Crowded trade increases turmoil again, say CROs

Speaking at the Risk USA conference in New York, CROs comment on causes of recent market volatility

NEW YORK - Chief risk officers from four major financial institutions argued that the distress in the financial markets has been partly caused by the concentration of money chasing too few trading ideas, when speaking on a panel at this year’s annual Risk USA conference in New York.

“People don’t realise that one of the main factors that contributed to this period’s recent stress was the crowded trade, and the lack of liquidity for a particular trade once everyone gets out of the same trade,” said Madelyn Antoncic, chief risk officer at Lehman Brothers in New York.

She added that crowded trades have been experienced in the past, but there was too much complacency going into the crisis. In the second quarter of 2006, Lehman Brothers noticed the deterioration in the housing market, and, as a result, increased the underwriting standards in its mortgage origination unit. According to a source, the Wall Street bank also began requiring that every tranche of its collateralised debt obligations of asset-backed securities (CDOs of ABSs) be placed. In the first quarter of 2007, Antoncic said the firm put on very large hedges on its mortgage and leveraged loan exposures. The hedges included shorting indexes and credit default swaps.

Jacob Rosengarten, head of the risk and performance analytics group at Goldman Sachs Asset Management, whose quantitative equity Global Alpha fund was down 32% for the year as of August 31, agreed that many firms underestimated the extent of the cross-over in trading styles and themes. His firm is in the process of developing models that go beyond VAR and capture liquidity risk. According to a September 18 investor letter, the firm will also place constraints on its leverage, which it previously did not do. But, he added, a firm’s culture is also important in getting the correct risk/reward balance. “The challenge of risk management is to measure with influence. That suggests history and the ability to translate numbers into English and English into numbers. After that point, it becomes a much more cultural statement. The next time there’s a crisis the models will be wrong again. Models get you to first base and in the door with senior management to have a discussion, and then it’s about the process,” he said.

Another important cause of the market distress was the timing mismatch between analysing complex instruments and the time to bid on them, said Kenneth Winston, global chief risk officer at Morgan Stanley Investment Management. For example, CDO of ABS traders often have 15 seconds to bid on a trade or not.

“I think what happened over the summer is that the markets froze up because of that complexity and because there wasn’t time to analyse the trades. People just stepped back,” he said. “What’s happening now is that a lot of the complex structures are being unwound and are being placed into new vehicles that are more transparent.”