbia University, November 3, Desired Use of ERM in Strategic Decisions: From “Decision Support” to “Decision Making” Business Objective Problem Definition Using the Language of ERM Solution and Implementation Benefits: Streamlined decision making process Leveraging of advanced frameworks and technologies Balance Sheet is Underweight Consumer Credit Risk “Optimal” risk-adjusted asset allocation is 10%

7 13th Annual CAP Workshop Columbia University, November 3, 2006 Current Market Environment Global Causes and Effects

8 13th Annual CAP Workshop Columbia University, November 3, Current Market Environment  Low interest rates are below historical yield bogeys – The 3-mo LIBOR/10-yr yield curve is inverted, and the “carry” (borrow short/lend long) trade is no longer viable Source: FRB

9 13th Annual CAP Workshop Columbia University, November 3, Current Market Environment  Spreads and fixed-income volatilities remain at historically low levels after having retreated from multi-year lows. Source: Bear Stearns

10 13th Annual CAP Workshop Columbia University, November 3, Current Market Environment  It took a massive interest rate rally to finally move implied volatilities away from multi-year lows Source: Bloomberg

11 13th Annual CAP Workshop Columbia University, November 3, Macroeconomic Factors stage of economic cycle, inflation, Fed transparency, Fed ability & determination Long rates Spreads Volatility  Rates & Spreads  Equities and FX Global Causes and Effects Challenges  Portfolio level  Balance sheet level  Enterprise level Short rates Changes in Investor Base FX regimes, foreign savings “glut,” CDOs, REITs, hedge funds, prop desks, GSEs Evolution of Financial Markets diminishing compensation for financial intermediation, securitization, hedging

12 13th Annual CAP Workshop Columbia University, November 3, Factors Responsible for Low Risk Premia  Long-term inflation expectations remain well-contained – The Fed is moving toward inflation targeting and is determined & able to control inflation  Fundamentals remain solid across corporate and consumer credit markets – The housing “bubble,” if any, remains the favorite speculation du jour  Large amounts of investment capital remain available worldwide, ready to be deployed in a large dislocation, potentially constraining losses  The pension reform in the U.S. presents a huge underlying bid for fixed income assets

13 13th Annual CAP Workshop Columbia University, November 3, Global Causes and Effects: Foreign Consumption of U.S. Assets Source: FRB

14 13th Annual CAP Workshop Columbia University, November 3, Global Causes and Effects: Growth of REIT Assets Source: SNL Financial

15 13th Annual CAP Workshop Columbia University, November 3, Global Causes and Effects: CDO Issuance Source: Bear Stearns

16 13th Annual CAP Workshop Columbia University, November 3, Global Causes and Effects: Hedge Funds Source: HFRI

17 13th Annual CAP Workshop Columbia University, November 3, Low Return Environment  Despite what some view as “unsustainable global imbalances,” we expect the current economic and market environment to persist in the foreseeable future – Robust real GDP growth (3%), well-contained inflation (2-2.5%), and low inflation risk premium, with 10-yr Treasury yields around 5% on average over the current decade.

18 13th Annual CAP Workshop Columbia University, November 3, Disintermediation In Action  Growth and globalization of capital markets have greatly reduced “arbitrage” opportunities on both portfolio and balance sheet levels – Example: Mortgage GSE business model (portfolio side) – Hot related topics: Separation of alpha and beta; Active betas

19 13th Annual CAP Workshop Columbia University, November 3, 2006 Scenarios for 2006: Desirable Risk Exposures Lessons Learned

20 13th Annual CAP Workshop Columbia University, November 3, Scenarios (from Jan 2006) and Lessons Learned Slower economic growth and well-contained inflation (including a decline in energy prices as well as forward-looking indicators) suggest that monetary neutrality has been reached. Interest rates remain range-bound for most of the year, with the yield curve very flat to slightly inverted. Volatility remains low. Spreads of structured products and corporates remain range-bound at current tight levels. Credit environment remains positive and liquidity plentiful. Monetary neutrality is not reached until 5% on the fed funds target rate. Economic growth remains robust and job growth solid. Business investment compensates for a slowdown in consumer spending, which results in a % real GDP growth. Measured interest rate hikes continue as core inflation trends higher. As the curve gets progressively inverted, any deleveraging (unwinding of the carry trade by foreign banks, REITs, etc.) is met with solid demand from Asian central banks, insurance companies, pension plans, and retail, keeping long rates range-bound. Spreads grind moderately wider, with credit curves steepening across asset classes. Volatility moderately increases, with the term structure of volatility steepening. 1. “Absence of Inflation; Early End of the Tightening Cycle” (10%) 2. “Some Inflation Pressures; More Hikes, Curve Inversion” (30%)

21 13th Annual CAP Workshop Columbia University, November 3, The key difference between Scenarios 2 and 3 lies in the assumed interaction between leveraged and buy-and- hold investors. Thus, as the curve gets progressively flatter/inverted while spreads remain tight, borrow short/invest long trades are unwound, driving long rates higher. Real money buying is unable to constrain the sell-off; spreads widen and credit spread curves steepen more than in Scenario 2. Volatilities increase across structures. In addition to inflation, a bear steepening scenario can be driven by a number of exogenous factors: greater uncertainty in the Bernanke-led Fed to effectively control inflation, a decline in foreign consumption of U.S. fixed income assets, or an asset reallocation from housing and fixed income into U.S. and global equities. A rise in core inflation forces the Fed to “overshoot” the monetary tightening, with the Fed hiking the fed funds target to the 5.5-6% range. The curve inverts, albeit at much higher long rates (5.5% on the 10-yr Treasury). A dramatic re-pricing across markets and increased risk aversion are likely to drive spreads significantly wider, with credit spread curves steepening. Volatilities would increase significantly, with TSOV steepening. At 5.5-6% fed funds, the monetary policy is likely to become restrictive, and interest rate cuts are likely to follow within several months. 3. “Some Inflation Pressures; Continuation of Hikes, Bear Steepener” (40%) 4. “Monetary Policy Overshooting; Curve Inversion at Higher Rates” (20%) 2006 Scenarios (from Jan 2006) and Lessons Learned

22 13th Annual CAP Workshop Columbia University, November 3, Portfolio #1: Structured Products

23 13th Annual CAP Workshop Columbia University, November 3, Portfolio #2: Structured Products Hedged With an IO

24 13th Annual CAP Workshop Columbia University, November 3, Portfolio #3: Structured Products and Credit

25 13th Annual CAP Workshop Columbia University, November 3, Portfolio #4: Structured Products & Credit Hedged with IO

26 13th Annual CAP Workshop Columbia University, November 3, Expected Returns vs. Interest Rate Risks  Alternative approaches to earnings spreads over funding/benchmarks: – Position for a single baseline scenario – Play the odds by constructing a balanced hedged portfolio that outperforms funding/benchmarks across a range of scenarios

27 13th Annual CAP Workshop Columbia University, November 3, Risk Decomposition Using Value-at-Risk  Value-at-Risk – the 5 th percentile of monthly P/L probability distribution – Systematic (“Six Factor”) VaR: interest rates, mortgage basis, spreads, volatility – Idiosyncratic (“Security-Specific”) VaR – Excludes carry

28 13th Annual CAP Workshop Columbia University, November 3, Market Risk Credit Risk Liquidity Risk Funding Risk Market Risk Credit Risk Liquidity Risk Funding Risk

29 13th Annual CAP Workshop Columbia University, November 3, 2006 Business Models of Financial Institutions

30 13th Annual CAP Workshop Columbia University, November 3, Dominant Strategic Discussion with Clients  The business of financial intermediation is likely to continue becoming increasingly challenging – Low return market environment, competition, transparency, disintermediation, innovation, and erosion of traditional competitive advantages – Waiting for the return of the “normal” market and business environments may not be a viable option. Need to ensure that the business model is viable across business cycles and that all available tools are used within a holistic framework  Business model – Drivers of earnings: alpha vs. collections of active betas – Market vs. credit risk choices. “Optimality” of capital and asset allocation  Current positioning – Is current asset-sensitive positioning reflective of macroeconomic views? – Opportunities for earnings improvement (e.g., volatility) and the role of “insurance” purchases (e.g., interest rate floors)  Business model flexibility – Capital allocation and risk exposures as dynamic functions of economic and market cycles – Potential triggers for balance sheet or portfolio restructuring

31 13th Annual CAP Workshop Columbia University, November 3, Business Model Choices for 2007  Baseline Expectation – Real GDP growth slows down to slightly below the trend-like pace of %. Inflation continues to increase in the near term, which is followed by its eventual tempering caused by the moderation of growth. The tightening cycle ends between 5.25 and 5.75%. The Fed remains on hold throughout  Competing View – Real GDP growth declines to the 2-3% level, reversing recent cyclical increases in inflation. The tightening cycle ends at the current fed fund target of 5.25%, and the Fed embarks on the easing cycle in early- to mid A bullish steepener ensues.  The complexity of the current market environment – along with related contradictory market signals and investor indecisiveness – are rooted in business models for portfolios and balance sheets being very scenario-dependent. – Baseline Scenario: Continue to deliver excess returns (A/L earnings) through spread exposures, credit risk, shorting options along with purchases of still-cheap insurance – Alternative View: Reduce exposures to prepayments, go up in credit, re-introduce the carry trade (liability-sensitive positioning)

32 13th Annual CAP Workshop Columbia University, November 3, Holistic Approach to Business Challenges Low Returns Flat Yield Curve Declining Fees Asset Strategies Hedging Debt Management Securitization M&A Capital Structure Product Design  The full power of the balance sheet needs to be utilized – Approaches that view a portfolio in isolation may lead to excessively defensive positioning

33 13th Annual CAP Workshop Columbia University, November 3, Strategic Decision-Making Framework Traditional ALM Static cash flow projections Premium/discount amortizations Accounting earnings drivers Margins, RoA, RoE across scenarios and time Asset/liability-sensitive positioning Risk Analysis Relevant dimensions of risk Exposures and replicating portfolios Value-at-Risk & scenario analyses Absolute and risk-adjusted economic expected returns Strategic Decisions Earnings and their volatility Asset and debt composition Balance sheet optimization Business line analysis Capital allocation Business models Franchise Features Management Team Legacy and Footprint Cross-selling opportunities Business-level diversification Equity market and rating agency perception

34 13th Annual CAP Workshop Columbia University, November 3, Conclusion  Institutional investors and financial institutions worldwide should continue facing challenges related to earnings and alpha generation  The low return environment is expected to persist indefinitely across asset classes. – Outperformance is likely to be increasingly linked to “structural” exposures – A set of desired dimensions of risks and related exposures should be determined and optimized. – This desired portfolio – the “business model” – should depend on macroeconomic views as well as company-specific circumstances. It should be dynamically managed over time.  Real-life challenges brought about by disintermediation and capital market evolution present an opportunity to add tremendous value through the use of advanced ERM tools and frameworks  Bear Stearns looks forward to providing its partners and clients with comprehensive advice and solutions for the complex market environment


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